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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
700 crore of capital expenditure and about Rs 1.PROJECT PLANNING & IMPLEMENTATION in order to give a further boost to the economy and in the process reduce poverty levels. The present level of urbanization of 28 per cent is expected to reach 40 per cent by 2020. the ULBs mandated to handle this task will have to be empowered and strengthened to take this responsibility. the ULBs mandated to handle this task will have to be empowered and strengthened to take this responsibility. 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. Hence. roads. This resource gap has come in the way of the capacity of ULBs to incur capital expenditure for urban infrastructure services. a major effort for reforms and capacity building is of utmost importance. street lighting etc. roads. ULBs have been dependent on funds from State Governments by way of grants. etc. solid waste management...000 crore per year towards operations and maintenance. Surely. ULBs have been dependent on funds from State Governments by way of grants. 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 identified new avenue is that of providing access to the capital markets wherein capital can be accessed RCUES. 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. Traditionally. sanitation. 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 is estimated that 60 per cent of the national income is contributed by urban India.000 crore each year. The estimate of requirement of investment in Karnataka as assessed by an Ad hoc Committee is about Rs 7. LUCKNOW 195 . Hence. Traditionally. Hence. a major effort for reforms and capacity building is of utmost importance. User charges seldom cover 0 & M expenditure. solid waste management. the major investments will have to take place in urban areas in basic services like water supply. loans through State guarantees. Surely. functions and financial position.000 crore each year. functions and financial position. 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. which will ultimately enhance economic activity and contribute to the national income. 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 major investments will have to take place in urban areas in basic services like water supply. In the recent years the extent of Government support towards urban infrastructure has been declining. User charges seldom cover 0 & M expenditure. Secondly. The ceiling on government guarantees also restricts borrowings by the ULBs. which will ultimately enhance economic activity and contribute to the national income. In this process the true costs of services have not been brought to focus and citizens are provided services at heavily subsidized prices.. sanitation. loans through State guarantees. etc.000 crore per year towards operations and maintenance. street lighting etc. The estimate of requirement of investment in Karnataka as assessed by an Ad hoc Committee is about Rs 7. to meet capital expenditure. 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. In this process the true costs of services have not been brought to focus and citizens are provided services at heavily subsidized prices.700 crore of capital expenditure and about Rs 1. to meet capital expenditure.. Secondly.
a SPV constituted for this purpose. The bonds are also to be listed in the stock exchange in order to make them tradable.5 crore will be maintained to meet any shortfall. thus. The Trust has appointed KUIDFC as the Fund Manager. The Greater Bangalore Water Supply and Sanitation Project (GBWASP). The Trust is a GOK Trust which will raise Rs 100 crore by way of bonds on behalf of the 8 ULBs.5 times the annual debt commitments. A guarantee from USAID covers 50 per cent principal amount. The above mechanism will be monitored by a Bond Trustee who will be appointed by the Fund Manager. 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. At the next level a Bond Service Fund of Rs 25.PROJECT PLANNING & IMPLEMENTATION through bonds. a state intercept will be provided to divert the state devolution funds in case of default by a participating ULB. At the first level. LUCKNOW . provides the structure and the means to access capital markets by a group of ULBs. The ‘Pooled Finance Development Facility’ (PFDF). help in financing a project. In order to make this instrument attractive. The concept of pooled finance has been successfully adopted in Tamil Nadu. Land Based Instruments As ULBs have substantial area of open land. These instruments. 1914. 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. a rating agency and is to be rated as AA (SO). which is now taken up for implementation has adopted the scheme in Karnataka. limits on the amount of loan. A credit enhancement structure has been framed for the comfort of the investors. Bonds are to be floated on behalf of the 8 ULBs through the Karnataka Water and Sanitation Pooled Fund Trust . Legal Framework for Municipal Borrowing Municipal government borrowing in India is regulated by the Local Authorities Loans Act. This fund will be contributed on a matching basis by GOI and GOK as per the guidelines of the proposed PFDF Scheme. which will be tapped when necessary and subsequently replenished by state intercept of devolution of funds. 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. The 8 ULBs plan to raise Rs 100 crore from the market to meet part of the cost. Banks and other Financial Organizations easily accept the instruments based on security of land. GOI offers tax exemption on the bonds floated by ULBs. The water supply component is estimated to cost Rs 340 crore. The structure and framework has been designed through the help of USAID and advice from ICRA. The instrument has been assessed by ICRA. In the third level. However. The scheme provides for credit enhancement for borrowings that are bankable. which is under the final stages of formulation. 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. RCUES. they can use those for the purpose of finance.
The manner of making applications for permission to borrow money. LUCKNOW 197 . and Repayment procedures. with a view to explore the feasibility of expanding the horizons of its rating operations. (CRISIL). With increasing requirements. Consequently. (CRISIL) The Credit Rating Information Services of India Ltd. the Standard and Poor’s Rating Services of USA. a credit rating agency in India. The Credit Rating is done by the following agencies: Credit Rating Information Services of India Ltd. Even when user charges are levied. which are to form the security for the loan. The sum to be charged against the funds. and (vii) The accounts to be kept in respect of loans. The attachment of such funds and the manner of disposing them. this has meant deficiency in volumes as well as quality of service.can borrow from the market. a framework for municipal credit evaluation and laid out the groundwork for credit rating of RCUES. the price per unit is too low to cover even the variable cost of providing the service. Since most urban infrastructure services have been treated as public services and the concept of cost recovery has never been considered relevant. Credit Rating The Urban Local Bodies (ULBs) own resources have been insufficient even to meet the operation and maintenance requirements of these 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. 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 . It is high time that a commercial approach is adopted. It involved the Ahmadabad Municipal Corporation (AHMC) and other municipal corporations in formulating what it called. these are expensive solutions. Even if the facilities were funded by loans. Security or collateral. The manner of raising loans. Subject to the limits imposed by this Act. From a societal point of view. unorganized sector for provision of many of these services has developed. The works for which money may be borrowed. the repayment of loans was generally book adjustments or paid out of grants made by state governments. 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. resulting in high prices and qualitatively deficient services. a commercial approach to these services has not been developed. undertook an exploratory exercise to evaluate the credit quality of municipal entities in India. a parallel.PROJECT PLANNING & IMPLEMENTATION (iii) (iv) (v) Duration of loans. drawing upon the experiences of its partner.
the credit standing of sovereign governments has a significant impact on the credit profile of sub-national and local governments. in its view. 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. expenditure trends. CRISIL studied the finances and operations of the AHMC. It assesses the system structure and management in terms of inter-governmental linkages. liquidity position and debt profile. degree of reliance on short term borrowings. a study of the rating rationale gives an indication of the underlying rating philosophy and broad criteria. In evaluating the financial performance. power to authorize specific issues. revenue and expenditure balance. amongst other factors. current debt burden. Although the criteria for evaluating bond issues by ICRA are not published. the level of local government autonomy and the administrative capability of local government. Investment Information and Credit Rating Agency (ICRA Ltd. revenue streams assigned for repayment of bonds. The analytical methodology used by Standard and Poor’s focuses on the range of economic system and administrative factors. Credit Analysis and Research Limited (CARE) The CARE considers parameters such as the fiscal profile of bond-issuing municipal body. and the financial position of the rating entity.PROJECT PLANNING & IMPLEMENTATION municipalities and project-specific debt issues. ending litigations affecting the status of debt and inter-governmental fiscal structure. maturity profile and state government approvals for borrowings. past revenue and expenditure profiles. While evaluating the fiscal profile. availability of financial resources to meet unforeseen contingencies and quantum of state budgetary support and the nature of operating expenses are examined. Also studied are major revenue heads in terms of trends and composition and expenditure patterns of key operating departments. liquidity. it analyses the revenue sources and flexibility therein. While evaluating local governments. and assigned an “A+” credit rating to the proposed Rs. revenue surplus or deficit. debt burden and off-balance sheet liabilities. Since then. Standard and Poor’s examines the parameters affecting the local economy. indicating a credit risk profile in the adequate safety category. the bond market in India has seen a noticeable growth in terms of issuers and investors. margin of surplus or deficit. financial parameters such as the composition of revenue and expenditures. sources and 198 RCUES. stability and supportiveness of the higher levels of government. past capital expenditure schedule. 1 billion bond issue. LUCKNOW . growth prospects and demographic profile of population. and management systems and policies. availability of general revenues to meet short-term delays in debt servicing of projectlinked debt instruments. instruments and volume of transactions. When the bond proceeds are to be used to finance a new project. debt service coverage ratio. It evaluates sovereign-related factors as. responsibility to repay debt. It evaluates the legal set-up within which the local body operates including the power to raise debt. viability of the new project in terms of the constitution of the project as a special purpose vehicle (SPV) or as a departmental project. It also appraises the ongoing and proposed projects from the point of improvements in service delivery and funding arrangements. profile of the project being financed and its related risk factors. budgetary performance and flexibility.) ICRA has assessed a number of municipal entities in terms of assigning credit rating for bond issues. revenue surplus or deficit. which include economic structure. revenue raising powers. It also studies the debt specific factors such as the delays in past loan repayments. It conducts a detailed assessment of the financial performance of municipalities in terms of the organisation of accounts.
while the private sector companies issue bonds and debentures. At sub-national levels. Traditionally. providing future revenue flows from the RCUES. Municipal Bonds in India A key development in the sphere of infrastructure financing in India has been the emergence of a municipal bond market. defined in the Ministry of Urban Development’s Guidelines for Issue of Tax Free Municipal Bonds (2001). local employment characteristics. lenders to entities in the infrastructure sector have sought a state or a sovereign guarantee as an important security mechanism. known as the India Infrastructure Report. instruments. Also evaluated are factors such as the state of the local economy. Municipal bonds in India are a securitized debt instrument. management information system. The fiscal incentives offered by the Government of India in the form of tax exemptions to eligible issuers. The guidelines stipulate that the issuers are to maintain a debt service coverage ratio of at least 1. Funds have generally been in the form of loans and grants from the central and state governments.25 throughout the tenure of the bond. floating rate bonds and inflation-indexed bonds. In order to facilitate borrowings. CARE’s methodology carefully analyses the linkages between the above-stated factors. in items of issuers and investors. and prioritization of expenditure across projects. while assigning an appropriate rating to the debt instrument. LUCKNOW 199 . by issuing bonds. For public sector companies. development indicators. This over collateralization and the provision of a debt service reserve account serve as measures to reduce risk to investors. trading volume and market awareness. the state-level public enterprises issue government-guaranteed bonds.PROJECT PLANNING & IMPLEMENTATION allocation of funds for the project being financed and analysis of major project related revenues and expenditures are assessed. The bond market in India has grown significantly in recent years. the Credit Rating (Repayment Capability) of ULBs play an important role in extending funds for the project. have given a further stimulus to the municipal bond market. The central government issues treasury bills. collection and enforcement mechanism. 6185 million. zero-coupon bonds. 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. The nine municipal corporations which have accessed the capital market have thus far been able to raise Rs. 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. tax billing. such as organizational structure. ability to implement plans and degree of autonomy given to the local body. zero-coupon bonds and floating rate bonds. The concept of municipal bonds as an instrument for raising resources for urban infrastructure projects. This report noted that urban infrastructure services are provided by local level agencies. the main issues comprise taxable and tax-free bonds. other bonds have been issued without a state government or a bank guarantee. demographics. An important feature of municipal bonds is that with the exception of bonds issued by the BMC and Indore Municipal Corporation. It looks at the administrative and legal issues.
