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SUB MODULE –3.4.1 FINANCIAL ASPECTS OF PROJECT MANAGEMENT
FINANCING A PROJECT Project Report:
A project is a pre-investment and comprehensive study of investment proposals of an organization which encompasses a through investigation relating to economic, technical, financial, social, managerial and commercial aspects. It is a working plan for implementation of project proposals after an organization has decided to undertake an investment project. It seeks to evaluate the socio-economic and technical viability of a project before it is undertaken. A project report deals with the various aspects of a new project with reference to:
Project Report provides:
1. 2. 3. 4. 5. 6. It lays down objectives in various spheres of project. It evaluates the objectives in the right perspective. Component wise cost breakup of the project It identifies constraints on resource, manpower It identifies constraints on resources viz. manpower, equipment, financial and technological etc. well in advance to take remedial measures in due course of time. It paves the way for management to seek financial accommodation from financial Institutions and banks financial Institutions require a detailed project report a detailed project report to evaluate the desirability of financing the project .Besides ,other financial intermediaries like merchant bankers and underwrites also require project report to evaluate project viability for raising funds from Capital market. Apart from this, the successful implementation of a project depends upon the line of action. Besides, comparison of results will depends upon the projected profitability and cash flows, production schedule and targets as laid down in the project report.
JNNURM envisages to provide funds varying from 35% to 50% of project cost for identified 63 cities and balance has to come form state govt. and ULB.
PROCUREMENT OF FUNDS Own Funds
The traditional approach domain the scope of financial management and limited the role of the financial manager simply to fund raising. ULB financing are meet from State grants, Finance Commission Grants and the revenue generation through Municipal Taxes, which are too meager to meet high demand of funds related to infrastructure. Therefore ULBs have raise funds to meet the ULB’s fund requirement for infrastructure development. 192
PROJECT PLANNING & IMPLEMENTATION
Sources of generating funds by the local body are: Toll Charges Land Instrument ( House Tax) User Charges Surcharges Securitization
Tolls are the tariff imposed by the local bodies on the persons for using certain type of infrastructural facilities. Generally it is imposed for availing the road facility. This increases the revenue aspect of government and used for financing the projects relating to the capital expenditure. Tolls shall be levied according to the distance traveled and the type of vehicle. Member States may vary the toll rates according to vehicle emission classes and the time of the day.
The most obvious, and in many ways the most sensible recommendation that can be made with respect to revenue structures at any level of government is that appropriate user charges should be employed whenever possible. While user charges are likely to be viewed by officials solely as a potential additional source of revenue, their main economic value is to promote economic efficiency by providing demand information to public sector suppliers and to ensure that what the public sector supplies is valued at least at (marginal) cost by citizens.
Types of user Charges:
At least three types of user charges, broadly defined, exist almost everywhere: (1) Service Fees : include such items as license fees (marriage, business, dog, vehicle) and various small charges levied by local governments for performing specific services, registering this or providing a copy of that. Public Prices : refer to the revenues received by local governments from the sale of private goods and services. All sales of locally-provided services to identifiable private agents - from public utility charges to admission charges to recreation facilities - fall under this general heading. Specific Benefit Charges are related in some way to benefits received by the taxpayer in contrast to such general benefit taxes as fuel taxes levied on road users as a class or local general business or property taxes viewed as a price paid for local collective goods.
To meet the cost of operation and maintenance, ULBs have to increase their sources of revenue. For this purposes, they generally impose an additional tax over other taxes which is known as surcharge. The amount received from this head is utilized for meeting the expenditure to be incurred on maintenance and operation of the system.
Securitization is the process of pooling and repackaging of homogenous liquid financial assets into marketable securities that can be sold to investors.
PROJECT PLANNING & IMPLEMENTATION
Viability Gap Funding It is a known fact that India does not have adequate Infrastructure of achieve GDP Growth of 7% to 8% on a sustainable basis. Thus building Infrastructure is of utmost Importance to the Government. The Governments effort to rope in the Private Sector in the Country’s infrastructure building has met with limited success. A long Gestation and payback Periods are the main reasons behind the private sectors lukewarm response. Keeping this fact in mind one has to welcome the concept of Viability Gap Funding that seeks to bridge the gap between Economic and Financial rates of Returns. Government is promoting Public Private Partnerships (PPP) in Infrastructure Development through a special facility envisaging support to PPP Projects through viability gap funding. Primarily this facility is meant to reduce capital cost of the projects by credit enhancement and to make them viable and attractive for private Investments through Supplementary Grant funding. Provision for this facility is made on a year to year basis.
The criteria for eligibility for funding are: a) b) The project must be implemented, i.e., constructed, maintained and operated during the project term, by an entity with at least 40 per cent private equity. The project must belong to one of the following sectors: (i) (ii) (iii) (iv) c) d) e) f) Roads Water supply Sewerage Solid Waste Management
The projects should have been endorsed by the concerned line ministries in the Government of India All central projects should have received requisite Government approval at the appropriate level. The total Government support required by the project must not exceed twenty per cent of the total project cost or the actual project cost, whichever is lower. The implementing agency must be selected through a transparent and open competitive process. The extent of viability gap funding shall be determined on the basis of the net present value of the actual viability gap funding required.
Viability gap funding can take various forms, including but not limited to capital grant, subordinated loans or interest subsidy. A mix of capital and revenue support may also be considered.
POOLED FINANCE DEVELOPMENT SCHEME
India is going through a rapid urbanization process. The present level of urbanization of 28 per cent is expected to reach 40 percent by 2020. It is estimated that 60 per cent of the national income is contributed by urban India. Hence, in order to achieve the planned growth rate of 8-9 per cent it is necessary that urban India is managed well 194
etc. street lighting etc.. The identified new avenue is that of providing access to the capital markets wherein capital can be accessed RCUES. It was estimated by a GOI Committee in 1996 that the annual requirement of investment for urban infrastructure was of the order of about Rs 28. User charges seldom cover 0 & M expenditure.000 crore per year towards operations and maintenance. In this process the true costs of services have not been brought to focus and citizens are provided services at heavily subsidized prices. Hence. Traditionally. In this process the true costs of services have not been brought to focus and citizens are provided services at heavily subsidized prices. a major effort for reforms and capacity building is of utmost importance. This resource gap has come in the way of the capacity of ULBs to incur capital expenditure for India is going through a rapid urbanization process. It is estimated that 60 per cent of the national income is contributed by urban India. The estimate of requirement of investment in Karnataka as assessed by an Ad hoc Committee is about Rs 7. the major investments will have to take place in urban areas in basic services like water supply. Secondly. It is a well-known fact that ULBs all over the country are in a poor state and hence they have to restructure their organizations.000 crore each year.. Hence. The ceiling on government guarantees also restricts borrowings by the ULBs. Surely. in order to achieve the planned growth rate of 8-9 per cent it is necessary that urban India is managed well in order to give a further boost to the economy and in the process reduce poverty levels. It was estimated by a GOI Committee in 1996 that the annual requirement of investment for urban infrastructure was of the order of about Rs 28. The estimate of requirement of investment in Karnataka as assessed by an Ad hoc Committee is about Rs 7. functions and financial position. etc. the ULBs mandated to handle this task will have to be empowered and strengthened to take this responsibility. Traditionally. the major investments will have to take place in urban areas in basic services like water supply. User charges seldom cover 0 & M expenditure.. the ULBs mandated to handle this task will have to be empowered and strengthened to take this responsibility. Secondly. to meet capital expenditure. solid waste management. sanitation. ULBs have been dependent on funds from State Governments by way of grants.PROJECT PLANNING & IMPLEMENTATION in order to give a further boost to the economy and in the process reduce poverty levels. a major effort for reforms and capacity building is of utmost importance. LUCKNOW 195 . loans through State guarantees. The present level of urbanization of 28 per cent is expected to reach 40 per cent by 2020. loans through State guarantees. This resource gap has come in the way of the capacity of ULBs to incur capital expenditure for urban infrastructure services. Surely. roads. to meet capital expenditure.700 crore of capital expenditure and about Rs 1.. It is a well-known fact that ULBs all over the country are in a poor state and hence they have to restructure their organizations. ULBs have been dependent on funds from State Governments by way of grants.700 crore of capital expenditure and about Rs 1. solid waste management.000 crore per year towards operations and maintenance. which will ultimately enhance economic activity and contribute to the national income. street lighting etc. which will ultimately enhance economic activity and contribute to the national income. sanitation. In the recent years the extent of Government support towards urban infrastructure has been declining. Under these circumstances it is inevitable that ULBs explore new avenues to raise resources to meet their ever-increasing requirements for providing quality infrastructure services. functions and financial position.000 crore each year. Hence. roads.
5 times the annual debt commitments. The concept of pooled finance has been successfully adopted in Tamil Nadu. Land Based Instruments As ULBs have substantial area of open land. The structure and framework has been designed through the help of USAID and advice from ICRA. 40 per cent revenue surplus from the 8 ULBs will be transferred to a water project account in order to maintain an amount equivalent to 1. This Act specifies the: (i) (ii) 196 Purposes for which local bodies may contract a loan. The instrument has been assessed by ICRA. The above mechanism will be monitored by a Bond Trustee who will be appointed by the Fund Manager.5 crore will be maintained to meet any shortfall. The scheme provides for credit enhancement for borrowings that are bankable. The Trust has appointed KUIDFC as the Fund Manager. However. a rating agency and is to be rated as AA (SO). which will be tapped when necessary and subsequently replenished by state intercept of devolution of funds. The Trust is a GOK Trust which will raise Rs 100 crore by way of bonds on behalf of the 8 ULBs. 1914. thus. limits on the amount of loan. The water supply component is estimated to cost Rs 340 crore. help in financing a project. These instruments. This fund will be contributed on a matching basis by GOI and GOK as per the guidelines of the proposed PFDF Scheme. A guarantee from USAID covers 50 per cent principal amount. they can use those for the purpose of finance.PROJECT PLANNING & IMPLEMENTATION through bonds. provides the structure and the means to access capital markets by a group of ULBs. a state intercept will be provided to divert the state devolution funds in case of default by a participating ULB. The 8 ULBs plan to raise Rs 100 crore from the market to meet part of the cost.a SPV constituted for this purpose. Banks and other Financial Organizations easily accept the instruments based on security of land. the smaller ULBs will find it difficult to directly access the market and hence the concept of pooled finance has been developed whereby a group of ULBs join together and approach the capital markets through a special purpose vehicle. GOI offers tax exemption on the bonds floated by ULBs. At the first level. The Greater Bangalore Water Supply and Sanitation Project (GBWASP). In the third level. In order to make this instrument attractive. Legal Framework for Municipal Borrowing Municipal government borrowing in India is regulated by the Local Authorities Loans Act. LUCKNOW . The bonds are also to be listed in the stock exchange in order to make them tradable. which is now taken up for implementation has adopted the scheme in Karnataka. Bonds are to be floated on behalf of the 8 ULBs through the Karnataka Water and Sanitation Pooled Fund Trust . The GBWASP plans an out lay of Rs 640 crore for the water supply and UGD components covering 8 ULBs surrounding Bangalore City but forming part of the Bangalore Metropolitan Area. RCUES. which is under the final stages of formulation. The innovative financing structure adopted as above in the GBWASP is path breaking and its success should pave the way to many such initiatives in future from the ULBs. The ‘Pooled Finance Development Facility’ (PFDF). A credit enhancement structure has been framed for the comfort of the investors. At the next level a Bond Service Fund of Rs 25.
(CRISIL). the Standard and Poor’s Rating Services of USA. With increasing requirements. with a view to explore the feasibility of expanding the horizons of its rating operations. The manner of making applications for permission to borrow money. Subject to the limits imposed by this Act. It is high time that a commercial approach is adopted. this has meant deficiency in volumes as well as quality of service. From a societal point of view. Security or collateral. undertook an exploratory exercise to evaluate the credit quality of municipal entities in India. and Repayment procedures. Even if the facilities were funded by loans. Credit Rating The Urban Local Bodies (ULBs) own resources have been insufficient even to meet the operation and maintenance requirements of these services. The attachment of such funds and the manner of disposing them. Consequently. a framework for municipal credit evaluation and laid out the groundwork for credit rating of RCUES. (CRISIL) The Credit Rating Information Services of India Ltd. The Credit Rating is done by the following agencies: Credit Rating Information Services of India Ltd. a parallel.PROJECT PLANNING & IMPLEMENTATION (iii) (iv) (v) Duration of loans. and (vii) The accounts to be kept in respect of loans. unorganized sector for provision of many of these services has developed. It involved the Ahmadabad Municipal Corporation (AHMC) and other municipal corporations in formulating what it called. The works for which money may be borrowed. resulting in high prices and qualitatively deficient services. The framework which is laid out in the state level municipal laws contains rules in respect of (i) (ii) (iii) (iv) (v) (vi) The nature of the funds on the security of which money may be borrowed. these are expensive solutions. Even when user charges are levied. The fact that infrastructure services do not pay for themselves and the government continues to subsidies the beneficiaries has resulted in low availability of funds. a commercial approach to these services has not been developed. Since most urban infrastructure services have been treated as public services and the concept of cost recovery has never been considered relevant. The manner of raising loans.can borrow from the market. drawing upon the experiences of its partner. LUCKNOW 197 . a credit rating agency in India. the repayment of loans was generally book adjustments or paid out of grants made by state governments. the state governments have the flexibility to determine the framework within which local governments – a term used to cover all forms of local bodies including the parastatals . The sum to be charged against the funds. which are to form the security for the loan. the price per unit is too low to cover even the variable cost of providing the service.
