Econo-Ch 1

UPES
CENTRE FOR CONTINUING EDUCATION
MBPF913D
FINANCING ENERGY
SECTOR PROJECTS
www.cce.upes.ac.in
Course Design
Advisory Council
Chairman
Mr. Sharad Mehra
Members
Dr. S J Chopra Dr. Sunil Rai Dr. Veena Dutta
Chancellor Vice Chancellor Registrar
Dr. Kamal Bansal Mr. Ashok Sahu

Dean-Academics Head-Online Business
SLM Development Team

Dr. Raju Ganesh Sunder Dr. Rajesh Gupta
Professor & Head-Academic Unit Sr. Associate Professor
Mr. Tarun Batra Mr. Rahul Sharma Mr. Shantanu Trivedi

Asst. Director-Product Development Lecturer Lecturer
Author
Prof. Raju Ganesh Sunder

Dr. Rajesh Gupta
Course Code: MBPF913D

Course Name: Financing Energy Sector Projects
Version: July 2019

Contents
Unit 1 Introduction to Return Concept–I ...................................................................... 3

Unit 2 Introduction to Return Concept–II ................................................................... 15
Unit 3 Introduction to Project Appraisal ..................................................................... 29
Unit 4 Financial Analysis .............................................................................................. 43
Unit 5 Case Study .......................................................................................................... 53
Unit 6 Concept of Business Entity ............................................................................... 81
Unit 7 Effective Utilisation of Funds ........................................................................... 93
Unit 8 Cost of Equity Models...................................................................................... 103
Unit 9 WACC and Equity Capital .............................................................................. 111
Unit 10 Case Study ........................................................................................................ 125
Unit 11 Sources of Finance–I ........................................................................................ 137
Unit 12 Sources of Finance–II ...................................................................................... 147
Unit 13 Risk Management ............................................................................................. 165
Unit 14 Risk Identification, Analysis and Control...................................................... 171
Unit 15 Case Study ........................................................................................................ 181
Unit 16 Risk Planning ................................................................................................... 189
Unit 17 Incentive for Non-conventional Projects ........................................................ 205
Unit 18 Financing Non-conventional Projects ............................................................. 219
Unit 19 IREDA and its Role ......................................................................................... 233
Unit 20 Case Study ........................................................................................................ 241
Unit 21 Project Economics and Viability–I .................................................................. 251
Unit 22 Project Economics and Viability–II ................................................................ 261
Unit 23 Electricity Sector in India–I ............................................................................ 271
Unit 24 Electricity Sector in India–II .......................................................................... 287
Unit 25 Case Study ........................................................................................................ 299
Block–I
Detailed Contents
UNIT-1: INTRODUCTION TO RETURN CONCEPTS–I
UNIT-2: INTRODUCTION TO RETURN CONCEPTS–II
UNIT-3: INTRODUCTION TO PROJECT APPRAISAL
UNIT-4: FINANCIAL ANALYSIS
UNIT-5: CASE STUDY

3
Unit 1 Notes
Introduction to Return Concept–I

Return ___________________
___________________
___________________
Learning Objectives: ___________________

After completion of this unit, the students will be able to explain:
___________________
\ Payback Period Method
___________________
\ Net Present Value and its Impolications
___________________
___________________
Introduction ___________________
Financial decisions are very important for any company or ___________________
business utility as the basic aim of creation of any business entity
is to maximize its wealth. All stakeholders are concerned about
the fact that whether its resources are being used effectively or
not. Return on investment calculation plays a vital role in financial
decision making.
Investments commonly involve returns that extend over a long
period of time. Decisions on investment have to be made based
on the returns that investment will make. Unless the project is
for only social reasons, if the investment is unprofitable in the
long run, it is not wise to invest in it.
Often, it would be good to know what the present value of the
future investment is, or how long it will take to mature (give
returns). It could be much more profitable putting the planned
investment money in the bank and earning interest or investing
in an alternative project.
Therefore, in approaching capital budgeting decisions, it is
necessary to employ techniques that recognize the time value of
money.
“A Rupee today is worth more than a Rupee
a year from now.”
The same concept applies while choosing among different
investment projects. Those projects that promise earlier returns
are preferable to those that promise later retunes. The capital
budgeting techniques that recognize the above two characteristics
of business investments most fully are those that involve
discounted cash flow.
Financing Energy Sector Projects
4
Two approaches to making capital budgeting decisions use
Notes
discounted cash flows. One is the net present value method and
other is the internal rate of return method.
___________________
___________________ Payback Period Method

___________________ Payback period in business and economics refers to the period
of time required for there turn on an investment to “repay” the
___________________
sum of the original investment. For example, if a project involves
___________________ a cash outlay of ` 600,000 and generates cash inflows of ` 100,000,
` 150,000, ` 150,000 and ` 200,000, in the first, second, third and
___________________
fourth year, respectively, its payback period is 4 years because
___________________ the sum of cash inflows during 4 years is equal to the initial
outlay.
___________________
When the annual cash inflow is a constant sum, the payback
___________________
period is simply the initial outlay divided by annual cash inflow.
___________________ For example, a project that has an initial cash outlay of` 1,000,000
and a constant annual cash in flow of ` 300,000 has a payback
period of ` 1,000,000/300,000 = 3.333 years.
The expression is also widely used in other types of investment
areas, often with respect to energy efficiency technologies,
maintenance, upgrades, or other changes. For example, a compact
fluorescent light bulb may be described of having a payback period
of a certain number of years or operating hours (assuming certain
costs); here, the return to the investment consists of reduced
operating costs. Although primarily in a financial term, the concept
of a payback period is occasionally extended to other uses, such
as energy payback period (the period of time over which the
energy savings of a project equals the amount of energy expended
since project inception).
The following other terms may not be standardized or widely
used:
The length of time required to recover the cost of an
investment:
The payback period is defined as the length of time required to
recover an initial investment through cash flows generated by
the investment. The payback period lets you see the level of
profitability of an investment in relation to time. The shorter the
time of payback period, better the investment opportunity is.
Payback period is calculated as:
Cost of Project (or) Investment

Pay Back Period =
Annual Cash Inflows
Unit 1: Introduction to Return Concepts–I
5
All other things being equal, the better investment is the
Notes
one with the shorter payback period.
For example, if a project costs ` 100,000 and is expected to return ___________________
` 20,000 annually, the payback period would be 100,000/20,000, or
___________________
five years.
___________________
Firms using this criterion, generally, specify the maximum
acceptable payback period. If this is n years, projects with a ___________________
payback period of n years or less are deemed worthwhile and
___________________
projects with a payback period exceeding n years are considered
unworthy. ___________________
Evaluation ___________________
In a widely used investment criterion, the payback period seems ___________________

to offer the following advantage: ___________________
1. It is simple, both in concept and application. It does not use ___________________
involved concepts and tedious calculation and has a few
hidden assumptions.
2. It is rough and ready method for dealing with risk. It favours
projects that generate substantial cash inflows in earlier
years and discriminates against projects, which bring
substantial cash inflows in later years but not in earlier
years. Now, if risk tends to increase with futurity – in
general, this may be true that the payback criterion may be
helpful in weeding out risky projects.
3. Since it emphasizes earlier cash inflows, it may be a sensible
criterion when the firm is pressed with problems of liquidity.
Limitations
The limitations of the payback criterion, however, are very serious:
1. It failed to consider the time value of money. Cash inflows,
in the payback calculation, are simply added without suitable
discounting. This violates the most basic principle of financial
analysis, which stipulates that cash flows occurring at
different points of time can be added or subtracted only
after compounding/discounting.
2. It ignores cash flows beyond the payback period. This leads
to discriminations against project that generates substantial
cash inflows in later years. To illustrates, consider the cash
flows of two projects, A and B:
6
Notes Years Cash Flow of A Cash Flow of B
0 (100,000) (100,000)
___________________
1 50,000 20,000
___________________
2 30,000 20,000
___________________ 3 20,000 20,000
___________________ 4 10,000 40,000
5 10,000 50,000
___________________
6 – 60,000
___________________
___________________ The payback criterion prefers A, which has a payback period

of 3 years in comparison to B, which has a payback period
___________________
of 4 years, even though B has very substantial cash inflows
___________________ in years 5 and 6.
___________________ 3. It is a measure of the project’s capital recovery not

profitability.
4. Though it measures a project’s liquidity, it does not indicate
the liquidity positions of the firm as a whole, which is more
important.
What is time value of money, i.e., ` 100 earned after two
years would have the same value as it is having today?
No, it would not have the same value as money loses its purchasing
power with time due to inflation (increase in interest rate).
As we know that the interaction of lenders with borrowers sets
an equilibrium rate of interest. Borrowing is only worthwhile if
the return on the loan exceeds the cost of the borrowed funds.
Lending is only worthwhile if the return is at least equal to what
can be obtained from alternative opportunities in the same risk
class.
The interest rate received by the lender is made up of:
1. The time value of money: The receipt of money is preferred
sooner rather than later. Money can be used to earn more
money. The earlier the money is received, the greater the
potential for increasing wealth. Thus, to forego the use of
money, you must get some compensation.
2. The risk of the capital sum not being repaid: This
uncertainty requires a premium as a hedge against the risk;
hence the return must be commensurate with the risk being
undertaken.
3. Inflation: Money may lose its purchasing power over time.
The lender must be compensated for the declining spending/
7
purchasing power of money. If the lender receives no
Notes
compensation, he/she will be worse off when the loan is
repaid than at the time of lending the money.
___________________
(a) Future Value/compound interest: Future Value (FV)
___________________
is the value in dollars at some point in the future of one
or more investments. ___________________
FV consists of: ___________________

(i) The original sum of money invested, and ___________________
(ii) The return in the form of interest.
___________________
The general formula for computing FV is as follows:
___________________
FVn = Vo (l + r)n
___________________
where,
___________________
Vo is the initial sum invested
___________________
r is the interest rate
n is the number of periods for which the investment
is to receive interest.
Thus, we can compute the future value of what Vo will
accumulate in n years when it is compounded annually at
the same rate of r by using the above formula.
We can derive the Present Value (PV) by using the formula:
FVn = Vo (I + r)n
By denoting Vo by PV we obtain:
FVn = PV (I + r)n
By dividing both sides of the formula by (I + r)n:
FVn
PV =
(I + r) n
Check Your Progress
Fill in the blanks:
1. ................. in business and economics refers to the period of time

required for the return on an investment to “repay” the sum of the
original investment.
2. The ................. must be compensated for the declining spending/

purchasing power of money.
8
Notes
Net Present Value (NPV)
NPV is a way of comparing the value of money now with the
___________________
value of money in the future. A dollar today is worth more than
___________________ a dollar in the future, because inflation erodes the buying power
of the future money, while money available today can be invested
___________________ and grown.
___________________ The NPV of a project is the sum of the present values of all the
___________________ cash flows – positive as well as negative that are expected to
occur over the life of the project. The general formula of NPV is:
___________________
n C
___________________ NPV of project = t = 1 (1 + tr) t − Initial Investment
___________________
Where, Ct = Cash flow at the end of year t.
___________________
n = Life of the project
___________________
r = Discount rate (The interest rate used in
discounting future cash flows)
To illustrate the calculation of net present value, a project that
has the following cash flow stream:
Year Cash Flow (`

`)
0 (1,000,000)
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
The cost of capital, r, for the firm is 10 per cent value of the
proposal:
1,000,000 200,000 200,000 300,000 300,000 350,000

NPV = + + + + +
. )0
(110 . )1
(110 . )2
(110 . )3
(110 . )4
(110 . )5
(110
= −5,273
The net present value represents the net benefits over and above
the compensation for time and risk. Hence, the decision rule
association with the net present value criterion is:
Accept the project if the net present value is positive and reject
the project if the net present value is negative. (If the NPV is
Zero, it is a matter of indifference).
9
What NPV Tells
Notes
With a particular project, if Ct is a positive value, the project is
in the status of cash inflow in the time of t. If Ct is a negative ___________________
value, the project is in the status of cash outflow in the time of ___________________
t. Appropriately risked projects with a positive NPV should be
accepted. This does not necessarily mean that they should be ___________________
undertaken since NPV at the cost of capital may not account for
___________________
opportunity cost, i.e., comparison with other available
investments. In financial theory, if there is a choice between two ___________________
mutually exclusive alternatives, the one yielding the higher NPV
___________________
should be selected.
___________________
The following table sums up the NPV’s various situations:
___________________
If... It means... Then...
___________________
NPV > 0 the investment would add the project should be accepted
value to the firm ___________________
NPV < 0 the investment would sub- the project should be rejected
tract value from the firm
NPV = 0 the investment would neither the project could be accepted

gain nor lose value for the as shareholders obtain the
firm required rate of return
Properties of the NPV Rule

The NPV has certain properties that make it a very attractive
decision criterion:
• NPVs are Additive: The net present value of a package of
projects is simply the sum of the net present values of
individual projects included in the package. This property
has several implications:
• The value of a firm can be expected as the sum of the present
value of projects in place as well as the net present value of
prospective projects:
Value of a firm = ∑Present value of projects +
∑NPV of expected future projects
The firm term on the right-hand side of this equation captures
the value of assets in place and the second term, the value
of growth opportunities.
• When a firm terminates an existing project, which has a
negative NPV based on its expected future cash flows, the
value of the firm increases by that amount. Likewise, when
a firm undertakes a new project that has a negative NPV,
the value of the firm decreases by that amount.
10
• When a firm divests itself of an existing project, the price at
Notes
which the project is divested affects the value of the firm. If
the price is greater/lesser than the present value of the
___________________
anticipated cash of the project, the value of the firm will
___________________ increase/decrease with the divestiture.
___________________ • When a firm takes a new project with a positive NPV, its
effects on the value of the firm depends on whether its NPV
___________________
is in line expectations. Hindustan Lever Limited, for example,
___________________ is expected to take on high positive NPV projects and this
expectation is reflected in its value. Even if the new projects
___________________ taken on by Hindustan Lever Limited have positive NPV,
___________________
the value of the firm may drop if the NPV is not in line with
the high expectation of investors.
___________________
• When a firm acquires and pays a price in excess of the
___________________ present value of the expected cash flows from the acquisition,
it is taking on a negative NPV project and hence, will
___________________
diminish the value of the firm.
NPV Calculation Permits Times Varying Discount Rates

It is assumed that the discount rate remains constant over time.
This need not always be the case. The NPV can be calculated
using time-varying discount rates. The general formula of NPV is
as follows:
n C
NPV = t = 1 (1 + tr) t − Initial Investment
Where, Ct = Cash flow at the end of year t

rt = discount rate for the year t
In even more general term, NPV is expected as follows:
n Ct
NPV = t =1 t
− Initial Investment
∏ (1 + rj )
j =1
Where, Ct = Cash flow at the end of year t

rj = One period discount rate
The discount rate may change over time for the following reasons:
• The level of interest rates may change over time – the term
structure of interest rates light on expected rates in future.
• The risk characteristics of the projects may change over time,
resulting in changes in the cost of capital.
11
• The financing mix of the project may vary over time, causing
Notes
changes in the cost of capital.
The cost of capital determines how a company can raise money ___________________
(through a stock issue, borrowing or a mix of the two).
___________________
To illustrate, assume that you are evaluating a 5-year project
___________________
involving software development. You believe that the technological
uncertainty associated with this industry leads to higher discount ___________________
rates in future.
___________________
Year Investment Cash Flows in ` Discount Rate (%) ___________________
0 (12000) – ___________________
1 4,000 14 ___________________
2 5,000 15 ___________________
3 7,000 16 ___________________
4 6,000 18
5 5,000 20
The present value of the cash flows can be calculated as follows:

PV of C1 = 4,000/1.14 = 3509
PV of C2 = 5,000/(1.14 × 1.15) = 3814
PV of C3 = 7,000/(1.14 × 1.15 × 1.16) = 4603
PV of C4 = 6,000/(1.14 × 1.15 × 1.16 × 1.18) = 3344
PV of C5 = 5,000/(1.14 × 1.15 × 1.16 × 1.18 × 1.20) = 2322
NPV of project = 3509 + 3814 + 4603 + 3344 + 2322 – 12000
= 5592
Limitations
Despite its advantage and a direct linkage to the objective of
value maximization, the NPV rule has its opponents who points
towards some limitations:
• The NPV is expressed in absolute terms rather than relative
terms and hence, does not factor in the scale of investment.
Thus, project A may have an NPV of 5,000 while project B
has an NPV of 2,500, but project A may require an investment
of 50,000 whereas project B may require an investment of
just 10,000. Advocates of NPV, however, argue that what
matters is the surplus value, over and above the hurdle rate,
irrespective of what the investment outlayis.
12
• The NPV rule does not consider the life of the project. Hence,
Notes
when mutually exclusive project with different lives are being
considered, the NPV rule is biased in favour of the longer-
___________________
term project.
___________________
• Each potential project’s value should be estimated using a
___________________ discounted cash flow (DCF) valuation, to find its net present
value (NPV). This valuation requires estimating the size and
___________________
timing of all of the incremental cash flows from the project.
___________________ These future cash flows are then discounted to determine
their present value. These present values are then summed,
___________________ to get the NPV. The NPV decision rule is to accept all positive
___________________
NPV projects in an unconstrained environment, or if projects
are mutually exclusive, accept the one with the highest NPV.
___________________
• The NPV is greatly affected by the discount rate, so selecting
___________________ the proper rate, sometimes called the hurdle rate is critical
to making the right decision. The hurdle rate is the minimum
___________________
acceptable return on an investment. It should reflect the
riskiness of the investment, typically measured by the
volatility of cash flows, and must take into account the
financing mix. Managers may use models such as the CAPM
or the APT to estimate a discount rate appropriate for each
particular project, and use the weighted average cost of
capital (WACC) to reflect the financing mix selected. A
common practice in choosing a discount rate for a project is
to apply a WACC that applies to the entire firm, but a higher
discount rate may be more appropriate when a project’s risk
is higher than the risk of the firm as a whole.
Check Your Progress
Fill in the blanks:
1. ........................ is a way of comparing the value of money now with

the value of money in the future.
2. The NPV is greatly affected by the discount rate, so selecting the proper
rate, sometimes called the ...................... is critical to making the right
decision.
3. The firm term on the right-hand side of this equation captures the value
of ........................ in place and the second term the value of
........................ .
Summary
Everyday life is full or risk. When you drive to work, you run the
risk of getting plastered by an 18-wheeler, and the simple act of
stepping off a curb could turn deadly if you’re not careful. But to
13
get anywhere or accomplish anything in life, you’ll probably have
Notes
to take at least some risk to receive a reward in return. This
concept is also true when it comes to investing your hard-earned
___________________
money. Low-risk investments offer a larger degree of safety. If
you put your money into a savings account at your local bank, you ___________________
can take comfort knowing that your money is insured up to
___________________
$ 250,000 by the Federal Deposit Insurance Corporation (FDIC).
Of course, in exchange for the safety, you’ll receive a minuscule ___________________
interest rate, meaning your return on investment over time will
___________________
also be small. You could always decide to avoid risk at all by
keeping your money in your piggy bank or under your mattress. ___________________
While your money is completely safe, unless a burglar steals your
piggy bank or you accidentally set the mattress on fire, your ___________________
return on investment will be zero. You may also have great ___________________
difficulty in achieving financial goals like having enough money
for retirement or for your kids’ college education. ___________________
___________________
Questions for Discussion
1. What is NPV?
2. What are the implications of the additively property of NPV?
3. Discuss the general formula of NPV when discount rates
vary over time.
4. What is the rationale for the NPV rule?
15
Unit 2 Notes
Introduction to Return Concept–II