12 The rating often serves. viz. ICRA and CARE together with their partners (Standard and Poor’s. completion of the process of pre-qualification of bidders. bridges and flyovers. Credit Rating for Debt Financing A credit rating11 is an independent opinion on the future ability. Capital investments in urban infrastructure namely. he signs away the right to an annual revenue flow in the future in favour of the lender. The borrower receives funds today to pay for project construction. roads. The more certain and predictable is the revenue stream. CRISIL. RCUES.. Credit rating is mandatory for debt instruments with a maturity exceeding 18 months. particularly in countries where interest regimes are allowed to operate freely. Project development consisting of an approved investment plan including phasing and a financing plan. Rating is important to issuers for two key reasons: (i) (ii) Investors are reluctant to buy bonds if they are not rated. benchmarks for commencement and completion including the milestone dates for the proposed components of the project. the central government does not permit sub-sovereigns to sell unrated bonds. and urban transport if it is a statutory municipalfunction. Borrowing for investment purposes is equivalent to capitalizing an income or revenue stream. generation of a stream of revenues sufficient to finance the project.PROJECT PLANNING & IMPLEMENTATION project as collateral.solid waste management. The three major credit rating agencies. the greater is the security for a loan. and Fitch Ratings) serve the Indian market in terms of rating bonds and debentures and other papers. 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. The frameworks that they use are outlined below. LUCKNOW Use of Funds Requirements Project Development Financial Viability 200 . In return. potable water supply. appointment of an Independent trustee for monitoring the Escrow account. Moody. and groups of local authorities through a financial intermediary. initiation of the process of Land acquisition and other statutory clearances. Financially viable i. drainage. in several countries. legal obligation and moral commitment of a borrower to meet its financial obligations of interest and principal in full and in a timely manner. The riskier the ability of a borrower to service debt payments. other local authorities constituted under relevant state government statutes like water supply and sewerage board. the higher the interest rate sub-sovereigns has to pay. sewerage or sanitation. to determine the interest rate at which sub-sovereigns can issue debt in the capital market. At the heart of any credit system is a revenue stream that the borrower does not use for day-to-day operations.e. Key Features of Tax-Free Municipal Bonds Key Features Eligible Issuers Local self governments.
Furthermore the tools of Capital Budgeting should also be used for determining the financial viability of the source.However it is not possible to gather funds from all these source . Capital budgeting involves a financial analysis of the various proposals regarding capital expenditure to evaluate RCUES. It generally reveals the expected amount of return. contribution of 20% of project cost from internal resources or grants. Cost. Risk and 3. with the option for buyback arrangements of the face value of the bonds. Control is also a significant aspect of Financial Sustainability . A proper analysis of all the above aspects has to make before making final selection of source of funds . debt-equity ratio not to exceed 3:1. 50 crore whichever islower. Capital Budgeting Budgeting means evaluation of several plans or policies and making a choice of the best plan out of available plans. Generally in case of borrowed funds. maintenance of a Debt Service Coverage Ratio (DSCR)** of 1.PROJECT PLANNING & IMPLEMENTATION Other Conditions Conformity with laws governing borrowing. Choice of the source depends on mainly three factors:1.This may knead to closure of the project. Project Account and Monitoring Investment.25 Through the tenure of the tax-free municipal bond. investors may demand for the repayment of their investment at any time . Maintenance of a separate account as also establishment of a separate Project Implementation Cell.The cost of funds should be kept at minimum for proper balancing of risk and control . 2. Minimum maturity of five years.it refers to the decision making power related to the project.3% or Rs. an investor wants on his investment.Each source has its own pros and cons. Mandatory to obtain an investment grade rating. Risk refers to the possibility of any uncertainty attached to the source of funds. Control Cost refers to the procurement cost of fund. A cost benefit analysis incorporating an overall result of the project during its whole period of operation should be made. Adherence to guidelines issued by the Securities and Exchange Board of India (SEBI). 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 . LUCKNOW 201 . Maximum amount of tax-free bonds as a % of total project cost will be 33.
50. However.000 and yields annually a profit of Rs 3. It stresses capital recovery rather than profitability. This method of evaluating proposals for capital budgeting is simple and easy to understand.PROJECT PLANNING & IMPLEMENTATION their impact on the financial aspect of project . 3. has practice approach.50.000 1.000 1. This is inadequate measure for evaluating two projects where the cash inflows are uneven. LUCKNOW . The first step would be to calculate the cash inflow from this project. 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.00.000 4. it has the advantage of making it clear that there is no profit of any project unless the pay back period is over.50. 2. Profit before tax Less: Tax @ 50% Profit after tax Add: Depreciation written off Cash Inflows 202 3.000 after depreciation @ 12 ½% (straight line method) but before tax @ 50%. 2. 4. 5.000 RCUES. which generate cash inflows in earlier years Thus it. It is done after the detailed cost estimation and implementation schedule of the project is made.000 calculated as follows: Rs. Illustration Suppose a project costs Rs 20. 2.00. the technique of payback period is not a very scientific method because of the following reasons: 1. 4.This Technique helps in taking decision as to whether or not money should be invested in long term policies. It is the period in which the profit expected from the project will be equal to the cost of project.000 2. 3.00. In the case of routine projects also use of payback period method favours projects. This method has the following pros: 1. By stressing earlier cash inflows the liquidity dimension is also considered in the selection criterion.00. Financial Manager uses the following technique:1. 6. The cash inflow is Rs.00. It does not give any consideration to time value of money. For this purpose.
By stressing earlier cash inflows liquidity dimension is also considered in the selection criterion. This method of evaluating proposals for capital budgeting is quite simple and easy to understand. depreciation is added back to profit after tax since it does not result in cash outflow.000 = 20% RCUES. But its major limitation is that every investment project does not satisfy the conditions on which this method is based. The cash generated from a project therefore is equal to profit after plus depreciation. This method becomes a very inadequate measure of evaluating two projects where the cash inflows are uneven.000 4. Sometimes the management has a set idea regarding what should be a maximum pay back period.PROJECT PLANNING & IMPLEMENTATION While calculating cash inflow. 3. Thus it has practice approach. Rs.00.000. 2. Illustration Suppose a project requires an initial investment of Rs. Pay Back Reciprocal It is a helpful tool for quickly estimating the rate of return of a project. 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.Similarly it cannot be used as an approximation of the rate of return if the project yields uneven cash inflows. In this example payback reciprocal will be: PI = Rs.000 Remarks The project with the lower payback period will be preferred. Evaluation This method has the following pros: 1. Thus management may for example. decide that they will not accept any project if the pay back period is more than 3 years.e. However. it has the advantage of making it clear that there is no profit of any project unless the pay back period is over. 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 . 20.00.00. In the case of routine projects also use of payback period method favours projects. 20.000 and it would give an annual cash inflow of Rs 4. 2. It stresses capital recovery rather than profitability. LUCKNOW 203 . 3.000 Rs. the technique of payback period is not a very scientific method because of the following reasons: 1. 4. 20. The payback period in this case is 5 years. which generate cash inflows in earlier years. i. The method does not give any consideration to time value of money.
000 yields profit after tax and depreciation as follows : Years 1 2 3 4 5 Total Profit after tax And depreciation Rs.000 75. 10.000 4. 204 RCUES. of years of profits i. Under this method profit from a project as percentage of total investment is considered.25.000*100 Rs.60.30.000 1. it ignores the effect of fluctuation in profits from to years .2% Remarks This rate is compared with the rate expected on other projects. it is based upon a crude average of profits of the future years. 50.000 1.000 * 5 years = 9. had the same funds been invested alternatively in those projects. the payback reciprocal will always exceed the rate of return. Average Rate of Return It provides the average annual yields on the project. It is calculated as follow:ARR= Total Profiles*100 Net Investment in the project *NO. 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.e. 4.60. 10.00. But its major limitation is that every investment project does not satisfy the conditions on which this method is based.000 In this case the rate of return can be calculated as follows Total profits *100 Net investments in the project * No.000 80. LUCKNOW . it cannot be used as an approximation of the rate of return if the project yields uneven cash inflows.PROJECT PLANNING & IMPLEMENTATION Evaluation The payback reciprocal is a useful technique to quickly estimate the true rate of return. Rs. Similarly. However.00. When the useful life of the project is not at least twice the payback period.It thus ignores the time value of money. Illustration Suppose a project requiring an investment of Rs.
78.000 Again. It explicitly recognizes the time value money . NET PRESENT VALUE It is the best method for evaluation of investment proposals.000 2.000 (Scrap Value) 13.28. Now. 2. supposed to be earned on this amount of Capital in Finance marked is 10% . we calculate present value of various years on the basis of discounting rate as follows:205 RCUES.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.73.000 and the rate of interest.000 2. It thus ignores the time value of money. 4. let this project requires an initial investment of Rs. However.The criterion of NPV is thus in conformity with basic financial objectives.83. It ignores the effect of fluctuations in profits from year to year. 10. 3.e. Illustration 1 Suppose a project will give profit as follows:Year End 1 2 3 4 5 6 Total Profit (Cash Inflow) 2.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.00.000 80. LUCKNOW . expresses cash flows in terms of current rupees. 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. it is based upon a crude average of profits of the future years.72.000 2.30.. 1.000 2. The net present value can be seen as the addition to the wealth of share holders . It is the classical economic method of evaluating the investment proposals. This 10 % is our discounting rate.