which include economic structure. revenue surplus or deficit. It assesses the system structure and management in terms of inter-governmental linkages. revenue raising powers. the level of local government autonomy and the administrative capability of local government. current debt burden. In evaluating the financial performance. revenue and expenditure balance. While evaluating the fiscal profile. Investment Information and Credit Rating Agency (ICRA Ltd. Although the criteria for evaluating bond issues by ICRA are not published. ICRA looks at the overall profile of the issuer in terms of the area that it services together with its demographic and socio-economic profile. Standard and Poor’s examines the parameters affecting the local economy. availability of general revenues to meet short-term delays in debt servicing of projectlinked debt instruments. It also studies the debt specific factors such as the delays in past loan repayments. and assigned an “A+” credit rating to the proposed Rs. It also appraises the ongoing and proposed projects from the point of improvements in service delivery and funding arrangements. revenue streams assigned for repayment of bonds. Credit Analysis and Research Limited (CARE) The CARE considers parameters such as the fiscal profile of bond-issuing municipal body. viability of the new project in terms of the constitution of the project as a special purpose vehicle (SPV) or as a departmental project. in its view. availability of financial resources to meet unforeseen contingencies and quantum of state budgetary support and the nature of operating expenses are examined. It evaluates the legal set-up within which the local body operates including the power to raise debt. profile of the project being financed and its related risk factors. degree of reliance on short term borrowings. indicating a credit risk profile in the adequate safety category. instruments and volume of transactions. responsibility to repay debt. 1 billion bond issue. power to authorize specific issues. While evaluating local governments. financial parameters such as the composition of revenue and expenditures. past revenue and expenditure profiles. CRISIL studied the finances and operations of the AHMC. Since then. LUCKNOW . the bond market in India has seen a noticeable growth in terms of issuers and investors. When the bond proceeds are to be used to finance a new project. and management systems and policies. and the financial position of the rating entity. stability and supportiveness of the higher levels of government. sources and 198 RCUES. ending litigations affecting the status of debt and inter-governmental fiscal structure. the credit standing of sovereign governments has a significant impact on the credit profile of sub-national and local governments. expenditure trends. Also studied are major revenue heads in terms of trends and composition and expenditure patterns of key operating departments. It conducts a detailed assessment of the financial performance of municipalities in terms of the organisation of accounts.PROJECT PLANNING & IMPLEMENTATION municipalities and project-specific debt issues. liquidity. growth prospects and demographic profile of population. past capital expenditure schedule. margin of surplus or deficit. amongst other factors. debt burden and off-balance sheet liabilities. The analytical methodology used by Standard and Poor’s focuses on the range of economic system and administrative factors. maturity profile and state government approvals for borrowings. revenue surplus or deficit. debt service coverage ratio. a study of the rating rationale gives an indication of the underlying rating philosophy and broad criteria. budgetary performance and flexibility. It evaluates sovereign-related factors as.) ICRA has assessed a number of municipal entities in terms of assigning credit rating for bond issues. it analyses the revenue sources and flexibility therein. liquidity position and debt profile.
local employment characteristics. trading volume and market awareness. An important feature of municipal bonds is that with the exception of bonds issued by the BMC and Indore Municipal Corporation.PROJECT PLANNING & IMPLEMENTATION allocation of funds for the project being financed and analysis of major project related revenues and expenditures are assessed. In order to facilitate borrowings. The bond market in India has grown significantly in recent years. providing future revenue flows from the RCUES. zero-coupon bonds and floating rate bonds. ability to implement plans and degree of autonomy given to the local body. LUCKNOW 199 . 6185 million. known as the India Infrastructure Report. have given a further stimulus to the municipal bond market. The nine municipal corporations which have accessed the capital market have thus far been able to raise Rs. and prioritization of expenditure across projects. The central government issues treasury bills. tax billing. which had been playing a crucial role in creating urban infrastructure projects in the United States of America (USA) and Canada was initially outlined in a seminar held in 1995 and subsequently elaborated on by an Expert Group on the Commercialization of Infrastructure Projects. This report noted that urban infrastructure services are provided by local level agencies.25 throughout the tenure of the bond. It looks at the administrative and legal issues. collection and enforcement mechanism. The fact that municipal entities have begun to raise resources in the capital market on the strength of their own credit standing and credit enhancements based on escrowing of the cash flows indicates a growing acceptance in India of municipal bonds as an instrument for raising resources for financing infrastructure projects. At sub-national levels. instruments. the state-level public enterprises issue government-guaranteed bonds. zero-coupon bonds. The fiscal incentives offered by the Government of India in the form of tax exemptions to eligible issuers. Traditionally. such as organizational structure. This over collateralization and the provision of a debt service reserve account serve as measures to reduce risk to investors. the main issues comprise taxable and tax-free bonds. Municipal Bonds in India A key development in the sphere of infrastructure financing in India has been the emergence of a municipal bond market. Funds have generally been in the form of loans and grants from the central and state governments. the Credit Rating (Repayment Capability) of ULBs play an important role in extending funds for the project. lenders to entities in the infrastructure sector have sought a state or a sovereign guarantee as an important security mechanism. Also evaluated are factors such as the state of the local economy. development indicators. CARE’s methodology carefully analyses the linkages between the above-stated factors. defined in the Ministry of Urban Development’s Guidelines for Issue of Tax Free Municipal Bonds (2001). other bonds have been issued without a state government or a bank guarantee. For public sector companies. in items of issuers and investors. Municipal bonds in India are a securitized debt instrument. while the private sector companies issue bonds and debentures. by issuing bonds. management information system. while assigning an appropriate rating to the debt instrument. demographics. The concept of municipal bonds as an instrument for raising resources for urban infrastructure projects. floating rate bonds and inflation-indexed bonds. The guidelines stipulate that the issuers are to maintain a debt service coverage ratio of at least 1.
The more certain and predictable is the revenue stream. and groups of local authorities through a financial intermediary. drainage. The riskier the ability of a borrower to service debt payments. The frameworks that they use are outlined below. initiation of the process of Land acquisition and other statutory clearances. roads. the greater is the security for a loan. sewerage or sanitation. LUCKNOW Use of Funds Requirements Project Development Financial Viability 200 . and urban transport if it is a statutory municipalfunction.12 The rating often serves. legal obligation and moral commitment of a borrower to meet its financial obligations of interest and principal in full and in a timely manner. Borrowing for investment purposes is equivalent to capitalizing an income or revenue stream. viz. RCUES. benchmarks for commencement and completion including the milestone dates for the proposed components of the project. Key Features of Tax-Free Municipal Bonds Key Features Eligible Issuers Local self governments... The borrower receives funds today to pay for project construction. Project development consisting of an approved investment plan including phasing and a financing plan. appointment of an Independent trustee for monitoring the Escrow account. other local authorities constituted under relevant state government statutes like water supply and sewerage board. other local authorities or public sector companies* duly constituted under an Act of Parliament or state legislature. creation of an ESCROW account for debt servicing. Credit rating is mandatory for debt instruments with a maturity exceeding 18 months. in several countries. potable water supply. completion of the process of pre-qualification of bidders. Capital investments in urban infrastructure namely. Financially viable i. he signs away the right to an annual revenue flow in the future in favour of the lender. In return.solid waste management. and Fitch Ratings) serve the Indian market in terms of rating bonds and debentures and other papers. the higher the interest rate sub-sovereigns has to pay. the central government does not permit sub-sovereigns to sell unrated bonds. Moody. ICRA and CARE together with their partners (Standard and Poor’s. to determine the interest rate at which sub-sovereigns can issue debt in the capital market. generation of a stream of revenues sufficient to finance the project. CRISIL.e. particularly in countries where interest regimes are allowed to operate freely. Credit Rating for Debt Financing A credit rating11 is an independent opinion on the future ability. Rating is important to issuers for two key reasons: (i) (ii) Investors are reluctant to buy bonds if they are not rated.PROJECT PLANNING & IMPLEMENTATION project as collateral. bridges and flyovers. At the heart of any credit system is a revenue stream that the borrower does not use for day-to-day operations. The three major credit rating agencies.
A proper analysis of all the above aspects has to make before making final selection of source of funds . Capital budgeting involves a financial analysis of the various proposals regarding capital expenditure to evaluate RCUES. Minimum maturity of five years.PROJECT PLANNING & IMPLEMENTATION Other Conditions Conformity with laws governing borrowing.The cost of funds should be kept at minimum for proper balancing of risk and control . Project Account and Monitoring Investment. contribution of 20% of project cost from internal resources or grants. A cost benefit analysis incorporating an overall result of the project during its whole period of operation should be made. It generally reveals the expected amount of return. Cost. Maturity and Buy-Back Ceiling on Amount Credit Rating Legal and Administrative Requirements Source (Financing Municipal Services – Reaching out to Capital Markets) * Details list of ULBs where funds have been procured through Municipal Bonds refer to annexure-I SELECTION OF APPROPRIATE SOURCE OF FINANCING There are many sources for obtaining funds .Each source has its own pros and cons.3% or Rs. maintenance of a Debt Service Coverage Ratio (DSCR)** of 1. an investor wants on his investment. Maximum amount of tax-free bonds as a % of total project cost will be 33. with the option for buyback arrangements of the face value of the bonds. Maintenance of a separate account as also establishment of a separate Project Implementation Cell. investors may demand for the repayment of their investment at any time .However it is not possible to gather funds from all these source . Capital Budgeting Budgeting means evaluation of several plans or policies and making a choice of the best plan out of available plans. Adherence to guidelines issued by the Securities and Exchange Board of India (SEBI).25 Through the tenure of the tax-free municipal bond. Furthermore the tools of Capital Budgeting should also be used for determining the financial viability of the source. Control Cost refers to the procurement cost of fund. Risk refers to the possibility of any uncertainty attached to the source of funds. Generally in case of borrowed funds.it refers to the decision making power related to the project. 50 crore whichever islower. Mandatory to obtain an investment grade rating. debt-equity ratio not to exceed 3:1. Choice of the source depends on mainly three factors:1. LUCKNOW 201 .This may knead to closure of the project. Risk and 3. 2. Control is also a significant aspect of Financial Sustainability .
4. It is the period in which the profit expected from the project will be equal to the cost of project. This method of evaluating proposals for capital budgeting is simple and easy to understand. The first step would be to calculate the cash inflow from this project. 3. the technique of payback period is not a very scientific method because of the following reasons: 1. It does not give any consideration to time value of money. it has the advantage of making it clear that there is no profit of any project unless the pay back period is over.PROJECT PLANNING & IMPLEMENTATION their impact on the financial aspect of project .000 calculated as follows: Rs.00.000 1. However. 2.50. By stressing earlier cash inflows the liquidity dimension is also considered in the selection criterion. The cash inflow is Rs. 4. This is inadequate measure for evaluating two projects where the cash inflows are uneven.00. In the case of routine projects also use of payback period method favours projects.00. It stresses capital recovery rather than profitability. Pay Back Period Pay Back Reciprocal Average Rate of Return Net Present Value Method Profitability Index Internal Rate of Return Pay Back Period It is one of the simplest at methods which calculates the period within which the cost of project will be completely recovered.50.00. which generate cash inflows in earlier years Thus it.000 RCUES.00.This Technique helps in taking decision as to whether or not money should be invested in long term policies. LUCKNOW . has practice approach. For this purpose.000 4. 3. Financial Manager uses the following technique:1. 6. This method has the following pros: 1. 2.000 after depreciation @ 12 ½% (straight line method) but before tax @ 50%.000 2. Illustration Suppose a project costs Rs 20.50. It is done after the detailed cost estimation and implementation schedule of the project is made. 2. Profit before tax Less: Tax @ 50% Profit after tax Add: Depreciation written off Cash Inflows 202 3.000 and yields annually a profit of Rs 3.000 1. 5.
20. Pay Back Reciprocal It is a helpful tool for quickly estimating the rate of return of a project. 4. 3. However. the technique of payback period is not a very scientific method because of the following reasons: 1. it has the advantage of making it clear that there is no profit of any project unless the pay back period is over.00. This method of evaluating proposals for capital budgeting is quite simple and easy to understand.e.000 and it would give an annual cash inflow of Rs 4. Thus management may for example. Illustration Suppose a project requires an initial investment of Rs.000 Rs.000 = 20% RCUES. depreciation is added back to profit after tax since it does not result in cash outflow. The method does not give any consideration to time value of money. decide that they will not accept any project if the pay back period is more than 3 years.000. Rs.Similarly it cannot be used as an approximation of the rate of return if the project yields uneven cash inflows.00.00. 3.PROJECT PLANNING & IMPLEMENTATION While calculating cash inflow.000 Remarks The project with the lower payback period will be preferred. 2. 2. 20. Evaluation This method has the following pros: 1. Thus it has practice approach. It stresses capital recovery rather than profitability. This method becomes a very inadequate measure of evaluating two projects where the cash inflows are uneven. i. When the useful life if the project is not at least twice the payback period the payback reciprocal will always exceed the rate of return . In the case of routine projects also use of payback period method favours projects. LUCKNOW 203 .000 4. The useful life of the project is estimated to 5 years. It can be calculated as follows:PBR=Average Annual Cash Inflow Initial Investment The payback reciprocal is a useful technique estimate the true rate of return. which generate cash inflows in earlier years. The cash generated from a project therefore is equal to profit after plus depreciation. Sometimes the management has a set idea regarding what should be a maximum pay back period. In this example payback reciprocal will be: PI = Rs. By stressing earlier cash inflows liquidity dimension is also considered in the selection criterion. But its major limitation is that every investment project does not satisfy the conditions on which this method is based. The payback period in this case is 5 years. 20.
10.00. Average Rate of Return It provides the average annual yields on the project. Under this method profit from a project as percentage of total investment is considered. However.000 4. of years of profits i.000*100 Rs. Of Years of profits This method is quite simple and popular because it is easy to understand and includes income from the project throughout its life. 10.000 1.000 yields profit after tax and depreciation as follows : Years 1 2 3 4 5 Total Profit after tax And depreciation Rs.It thus ignores the time value of money.e. it is based upon a crude average of profits of the future years.000 75. Illustration Suppose a project requiring an investment of Rs. 50.000 1.000 * 5 years = 9. it ignores the effect of fluctuation in profits from to years . Similarly. It is calculated as follow:ARR= Total Profiles*100 Net Investment in the project *NO.60. But its major limitation is that every investment project does not satisfy the conditions on which this method is based. 4.000 In this case the rate of return can be calculated as follows Total profits *100 Net investments in the project * No. the payback reciprocal will always exceed the rate of return. When the useful life of the project is not at least twice the payback period.25. LUCKNOW .00. had the same funds been invested alternatively in those projects.PROJECT PLANNING & IMPLEMENTATION Evaluation The payback reciprocal is a useful technique to quickly estimate the true rate of return.2% Remarks This rate is compared with the rate expected on other projects.000 80. 204 RCUES. Rs. it cannot be used as an approximation of the rate of return if the project yields uneven cash inflows.30.60.