Return ___________________
___________________
___________________

___________________
\ Internal Rate of Returns and its Problems
___________________
\ Time Value of Money
___________________
___________________
Introduction
___________________
The rate used to discount future cash flows to their present values
___________________
is a key variable of this process. A firm’s weighted average cost
of capital (after tax) is often used, but many people believe that
it is appropriate to use higher discount rates to adjust for risk
for riskier projects. A variable discount rate with higher rates
applied to cash flows occurring further along the time span might
be used to reflect the yield curve premium for long-term debt.
Another approach to choosing the discount rate factor is to decide
the rate which the capital needed for the project could return if
invested in an alternative venture. If, for example, the capital
required for Project A can earn five per cent elsewhere, use this
discount rate in the NPV calculation to allow a direct comparison
to be made between Project A and the alternative. Related to this
concept is to use the firm’s Reinvestment Rate. Reinvestment
rate can be defined as the rate of return for the firm’s investments
on average. When analysing projects in a capital constrained
environment, it may be appropriate to use the reinvestment rate
rather than the firm’s weighted average cost of capital as the
discount factor. It reflects opportunity cost of investment, rather
than the possibly lower cost of capital.
NPV value obtained using variable discount rates (if they are
known) with the years of the investment duration better reflects
the real situation than that calculated from a constant discount
rate for the entire investment duration.
For some professional investors, their investment funds are
committed to target a specified rate of return. In such cases, that
rate of return should be selected as the discount rate for the
NPV calculation. In this way, a direct comparison can be made
between the profitability of the project and the desired rate of
return.
16
Notes
Discount Rate
To some extent, the selection of the discount rate is dependent
___________________
on the use to which it will be put. If the intent is simply to
___________________ determine whether a project will add value to the company, using
the firm’s weighted average cost of capital may be appropriate. If
___________________ trying to decide between alternative investments in order to
___________________ maximize the value of the firm, the corporate reinvestment rate
would probably be a better choice.
___________________
Using variable rates over time or discounting “guaranteed” cash
___________________ flows different from “at risk” cash flows may be a superior
___________________
methodology but is seldom used in practice. Using the discount
rate to adjust for risk is often difficult to do in practice (especially
___________________ internationally) and is really difficult to do well. An alternative
to using discount factor to adjust for risk is to explicitly correct
___________________
the cash flows for the risk elements, then discount at the firm’s
___________________ rate.
Calculating NPV
The NPV method is used for evaluating the desirability of
investments or projects.
C1 C2 C3 Ct
NPV = + + + ... + − I0
I + r (I + r) 2 (I + r) 3 (I + r) t
n C
NPV = t = 1 ( I + tr) t − I0
Where, Ct = The net cash receipt at the end of year t
I0 = The initial investment outlay
r = The discount rate/The required minimum rate of
return on investment
n = The project/investment’s duration in years.
The discount factor r can be calculated using:
1
q (t, i) =
(1 + i) t
Examples:
1
q (1, 10%) = = 0.9091
1.1
1
q (2, 10%) = = 0.8264
. )2
(11
1
q (3, 10%) = = 0.7513
. )3
(11
Unit 2: Introduction to Return Concepts–II
17
In financial theory, if there is a choice between two mutually
Notes
exclusive alternatives, the one yielding the higher NPV should
be selected.
___________________
The following sums up the NPVs in various situations:
___________________
If... It means... Then...
___________________
NPV > 0 the investment would add the project may be accepted
___________________
value to the firm
___________________
NPV < 0 the investment would sub- the project should be rejected
tract value from the firm ___________________
NPV = 0 the investment would neither We should be indifferent in ___________________

gain nor lose value for the the decision whether to
firm accept or reject the project. ___________________
This project adds no mone-
___________________
tary value. Decision should
be based on other criteria, ___________________
e.g., strategic positioning or
other factors not explicitly
included in the calculation.
However, NPV = 0 does not mean that a project is only expected

to break even, in the sense of undiscounted profit or loss
(earnings). It will show net total positive cash flow and earnings
over its life.
Example
X corporation must decide whether to introduce a new product
line. The new product will have startup costs, operational costs
and incoming cash flows over six years. This project will have an
immediate (t = 0) cash outflow of ` 100,000 (which might include
machinery, and employee training costs). Other cash outflows for
years 1–6 are expected to be ` 5,000 per year. Cash inflows are
expected to be ` 30,000 per year for years 1–6. All cash flows are
after-tax, and there are no cash flows expected after year 6. The
required rate of return is 10%. The present value (PV) can be
calculated for each year:
T = 0 – 100,000 / 1.100 = –100,000 PV
T = 1 (30,000 – 5,000) / 1.101 = 22,727 PV
T = 2 (30,000 – 5,000) / 1.102 = 20,661 PV
T = 3 (30,000 – 5,000) / 1.103 = 18,783 PV
T = 4 (30,000 – 5,000) / 1.104 = 17,075 PV
T = 5 (30,000 – 5,000) / 1.105 = 15,523 PV
T = 6 (30,000 – 5,000) / 1.106 = 14,112 PV
18
The sum of all these present values is the net present value,
Notes
which equals 8,881. Since the NPV is greater than zero, the
corporation should invest in the project.
___________________
___________________ Check Your Progress

___________________ Fill in the blanks:
___________________ 1. To some extent, the selection of the .................... is dependent on the

use to which it will be put.
___________________
2. Using variable rates over time, or discounting .................... cash flows
___________________ different from .................... cash flows may be a superior methodology,
but is seldom used in practice.
___________________
___________________
Internal Rate of Return (IRR)
___________________
The Internal Rate of Return (IRR) of a project is the discount
___________________ rate that makes its NPV equal to zero. Put differently, it is
discount rate, which equates the present value of future cash
flows with the initial investment. It is the value of r in the
following equation:
n C
Investment = t = 1 ( I + tr) t
Where, Ct = Cash Flow at the end of year
r = Internal rate of return (IRR)
In the NPV calculation, we assume that the discount rate (cost of
capital) is known and determine the NPV. In the IRR calculation,
we set the NPV equal to zero and determine the discount rate
that satisfies this condition.
To illustrate the calculation of IRR, consider the cash flows of a
project being considered by M/s ABC Limited.
Year 0 1 2 3 4
Cash Flow (100,000) 30,000 30,000 40,000 45,000
The IRR is the value of r which satisfies the following equation:
30,000 30,000 40,000 45,000

100,000 = + + +
(1 + r)1 (1 + r) 2 (1 + r) 3 (1 + r) 4
The calculation of r involves a process of trial and error. We try
different values of r till we find that the right-hand side of the
19
above equation is equal to 100,000. Let us, to begin with, try r =
Notes
15 per cent. This makes the right-hand side equal to:
30,000 30,000 40,000 45,000 ___________________

+ + + = 100,802
(1.15)1 (115
. ) 2 (1.15) 3 (1.15) 4 ___________________
This value is slightly higher than our target value, 100,000. So we ___________________
increase the value of r from 15 per cent to 16 per cent. (In general,
a higher r lowers and a smaller r increases the right-hand side ___________________
value). The right-hand side becomes: ___________________
30,000 30,000 40,000 45,000

+ + + = 98,641 ___________________
(1.16)1 (116
. ) 2 (1.16) 3 (1.16) 4
___________________
Since this value is now less than 100,000, we conclude that the
value of r lies between 15 per cent and 16 per cent. For most of ___________________
the purpose this indication suffices. ___________________
1. Determine the net present value of the two closest rates of ___________________
return.
(NPV/15%) 802
(NPV/16%) (1,359)
2. Find the sum of the absolute values of the net present values
obtained in step 1:
802 + 1,359 = 2,161
3. Calculate the ratio of the net present values of the smaller
discount rate, identified in step 1, to the sum obtained in
step2:
802/2,161 = 0.37
4. Add the number obtained in step 3 to the smaller discount
rate: 15 + 0.37 = 15.37%.
The internal rate of return, calculated in this manner, is a very
close approximation to the true rate of return.
The decision rule for IRR is as follows:
• Accept: If the IRR is greater than the cost of capital.
• Reject: If the IRR is less than the cost of capital.
The IRR is defined as the discount rate that gives an NPV of
zero. It is a commonly used measure of investment efficiency.
The IRR method will result in the same decision as the NPV
method for independent (non-mutually exclusive) projects in an
unconstrained environment, in the usual cases where a negative
cash flow occurs at the start of the project, followed by all positive
20
cash flows. In most realistic cases, all independent projects that
Notes
have an IRR higher than the hurdle rate should be accepted.
Nevertheless, for mutually exclusive projects, the decision rule
___________________
of taking the project with the highest IRR, which is often used
___________________ may select a project with a lower NPV.
___________________ In some cases, several zero NPV discount rates may exist, so
there is no unique IRR. The IRR exists and is unique if one or
___________________
more years of net investment (negative cash flow) are followed by
___________________ years of net revenues. But if the signs of the cash flows change
more than once, there may be several IR. The IRR equation,
___________________
generally, cannot be solved analytically but only viaiterations.
___________________
One shortcoming of the IRR method is that it is commonly
___________________ misunderstood to convey the actual annual profitability of an
investment. However, this is not the case because intermediate
___________________ cash flows are almost never reinvested at the project’s IRR; and,
___________________ therefore, the actual rate of return is almost certainly going to be
lower. Accordingly, a measure called Modified Internal Rate of
Return (MIRR) is often used.
Despite a strong academic preference for NPV, surveys indicate
that executives prefer IRR over NPV, although they should be
used in concert. In a budget-constrained environment, efficiency
measures should be used to maximize the overall NPV of the
firm. Some managers find it intuitively more appealing to evaluate
investments in terms of percentage rates of return than dollars
of NPV.
Accept/Reject Rule for IRR

IRR thus determined (calculated) for the given investment
project(s) is compared with the required rate of return (the
minimum rate accepted by the shareholders), also known as
opportunity cost of capital of the firm i.e., ‘k’.
When, IRR > k then, one ACCEPTs the projects proposal.
IRR < k then one, REJECTs the projects proposal.
IRR = k then, one is INDIFFERENT to the project’s
proposal.
Graphical Explanation for IRR

IRR is defined as the discount rate that makes the project has a
zero NPV. IRR is an alternative method of evaluating software
investments without estimating the discount rate. IRR takes into
account the time value of money by considering the cash flows
over the lifetime of a project. The IRR and NPV concepts are
related but they are not equivalent.
21
The IRR uses the NPV equation as its starting point:
Notes
Initial Cash flow year 1 Cash flow year n
NPV = 0 = + 1
+ ... ___________________
Investment (1 + IRR) (1 + IRR) n
• Initial investment: The investment at the beginning of the ___________________
project. ___________________
• Cash flow: Measure of the actual cash generated by a ___________________
company or the amount of cash earned after paying all
expenses and taxes. ___________________
• IRR: Internal Rate of Return. ___________________
• n: Last year of the lifetime of the project. ___________________
Calculating the IRR is done through a trial-and-error process ___________________

that looks for the discount rate that yields an NPV equal to zero.
The trial-and-error calculation can be accomplished by using the ___________________
IRR function in a spreadsheet program or with a programmable ___________________

calculator.
A project that has a discount rate less than the IRR will yield a
positive NPV. The higher the discount rate the more the cash
flows will be reduced, resulting in a lower NPV of the project.
The company will approve any project or investment where the
IRR is higher than the cost of capital as the NPV will be greater
than zero.
For example, the IRR for a particular project is 20%, and the cost
of capital to the company is only 12%. The company can approve
the project because the maximum value for the company to make
money would be 8% more than the cost of capital. If the company
had a cost of capital for this particular project of 21%, then there
would be a negative NPV and the project would not be considered
a profitable one.
The IRR is, therefore, the maximum allowable discount rate that
would yield value considering the cost of capital and risk of the
project. For this reason, the IRR is sometimes referred to as a
break even rate of return. It is the rate at which the value of cash
outflow equals the value of cash inflow.
There are some special situations where the IRR concept can be
misinterpreted. This is usually the case when periods of negative
cash flow affect the value of IRR without accurately reflecting
the underlying performance of the investment. Managers may
misinterpret the IRR as the annual equivalent return on a given
investment. This is not the case, as the IRR is the break even
rate and does not provide an absolute view on the project return.
22
Notes Check Your Progress
Fill in the blanks:

___________________
1. The Internal Rate of Return (IRR) of a project is the discount rate that
___________________
makes its NPV equal to ...................... .
___________________ 2. In the NPV calculation, we assume that the discount rate (cost of capital)
is ...................... and determines the NPV.
___________________
3. ...................... is an alternative method of evaluating software investments
___________________
without estimating the discount rate.
___________________
___________________ Advantages and Disadvantages of IRR and NPV

___________________ • A number of surveys have shown that, in practice, the IRR
method is more popular than the NPV approach. The reason
___________________ may be that the IRR is straightforward, but it uses cash
flows and recognizes the time value of money, like the NPV.
___________________
In other words, while the IRR method is easy and
understandable, it does not have the drawbacks of the ARR
and the payback period, both of which ignore the time value
of money.
• The main problem with the IRR method is that it often gives
unrealistic rates of return. Suppose the cut off rate is 11%
and the IRR is calculated as 40%. Does this mean that the
management should immediately accept the project because
its IRR is 40%? The answer is NO. An IRR of 40% assumes
that a firm has the opportunity to reinvest future cash flows
at 40%. If past experience and the economy indicate that
40% is an unrealistic rate for future reinvestments, an IRR
of 40% is suspect. Simply speaking, an IRR of 40% is too
good to be true. So, unless the calculated IRR is a reasonable
rate for reinvestment of future cash flows, it should not be
used as a yardstick to accept or reject a project.
• Another problem with the IRR method is that it may give
different rates of return. Suppose there are two discount
rates (two IRRs) that make the present value equal to the
initial investment. In this case, which rate should be used
for comparison with the cut off rate? The purpose of this
question is not to resolve the cases where there are different
IRRs. The purpose is to let you know that the IRR method,
despite its popularity in the business world, entails more
problems than a practitioner may think.
Why the NPV and IRR sometimes Select Different Projects

When comparing two projects, the use of the NPV and the IRR
methods may give different results. A project selected according
to the NPV may be rejected if the IRR method is used.
23
Suppose there are two alternative projects, X and Y. The initial
Notes
investment in each project is ` 2,500. Project X will provide annual
cash flows of ` 500 for the next 10 years. Project Y has annual
___________________
cash flows of ` 100, ` 200, ` 300, ` 400, ` 500, ` 600, ` 700, ` 800,
` 900, and ` 1,000 in the same period. Using the trial-and-error ___________________
method, the IRR of Project X is 17% and the
___________________
IRR of Project Y is around 13% ___________________
If we use the IRR, Project X should be preferred because its IRR ___________________
is 4% more than the IRR of Project Y. But what happens to the
decision if the NPV method is used? The answer is that the ___________________
decision will change depending on the discount rate we use. For ___________________
instance, at a 5% discount rate, Project Y has a higher NPV than
X does. But at a discount rate of 8%, Project X is preferred because ___________________
of a higher NPV.
___________________
The purpose of this numerical example is to illustrate an
___________________
important distinction. The use of the IRR always leads to the
selection of the same project, whereas project selection using the
NPV method depends on the discount rate chosen.
Project Size and Life

There are reasons why the NPV and the IRR are sometimes in
conflict. The size and life of the project being studied are the
most common ones. A 10-year project with an initial investment
of ` 100,000 can hardly be compared with a small 3-year project
costing ` 10,000. The large project could be thought of as ten
small projects.
So, if you insist on using the IRR and the NPV methods to compare
a big, long-term project with a small, short-term project, don’t be
surprised if you get different selection results.
Different Cash Flows

Furthermore, even two projects of the same length may have
different patterns of cash flow. The cash flow of one project may
continuously increase over time, while the cash flows of the other
project may increase, decrease, stop, or become negative. These
two projects have completely different forms of cash flow, and if
the discount rate is changed when using the NPV approach, the
result will probably be in different orders of ranking. For example,
at 10% the NPV of Project A may be higher than that of Project
B. As soon as you change the discount rate to 15%, Project B may
be more attractive.
24
When are the NPV and IRR Reliable?
Notes
You can use and rely on both the NPV and the IRR if two
___________________ conditions are met. First, if projects are compared using the NPV,
___________________
a discount rate that fairly reflects the risk of each project should
be chosen. There is no problem if two projects are discounted at
___________________ two different rates because one project is riskier than the other.
Remember that the result of the NPV is as reliable as the discount
___________________
rate that is chosen. If the discount rate is unrealistic, the decision
___________________ to accept or reject the project is baseless and unreliable. Second,
if the IRR method is used, the project must not be accepted only
___________________
because its IRR is very high. Management must ask whether
___________________ such an impressive IRR is possible to maintain. In other words,
management should look into past records, and existing and
___________________
future business, to see whether an opportunity to reinvest cash
___________________ flows at such a high IRR really exists. If the firm is convinced
that such an IRR is realistic, the project is acceptable. Otherwise,
___________________ the project must be re-evaluated by the NPV method, using a
more realistic discount rate.
The internal rate of return (IRR) is a popular method in capital
budgeting. The IRR is a discount rate that makes the present
value of estimated cash flows equal to the initial investment.
However, when using the IRR, you should make sure that the
calculated IRR is not very different from a realistic reinvestment
rate.
Check Your Progress
Fill in the blanks:
1. The main problem with the IRR method is that it often gives ...................
rates of Return.
2. A project selected according to the NPV maybe ................... if the IRR

method is used.
3. The IRR is a ................... that makes the present value of estimated

cash flows equal to the initial investment.
Summary
The rate used to discount future cash flows to their present values
is a key variable of this process. A firm’s weighted average cost
of capital (after tax) is often used, but many people believe that
it is appropriate to use higher discount rates to adjust for risk
for riskier projects.
25
The internal rate of return (IRR) of a project is the discount rate
Notes
that makes its NPV equal to zero. Put differently, it is discount
rate which equates the present value of future cash flows with
___________________
the initial investment.
___________________
A number of surveys have shown that, in practice, the IRR method
is more popular than the NPV approach. The reason may be that ___________________
the IRR is straightforward, but it uses cash flows and recognizes
___________________
the time value of money, like the NPV. In other words, while the
IRR method is easy and understandable, it does not have the ___________________
drawbacks of the ARR and the payback period, both of which
___________________
ignore the time value of money. You can use and rely on both the
NPV and the IRR if two conditions are met, which have been ___________________
discussed in this unit.
___________________
Questions for Discussion ___________________

1. What is IRR? Discuss the problems associated with IRR. ___________________
2. Why does money have time value?
3. State the general formula for the future value of the single
amount.
4. What is the difference between compound and simple
interest?
5. State the formula for the future value of an annuity.
6. If you deposit ` 5,000 today at 12 per cent rate of interest
in how many years (roughly) will this amount grow to
` 1,60,000?
7. Modern Enterprises Ltd. is considering the purchase of a
new computer system for its Research and Development
Division, which would cost ` 35 lakh. The operation and
maintenance costs (excluding depreciation) are expected to
be ` 7 lakh per annum. It is estimated that the useful life of
the system would be 6 years, at the end of which the disposal
value is expected to be ` 1 lakh.
The tangible benefits expected from the system in the form
of reduction in design and draughtsman ship costs would be
` 12 lakh per annum. Besides, the disposal of used drawings,
office equipment and furniture, initially, is anticipated to
net ` 9 lakh.
Capital expenditure in research and development would
attract 100% write-off for tax purposes. The gains arising
from disposal of used assets may be considered tax-free.
The company’s effective tax rate is 50%. The average cost of
capital to the company is 12%. The present value factors at
12% discount rate are:
26
Notes Year PVF
1 0.892
___________________
2 0.797
___________________
3 0.711
___________________
4 0.635
___________________
5 0.567
___________________
6 0.506
___________________
___________________ After appropriate analysis of cash flows, advise the company

of the financial viability of the proposal.
___________________
8. Which of the following statements are correct?
___________________
(a) The net present value and the internal rate of return
___________________ mean the same thing.
(b) There is no risk of uncertainty involved in working out
the estimates of cash flows from a project.
(c) Cash flows from a project can be worked out on the
basis of probabilities.
(d) Since the future changes in price levels are uncertain, it
is no use taking into account the inflation or deflation
factor while working out the future cash inflows and
outflows.
(e) A delay in the execution of project increases cost and,
therefore, it is imperative that estimate is made
regarding the likely increase in costs due to possible
delay in the implementation of a project.
(f) The expansion of an existing project will not require
additional working capital.
(g) There is no use taking working capital requirements as
a cash outflows and then taking the realized working
capital after the useful life of the projects as cash inflow
since both cancel out each other.
(h) In case the funds are in short supply, the estimates for
additional working capital may be ignored since one has
to pay the cost of the plant and machinery immediately.
(i) The sale estimates should be made at various probability
levels.
27
9. Define the following terms in not more than three line seach:
Notes
(a) Social cost benefit analysis
___________________
(b) Social costs
(c) Shadow pricing ___________________
10. S Engineering Company is considering replacing or repairing ___________________

a machine, which has just broken down. ___________________
Last year, this machine costed ` 20,000 to run and maintain.
___________________
These costs have been increasing in real terms in recent
years with the age of the machine. A further useful life of ___________________
5 years is expected, if immediate repairs of ` 19,000 are
carried out. If the machine is not repaired, it can be sold ___________________
immediately to realize about ` 5,000 (ignore loss/gain on ___________________
such disposal).
___________________
Alternatively, the company can buy a new machine for
` 49,000 with an expected life of 10 years with no salvage ___________________
value after providing depreciation on straight line basis. In
this case, running and maintenance costs will reduce to
` 14,000 each year and are not expected to increase much in
real terms for a few years at least. S Engineering Company
regards a normal return of 10% p.a. after tax is a minimum
requirement on any new investment. Considering capital
budgeting techniques, which alternative will you choose?
Take corporate tax rate of 50% and assume that depreciation
on straight line basis will be accepted for tax purposes also.
Given cumulative present value of ` 1 p.a. at 10% for 5 years
` 3.791, 10 years ` 6.145.
11. What aspect of project financing do you think requires the
most time? Why?
12. Describe the project appraisal process.
13. Why discounting methods of appraisal are better than the
non-discounting methods?
14. Explain the difference between IRR and NPV with a suitable
example. Which one is better and why?
29
Unit 3 Notes
Introduction to PProject
roject Appraisal ___________________
___________________
___________________

___________________
\ Project Appraisal and Steps Followed
___________________
\ Various Aspects of Project Appraisal
___________________
\ Importance and Difficulties of Project Appraisal
___________________
\ Importance of Economic Appraisal
___________________
___________________
Introduction
The objective of project appraisal should assess the overall viability
of a project for an organization. It covers every aspect of project
i.e., Technical, Financial, environmental, Social and Political.
However, in many cases it has concentrated on the assessment of
the financial and technical feasibility of a project only. A major
reason why non-financial and non-technical aspects are not
considered more fully during project appraisal is probably the
lack of an analytical framework that would highlight the
importance of those aspects and would provide guidelines on
how to incorporate them into the appraisal. In other words, project
appraisal is a process of analysing the technical feasibility and
economic viability of a project proposal with a view to financing
their costs.
What are Projects?