10. Remarks The project can be accepted if NPV is positive i.000 2.778 1. LUCKNOW Present Value of Cash in flows (B) Net Present Value (B-A) 206 .826 .000 Hence.683 .14. Factor 1 . Rs. 14.83.500 now and is expected to generate year-end cash inflows of Rs 900.69.000 80. NPV = 0 implies that project generates cash flows at a rate just equal to the opportunity cost of capital. Rs 600 and Rs 500 in years 1 through 5.30. Illustration 2 Assume that Project X Costs Rs 2.289 1.118 Thus.00.070 1. 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.000 2.88.909 .14.PROJECT PLANNING & IMPLEMENTATION Year End (i) 1 2 3 4 5 6 Cash Inflow (ii) 2. If NPV = 0. a project may be accepted.e.000 2.118 whereas total investment required is Rs.751 .621 Amount 2500 900 800 700 600 500 Present Value 2500 2500 818 661 525 409 310 2725 225 RCUES. V. NPV>0.118 is the Net Present Value.28.826 .120 10. NPV>0 and rejected when NPV is negative i.909 .08.09.683 .533 45. 10.564 Total Present Value iv (ii * iii) 2.000 2. the total present value of all cash inflows is Rs.621 . Rs 800.78.e.000 Discount Factor at 10% (iii) .73.93.751 . Rs 700. The opportunity cost of the capital may be assumed to be 10 per cent.328 2.
The factor helps us in ranking various projects.30. Evaluation 1.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 . therefore.500).00. it generates a positive net present value (NPV = + Rs 225).000 (b) Rs. 75. The NPV uses the discounted cash flows i.000 Remarks It would be seen that in absolute terms project (c) gives the highest cash inflows yet its desirability factor is low.30.20.000. 6.One of the methods of comparing such proposals is to work out profitability index .000 (c) Rs. The desirability factors for the three projects would be as follows: (a) Rs. each involving discounted cash outflow of Rs.27 Rs. 6. Illustration Suppose we have three projects in view. 1. The whole stream of cash flows is considered. Thus. LUCKNOW 207 . Rs. 1. PROFITABILITY INDEX In certain cases we have to compare a number of proposals each involving different amount of cash inflows .000.50.PROJECT PLANNING & IMPLEMENTATION Project X’ s present value of cash inflows (Rs 2. 95. 5. Evaluation Profitability index as a guide in resolving capital rationing fails where projects are indivisible. This is because the outflow is very high also.000 = 1.18 Rs. 75. NPV method takes into account the time value of money.00.000 and Rs. The net present value can be seen as the addition to the wealth of share holders.000 = 1.e.50.50. expresses cash flows in terms of current rupees.00.000. The criterion of NPV is thus in conformity with basic financial objectives. RCUES. 5. 1. Suppose further that the sum of discounted cash inflows for these projects are Rs. Project X adds to the wealth of owners.000 = 1. 95.18 Rs.000 and 100.50.000.. 4. 3. it should be accepted.725) is greater than that of cash outflow (Rs 2.20. 2.
IRR method has the following merits: The time value of money is taken into account. we try a 20 % (arbitrary) discount rate.At this rate discounted cash inflows are equal to the discounted cash outflows. 16000+ Rs. The IRR approach creates a peculiar situation if we compare to projects with different inflow outflow patterns.20) = -Rs.16)+Rs. IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital. 14996 = . the interpretation of which is difficult. 1004 at 20 % indicates that the project’s true rate of return is lower than 20%. 15943 = . Rs. 16000 and is expected to generate cash inflows of Rs. Illustration Suppose a project costs Rs. 6000 at the end of each year for next 3 years.0. Here we briefly mention the problems that IRR method may suffer from: The calculation process is tedious. All the cash flow in the project is considered. 57 208 RCUES.743+Rs 6000*0. 16000+ Rs. As a first step. Let us try 16 % as the discount rate. 8000*0.694+Rs 6000*0. 6000(PVF3. We know that IRR is the rate at which project will have a 0 NPV. 16000+Rs. Demerits However. 16000+Rs. 7000(PVF2. there can be multiple IRRs.20)+ Rs. At 16 %.0. LUCKNOW .20)+Rs.Rs. Therefore in the method Net present Value is equal to zero and the discount rate which satisfies this condition is determined. 8000 (PVF1. If there is more than one cash outflow interspersed between the cash inflows. 16000+Rs.0.870+Rs.579 = -Rs.0. The project’s NPV at 20 % is: NPV= -Rs. If mutually exclusive projects are considered as investment options which have considerably different outlays.0. It is a popular investment criterion since it measures profitability as a % and can be easily compared with the cost of capital.641 = -Rs.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 .8333+Rs. 8000*0. 7000 and Rs.16) = -Rs. 8000 (PVF1. the project’s NPV is: NPV= -Rs.Rs. 16000+Rs. 8000. 6000(PVF3. 7000*0. 1004 A negative NPV of Rs.0. By trial and error method we try to calculate the rate which satisfies our requirements. 7000*0. 7000(PVF2. IRR method can give misleading and inconsistent results under certain circumstances.16)+ Rs.
is to accept the project if its internal rate of return is higher than the opportunity cost of capital (r > k). IRR method has the following merits: 1. 16000 Rs. 7000*0.reject rule. 6000(PVF3. 16% Rs. 8000*0. 15943 R = 15% + (16%-15%) 200/ 257 = 15% + 0. 16000+Rs.15)+ Rs.658 = -Rs. 16200 = . using the IRR method. 7000(PVF2. 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.8 % Remarks The accept – or .15)+Rs. 16000+ Rs. 15% PV at higher rate.0. 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. However.15) = -Rs. LUCKNOW 209 . The time value of money is taken into account. or the cut-off.870+Rs. 16200 Rs.0.80% = 15. 2.PROJECT PLANNING & IMPLEMENTATION Since the project’s NPV is still negative at 16%.0. When we select 15% as the trial rate. 200 The true rate of return should lie between 15 % -16 %. Note that k is also known as the required rate of return.Rs. 3. It is a popular investment criterion since it measures profitability as a % and can be easily compared with the cost of capital. IRR method can give misleading and inconsistent results under certain circumstances. Here we briefly mention the problems that IRR method may suffer from:- RCUES.756+Rs 6000*0. IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital. 16000+Rs. or hurdle rate. 200: NPV= -Rs. 8000 (PVF1. we find that the project’s NPV is Rs. All the cash flows in the project are considered. a rate lower than 16% should be tried. The project shall be rejected if its internal rate of return is equal to the opportunity cost of capital.
i. As a Finance Manager having a number of proposals regarding various projects. The Profitability Index Method also gives the same result as that of the NPV method. the interpretation of which is difficult. The methods analyzing a project depends. on the need of the person. For example. It is considered superior because the best project is the one which adds most among the available alternatives. 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. requirement of law etc. Two Important Elements For understanding the above concept the two important aspects are: Time Value of Money Discount Rate i. Cash Inflow and Cash Outflow. there can be multiple IRRs. The benefits arising out of the acquisition of such assets will be spread over a number of years in the future.e. terms loans from financial institutions.e. On the other hand. SELECTION OF BEST METHOD After making an in-depth study of merits and demerits of all the methods. It is the most used technique. PI method states the result in terms of percentages whereas NPV method shows result in absolute terms. 3. The IRR approach creates a peculiar situation if we compare two projects with different inflow outflow patterns. If the timing and risk of cash flows is not considered. A financial decision today has implications for a number of years. sale of debentures and so on . It is on the basis of the comparison of the cash outflows (outlays) and the benefits (cash 210 RCUES. 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. 2. also influence the decision of a Financial Manager. because both method use the same constituents. If mutually exclusive projects are considered as investment options which have considerably different outlays. it spreads into the future. If there is more than one cash outflow interspersed between the cash inflows. However the Net Present Value Method is considered best. However. bank borrowings. that is. till the working life of the assets. . LUCKNOW . Cost of Capital TIME VALUE OF MONEY The recognition of the Time Value of Money and risk is extremely vital in decision making. Thus. apart from these financial considerations several other factors such as welfare of the staff/society. we are now able to judge any financial projects with the help of these methods. firms have to acquire fixed assets for which they have to pay a certain sum of money to vendors. The calculation process is tedious. to the owners’ wealth. the firm may make decisions that may allow it to miss its objective of maximized the owners’ welfare.PROJECT PLANNING & IMPLEMENTATION 1. which is the ultimate objective of Financial Management and NPV helps in arriving at that project. He has to compare and evaluate all these projects and decide which one to take up and which one to reject.
In many instance we may be interested in the future value of a series of payments made at different time periods. The term principal refers to the amount of money on which interest is received. RCUES. 1000 (1+.157625 = Rs. Illustration If Mr. There are two techniques for doing this: Compounding. 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. 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. X invests Rs. One basic requirement of comparability is the incorporation of the time element in the calculation. 1000 * 1. at the end of the third year its compounded value will be: A = P (1+i) n = Rs. 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 . LUCKNOW 211 . in order to have a logical and meaningful comparison between cash flows that accrue in different time periods. rather than the same amount at some future time. In other words.PROJECT PLANNING & IMPLEMENTATION inflows) that financial decisions are made. For a meaningful comparison the two variables must be strictly comparable.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. it is necessary to convert the sum of money to common point of time. 1157.05) 3 = Rs. 1000 at 5% interest compounded annually.Time preference for money is an individual’s preference for possession of a given amount of money now.