The net present value can be seen as the addition to the wealth of share holders .83. This 10 % is our discounting rate.000 2.The criterion of NPV is thus in conformity with basic financial objectives.000 and the rate of interest. The NPV uses the discounted cash flows i. NPV method takes into account the time value of money The whole stream of cash flows is considered. Illustration 1 Suppose a project will give profit as follows:Year End 1 2 3 4 5 6 Total Profit (Cash Inflow) 2. 10. However.000 80. we calculate present value of various years on the basis of discounting rate as follows:205 RCUES. 2.73. It explicitly recognizes the time value money . expresses cash flows in terms of current rupees.72. It ignores the effect of fluctuations in profits from year to year.It correctly postulates that cash inflows arising at different time periods differ in value and are comparable only when their equivalents-present values –are found out.00. NET PRESENT VALUE It is the best method for evaluation of investment proposals.000 2. let this project requires an initial investment of Rs.000 (Scrap Value) 13. supposed to be earned on this amount of Capital in Finance marked is 10% .. LUCKNOW . 1.e.28.30. It is the classical economic method of evaluating the investment proposals.000 2. 4.000 2.PROJECT PLANNING & IMPLEMENTATION Evaluation This method is quite simple and popular because it is easy to understand and includes income from the project throughout its life.000 Again. Now.78. 3. It thus ignores the time value of money. it is based upon a crude average of profits of the future years.
120 10.000 2.e.751 .683 .88.000 Discount Factor at 10% (iii) .09.328 2.500 now and is expected to generate year-end cash inflows of Rs 900.000 Hence. NPV>0.289 1.000 2. The net present value for Project X can be calculated as follows : STATEMENT OF NET PRESENT VALUE Particulars Cash Outflow Cost of Project Present Value of Cash Outflow (A) Cash Inflows Time 0 1 2 3 4 5 P. Remarks The project can be accepted if NPV is positive i.000 2. the total present value of all cash inflows is Rs. 10.118 is the Net Present Value. NPV>0 and rejected when NPV is negative i. NPV = 0 implies that project generates cash flows at a rate just equal to the opportunity cost of capital. If NPV = 0.118 whereas total investment required is Rs.118 Thus.909 .78.73.564 Total Present Value iv (ii * iii) 2.93. Illustration 2 Assume that Project X Costs Rs 2.00.683 .751 . V.826 .000 2.PROJECT PLANNING & IMPLEMENTATION Year End (i) 1 2 3 4 5 6 Cash Inflow (ii) 2.826 .14. a project may be accepted. Rs 800.909 . 10. The opportunity cost of the capital may be assumed to be 10 per cent.28.e. LUCKNOW Present Value of Cash in flows (B) Net Present Value (B-A) 206 .533 45.621 Amount 2500 900 800 700 600 500 Present Value 2500 2500 818 661 525 409 310 2725 225 RCUES.83.778 1.08. Factor 1 .30.070 1. Rs 700.000 80. 14. Rs 600 and Rs 500 in years 1 through 5. Rs.69.14.621 .
Evaluation 1. Project X adds to the wealth of owners.000 (c) Rs. The whole stream of cash flows is considered.30. NPV method takes into account the time value of money. Thus.e.18 Rs. 6.000 and 100. it generates a positive net present value (NPV = + Rs 225). 6. it should be accepted.50. PROFITABILITY INDEX In certain cases we have to compare a number of proposals each involving different amount of cash inflows .20. The factor helps us in ranking various projects.000 = 1. Rs. 75.One of the methods of comparing such proposals is to work out profitability index .000. 1.PROJECT PLANNING & IMPLEMENTATION Project X’ s present value of cash inflows (Rs 2.000 = 1.50.000 and Rs. LUCKNOW 207 .000. The criterion of NPV is thus in conformity with basic financial objectives. therefore. 95. The NPV uses the discounted cash flows i.50.27 Rs. 95. 1.000. 3.00. 2.50. Evaluation Profitability index as a guide in resolving capital rationing fails where projects are indivisible. RCUES.It is calculated as below:Profitability Index=Sum of Discounted Net Cash Inflows Initial Cash Outlay This factor helps us in ranking us in ranking various projects Profitability index as a guide in resolving capital rationing fails where projects are indivisible . expresses cash flows in terms of current rupees. 5.000. 4.000 (b) Rs.20. The desirability factors for the three projects would be as follows: (a) Rs. Illustration Suppose we have three projects in view. 1.500). This is because the outflow is very high also.725) is greater than that of cash outflow (Rs 2. Suppose further that the sum of discounted cash inflows for these projects are Rs.000 Remarks It would be seen that in absolute terms project (c) gives the highest cash inflows yet its desirability factor is low.00.00.18 Rs. each involving discounted cash outflow of Rs. 5.. The net present value can be seen as the addition to the wealth of share holders.000 = 1.30. 75.
641 = -Rs. Illustration Suppose a project costs Rs. 8000 (PVF1.694+Rs 6000*0. 8000 (PVF1. 16000+ Rs. 16000+Rs. If there is more than one cash outflow interspersed between the cash inflows. 1004 at 20 % indicates that the project’s true rate of return is lower than 20%. 16000+Rs. All the cash flow in the project is considered. Rs.8333+Rs.At this rate discounted cash inflows are equal to the discounted cash outflows. 14996 = . 7000(PVF2. 8000*0. If mutually exclusive projects are considered as investment options which have considerably different outlays.0.Rs.0. 16000+ Rs. Therefore in the method Net present Value is equal to zero and the discount rate which satisfies this condition is determined. 16000+Rs.16)+Rs.20)+Rs. By trial and error method we try to calculate the rate which satisfies our requirements. The IRR approach creates a peculiar situation if we compare to projects with different inflow outflow patterns.0.743+Rs 6000*0. 16000+Rs. 7000(PVF2.20) = -Rs.579 = -Rs.Rs. we try a 20 % (arbitrary) discount rate. IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital.0.16)+ Rs. the project’s NPV is: NPV= -Rs. At 16 %. Demerits However. It is a popular investment criterion since it measures profitability as a % and can be easily compared with the cost of capital. 7000*0. IRR method can give misleading and inconsistent results under certain circumstances. The project’s NPV at 20 % is: NPV= -Rs. 6000 at the end of each year for next 3 years. We know that IRR is the rate at which project will have a 0 NPV. LUCKNOW . As a first step. 15943 = . 8000*0. 16000 and is expected to generate cash inflows of Rs. 1004 A negative NPV of Rs.20)+ Rs. 6000(PVF3. 57 208 RCUES.870+Rs. there can be multiple IRRs. 7000*0. Here we briefly mention the problems that IRR method may suffer from: The calculation process is tedious. 8000.16) = -Rs. IRR method has the following merits: The time value of money is taken into account.0. Let us try 16 % as the discount rate.PROJECT PLANNING & IMPLEMENTATION INTERNAL RATE OF RETURN (IRR) It is the rate expected to be earned from a project involving a certain a sum of cash out lay .0. 6000(PVF3. the interpretation of which is difficult. 7000 and Rs.
870+Rs.reject rule.Rs.15) = -Rs.756+Rs 6000*0. We can find out a close approximation of the rate of return by the method of linear interpolation as follows: PV required PV at lower rate. 16200 = . LUCKNOW 209 . IRR method has the following merits: 1. Thus the IRR acceptance rules are: Accept the project when Reject the project when May accept the project when r>k r<k r=k Evaluation IRR method is like the NPV method. 7000*0. or the cut-off.8 % Remarks The accept – or .15)+Rs. 7000(PVF2.0. using the IRR method. The time value of money is taken into account.658 = -Rs. 16200 Rs. or hurdle rate. When we select 15% as the trial rate. 16000 Rs.0. 8000 (PVF1. It is a popular investment criterion since it measures profitability as a % and can be easily compared with the cost of capital. However.PROJECT PLANNING & IMPLEMENTATION Since the project’s NPV is still negative at 16%. a rate lower than 16% should be tried. 15% PV at higher rate.15)+ Rs. Here we briefly mention the problems that IRR method may suffer from:- RCUES. IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital. 8000*0. IRR method can give misleading and inconsistent results under certain circumstances. we find that the project’s NPV is Rs. 200: NPV= -Rs. The project shall be rejected if its internal rate of return is equal to the opportunity cost of capital. 200 The true rate of return should lie between 15 % -16 %. 2. 16000+ Rs. 16000+Rs. 15943 R = 15% + (16%-15%) 200/ 257 = 15% + 0. Note that k is also known as the required rate of return. 6000(PVF3.80% = 15.0. 3. All the cash flows in the project are considered. 16% Rs. 16000+Rs. is to accept the project if its internal rate of return is higher than the opportunity cost of capital (r > k).
there can be multiple IRRs. terms loans from financial institutions. the interpretation of which is difficult. The benefits arising out of the acquisition of such assets will be spread over a number of years in the future.e. Two Important Elements For understanding the above concept the two important aspects are: Time Value of Money Discount Rate i. The Profitability Index Method also gives the same result as that of the NPV method. A financial decision today has implications for a number of years. For example. The methods analyzing a project depends. that is. which is the ultimate objective of Financial Management and NPV helps in arriving at that project. PI method states the result in terms of percentages whereas NPV method shows result in absolute terms. because both method use the same constituents. These involve a cash inflow at the time of raising funds as well as an obligation to pay interest/dividend and return the principal in future. Thus. SELECTION OF BEST METHOD After making an in-depth study of merits and demerits of all the methods. till the working life of the assets. the firm may make decisions that may allow it to miss its objective of maximized the owners’ welfare. The IRR approach creates a peculiar situation if we compare two projects with different inflow outflow patterns. However the Net Present Value Method is considered best. It is on the basis of the comparison of the cash outflows (outlays) and the benefits (cash 210 RCUES. If the timing and risk of cash flows is not considered. If mutually exclusive projects are considered as investment options which have considerably different outlays. Cost of Capital TIME VALUE OF MONEY The recognition of the Time Value of Money and risk is extremely vital in decision making. If there is more than one cash outflow interspersed between the cash inflows. to the owners’ wealth. also influence the decision of a Financial Manager. 3.PROJECT PLANNING & IMPLEMENTATION 1. It is considered superior because the best project is the one which adds most among the available alternatives. i. It is the most used technique. As a Finance Manager having a number of proposals regarding various projects. On the other hand. sale of debentures and so on . we are now able to judge any financial projects with the help of these methods. Cash Inflow and Cash Outflow. However. 2. requirement of law etc. bank borrowings. LUCKNOW . it spreads into the future. The calculation process is tedious. . on the need of the person. apart from these financial considerations several other factors such as welfare of the staff/society. Project budgeting is necessary step before taking any decision. funds have to be procured from different sources such as raising of capital through new issues.e. He has to compare and evaluate all these projects and decide which one to take up and which one to reject. firms have to acquire fixed assets for which they have to pay a certain sum of money to vendors.
157625 = Rs. One basic requirement of comparability is the incorporation of the time element in the calculation. in order to have a logical and meaningful comparison between cash flows that accrue in different time periods. There are two techniques for doing this: Compounding. Three reasons may be attributed to the individual’s time preference for money: Risk Preference for Consumption Investment Opportunities Technique The preceding discussion has revealed that in order to have logical and meaningful comparisons between cash flows that result in different time periods it is necessary to convert the sum of money to a common point in time.Time preference for money is an individual’s preference for possession of a given amount of money now. rather than the same amount at some future time. 1000 at 5% interest compounded annually. it is necessary to convert the sum of money to common point of time.05) 3 = Rs. In other words. TIME PREFERENCE FOR MONEY Most individuals value the opportunity to receive money now higher than waiting for one or more periods to receive the same amount . 1000 (1+. 1157. Illustration If Mr. LUCKNOW 211 .PROJECT PLANNING & IMPLEMENTATION inflows) that financial decisions are made. In many instance we may be interested in the future value of a series of payments made at different time periods. RCUES. The term principal refers to the amount of money on which interest is received.625 Compounded Value of a Series of Payments So far we have considered only the future value of a single payment made at time zero. and Discounting Compounding Technique: Interest is compounded when the amount earned on an initial deposit (the initial principal) becomes part of the principal at the end of the first compounding period. at the end of the third year its compounded value will be: A = P (1+i) n = Rs. For a meaningful comparison the two variables must be strictly comparable. 1000 * 1. X invests Rs.
00 2500. LUCKNOW . Illustration Mr X deposits Rs 2. Annuities involve calculations based upon the regular periodic contribution or receipt of a fix sum of money.500 in his saving bank account for 5 years .103 1. The interest rate is 5 per cent. The future value of the entire stream of payments is the sum of the individual future values.000. the first deposit will earn interest for four years. He wants to determine how much sum of money he will have at the end of the 5th year. Rs1. 500 1000 1500 2000 2500 4 3 2 1 0 1. Rs1. the future value remains Rs 2.050 1. Mr X deposits each year Rs 500.00 1654. Following table presents the calculations required to determine the sum of money he will have.158 1. the second for three years and so on.000. Annual Compounding of a Series of Payments End of Year 1 1 2 3 4 5 Amount Deposited 2 Rs.50 2100. 608.500 comes at the end of the fifth year and.000 at the end of every year for 5 years in his saving account paying 5 per cent interest compounded annually. Rs.500. Rs 2.500. that is. therefore.00 1158. The last payment of Rs 2. 8. The calculations required to find the sum of an annuity on which interest is paid at a specified rate compounded annually. He wished to find the future value of his deposits at the end of the 5th year.50 Compound Sum of an Annuity An annuity is a stream of equal annual cash flows.PROJECT PLANNING & IMPLEMENTATION Illustration Suppose.020.000 Total Number of years compounded 3 Compounded Interest Factor 4 Future Value (2*4) 5 Rs.216 1.00 8020. Solution Following Table presents the relevant calculations: 212 RCUES.50 Column 3 of Table indicated that since the deposits are made at the end of the year. and Rs 2.
PROJECT PLANNING & IMPLEMENTATION
Annual Compounding of Annuity End of Year 1 Amount Deposited 2 Rs. 1 2 3 4 5 2000 2000 2000 2000 2000 4 3 2 1 0 1.216 1.158 1.103 1.050 1.000 Total Thus, the future value of the entire stream of annuity is Rs. 11054. Number of years compounded 3 Compounded Interest Factor 4 Future Value (2*4) 5 Rs. 2432 2316 2206 2100 2000 11054
PRESENT VALUE OR DISCOUNTING TECHNIQUE
The concept of the present value is the exact opposite of that of compound value. While in the letter approach money invested now appreciates in value because compound interest is added, in the former approach (present value approach) money is received at some future date and will be worth less because the corresponding interest is lost during the period .In other words, the present value of a Rupee that will be received in the future will be less than the value of a rupee in hand today. Thus, in contrast to the compounding approach where we convert present sums into future sums, in present value approach future sums are converted into present sums .Given a positive rate of interest , the present value of future rupees will always be lower. It is for this reason, therefore that the procedure of finding present values is commonly called discounting. It is concerned with determining the present value of a future amount, assuming that the decision maker has an opportunity to earn a certain return on his money. This return is designated in financial literature as the discount rate, the cost of capital or an opportunity cost.