A project is a specific plan or design presented for consideration.
Projects are discrete package of investments, policy measures
and institutional and other actions designed to meet specific
development objectives. Projects are common terms used by many
flexibly to denote specific action plans. There are projects to
develop a new road, new car, new motorbike, marketing plan,
construction of buildings, transport and communication. A project
can be long-term or short-term, limited or comprehensive, single
sector concentrated or multi sector concentrated. A Project can
be defined thus as:
30
• A scientifically evolved work plan
Notes
• Devised to achieve specific objectives
___________________
• Within specified time limit
___________________ • Consuming planned resources
___________________ Before the formulation of a project problem, many questions are
___________________ to be asked by the project initiators:
___________________
• What for: The objectives of the project.
• How: The process, and the internal and external resources.
___________________
• Who: For whom, by whom – project partners, stakeholders.
___________________
• When: The time factor.
___________________
• Where: The location.
___________________
• What: The activity.
___________________
Project Appraisal
Project appraisal is defined as systematic and comprehensive
review of the economic, environmental, financial, social, technical
and other such aspects of a project to determine if it will meet
its objectives.
Project appraisal is the process of assessing the project viability,
both economic and technical, in a structured way, using economic
appraisal or some other decision analysis.
It is the process of assessing the project viability, both economic
and technical, in a structured way, using economic appraisal or
some other decision analysis. Appraisal exercises are basically
aimed at determining the viability of a project and sometimes,
also in reshaping the project to upgrade its viability. The factors,
generally, considered by institutions while appraising a project
included technical, financial, commercial, economic, ecological,
social and managerial aspects. This makes it necessary to
recognize the interrelationship underlying the various aspects of
a project. For example, the size of the initial market and the
estimates for demand build-up would determine the profitability,
which, in turn, would determine the means of financing. Location
also has an important bearing on project cost and cost of
production. Above all, the management behind the project has a
decisive influence on most of these aspects. These considerations
imply that project appraisal is viewed as a composite process as
against the approach of viewing each aspect individually.
From the point of view of the lender, project appraisal is an
exercise whereby a lending financial institution makes an
Unit 3: Introduction to Project Appraisal
31
independent and objective assessment of various aspects of an
Notes
investment proposition to arrive at the financing decision.
The exercise of project appraisal simply means the assessment of ___________________
a project in terms of its economic, social and financial viability.
___________________
This exercise is critical as it calls for a multi-dimensional analysis
of the project that is, a complete scanning of the project. Financial ___________________
institutions and banks make a critical appraisal of projects, which
___________________
are submitted to them by the entrepreneurs for getting loans.
They have traditionally been accepting the data provided by the ___________________
entrepreneur as valid while assessing the project.
___________________
In project appraisal, the promoter takes a second look critically
___________________
and carefully at a project as presented by the promoter person
who is in way involved in or connected with its preparation and ___________________
who is as such able to take an independent, dispassionate and
objective view of the project in its totality as also in respect of its ___________________
various components. The person who carries out appraisal of a ___________________
project is usually an official from the financial institutions or
team of institutional officials. Since all ending activities involve
risk in a smaller or larger measure, project appraisal aims at
sizing up the quality of projects and their long-term profitability
aims at minimizing the risk of lending by rectifying their
weaknesses and improving their quality by incorporating into
them features/safeguards missed by the promoters either because
of lack of knowledge or information.
Scope of Appraisal
The appraisal of a project is undertaken by the financial
institutions with the twin objectives of determining the market
potential of a project and selecting an optimal strategy. The
methods of analysis vary from project to project.
There are certain common aspects of study from the angle of
technology and engineering:
• Choice of technical process and/or appropriate technology.
• Technical collaboration arrangements, if any.
• Size and scale of operations.
• Locational aspects of the project and availability of
infrastructural facilities.
• Selection of plant, machinery and equipment together with
background, competence and capability of machinery/
equipment suppliers.
• Plant layout and factory buildings.
• Technical engineering services.
32
• Project design and network analysis for the assessment of
Notes
project implementation schedule.
___________________ • Aspects relating to effluent disposal, management of entry,
utilisation of by-products.
___________________
• Project cost and its comparison with other similar projects,
___________________ based on technology, equipment, product mix and time spread.
___________________ • Determination of project cost estimates, profitability
___________________
projections, etc.
• Sensitivity analysis.
___________________
It must be remembered that the different aspects of a project are
___________________
not independent entities but are highly interrelated; and a
___________________ meaningful project appraisal depends upon the appreciation of
this fundamental fact. For example, the size of the total market
___________________
for a product as it exists now and the year to year estimates of
___________________ the future progressive call for expansion of demand would
determine planned capacity of the proposed unit and the phasing
of production over the years. These in turn would influence the
project cost and profitability, which would determine the means
of financing. The cost of the project and profitability are influenced
to a significant extent by its location, Over and above this, the
management behind the project, has a decisive role to play in
almost all aspects of the project.
Check Your Progress
Fill in the blanks:
1. ........................ are common terms used by many flexibly to denote

specific action plans.
2. ........................ is the process of assessing the project viability, both

economic and technical, in a structured way, using economic appraisal
or some other decision analysis.
Steps Followed in Project Appraisal

Project appraisal is a scientific tool. It follows a specific pattern.
First and foremost, an analysis of a region’s economy provides a
general framework within which the assessment of any project is
made. This analysis indicates whether the project is in a potential
environment, which enjoys priority for economic development of
the region/state concerned. This exercise itself involves the
investigation of six different aspects - economic, technical,
organizational, managerial, operational and financial. The relative
importance of these different aspects can vary considerably
according to circumstances and type of project. The main stages
of the system of project appraisal are:
33
Step-1: Economic – Indicates priority use
Notes
Step-2: Technical – Involves scale of the project and the process
adopted ___________________
Step-3: Organisational – Suitability is examined ___________________
Step-4: Managerial – Adequacy and competence are critically ___________________

scrutinized
___________________
Step-5: Operational – Capability of the project
___________________
Step-6: Financial – Determines the financial viability for sound
implementation and efficient operation ___________________
The economic aspects of appraisal are fundamental as they ___________________

logically precede all other aspects. This is so because the bank
___________________
will not finance a project unless it stands assured that the project
represents a high priority use of a region’s resources. However, ___________________
a purely financial analysis normally does not provide an adequate
basis for judging a project’s value to the economy. Since the financial ___________________
analysis looks at the project only from a limited viewpoint of the

revenues entering the project’s own accounts, an economic or
social analysis looks at the project from the viewpoint of the
whole economy, asking whether the latter will show benefits
sufficiently greater than project costs to justify investment in it.
The economic benefits brought about by a successful project
normally take the form of an increased output of goods or service,
either directly or indirectly as in a large class of cost reducing
projects. This increased production will also generate many
different forms of additional income, such an increased wages or
employment of labour, larger government revenues, higher
earnings for the owners of capital or most frequently a combination
of these income benefits.
In a large majority of cases, it is possible to quantify project costs
and benefits, and to construct a rate of return or some other
appropriate move. Future costs and benefits are calculated, using
either market or shadow prices as found appropriate. Further
both costs and benefits are put under subsidence to initiate the
projects’ estimated rate of return. The latter is then compared
with the minimum earning power capital judged appropriate for
each country. While the rate of return is an important test that
all projects with quantifiable cost and benefits must pass,
importance and its significance are usually overestimated.
The rate of return is a necessary confirming test of projects that
have to be justified within a much wider frame of reference, in
which basic project objectives and the nature of project benefits,
for example, foreign exchange savings, increased employment and
improved income distribution play major roles.
34
Notes
Organisational Aspects
There is a need for an efficient organisation and responsible
___________________
management for the execution of the project. During appraisal,
___________________ these two essential dimensions of a project are examined. If one
or the other is found wanting, short-term remedial steps are
___________________ recommended such as the recruitment of individuals or an
___________________ organisation qualified to assist in running the enterprise, at least
during the initial phase; or those for a longer term such as a
___________________ management study, reorganization or creation of a new
___________________
autonomous agency to operate the project.
___________________
In either case, the need for training local staff to fill positions at
all levels is examined, and training programmes may be included
___________________ as part of the project. The objective of this aspect of appraisal is
to make sure that the product is adequately carried out and that
___________________
a locally staffed institution, capable of contributing effectively to
___________________ the development of the sector in question, is Created.
Managerial Aspects
If the management is incompetent, even a good project may fail.
It is rightly pointed out that if the project is weak, it can be
improved upon, but if the promoters are weak and lack in business
acumen, it is difficult to reverse the situation.
If a proper appraisal of the managerial aspects is made in the
beginning itself, future problems in these areas can be avoided to
a large extent. It is, therefore, necessary that the overall
background of the promoters, their academic qualifications,
business and industrial experience, their past performance etc.
are looked into in greater detail to assess their capabilities for
implementing the project.
Technical Aspects
The importance of technical appraisal in project evaluation needs
no emphasis. Technical appraisal of a project broadly involves a
critical study of the following:
Location and Site

An industrial feasibility study aspect refers to the appropriate
and location selection of a geographical area where the project
should be located the selection. The required site characteristics
shall be kept in mind while selecting the location.
There are several important factors that influence industrial
location because the site may significantly influence the cost of
35
production and distribution, distribution efficiency, the operating
Notes
environment etc.
The site selection gets complicated by the fact that at a particular ___________________
location where one or a few factors are favourable, the problem
___________________
revolves around the combined consideration and evaluation of all
the relevant factors. ___________________
Size of the Plant/Scale of Operation ___________________
The size of the plant or scale of operations is an important factor ___________________

that determines the economic and financial viability of a project. ___________________
In many industries, there are certain technological plant ___________________

capacities, which are economical. If the size is sub-optimal, there
will be diseconomies of scale. ___________________
This is one of the important reasons for poor performance of ___________________

many industrial units in India. Diseconomies of scale result in ___________________
high cost and make survival in a competitive market, particularly
in the international market, very difficult. The government of
India in this context has emphasized that the plants or scale of
operations should be of economic size.
An important aspect of technological size is that the available
process technology and equipment are often standardized at
specific capacities in production sectors. Operative capacities in
such sectors are, therefore, available only in certain multiples.
There are, however, certain factors that may come in the way of
optimal scale. For example, there may be demand constraints,
i.e., the market demand may be too low that it cannot absorb the
output of the large plant, in some cases there may be resource
and input constraints. For example, the available raw material in
a region may not be enough to feed a large plant. When there is
important control, non-availability of economic size plants or
equipments domestically makes the adoption of optimal scale
impossible. Sometimes, there will also be scarcity of finance.
Another factor that may discourage the establishment of large-
scale facilities is the risk of rapid obsolescence of technology.
Technical Feasibility
Appraisal of ethnical aspects of a project involves scrutiny of
such aspects of the project as:
• Process/technology selected
• Technical collaboration arrangements made, if any.
• Capacity/size of the project and the scale of operations.
36
• Location of the project.
Notes
• Availability of physical and social infrastructural facilities.
___________________
• Availability of various inputs covering raw materials as well
___________________ as utilities.
___________________ • Selection of plant, machinery and equipment together with

background, competence and capability of machinery/
___________________ equipment suppliers.
___________________ • Plant layout and factory building.
___________________ • Technical engineering services.
___________________ • Project design and network analysis for assessing the project’s
implementation schedules.
___________________
The technical feasibility study should consider the adequacy and
___________________ suitability of the plant, the equipments and their specifications,
___________________ plant layout, balancing of different sections of the plant, proposed
arrangements for procurement of the plant and equipments,
reputation of the machinery suppliers, etc.
The feasibility study should also consider the technology required
for a particular project, evaluate technological alternatives and
select the most appropriate technology in terms of optimum
combination of project components. The various implications of
the acquisition of such technology should be assessed, including
contractual aspects of technology licensing where applicable etc.
Government of India’s policy in this respect clearly states that
while evaluating applications for industrial licensing, the following
factors will be specifically considered:
• Whether the proposed capacity is of economic size.
• Whether the processes proposed to be adopted are efficient
from a techno-economic point of view.
• The extent to which diversification and expansion proposals
will result in fuller utilisation of capacity and economies of
scale. Besides, proper evolution of alternative technologies
is essential for selection of the appropriate one. This
evaluation should be related to plant capacity and should
commence with quantitative assessment of output, production
build-up and gestation period and qualitative assessment of
product quality and marketability.
The selection of technology has to be related to the nature of the
principal inputs that may be available for a project and to an
appropriate combination of factor resources for both short and
long periods.
37
Financial Aspects of Project Appraisal Notes
The purpose of the appraisal of financial aspects of a project is
___________________
to ensure its initiation of financial conditions for the sound
implementation and efficient operation. The scope of this aspect ___________________
of appraisal varies, of course, considerable with the nature of the
project and whether it is revenue producing (e.g., industry, ___________________
utilities, agriculture) or not (e.g., education, most highway ___________________

projects).
___________________
It is necessary to ensure that satisfactory accounts are maintained
for effective control over expenditure and revenue, and to disclose ___________________
the project and entity carrying it out also, since the banks finance ___________________
only a part of the investment cost of a project, it is necessary to
ensure that funds from other sources are available on acceptable ___________________
terms to meet the balance of the cost.
___________________
This may be relatively simple where the government is able,
___________________
without difficulty, to provide the rest of the necessary funds from
budgetary sources, or it may be complicated, as in a project to
expand or modernize a revenue-earning concern, where all the
financial requirements of the concern during the construction of
the project must be considered.
Financial appraisal also evaluates capacity of revenue-producing
investments from the standpoint of the entity. Industrial sponsor
or other investor, who would make them, in order to ascertain
whether it is sufficiently attractive to warrant their participation
establishing that the entity carrying out the project is in a position
to manage its business in a cost-effective fashion, is another
important aspect.
The financial aspect of project appraisal covers the following areas:
• Cost analysis: In the case of cost analysis, it is to be decided
or to be worked out what would be the cost of production.
There are different methods of finding out cost.
• Pricing: This strategy concerns the fixing up of the product’s
price. Price fixation is a very tedious job. The price must be
fixed very judiciously, because the price is the cause of
demand.
• Financing: The fund needed to finance the project is an
important aspect of project appraisal. It is concerned with
raising the funds and making their most efficient use. The
funds must be raised from places where the rate of interest
is lower.
• Income and Expenditure: The income and expenditure
profile is concerned with the estimates regarding the income
38
expected and expenditure involved in the project. This helps
Notes
in ascertaining the cost involved in production and profit
expected there from. Detailed proposed accounts should be
___________________
made for future reference to know whether the plans are
___________________ working out properly or not.
___________________
Market/Commercial Aspects
___________________
In setting up an industrial project, estimation of demand for the
___________________ product/group of products proposed to be produced by a promoter
is the first important step. Ideally, the market analysis should
___________________
give a comprehensive account of the market opportunity, as well
___________________ as of the marketing strategy appropriate for converting the
opportunity into a reality. Marketing strategy in this context
___________________
could be defined as an ever-evolving design or blueprint consisting
___________________ of a set of inputs like quality, price, agency (bulk) discounts,
distribution network/channels etc.
___________________
To be of maximum benefit to a promoter, whether new or already
established, market analysis should cover the following major
aspects:
• Analysis of market opportunity and specifying marketing
objectives. This involves a scientific assessment of:
– total size of the market for a product; and
– the share that could be secured by a firm, existing or new.
• Planning the process of marketing the product.
• Organisation of the marketing process.
• Control of the implementation of the marketing plan, which
facilitates taking corrective action when the actual results
deviate from the estimates or expectations.
An intensive scanning and analysis of the proposed environment
in which the industrial unit has to function should from the basis
for analysing market opportunities as well as for specifying the
marketing strategy. This is because the ever-changing
environment, in which the industry sector functions, restricts or
some other in appraisal industry expands the opportunities
available to and the threats to be faced by an industrial unit.
Market opportunities expressed in terms of demand forecasts
and market shares are based on a host of factors outside the
control of the promoter, whereas marketing strategy and
marketing process are largely under his control. Hence, the
formulation of a detailed marketing plan, specification of a proper
marketing strategy, and the manner in which the marketing
process should be undertaken, would enable the promoter to cope
39
with the uncertainties in the marketplace more effectively than
Notes
otherwise. It is also a fact that the estimated markets share of a
promoter and his marketing strategy influence and reinforce each
___________________
other and should never be viewed in isolation.
___________________
Political and Labour Considerations
___________________
Attention is to be paid to political environment and labour
conditions of the area where the project is to be located. Strikes, ___________________
lockouts, industrial peace and communal harmony in the area ___________________
play a decisive role in examining success or failure of the project.
___________________
Check Your Progress ___________________

Fill in the blanks: ___________________
1. The .................... aspects of appraisal are fundamental as they logically
___________________
precede all other aspects.
___________________
2. An .................... study aspect refers to the appropriate and location
selection of a geographical area where the project should be located the
selection.
3. In setting up an .................... project, estimation of demand for the

product/group of products proposed to be produced by a promoter is the
first important step.
Project Appraisal for Power Sector

In power sector, for example, PFC has a wide and comprehensive
role for promoting least cost, technically sound, efficient and
reliable power sector in India including generation, transmission
and distribution systems, through its financial, technical and
managerial services. Several entities, such as the State Electricity
Boards, NTPC, IPPs such as Ispat Industries Ltd. approach PFC
for providing financial assistance for their projects. These entities
provide a Detailed Project Report (DPR) along with their request
for loan, which furnishes the necessary details about the project
to the PFC. Besides that, the entity details and eligibility for
loan sanction are evaluated by the IAD of PFC.
Project appraisal (the process of assessing and questioning
proposals before resources are committed) is done by the Project
Appraisal Division. This is done by using the DPR and the entity
details provided by IAD, thereby evaluating the viability of a
project. The parameter under which the project appraisal is done
depends on the project and its purpose. The various types of
power projects have different appraisal formats, depending on
the specific features of the project.
40
Appraising a project involves examining the Sector viability and
Notes
the Govt. policies in this regard and the project’s financial &
economic viability. For example, for any company that provides
___________________
loan for the project, parameters such as FIRR, DSCR, etc. would
___________________ be the most important factors on the basis of which they decide
whether or not to provide financial assistance. Since PFC is
___________________
committed to the economic betterment of the country, the
___________________ economic returns/benefits are also evaluated. For certain projects,
even if the financial returns are not very attractive but the
___________________
economic benefits that will accrue to the society are substantial,
___________________ the loans are sanctioned. The need and necessity of the project
is established before appraising it.
___________________
Project appraisal is an essential part of project finance; it involves
___________________ a thorough analysis of the ability of the project to fulfill the
___________________ desired objectives. Lending to power sector involves long
gestation period, it is necessary for the lending institution to
___________________ study the financial, technical & related credibility of the project
as well as the entity. The study of financial background of the
project and the promoters tells about the ability to handle project
efficiently.
The project is usually examined under the following heads:
• Credit worthiness of the borrower.
• Project eligibility and preference.
• Moratorium and repayment period.
• Security and guarantees provided.
For financial and economic appraisal, the financial internal rate
of return and economic internal rate of return are calculated.
The Profit and Loss calculations are done and the Debt Service
capability is calculated. Besides this, Sensitivity analysis is also
done to evaluate the effect of various factors on the generation of
electricity and hence, the revenue realization. The project is
undertaken with the following objectives in mind:
• To evaluate the financial and economic returns of the
proposed projects.
• To calculate the future cash flows and the DSCR of the IPP.
The projects that are finally selected for funding should have the
following attributes.
• The benefits from the project should be realizable and
deliverable.
• It should involve local people and compensate adequately
those displaced taking into account their needs.
41
• The project should be sustainable in the long run and care
Notes
should be taken so that it does not run into financial or
technical problems.
___________________
• The entities involved should ensure that projects will be
___________________
properly managed, by ensuring appropriate financial and
monitoring systems are in place, that there are contingency ___________________
plans to deal with risks.
___________________
Importance of Project Appraisal
___________________
• It is a capital investment decision.
___________________
• It has long-term effects.
___________________
• Decision once taken is irreversible.
___________________
• Expenditures are high.
___________________
Difficulties in Respect of Project Appraisal
___________________
• Difficult measurement of costs and potential benefits.
• High degree of uncertainty.
• Long-term spread – time value of money.
Check Your Progress
Fill in the blanks:
1. Project appraisal (the process of assessing and questioning proposals

before resources are committed) is done by the .................. .
2. ................. is an essential part of project finance; it involves a thorough

analysis of the ability of the project to fulfil the desired objectives.
Summary
Project appraisal is the review of the economic, environmental,
financial, social, technical and other such aspects of a project to
determine if it will meet its objectives. Project financing connotes
financing that as a priority does not depend on the soundness or
creditworthiness of the sponsors. Instead, it is a function of the
project’s ability to repay the debt contracted and remunerate
capital invested at a rate commensurate with degree of risk
associated with the project. Project appraisal is important because
it is capital investment decision and has long-term effects in
which decisions taken at once are not irreversible and
expenditures are high.
42
Notes
1. What do you understand by the term Project? Explain it.
___________________
2. What aspect of project appraisal do you think requires the
___________________ most time? Why?
___________________ 3. What is the major objective of making the promoter’s go
through this rigorous exercise of project appraisal?
___________________
4. What major points are covered in the institutional appraisal?
___________________
5. What do you understand by economic appraisal? Why is that
___________________ important?
___________________ 6. What do you understand by market appraisal? What are the
important points that are to be considered while doing
___________________
market appraisal for a green field power project?
___________________
7. What do you understand by financial appraisal? Write all
___________________ the steps involved in assessing the financial viability of a
gas-based power plant.
8. What do you understand by technical appraisal? Explain its
basic points.
9. What do you understand by managerial appraisal? What is
its importance in taking a decision for the execution of a
project?
43
Unit 4 Notes
Financial Analysis ___________________
___________________
___________________