The last payment of Rs 2.00 1654. The interest rate is 5 per cent. the first deposit will earn interest for four years.158 1. Rs1.500 in his saving bank account for 5 years .PROJECT PLANNING & IMPLEMENTATION Illustration Suppose. LUCKNOW .000. Solution Following Table presents the relevant calculations: 212 RCUES.500 comes at the end of the fifth year and. The future value of the entire stream of payments is the sum of the individual future values. 608.216 1. therefore. that is. The calculations required to find the sum of an annuity on which interest is paid at a specified rate compounded annually.050 1. and Rs 2.500.000 at the end of every year for 5 years in his saving account paying 5 per cent interest compounded annually. Annuities involve calculations based upon the regular periodic contribution or receipt of a fix sum of money. Illustration Mr X deposits Rs 2.500.00 1158.00 2500. Rs1. Following table presents the calculations required to determine the sum of money he will have. the future value remains Rs 2. He wished to find the future value of his deposits at the end of the 5th year.103 1. 500 1000 1500 2000 2500 4 3 2 1 0 1. Mr X deposits each year Rs 500. 8.50 2100. Rs 2. He wants to determine how much sum of money he will have at the end of the 5th year.50 Column 3 of Table indicated that since the deposits are made at the end of the year. the second for three years and so on.020.000. Annual Compounding of a Series of Payments End of Year 1 1 2 3 4 5 Amount Deposited 2 Rs.000 Total Number of years compounded 3 Compounded Interest Factor 4 Future Value (2*4) 5 Rs. Rs.00 8020.50 Compound Sum of an Annuity An annuity is a stream of equal annual cash flows.
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
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. there is no obligation to pay a return on the fund invested by the organisation. what could have been accomplished with the resources expanded in the undertaking. and the corporate tax rate is 35 %. the lower will be the amount of tax payable by the firm.e. assumed that there is no cost involved for procuring capital from owned capital no return has to be given on it. like other sources of fund. therefore. An unprofitable firm is not required to pay any taxes. It would not gain any tax benefit associated with the payment of interest. But there are other investment options available in which these funds can be invested.. The higher the interest charges. if before tax cost of bond in our example is 16. LUCKNOW . therefore. The before tax cost of debt. If benefit from that opportunity is higher than the benefit 216 RCUES. appear that capital does not carry any cost.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. the after tax cost of bond will : Kd (1-T) = 0. Cost of Owned Capital In case of ULBs no return is expected from the investment since it is guided by the service motive. Apart from the absence of any commitment to pay return . In fact. it is free from the risk of repayment.1650 (1-0. This implies that the government indirectly pays a part of the lenders required rate of return. It may. Capital. As a result of the interest tax shield. Opportunity cost is the value of the best alternative that was not chosen in order to pursue the current endeavor i. be adjusted for the tax effect as follows After tax cost of Debt = Kd (1-T) Where T is the corporate tax rate. therefore prima facie. It is.5%.1073 or 10. But this is not true. and its true cost of debt is the before tax cost.35) = 0. Kd should. It represents opportunities foregone. the after tax cost of debt to the firm will be substantially less than the investor required rate of return. does certainly involve a cost to the firm which is in the form of opportunity cost of capital.
they are multiplied by the proportions of the respective sources of capital to obtain the weighted average cost of capital WACC). If we assume that a firm has only debt and equity in its capital structure. a commercial organization is concerned. WACC is the composite or overall cost of capital. the component costs should be the after tax costs. obviously. they expected to derive.PROJECT PLANNING & IMPLEMENTATION accrued from the investment. The proportions of capital must be based on target capital structure. the cost of its capital is in the form of the return. Illustration Let dividend per share of a firm is expected to be Re. 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. the after tax cost of debt and equity. In the financial decision making. Conceptually. Add the weighted component costs to get the WACC. respectively. the cost of capital should be calculated on an after tax basis. fund will be invested in that opportunity. the ULB has to arrange all its projects in terms of benefit derived from them and use the fund accordingly to derive maximum benefit. Kd (1-T) and ke are. Because of higher risk. 1 per share. If the market price per share is Rs.04 or 4% Here. Here. LUCKNOW 217 . D is the amount of debt and E is the amount of equity. D = Dividend to be received P = Net Amount Received THE WEIGHTED AVERAGE COST OF CAPITAL Once the components cost have been calculated. 25 the cast of equity capital will be = D P = 1 25 = 0. the cost of capital is highest among all the sources funds. then the WACC (ko) will be: Where ko is the WACC. 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. As far as. Therefore. RCUES.
The financial manager is able to determine the best combination of debt and equity. The use of debt affects the return and risks of share holders. he or she must raise the appropriate amount through the best available sources. flexibility. LUCKNOW . 600000 Rs. loan covenants.4 % 0. In practice. in deciding its capital structure. The central issue before him or her to determine the appropriate proportion of equity and debt. the shareholder’s return is equal to firm’s return.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. the market value per share will be maximized and the firm’s capital structure would be considering optimum. he or she must decide when.4 0. The change in the shareholder’s return cause by change in profits is called financial leverage. 400000 Rs.08 0. a firm considers many other factors such as control. 1000000 Computation of Weighted Average Cost of Capital Sources of Fund 1 Amount 2 Rs. legal aspects etc. where from and how to acquire funds to meet the firm’s investments needs. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. In the absence of debt.0 0.134 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. When the e shareholder’s is maximized with given risks.102 0. 218 RCUES. It may increase the return on equity funds. Debt Equity 400000 600000 1000000 Weighted Average Cost of Capital = 13.032 0. The mix of debt and equity is known as the firm’s capital structure. Broadly. A proper balance will have to be struck between return and risks.6 1.17 0. The firm’s capital structure is considered optimum when the market value of shares is maximized. but it always increase risks as well.
The risk of becoming technically insolvent is measured using Net Working Capital . bonus shares and cash dividends in practice. Lack of liquidity in extreme situation can lead to the firm’s insolvency.a proper trade –off must be achieved between profitability .three basis assumptions. In fact. But the firm may issue bonus shares.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. It is because of the fact that they have not to take any returns on the investments. or retain them. For them.It is assumed that the greater the amount of net working capital .Conversely. Bonus shares are share issued to take the existing shareholders without any charge. Like the debt policy. However. it must also increase its risk . the dividend policy should be determined in terms of its impact on the shareholders value.payout ratio and the retain portion of profits is known as the as retention ratio.risks . Current assets management that affects a firm’s liquidity is yet another important finance function. The term profitability used in this context is measured by profits after expenses. A conflict exists between profitability and liquidity while managing current assets . Nature of Trade –off If an ULB wants to increase its profitability. In evaluating the profitability risk trade –off related to the level of net working capital . Current assets should be managed efficiently for safeguarding the firm against the risks of illiquidity.are : RCUES.The profitability and liquidity trade –off requires that the financial manager should develop sound technique of managing current assets . They have not to distribute the surplus rather they have to reinvest it in other projects having large social welfare.the more liquid is the firm and therefore .He or she should estimate firm’s needs for current assets and make sure that funds would be made available when needed.The relationship between liquidity. The financial manager should consider the questions of dividend stability. Dividends are generally paid in cash. LUCKNOW 219 . if shareholders are not indifferent to the firm’s dividend policy.If it is to decrease risk it must decrease profitability . the real benefit lies in long life period of infrastructural assets. they are guided by service motive whose main aim is to get maximum welfare from the investment of the firm. The term risk is defined as the probability that a firm will become technically when they become due for payment \. The proportion if profits distributed a dividends is called the dividend. Liquidity Decision Investment in current assets affects the firm’s profitability and liquidity. lower levels of net working capital and liquidity are associated with increasing levels of risk . Thus.If may become illiquid and therefore .Thus . the financial manager must determine the optimum dividend payout ratio.PROJECT PLANNING & IMPLEMENTATION Dividend Decision Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits. net working capital and risk is such that if either net working capital or liquidity increases the firm’s risk decrease .the less likely it is to become technically insolvent . distribute a portion and retain the balance.But it would lose profitability . there is not much importance of this function.as idle current assets would not earn anything . which are generally true . The optimum dividend policy is one that maximizes the market value of the firm’s share. in the case of ULBs.
but that there was a mismanagement of financial affairs. 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. and That shout term funds are less expensive than long term funds. 220 RCUES. profit is vague term in itself. marketing and other functions of the firm. 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. Profit maximization on the cost of social benefit may prove evil for the organization. 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. It provides the yardstick by which economic performance can be judged. Profit maximization cannot viewed as sole objective of business. 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. make high profits there is also a fear of liquidation because of bad financial management . 3.Profit maximization is the primary objective of an organization. However a sound system of financial management has to be cultivated among bureaucrats. Its precise meaning defers from one sector to another. It is in this context that finance function are said to influence production. 2.PROJECT PLANNING & IMPLEMENTATION 1. profitability and risks of the firm and ultimately value of the firm. Financial management is essential in a Planned Economy as well as in capitalist set up as it involves efficient use of the resources. Profit Maximization-As profit oxygen for any organization. the need of proper financial management is required. The reason behind this is simple that profit is a test of economic efficiency. In a country like India where resources are scarce and the demand for funds are many. That we are dealing with a manufacturing firm. when a co. growth. Also. That current assets are less profitable than fixed assets . Financial management is very important in case of non-profit organizations. An organization cannot expect to run long without making profit .engineers. Specialy in case of public sector. On sum. Financial management optimizes the output from the given input of funds. FINANCIAL MANAGEMENT OBJECTIVES Efficient financial management requires the existence of some objectives. Scope of Financial management Sound financial management is the essential in all types of organizations whether it be profit or non-profit. educationalists and public at large. even in a boom period. Hence finance function may affect the size. So it has to be implemented in the long term interest of the nation. which are as follows: 1. the manager will select the solution which result in more profit and reject others. which do not pay adequate attentions to financial management . administrators . LUCKNOW . Even though. While making a decision.
thus an undertakings which reveals greater benefit to the public in large should be accepted.Their purposes may differ from each other. It cannot be separated.resources generated to various means from public . terms and condition of reference etc. an alteration of it which can overcome these shortcomings . government.In the public sector . 2. LUCKNOW 221 . 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. When final draft becomes accepted by all. basically infrastructural assets in public sector so that infrastructural facilities can be improved.. The value of a course of action must be viewed in terms of its work to those providing the resources necessary for its undertaking . Certain terms and condition are prepared to bind these parties. The worth of an action can be judge only in the terms of benefit it produces less the cost of undertaking it. It takes account of uncertainty of risk It considers the time value of money. The benefit of Wealth Maximization is in creation of assets. is required. Thus. 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. But completion of the projects is necessary to fulfill these purposes. 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.e. cash flow precise term with definite connotation. This agreement is prepared with mutual understanding Of the parties after a number of revisions.e. The final stage when all the parties of the project becomes agree as to a formal agreement shows the constituents. It also incorporate the time value of money i. in considering the wealth maximization as objective of financial management following benefit will occur: 1. Such an alternative is Wealth Maximization. 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 . It is the fruit of joint efforts of various groups. Thus. investor experience and project size. A profitable investment is risky too. FINANCIAL CLOSURES Financial Closure is the stage in the project development cycle when the principal stakeholders (sponsors. so that project can be carried over smoothly. It also ignores risk factor as profit is the counter part of risk profit and risk go hand by hand. in countries with prior ppp experience or strong political commitment RCUES. To conclude. 2.PROJECT PLANNING & IMPLEMENTATION Another difficulty in considering Profit maximization as objective of financial management is that it ignores time value of money. structures. A project can not be operated solely by one of the party. it is the financial closure. These groups are associated with the project for their own interest . Generally closure has been faster for smaller projects. Differing closure speed reflects differences in country commitment.. the term used in Wealth Maximization i.