Mr. X has been given an opportunity to receive Rs 1,060 one year from now. He knows that he can earn 6 per cent interest on his investments. The question is: what amount will he be prepared to invest for this opportunity? To answer this question, we must determine how many rupees must be invested at 6 per cent today to have Rs 1,060 one year afterwards. Let us assume that P is this unknown amount, and using the compound technique, we have: P (1+0.06) = Rs 1,060 Solving the equation for P, P = Rs 1,060 1.06 = Rs 1,000
PROJECT PLANNING & IMPLEMENTATION
Thus, Rs 1,000 would be the required investment to have Rs 1,060 after the expiry of one year. In other words, the present value of Rs 1,060 received one year from now, given the rate of interest of 6 per cent, is Rs 1,000. Mr X should be indifferent to whether he receives Rs 1,000 today or Rs 1,060 one year from today. If he can either receive more than Rs 1,060 by paying Rs 1,000 or Rs 1,060 by paying less than Rs 1,000, he would do so.
DISCOUNT RATE i.e., COST OF CAPITAL
The discussions relating to capital budgeting have shown the relevance of a certain required rate of return as a discussion criterion. Such a rate is the cost of capital of a firm. Apart from its usefulness as an operational criterion to accept / reject an investment proposal, cost of capital is also an important factor in designing capital structure.
IMPORTANCE AND CONCEPT
Definition In operational; terms cost of capital refers to the discount rate that is used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. In this sense it may be defined as the minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged. The cost of capital is composed of several elements. These elements are different sources of capital from which it is produced. Each source of fund has its own cost of capital which is known as specific cost of capital. When these specific costs are combined to arrive at overall cost of capital, it is known as weighted cost of capital. Actually, wherever the term cost of capital is used it means Composite cost of capital. Importance As mentioned above, the cost of capital is an important element, basic input information, in capital investment decisions. In the present value method of discounted cash flow technique, the cost of capital is used as the discount rate to calculate the NPV. The profitability of index or benefit-cost ratio method similarly employs it to determine the present value of future cash flows. When the internal rate of return method is used, the computed IRR is compared with the cost of capital. The cost of capital, thus, constitutes an integral part of investment decisions. It provides a yardstick to measure the worth of investment proposal capital. It is also referred to as cut-off rate, target rate, hurdle rate minimum required rate of return, standard return, opportunity cost and soon. The cost of capital, as an operational criterion, is related to the firms’ objective of wealth maximization. The accept reject rules requires that a firm should avail only such investment opportunities as promise the rate of return is higher than the cost of capital. Conversely, the firm would be well advised to reject proposals whose rates of returns are less than the cost of capital. If the firm accepts a proposal having a rate of return higher than the cost of capital, it implies that the proposal yields returns higher than the minimum require by the investors and the prices of shares will increase, and thus, the shareholders’ wealth. By virtue of the same logic, the shareholders’ wealth will decline on acceptance of a proposal in which the actual return is less than the cost of capital. The cost of capital, thus, provides a rational mechanism for making optimum investment decision. In brief, the cost of capital is important because of its practical utility as an acceptance- rejection decision criterion. 214
PROJECT PLANNING & IMPLEMENTATION
The considerable significance of cost of capital in terms of its practical utility not with standing, it probably the most controversial topic in financial management. There are varying opinions as to how this can be computed.
COST OF CAPITAL
As we know the term of cost of capital is the overall cost. This is the combined cost of the specific costs associated with specific sources of financing. The computation of cost of capital, therefore, involves two steps: 1. 2. The computation of the different elements of the cost terms the cost of different sources of finance and The calculation of overall cost by combining the specific cost into a composite cost.
Cost of Different Elements of Capital From the view point of capital budgeting decisions in the long term sources of funds are relevant as they constitutes the major source of financing the fixed assets. Long term sources of finance can be divided into the following two parts: 1 2. Borrowed fund Owned fund
Cost of Borrowed fund The cost of fund rose through borrowing or debt in the form of long term loan from financial institutions mainly constitutes the interest payable. Here, the debt can be either perpetual or redeemable. Cost of Perpetual debt It is the rate of return, which the lenders expect. The debt carries a certain rate of interest. The coupon interest or the market yield on debt can be said to represent an approximation of the cost of debt. Finally, the Bonds and Debentures (debt) can be issued at (i) Par (ii) Discount, and (iii) Premium. The coupon rate of interest will require adjustment to find out the true cost of debt. Symbolically, Ki = I___ SV Ki = Before cost tax of debt I = annual interest payment SV= sale proceeds of the bond / debenture Cost of Redeemable Debt In the case of calculation of cost of redeemable debt, account has to be taken, in additions to interest payments, of the repayment of the principal. When the amount of the principal is repaid in one lump-sum at the time of maturity the cost of debt would be given by solving following equation: K d = I + (F + D + Pr - Pi) / Nm (RV + SV) / 2
The higher the interest charges.5%. assumed that there is no cost involved for procuring capital from owned capital no return has to be given on it. Apart from the absence of any commitment to pay return . If benefit from that opportunity is higher than the benefit 216 RCUES. appear that capital does not carry any cost. and the corporate tax rate is 35 %. Capital. therefore. In fact.35) = 0. therefore. It would not gain any tax benefit associated with the payment of interest.. Cost of Owned Capital In case of ULBs no return is expected from the investment since it is guided by the service motive. therefore prima facie. LUCKNOW .e. It is.73% It should be noted that the tax benefit f interest deducibility would be available only when the firm is profitable and is paying taxes. the after tax cost of bond will : Kd (1-T) = 0. The before tax cost of debt. if before tax cost of bond in our example is 16. It may. But this is not true. the after tax cost of debt to the firm will be substantially less than the investor required rate of return. Kd should.1650 (1-0.1073 or 10. it is free from the risk of repayment. the lower will be the amount of tax payable by the firm. But there are other investment options available in which these funds can be invested. there is no obligation to pay a return on the fund invested by the organisation. does certainly involve a cost to the firm which is in the form of opportunity cost of capital. This implies that the government indirectly pays a part of the lenders required rate of return. like other sources of fund. what could have been accomplished with the resources expanded in the undertaking. Opportunity cost is the value of the best alternative that was not chosen in order to pursue the current endeavor i. It represents opportunities foregone. As a result of the interest tax shield.PROJECT PLANNING & IMPLEMENTATION where Kd = Cost of debt I = annual interest payment RV = Redeemable value of debt SV = Net sales proceeds from the e issue of debt Nm = Term of Debt F = Flotation cost D = discount on issue of debentures / loan Pi = Premium on issue of Debentures Pr = premium on redemption of debentures Tax Adjustment The interest paid on debt is tax deductible. be adjusted for the tax effect as follows After tax cost of Debt = Kd (1-T) Where T is the corporate tax rate. and its true cost of debt is the before tax cost. An unprofitable firm is not required to pay any taxes.
Therefore. 1 per share. fund will be invested in that opportunity. Illustration Let dividend per share of a firm is expected to be Re. respectively. In the financial decision making. the ULB has to arrange all its projects in terms of benefit derived from them and use the fund accordingly to derive maximum benefit. Because of higher risk. they expected to derive. WACC is the composite or overall cost of capital. D = Dividend to be received P = Net Amount Received THE WEIGHTED AVERAGE COST OF CAPITAL Once the components cost have been calculated. Here. a commercial organization is concerned. D is the amount of debt and E is the amount of equity. 25 the cast of equity capital will be = D P = 1 25 = 0. the cost of capital is highest among all the sources funds. the after tax cost of debt and equity.PROJECT PLANNING & IMPLEMENTATION accrued from the investment.04 or 4% Here. RCUES. LUCKNOW 217 . they are multiplied by the proportions of the respective sources of capital to obtain the weighted average cost of capital WACC). The proportions of capital must be based on target capital structure. the component costs should be the after tax costs. Conceptually. the cost of capital should be calculated on an after tax basis. Add the weighted component costs to get the WACC. then the WACC (ko) will be: Where ko is the WACC. If the market price per share is Rs. As far as. If we assume that a firm has only debt and equity in its capital structure. the cost of its capital is in the form of the return. The following steps are involved for calculating the firm’s WACC: Calculate the cost of specific sources of funds Multiply the cost of each source by its proportion in the capital structure. the cost of equity capital may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the share of the firm. obviously. Kd (1-T) and ke are.
The use of debt affects the return and risks of share holders. The change in the shareholder’s return cause by change in profits is called financial leverage. the market value per share will be maximized and the firm’s capital structure would be considering optimum.PROJECT PLANNING & IMPLEMENTATION Illustration A firm’s after tax cost of capital of the specific sources is as follows: Cost of Debt Cost of Equity Capital The following is the capital structure: Source Debt Equity Capital Amount Rs. he or she must decide when. LUCKNOW . When the e shareholder’s is maximized with given risks.134 Proportion 3 Cost (%) 4 Weighted cost (3*4) 5 8% 17% FINANCIAL DECISION Financial decision is the second important function to be performed by he financial manager.08 0. The central issue before him or her to determine the appropriate proportion of equity and debt. Debt Equity 400000 600000 1000000 Weighted Average Cost of Capital = 13. The financial manager is able to determine the best combination of debt and equity. the shareholder’s return is equal to firm’s return. In the absence of debt.0 0. he or she must raise the appropriate amount through the best available sources. loan covenants. where from and how to acquire funds to meet the firm’s investments needs.032 0.17 0. legal aspects etc. A proper balance will have to be struck between return and risks. in deciding its capital structure. 400000 Rs. In practice. but it always increase risks as well. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. a firm considers many other factors such as control. Broadly. 218 RCUES.102 0. It may increase the return on equity funds. The mix of debt and equity is known as the firm’s capital structure. 1000000 Computation of Weighted Average Cost of Capital Sources of Fund 1 Amount 2 Rs.4 % 0.6 1. The firm’s capital structure is considered optimum when the market value of shares is maximized.4 0. 600000 Rs. flexibility.
Like the debt policy. if shareholders are not indifferent to the firm’s dividend policy.Conversely. distribute a portion and retain the balance. In evaluating the profitability risk trade –off related to the level of net working capital . The term profitability used in this context is measured by profits after expenses.as idle current assets would not earn anything .risks . However. The proportion if profits distributed a dividends is called the dividend. which are generally true .It is assumed that the greater the amount of net working capital .three basis assumptions. the financial manager must determine the optimum dividend payout ratio. It is because of the fact that they have not to take any returns on the investments. Current assets management that affects a firm’s liquidity is yet another important finance function.The trade –off between these variables is that regardless of how the ULB increases its profitability through the manipulation of working capital the consequence is a corresponding increase in risk as measured by the level of net working capital. In fact. in the case of ULBs. Lack of liquidity in extreme situation can lead to the firm’s insolvency.are : RCUES.a proper trade –off must be achieved between profitability . The optimum dividend policy is one that maximizes the market value of the firm’s share.The profitability and liquidity trade –off requires that the financial manager should develop sound technique of managing current assets . there is not much importance of this function.He or she should estimate firm’s needs for current assets and make sure that funds would be made available when needed.If may become illiquid and therefore . the dividend policy should be determined in terms of its impact on the shareholders value. they are guided by service motive whose main aim is to get maximum welfare from the investment of the firm. Nature of Trade –off If an ULB wants to increase its profitability.Thus .The relationship between liquidity. But the firm may issue bonus shares. For them.But it would lose profitability . The financial manager must decide whether the firm should distribute all profits. A conflict exists between profitability and liquidity while managing current assets . net working capital and risk is such that if either net working capital or liquidity increases the firm’s risk decrease . They have not to distribute the surplus rather they have to reinvest it in other projects having large social welfare. the real benefit lies in long life period of infrastructural assets. LUCKNOW 219 . lower levels of net working capital and liquidity are associated with increasing levels of risk . Bonus shares are share issued to take the existing shareholders without any charge. The term risk is defined as the probability that a firm will become technically when they become due for payment \. Thus. The risk of becoming technically insolvent is measured using Net Working Capital .the less likely it is to become technically insolvent .the more liquid is the firm and therefore . it must also increase its risk .payout ratio and the retain portion of profits is known as the as retention ratio. The financial manager should consider the questions of dividend stability. bonus shares and cash dividends in practice. Current assets should be managed efficiently for safeguarding the firm against the risks of illiquidity.If it is to decrease risk it must decrease profitability . or retain them. Liquidity Decision Investment in current assets affects the firm’s profitability and liquidity.PROJECT PLANNING & IMPLEMENTATION Dividend Decision Dividend decision is the third major financial decision. Dividends are generally paid in cash.
the manager will select the solution which result in more profit and reject others. It is in this context that finance function are said to influence production. Scope of Financial management Sound financial management is the essential in all types of organizations whether it be profit or non-profit. An organization cannot expect to run long without making profit . The reason behind this is simple that profit is a test of economic efficiency. marketing and other functions of the firm. educationalists and public at large. Profit Maximization-As profit oxygen for any organization. Financial management optimizes the output from the given input of funds. administrators . Also. So it has to be implemented in the long term interest of the nation. even in a boom period. In case of newly started companies with the high growth rate it is more important to have sound financial management since finance an alone guarantees their survival.engineers. but that there was a mismanagement of financial affairs. Even though. which are as follows: 1. That current assets are less profitable than fixed assets . That we are dealing with a manufacturing firm. profitability and risks of the firm and ultimately value of the firm. Financial management is very important in case of non-profit organizations. 2. Specialy in case of public sector. LUCKNOW . and That shout term funds are less expensive than long term funds. profit is vague term in itself. On sum. growth. 3. In a country like India where resources are scarce and the demand for funds are many. Hence finance function may affect the size.PROJECT PLANNING & IMPLEMENTATION 1. when a co. FINANCIAL MANAGEMENT OBJECTIVES Efficient financial management requires the existence of some objectives. Its precise meaning defers from one sector to another. Only financial viability of a project is not enough to justify it commitment to project as it belongs to the whole nation and evolves huge cost. Profit maximization on the cost of social benefit may prove evil for the organization. which do not pay adequate attentions to financial management . the need of proper financial management is required. Profit maximization cannot viewed as sole objective of business.Profit maximization is the primary objective of an organization. financial decisions directly concern the firm’s decision to acquire or dispose off assets and requirements commitment or recommitment of funds on a continuous basis. 220 RCUES. Financial management is essential in a Planned Economy as well as in capitalist set up as it involves efficient use of the resources. While making a decision. make high profits there is also a fear of liquidation because of bad financial management . However a sound system of financial management has to be cultivated among bureaucrats. It provides the yardstick by which economic performance can be judged. From time to time it is observed that many firms have been liquidated not because their technology was obsolete or because their products were not in demand or their labour was not skilled and motivated.