___________________
\ Various Liquidity Ratios
___________________
\ Income Statement Ratio Analysis
___________________
\ Working Capital
___________________
\ Profitability Ratios
___________________
___________________
Introduction
Planning and Control are the two most important ingredients to
a successful business. A business plan takes most of the guess
work out of business strategy and control through solid financial
analysis. By having a Financial Management system supported
by financial data in place, one can easily identify early warning
signs or spot particularly profitable areas. Financial Data Analysis
and Management are vitally important to run a successful business.
Strong and effective finance management system provides a way
to gauge any business and analyse strategic plan. It also provides
information about where changes in a business plan are necessary.
Financial Analysis
The process of evaluating businesses, projects, budgets and other
finance-related entities is to determine their suitability for
investment. Typically, financial analysis is used to analyse
whether an entity is stable, solvent, liquid, or profitable enough
to be invested in. When looking at a specific company, the financial
analyst will often focus on the income statement, balance sheet
and cash flow statement. In addition, one key area of financial
analysis involves extrapolating the company’s past performance
into an estimate of the company’s future performance.
One of the common ways of analysing financial data is to calculate
ratios from the data to compare against those of other companies
or against the company’s own historical performance. For example,
return on assets is a common ratio used to determine how efficient
a company is at using its assets and as a measure of profitability.
44
This ratio could be calculated for several similar companies and
Notes
compared as part of a larger analysis.
___________________ Important balance sheet ratios measure liquidity and solvency (a
business’s ability to pay its bills as they come due) and leverage
___________________
(the extent to which the business is dependent on creditors’
___________________ funding).
___________________
Liquidity Ratios
___________________
These ratios indicate the ease of turning assets into cash and
___________________ include Current Ratio, Quick Ratio and Working Capital.
___________________ 1. Current Ratios: The Current Ratio is one of the best-known
measures of financial strength. It is calculated as:
___________________
Total Current Assets
___________________ Current Ratio =
Total Current Liabilities
___________________ The main question this ratio addresses is: “Does your business
have enough current assets to meet the payment schedule
of its current debts with a margin of safety for possible
losses in current assets, such as inventory shrinkage or
collectable accounts?” A generally acceptable current ratio
is 2 to 1. But whether or not a specific ratio is satisfactory
depends on the nature of the business and the characteristics
of its current assets and liabilities. The minimum acceptable
current ratio is obviously 1:1, but that relationship is usually
playing it too close for comfort.
If the business’s current ratio is too low, it can be raised by:
• Paying some debts.
• Increasing your current assets from loans or other
borrowings with a maturity of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity
contributions.
• Putting profits back into the business.
2. Quick Ratios: The Quick Ratio is sometimes called the “acid-
test” ratio and is one of the best measures of liquidity. It is
calculated as:
Cash + Government Securities + Receivables
Quick =
Total Current Liabilities
The Quick Ratio is a much more exact measure than the
Current Ratio. By excluding inventories, it concentrates on
the liquid assets, with value that is fairly certain. It helps
Unit 4: Financial Analysis
45
answer the question: “If all sales revenues should disappear,
Notes
could the business meet its current obligations with the
readily convertible ‘quick’ funds on hand?”
___________________
An acid-test of 1:1 is considered satisfactory unless the
___________________
majority of your “quick assets” are in accounts receivable,
and the pattern of accounts receivable collection lags the ___________________
schedule for paying current liabilities.
___________________
3. Working Capital: Working Capital is a measure of cash
flow than a ratio. The result of this calculation must be a ___________________
positive number. It is calculated as shown below: ___________________
Working Capital = Total Current Assets – Total Current
___________________
Liabilities
___________________
Bankers look at Net Working Capital over time to determine a
company’s ability to weather financial crises. Loans are often ___________________
tied to minimum working capital requirements.
___________________
A general observation about these three Liquidity Ratios is that
the higher they are the better it is, especially, if you are relying
to any significant extent on creditor money to finance assets.
Leverage Ratio
This Debt/Worth or Leverage Ratio indicates the extent to which
the business is reliant on debt financing (creditor money versus
owner’s equity):
Total Liabilities
Debt/Worth Ratio =
Net Worth
Generally, the higher this ratio, the riskier a creditor will perceive
its exposure in your business, making it correspondingly harder
to obtain credit.
Check Your Progress
Fill in the blanks:
1. ...................... is used to analyse whether an entity is stable, solvent,

liquid, or profitable enough to be invested in.
2. ...................... ratios indicate the ease of turning assets into cash.
3. ...................... is more a measure of cash flow than a ratio.
Income Statement Ratio Analysis

The following Income Statement Ratios measure profitability:
46
Gross Margin Ratio
Notes
This ratio is the percentage of sales dollars left after subtracting
___________________ the cost of goods sold from net sales. It measures the percentage
___________________
of sales dollars remaining (after obtaining or manufacturing the
goods sold) available to pay the overhead expenses of the company.
___________________
Comparison of your business ratios to those of similar businesses
___________________ reveals the relative strengths or weaknesses in your business.
The Gross Margin Ratio is calculated as follows:
___________________
Gross Profit
___________________ Gross Margin Ratio =
Net Sales
___________________
(Gross Profit = Net Sales – Cost of Goods Sold)
___________________
Net Profit Margin Ratio
___________________
This ratio is the percentage of sales dollars left after subtracting
___________________
the Cost of Goods sold and all expenses, except income taxes. It
provides a good opportunity to compare your company’s “return
on sales” with the performance of other companies in your
industry. It is calculated before income tax because tax rates and
tax liabilities vary from company to company for a wide variety
of reasons, making comparisons after taxes much more difficult.
The Net Profit Margin Ratio is calculated as follows:
Net Profit before Tax

Net Profit Margin Ratio =
Net Sales
Management Ratios
Other important ratios, often referred to as Management Ratios,
are also derived from Balance Sheet and Statement of Income
information.
Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is
important because the more times inventory can be turned in a
given operating cycle, the greater the profit. The Inventory
Turnover Ratio is calculated as follows:
Net Sales
Inventory Turnover Ratio =
Average Inventory at Cost
Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being
collected. If receivables are not collected reasonably in accordance
with their terms, management should rethink its collection policy.
47
If receivables are excessively slow in being converted to cash,
Notes
liquidity could be severely impaired. The Accounts Receivable
Turnover Ratio is calculated as follows:
___________________
Accounts Receivable
Accounts Receivable Turnover (in days) = ___________________
Daily Credit Sales
___________________
Where, daily credit sales is defined as:
___________________
Net Credit Sales / Year
Daily Credit Sales = ___________________
365 Days
___________________
Return on Assets Ratio
___________________
This measures how efficiently profits are being generated from
the assets employed in the business when compared with the ___________________
ratios of firms in a similar business. A low ratio in comparison ___________________
with industry averages indicates an inefficient use of business
assets. The Return on Assets Ratio is calculated as follows: ___________________

Return on Assets =
Total Assets
Return on Investment (ROI) Ratio

The ROI is perhaps the most important ratio of all. It is the
percentage of return on funds invested in the business by its
owners. In short, this ratio tells the owner whether or not all the
efforts put into the business has been worthwhile. If the ROI is
less than the rate of return on an alternative, risk-free investment
such as a bank savings account, the owner may be wiser to sell
the company, put the money in such a savings instrument, and
avoid the daily struggles of small business management. The ROI
is calculated as follows:

Return on Investment =
Net Worth
A project collects funds from two sources for long-term investment.
The amount collected is used to create assets and operation,
which generates surplus for the enterprise. Surplus is required
to be distributed to the contributors of the funds. Interest is the
compensation given to contributors of borrowed capital, and net
profit and depreciation are given to contributors of own capital.
Why should one add depreciation here? Though depreciation
reduces profit, it is a non-cash provision made to recover the
original investment. Thus, the cash profit of the enterprise is
increased to the extent of depreciation.
48
The simple rule to assess the viability is that the ROI must be
Notes
greater than the cost of investment. Investment comprises two
major components:
___________________
1. Borrowed Capital (Normally, taken as loans from banks and
___________________
financial institutions).
___________________ 2. Own Capital (Normally, contributed by entrepreneurs).
___________________
It is simple to calculate the cost of borrowed capital. Any borrower
___________________ is required to commit the fixed service charge, i.e. interest at the
time of sanctioning loan. Thus, the interest becomes the cost of
___________________ borrowed capital. Interest is tax-allowed expense and, therefore,
___________________
its effective weight is reduced by the actual rate of tax paid by
the borrower. The entrepreneurs may have more than one
___________________ investment alternative and under such conditions, the opportunity
cost becomes the cost of entrepreneur’s capital.
___________________
___________________ Debt Service Coverage Ratio (DSCR)

Running an enterprise with financial support from banks/financial
institutions requires their loans to be repaid with interest.
Therefore, an entrepreneur must generate surplus, adequate to
meet repayment obligations. The DSCR is a tool used to determine
this. Its formula is:
Net Profit + Interest (on Long - term Loans) + Depreciation

DSCR =
Interest (on Long - term Loans) + Principal Loan
A project is considered financially viable if the cumulative DSCR
during repayment period is at least 2:1.
Check Your Progress
Fill in the blanks:
1. ................... ratio is the percentage of sales dollars left after subtracting

the cost of goods sold from net Sales.
2. ................... ratio is the percentage of sales dollars left after subtracting

the Cost of Goods sold and all expenses, except income taxes.
3. ................... ratio reveals how well inventory is being managed.
4. ................... ratio indicates how well accounts receivable are being

collected.
These Liquidity, Leverage, Profitability, and Management Ratios

allow the business owner to identify trends in a business and to
compare its progress with the performance of others through
data published by various sources. The owner may thus determine
the business’s relative strengths and weaknesses.
49
Project Finance Notes
Project finance is the long-term financing of infrastructure and
___________________
industrial projects based upon the projected cash flows of the
project rather than the balance sheets of the project sponsors. ___________________
Usually, a project financing structure involves several equity
investors, known as sponsors, as well as a syndicate of banks ___________________
that provide loans to the operation. The loans are most commonly ___________________
non-recourse loans, which are secured by the project assets
and paid entirely from project cash flow, rather than from the ___________________
general assets or creditworthiness of the project sponsors, a ___________________
decision in part supported by financial modelling. The financing
is typically secured by all the project assets, including the ___________________
revenue- producing contracts. Project lenders are given a lien on
___________________
all of these assets and are able to assume control of a project if
the project company has difficulties complying with the loan terms. ___________________
Generally, a special purpose entity is created for each project, ___________________

thereby shielding other assets owned by a project sponsor from
the detrimental effects of a project failure. As a special purpose
entity, the project company has no assets other than the project.
Capital contribution commitments by the owners of the project
company are sometimes necessary to ensure that the project is
financially sound. Project finance is often more complicated than
alternative financing methods. Traditionally, project financing has
been most commonly used in the mining, transportation,
telecommunication and public utility industries.
A riskier or more expensive project may require limited
recourse financing secured by a surety from sponsors. A complex
project finance structure may incorporate corporate finance,
securitization, options, insurance provisions or other types of
collateral enhancement to mitigate unallocated risk.
The following is a hypothetical description of a basic project finance
scheme:
ABC Co. imports coal. XYZ Inc. supplies energy to consumers.
The two companies agree to build a power plant to accomplish
their respective goals. Typically, the first step would be to sign
a memorandum of understanding to set out the intentions of the
two parties. This would be followed by an agreement to form a
joint venture.
ABC Co. and XYZ Inc. form a Special Purpose Company (SPC)
called PP Inc. and divide the shares between them according to
their contributions. ABC Co., being more established, contributes
more capital and takes 70% of the shares. XYZ Inc. is a smaller
company and takes the remaining 30%. The new company has no
assets.
50
Power Holdings then signs a construction contract with AA
Notes
Construction to build a power plant. AA Construction is an affiliate
of ABC Co. and the only company with the know-how to construct
___________________
a power plant in accordance with their delivery specification.
___________________
A power plant can cost hundreds of millions of dollars. To pay
___________________ AA Construction, PP Inc. receives financing from a development
bank and a commercial bank. These banks provide a guarantee to
___________________
AA Construction’s financier that the company can pay for the
___________________ completion of construction. Payment for construction is generally
paid as such: 10% up front, 10% midway through construction,
___________________
10% shortly before completion, and 70% upon transfer of title to
___________________ PP Inc., which becomes the owner of the power plant.
___________________ ABC Coal and XYZ form Power Manage Inc., another SPC, to
manage the facility. The ultimate purpose of the two Power
___________________ Holding and Power Manage (SPCs) is primarily to protect ABC
___________________ Co. and XYZ Inc. If a disaster happens at the plant, prospective
plaintiffs cannot sue ABC Co. and XYZ Inc. and target their assets
because neither company owns nor operates the plant.
A Sale and Purchase Agreement (SPA) between Power Manage
and ABC Co. supplies raw materials to the power plant.
Electricity is then delivered to XYZ Inc. using a wholesale delivery
contract. The cash flow of both ABC Co. and XYZ Inc. from this
transaction will be used to repay the financiers.
This is a simple explanation that does not cover the mining,
shipping, and delivery contracts involved in importing the coal
(which could be more complex than this scheme), nor the contracts
for delivering the power to consumers. However, this explains
how and why companies create SPCs and obtain financing for
major projects.
Minority owners of a project may wish to use “off-balance-sheet”
financing, in which they disclose their participation in the project
as an investment and excludes the debt from financial statements
by disclosing it as a footnote related to the investment. In the
United States, this eligibility is determined by the Financial
Accounting Standards Board. Many projects in developing
countries must also be covered with war risk insurance, which
covers acts of hostile attack, derelict mines and torpedoes, and
civil unrest which are not generally included in “standard”
insurance policies. Today, some altered policies that include
terrorism are called Terrorism Insurance or Political Risk
Insurance. In many cases, an outside insurer will issue a
performance bond to guarantee timely completion of the project
by the contractor.
51
Publicly funded projects may also use additional financing methods
Notes
such as tax increment financing or Private Finance Initiative
(PFI). Such projects are often governed by a Capital Improvement
___________________
Plan, which adds certain auditing capabilities and restrictions to
the process. ___________________
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. ................... is the long-term financing of infrastructure and industrial
projects based upon the projected cash flows of the project rather than ___________________
the balance sheets of the project sponsors.
___________________
2. A riskier or more expensive project may require ................... recourse
financing secured by a surety from sponsors. ___________________
___________________
Summary
___________________
One of the most common ways of analysing financial data is to
calculate ratios from the data to compare against those of other
companies or against the company’s own historical performance.
For example, return on assets is a common ratio used to
determine how efficient a company is at using its assets and as
a measure of profitability. This ratio could be calculated for
several similar companies and compared as part of a larger
analysis.

1. What is the purpose of ratio Analysis?
2. How ratio analysis helps stakeholders?
3. What is working Capital? What is its relevance in business?
4. What do you understand by the term Financial Analysis?
Discuss its relevance in business context.
5. What is liquidity? What are the liquidity ratios?
6. Explain Liquidity ratios that are analysed to assess liquidity
of business.
7. What is Leverage? What are the leverage ratios?
8. Explain how leverage ratio analysis helps the business.
9. What is Profitability? What are the Profitability Ratios?
10. Discuss the relevance of Profitability Ratios in the context
of stakeholders.
11. What are the Management Ratios? Explain its relevance.
53
Unit 5 Notes
Case Study ___________________
___________________
___________________
Case Study: Financial Appraisal Report (FAR): ABC
___________________
Limited
___________________
ABC (“ABC” or “the Company”) was incorporated on 12th December
2005 as ABC Limited owned by the Government of India. ___________________
Currently, ABC owns and operates 15 plant locations (4 of them through ___________________
Joint Venture) of aggregate capacity of 2500 MW spread across 3
Indian states. Out of 15 plants, 7 are coal-based while remaining 8 are ___________________
gas-based stations. In addition, ABC also has projects under execution
amounting to 11,360 MW capacity. ___________________
ABC is pursuing an ambitious target of setting up an additional 30,000 ___________________

MW capacity over the X and XI Plan periods. Out of this, nearly 4710
MW capacity has been added during the X Plan period till date. With
ownership of just 19.3% of total installed generation capacity in the
country, total power generation from ABC plants constitute about
27.7% of the total power generated during FY 2005-06 essentially
through better O&M practices resulting in higher PLF. Till date, ABC
has its presence only in coal and gas based generation sector. However,
GoI has now allowed ABC to venture into hydroelectric power
development and other non-conventional energy development and
company is making efforts in this regard.
ABC has an ambitious growth plan of becoming of about 10,000 MW
plus company by the year 2012 and about 25,000 MW company by
2017. In this direction, ABC has been continuously exploring/identifying
new project sites, wherein green field projects could be set up apart
from expansion of existing plants wherever feasible. Accordingly, a
site near XYZ in TRF district of UK State has been identified for
fulfilling a part of ABC’s thermal initiatives.
The Project
ABC proposes to set up a greenfield thermal power project of 1000
MW [2 × 500 MW] capacity at XYZ (MTPP) in TRF district of UK. XYZ
TPP (2 × 500 MW) is being set up for supply of power to the states
and union territories in the Western Region. The project is envisaged
to be commissioned in financial year 2011-12.
The Project is proposed to be set up on company balance sheet at an
estimated total outlay of ` 54,568.72 million (including margin money)
and ` 53,553.03 million (excluding margin money) at debt: equity ratio
of 70:30. The equity component of ` 16,065.91 million is envisaged to
be brought in by the company through internal accruals. The debt of
` 37,487.12 million would be raised as a combination of long-term
rupee term debt in domestic market and foreign currency (USD) debt
from external debt market.
Contd…
54
Notes ABC has approached PQR Capital Markets Limited (“PQRCAP”) to
undertake financial appraisal of the project for its financial/economic
___________________ feasibility and advise ABC on various issues associated with the Project.
Past Financial Performance of ABC

___________________
Some of the highlights of the financial performance of ABC over the
___________________ last 4 years are presented in the following table (The figures are
indicative only it is not real).
___________________
Table 1: ABC’s Past Financial Performance (FY 2003–06) Year
___________________ ending 31st March
(in ` million)
___________________
2003 2004 2005 2006
___________________ Balance Sheet Data
___________________ Equity Share Capital 125 125 455 455
Reserves and Surplus including 002 376 308 132
___________________ share premium
___________________ Tangible Net Worth (TNW) 127 501 763 587

Long-term Loans 090 415 719 195
Working Capital Loans 067 113 159 8
Total Loan Funds 157 528 878 973
Deferred Tax Liability
Deferred Revenue 375 374 408
Total Liability 556 405 416 969
Net Fixed Assets 650 545 148 895
Capital Work in Progress 863 953 285 340
Net current Assets 282 527 606 843
Investments 674 380 977 891
Misc. Exp. not W/o - - -
Total Assets 556 405 416 969
Profitability Data
Total Income 2315 2351.27 2101.9 2435.67
PBDIT 922.6 1198.7 1461.5 1373.2
Interest & Finance Charges 91.6 69.7 95.5 63.2
Depreciation 291 232 584 477
Profit Before Tax (“PBT”) 540 897 782 833
Profit After Tax (“PAT”) 429.43 494.71 489.74 492.98
PBDIT / Total Income (%) 32.26% 35.13% 39.06% 34.20%
PAT / Total Income (%) 18.55% 21.04% 23.30% 20.24%
Net Cash Accruals 366 840 654 679
Return on Networth 11.44% 14.80% 13.90% 12.94%
Debt / TNW 0.40 0.42 0.40 0.45
Source: ABC Annual Report (Some Figures are altered to maintain

confidentiality)
Contd…
Unit 5: Case Study
55
In FY06, ABC generated ` 2435 million in revenue and ` 1373 million Notes
as Profit Before Interest Depreciation & Tax (PBDIT). The net profit
of ` 202 million registered in FY’06 is almost the same as achieved ___________________
in FY 05. However, there has been a significant jump in the net profit
logged by the company during H1 of FY 07, which stood at ` 267 ___________________
million. The debt equity ratio of the company is 0.45 as on 31st March
2006. ___________________
Project Details ___________________
Broad configuration of the project ___________________

The proposed Greenfield Thermal Power Project would be of 1000 ___________________
MW (2X500 MW) capacity to be located at a site near XYZ in TRF
district of UK State. ABC has prepared a feasibility report along with ___________________
cost estimates for the project and the technical details mentioned in
this report have entirely been taken from the said report made ___________________
available by the company.
___________________
The main generating equipment will comprise of two sub-critical drum
___________________
type [natural & assisted circulation] or once through steam generators
of 500 MW along with other related equipment such as turbines, coal
transportation & handling system, fly ash handling & disposal system,
cooling towers, generator transformer, switchyard, water system, etc.
The first unit of 500 MW of MTPP is likely to be commissioned within
42 months from the award of Main Plant and second unit at an
interval of 6 months thereafter. The Commercial Operation Date (CoD)
of first unit shall be 45 months from the date of Main Plant Award.
Location & Site
The plant site is proposed to be located in XYZ tehsil of district TRF,

UK, having latitude and longitude of 21° 10´ 50´´ N and 79° 23´ 52´´
E respectively. While the township is proposed to be located on North
West side of the plant area on XYZ – Ramtek road, the ash disposal
area is proposed towards eastern side adjacent to the plant.
The selected site has the following locational advantages:

1. Nearest railway station of ILK on TRF - Kolkata Broad Gauge
Main line is at a distance of about 8 kms from the proposed Project
site.
2. Nearest town of XYZ is located at a distance of about 4 kms from
Project site.
3. The road distances from other major cities/towns are as follows:
(a) TRF – 37 kms
(b) Bhandara – 25 kms
4. The nearest commercial airport at TRF is located at a distance of
approximately 42 Kms from the project site.
Contd…
56
Notes
Land Requirement and Availability
The total area required for plant, township, ash disposal area and
___________________ other facilities is about 1580 acre as per following break up [in acres]:
___________________ Table 2: Land required in acres
___________________ Main Plant 525
___________________ Ash Disposal Area 600
___________________ Other Facilities 153
___________________ Green Belt 150
___________________ Township 152
___________________ Total 1580
___________________ ABC has already received an in-principle clearance for availability of

the land from TRF district authority vide letter dated 27.03.2001 and
___________________
company proposes to complete the acquisition of land soon.
Coal Block/Availability & Coal Quality

Coal Requirement and Availability
Annual coal requirement for XYZ TPP (2X500 MW) at PLF of 80% is
estimated to be 5.24 MTPA (5.87 MTPA at a PLF of 90%) for the
Gross calorific value of coal considered at 3250 Kcal/kg. The coal
would be sourced from Ib-Valley Coalfields of Coalfields Limited (CL),
the linkage for which has already been granted by Standing Linkage
Committee (Long Term).
Coal Quality
Following quality parameters of raw coal from Ib-Valley Coalfields of

MCL mines have been considered for project appraisal purposes:
Quality Parameters Unit
Total moisture 15 – 17%
Grade F
Ash 35 – 40%
GCV (kcal/kg) 3000 – 3400
List of major equipment / system
Based on the feasibility prepared by the company, the project would

consist of following major equipment/systems:
Contd…
Unit 5: Case Study
57
Table 3: Mechanical Works Notes
S. No. Description
___________________
1. Steam generator with associated auxiliaries
___________________
2. Electrostatic Precipitator
___________________
3. 500 MW Steam Turbine Generator with associated
auxiliaries ___________________
4. Coal Handling System
___________________
5. Control & Instrumentation incl. DAS
___________________
6. Ash Handling System & AWRS
7. CW Pumps including Makeup water system ___________________
8. Cooling Towers incl. Civil Works ___________________
9. Water Treatment Plant, ETP & DM Plant ___________________

10. Miscellaneous Pumps
___________________
11 Fuel Oil Handling system
12 Fire Protection System
13 Air Conditioning & Ventilation
14. Workshop & Lab. Equipment
15. Hoisting Equipment
16. Diesel Generator
17. Station Piping
Table 4: Electrical Works
S. No. Description
1. Generator Bus Duct. &11 / 3.3 KV Busduct
2. Transformers (excl GT/ICT)
3. Outdoor Transformers
4. L.T. Indoor Transformer
5. HT Busduct
6. H T Switchgear
7. L T Switchgear
8. D C Battery & Chargers
9. Station Lighting System
10. C& I
11. H T Power Cables
12. L T Power, Control Cables & Instrumentation
Contd…
58
Notes 13. Cabling, Earthing & Lighting Protection system
14. Generator Transformer & Tie Transformer
___________________
15. 400/132kV Switchyard
___________________
16. 132 kV Switchyard Equipments
___________________ 17. Shunt Reactor with NGR & LA
___________________ 18. Switchyard Erection (Incl. other equipment &
structures)
___________________
19. Switchyard Civil works
___________________
20. Computer Facilities
___________________ 21. Satellite Communication System
___________________ 22. Common Facilities
___________________
Table 5: Civil Works
___________________
S. No. Description
1. Survey & Soil Investigation
2. Land development
3. Site Clearance & Levelling
4. Township - Land Development, construction of dwelling
unit, non- residential building & bulk facility
5. Permanent Siding
6. Boundary Wall & Permanent Fencing
7. Infrastructure
8. Administrative & Service Building
9. Piling & Foundation
10. Main plant Civil and Structural Works
11. Structural Steel Works
12. Chimney
13. Coal Handling System
14. Raw Water Reservoir
15. C. W. System/M U Water System
16. Water Treatment Plant
17. Ash Handling System
18. Ash Dyke-First 9 years
ABC, as per its existing project implementation practice, is likely to

award separate packages for different components of the Project.
Contd…
Unit 5: Case Study
59
Cost of the Power Project Notes
Components of Project Cost
___________________
The cost of the Project is estimated at ` 568.72 million (including
margin money) and ` 553.03 million (excluding margin money). The ___________________
Project cost includes the expenses towards preliminary & civil work,
mechanical equipment, electrical equipment, physical contingency, ___________________
miscellaneous tools and plants, pre-commissioning expenses, project
___________________
management expense (including establishment, training of staff and
losses on stock), consultancy charges, financing expenses, margin money ___________________
for working capital and Interest During Construction (“ÏDC”). The
summary of the Project cost is asunder: ___________________
Table 6: Project Cost Break-up ___________________
Capital Cost (` million) ___________________
S.No. Item FC IC Total ___________________

1 Preliminary & Civil Works - 949.91 949.91
___________________
2 Plant & Equipment
2.1 Mechanical Equipment 291.00 604.21 895.21
2.2 Electrical Equipment - 394.17 394.17
2.3 Misc. Tools & Plants - 107.15 107.15
2.4 Coal Transportation 617.66 617.66
Sub-Total (2.0) 291.00 723.19 014.19
Works Cost (1.0+2.0) 291.00 673.10 964.10
3 Physical Contingency 188.26 097.45 285.71
4 Pre Commissioning Expenses - 221.25 221.25
5 Project Management - 212.49 212.49
6 Consultancy & training - 135.62 135.62
Project Cost excl. IDC 479.26 339.91 819.17
(1.0 to 6.0)
7 Financing Charges 214.21 80.33 294.54
Interest During Construction 598.44 840.88 439.32
(IDC)
IDC + Financing Charges 812.65 921.21 733.86
Project Cost incl. IDC 291.91 261.12 553.03
(1.0 to 7.0)
8 Working Capital Margin (WCM) - 015.69 015.69
Total Project Cost 291.91 276.81 568.72
Contd…
60
Notes
Land and Civil Works
The total area proposed for plant, township, ash disposal area and
___________________ other facilities is about 1580 acres. ABC has already received an in-
principle land availability clearance from Collector, TRF vide letter
___________________
dated. 27.03.2001. The company proposes to acquire the required land
___________________ soon.
___________________ Civil and structural work for the main plant is proposed to be
implemented through a separate package.
___________________
The estimated cost for land and civil works is summarized as under:
___________________
Table 7: Land and Civil Works
___________________ (in ` Million)
___________________ S. No. Item Total

(all costs in IC)
___________________
1.1 Survey & Soil Investigation 10.00
___________________
1.2 Land 29.80
1.3 Site Clearance & Levelling 01.50
1.4 Township 00.00
1.5 Boundary Wall & Permanent Fencing 6.42
1.6 Infrastructure 48.57
1.7 Administrative & Service Building 14.92
1.8 Main plant Civil and Structural Works 698.26
1.9 Chimney 63.71
1.10 Raw Water Reservoir 37.34
1.11 Cooling Water/Make Up Water System 30.20
1.12 Ash Dyke- First 9 years 29.20
1 Total 949.91
Mechanical Equipment
The cost of the mechanical equipment has been taken based on the
estimates provided by ABC. Separate packages are proposed to be
undertaken for the individual components of mechanical works. Around
23% of the mechanical equipment cost is in foreign currency while
balance 77% cost of mechanical works is denominated in Indian Rupees.
These costs assume 0% customs duty and excise duty considering the
mega power status proposed for the project. The below mentioned
table lists in details the various components that form part of the
mechanical works and the estimated costs thereof.
Contd…
Unit 5: Case Study
61
Table 8: Mechanical Equipment Notes
(in ` Million)
___________________
S.No. Item Description FC IC Total
___________________
2.1.1 Steam Generator with assoc. aux. 05.59 86.80 492.39
___________________
2.1.2 Turbine Generator with assoc. 666.85 046.29 713.14
aux. ___________________
2.1.3 Condensate Polishing Plant - 48.32 48.32
___________________
2.1.4 Coal Handling System - 473.72 473.72
___________________
2.1.5 C & I incl. DAS 18.56 20.90 39.46
___________________
2.1.6 Ash Handling System incl. AWRS - 496.39 496.39
___________________
2.1.7 CW Pumps incl. Makeup water 07.10 07.10
sys. IC ___________________
2.1.8 Cooling Towers incl. Civil Works - 66.99 66.99
___________________
2.1.9 Water Treatment Plant, ETP & - 98.51 98.51
DM Plant
2.1.10 DM Plant - 44.76 44.76
2.1.11 Miscellaneous Pumps - 2.23 2.23
2.1.12 Fuel Oil Handling system - 63.78 63.78
2.1.13 Fire Protection Sys. incl. Civil - 28.92 28.92
Works
2.1.14 Air Conditioning & Ventilation - 67.44 67.44
2.1.15 Workshop & Lab. Equipment - 1.09 1.09
2.1.16 Hoisting Equipment - - 0.00
2.1.17 Diesel Generator - 2.95 2.95
2.1.18 Station Piping - 58.02 58.02
2.1 Total 91.000 214.210 295.210
Electrical Equipment
The cost of developing the electrical equipment for the project includes
the costs associated with the electrical system, switchyard and computer
& satellite communication systems. Separate packages are proposed
to be undertaken for the individual components of electrical works.
All the costs are denominated in Indian rupees. A detailed breakup of
these costs is provided hereunder. These costs are inclusive of spares,
central sales tax and service tax.
Contd…
62
Notes Table 9: Electrical Equipment
(in Million)
___________________
S. No. Item Description
___________________
2.2.1 Electrical System
___________________
2.2.1.1 Generator Bus Duct.& NGE
___________________
2.2.1.2 Unit station & Misc. Service Transformers
___________________
2.2.1.3 Outdoor Transformers
___________________
2.2.1.4 L.T.Indoor Transformer
___________________
2.2.1.5 HT Busduct
___________________
2.2.1.6 H T Switchgear
___________________
2.2.1.7 L T Switchgear
___________________
2.2.1.8 D C Battery & Chargers
2.2.1.9 Station Lighting System
2.2.1.10 C & I
2.2.1.11 H T Power Cables
2.2.1.12 L T Power & Control Cables
2.2.1.13 Cabling, Earthing & Lightning Protection
2.2.1.14 Generator Transformer & Tie Transformer
2.2.1.15 400/132kV Switchyard & 132 kV Line
2.2.1.16 132 kV Switchyard Equipments
2.2.1.17 Shunt Reactor with NGR & LA
2.2.1.18 Switchyard Erection (Incl. other equipment)
2.2.1.19 Switchyard Civil works
2.2.1.20 Computer Facilities
2.2.1.21 Satellite Communication System
2.2.1.22 Common Facilities
2.2 Total
Coal Transportation System

Coal is proposed to be transported through Indian Railways network
from Ib-Valley Coalfields about 600 kms away. Further, railway siding
Contd…
Unit 5: Case Study
63
required for the project is proposed to be drawn from Chacher Railway Notes
Station located on the north of the proposed plant site. Details of the
coal transportation system are as follows: ___________________
Table 10: Coal Transportation System ___________________
(in Million)
___________________
S. No. Item Description
___________________
2.3.1 Perm.Way incl. E/W, Bridges etc.
___________________
2.3.2 Wagons incl. Line side Equipment.
___________________
2.3.3 Locomotives
___________________
2.3.4 Signalling & Telecommunication
___________________
2.3.5 In Motion Weigh Bridge
___________________
2.3 Total
___________________
Miscellaneous Tools & Plants
A provision of 0.25% of the total hard cost of the Project has been
earmarked as costs of miscellaneous tools & plants and the same
works out to 107.15 million.
Contingency
Since the company is yet to begin the process of finalizing the contracts
for various packages for electrical, mechanical & civil works, the costs
of these contracts are yet to be firmed up.
Accordingly, a contingency provision of 3% of the total hard cost of the

Project has been made which works out to ` 1,285.71 million.
Other Expenses
These expenses include the pre-commissioning expenses, project
management expenses (4.5% of the total works cost towards
establishment charges including audit & accounts, 0.5% of the total
works cost towards corporate/regional headquarters, training of O&M
staff and losses on stock), consultancy charges. Also there is a provision
of ` 135.62 million for Consultancy and O &M Staff training. The total
estimated cost under this head is ` 2569.36 million as per details below:
Table 11: Other Expenses

(In ` Million)
S. No. Item Description Total in IC
1.0 Pre Commissioning Expenses
2.0 Project Management

3.0 Consultancy & training
Total
Contd…
64
Notes Interest during Construction
IDC has been estimated at ` 6,439.32 million based on drawl of equity,
___________________ foreign debt and domestic debt on a pro-rata basis, i.e., in the same
ratio as the ratio of project cost funding from these sources during the
___________________ implementation period. The interest rate for rupee term loan of
` 16,065.91 million is assumed at 10.00% per annum: and foreign
___________________ currency loan equivalent to ` 21,421.21 million is considered at 9.50%
per annum based on the prevailing trends for borrowing costs for ABC.
___________________
Further a financing charge of towards the debt component of the
___________________ project is estimated at ` 294.54 million comprising ` 214.21 million
(1% of foreign debt) and ` 80.33 million (0.50% of the rupee debt).
___________________
Margin Money for Working Capital
___________________
A sum of ` 1,015.69 million has been provided as margin money
___________________ towards 25% of the total net working capital requirement for the first
full year of operations of the Project. This has been arrived at, on the
___________________ basis of the following norms:
1. Receivables of 2 months;
___________________
2. O&M expenses for 1 month;
3. Maintenance spares at 1% of the project cost escalated at 6% p.a;
4. Fuel Expenses of 2 months.
It is proposed that this margin money shall be funded entirely through
loan from banks or financial institutions and shall not be funded in
the ratio of debt and equity at which the project is proposed to be
funded.
Project Cost Comparison
The cost of the Project at ` 54,568.72 million translates into a per
MW cost of ` 54.57 million. Given below are few coal-based projects,
along with their project costs that have been implemented or are
being implemented in the country.
Table 12: Project Cost Comparison with other Projects
Project Capacity Cost ` million Base Nature of

(MW) (`
` million) /MW Date expansion
STPP– 500 24484.9 48.97 Q1, 2006 Non-Mega,

Stage III Expansion
F III 500 25704.4 51.40 Q2, 2006 Non-Mega,

Expansion
TNEB JV 2 X 500 57000 57 Q2, 2006 Mega,

Greenfield
PQR TPP 2 X 500 54000 54 Q3, 2006 Mega,

Expansion
DV ‘B’ 2 X 500 50190 50.19 Q3, 2006 Mega,

Expansion
Source: CERC & PQRCAP

Contd…
Unit 5: Case Study
65
The above table reveals that the cost per MW for XYZ TPP, which is Notes
` 54.57 million/MW, is much higher as compared to the cost per MW
of many other coal based projects being set up in the country (including ___________________
few projects being set up by ABC). Although XYZ TPP is comparable
to TNEB JV TPP as it is also a greenfield project, its cost is marginally ___________________
higher by around 2% in comparison to TNEB JV. As XYZ TPP is a
___________________
greenfield project, approximately
` 5.0 million per MW of project cost is attributable to the greenfield ___________________

nature of the project.
___________________
Means of Finance
___________________
The Project is being implemented by ABC on its balance sheet and
___________________
would be financed through internal accruals and raise the required
debt required for the project. At present the Company has a debt ___________________
equity ratio of 0.45:1 leaving room for further leverage to finance
various proposed projects being implemented by ABC, including 1000 ___________________
MW XYZ Thermal Power Plant
___________________
The cost of the Project estimated at approximately ` 53,553.03 million
(without margin money) is proposed to be funded at a debt-equity ratio
of 70:30, which is the generally accepted financing norm considered
prudent by banks and financial institutions for financing power
generation and other infrastructure projects. Central Electricity
Regulatory Commission (“CERC”) has also stipulated the same ratio in
the CERC (Terms and Conditions of Tariff) Regulations 2004 as norm
for determination of tariff on cost-plus basis. Corresponding to DE
ration of 70:30, the estimated debt and equity requirement for the
Project works out to ` 37,487.12 million and ` 16,065.91 million
respectively. ABC proposes to raise the debt component of the Project
cost through a combination of rupee term loan and foreign currency
loan (USD denominated) in the ratio 30:40 of the project cost. The
proposed funding pattern is asunder:
Table 13: Proposed Funding pattern
Source of Funds % of Project Cost
Equity 30%
Debt
Rupee Term Loan 30%
Foreign Currency Loan 40%
Total 100%
The equivalent rupee amount for the quantum of required foreign

debt has been worked out as per following assumptions:
• Foreign currency loan raised in USD
• Drawal of loan as per drawal schedule
Contd…
66
Notes • INR / USD conversion rate –44.50.
• Rupee depreciation –0%.

___________________
Since the majority of the expenditure including main plant package,
___________________ is proposed to be incurred in Rupees, there could be a little mismatch
between sources of funds and cost of the project. However, the Project
___________________
being planned to be developed on ABC balance sheet, such slight
___________________ mismatch is not apprehended to impact the development of the Project.
___________________ It is proposed to infuse the necessary funds on a pro rata basis, i.e.,
as per overall ratio envisaged for funding of the project by various
___________________ sources of finance namely equity, Rupee term loan and foreign currency
loan [in the ratio of – 30:30:40).
___________________
Equity
___________________
It is proposed, that the equity contribution to the project of ` 16,065.91
___________________ million, will be brought in by ABC from internal accruals which is a
reasonably feasible given the gross cash accruals of ABC of ` 78,680
___________________
million during FY 2005-06.
Rupee Term Loan
The Company proposes to part finance the project by raising Rupee

term loan aggregating ` 16,065.91 million, at the following terms:
Table 14: Rupee Term Loan-terms
Particulars Terms
Facility Rupee Term Loan
Tenure of Loan Door to door 7 years
Moratorium Nil
Repayment Bullet repayment 7 years from disbursement

of each yearly tranche.
Interest Rate 10.00% p.a. – in line with recent hardening of

interest rates
Financing Fee 0.50%, payable at the time of drawl of the

respective tranche
Alternatively, company may also raise bonds for y-o-y requirement

payable after 7 years from the disbursal year and the envisaged project
financing structure is suited for the same.
Foreign Currency Loans
ABC proposes to fund the remaining Project cost by raising foreign

currency loans denominated in USD aggregating ` 21,421.21 million
equivalent. ABC proposes to finance the same at following terms:
Contd…
Unit 5: Case Study
67
Table 15: Foreign Currency Loans-terms Notes
Particulars Terms
___________________
Facility Foreign Currency Loan
___________________
USD Equivalent 462.37 million USD
___________________
Tenure of Loan Door to door 7 years
___________________
Moratorium Nil
___________________
Repayment Bullet repayment 7 years from disbursement
of each yearly tranche ___________________
Interest Rate 9.50% p.a. – includes all borrowing costs and ___________________
rupee devaluation.
___________________
Financing Fee 1.0%, payable at the time of drawl of the
respective tranche ___________________
___________________
Adequacy of Financing Plan and Associated Risks
Adequacy of funds for the Project
ABC intends to implement the Project on its balance sheet and

accordingly, equity contribution for the project will be brought through
internal accruals while debt will be raised leveraging the existing
strong balance sheet of the company. Given the excellent track record
of ABC in development and operation of power generation projects,
XYZ TPP project is likely to be implemented as per estimated cost
and schedule without any undue stress in obtaining funds for the
project provided the tariff remains competitive.
Foreign Exchange Rate Variation [FERV] Risk
As per envisaged funding plan, 40% of the Project cost would be

funded through foreign currency loans denominated in USD. On the
revenue side, ABC plans to sell 85% of the electricity generated to
utilities of Western region through long term PPA at a tariff
determined as per CERC’s Terms & Conditions of Tariff regulations.
In accordance with the said tariff regulations, all FERV on such sale
would be a pass through and ABC would not get adversely affected due
to forex rate fluctuations. However, in case the sale of power is finalized
through competitive bidding, company will have to bear the forex
exposure risk as the relevant Competitive Bidding guidelines stipulate
tariff to be denominated in INR only while all liabilities on account of
foreign currency exposure is entirely to the account of the seller. As
per power marketing plans, balance 15% power would be available
with ABC for sale outside long term PPA and for the projected power
deficit scenario including peak deficit, company may reasonably realize
tariff for balance 15% power at par with tariff for 85% long term PPA
power including concurrent FERV.
Contd…
68
Profitability Projections
Notes
Assumptions
___________________
The profitability projections for the proposed project are based on the
___________________ assumptions and project cost estimates provided by ABC. The project
cost of ` 46,819.17 million (excluding IDC and margin money) has
___________________ been arrived at, based on the cost estimated by ABC in the feasibility
report prepared for the Project. IDC has been calculated as per the
___________________ proposed phasing schedule for expenses required to be incurred for
the various packages that constitute the Project.
___________________
Some of the major assumptions underlying the profitability analysis
___________________
are as under:
___________________ • Domestic Loan: Foreign Currency Loan: Equity –30:40:30
___________________ • Interest Rate on Domestic Debt –10.0%
___________________ • Interest Rate on Foreign Debt –9.5%