This has taken even longer where investors . political charges have affected government commitment and anti PPP protests were stronger than anticipated. Issues in reaching Financial Closure Being such an important task.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 . It is here where the investment starts assuming that the disbursements of fund are met. 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 . Because unless and until this final agreement is made.All these are important for starting a project . If the risks in question has a direct impact on the project viability or operating margins. The efficiency of the financial closing process and the need to allocate risks among the lenders and the developers. attempt should be made to reach these stages as soon as possible . 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.PROJECT PLANNING & IMPLEMENTATION . because it provides foundation for the commencement of the project . no works will be done as a part of the project. in what manner . Conversely. Completed transactions on the other hand attract publicity and spur the interest or other investors and lenders. 3. Importance of Financial Closure: This is very significant part of the project. the priorities of them.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.Delays have resulted from difficulties in resolving issues of risk allocation among the various participants of a project . 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 . This stage indicates the ways in which work is being done and by whom. LUCKNOW . Achieving Financial Closure involves appraisal and negotiations to meet the requirement of three major parties concerned namely the government investors and lenders.Its importance is as: 1. 2.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 . A dynamic “link “between transaction and policy evolution often starts. failure to close may send negative signals about investment climate to potential investors. the lender may impose financial incentives and penalties on the developer. if government delays are the cause rather than poorly structured or uncompetitive projects proposals. 222 RCUES.Efforts should be made collectively from all the parties since there are various groups associated with this project.lenders or government officials have been inexperienced.Its end is start of implementation of project.
Delays can result from unrealistic expectations or the need to adapt procedures.and where government reform will take time to improve credit worthiness .: Delays in determining the availability and the kind of government support have affected India‘s power programs. In experience Reaching financial closure requires good understandings of the project financial techniques.investors and lender may possess expertise in one or two of these fields. LUCKNOW 223 . Intra Government Co-ordination Several projects have been be set by delays arising from poor coordinator between different part of the government. both at the central and at the local level. Lenders in particulars would be concerned whether debt services would be covered in the event of lower than expected volumes and traffic. They may at the time be politically controversial. Legal Frameworks Inadequate legal infrastructure has contributed to delay in achieving financial closure in many projects. where there is no track record of cash flows.financiers may ask for government support in the from of guaranties . seldom does each of the party has expertise in all the three areas . RCUES. infrastructure regulation and country risks. airports and mass transit) and new investments.g. While government officials .PROJECT PLANNING & IMPLEMENTATION There are several issues that can delay the projects these are. Delays have tended to be longer when a regional government entity was awarded a concession but needed a policy agreement to conclude the transaction. 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. They therefore may require independent market assessment. Tenders Security It is often difficult for lenders to establish mortgage claim over the physical assets of a project. Assessing the Market This mainly affects transport projects (ports. railroads. the large no. of financers required and the complexity of co-coordinating numerous government agencies and technical studies. Size Large projects may take longer to close because of the need for extensive public consultation. E. 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.While such guarantees can help in the starting if PPP projects.which are in the best of financial health . This may serve as amatory constraint in securing funds from lenders. Government Support Arrangements When PPP project are selling to or purchasing from state-owned companies . roads.
. All receipts and payments. in what manner. Some distinct features are: It is an abbreviated copy of the Cash Book. Completed transactions attract publicity and spur the interest or other investors and lenders. Receipt and Payments Receipt and payment account is the Cash summary for a particular period. LUCKNOW . The balance of Receipts and Payments Account must be debit. Therefore successful closure also implies that an infrastructure project has been made bankable after a rigorous project development process. Due to this a dynamic “link” between the transaction and policy evolutions often starts. contras between Cash and Bank are eliminated. For e. unless there is a Bank Overdraft. 224 RCUES. similarly negotiation on the level of road tolls have also delayed closures on some road projects. where tariff tend to below cost and adjustment has a high political profile. being cash in hand and at Bank. and power is being purchase by another and therefore the linkages need to be tied up before power is generated.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. In a power generation project this can be important particularly. usually merging Cash and Bank items. whether of a revenue or a capital nature are included. It starts with the opening Cash and Bank Balances. Income and Expenditure Income and Expenditure Account is similar to Profit & Loss A/c. The regularly Regime of Tariff This has been a major in several sectors particularly in water projects.g. Financial closure for an infrastructure projects draws the project development to a close. shows all types of collections and payments during the period and closing Cash and Bank balances. Advantages of Financial Closure It indicates the ways in which work is being done and by whom. It is here where the investment start assuming that the disbursement of funds are met. where fuel is being supplied by one state ownered co. Land Development Rights This can be important factor for projects relating to roads. bridges etc.
LUCKNOW 225 . grants etc. sports expenses etc. the excess is shown as surplus or Excess of Income over Expenditure. honorarium. as appropriate by the amount refundable. * Case Study attached as Annexure. A specific grant that becomes refundable is treated as an extraordinary item. subscriptions. depreciation etc. Only items of revenue nature pertaining to the period of account are included therein.II RCUES. expenses. donations.g. 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. Non Cash items e. 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 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. the relevant amount recoverable by the granting agency is reduced from the capital reserve. 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. Is also brought into account. Refund Of Specific Grant Specific grants sometimes become refundable because certain conditions are not fulfilled. If Income is higher than expenditure. to the government or non-fulfillment of some specified conditions. Expenditure includes salaries.PROJECT PLANNING & IMPLEMENTATION Income includes fees. Where a grant which is in the nature of promoter’s contribution becomes refundable. in part or in full. entertainment.
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. It is advisable to have the budgets whether 226 RCUES. Budgeting Process: Budget shall reflect the estimated inflows. To facilitates this. Public expenditure must be spent in the most productive way. surplus/deficit under the various Receipt and payment head.In other terms budget is an organizational plan stated in monetary terms. are mandatory. outflows. The receipt and payment shall be estimated for each of the accounting subjects under every budgeting centre. three broad categories of Budgeting Centers are defined. Hence a budget code is defined as a combination of budget centre and account code.4. capital receipts and capital expenditure. revenue expenditure. Any receipt payment shall reflect the above said objectives. 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. major heads minor heads. Establishing specific targets for future operations is part of the planning function of management. Decentralize planning which citizens participation facilitates in achieving this objective. Budget must also enable ULB in measuring and promoting accountability in respect of service delivery. opening and closing balances. LUCKNOW . while executing actions to meet the goals is the directing function of management.PROJECT PLANNING & IMPLEMENTATION SUB MODULE-3. Budget shall reflect the principles and programs of the ULB. The receipt and payment shall classified under four broad heads revenue receipts. 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. 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.2 FINANCIAL MANAGEMENT PROJECT BUDGETING Budget generally refers to a list of all planned expenses and revenues .
if the state and ULB maintain separate fund wise only. 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.PROJECT PLANNING & IMPLEMENTATION budget would be prepared at the field level like zones. Estimates shall be made from the lowest unit and then consolidated at the head office. 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. LUCKNOW 227 . BUDGET REVISION Once a budget has been prepared subsequent revisions to the amount budgeted may arise. Some of the forms in which budget allocations are changed are Re-appropriation. The State Laws or governing Acts shall define shall define the approving authority for approval of the budgets of the ULBs. Budget preparation shall be based on bottom up approach. The accounting system can hence provide details actual against each budget heads. RCUES. 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. A budget may not be a valid document unless it is properly approved /authorized by an approving authority. ULBs are advice to move towards decentralizes budgeting at the field level. circles or wards. Budgeting Calendar The budget preparatory process follows a budget calendar. The time schedule for preparation. Generally in the cases of ULBs. Bottom up Budgeting The basic for preparing the budget will be the inputs from various departments/units. 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. Additional Budget. reduction on Budget and Budget Cut. the following control requirements are to be built into the budgeting system: No expenditure can be incurred unless backed by a budget. The budgets heads are hence are integrated with the account head. APPROVAL OF BUDGET The Budget is the key document of any governmental set up. Any expenditure prior to being incurred must be identified to its budget head for allocation of money. The State laws or Act governing the ULBs may define the circumstances for revision of budgets. In the term. 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.
if any. if that be not possible.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. Determining the variety of activities that should be undertaken for the achievement of the objectives. for the revision of the plan. in physical as well as monetary terms for the full budget period and its parts. estimating and planning for the future and to facilitate the analysis of the variation between estimated an actual performance. Staff co-operation is usually not available during budgetary control exercise. and the policy or policies that might be adopted for achievement of these ends. its financial structure (including its liquidity and solvency). 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. Drawing up a plan or a scheme of operation in respect of each class of activity. Budgets are considered as rigid document. Budgets cannot be executed automatically. It is a system to assist management in the allocation of responsibility and authority. Ensuring that corrective action will be taken where the plan is not being achieved and. 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. The statement classifies the cash flows during the period from Operating. 228 RCUES. 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. Benefits of cash flows: A cash flow statement. Salient Features of Budgetary Control Determining the objectives to be achieved. section or department with relevant budget and determination of causes for the discrepancies. as they are based on estimates. Investing and Financing activities. Limitations of Budgetary Control System Budgets may or may not be true. 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. over the budget period. Its implementation is quite expensive.