basically infrastructural assets in public sector so that infrastructural facilities can be improved. It also ignores risk factor as profit is the counter part of risk profit and risk go hand by hand. To conclude. is required. 2.e. A profitable investment is risky too. Certain terms and condition are prepared to bind these parties. The final stage when all the parties of the project becomes agree as to a formal agreement shows the constituents. Differing closure speed reflects differences in country commitment. It also incorporate the time value of money i. government. Thus. These groups are associated with the project for their own interest .Their purposes may differ from each other. Wealth Maximization –The Wealth Maximization criterion is based the concept cash flows generated by the decisions rather than accounting profit which is the basis of the measurement of benefit in the case of profit maximization criterion.PROJECT PLANNING & IMPLEMENTATION Another difficulty in considering Profit maximization as objective of financial management is that it ignores time value of money. the term used in Wealth Maximization i. and lenders) reach a formal agreement on the fundamental business structure of the project and the underlying terms and condition of the projects financing plan. A penny held in present is more valuable than a penny receivable in future because the penny held in present can be invested in profitable ventures. When final draft becomes accepted by all. This agreement is prepared with mutual understanding Of the parties after a number of revisions. A project can not be operated solely by one of the party. Generally closure has been faster for smaller projects. But completion of the projects is necessary to fulfill these purposes. FINANCIAL CLOSURES Financial Closure is the stage in the project development cycle when the principal stakeholders (sponsors. investor experience and project size. It takes account of uncertainty of risk It considers the time value of money. so that project can be carried over smoothly. it is the financial closure. structures.In the public sector . The worth of an action can be judge only in the terms of benefit it produces less the cost of undertaking it. The value of a course of action must be viewed in terms of its work to those providing the resources necessary for its undertaking . required adjustment in the cash flow pattern in order to incorporate the risk and secondly to make an allowances for differences in the timing of benefit . cash flow precise term with definite connotation. The benefit of Wealth Maximization is in creation of assets. terms and condition of reference etc. in countries with prior ppp experience or strong political commitment RCUES. It is the fruit of joint efforts of various groups.. LUCKNOW 221 . Such an alternative is Wealth Maximization. in considering the wealth maximization as objective of financial management following benefit will occur: 1.resources generated to various means from public .. 2. an alteration of it which can overcome these shortcomings . It cannot be separated. Thus.e.thus an undertakings which reveals greater benefit to the public in large should be accepted.
Even more crucial a project might be required to meet a targeted date of commercial operation pursuant to the power purchase agreement or otherwise face the consequence of an obligation to pay damages to the purchasing utility or possible termination of the agreement . the priorities of them. if government delays are the cause rather than poorly structured or uncompetitive projects proposals. Issues in reaching Financial Closure Being such an important task. Importance of Financial Closure: This is very significant part of the project. failure to close may send negative signals about investment climate to potential investors. LUCKNOW . This stage indicates the ways in which work is being done and by whom. attempt should be made to reach these stages as soon as possible .This has taken even longer where investors . The efficiency of the financial closing process and the need to allocate risks among the lenders and the developers.Its importance is as: 1. the lender may impose financial incentives and penalties on the developer.Efforts should be made collectively from all the parties since there are various groups associated with this project. Achieving Financial Closure involves appraisal and negotiations to meet the requirement of three major parties concerned namely the government investors and lenders.All these are important for starting a project . 2.Delays have resulted from difficulties in resolving issues of risk allocation among the various participants of a project . political charges have affected government commitment and anti PPP protests were stronger than anticipated. It is here where the investment starts assuming that the disbursements of fund are met.Flexibility will often be necessary given the need to close a transaction before costs escalate often must be prepared to fund commencement of construction by a date certain on face cost escalation under the construction contract . Conversely. because it provides foundation for the commencement of the project . will depend on a large part on how the developers has structured risks and in the outcome of the due diligence taken by the lenders.lenders or government officials have been inexperienced. 222 RCUES. for example if the lender believes that additional fuel sources might be necessary for the long term operation of a cogeneration facility the lender might insist that all or a percentages of a project sponsors development fee and equity distribution be placed in a reserve account until the additional fuel sources are secured . Because unless and until this final agreement is made. Covenants and reserve accounts offer both the lender and the developer the ability to allocate risks over time as well as the flexibility to resolve risks after financial closing has occurred . in what manner .The use of the reserve accounts to address specific risk imposes on the developer sufficient incentive to resolve outstanding issues and gives protection to the lender though an ability to an ability to draw 0 the reserve to repay loans if the developer does not implement the upon solution by a certain date. If the risks in question has a direct impact on the project viability or operating margins. 3.PROJECT PLANNING & IMPLEMENTATION . Completed transactions on the other hand attract publicity and spur the interest or other investors and lenders. A dynamic “link “between transaction and policy evolution often starts. no works will be done as a part of the project.Its end is start of implementation of project.
where there is no track record of cash flows. Assessing the Market This mainly affects transport projects (ports. E. RCUES. Government Support Arrangements When PPP project are selling to or purchasing from state-owned companies .Delays can result from unrealistic expectations or the need to adapt procedures. seldom does each of the party has expertise in all the three areas . Weakness in laws relating to claim on intangible assets (such as concession agreement and other construction arrangements) and absence of efficient registers have also created problems foot loan security. While government officials . Delays have tended to be longer when a regional government entity was awarded a concession but needed a policy agreement to conclude the transaction.and where government reform will take time to improve credit worthiness . Lenders in particulars would be concerned whether debt services would be covered in the event of lower than expected volumes and traffic. Intra Government Co-ordination Several projects have been be set by delays arising from poor coordinator between different part of the government. LUCKNOW 223 . Size Large projects may take longer to close because of the need for extensive public consultation. both at the central and at the local level. of financers required and the complexity of co-coordinating numerous government agencies and technical studies.financiers may ask for government support in the from of guaranties .investors and lender may possess expertise in one or two of these fields.g. In experience Reaching financial closure requires good understandings of the project financial techniques. the large no. They therefore may require independent market assessment. may prefer more conservative projections than those of the sponsors and may also require some sponsor to cover the debt service in the event of inadequate cash flow. This may serve as amatory constraint in securing funds from lenders.which are in the best of financial health . roads. Tenders Security It is often difficult for lenders to establish mortgage claim over the physical assets of a project. airports and mass transit) and new investments. railroads.While such guarantees can help in the starting if PPP projects.: Delays in determining the availability and the kind of government support have affected India‘s power programs. They may at the time be politically controversial. infrastructure regulation and country risks.PROJECT PLANNING & IMPLEMENTATION There are several issues that can delay the projects these are. Legal Frameworks Inadequate legal infrastructure has contributed to delay in achieving financial closure in many projects.
unless there is a Bank Overdraft. Due to this a dynamic “link” between the transaction and policy evolutions often starts. Advantages of Financial Closure It indicates the ways in which work is being done and by whom. Therefore successful closure also implies that an infrastructure project has been made bankable after a rigorous project development process. Completed transactions attract publicity and spur the interest or other investors and lenders. whether of a revenue or a capital nature are included.. In a power generation project this can be important particularly. The balance of Receipts and Payments Account must be debit. It starts with the opening Cash and Bank Balances. The regularly Regime of Tariff This has been a major in several sectors particularly in water projects. Some distinct features are: It is an abbreviated copy of the Cash Book. shows all types of collections and payments during the period and closing Cash and Bank balances. similarly negotiation on the level of road tolls have also delayed closures on some road projects. Receipt and Payments Receipt and payment account is the Cash summary for a particular period. bridges etc. Income and Expenditure Income and Expenditure Account is similar to Profit & Loss A/c. Financial closure for an infrastructure projects draws the project development to a close. Land Development Rights This can be important factor for projects relating to roads.g. It is here where the investment start assuming that the disbursement of funds are met. All receipts and payments. usually merging Cash and Bank items. being cash in hand and at Bank. LUCKNOW . For e. in what manner. contras between Cash and Bank are eliminated. where tariff tend to below cost and adjustment has a high political profile.PROJECT PLANNING & IMPLEMENTATION Apart from the above listed factors there are also certain sector specific issues: Inter-connection rights forward & backward Linkages Some projects get delayed because state ownered operator takes a long time to negotiate the inter connection rights with the private entrants. where fuel is being supplied by one state ownered co. and power is being purchase by another and therefore the linkages need to be tied up before power is generated. 224 RCUES.
expenses.II RCUES. If the expenditure is higher than income it is designed as deficit or Excess of Expenditure over Income. The amount refundable in respect of a specific grant related to revenue is applied first against any unamortized deferred credit remaining in respect of the grant. Refund Of Specific Grant Specific grants sometimes become refundable because certain conditions are not fulfilled. Where a grant which is in the nature of promoter’s contribution becomes refundable. grants etc. the excess is shown as surplus or Excess of Income over Expenditure. the relevant amount recoverable by the granting agency is reduced from the capital reserve. Expenditure includes salaries. A specific grant that becomes refundable is treated as an extraordinary item.PROJECT PLANNING & IMPLEMENTATION Income includes fees. * Case Study attached as Annexure. depreciation etc. Non Cash items e. sports expenses etc. in part or in full. honorarium.g. subscriptions. The amount refundable in respect of a specific grant related to a specific fixed asset is recorded by increasing the book value of the asset or by reducing the capital reserve or the differed income balance. LUCKNOW 225 . If Income is higher than expenditure. to the government or non-fulfillment of some specified conditions. Is also brought into account. as appropriate by the amount refundable. Only items of revenue nature pertaining to the period of account are included therein. The preparation of account requires adjustment in relevant accounts of outstanding income and expenditure as also exclusion of amounts paid in advance before these are included in Income & Expenditure Account. donations. entertainment.
Hence a budget code is defined as a combination of budget centre and account code. surplus/deficit under the various Receipt and payment head.In other terms budget is an organizational plan stated in monetary terms. three broad categories of Budgeting Centers are defined. Budget shall reflect the principles and programs of the ULB. Budgeting Process: Budget shall reflect the estimated inflows. It is advisable to have the budgets whether 226 RCUES. The receipt and payment shall be estimated for each of the accounting subjects under every budgeting centre. revenue expenditure. Budgets shall establish a close linkage between the Accounting subjects (nature of receipts and payments) and The function The functionary as identifiable of personnel responsible for any function The field as identifiable by the geographical boundaries over which the cost is incurred.4. major heads minor heads. capital receipts and capital expenditure.PROJECT PLANNING & IMPLEMENTATION SUB MODULE-3. Public expenditure must be spent in the most productive way. LUCKNOW .2 FINANCIAL MANAGEMENT PROJECT BUDGETING Budget generally refers to a list of all planned expenses and revenues . opening and closing balances. Budget must also enable ULB in measuring and promoting accountability in respect of service delivery. Decentralize planning which citizens participation facilitates in achieving this objective. outflows. while executing actions to meet the goals is the directing function of management. Establishing specific targets for future operations is part of the planning function of management. 2 APPROACH TO BUDGETING The objective of the budgeting system of an ULB is to arrive at a scientific basis for building linkage between the nature of receipts and payments with the function/ services or other budget control centers. are mandatory. To facilitates this. Any receipt payment shall reflect the above said objectives. The budget shall be prepared for each of the revenue and capital account heads This form is to be prepared by individual budgeting units for each of the major and minor heads of account along with the details of the functions and functionaries functionary. Objectives of Budgeting: 1 The process of budgeting is initiated with the establishments of specific targets of performance and is followed by executing plans to achieve such desired goals and from time to time comparing actual results with the targets of performances/ goals. The receipt and payment shall classified under four broad heads revenue receipts.