• Average PLF - 80%, auxiliary consumption –7.50%
___________________
• Coal price - ` 1016.6 per MT, Noescalation
• SHR - 2450 kcal/kWh, GCV – 3250 kcal/kg
• Annual rupee depreciation – 0% against US Dollar
• Implementation Period – Commercial operations in 45 months for
unit 1 and 51 months for unit 2 from main plant award (including
3 months of stabilization period)
• O&M Expense – Based on CERC norms for the start year of FY
2011–12 but with no escalation thereafter.
• Minimum Alternate Tax – NIL, Corporate Tax –NIL
• Working Capital Calculations – Based on CERC norms
• Tariff – Based on CERC norms (except tax and FERV).
Projected Financials
The projected balance sheet, profit & loss statement and cash flow
statement for the Project have been prepared based on the project
cost estimates and assumptions discussed earlier and are presented as
annexure II, III and IV respectively (for the first eight years, one year
after the loan is being fully repaid).
It may be observed from the annexures that the Project is profit

making throughout the projection period. Lower profit for year 0,
when compared to the profit figures for the following years is on
account of only 1 unit of the Plant being operations only for 7 months
during the first year (year 0) and cannot be attributed to any weakness
associated with the project.
Financial Indicators
Important indicators such as debt: equity ratio, debt service coverage

ratio (“DSCR”) for the Project through the tenor of the loan for the
Contd…
Unit 5: Case Study
69
Project, average DSCR, minimum DSCR, tariff of the power generated Notes
from the Project, levelised tariff, minimum DSCR and Project IRR are
presented here under. ___________________
Table 16: Financial Indicators
___________________
Year Ending 2011 2012 2013 2014 2015 2016 2017 2018 2019
31st Mar ___________________
Long-Term 2.33 2.33 2.33 2.12 1.74 1.03 0.57 0.13 ___________________
Debt:Equity
___________________
DSCR 2.24 2.15 2.08 1.31 0.94 0.58 0.79 0.82
___________________
Average 1.05
DSCR ___________________
Minimum 0.58 ___________________

DSCR
___________________
Tariff 2.60 2.31 2.30 2.55 2.48 2.38 2.21 2.10
___________________
Levelised 2.09
Tariff
Project IRR 11.06%
It may be reiterated that the above projections take CERC norms as

the base, except that tax, FERV and escalation in fuel and O&M costs
are excluded from tariff. Any upsides in profitability obtained due to
sale under competitive bidding route have not been taken into account
in the base case.
It may also be observed that Avg. DSCR is 1.05. While minimum

DSCR is less than 1 at 0.58, ABC has confirmed that in case of DSCR
falling below one in those respective years, cash flow support would
be provided from company’s balance sheet to take care of the debt
servicing of the project.
Sensitivity Analysis
Towards assessing the robustness of the Project, in the event the

Project experiencing changes in one or more project parameters,
sensitivity analysis has been carried out for the below mentioned
scenarios.
• Change in rate of Rupee depreciation against US Dollar

• Change in fuel price escalation
• Change in actual O&M cost escalation
• Change in Interest Rates
Rupee Depreciation against US Dollar

This scenario has been considered to assess the impact of variation in
the Rupee USD depreciation rate on the profitability of the Project.
Contd…
70
Notes The base case assumes no Rupee depreciation. It was seen that if
Rupee depreciates by 2%, then average DSCR falls from 1.05 to 0.99
___________________ and minimum DSCR falls from 0.58 to0.53
___________________ Since power generated by the Project is proposed to be sold to Western

Region through long term PPA, FERV would be passing through on
___________________ tariff charged to SEBs.
___________________ Fuel Price Escalation
___________________ The base case assumes a base (all inclusive) coal price of ` 1016.6 per
MT, without any annual escalation in coal price. Considering the fact
___________________ that the variable charges (fuel price) have a very important bearing
on the competitiveness of power generated by a Project, a sensitivity
___________________
analysis has been carried out to assess the impact of the same on the
___________________ levelised tariff. As part of this scenario, escalation in the price of
landed cost of coal has been changed from 0% p.a. to 4% p.a. The
___________________ impact of increased escalation in fuel cost can be seen in the levelised
tariff for the power generated by the Project increasing to ` 2.44 per
___________________ unit from ` 2.09 per unit in the base case. It may be mentioned here
that average coal price increase over the last few years from CIL
subsidiaries has been in line with inflation increase, i.e., in the range
of 4%-6% per annum.
O&M Escalation
The base case assumes no escalation in O&M expenses whereas

according to CERC tariff regulations for 2004–2009, annual escalation
of 4% p.a. is permissible. The impact of this escalation in O&M expenses
can be seen in the levelised tariff for the power generated by the
Project increasing to ` 2.17 per unit from ` 2.09 per unit in the base
case.
Increase in Interest Rates
The base case assumes 10.0% p.a. and 9.5% p.a. interest on domestic
and foreign debt respectively. Considering the interest rate scenario
in the country, a scenario has been built at interest rate of 10.0% for
foreign debt also. The impact of this increase in interest rate can be
seen in the levelised tariff for the power generated by the Project
increasing to ` 2.10 per unit from ` 2.09 per unit in the base case
whereas tariff for power generated by the Project in first year of full
operation decreasing to ` 2.32 per unit from ` 2.31 per unit in the
base case.
Completed Cost assuming escalation
This scenario has been calculated assuming 5% p.a. escalation in the

hard cost (except for land and Survey & Soil Investigation) of the
Project denominated in Indian rupee and 2% p.a. escalation for hard
cost denominated in USD. This escalation has been assumed to account
for the time lag between the date of Project cost estimation and the
actual date of placing the order with the vendor. Full escalation is
Contd…
Unit 5: Case Study
71
assumed for the period from base date, i.e., Nov 15, 2006 and the Notes
Main Plant Award Date but only two thirds escalation is assumed for
the period thereafter as specified in the EPC contract. ___________________
In this scenario, the completed project cost is found out to be ___________________

` 60,897.94 million (including margin money) and ` 59,828.27 million
(excluding margin money). The levelised tariff comes out to be ` 2.21 ___________________
per unit and first full year tariff is ` 2.46 per unit (variable charges
___________________
– ` 0.87 per unit and fixed charges – ` 1.59 per unit). The following
table compares the current cost with the completed cost. ___________________
Composite Sensitivity: Most Likely Scenario ___________________

While the various assumptions underlying the base case have been ___________________
taken, as advised by ABC, some factors such as 0% escalation in fuel
cost, 0% escalation in O&M cost, no rupee USD fluctuation, etc. are ___________________
unlikely to fructify in reality. This scenario has been carried out
based on the following set of assumptions that are considered ___________________
reasonable by PQRCAP for a project of this nature. The assumptions
___________________
that constitute this scenario and that are at divergence to the base
case are:
• 4% escalation in landed cost of fuel price.

• 4% escalation in O&M cost.
• 2% p.a. depreciation of rupee vis-à-vis USD.
In this scenario, the tariff comes out to be ` 2.54 per unit levelised
and ` 2.42 per unit for the first full year of operation. It may be noted
though the tariff increases the average DSCR decreases from 1.05 in
the base case to 0.99. The scenario will have to be borne in mind by
ABC while actually selling the power in the openmarket.
Risk & SWOT Analysis
Risk Analysis – Allocation & Mitigation
Risk Factor Allocated To Proposed Mitigation Mechanism
Management Risk
Sponsor Risk ABC The equity contribution for the Power

Project would be brought in by ABC
through internal accruals.
Pre-completion Risks
Approvals and ABC MoEF clearance would be required

Permits especially for the project site based on EIA to
environment be prepared by the company. However,
clearance from the plant location being far from any
MoEF big city may help in getting the MoEF
clearance.
Contd…
72
Notes Construction Various/ ABC intends to award separate
Period/ Cost separate contracts for different packages for
___________________ Overrun package EPC the construction of the Power Project
Contractors on a fixed price, fixed time basis.
___________________ These contracts shall have
appropriate liquidated damages
___________________ clauses so as to protect ABC against
cost over runs. Further contingency
___________________ provision has been made in the
project cost to take into account, any
___________________ additional works.
___________________ Land Availability ABC In-principle approval for land

availability from district
___________________ administration has been received for
the project and accordingly, the
___________________ acquisition of land may not be a very
difficult process.
___________________
Debt funding risks ABC ABC proposes to raise the debt
___________________ finance in domestic currency and USD
by raising 7 year bonds or ECB for 7
years. ABC’s leverage ratios are low
while the coverage ratio is adequate
as supported by stable cash flows.
Liquidity is also comfortable for ABC
considering access to large syndicated
facilities and a balanced debt
maturity profile and significant
cashbalances.
Debt Servicing ABC As per the proposed repayment

schedule of bulleted repayments to
be paid for each 4 quarterly
disbursements in a year tobepaid
at the end of 7 year, the minimum
DSCR falls below 1 with average
DSCR of1.05. However ABC has
proposed for support of internal
accruals for such accelerated debt
repayments resulting in minimum
DSCR below 1.0
Foreign Exchange ABC All the Project cost components are

Risk being paid for, in domestic currency.
However, 40% of the total Project cost,
excluding margin money is being
funded through USD denominated
loans. However, as bulk of the power
is proposed to be sold through long
term PPA with tariff determined on
cost plus basis, the risk associated
with depreciation of rupee will be a
pass through to the consumers except
for the 15% power proposed to be sold
outside the long term PPA.
Contd…
Unit 5: Case Study
73
Post completion risks Notes
Fuel Supply ABC As per the feasibility report, the daily ___________________
maximum coal requirement (for
2×500 MW units) shall be about ___________________
17944 MT based on average Gross
Calorific Value of 3250 Kcal/kg, 100% ___________________
plant load factor and 2450 Kcal/KWh
unit heat rate. Annual coal ___________________
requirement for both units shall be
5.24 MTPA considering PLF of 80% ___________________
and the same is proposed to be met
from Ib- Valley Coalfields of MCL ___________________
and linkage for the same has been
achieved. ___________________
Transportation ABC For coal transportation, though ABC ___________________

of Fuel will make use of the existing railway
network while the railway siding and ___________________
additional coal transportation facility
within plant area needs to be created ___________________
and the same has been factored in
project cost estimates.Secondary fuel,
that is Light Diesel Oil, shall be used
for the start-up operation and shall
be sourced and brought to the Power
Project site by lorry tankers from the
nearest depot of oil company.
Environmental EPC ABC has to obtain Minutes of Public

Risks contractor Hearing (yet to be conducted) from
/ABC MSPCB and environmental clearance
from MoEF. Further, various packaged
contracts for Project components
should also have suitable clauses
with respect to guarantees for
emission standards.
Availability of ABC The make up water requirement for

water the expansion project would be about
44 – 58 cusecs, which is proposed to
be drawn from nearby Gosikhurd
Reservoir (nearing completion) on
river Wain Ganga. Government of UK
has already accorded in- principle
water commitment, vide letter- dated
10.12.2002.
Evacuation Risks ABC ABC has proposed to sell the power

generated to different states & Units
in Western region and as such would
not require any inter regional
transmission corridor. Power
generated from the Project will be
stepped up and evacuated through 400
kV transmission lines. The issue of
Contd…
74
Notes power evacuation from the plant shall
be taken up with Central Trans-
___________________ mission Utility (CTU)/appropriate
authorities. The provisions for power
___________________ evacuation as considered presently
shall be reviewed based on the
___________________ finalized ATS of the project.
___________________ Market Risk
___________________ Off take Risk ABC Sufficient future demand is projected

to exist in Western region and the
___________________ proposed sale through long term PPA
will mitigate the off- take risk to a
___________________ very large extent.
___________________ Payment Risk ABC As power generated from the Power

Project shall be sold to various states
___________________ in Western region, appropriate
payment security mechanism should
___________________ be negotiated/entered into. ABC
would be exposed to the credit risk
arising from the financials of
respective distributions companies.
However, provision for Letter of credit
may be incorporated in the PPA to be
entered with the off-takers in addition
to any other agreement between
utilities and related Governments for
payment of receivables. Further,
escrow of receivables in case of
distribution licensees may also be
explored.
Financial Risks
Foreign Exchange ABC The entire revenues of ABC during

the Power Project operations period
shall be in Indian Rupees. However,
due to 40% of the Project cost being
funded through USD denominated
loans, cash outflows in USD would be
required to be made by ABC
throughout the tenor of the loan
(principal and interest). Since FERV
is a pass through for sale to SEBs as
per CERC guidelines, ABC would be
insulated form this risk as the power
is proposed to be sold through long
term PPA.
Fuel Price ABC The primary fuel, that is coal, is

proposed to be supplied from Ib-
valley coal fields of MCL, linkage for
which has already been provided. The
estimated price is assumed at ‘
Contd…
Unit 5: Case Study
75
1016.6 per MT inclusive of Notes

transportation cost of‘ 501.8 per
MT.Further ABC shall be susceptible ___________________
to the price fluctuations in the price
of start-up fuel that is LDO. The base ___________________
case scenario has taken account of
escalation in cost of LDO. Also, as ___________________
LDO is proposed to be used only for
start-up operation, this shall form a ___________________
very small component of the total
operating costs. ___________________
Technology Risks ___________________
Equipment under Vendor/ABC The various packaged contracts ___________________

Performance should provide for suitable Liqui-
dated Damages for performance of ___________________
Plant as per the specifications.
___________________
Further, O&M shall be
undertaken in house through a ___________________
proper mix of fresh and
experienced officials. The
Company expects to leverage the
experience gained while Operation
& Maintenance of the existing
power plants.
Political Risks
Rehabilitation & ABC The rehabilitation liability of

Resettlement project is yet to be fully assessed.
Risk
SWOT Analysis
Strengths Weakness
• Established reputation in the • Firm cost of the Project has

field of setting up power stations not been tied up. However,
and operating plants in India. since the cost estimates are
based on the recent orders
placed by ABC, with price
escalation clauses, as well as
3% of hard costs as
contingency, the completed cost
of the Project may be
considered reasonably accurate.
It is recommended that ABC
enter into firm contracts as
soon as possible.
Contd…
76
Notes
• Enjoys operational efficiency, • ABC proposes to take up the
with competitive fuel sourcing implementation risk on itself.
___________________
and Project execution skills. However, since ABC has been
___________________ • The proposed expansion project successfully commissioning its
i.e., MTPP is proposed to be projects well within the estimated
___________________ Mega Power Project, hence can time frame, no problems are
avail mega power benefits. envisaged in this regard.
___________________
Opportunities Threats
___________________
• Continuing electricity • Ultra Mega Power Projects
___________________
shortage/deficit by 2012, (UMPPs) bids may impact the
___________________ apprehended slippages in the benchmark tariff and which
actual capacity addition against may create difficulties in sale
___________________ targets in the fore see able of high tariff power. A
future. rationalization of capital cost
___________________
• Electricity Act 2003 has opened and operational expenditure
___________________ up several opportunities for the may mitigate such threat.
power sector. Including sale of
power directly to distribution
and trading licensees and this
leaves an additional window of
power sale to ABC through their
trading arm NVVNL.
Conclusion
XYZ TPP 1000 MW (2x500 MW) Power Project is envisaged as an

interstate power station in the state of UK. Sale of power for entire
capacity will be based on CERC’s cost-plus tariff setting principles –
ABC proposes to enter into long-term PPAs with target states in
Western region. In doing so, ABC will be taking advantage of the 5
year exemption (or such other period as determined by the Commission)
provided to State owned/ controlled companies, from sale of power
based on competitively bid tariffs. The cost-plus regime would offer
ABC the advantage of a pass-through of FERV, a guaranteed return
on equity of 14% and relative insulation from regulatory risk on account
of a new competitive tariff framework provided the tariff remains
competitive within the given set of power generators.
For timely construction and commercial operation of the plant, receipt

of all approvals/clearances including environmental clearances from
MoEF and acquisition of land would need to be addressed quickly.
ABC would also need to reassess the prudence of maintaining a 7 year

door-to-door tenor on its domestic and foreign debt which results in
a Debt Service Coverage Ratio (DSCR) of less than 1 from Year 4 to
Year 8 of commissioning of the project despite availing benefit of
Advance Against Depreciation (AAD) in tariff. However, since the debt
is being taken on the balance sheet of ABC, ABC’s existing cash flows
Contd…
Unit 5: Case Study
77
can be used for repayment. However, funds that could instead be Notes
leveraged for other projects will have to be used to support the debt
servicing capability of this project. ___________________
Subject to the risk analysis and mitigation mechanisms, the weaknesses ___________________
and threats enumerated in the SWOT analysis, the impact of the
various scenarios as envisaged under the sensitivity analysis and the ___________________
additional support to be provided for debt servicing out of the Company’s
___________________
internal accruals, the Proposed Project of ABC 1000 MW (2 × 500 MW
coal-based XYZ TPP) is viewed as financially viable. ___________________
Questions ___________________
1. Analyse the case and interpret it.
___________________
2. Write down the casefacts.
___________________
3. Write down an effective executive summary of given case.
___________________
___________________
Block–II
Detailed Contents
UNIT-6: CONCEPT OF BUSINESS ENTITY
UNIT-7: EFFECTIVE UTILISATION OF FUNDS
UNIT-8: COST OF EQUITY MODELS
UNIT-9: WACC AND EQUITY CAPITAL
UNIT-10: CASE STUDY

81
Unit 6 Notes
Concept of Business Entity ___________________
___________________
___________________
___________________
___________________
\ The Need to Create Corporation
___________________
\ The Separate Entity Concept
\ The Closure of a Company ___________________
\ The Types of Business Entities ___________________
___________________
Introduction
A corporation is a formal business association with a publicly
registered charter recognizing it as a separate legal entity having
its own privileges, and liabilities distinct from those of its
members. There are many different forms of corporations, most
of which are used to conduct business. Corporations exist as a
product of corporate law, and their rules balance the interests of
the management who operate the corporation, creditors,
shareholders, and employees who contribute their labour.
Corporation: An Overview
An important feature of a corporation is limited liability. If a
corporation fails, shareholders normally stand to lose their
investment, and employees lose their jobs. But neither will be
further liable for debts that remain owing to the corporation’s
creditors.
Despite not being natural persons, corporations are recognized
by the law to have rights and responsibilities like natural persons
(“people”). Corporations can exercise human rights against real
individuals and the state, and they are often responsible for
human rights violations. Just as they are “born” into existence
through its members obtaining a certificate of incorporation, they
can “die” when they are “dissolved” either by statutory operation,
order of court, or voluntary action on the part of shareholders.
Insolvency may result in a form of corporate ‘death’, when creditors
force the liquidation and dissolution of the corporation under
court order, but it most often results in a restructuring of
82
corporate holdings. Corporations can even be convicted of criminal
Notes
offenses, such as fraud and manslaughter.
___________________ Although corporate law varies in different jurisdictions, there
are four core characteristics of the business corporation:
___________________
1. Legal personality
___________________
2. Limited liability
___________________
3. Transferable shares
___________________
4. Centralized management under a board structure
___________________
Subchapter-S Corporations (S-Corporations)
___________________
A Subchapter-S corporation (or S-corp) is a corporation that has
___________________
the benefits of limited liability of a corporation but is taxed as a
___________________ partnership, with the income or losses flowing through to the
individual shareholders.
___________________
Professional Corporations (PCs)
A professional corporation is a specific type of corporation for
professionals, such as attorneys, doctors, architects and
accountants. In some states, these professionals can form a
corporation, but with the distinction that each professional is
still liable for his or her own wrongful professional actions.
Legal Status of Corporation