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. 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. LUCKNOW 229 .) 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. (Mobilization advance. repay loans and make new investments without recourse to external sources of financing. Therefore they generally results from the transactions and other events that enter into the determination of net profit or loss. (Procurement of raw material. 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. except to the extend that cash flows are reported on a net basis RCUES. 3 months or less from the date of acquisition. 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 equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. Cash management includes the investment of excess cash in cash equivalents. advance payments against railway receipts for material used in construction) 2. An investment normally qualifies as a cash equivalent only when it has a short maturity of. construction tools/ plants etc. investing and financing activities. For an investment to qualify as a cash equivalent. say. PROJECT’S CASH FLOW STATEMENT 1. 3. investing and financing activities.PROJECT PLANNING & IMPLEMENTATION An enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented. Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the enterprise. it must be readily convertible to a know amount of cash and be subject to an insignificant risk of changes in value. 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.
Three types of explanation of Cost Overrun exist: 1. and the maturities are short. These standards must be sets with a high degree of cautious because a minor degree of defect may impact overall cost of the project. Cost Overrun is also sometimes called “ cost escalation. inadequate data. and overrun had been constant for the 70 years for which the data were available.PROJECT PLANNING & IMPLEMENTATION Reporting Cash Flows on a Net Basis Cash flows arising from the following operating. and technology projects. Technical explanations account for Cost Overrun in terms of imperfect forecasting techniques. Detection of defect at its earlier stage helps in maintaining quality as well as quantity of work of a project. 50 to 100 % were common. Thus. Timely detection of deviations helps in taking timely corrective measures. the amounts are large. weekly And monthly report helps to monitor the outcome of the project. the Sydney Opera House with 1400%. Evaluation of work done can be made through completion certificate and utilization certificates. This estimate helps the project manager to make a management for additional resources. which should be removed in time. These help us to detect the errors as and when they occur so that corrective measures can be taken timely. a project manager can make the estimates about the time and resources required to complete the remaining work. it avoids not only delay in completion but also the cost incurred in the project. that the project work may not be hurdled. its monitoring is also necessary unless a regular watch on the project is made it timely a regular watch on the project is uncertain. overrun was found in each of 20 nations and five continents covered by the study. MONITORING AND MANAGING LEAKAGES. a standard of work done has to be prepared against which actual work can be measured. However for this purpose. One of the most comprehensive studies of Cost Overrun that exists found that 9 out of 10 projects had overrun. Monitoring and Managing Leakages After implementation of a project.” “cost increase. Thus. The evaluation of work done against these standards reveals the deviations. building. and the Concorde supersonic aero plane with 1100%. etc. Cost Overrun Defined as access of actual cost over budget. and Cash receipts and payments of items in which the turnover is quick. 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.” Cost Overrun is common in infrastructure. Spectacular examples of Cost Overrun are the Suez Canal with 1900 %. submitted by there work manager. These certificates state the amount of the work done as well as the amount of the resources released on the work. LUCKNOW 230 . “or “budget overrun. 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. It provides benefit in order of time as well as money. Daily. COST OVER-RUN. so that. in advance. To remove avoidable delay. RCUES.
Types of Variances: 1. the difference is known as yield variance. Cost Overrun is typically calculated in one of the two ways. Example: If the production controller has failed to place orders in time and extra payment has been made for it.PROJECT PLANNING & IMPLEMENTATION 2. actual cost divided by budgeted cost. Controllable: These are the variances which can be controlled by the departmental heads.When the standard yield is given and the actual consumption deviates from standard consumption. if the budget for building a new bridge was Rs. Either as a percentage.5. in percent of budgeted cost. For example. political economic explanations see overrun as the result of strategic misrepresentation of budgets. 3. RCUES.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. Or as a ratio. Un-controllable: These are the variances which are beyond the control of departmental heads. Labour Rate Variance measures the deviations in the actual rate of pay and the ones estimated. Mix Variance: If two or more materials are mixed in a process. Material Price Variance arises due to differences between the planned and the actual material prices paid to the suppliers.weight. Finally. and consequently the standard loss of material can be readily computed. an optimum or standard mixture is decided upon by the production planning department. Example: Price increase is due to fluctuations of prices in the market.If actual mix is different from the standard mix . Psychological explanations account for overrun in terms of optimism bias with forecasters. LUCKNOW 231 . viz. a variance arises. Yield Variance : In some industries the finished product can be related to the raw material input in terms of units. 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.150 million then the Cost Overrun may be expressed as 50% or by the ratio 1.100 million and the actual cost was Rs. This relationship is known as the yield . mainly actual cost minus budgeted cost. 2.
For instance actual tax collection is more than the projected say in ward or a Zone . 2. The BVR forms the bases of control as it can provide information on: a. b. 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. Negative variance. 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. 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. If the standard variable overhead exceeds the actual variable overhead. We can understand all these budgeting process by taking a fiduciary illustration –for preparing budget 232 RCUES. Positive variance shall be analyzed for reasons.Review mechanisms for disposing of the unfavorable variances would add value to the Management of ULB. For and cost control measures identified .For instance the increase in maintenance expenses or finance charges could indicate lack of planning or implementation follow-up . At each of the Budgeting centers.The reasons for the same can be analyzed and replicated.PROJECT PLANNING & IMPLEMENTATION Overhead Overhead variances arise due to the difference between actual overheads and absorbed overheads. LUCKNOW . Expenditure Variance It represents the difference between the fixed overheads as per budget and the actual fixed overheads incurred. shall be analyzed for reasons. The BVR should be prepared on a monthly basis or such periods as the State laws/Acts governing the ULB may define .
a time schedule is also made for completion of different aspects of Budge. 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.PROJECT PLANNING & IMPLEMENTATION estimates of any financial Year data have to collect from the lowest unit of ULB. 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. LUCKNOW . Within the stipulated time schedule all units are required to submit their estimations. is collected ward wise . When payment is made payment certificates is made to provide an authenticated proof of the payment made. A detailed estimate of revenue likely to be collected from differences sources such as tax. charts. diagrams.Similarly amount for expenditure is also collected . methods adopted. WORK COMPLETION AND PAYMENT CERTIFICATES All the projects have a Work completion certificates & payment certificates as an essential part of it. data collected supported by necessary table. Thus a completion certificates is not important only for the project manager but is equally useful for the contactor.In all these process. These certificates help the project manager to identify the progress of work. while implementing projects and reasons thereof: Experimental work giving full details of experimental set up. if any Financial Position: 233 future work: RCUES. This information collected from different Zones is consolidated at Head Office for ultimate preparation of Budget. rent etc. It reveals the stage of completion of the work on the basis of which the payments to the contractors has to made. Depending upon the terms & conditions both the certificates must be issued but a designated authority.
______________________ (Project Engineer) Work Certified In large contracts it is usual for the contractor to obtain sums time to time from the contractee.PROJECT PLANNING & IMPLEMENTATION No.The contractor will get money according to this certificate. Mathematically: Cost of Work Certified=Cost of work to date – (Cost of work uncertified+ Material in hand + Plant at site) 234 RCUES. 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. ______________________ (Projects head) b. Procurement/ usage of Equipment a) S no. As the work proceeds. the surveyor appointed by the contractee issues certificates to the effect that to so much portion has been completed . LUCKNOW . 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.
The proportion that contract costs incurred for work performed upto the reporting date bear to estimated total contract costs. 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 . * Format of Utilization Certificate attached as Annexure . Contractee retains some amount (say 10% to 20%) to be paid.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 . RCUES. 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. and The amount of profit taken as credit. LUCKNOW 235 .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.It is always shown at cost price. Work-In –Progress In contract accounts. 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. Progress billings are amount billed for work performed on a contract whether or not they have been paid by the customer. Plant in site. The cost of work uncertified may be ascertained as follows: Rs. Completion of a physical proportion of the contract work. Cost of work uncertified. Total costs to date LESS: Costs of work certified Material in hand.
which may be sub-divided into a work break down structure. Funding advances and actual to budget costs variances are calculated using the project budget adjusted to % of completion. 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. it is usually necessary for employees to fill out a time sheet in order to generate the data to allocate the project costs. where the ability to account for costs by contracts (and sometimes contract lying item. Project accounting is commonly used at Government Contractors. Standard accounting is primarily aimed at monitoring financial progress of organizational elements (geographical or functional departments. Where labour costs are a significant portion of overall cost project. We have to 236 RCUES. quarters and years) Projects differ in that they frequently cross organizational boundaries.in a project management environment costs (both direct and overhead) and revenues are also allocated to projects. which can then be used by the managers to aid project management. may last for anything from a few days or weeks to a number of years. divisions and the enterprise as a whole) over defined time periods (typically weeks.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. LUCKNOW . or CLIN) is usually a requirement for interim payments. 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. A movie studio will employ production accounting to track the costs of its many separate projects. An interesting specialized form of project accounting is production accounting. Project accounting of the costs and benefits can provide crucially important feed back on the quality of these important decisions. They may also be one of a number of projects that make up a larger overall project or program. and The amount of retentions. Consequently . Percentage of completion is frequently independently assessed by a project manager. The amount of advances received . To maintain accounts for a project is a different aspect as a project is not a going concern and has a limited period. and often allows comparison with historical as well as current budgets. during which time budgets may also be revised many times. which tracks the costs of individual movie and television episode film production costs. Investments go/ no –go decisions are largely based on Net Present Value (NPV) assessments. A real estimate of project can be made only when proper accounts maintained for the work done. and grouped together into project hierarchies. Project accounting permits reporting at any such level that has been defined.
e. its revenues indicate a loss. RCUES. 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.PROJECT PLANNING & IMPLEMENTATION make closing of accounts at the vary point the project is completed. claims and incentive payments. 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. revenue is recognised only when the contract is completed. Accounting principles and policies can be taken into consideration for its preparation.under this method. and they are capable of being reliably measured for a change in the scope of work to be performed under the contract. 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. LUCKNOW 237 . The project manager may use both methods simultaneously for different projects depending circumstances. Whatever method is selected. Thus it reduces the risk of recognition of unrealized profit. the main objective of preparing accounts for the project is to know its Profit or Loss i. A comparative evaluation may be made of both methods and suitable method may be selected accordingly. This may lead to an increase or decrease in contract revenue. difference between the project revenue and project costs. Completed Contract Method: . Accounts should be maintained project vise so that the financial result of each project can be found separately. 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. An escalation clause should also propose in respect of contingent losses uncertainties. Project Revenue It should comprise: The initial amount of revenue agreed in the contract and Variation in contract work. While making estimates of total project costs. provision is made for entire loss on the project irrespective of the stage of completion of project. To the extend that it is probable that they will result in revenue.