The budgeting activity for any financial year shall commence by September or any other month (as may be specified in the State Laws or acts governing the ULB) of the financial year preceding it. The State laws or Act governing the ULBs may define the circumstances for revision of budgets. The various stages of budget preparation and approval should be within the time limits as stipulated in the regard by the relevant State Laws/ Acts governing the ULBs. The approving authority may be the Municipal Councils. the following control requirements are to be built into the budgeting system: No expenditure can be incurred unless backed by a budget. LUCKNOW 227 . Some of the forms in which budget allocations are changed are Re-appropriation.PROJECT PLANNING & IMPLEMENTATION budget would be prepared at the field level like zones. In the term. A budget may not be a valid document unless it is properly approved /authorized by an approving authority. RCUES. Bottom up Budgeting The basic for preparing the budget will be the inputs from various departments/units. Budgeting Calendar The budget preparatory process follows a budget calendar. if the state and ULB maintain separate fund wise only. Budget Utilization should be reviewed at quarterly and such other periodic rests as may be determined by State / Act to identify and plan for any budgetary revision well in advance would be in accordance with the provisions laid out in this regard by the State /Act in this regard. APPROVAL OF BUDGET The Budget is the key document of any governmental set up. reduction on Budget and Budget Cut. BUDGET REVISION Once a budget has been prepared subsequent revisions to the amount budgeted may arise. ULBs are advice to move towards decentralizes budgeting at the field level. circles or wards. The “budget calendar” provides various details of dead lines dated by various officials in the ULB need to prepare and place the budget before the concerned authorities. BUDGETARY CONTROLS In keeping with the objectives. Estimates shall be made from the lowest unit and then consolidated at the head office. The budgets heads are hence are integrated with the account head. Generally in the cases of ULBs. The time schedule for preparation. placing and revision of the budget and budget approval by Standing Committee/ Councils would be governed by the provisions of the state laws of acts governing the ULBs. In addition. The State Laws or governing Acts shall define shall define the approving authority for approval of the budgets of the ULBs. Additional Budget. The accounting system can hence provide details actual against each budget heads. Any expenditure prior to being incurred must be identified to its budget head for allocation of money. Budget preparation shall be based on bottom up approach.
its financial structure (including its liquidity and solvency). Fund Flow Management in a Project: Information about the cash flows of a project is useful in providing users of financial statements with a basis to assess the ability of the urban local body to generate cash and cash equivalents and the need of the project to utilize those cash flows.PROJECT PLANNING & IMPLEMENTATION Any expenditure prior to being incurred should be backed by appropriate sanctions (administrative / technical sanctions as the case may be) in accordance with the procedures lay down by the State /Act in this regards. and the policy or policies that might be adopted for achievement of these ends. LUCKNOW . Cash and Cash Equivalents: Cash equivalents are held for the purpose of meeting short term cash commitments rather than for investment or other purpose. to provide it with aid for making. Salient Features of Budgetary Control Determining the objectives to be achieved. when used in conjunction with the other financial statements provides information that enables users to evaluate the changes in net assets of an urban local body. Laying out a system of comparison of actual performance by each person. over the budget period. Staff co-operation is usually not available during budgetary control exercise. For an investment to qualify as cash equivalent it must be readily convertible to known amount of cash and be subject to an insignificant risk of changes in value. Budgets cannot be executed automatically. 228 RCUES. Budgets are considered as rigid document. for the revision of the plan. Investing and Financing activities. The statement classifies the cash flows during the period from Operating. Benefits of cash flows: A cash flow statement. if any. Its implementation is quite expensive. Drawing up a plan or a scheme of operation in respect of each class of activity. Limitations of Budgetary Control System Budgets may or may not be true. section or department with relevant budget and determination of causes for the discrepancies. Determining the variety of activities that should be undertaken for the achievement of the objectives. Ensuring that corrective action will be taken where the plan is not being achieved and. estimating and planning for the future and to facilitate the analysis of the variation between estimated an actual performance. if that be not possible. It is a system to assist management in the allocation of responsibility and authority. as they are based on estimates. in physical as well as monetary terms for the full budget period and its parts.
investing and financing activities. (Mobilization advance.) Financing Activities: The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the ULB’s. Information about the cash flows of an enterprise is useful in providing users of financial statements with a basis to assess the ability of the enterprise to generate cash & cash equivalents and the needs of the enterprise to utilize those cash flows. Therefore they generally results from the transactions and other events that enter into the determination of net profit or loss. Cash flows exclude movements between items that constitute cash or cash equivalents because these components are part of cash management of an enterprise rather than part of its operating. 3. it must be readily convertible to a know amount of cash and be subject to an insignificant risk of changes in value. Reporting Cash Flows from Financing and Investing Activities An ULB should report separately major classes of gross cash receipts and gross cash payments arising from investing and financing activities. Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the enterprise. Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. PROJECT’S CASH FLOW STATEMENT 1. An investment normally qualifies as a cash equivalent only when it has a short maturity of. construction tools/ plants etc. say. 3 months or less from the date of acquisition.PROJECT PLANNING & IMPLEMENTATION An enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented. (Procurement of raw material. LUCKNOW 229 . Cash management includes the investment of excess cash in cash equivalents. The statement deals with the provision of information about the historical changes in cash & cash equivalents of an enterprise by means of cash flow statement which classifies cash flows during the period from operating. except to the extend that cash flows are reported on a net basis RCUES. For an investment to qualify as a cash equivalent. Operating Activities: The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flow to maintain the operating capability of the enterprise. investing and financing activities. Investing Activities: The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which the expenditures have been made for resources intended to generate future income and cash flows. advance payments against railway receipts for material used in construction) 2. repay loans and make new investments without recourse to external sources of financing.
Three types of explanation of Cost Overrun exist: 1. However for this purpose. and the maturities are short. an eye-sight of the project work should be made on a regular basis so that any deviation can be found from its inception point. in advance. “or “budget overrun. Daily. The evaluation of work done against these standards reveals the deviations. which should be removed in time. To remove avoidable delay. These standards must be sets with a high degree of cautious because a minor degree of defect may impact overall cost of the project. investing or financing activities may be reported on a net basis: a b Cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the enterprise. its monitoring is also necessary unless a regular watch on the project is made it timely a regular watch on the project is uncertain. submitted by there work manager. the Sydney Opera House with 1400%. RCUES. weekly And monthly report helps to monitor the outcome of the project. and overrun had been constant for the 70 years for which the data were available. Technical explanations account for Cost Overrun in terms of imperfect forecasting techniques. so that. etc. a standard of work done has to be prepared against which actual work can be measured. overrun was found in each of 20 nations and five continents covered by the study. and Cash receipts and payments of items in which the turnover is quick. These help us to detect the errors as and when they occur so that corrective measures can be taken timely. This estimate helps the project manager to make a management for additional resources.PROJECT PLANNING & IMPLEMENTATION Reporting Cash Flows on a Net Basis Cash flows arising from the following operating. Thus. Spectacular examples of Cost Overrun are the Suez Canal with 1900 %. COST OVER-RUN. One of the most comprehensive studies of Cost Overrun that exists found that 9 out of 10 projects had overrun. a project manager can make the estimates about the time and resources required to complete the remaining work. 50 to 100 % were common. These certificates state the amount of the work done as well as the amount of the resources released on the work. that the project work may not be hurdled. Evaluation of work done can be made through completion certificate and utilization certificates. and technology projects. inadequate data. It provides benefit in order of time as well as money. LUCKNOW 230 . Cost Overrun is also sometimes called “ cost escalation. and the Concorde supersonic aero plane with 1100%. Timely detection of deviations helps in taking timely corrective measures.” “cost increase.” Cost Overrun is common in infrastructure. the amounts are large. Thus. it avoids not only delay in completion but also the cost incurred in the project. Detection of defect at its earlier stage helps in maintaining quality as well as quantity of work of a project. building. Cost Overrun Defined as access of actual cost over budget. MONITORING AND MANAGING LEAKAGES. Monitoring and Managing Leakages After implementation of a project.
3. Either as a percentage. LUCKNOW 231 . the difference is known as yield variance. and consequently the standard loss of material can be readily computed. Psychological explanations account for overrun in terms of optimism bias with forecasters.volume etc. Types Of Variances Material Labour Overhead Material Material Usage Variance arises due to variations in the quantity of materials consumed when compared with what should have been consumed as per the established standards.5.weight.PROJECT PLANNING & IMPLEMENTATION 2. if the budget for building a new bridge was Rs. actual cost divided by budgeted cost. Yield Variance : In some industries the finished product can be related to the raw material input in terms of units. Un-controllable: These are the variances which are beyond the control of departmental heads. mainly actual cost minus budgeted cost. Controllable: These are the variances which can be controlled by the departmental heads. a variance arises. Or as a ratio. Labour Labour efficiency variance measures the efficiency of labour by identifying the difference between the actual hours worked and the hours which should have been worked as per the established standards. Example: Price increase is due to fluctuations of prices in the market. political economic explanations see overrun as the result of strategic misrepresentation of budgets. Cost Overrun is typically calculated in one of the two ways. 2. Mix Variance: If two or more materials are mixed in a process. an optimum or standard mixture is decided upon by the production planning department.If actual mix is different from the standard mix . Material Price Variance arises due to differences between the planned and the actual material prices paid to the suppliers. For example. Types of Variances: 1. viz. Labour Rate Variance measures the deviations in the actual rate of pay and the ones estimated.When the standard yield is given and the actual consumption deviates from standard consumption. This relationship is known as the yield . Finally. Example: If the production controller has failed to place orders in time and extra payment has been made for it.150 million then the Cost Overrun may be expressed as 50% or by the ratio 1. RCUES. in percent of budgeted cost.100 million and the actual cost was Rs.
They can be broadly classified into: Variable Overhead Variances: These variances arise due to the difference between the standard variable overhead for actual output and the actual variable overhead. For and cost control measures identified . Positive variance shall be analyzed for reasons. At each of the Budgeting centers.The reasons for the same can be analyzed and replicated. shall be analyzed for reasons.For instance the increase in maintenance expenses or finance charges could indicate lack of planning or implementation follow-up .PROJECT PLANNING & IMPLEMENTATION Overhead Overhead variances arise due to the difference between actual overheads and absorbed overheads. Expenditure Variance It represents the difference between the fixed overheads as per budget and the actual fixed overheads incurred. We can understand all these budgeting process by taking a fiduciary illustration –for preparing budget 232 RCUES. They can be further classified into: Variable Overhead Budget or Expenditure Variance Variable Overhead Efficiency Variance Fixed Overhead Variances : It can be divided into two parts 1. the variance is favorable and vice versa. Negative variance. Volume Variance It arises mainly because of the use of pre-determined overhead recovery rate based on a normal volume of activity and of the activity being less or more than normal volume so selected BUDGET VARIANCE REPORT (BVR) An important budgetary control tool used for monitoring and measurement is Budget variance report (BVR) and shall be prepared at the following levels: At an overall ULB level. 2. The BVR should be prepared on a monthly basis or such periods as the State laws/Acts governing the ULB may define .Review mechanisms for disposing of the unfavorable variances would add value to the Management of ULB. LUCKNOW . If the standard variable overhead exceeds the actual variable overhead. The BVR forms the bases of control as it can provide information on: a. For instance actual tax collection is more than the projected say in ward or a Zone . b.
Similarly amount for expenditure is also collected . data collected supported by necessary table. This information collected from different Zones is consolidated at Head Office for ultimate preparation of Budget. Depending upon the terms & conditions both the certificates must be issued but a designated authority. methods adopted. PROJECT COMPLETION REPORT 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) 14) 15) Name of the project: Name of the project head: Implementing agency and other collaborating agency: Date of commencement: Planned date of Completion: Actual date of completion: Objectives as stated in the project proposal: Deviation made from original objectives if any. diagrams. LUCKNOW .PROJECT PLANNING & IMPLEMENTATION estimates of any financial Year data have to collect from the lowest unit of ULB. It reveals the stage of completion of the work on the basis of which the payments to the contractors has to made. Within the stipulated time schedule all units are required to submit their estimations. while implementing projects and reasons thereof: Experimental work giving full details of experimental set up. a time schedule is also made for completion of different aspects of Budge. if any Financial Position: 233 future work: RCUES. rent etc. design & photographs: Detailed analysis of results indicating contributions made towards successful completion of the project: Conclusions summarizing the achievements and indication of scope for S & T benefits accrued: Manpower trained on the project Patents taken.In all these process. Thus a completion certificates is not important only for the project manager but is equally useful for the contactor. When payment is made payment certificates is made to provide an authenticated proof of the payment made. is collected ward wise . A detailed estimate of revenue likely to be collected from differences sources such as tax. These certificates help the project manager to identify the progress of work. charts. WORK COMPLETION AND PAYMENT CERTIFICATES All the projects have a Work completion certificates & payment certificates as an essential part of it.
______________________ (Project Engineer) Work Certified In large contracts it is usual for the contractor to obtain sums time to time from the contractee. Name of Equipment Make/ model Cost (FE/Rs) Cite of installation Utilization Rate (%) Remarks regarding maintenance/ breakdown b) Plans for utilizing the equipment facilities in future Name and Signature with Date a.PROJECT PLANNING & IMPLEMENTATION No. ______________________ (Projects head) b.The contractor will get money according to this certificate. the surveyor appointed by the contractee issues certificates to the effect that to so much portion has been completed . Procurement/ usage of Equipment a) S no. Mathematically: Cost of Work Certified=Cost of work to date – (Cost of work uncertified+ Material in hand + Plant at site) 234 RCUES. LUCKNOW . As the work proceeds. I II III IV V VI VII Financial position/ budget head Salaries/ Manpower costs Equipments Supplies & materials Contingencies Travel Overhead expenses Others if any Total Funds sanctioned Expenditures % of total cost 100% 1.
RCUES. Plant in site. The proportion that contract costs incurred for work performed upto the reporting date bear to estimated total contract costs.III) _____ _____ _____ ____ ____ Retention Money & Progress Payments Retention are amounts of progress billings which are not paid until the satisfaction of conditions specified in the contract for the payment of such amounts or until defects have been rectified. * Format of Utilization Certificate attached as Annexure . the value of the work –in-progress consists of: The cost of work completed both certified and uncertified The cost of work not yet completed . Completion of a physical proportion of the contract work. Work-In –Progress In contract accounts. The cost of work uncertified may be ascertained as follows: Rs. Total costs to date LESS: Costs of work certified Material in hand. LUCKNOW 235 . Contractee retains some amount (say 10% to 20%) to be paid. Progress billings are amount billed for work performed on a contract whether or not they have been paid by the customer. Cost of work uncertified.It is always shown at cost price.PROJECT PLANNING & IMPLEMENTATION Work Uncertified It represents the cost of the work which has been carried out by the contractor but not has been certified by the contratee’s architect . and The amount of profit taken as credit. Retention money provides a safeguard against the risk due to faulty workmanship. after some time when it is ensured that there is no fault in the work carried out by the contractor. Determination of Stage of Completion The enterprise can uses the method that measures reliably the work performed depending on the nature of the contract: Surveys or work performed.
LUCKNOW . Project accounting is commonly used at Government Contractors. We have to 236 RCUES. and The amount of retentions. A movie studio will employ production accounting to track the costs of its many separate projects. Standard accounting is primarily aimed at monitoring financial progress of organizational elements (geographical or functional departments. PROJECT ACCOUNTING Project accounting (sometimes referred to as job cost accounting) is the practice of creating financial reports specifically designed to track the financial progress of projects. months. The capital budget processes of corporations and governments are chiefly concerned with major investment projects that typically have upfront costs and other longer term benefits. Funding advances and actual to budget costs variances are calculated using the project budget adjusted to % of completion. Project accounting permits reporting at any such level that has been defined. Project accounting of the costs and benefits can provide crucially important feed back on the quality of these important decisions. Consequently .PROJECT PLANNING & IMPLEMENTATION Disclosure An enterprise should disclose the following for contracts in progress at the reporting date: The aggregate amount of costs incurred and recognized profits (less unrecognized losses) upto the reporting date. They may also be one of a number of projects that make up a larger overall project or program. or CLIN) is usually a requirement for interim payments. Where labour costs are a significant portion of overall cost project. Investments go/ no –go decisions are largely based on Net Present Value (NPV) assessments. divisions and the enterprise as a whole) over defined time periods (typically weeks. and often allows comparison with historical as well as current budgets. To maintain accounts for a project is a different aspect as a project is not a going concern and has a limited period. may last for anything from a few days or weeks to a number of years. which can then be used by the managers to aid project management.in a project management environment costs (both direct and overhead) and revenues are also allocated to projects. Percentage of completion is frequently independently assessed by a project manager. it is usually necessary for employees to fill out a time sheet in order to generate the data to allocate the project costs. An interesting specialized form of project accounting is production accounting. which may be sub-divided into a work break down structure. which tracks the costs of individual movie and television episode film production costs. A real estimate of project can be made only when proper accounts maintained for the work done. during which time budgets may also be revised many times. and grouped together into project hierarchies. where the ability to account for costs by contracts (and sometimes contract lying item. quarters and years) Projects differ in that they frequently cross organizational boundaries. The amount of advances received .