Within the official framework, a corporation or in some
jurisdictions a company is a legal, artificial entity with or without
shareholders, who may be humans, trusts or other corporations.
When there are no stockholders this may be a non-stock
corporation, a membership corporation or similar name; this
second type of corporations are not-for-profit corporations. In
either category, the corporation is a collective of individuals with
a distinct legal status with special privileges that are not given
to ordinary unincorporated businesses, voluntary associations or
groups of individuals. Corporations are chartered by a state and
regulated by the laws enacted by that state. Its activities are
regulated by the law of the state in which the corporation operates,
if different from the state in which it was formed.
Shareholders are the owners of the business, and they choose to
register a new artificial “person” on the paper, named
corporations, which shall have rights like the living person.
Some jurisdictions do not allow the use of the word company
alone to denote corporate status, since the word company may
refer to a partnership or may merely be part of the business
Unit 6: Concept of Business Entity
83
entity’s name. Some of the magic words used to signify corporation
Notes
status that can only be used with state sanction include: Limited
(Ltd.), Unlimited, Incorporated (Inc.), Corporation (Corp.), S.A.
___________________
(Société anonyme), and GmbH (Gesellschaft mit beschränkter
Haftung). ___________________
Some jurisdictions require that one of the terms or abbreviations ___________________

appears in the corporate name. If a corporate, be it domestically
___________________
created or foreign (from another jurisdiction), it must be registered
to conduct business in a state. Such a registry will also designate ___________________
the principal address of the corporation, i.e. where it may be
___________________
contacted for legal process.
___________________
Sometimes called a fictional person, legal person or a moral person
(as opposed to a natural person); in the United States this is ___________________
known as the doctrine of corporate personhood. Under such a
doctrine, obviously a legal fiction, a corporation enjoys many (or ___________________
all) of the rights and obligations of individual citizens such as the ___________________
ability to own property, sign binding contracts, pay taxes, have
constitutional rights and otherwise participate in society.
Typically, a corporation is governed by a Board of Directors, which
has a fiduciary duty to look after the interests of the corporation.
The corporate officers such as the CEO, president, treasurer and
other titled officers manage the affairs of the corporation.
Check Your Progress
Fill in the blanks:
1. An important (but not universal) feature of a corporation is ............. .
2. ............... are chartered by a state, and regulated by the laws enacted

by that state.
3. Typically, a corporation is governed by a ..............., which has a fiduciary

duty to look after the interests of the corporation.
Types of Business Entities

A business entity is an entity that is a group of people organized
for some profitable or charitable purpose. Business entities include
organizations such as corporations, partnerships, charities, trusts,
and other forms of organization. Business entities, just like
individual persons, are subject to taxation and must file a tax
return. Some business entities are exempt from federal income
tax. These include non-profit charities, S-corporations, and
partnerships. Business entities may be subject to state income
tax, depending on the laws of the state or states where they
conduct business.
84
Broadly, all the business can be classified in the following two
Notes
common types of businesses:
___________________ 1. “Pass-through” Businesses: Pass-through businesses are
those in which the profits and losses of the business pass
___________________
through to the owners. In other words, the business income
___________________ is considered as the owner’s income, and the owner pays the
tax on his or her personal tax return.
___________________
2. Separate Business Entities: Corporations are separate
___________________
businesses entities. The profits and losses of the corporation
___________________ are taxable to the corporation, not the owners (shareholders).
Corporations are set up as separate business entities.
___________________
Based on that, there are different types of business entities defined
___________________ in the legal systems of various countries. These include
___________________ corporations, cooperatives, partnerships, sole traders, Limited
Liability Company and other specialized types of organizations.
___________________
Corporations are defined above and other business entities are:
• A cooperative (also co-operative; often referred to as a
co-op) is a business organization owned and operated by a
group of individuals for their mutual benefit. Cooperatives
are defined by the International Co-operative Alliance’s
Statement on the Co-operative Identity as autonomous
associations of persons united voluntarily to meet their
common economic, social, and cultural needs and aspirations
through jointly owned and democratically controlled
enterprises. A cooperative may also be defined as a business
owned and controlled equally by the people who use its
services or by the people who work there. Cooperative
enterprises are the focus of study in the field of cooperative
economics.
• A partnership is an arrangement where entities and/or
individuals agree to cooperate to advance their interests. In
the most frequent instance, a partnership is formed between
one or more businesses in which partners (owners) co-labor
to achieve and share profits or losses.
Partnerships are also frequent regardless of and among
sectors. Non-profit organizations, for example, may partner
together to increase the likelihood of each achieving their
mission. Governments may partner with other governments
to achieve their mutual goals, as may religious and political
organizations. In education, accrediting agencies increasingly
evaluate schools by the level and quality of their partnerships
with other schools and across sectors. Partnerships also occur
at personal levels, such as when two or more individuals
85
agree to domicile together. Partnerships between
Notes
governments, interest-based organizations, schools,
businesses, and individuals, or some combination thereof,
___________________
have always been and remain commonplace.
___________________
Partnerships have widely varying results and can present
partners with special challenges. Levels of give-and-take, ___________________
areas of responsibility, lines of authority, and over arching
___________________
goals of the partnership must all be negotiated. While
partnerships stand to amplify mutual interests and success, ___________________
some are considered ethically problematic, or at least
___________________
debatable. When a politician, for example, partners with a
corporation to advance the corporation’s interest in exchange ___________________
for some benefit, a conflict of interest may make the
partnership problematic from the standpoint of the public ___________________
good. Developed countries often strongly regulate certain ___________________
partnerships via anti-trust laws, so as to inhibit monopolistic
practices and foster free market competition. ___________________
Among developed countries, business partnerships are often

favoured over corporations in taxation policy, since dividend
taxes only occur on profits before they are distributed to the
partners. However, depending on the partnership structure
and the jurisdiction in which it operates, owners of a
partnership may be exposed to greater personal liability than
they would as shareholders of a corporation.
(a) General Partnerships: A general partnership is a
partnership that includes only general partners. Under
this structure, all partners participate in the day-to-day
operations of the partnership and all partners bear
personal responsibility for debts and liabilities of the
partnership.
(b) Limited Partnerships: If a partnership has both general
partners and limited partners, it is sometimes termed a
“limited partnership.” A limited partnership is an entity
distinct from its partners. As with a “partnership,” the
general partners deal with the day-to-day operations of
the partnership and they have liability for debts and for
actions of the partners. Limited partners do not
participate in day-to-day operations of the partnership
and they bear no liability for debts or actions of the
partnership.
(c) Limited Liability Partnerships (LLPs): LLPs are formed
with general partners, but all general partners are
shielded from liability for the acts of other partners or
employees. The LLP is similar to a limited liability
company (LLC), but the LLP operates under partnership
rules.
86
• A sole proprietorship, also known as a sole trader or
Notes
simply a proprietorship, is a type of business entity that is
owned and run by one individual and in which there is no
___________________
legal distinction between the owner and the business. The
___________________ owner receives all profits (subject to taxation specific to the
business) and has unlimited responsibility for all losses and
___________________
debts. Every asset of the business is owned by the proprietor
___________________ and all debts of the business are owned by the proprietor.
This means that the owner has no less liability than if they
___________________
were acting as an individual instead of as a business. It is a
___________________ “sole” proprietorship in contrast with partnerships. A sole
proprietor may use a trade name other than his or her legal
___________________ name after filing a doing business as statement with the
___________________ local authorities.
• A limited liability company (LLC) operates like a
___________________
partnership, but it has members instead of partners, and an
___________________ operating agreement instead of a partnership agreement. The
advantage to an LLC is that the liability of members is
limited to their investment. Most states allow a single-
member LLC to form. A single-member LLC is taxed as a
sole proprietorship, while a multiple-member LLC is taxed
as a partnership.
Advantages
Advantages of corporations include - the ability to raise capital
either publicly or privately, to limit the personal liability of the
officers and managers, and to limit risk to investors.
The disadvantages of corporations are advantages to
proprietorship and include - the reduced cost of a business as
corporations must do many things like purchasing, accounting,
and legal actions in more expensive ways and are subject to special
taxes and fees; easier and cheaper to start and discontinue
without required fees and legal expenses; and easier management,
particularly when a sole owner wishes to have exclusive control,
as most corporations are required to be controlled by the Board
of Directors of several persons.
“Holding everything else constant, small corporations are less
creditworthy than small non-corporate firms, because the former
have only the corporation’s assets to back up business debt, while
the latter have both the firm’s assets and the owner’s personal
assets.
Lenders also know that owners of small corporations can easily
shift assets between their personal accounts and their
corporations’ accounts, so that lenders may not view the corporate/
non-corporate distinction as meaningful for small firms. In making
87
loans to small corporations, lenders, therefore, may require that
Notes
owners personally guarantee the loans. This abolishes the legal
distinction between corporations and their owners for purposes
___________________
of the loan and puts the owner’s personal assets at risk to repay
the loan.” ___________________
Disadvantages ___________________
• Raising capital for a proprietorship is more difficult because ___________________

an unrelated investor has less peace of mind concerning the
___________________
use and security of his or her investment and the investment
is more difficult to formalize; other types of business entities ___________________
have more documentation.
___________________
• As a business becomes successful; the risks accompanying
___________________
the business tend to grow. One of the main disadvantages of
sole proprietors is unlimited liability where the personal ___________________
assets can be taken away. This is particularly true for
wrongdoing or liabilities created by employees; a corporation ___________________
only partially shields an owner or officer for his own actions
according to the principle of piercing the corporate veil. Sole
proprietors also commonly end their business shortly, or
lacking continuity. Also, being alone in business, sole
proprietors generally have a lack of money which will lead
to a failure in business. The small size of the business causes
limited management skills because there are less people
working together. Employees, generally, want to be hired
into a stable business or company and so small independent
businesses that have a high chance of failing, having less
skilled employees wanting a job there. Certain business
structures such as Limited Liability Company allow shielding
of personal assets, and sometimes, favourable tax treatment,
but there are disadvantages and limitations also.
• A Limited Liability Company (LLC), also known as a
company With Limited Liability (WLL), is a flexible form
of enterprise that blends elements of partnership and
corporate structures. It is a legal form of company that
provides limited liability to its owners.
Often incorrectly called a “limited liability corporation” (instead
of company), it is a hybrid business entity having certain
characteristics of both a corporation and a partnership or sole
proprietorship (depending on how many owners there are). An
LLC, although a business entity, is a type of unincorporated
association and is not a corporation. The primary characteristic
an LLC shares with a corporation is limited liability, and the
primary characteristic it shares with a partnership is the
availability of pass-through income taxation. It is often more
88
flexible than a corporation and it is well-suited for companies
Notes
with a single owner.
___________________ It is important to understand that limited liability does not imply
that owners are always fully protected from personal liabilities.
___________________
Courts can and will pierce the corporate veil of corporations (or
___________________ LLCs) when some type of fraud or misrepresentation is involved.
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. A .................. is an entity that is a group of people organized for some
___________________ profitable or charitable purpose.
___________________ 2. A .................. is a business organization owned and operated by a

group of individuals for their mutual benefit.
___________________
3. A .................. is an arrangement where entities and/or individuals
___________________ agree to cooperate to advance their interests.
4. If a partnership has both general partners and limited partners, it is

sometimes termed as .................. .
5. The advantage to an .................. is that the liability of members is

limited to their investment.
Separate Entity Concept

In accounting, the separate entity concept treats a business as
distinct and separate from its owners. The business stands apart
from other organizations as a separate economic unit. It is
necessary to record the business’s transactions separately, to
distinguish them from the owner’s personal transactions. This
concept can be extended to accounting separately for the various
divisions of a business in order to ascertain the financial results
for each division.
The idea here is that the financial transactions of one individual
or a group of individuals must be kept separate from any unrelated
financial transactions of those same individuals or group.
An example is a sole trader or one-man business: the sole trader
takes money from the business by way of ‘drawings’: money for
his own personal use. Despite it being his business and apparently
his money, there are still two aspects to the transaction - the
business is ‘giving’ money and the individual is ‘receiving’ money.
Even though there is no other legal distinction between the sole
trader and the business, and the sole trader is liable for all of the
debts of the business, business transactions will probably still be
taxed separately from personal transactions, and the proprietor
of the business may also find it useful to see the financial results
89
of the business. For these reasons, the affairs of the individuals
Notes
behind a business should be kept separate from the affairs of the
business itself.
___________________
Closure of a Company ___________________
Every aspiring entrepreneur starts a business with dreams of ___________________

success and growth. But during the whole process of expanding
the organisation, it is possible that he/she is unable to continue ___________________
the business in a profitable manner on a sustained basis. So, it
___________________
may become necessary for him/her to change the type/form of the
business organization or close the whole business organization. ___________________
This change may be from a public company to a private company
___________________
or vice versa. The Companies Act, 1956 contains the provisions
and procedures for such conversions. It is also possible that the ___________________
entrepreneur has to wind up or close down his company. Closure
of a business unit refers to shutting down of the various functional ___________________
as well as non-functional areas of the company. The various
___________________
conditions that may be responsible for closing a company include:
• Economic recession in the economy.
• Intense competition.
• Use of obsolete techniques of production.
• Poor infrastructural facilities in an organisation.
• Dissatisfaction among workers and trade workers, conflict
between labour and management, lockouts, strikes, etc.
• Lack of resources/funds to finance various activities of as
organisation.
Even though, changing a business type or winding up a business
setup is a negative experience for an entrepreneur, but it releases
the resources invested by him/her for more productive and
profitable use elsewhere. In other words, it can mean better
opportunities and unexplored challenges for him/her. Also, the
Government of India has enacted several policies and schemes,
which not only helps an entrepreneur in easy winding up of a
business, but also helps him/her in reinvesting the resources in
newer avenues.
If a company is a corporation, limited liability company (LLC), or
partnership, in order to close the business, all associates must
jointly agree to the closure, following procedures set out in
organizational documents and/or the requirements of the business
statutes of state. The Company Secretary must read the documents
to ensure that they are voted correctly, or check the rules as
defined by the state’s corporate, LLC, or partnership statutes.
Make certain record of the decisions with a written consent form
or with a resolution in the minutes of a meeting.
90
If you have been doing business as a corporation or LLC, you
Notes
need to:
___________________ • Officially dissolve the entity so that directors/partners are
no longer liable for business taxes or filings in your state.
___________________
• Put creditors on notice that your entity can no longer incur
___________________ business debts.
___________________ • Complete the appropriate paperwork. Your state corporations
or LLC unit, usually, a division of the secretary of state
___________________
should be able to provide the necessary forms. These forms
___________________ set out the disposition of your corporation’s debts and
liabilities, the distribution of your business assets, and how
___________________
you and your co-shareholders elected to dissolve your
___________________ business. LLCs have to file similar documents, sometimes
called “articles of dissolution”.
___________________
If your business is a partnership, you might need to file a form
___________________ of dissolution with the state, especially if you had filed paperwork
when you formed your partnership. It’s an excellent idea to file
dissolution paperwork whether or not it’s required, because this
is a way of notifying creditors that the partnership can no longer
incur debts.
Checklist for Closure of a Company Registered Under Companies

Act
1. Check the minimum no. of Directors as required in Private
Company & Public Company.
2. Board Resolution is required containing the following points:
(a) Unanimous approval of Board for making an application
for striking off the name of Company from the Register
as per Section 560.
(b) To authorize the directors of the Company for execution
and signing the Affidavits and Indemnity Bond.
(c) To approve the audited financial statement or statement
of accounts as prepared for a period not prior to the one
month from the date of application.
(d) To authorize the MD/WTD/Director of the Company to
apply in prescribed form (Form No. 61) to the ROC for
striking off name of the Company.
(e) To approve the Audited Financial Statements as
prepared not earlier than one month from the date of
application.
3. Prepare an application in Form no. 61 to ROC for striking
off the name of the Company along with the following
annexure:
91
(a) Audited Financial Statements showing no assets and
Notes
liabilities (Nil Balance Sheet).
(b) Duly Attested Affidavits on Non-Judicial Stamp Paper ___________________
from each Director of the Company that Company is not
___________________
doing any business, it does not have any dues, he will
pay/indemnify for any loss/damages, if caused to any ___________________
person due to striking off name of the Company u/s 560.
___________________
(c) Duly Attested Indemnity Bond on Non-Judicial Stamp
Paper from each Director of the Company that Company ___________________
is not doing any business, it does not have any dues, he ___________________
will pay/indemnify for any loss/damages, if caused to
any person due to striking off name of the Company ___________________
u/s 560 and Company has no worker as on date.
___________________
(d) Certified copy of Bank Accounts, if any, maintained by
___________________
the Company.
4. To give brief particulars of all the litigations, if any, pending ___________________
against or involving the company along with case no., state

of authority, where it is pending, etc. with application.
5. Statutory Auditor Certificate that Company is not doing any
business since inception or Company is inoperative and
Company has no Statutory dues pending towards banks,
Financial Institutions, Govt. organizations, creditors and to
other person.
6. Certificates from each Director of the Company clearly
mentioning that Company is not doing any business since
inception or Company is inoperative and Company has no
statutory dues pending towards banks, Financial
Institutions, Govt. organizations, creditors and to other
persons.
Check Your Progress
Fill in the blanks:
1. In accounting, the ................. concept treats a business as distinct and

separate from its owners.
2. ................. of a business unit refers to shutting down of the various

functional as well as non-functional areas of the Company.
Summary
A business entity is a group of people organized for some profitable
or charitable purpose. Business entities include organizations
such as corporations, partnerships, charities, trusts, and other
forms of organization. Business entities, just like individual
92
persons, are subject to taxation and must file a tax return. Some
Notes
business entities are exempt from federal income tax. These
include non-profit charities, S-corporations, and partnerships.
___________________
Business entities may be subject to state income tax, depending
___________________ on the laws of the state or states where they conduct business.
___________________
___________________
1. What is corporation? Explain its characteristics.
___________________
2. What is the need to create corporation? What are different
___________________ types of corporations?
___________________
3. Explain Co-operative Housing Society in detail.
4. What is a Limited Liability Company (LLC)? What are the
___________________
advantages and disadvantages of LLCs?
___________________
5. Why the companies are closed?
___________________ 6. What is separate entity concept?
93
Unit 7 Notes
Effective Utilisation of FFunds

unds ___________________
___________________
___________________

___________________
\ Utilization of Funds
___________________
\ Opportunity Cost of Capital
___________________
\ Cost of Debt
___________________
\ Cost of Preferences Shares
\ Cost of Equity ___________________
___________________
Introduction
As funds can be procured from multiple sources so procurement
of funds is considered an important problem of business concerns.
While evaluating the source of the fund, one has to consider the
cost of that fund and the risk associated in raising that fund.
There are mainly two ways of raising funds, i.e. through equity
or through borrowings/debt.
Equity Shares: Funds issued by the issue of equity shares are
the best from risk point of view for the company as there is no
question of repayment of equity capital except when the company
is liquidated. From the cost point of view, equity capital is the
most expensive source of funds as dividend expectations of
shareholders are normally higher than that of prevailing interest
rates.
Borrowings/Debts: Funds can be raised either through the
domestic market or from abroad. Foreign Direct Investment (FDI)
as well as Foreign Institutional Investors (FII) are two major
sources of raising funds from foreign market.
The key differences between equity and debt are:
• Interest paid to debt holders is tax-deductible while the
dividend, paid to equity holders is not.
• Debt has a fixed maturity whereas equity has an infinite life.
• Equity holders control the affairs of the firm while debt
holders play a passive role.
94
• Debt claim is on contractual set of cash flow (Interest +
Notes
Principal) while equity claim is the residual one.
___________________ Table 7.1: Comparison of Debt and Equity as a
___________________ Source of Finance
___________________ Characteristics Debt Equity
___________________ Claim on profits & assets Fixed claim Residual claim
___________________ Tax treatment Tax deductible Not tax deductible
___________________ Priority in repayment High Lowest
___________________ Maturity Fixed Infinite life
___________________ Control in management No control Controls the management
___________________
Utilization of Funds
___________________
Effective utilization of funds is an important aspect of financial
management as it avoids the situations where funds are either
kept idle or proper uses are not being made. Funds procured
involve a certain cost and risk. If the funds are not used properly,
running the business will be too difficult. It is also considered
when making dividend decisions. Therefore, it is crucial to employ
the funds properly and profitably.
When should a firm use more equity and when should a firm
use more debt?
Table 7.2: Checklist for Utilization of Funds
Use more equity when Use more debt when
The corporate tax rate applicable The corporate tax rate applicable
to the firm is negligible. to the firm is high.
Business risk exposure is high. Business risk exposure is low.
Dilution of control is not an Dilution of control is an issue.