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. Incentive payable is additional amount payable to the project developer specified performance standards are met or exceeded. 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. Depreciation of plant and equipment used on the contract. and Costs Directly Related To a Specific Contract Site labour costs. Costs of hiring plant and equipment. LUCKNOW . Costs of moving plant. 238 RCUES. Research and development costs for which reimbursement is not specified in the contract. 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 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. Selling costs. A claim may be arising from. including site supervision. equipment and materials to and from the contract site. 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. 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. for example errors in specification or design and disputed variation in contract work. The estimated costs of rectification and guarantee work. Contract Costs Contract costs should compromise: Costs that relate directly to a specific contract . and Claims from third parties. Costs of design and technical assistance that is directly related to the contract. 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. However. Costs of material used in construction. including expected warranty costs.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.
Authoritative documents include purchase invoices. and all other documents which are created as various transactions take place. balance with banks can be verified by obtaining written statements from competent parties. an auditor collects and evaluates evidences to establish facts and to draw conclusions and inferences.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. 3. Statement s by independent & competent parties provides highly evidence to the auditor. inspection or counting is a strong evidence of the existence of tangible assets.PROJECT PLANNING & IMPLEMENTATION Auditing is a specialized function having complex legal economic and ethical implications. cash. The project carried by Government should be audited periodically in order to check the efficiency status of the work . Physical Verification Direct examination. cancelled cheques . The auditors examine and report on economic information relating to organizations in which millions of people have a stake. It does not prove ownership of assets since mere existence is not indication of ownership. it is necessary to keep check on it . RCUES.memos. provided that the party is competent to make such a statement. which affect his judgment about the truthfulness of propositions summated to him for review . For example.As these projects are large enough and huge amount is invested in it. In this process. if an auditor counts the cash in hand on a surprise visit. 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. 2. 1. LUCKNOW 239 . The audit work should be planned properly in advance .Basically auditing is concerned with the verification and examination of quantitative information.however there are following limitations: Such evidences can not be used for each type of checking. 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. bills receivables.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. its auditing is equally necessary as auditing reveals the financial frauds and errors. Authorities documents These constitutes the main source of evidence available to man auditor. it would constitute a good evidence to sup[port the existence of cash . With proper accounting projects. Sundry creditors.
Subsidiary or Detailed Records with no significant Indications of Irregularity Subsidiary or detailed records such as stores ledger.The Subsequent realization of sundry debtors is evidence regarding the reliability of such debtors on the Balance sheet date . finished stock ledger. 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. of assertions in certain actions and events taking place after the balance sheet date . accounting data can be interrelated with other data . etc. 9.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.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.Sufficiency refers to the quantum of audit evidence obtained . 6. on the basis of valid evidence collected by the auditor. Interrelationship with other data Often. Statement by officers and employees of the enterprises under audit In the absence of auspicious circumstances. 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.For example .Appropriateness relates to its relevance and reliability . an auditor can rely to some extent. the reliability of the data generated but such records increases. on the statement by officers and employees of the enterprise under audit. 7. 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.. 8. This evidence is not as the statements made by independent parties.Such events and action gives the auditors the advantages of hindsight. Evaluation of raw audit Evidence Having collected the evidence .PROJECT PLANNING & IMPLEMENTATION 4.Most of these events are not accessible to observation .Hence. 5.the production records show the quantity of raw material consumed .Only inference can be drawn about them from testimony and intuition . an auditor should question and evaluation the evidence carefully.Yet. For proper control over the work . LUCKNOW .internal control system should also be developed by the project promoter 240 RCUES. Subsequent actions by the enterprise under audit and others An auditor can find evidence for a no.this quantity can be roughly to the total cost of raw material consumed as shown in the accounting statements.By valuing it at average cost . A satisfactory internal control system provides assurance to the auditor that the records are reliable. maintained properly and without any prima facie indications of irregularity.the auditor should evaluate it critically with regard to its sufficiency and appropriateness . Consequently.
PROJECT PLANNING & IMPLEMENTATION because it has a great effect on the work of audit as.As the volume of work is increasing . 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. 2. 1.In such situation internal auditor helps a lot as on auditors now can concentrate only on the point reported in the internal auditors report . Internal Audit When the work of audit is got carried by the management itself . roles and responsibility and critical dependencies as well as draw attention to check point meeting and critical target dates. A reference point making a major event in a project and used to monitor the project progresses. it determine the checkpoints where loopholes can be expected as well as the procedures which should be carried to conduct audit.The Internal auditor will assess the operation of the project financial management system and will review internal control mechanism. Audit Developments Recent Corporate accounting and financial scandals have led to sweeping regulatory changes –and dramatically increases audit requirements. 2. Whether the auditors are an outside auditors or part of the Internal Audit Team .it is known as internal audit . The auditor can also mark any task of any duration as a milestone.it is not possible for an auditor to check each and every aspect . The template is organized into following phase’s methodology which uses phase completion mile stone as a mechanism for reporting. Phase 1 Identification of AUDIT firm Related Matters. The employees should also be rotated period wise. 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. Specially designed audit templates for projects The objective of this template is to identify & correlate the activities required for an audit preparation process. LUCKNOW 241 .his audit process should be under intense security. Schedules and Fees Phase 2 Pre audit view by Management. Internal Staff and Audit Firm Phase 3 Implementation of Pre Audit Preview Phase 4 Final Audit Performances RCUES. Auditing Process. the project plan must include detailed tasks. To be effective.Considering the large size of the operation and multiplicity of spending units. The templates are observed on a Phased methodology which uses phase completion mile stone as a mechanism for reporting.) The template is organized into following phases. (Milestone. Internal controls can be applied by two methods 1. management oversight will be strengthened by internal audit reports . Any task with zero duration is automatically displayed as a mile stone.
on occurrence of claims and obligation in respect of incomes or expenditures. 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.e. 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 Hon’ble Court also stated that necessary amendments to the regulations be carried out by the Government of India. Accrual System of Accounting Accrual System of Accounting means a method of recording financial transactions based on accrual.. etc. 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 transaction may be defined as the actions and reactions having monetary implications of one person to another person. There are two system for recording transaction Single entry Accounting System Under single entry accounting system some transactions are not recorded at all. A transaction involves transfer of money or money’s worth (Goods or services) from one person to another. Significant accounting principles to be followed by the ULBs shall be given as a separate schedule forming part of the accounts. Budget formats with codification need to be adopted uniformly by all ULBs. LUCKNOW . 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. Primary Schools & Hospitals. while some transactions are recorded in only one of their aspects-either debit aspect or credit aspect. i. The CAG Task Force had issued a ‘Report on Accounting and Budget Formats for ULBs’. assets or liabilities based on happening 242 RCUES.PROJECT PLANNING & IMPLEMENTATION Accrual Based Double Entry Accounting System Statutory Mandate For Accrual Based Double Entry Accounting System :In the year 2001. Suggested formats for determining the cost of important utilities and services like Water Supply. Following recommendations were made by the Task Force: The ULBs should uniformly follow the suggested formats for presentation of annual financial statements. in response to a writ petition before it. be adopted by all the ULBs and presented as supplementary information.
to Mar. For Case Study on DEAS refer annexure-4 243 5. 10. Ease in financial appraisals by the financial institutions. This helps in correct presentation of financial statement .00. Revenue is recognized as it is earned and thus “Income” constitutes both revenue received and receivable. It facilitates proper financial analysis and reporting. etc. it is found that rent for the month of March’07 Rs. 8. decision making and control at each level of management. the statements of Income & Expenditure for 2006-07 will not give the correct position of profit/loss or surplus/deficit.for the period Jan.has not been received.000/. even though actual receipts or payments of money may not have taken place.5. Now if the Expenses of Rent and Income from property tax for the current year 2006-07 are not recorded in books of accounts. passage of time. 9. Lets Take An Example: A ULB prepares its annual accounts for the period 1st April to 31st March. which is a pre-requisite for mobilizing funds in the financial markets through debts instruments. BENEFITS OF ACCRUAL SYSTEM OF ACCOUNTING 1. rendering of services. right quality and nature of information for planning. Therefore. 6.2. It helps in providing timely. Expenses are matched with the income earned in the financial year. It also facilitates credit rating through approved credit rating agencies. the Receipt & Payment Account.. 3. 4. On 31st March 2007 when books of accounts are being closed. It assists in effective follow up of the receivables by the municipal body and proper ascertainment of payables by the municipal bodies. It presents a true picture of the financial position of an ULB and helps in better financial management. 7.has not been paid and property tax amounting Rs. A distinct difference is maintained between items of revenue nature and capital nature . * RCUES. an entry for both transactions has to be recorded on the accrual basis by creating liability for rent and receivable for property tax. Expenditure is recognised as and when the liability for payment arises and thus it constitutes both amount paid & payable.000/. viz . diminution in values(depreciation).PROJECT PLANNING & IMPLEMENTATION of any event. 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.’07. LUCKNOW . fulfillment (partially or fully) of contracts. 2. the Income and Expenditure statement and the Balance Sheet.60.
1 RCUES. million) Placement Guarantee Interest Escrow 100 1000 Private Private Yes No MUNICIPAL BONDS 13% 14.5% 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. street drains A-(SO) State government grants and property tax 13.75% 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 . LUCKNOW .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.
RCUES. 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 .5% Nonresidential Property taxes. Advertisement tax.2 PROJECT PLANNING & IMPLEMENTATION 245 .20% Monthly Payments equal to one-ninth of their annual Payments. LUCKNOW Tamil Nadu (pooled 110 Private * 9. Profession tax. 8. etc.