The government prefers to give project on costs plus basis Fixed Price Project: It is rather a project in which the projector agrees a fixed price for the project. A comparative evaluation may be made of both methods and suitable method may be selected accordingly. While making estimates of total project costs. claims and incentive payments. LUCKNOW 237 . Whatever method is selected. Completed Contract Method: . and they are capable of being reliably measured for a change in the scope of work to be performed under the contract. provision is made for entire loss on the project irrespective of the stage of completion of project. Project Revenue It should comprise: The initial amount of revenue agreed in the contract and Variation in contract work. RCUES. This may lead to an increase or decrease in contract revenue. To the extend that it is probable that they will result in revenue. Thus it reduces the risk of recognition of unrealized profit. Accounts should be maintained project vise so that the financial result of each project can be found separately. the main objective of preparing accounts for the project is to know its Profit or Loss i. revenue is recognised only when the contract is completed. An escalation clause should also propose in respect of contingent losses uncertainties. Accounting principles and policies can be taken into consideration for its preparation. difference between the project revenue and project costs. It is generally adopted in those cases where the probable cost of project cannot be completed in advance with a project cannot be completed in advance with a reasonable degree of certainty. The project manager may use both methods simultaneously for different projects depending circumstances. The accounting methods for maintenance of accounts are generally of two types: Percentage of Completion Method:-Under this method revenue is recognised with reference to stage of completion of the project at the end of each period and expenditure as well.PROJECT PLANNING & IMPLEMENTATION make closing of accounts at the vary point the project is completed. Besides following accounting convention should be considered: Convention of consistency Convention of full disclosure Convention of conservatism and prudence Convention of materiality Projects may be of two types Cost plus project is a project in which the value of project is ascertained by adding a certain percentage of profit over the total cost of the work.under this method.e. its revenues indicate a loss.
Research and development costs for which reimbursement is not specified in the contract. Costs of material used in construction. including site supervision. Costs of design and technical assistance that is directly related to the contract. However. costs that relate directly to a contract and which are incurred in securing the contract are also included as a part of the contract costs. Costs of moving plant. Costs specifically chargeable to the customer under the terms of contract Costs that are attributable to contract activity in general and can be allocated to the contract. Selling costs. including expected warranty costs. Contract Costs Contract costs should compromise: Costs that relate directly to a specific contract . for example errors in specification or design and disputed variation in contract work. and Claims from third parties. Costs That Can Not Be Allocated and Attributed to a Contract activity or cannot be allocated to a contract are excluded from the costs of a construction contract. equipment and materials to and from the contract site. LUCKNOW . Such costs include: General administration costs for which reimbursement is not specified in the contract. and Depreciation of idle plant and equipment that is not used on a particular contract. A claim may be arising from. and Costs Directly Related To a Specific Contract Site labour costs. Costs of hiring plant and equipment. Costs that are specifically chargeable to the customer under the terms of the contract may include some general administration costs and development costs for which reimbursement is specified in the terms of the contract. The estimated costs of rectification and guarantee work. Depreciation of plant and equipment used on the contract. Contract costs include the costs attributable to a contract for the period from the date of securing the contract to the final completion of the contract. 238 RCUES. Incentive payable is additional amount payable to the project developer specified performance standards are met or exceeded.PROJECT PLANNING & IMPLEMENTATION A claim is an amount that contract seeks to collect as reimbursement for costs not included in contract price from any party. Costs Attributable to Contract Activity In General and can be allocated to specific contracts include: Insurance Costs of design and technical assistance that is not directly related to a specific contract and Construction overheads.
2. balance with banks can be verified by obtaining written statements from competent parties. 3. Physical Verification Direct examination. 1. inspection or counting is a strong evidence of the existence of tangible assets. It does not prove ownership of assets since mere existence is not indication of ownership. bills receivables.The basic elements of auditing are: Collection of evidences Evaluation of Audit Evidence Formation of judgment Collection of Evidence Evidence includes all influences of an auditor. In this process. and all other documents which are created as various transactions take place.Basically auditing is concerned with the verification and examination of quantitative information. The auditors examine and report on economic information relating to organizations in which millions of people have a stake. provided that the party is competent to make such a statement.Audit is a mean to find out frauds and errors and indicate the way in which corrective actions have to be taken in advance so as to avoid re-occurrence of such frauds. cash. The audit work should be planned properly in advance . if an auditor counts the cash in hand on a surprise visit.however there are following limitations: Such evidences can not be used for each type of checking. Sundry creditors.memos. LUCKNOW 239 . Authorities documents These constitutes the main source of evidence available to man auditor. an auditor collects and evaluates evidences to establish facts and to draw conclusions and inferences. The project carried by Government should be audited periodically in order to check the efficiency status of the work . cancelled cheques . Statement s by independent & competent parties provides highly evidence to the auditor. which affect his judgment about the truthfulness of propositions summated to him for review . Audit has been conceived to provide a highly useful technical service to the economy to know performances in financial and other appropriate terms in a reliable manner. For example. its auditing is equally necessary as auditing reveals the financial frauds and errors. Authoritative documents include purchase invoices. RCUES. it would constitute a good evidence to sup[port the existence of cash . it is necessary to keep check on it .PROJECT PLANNING & IMPLEMENTATION Auditing is a specialized function having complex legal economic and ethical implications.As these projects are large enough and huge amount is invested in it. Statement by independent third parties An auditor can have strong evidence if an independent party makes a written or oral statement in support of certain facts. With proper accounting projects.
6. For proper control over the work . etc. provide supporting evidence to the auditor that the main data supported by such records are reliable. Calculation by the auditor The assertions regarding mathematical accuracy can be supported best by recalculation of amounts by the auditor.By valuing it at average cost .Yet.in many cases it may be quite useful since some explanations and affirmations can be provided only by the officers and employees of the enterprise under the audit.Most of these events are not accessible to observation . Consequently. on the statement by officers and employees of the enterprise under audit. accounting data can be interrelated with other data . an auditor should question and evaluation the evidence carefully. on the basis of valid evidence collected by the auditor.this quantity can be roughly to the total cost of raw material consumed as shown in the accounting statements.Sufficiency refers to the quantum of audit evidence obtained . Interrelationship with other data Often. Subsequent actions by the enterprise under audit and others An auditor can find evidence for a no. Evaluation of raw audit Evidence Having collected the evidence .the production records show the quantity of raw material consumed . This evidence is not as the statements made by independent parties. the reliability of the data generated but such records increases. 8. maintained properly and without any prima facie indications of irregularity.internal control system should also be developed by the project promoter 240 RCUES. 5. 9. A satisfactory internal control system provides assurance to the auditor that the records are reliable.PROJECT PLANNING & IMPLEMENTATION 4.For example .Appropriateness relates to its relevance and reliability . For this purposes he should find evidence which assures a reasonable and competent man that the accounting data under report fairly represent the reality as for as it can be determined.the auditor should evaluate it critically with regard to its sufficiency and appropriateness . LUCKNOW . of assertions in certain actions and events taking place after the balance sheet date . Statement by officers and employees of the enterprises under audit In the absence of auspicious circumstances.Only inference can be drawn about them from testimony and intuition . Satisfactory internal control system By evaluating the internal control system an auditor can determine the degree of reliance that he can place on the various system and procedures.Such events and action gives the auditors the advantages of hindsight. finished stock ledger.An auditor has to use evidence to support events which have happened primarily in the past . Formation of Judgment: The last phase is to from an opinion on the various assertions.The Subsequent realization of sundry debtors is evidence regarding the reliability of such debtors on the Balance sheet date . 7.Hence. Subsidiary or Detailed Records with no significant Indications of Irregularity Subsidiary or detailed records such as stores ledger.. an auditor can rely to some extent.
it determine the checkpoints where loopholes can be expected as well as the procedures which should be carried to conduct audit.it is not possible for an auditor to check each and every aspect .) The template is organized into following phases. Internal Audit When the work of audit is got carried by the management itself . Internal controls can be applied by two methods 1. (Milestone. management oversight will be strengthened by internal audit reports . the project plan must include detailed tasks. Schedules and Fees Phase 2 Pre audit view by Management.his audit process should be under intense security. The employees should also be rotated period wise. The templates are observed on a Phased methodology which uses phase completion mile stone as a mechanism for reporting.The Internal auditor will assess the operation of the project financial management system and will review internal control mechanism. 2. 1.As the volume of work is increasing . roles and responsibility and critical dependencies as well as draw attention to check point meeting and critical target dates. Whether the auditors are an outside auditors or part of the Internal Audit Team . Specially designed audit templates for projects The objective of this template is to identify & correlate the activities required for an audit preparation process. The template is organized into following phase’s methodology which uses phase completion mile stone as a mechanism for reporting.PROJECT PLANNING & IMPLEMENTATION because it has a great effect on the work of audit as. The auditor can also mark any task of any duration as a milestone. LUCKNOW 241 . Audit Developments Recent Corporate accounting and financial scandals have led to sweeping regulatory changes –and dramatically increases audit requirements. 2.it is known as internal audit . Any task with zero duration is automatically displayed as a mile stone. Issues arising in the external and internal audits would need to be promptly addressed and acted upon in a timely manner by the project authorities. Internal checks Internal Audit Internal checks Internal checks are operated when the work is divided among employees so that work done by one is automatically checked by others. Internal Staff and Audit Firm Phase 3 Implementation of Pre Audit Preview Phase 4 Final Audit Performances RCUES. To be effective. Auditing Process. Phase 1 Identification of AUDIT firm Related Matters. A reference point making a major event in a project and used to monitor the project progresses.In such situation internal auditor helps a lot as on auditors now can concentrate only on the point reported in the internal auditors report .Considering the large size of the operation and multiplicity of spending units.
on occurrence of claims and obligation in respect of incomes or expenditures. There are two system for recording transaction Single entry Accounting System Under single entry accounting system some transactions are not recorded at all. For this purpose a Task Force was constituted by Comptroller and Auditor General of India (CAG) to recommend budget and accounting formats for Urban Local Bodies (ULBs) in India. Significant accounting principles to be followed by the ULBs shall be given as a separate schedule forming part of the accounts. in response to a writ petition before it. A transaction involves transfer of money or money’s worth (Goods or services) from one person to another. The Hon’ble Court also stated that necessary amendments to the regulations be carried out by the Government of India. Primary Schools & Hospitals. etc. be adopted by all the ULBs and presented as supplementary information.. i. Double entry Accounting System Double entry Accounting system recognizes the fundamental fact that a transaction is double sided affairs that is both the debit and credit aspects of the transaction is recorded. while some transactions are recorded in only one of their aspects-either debit aspect or credit aspect. Budget formats with codification need to be adopted uniformly by all ULBs. assets or liabilities based on happening 242 RCUES. A transaction may be defined as the actions and reactions having monetary implications of one person to another person. Accrual System of Accounting Accrual System of Accounting means a method of recording financial transactions based on accrual. Suggested formats for determining the cost of important utilities and services like Water Supply. The CAG Task Force had issued a ‘Report on Accounting and Budget Formats for ULBs’. Following recommendations were made by the Task Force: The ULBs should uniformly follow the suggested formats for presentation of annual financial statements.e. LUCKNOW .PROJECT PLANNING & IMPLEMENTATION Accrual Based Double Entry Accounting System Statutory Mandate For Accrual Based Double Entry Accounting System :In the year 2001. Double entry Accounting System: A systematic record of the daily event of a entity leading to presentation of a complete & true financial pictures is known as accounting. a Bench of the Hon’ble Supreme Court of India ordered that the Municipal Corporation of Delhi and the New Municipal Corporation “will be required to maintain accounts as per the mercantile system of accounting”.
the statements of Income & Expenditure for 2006-07 will not give the correct position of profit/loss or surplus/deficit. 7. Expenditure is recognised as and when the liability for payment arises and thus it constitutes both amount paid & payable. Now if the Expenses of Rent and Income from property tax for the current year 2006-07 are not recorded in books of accounts. etc. 3. to Mar. On 31st March 2007 when books of accounts are being closed. This helps in correct presentation of financial statement .for the period Jan. 10. 2. diminution in values(depreciation). Revenue is recognized as it is earned and thus “Income” constitutes both revenue received and receivable. 6. the Receipt & Payment Account. BENEFITS OF ACCRUAL SYSTEM OF ACCOUNTING 1. even though actual receipts or payments of money may not have taken place.has not been paid and property tax amounting Rs. It assists in effective follow up of the receivables by the municipal body and proper ascertainment of payables by the municipal bodies.. The surplus or deficit as shown at the year end represents the correct Financial position of the ULB arising out of the various transaction during the year. passage of time.000/.PROJECT PLANNING & IMPLEMENTATION of any event. it is found that rent for the month of March’07 Rs. A distinct difference is maintained between items of revenue nature and capital nature .5. 8.has not been received. 4. Ease in financial appraisals by the financial institutions. LUCKNOW . * RCUES.2. viz . For Case Study on DEAS refer annexure-4 243 5. an entry for both transactions has to be recorded on the accrual basis by creating liability for rent and receivable for property tax. decision making and control at each level of management.’07. right quality and nature of information for planning. It facilitates proper financial analysis and reporting. fulfillment (partially or fully) of contracts. It presents a true picture of the financial position of an ULB and helps in better financial management. which is a pre-requisite for mobilizing funds in the financial markets through debts instruments.000/. It also facilitates credit rating through approved credit rating agencies. It helps in providing timely. 9. Therefore. the Income and Expenditure statement and the Balance Sheet. Expenses are matched with the income earned in the financial year. Lets Take An Example: A ULB prepares its annual accounts for the period 1st April to 31st March.60.00. rendering of services.
75% Improve ment of city roads Water supply project LAA-(SO) Octroi from four octroi collection points City road project A (SO) Water supply and sanitation project AA-(SO) Purpose A(SO) AA-(SO) Rating ANNEXURE . million) Placement Guarantee Interest Escrow 100 1000 Private Private Yes No MUNICIPAL BONDS 13% 14.PROJECT PLANNING & IMPLEMENTATION 244 Indore 500 Private No 13% Property tax and water charges Water & sewerage taxes and charges Water supply and sanitation project LAA-(SO) City roads. street drains A-(SO) State government grants and property tax 13.1 RCUES.5% to 14% 14% Ahmadabad 1000 Public & No 14% No State government 13% No Private Private Public & Private 100 1250 1000 Nasik Nagpur Ludhiana Bangalore Ahmadabad City Amount (in Rs. LUCKNOW .
5% Nonresidential Property taxes. Water supply and Sanitation projects in 14 ULBs No Private 825 1000 Private No 9% Hyderabad (tax free) Ahmadabad (tax free) Property taxes of two zones Source (Financing Municipal Services – Reaching out to Capital Markets) AA-(SO) Road construction and widening ANNEXURE . etc. Profession tax. 8.2 PROJECT PLANNING & IMPLEMENTATION 245 . LUCKNOW Tamil Nadu (pooled 110 Private * 9.20% Monthly Payments equal to one-ninth of their annual Payments.RCUES. Advertisement tax.
There are around 9 control rooms spread all over the city for redressal of complaints regarding thestreet lights. LUCKNOW . including cost of material and establishment. Payment by the corporation is based on the maintenance of each tube light. The whole process was too lengthy and cumbersome. it has around 62. Description of the Initiative The Jaipur Municipal Corporation decided to privatize maintenance of street lights and issue contracts ward wise. The cost of maintenance. An efficient complaint redressal system can impart 100 per cent efficiency to the system. Jaipur Municipal Corporation decided to privatize the maintenance of street lights. while expenditure has reduced by more than 50 percent. The corporation procured material worth almost Rs 150 lakh annually. of one tube light per year was more than Rs 80. labour and other services like transport.014 tube lights and around 28.PROJECT PLANNING & IMPLEMENTATION ANNEXURE-2 Case Study: Rajasthan Privatization of Street Light Maintenance Jaipur Municipal Corporation For improving the level of illumination in the city. The initiative of privatizing the maintenance of street lights has remarkably increased the efficiency. The Store keeper would issue the material to the lineman who would then go to the fault point and carry out the repairs. further privatization of maintenance of street lights was undertaken in phases and till date 52 wards have been privatized and given on contract. After the success of the pilot testing in the first phase. a driver with one vehicle and two helpers. the corporation has introduced solar timers in the city to bring about energy efficiency and cost savings.016 sodium lights. a street light policy is also under formulation for other cities of Rajasthan State. Twenty contractors are involved in maintaining the street lights. Situation before the Initiative The area of Jaipur Municipal Corporation encompasses around 46. These timers have been set according to the time of sunrise and sunset. Significant energy saving can be achieved by implanting timers and through timely switching on/off of the same. Lessons Learned Privatization of maintenance of street lights has reduced operation costs. The contract includes materials. In the first phase of the project. The efficiency level was 70 to 75 per cent in the maintenance of the tube lights. Taking these efforts ahead. and a lineman would visit the fault point.000 acres and to illuminate this. In case of a complaint. The efficiency level in the maintenance of the tube lights and sodium lights has increased from 70 to 99 per cent. only 6 out of the 70 wards were given on contract. The maintenance of these solar timers has also been given on contract. diagnose the fault and then report to the junior engineer. A total of 706 street light timers have been installed. As a result of privatization the municipal corporation is now able to provide a better level of service using less of its internal resources. 246 RCUES. etc. The junior engineer would in turn report this fault to the store keeper for the particulars of the material required for carrying out the repairs. Further to the privatization initiatives of the maintenance of street lights. The initiative in its first phase was experimented in six municipal wards only. Results Achieved The results of the privatization are overwhelming.
During this process. The dry powder is used as feed in poultry farms. the fat of the dead animal is sold for the manufacture of soaps and detergents. The contractor is required to lift the carcass within 12 hours. April-june 2005) RCUES. A contractor has been appointed for processing and maintenance of the carcass plant. of the National Institute of Urban Affairs. the contractor did not have a proper place to de-skin the could lead to serious health and environment hazards.786 per year in 2003) Lessons Learned Commissioning of a proper plant with modern technology can give the city a clean environment. For this the Corporation was taking a leasing amount of about Rs 50. their skin is removed and after cleaning. (Source: Urban Finance. Even though the process was contracted to a private party. Regular inspection of the carcass plant is carried out by the health department of the corporation. The plant has been operational since 2000. about 40 carcasses are lifted from the city per day. they were also being attacked by other animals. Situation before the Initiative Before the commissioning of the carcass plant. to solve the problem of disposal of dead animals. 17 kms from Jaipur. On an average. LUCKNOW 247 .33 crore has been set up at Chainpur. The provision of a modern carcass plant that provides a clean environment to the workers and which is not a nuisance to the nearby area is a good initiative. All this added to their nuisance value. 8 No.PROJECT PLANNING & IMPLEMENTATION Modern Carcass Utilization Plant & Slaughter House Jaipur Municipal Corporation Schedule XII of the 74 Constitution Amendment Act states that provision of slaughter houses is one of the mandatory functions of any urban local body. they are put for sale. For lifting the carcasses the Jaipur Municipal Corporation has provided the contractor with 3 vehicles. Jaipur Municipal Corporation had contracted the lifting of carcasses from all parts of the city to a private contractor. free from foul smell. The remaining carcass is then crushed and reduced to a dry powder form. Of the total budget the State Agricultural Department provided financial support of Rs 148 lakh and the remaining Rs 85 lakh was funded by the Jaipur Municipal Corporation. Jaipur city has 8 points from where a request for lifting of any carcass lying in public places can be lodged. Quarterly Newsletter. Vol. Rajasthan is famous for its leather products. and each vehicle has about 10 persons. The money from the sale of the fat and the dry powder also goes to the contractor. The sale proceeds are kept by the contractor. has been increased to Rs 1. illegal slaughtering is widely rampant in cities. etc. since many cities do not have a proper facility with modern technology for the purpose. Description of the Initiative A carcass utilization plant costing Rs 2. The carcasses emanated a foul smell. However.105. this initiative would in future be one of the sources of revenue generation. failing which he is charged a fine of Rs 1. Results Achieved The city has benefited as it now has a clean environment. covering the 6 zones in the city.000 to Rs 1 lakh per year Despite several measures. as the contract will be renewed every year. after the recovery of the initial investment in the commissioning of the plant. illegal slaughtering of animals was widely rampant. The contractor gives the leasing amount to the Jaipur Municipal Corporation. 2. After the carcasses are collected from different parts of the city.000 per day. (The lease amount of the carcass plant which was Rs 5 lakh till 2002. For Jaipur Municipal Corporation.
4. (Statement of expenditure enclosed) : 7. 8. & date in which authority to carry forward the said amount was given : : : : : 6. 5. 2. In lakh) 1.PROJECT PLANNING & IMPLEMENTATION ANNEXURE .6. Title of the project/scheme Name of the Organization Project Head Sanction order No. : 248 RCUES. 3. and dates of sanction orders showing the amounts paid). if any. LUCKNOW . & date of sanctioning the project Amount brought forward from the previous financial year quoting letter No. on the grants Total amount that was available for expenditure during the financial year( Sl.) (Rs. Amount received from during the financial year (Please give No. 5. It should be issued on the following format: FORMAT OF UTILISATION CERTIFICATION Utilization Certificate (For the financial year ending 31st March…. : Other receipts /interest earned . nos.3 Utilization Certificate This certificate provides the necessary information regarding the utilization of the resources received for the purpose of the project.7) Actual expenditure( excluding commitments) incurred during the financial year. Thus it helps in making estimates of additional resources to be utilized in the project and timely arrangement of those of those. : 9.
5.PROJECT PLANNING & IMPLEMENTATION 10. 4.next ………………. if any(Please give details of Cheque No. etc. year. 12. LUCKNOW 249 . (PROJECT HEAD) ( FINANCE OFFICER) RCUES..(Vide No………………. Unspent balance refunded.remaining unutilized at the end the year has been surrendered to Govt. Certified that I have satisfied myself that the condition on which the grants-in –aid was sanctioned have been duly fulfilled /are being fulfilled and that I have exercised the following checks to see that the money was actually utilized for the purpose for which it was sanctioned. Kind of checks exercised: 1. 3.) Balance amount available at the end of the financial year Amount allowed to be carried forward to the next financial year vide letter No. & Date : : 11.9 has been utilized on the project /scheme for the purpose for which it was sanctioned and the balance of Rs………. ………mentioned against col.dated ……………………)/will be adjusted towards –in-aid payable during ………………… the………………………. : Certified that the amount of Rs. 2.
“Capacity Development for Decentralized Urban Governance. where it is located. There was a problem of performance monitoring on better and more efficient utilization of resources because it would be difficult to know to whom money is owing and who owes money. Steps In Implementation Identification & Analysis of Functions: The Nagar Nigam Meerut is divided into three Zones namely Mukhyalaya zone. Preparation of Opening Balance Sheet: A cut off date (Ist April 2006) was fixed for preparation of opening Balance Sheet. arithmetic accuracy of books can not be proved. no impersonal accounts relating to assets. LUCKNOW . IV. Description of the Initiative Meerut Nagar Nigam was selected under GOI-UNDP project. III. Kankar Khera zone and Shastri nagar zone consisting seventy wards along with three dispensaries and one school. are kept. for e. Income & Expenditure Account and the Balance Sheet cannot be prepared. No trail Balance can be prepared and hence.. Mapping of Fixed Assets: Information regarding the Fixed Assets have been ascertained on the basis of information in the Twenty Nine Forms provided in the National Municipal Accounting Manual. Generally .” For the implementation of this project a Financial Consultant was appointed. expenses. date of acquisition etc. II. Situation Before the Initiative Before applying Accrual Based Double Entry Accounting System in Nagar Nigam Meerut the Accounting was followed on Single Entry System. Different functions and functionaries (responsibility centers/ department ) where identified and analyzed. “Capacity development for decentralised Urban Governance”. dimensions of the assets. In single entry system it was a difficult task to fix the proper value of assets...PROJECT PLANNING & IMPLEMENTATION ANNEXURE-4 CASE STUDY Implementation of Accrual Based Double Entry Accounting System at Nagar Nigam Meerut under GOI-UNDP Project. cost of construction /acquisition by the ULB. Hence the single entry system was subject to the following defects:I. Any information obtained under single entry system was not free from doubt. It is not possible to know what the total payments or receipts are. gains etc.g. description of the assets. In the absence of real and nominal accounts the Receipts & Payments Account. These forms contains the detailed information with regards to the specific assets. Completeness of records as is possible under Accrual Based Double Entry System was absent. 250 RCUES.
Punching of Data Feeding of entry for the financial year 2006-07 on accrual based Double Entry Accounting System was started. One of the computer system of the accounts department was connected with LAN. Up-dation of Opening Balance Sheet: The opening Balance Sheet was updated as certain assets and liabilities were identified after preparation of draft opening Balance Sheet these new assets and liabilities were accounted for under the accounts head “Adjustments to opening Balance Sheet’’. LUCKNOW . b. Simultaneously. Receipts and Payments Accounts Income And Expenditure Accounts Balance Sheet 251 RCUES. Discussions were held with the officials of CMC limited and it was clarified that the data feeded on Tally 9.0 will be compatible with the software being prepared by the CMC limited. as one of the systems in the accounts departments was connected with LAN. Preparation of Financial Statements: For the financial year ending 31st march 2007. and were shown as an addition to the municipal fund at the time of preparation of the Balance Sheet. Accounting concepts and conventions. Tally 9.0 (multiuser) was installed. online training was provided to the accounts personnel on a regular basis. Nagar Nigam Meerut has seventeen Bank Accounts which were not reconciled and hence preparation of Bank Reconciliation statement of all these bank accounts were prepared. where six computer peripherals were installed on Local Area Network Facility. the following financial statements were prepared :a. Feeding of demand and collection register was started to determine the true position of property tax receivables as well as water tax receivables. Conducting of Training Programmes: Specific orientation and Training programmes were conducted for the departmental heads as well as for the accountants. Merits of double entry accounting system. c. Discussions on Uttar Pradesh Municipal Accounts Manual.PROJECT PLANNING & IMPLEMENTATION Installation of Hardware and Software: A proper space was provided by the Nagar Nigam officials. Some of the topics covered during the training programmes were as under:Significance of accrual based double entry accounting system. Need for double entry accounting system. A specific software for implementation of accrual based Double Entry Accounting System is being prepared by CMC limited.
K.Y. Jain Advanced cost and Management Accounting By V. Vashistha 252 RCUES. Saxena & C. II. Regular physical verification of fixed assets as well as of inventories should be undertaken and the respective registers should be updated. At least two staff members from the accounts departments should be designated on this specific project. so that information can be collected on time. 5. Khan & P.PROJECT PLANNING & IMPLEMENTATION Constraints in Implementation of Accrual Based Double Entry Accounting System Few transitional issues were encountered while transforming data from manual system of accounting to a computerized data environment. LUCKNOW . ____________________________________________________________________________________ Notes & References: National Municipal Accounting Manual Financing Municipal Services – Reaching out to Capital Markets Financial Management By M. Attendance of the staff members should be monitored by the departmental heads in the training programmes. Suggestions: 1. 4. The knowledge and understanding capacity of the staff members was lacking due to which retrieval of information became difficult.D. Formats for the preparation of Opening Balance sheet should be circulated well in advance to the respective departmental heads. to ensure smooth shift to the new computerized accounting system. :I. Monthly Bank Reconciliation Statements of all the Bank accounts should be prepared. 3. Non Availability of historical data/ past records were not kept in good conditions due to which complete information with regards to the Fixed Assets could not be ascertained.K. 2.
LUCKNOW 253 .PROJECT PLANNING & IMPLEMENTATION RCUES.
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