Payment by the corporation is based on the maintenance of each tube light. 246 RCUES. Jaipur Municipal Corporation decided to privatize the maintenance of street lights. Situation before the Initiative The area of Jaipur Municipal Corporation encompasses around 46. and a lineman would visit the fault point. etc. Results Achieved The results of the privatization are overwhelming. Lessons Learned Privatization of maintenance of street lights has reduced operation costs. while expenditure has reduced by more than 50 percent.000 acres and to illuminate this. In case of a complaint. of one tube light per year was more than Rs 80. The Store keeper would issue the material to the lineman who would then go to the fault point and carry out the repairs. LUCKNOW .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 corporation procured material worth almost Rs 150 lakh annually. Further to the privatization initiatives of the maintenance of street lights. The initiative in its first phase was experimented in six municipal wards only. Description of the Initiative The Jaipur Municipal Corporation decided to privatize maintenance of street lights and issue contracts ward wise. The contract includes materials. These timers have been set according to the time of sunrise and sunset. a driver with one vehicle and two helpers. Twenty contractors are involved in maintaining the street lights. further privatization of maintenance of street lights was undertaken in phases and till date 52 wards have been privatized and given on contract. A total of 706 street light timers have been installed. The efficiency level in the maintenance of the tube lights and sodium lights has increased from 70 to 99 per cent.014 tube lights and around 28.016 sodium lights. Significant energy saving can be achieved by implanting timers and through timely switching on/off of the same. only 6 out of the 70 wards were given on contract. After the success of the pilot testing in the first phase. a street light policy is also under formulation for other cities of Rajasthan State. As a result of privatization the municipal corporation is now able to provide a better level of service using less of its internal resources. labour and other services like transport. diagnose the fault and then report to the junior engineer. 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. the corporation has introduced solar timers in the city to bring about energy efficiency and cost savings. it has around 62. The initiative of privatizing the maintenance of street lights has remarkably increased the efficiency. In the first phase of the project. The cost of maintenance. An efficient complaint redressal system can impart 100 per cent efficiency to the system. There are around 9 control rooms spread all over the city for redressal of complaints regarding thestreet lights. including cost of material and establishment. The whole process was too lengthy and cumbersome. Taking these efforts ahead. The efficiency level was 70 to 75 per cent in the maintenance of the tube lights. The maintenance of these solar timers has also been given on contract.
of the National Institute of Urban Affairs. free from foul smell. The remaining carcass is then crushed and reduced to a dry powder form. However. Jaipur Municipal Corporation had contracted the lifting of carcasses from all parts of the city to a private contractor. since many cities do not have a proper facility with modern technology for the purpose. after the recovery of the initial investment in the commissioning of the plant. April-june 2005) RCUES. The carcasses emanated a foul smell. Rajasthan is famous for its leather products. A contractor has been appointed for processing and maintenance of the carcass plant. their skin is removed and after cleaning. to solve the problem of disposal of dead animals. Jaipur city has 8 points from where a request for lifting of any carcass lying in public places can be lodged.786 per year in 2003) Lessons Learned Commissioning of a proper plant with modern technology can give the city a clean environment. covering the 6 zones in the city.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. The dry powder is used as feed in poultry farms. as the contract will be renewed every year. Description of the Initiative A carcass utilization plant costing Rs 2. 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. 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. about 40 carcasses are lifted from the city per day. (The lease amount of the carcass plant which was Rs 5 lakh till 2002. During this process. they are put for sale. Vol. illegal slaughtering is widely rampant in cities.105. The plant has been operational since 2000. All this added to their nuisance value. For Jaipur Municipal Corporation. After the carcasses are collected from different parts of the city. etc. For this the Corporation was taking a leasing amount of about Rs 50. The money from the sale of the fat and the dry powder also goes to the contractor. 17 kms from Jaipur. Quarterly Newsletter. For lifting the carcasses the Jaipur Municipal Corporation has provided the contractor with 3 vehicles.000 to Rs 1 lakh per year Despite several measures. The contractor is required to lift the carcass within 12 hours. has been increased to Rs 1. failing which he is charged a fine of Rs 1. On an average. the contractor did not have a proper place to de-skin the could lead to serious health and environment hazards. they were also being attacked by other animals. Regular inspection of the carcass plant is carried out by the health department of the corporation.33 crore has been set up at Chainpur. and each vehicle has about 10 persons. this initiative would in future be one of the sources of revenue generation. illegal slaughtering of animals was widely rampant. Results Achieved The city has benefited as it now has a clean environment. 8 No. the fat of the dead animal is sold for the manufacture of soaps and detergents. 2. (Source: Urban Finance.000 per day. The contractor gives the leasing amount to the Jaipur Municipal Corporation. The sale proceeds are kept by the contractor. Situation before the Initiative Before the commissioning of the carcass plant. LUCKNOW 247 . Even though the process was contracted to a private party.
2. : 9.6. nos. : 248 RCUES.PROJECT PLANNING & IMPLEMENTATION ANNEXURE .7) Actual expenditure( excluding commitments) incurred during the financial year. and dates of sanction orders showing the amounts paid). on the grants Total amount that was available for expenditure during the financial year( Sl. LUCKNOW . 5. 8. & date in which authority to carry forward the said amount was given : : : : : 6.3 Utilization Certificate This certificate provides the necessary information regarding the utilization of the resources received for the purpose of the project. 5. 3. Title of the project/scheme Name of the Organization Project Head Sanction order No. In lakh) 1. if any. : Other receipts /interest earned . (Statement of expenditure enclosed) : 7. 4. Amount received from during the financial year (Please give No. It should be issued on the following format: FORMAT OF UTILISATION CERTIFICATION Utilization Certificate (For the financial year ending 31st March…. Thus it helps in making estimates of additional resources to be utilized in the project and timely arrangement of those of those.) (Rs. & date of sanctioning the project Amount brought forward from the previous financial year quoting letter No.
………mentioned against col. 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.. 3. 4. if any(Please give details of Cheque No. year. & Date : : 11.PROJECT PLANNING & IMPLEMENTATION 10. 5. 12.9 has been utilized on the project /scheme for the purpose for which it was sanctioned and the balance of Rs……….next ………………. etc.remaining unutilized at the end the year has been surrendered to Govt. Unspent balance refunded. (PROJECT HEAD) ( FINANCE OFFICER) RCUES.) Balance amount available at the end of the financial year Amount allowed to be carried forward to the next financial year vide letter No. : Certified that the amount of Rs. LUCKNOW 249 . Kind of checks exercised: 1. 2.dated ……………………)/will be adjusted towards –in-aid payable during ………………… the……………………….(Vide No……………….
Steps In Implementation Identification & Analysis of Functions: The Nagar Nigam Meerut is divided into three Zones namely Mukhyalaya zone. LUCKNOW . gains etc. arithmetic accuracy of books can not be proved. In single entry system it was a difficult task to fix the proper value of assets. dimensions of the assets. These forms contains the detailed information with regards to the specific assets. Hence the single entry system was subject to the following defects:I... no impersonal accounts relating to assets. where it is located. Different functions and functionaries (responsibility centers/ department ) where identified and analyzed. Generally . III. Description of the Initiative Meerut Nagar Nigam was selected under GOI-UNDP project. 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.” For the implementation of this project a Financial Consultant was appointed. Income & Expenditure Account and the Balance Sheet cannot be prepared. No trail Balance can be prepared and hence. IV. 250 RCUES.. Preparation of Opening Balance Sheet: A cut off date (Ist April 2006) was fixed for preparation of opening Balance Sheet. date of acquisition etc. cost of construction /acquisition by the ULB. description of the assets. for e. are kept. In the absence of real and nominal accounts the Receipts & Payments Account. Completeness of records as is possible under Accrual Based Double Entry System was absent. 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.g. It is not possible to know what the total payments or receipts are. II. expenses. “Capacity development for decentralised Urban Governance”. Any information obtained under single entry system was not free from doubt. “Capacity Development for Decentralized Urban Governance. Situation Before the Initiative Before applying Accrual Based Double Entry Accounting System in Nagar Nigam Meerut the Accounting was followed on Single Entry System. Kankar Khera zone and Shastri nagar zone consisting seventy wards along with three dispensaries and one school.PROJECT PLANNING & IMPLEMENTATION ANNEXURE-4 CASE STUDY Implementation of Accrual Based Double Entry Accounting System at Nagar Nigam Meerut under GOI-UNDP Project.
Feeding of demand and collection register was started to determine the true position of property tax receivables as well as water tax receivables. Tally 9. Need for double entry accounting system. 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’’.PROJECT PLANNING & IMPLEMENTATION Installation of Hardware and Software: A proper space was provided by the Nagar Nigam officials. c. 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. Simultaneously. as one of the systems in the accounts departments was connected with LAN. online training was provided to the accounts personnel on a regular basis. b. LUCKNOW . Some of the topics covered during the training programmes were as under:Significance of accrual based double entry accounting system. Receipts and Payments Accounts Income And Expenditure Accounts Balance Sheet 251 RCUES.0 (multiuser) was installed.0 will be compatible with the software being prepared by the CMC limited. Discussions were held with the officials of CMC limited and it was clarified that the data feeded on Tally 9. 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. the following financial statements were prepared :a. One of the computer system of the accounts department was connected with LAN. where six computer peripherals were installed on Local Area Network Facility. Preparation of Financial Statements: For the financial year ending 31st march 2007. Punching of Data Feeding of entry for the financial year 2006-07 on accrual based Double Entry Accounting System was started. Accounting concepts and conventions. A specific software for implementation of accrual based Double Entry Accounting System is being prepared by CMC limited. Discussions on Uttar Pradesh Municipal Accounts Manual. and were shown as an addition to the municipal fund at the time of preparation of the Balance Sheet.
5. 3. At least two staff members from the accounts departments should be designated on this specific project. Regular physical verification of fixed assets as well as of inventories should be undertaken and the respective registers should be updated. Monthly Bank Reconciliation Statements of all the Bank accounts should be prepared. LUCKNOW . Vashistha 252 RCUES.K.D.K. Saxena & C. Khan & P. Attendance of the staff members should be monitored by the departmental heads in the training programmes. Suggestions: 1.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. The knowledge and understanding capacity of the staff members was lacking due to which retrieval of information became difficult. :I. 2. Formats for the preparation of Opening Balance sheet should be circulated well in advance to the respective departmental heads. 4. Jain Advanced cost and Management Accounting By V. II.Y. 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. to ensure smooth shift to the new computerized accounting system. so that information can be collected on time. ____________________________________________________________________________________ Notes & References: National Municipal Accounting Manual Financing Municipal Services – Reaching out to Capital Markets Financial Management By M.
PROJECT PLANNING & IMPLEMENTATION RCUES. LUCKNOW 253 .
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