important issue.
The assets of the firm are mostly The assets of the firm are mostly
intangible. tangible.
The firm has many valuable The firm has few growth options.
growth options.
Unit 7: Effective Utilisation of Funds
95
Check Your Progress Notes
Fill in the blanks:
___________________
1. ....................... of funds as an important aspect of financial management
avoids the situations where funds are either kept idle or proper uses are ___________________
not being made.
___________________
2. Funds procured involve a certain and ....................... .
___________________
___________________
Opportunity Cost of Capital
___________________
The opportunity cost is the rate of return foregone on the next
best alternative investment opportunity of comparable risk, i.e. ___________________
in other words, the required rate of return. ___________________
Viewed from all investors’ point of view, the firm’s cost of capital ___________________
(COC) is the rate required by them for supplying capital for
financing the firm’s investment projects by purchasing various ___________________
securities.
A firm’s COC is the ‘average’ of the opportunity costs (or required
rates of return) of various securities, which have claims on the
firm’s assets, reflecting both business (operating) risk and the
financial risk resulting from debt capital. Whenever we talk about
money, we also talk about its application. There can be several
alternative uses or several investment opportunities of a certain
amount of funds. The opportunity cost is the rate of return
foregone on the next best alternative investment opportunity of
comparable risk.
Capital employed by the firm is obtained from various sources.
The following are the categories of capital employed by a firm:
• Long-term debt (debentures, bonds, and term loans)
• Preference capital
• Equity capital
• Retaining earning
Overall COC of the firm is the overall, or average, required rate
of return on the total funds or capital used by the firm for carrying
out its business operations. Cost of different components of capital
is different and is called component cost.
Cost of Debt
The cost of capital is the interest rate a company pays on all of
its debt, such as loans and bonds. Debts are liabilities of firm.
Term loans are loans taken from banks and financial institutions
96
for a specified period of time at a certain rate of interest having
Notes
maturity period of more than 3 years. Debentures and bonds debt
instruments are issued by the corporate to the public or
___________________
institutions at a specified interest rate for a specified period of
___________________ time, creating creditors to the company. A debenture or bond
may be issued at par or at a discount or premium.
___________________
The effective rate is the rate that a company pays on its current
___________________
debt. This can be measured in either before- or after-tax returns.
___________________ However, because interest expense is deductible, the after-tax
cost is seen most often. This is one part of the company’s capital
___________________
structure, which also includes the cost of equity.
___________________
A company will use various bonds, loans and other forms of debt,
___________________ so this measure is useful for giving an idea as to the overall rate
being paid by the company to use debt financing. The measure
___________________ can also give investors an idea as to the riskiness of the company
___________________ compared to others, because riskier companies generally have a
higher cost of debt.
Interest rate times 1 minus the marginal tax rate because interest
is a tax deduction-symbolically, i (1 – t). Hence, an increase in the
tax rate decreases the cost of debt.
To get the after-tax rate, you simply multiply the before-tax rate
by one minus the marginal tax rate (before-tax rate × (1 – marginal
tax)). If a company’s only debt were a single bond in which it paid
5%, the before-tax cost of debt would simply be 5%. If, however,
the company’s marginal tax rate were 40%, the company’s after-
tax cost of debt would be only 3% (5% × (1 – 40%)).
After-tax cost of debt = Interest rate × (1 – Tax Rate)
Example:
0.08 = 10% × (1 – 0.2)
Where,
Interest Rate: The rate at which you can borrow money to finance
the equipment you want to buy.
Tax Rate: Combined federal and provincial business tax rate.
The rate of interest at which the debt is issued is the basis of
calculating the cost of any type of debt. The explicit cost of debt,
i.e., Kb is the discount rate which equates the present value of
cash flows to the creditors (Suppliers of debt) with the current
market price of the new debt issue. Kb can be solved by the help
of the following formula:
97
n
I t + Pt
P0 =
t = 1 (1 + K b )
t
Notes
___________________
Where, ∑ = Summation for period 1 through n
___________________
It = Interest payment in period t on the principal
___________________
Pt = Payment of principal in period t (return of principal)
___________________
P0 = Current Market Price of debt
___________________
Kb = Cost of debt (Before tax)
___________________
After tax cost of debt, which is denoted by Kd can be determine
___________________
by the equation:
___________________
Kd = Kb (1 – t)
___________________
Where Kb is before tax cost of debt and Kd is after tax cost of
debt. But before further discussion, let us understand the concept ___________________
of after tax and before tax cost of debt. As already stated, cost of
debt, has two dimensions of calculation, before-tax and after-tax
basis. Before tax cost of debt i.e., Kb can be determined by simply
considering the interest payables as follows:
Interest
Kb =
Principal
For example, if a firm borrows ` 1,00,000 for one year at 10%. The
cost of debt is ` 10,000/-.
What is the annual interest?
10,000
Kb = = 10%
1,00,000
After tax cost of debt i.e., Kd is calculated by adjusting before tax
cost for the tax rate (t) applicable. The formula for after tax cost
of debt will be as follows:
Kd = Kb (1 – t)
For example, if before tax cost of debt is 12% and tax rate is 50%
the after-tax cost of debt will be calculated as follows:
Kd = Kb (1 – t) = 12 (1 – 0.5) = 6%
Debt may be two types:
• Perpetual debt
• Redeemable/Convertible debt
1. Perpetual Debt: Perpetual debt is the debt that has no
maturity value. Such debts do not have any principal
98
repayment as long as the company is operating. Cost of
Notes
perpetual debt can be calculated as follows:
___________________ I
Kb =
___________________
SP
I (1 − t)
___________________ Kb =
SP
___________________ Where, I = annual interest payments, SP = Net Sales
___________________ Proceeds of debt, t = tax rate.
2. Redeemable debt: Redeemable debt has a maturity value
___________________
i.e., this debt is issued for specific time period. Cost of
___________________ redeemable debt can be calculated as follows:
___________________ M − Pbt
1+
___________________ Kb = N
M + Pb
___________________ 2
M − Pb
I (1 − t) +
Kb = N
M + Pb
2
Where, Kb = Before tax cost of debt
Kd = After tax cost of debt
It = Periodic Interest Payment
M = Par or maturity value of debt or Redemption value
Pb = Debt’s issue price or its purchase price or Net
realized amount
M – Pb = Share Premium
N = Life of debt or no. of years to maturity
Illustration
A Ltd. issues a non-convertible debt for ` 400 lakh. Each debt has
a face value of ` 100 and carries a rate of interest of 14%. The
interest is payable annually and the debenture is redeemable at
a premium of 5% after 10 years. If A ltd realizes ` 97 per debt and
corporate tax rate is 50%, what is the cost of debt to the company.
10.5 − 97
14 (1 − 0.5) +
Kd = 10 = 7.7%
105 + 97
2
99
Cost of Preferences Shares
Notes
Preferred stocks are a hybrid security i.e., a hybrid between debt
and common/equity stock. Like debt preferred stock gets fixed, ___________________
periodic payment (cash inflows in form of fixed dividends) and ___________________
during liquidation they get 1st claim over those of common
stockholders. ___________________
Unlike debt it is neither bound by legal provisions of debt nor ___________________

has voting rights (ownership privilege) of equity shares. To the
___________________
firm preferred stock is more risky than common stock but less
risky than debts. To the investor preferred stock is less risky ___________________
than equity or common stock but more than debt. Cost of
___________________
preference shares is determined by the dividend paid to the
preference stockholders i.e., ___________________
___________________
Preferred Dividend DP
PY Preferred Yield = =
Price of Preferred Stock PPS ___________________
A perpetuity selling for ` 80/- a share pays annual dividend of

` 8. Its yield is
8
PY = = 10%
80
DP
Thus, KP =
PP
Where, DP = annual dividend of preference share

PP = market Price/Sales Price of preference share
If floatation costs are included then,
DP
Kp =
PP − f
Where, f = floatation cost, (i.e., cost of selling the debt)

Redeemable Preference Shares: These are preference shares
having maturity value. They are held for a specified time period.
M − PbP
D+
Kp = N
M + Pb
2
100
Where, DP = Dividend
Notes
M = Redemption value
___________________
Pb = Purchased Price/Net realized amount
___________________
N = Life of preference Capital
___________________
Excel Co. Ltd, each preference share has a face value of 100 and
___________________ carries a rate of dividend of 14% p.a. Shares is redeemable after
___________________
12 years at par. Net amount per share is 95. What is the cost of
Preference Capital?
___________________
100 − 95
___________________ 14 +
Kp = 12 = 14.7%
___________________ 100 + 95
___________________ 2
___________________
Cost of Equity
In finance, the cost of equity is the minimum rate of return a firm
must offer shareholders to compensate for waiting for their
returns, and for bearing some risk.
The cost of equity capital for a particular company is the rate of
return on investment that is required by the company’s ordinary
shareholders. The return consists both of dividend and capital
gains, e.g., increases in the share price. The returns are expected
future returns, not historical returns, and so the returns on equity
can be expressed as the anticipated dividends on the shares every
year in perpetuity. The cost of equity is then the cost of capital
which will equate the current market price of the share with the
discounted value of all future dividends in perpetuity.
The cost of equity reflects the opportunity cost of investment for
individual shareholders. It will vary from company to company
because of the differences in the business risk and financial or
gearing risk of different companies.
In financial theory, the cost of equity capital is the return that
stockholders require for a company. The traditional formula is
the dividend capitalization model.
The cost of equity is calculated by the following formula:
Next Year’ s Dividends per Share

Cost of Equity =
Current Market Value of Stock
+Growth Rates of Divident

101
D1 Notes
Where, Ke = + g
P0
___________________
P0 = D1/(Ke – g) s
___________________
D1 = D0(1 + g)
___________________
A firm’s cost of equity represents the compensation that the market
___________________
demands in exchange for owning the asset and bearing the risk
of ownership. ___________________
Let’s look at a very simple example, let’s say you require a rate ___________________
of return of 10% on an investment in TSJ Sports. The stock is
___________________
currently trading at ` 10 and will pay a dividend of ` 0.30. Through
a combination of dividends and share appreciation, you require a ___________________
` 1 return on your ` 10 investment. Therefore, the stock will
___________________
have to be appreciated by ` 0.70, which combined with the ` 0.30
from dividends gives you your 10% cost of equity. ___________________
The capital asset pricing model (CAPM) is another method used

to determine cost of equity.
The formula above calculates the cost of equity based on a firm’s
current rate of return. If one assumes a perfect market, industry-
specific costs of equity reflect the riskiness of particular
industries. A high cost of equity would then indicate a higher-
risk industry that should command a higher return to compensate
for the higher risk.
Estimation of the cost of equity is based upon forecasting of future
earnings of equity shareholder in the form of dividends and capital
gain and forecasting of stock value of equity shares. Among all
the components of financing available to a firm the cost of equity
is most difficult and complex to ascertain. One can easily forecast
the expected interest payment of debt commensurate with its
risk structure and preferred dividend rate as specified by the
firm. This simplicity is due to the fact that interest on debt and
preferred dividends remain fixed and constant over a period of
time. But unlike interest and preferred dividend, equity dividends
are expected to grow with time and hence do not remain constant.
Further as already stated when it comes to estimating the cost
of equity capital the none has to value the future forecasted cash
inflows (earning) associated with it. Due to the uncertainty of
future earning, the risk element of equity capital increases,
thereby increasing the cost of equity capital.
There are two approaches involved with estimated of cost equity
namely (a) dividend valuation approach and (b) Capital Asset
Pricing Model (CAPM) approach.
102
Fill in the blanks:

___________________
1. ..................... is the rate at which you can borrow money to finance
___________________ the equipment you want to buy.
___________________ 2. ..................... is combined federal and provincial business tax rate.
___________________ 3. ..................... is the debt, which has no maturity value.
___________________ 4. ..................... has a maturity value i.e., these debts are issued for
specific time period.
___________________
5. ..................... are a hybrid security i.e., a hybrid between debt and
___________________ common/equity stock.
___________________ 6. ..................... are preference shares having maturity value. They are
held for a specified time period.
___________________
7. ..................... is the minimum rate of return a firm must offer shareholders
___________________ to compensate for waiting for their returns, and for bearing some risk.
Summary
Equity, or partial ownership of a corporation, is divided into
shares that may (optionally) be of many different classes. There
are typically “common” shares and “preferred” shares of classes
lettered A, B, C, etc. The market determines the value of the
common shares and the corporate Board of Directors determines
the value of the preferred shares.
For example, a preferred Class A share may be convertible into
a large number of common shares (or options to purchase common
shares at some low price), but only at some specific time or event
in the future, with some other “bonus” the board thought necessary
to entice investors for the first round of equity financing. Class
B may be fewer shares, or some other requirements to become
vested.

1. What is the difference between debt and equity?
2. What are the advantages and disadvantages of debt and
equity?
3. Compare and contrast between Debt and Equity.
103
Unit 8 Notes
Cost of Equity Models ___________________
___________________
___________________

___________________
\ Dividend valuation approach or Constant Dividend Growth Model
(Gordon’s Model) ___________________
\ Capital Assets Pricing Model (CAPM) approach ___________________
___________________
Introduction ___________________
___________________
This unit discusses how to calculate the firm’s cost of capital and
the discount rate applied to future cash flows. You will learn two
models for calculating the cost of equity and the discount rate
applied to equity cash flows.
The Gordon model calculates the cost of equity based on the
anticipated dividends of the firm. The capital asset pricing model
(CAPM) calculates the cost of equity based on the correlation
between the firm’s equity returns and the returns of a large,
diversified, market folio. As we will see, the CAPM can also be
used to calculate the cost of the firm’s debt.
Dividend Valuation Approach or Constant Dividend

Growth Model (Gordon’s Model)
It states that expected return to investors from equity stock
comprises of 2 components of benefits:
Dividend Receipts expected in each year till a particular
time period
Capital gain associated with the equity stock at the end of a
particular time period. In other words, it is the value of stock
(Selling Price of Stock – Purchase Price of Stock).
Thus,
Expected Dividend Stream
+ Expected Value of Stock at Time Period t
P0 =
1 + Required rate of return
D1 + P1
P0 =
1 + Ke
104
Where, D1 = Dividend paid at the end of Period
Notes
1.P1 = Market price of stock at the Period 1
___________________
Ke = Required rate of return on equity shares (cost of
___________________ equity)
___________________ P0 = Current Market price of stock
___________________ In future, cash inflows are expected to grow at a growth rate ‘g’
___________________
then,
D1 + P1 (1 + g)
___________________ P0 =
1 + Ke
___________________
D1
P0 =
___________________ Ke − g
___________________ D1
K = + g
___________________
P0
Expected Dividend Expected Increase in Price
Thus, Ke = +
Present Price Present Price
Cost of New Equity: If fresh or new equity is issued, then floating
cost is also considered while calculating cost of equity. Floating
cost is the cost incurred in issuing the equity shares to the
investors, by the company.
D1
Ke = + g Where, f = floating costs
P0 (1 − f )
From the given data calculate the cost of equity shares of Co.
X: Current market price of shares = ` 120
Cost of floatation/shares on new shares = ` 5
Dividend paid on outstanding share for the past three years:
Year 1 ` 10.5 per shares
Expected dividend on the new shares at the end of the current
year is ` 15.0 per share.
Over the three years of dividends have increased from ` 10.5 to
14.5 giving a compound factor of 14.5/10.5 = 1.37. (We look for
growth % in compound factor table at 3 years row for a value of
over the three years of dividends have increased from ` 10.5 to
14.5 giving a compound factor of 14.5/10.5 = 1.37. (We look for
growth % in compound factor table at 3 years row for a value of
1.37. At 11% we get 1.38).
Unit 8: Cost of Equity Models
105
Thus, the sum of ` 1 would amount to ` 1.37 in 3 years @ 11%
Notes
interest.
15 15 ___________________
Ke = + 11.00% = + 11.00 = 24.04%
(120 − 5) 115 ___________________
1. ..................... states that expected return to investors from equity stock ___________________
comprises of 2 components of benefits.
___________________
2. ..................... is the cost incurred in issuing the equity shares to the
investors, by the company. ___________________
___________________
Capital Assets Pricing Model (CAPM) Approach ___________________
The CAPM is used in finance to determine a theoretically ___________________

appropriate required rate of return (and thus the price if expected
cash flows can be estimated) of an asset, if that asset is to be
added to an already well-diversified portfolio, given that asset’s
non-diversifiable risk. The CAPM formula takes into account the
asset’s sensitivity to non-diversifiable risk (also known as
systematic risk or market risk); in a number often referred to as
beta (β) in the financial industry, as well as the expected return
of the market and the expected return of a theoretical risk-free
asset.
The CAPM is an equilibrium model which describes the pricing
of assets, as well as derivatives. The model concludes that the
expected return of an asset (or derivative) equals the riskless
return plus a measure of the assets non- diversifiable risk (“beta”)
times the market-wide risk premium (excess expected return of
the market portfolio over the riskless return). That is:
Expected Security Return = Riskless Return + Beta
× (Expected Market Risk Premium)
It concludes that only the risk which cannot be diversified away
by holding a well-diversified portfolio (e.g., the market portfolio)
will affect the market price of the asset. This risk is called
systematic risk, while risk that can be diversified away is called
diversifiable risk (or “non-systematic risk”).
Unfortunately, the CAPM is more difficult to implement in
practice than the binomial option pricing model or the Black-
Scholes formula because to price an asset it requires measurement
of the asset’s expected return and its beta. But, on the other
hand, it also attempts to answer a more difficult question.
106
The binomial option pricing model or the Black-Scholes formula
Notes
asks, what is the value of a derivative relative to the concurrent
value of its underlying asset? The CAPM asks what is the value
___________________
of an asset (or derivative) relative to the return of the market
___________________ portfolio? Because of this, the option models are often referred
to as “relative” valuation models, while the CAPM is considered
___________________
an “absolute” valuation model.
___________________
___________________ Asset
return
___________________
___________________
___________________
Risk-free
___________________ rate of
return
___________________
Beta
Figure 8.1
The model was introduced by Jack Treynor, William Sharpe, John

Lintner and Jan Mossin independently, building on the earlier
work of Harry Markowitz on diversification and modern portfolio
theory. Sharpe received the Nobel Memorial Prize in Economics
(jointly with Harry Markowitz and Merton Miller) for this
contribution to the field of financial economics.
The Security Market Line, seen here in a graph, describes a
relation between the beta and the asset’s expected rate of return.
A model that describes the relationship between risk and
expected return and that is used in the pricing of risky securities.
rn lim = rr + β n (rm − rf )
x→∞
Where rf = Risk free rate

βn = Beta of the security
–
rm = Expected marked return
The general idea behind CAPM is that investors need to be
compensated in two ways: time value of money and risk. The
time value of money is represented by the risk-free (rf) rate in
the formula and compensates the investors for placing money in
any investment over a period of time. The other half of the formula
represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by
taking a risk measure (beta) that compares the returns of the
107
asset to the market over a period of time and to the market
Notes
premium (Rm – rf).
The CAPM says that the expected return of a security or a portfolio ___________________
equals the rate on a risk-free security plus a risk premium. If
___________________
this expected return does not meet or beat the required return,
then the investment should not be undertaken. The security ___________________
market line plots the results of the CAPM for all different risks
___________________
(betas).
___________________
Using the CAPM model and the following assumptions, we can
compute the expected return of a stock: if the risk-free rate is ___________________
3%, the beta (risk measure) of the stock is 2 and the expected
___________________
market return over the period is 10%, the stock is expected to
return 17% (3% + 2 (10% – 3%)). ___________________
Assumptions ___________________
• All investors have rational expectations. ___________________
• There are no arbitrage opportunities.

• Returns are distributed normally.
• Fixed quantity of assets.
• Perfectly efficient capital markets.
• Separation of financial and production sectors.
• Thus, production plans are fixed.
• The risk-free rates exist with limitless borrowing capacity
and universal access.
• The risk-free borrowing and lending rates are equal.
• No inflation and no change in the level of interest rate exist.
Perfect information, hence, all investors have the same
expectations about security returns for any given time period.
The CAPM calculates cost of capital of equity by considering risk
free interest rate prevalent in the economy and the risk premium
desired by the investor. It also considers β to specify the
relationship between the market and the equity. The CAPM
determine real value of equity in the market.
Ke = Rf + β (Rm – Rf)
Where, Ke = Cost of Equity
Rf = Risk free interest rate in the market
Rm = Market Return/return
108
β = Coefficient or sensitivity of security or relationship
Notes
of security with the market.
___________________ Rm, Rf = Risk premium
___________________ Assume that Rm = 18% and Rf = 9%. If a security has a beta factor
of (a) 1.4 (b) 1.0 and (c) 2.3. Find out the expected return of the
___________________
security.
___________________
Ke = Rf + β (Rm – Rf)
___________________
Ke = 9% + (18% – 9%) 1.4 = 21.6%
___________________
Ke = 9% + (18% – 9%) 1.0 = 18%
___________________
Ke = 9% + (18% – 9%) 2.3 = 29.7%
___________________
Calculate market portfolio return and expected return on security
___________________ using CAPM.
___________________ Investment in Initial Price Dividend Year-end β(4)
Equity Shares (1) (2) Market
Price (3)
Cement Ltd 30 3 50 0.8
Steel Ltd 45 3 60 0.7
Liquor Ltd 55 3 135 0.5
Govt. of India 1000 150 1015 0.99

Bonds
Risk Return 14%

Solution:
Dividend Capital Total Investment

Appreciation Return
(3 – 1)
Cement Ltd 3 20 23 30
Steel Ltd 3 15 18 45
Liquor Ltd 3 80 83 55
Govt. of India 150 15 165 1000

Bonds
Total 150 130 289 1130
Return on Mkt. Portfolio = 289/1130 = 25.57%

109
Return on
Notes
Cement = 14% + 0.8 (25.57 – 14) = 23%
___________________
Steel = 14% + 0.7 (25.57 – 14) = 22.1%
___________________
Liquor = 14% + 0.5 (25.57 – 14) = 19.78%
___________________
Govt. of India Bond = 14% + 0.99 (25.57 – 14) = 23%
___________________
Cost of Retained Earnings (profit the company makes, but does
not give to the shareholders in the form of dividends) ___________________
This is kind of weird to think about. It takes some time to ___________________

understand so take it slowly. After a company makes money ___________________
(earnings), who owns that money? The shareholders, right? But
when you retain earnings you are not giving the money to the ___________________
shareholders. You are keeping it. In a way, you are investing it
___________________
for them in your company. Well those shareholders want some
return on that money you are keeping. How much return do they ___________________
expect? They want the same amount as if they had gotten the
retained earnings in the form of dividends and bought more stock
in your company with them. THAT is the cost of retained earnings.
You as a financial genius, have to ensure that if you are retaining
earning, that the shareholders will get at least as good a return
on the money as if they had re-invested the money back into the
company.
If you don’t understand this, re-read it and re-think it until you
do get it. There is really no “cost” in the cost of retained earnings.
I mean, no money is changing hands. You aren’t paying anyone
anything. But you are keeping the shareholders money. You can’t
say it is “free” money. Frankly if you did, it would screw up your
capital budgeting. So, when you are doing your capital budgeting,
to ensure that the shareholders are getting a decent rate of return,
you “guess” a cost of retained earnings. How? One way is CAPM.
Another way is the bond yield plus risk premium approach, in
which you take the interest rate on the company’s own long-term
debt and then add between 5% and 7%. Again, you are kind of
guessing here. A third way is the discounted cash flow method,
in which you divide the dividend by the price of stock and add
the growth rate. Again, a lot of guessing.
The cost of retained earnings (internal actual) is usually taken to
be the same as cost of equity.
Kr (Cost of Retained earnings) = Ke
But when floatation costs are involved then,
Ke =
FG K IJ , (f= Floatation cost)
H1 − f K
110
For example, say a company issues fresh share to raise its equity,
Notes
equity investors expect a rate of return of 18%. The cost of issuing
external equity is 6%. What is the cost of retained earnings and
___________________
cost of external equity?
___________________
Kr = Ke = 18%
___________________
Cost of external equity raised by the company.
___________________
Ke = 0.18/(1 – 0.06) = 19%
___________________
Fill in the blanks:

___________________
1. .................. is an equilibrium model which describes the pricing of
___________________
assets, as well asderivatives.
___________________
2. .................. asks what is the value of a derivative relative to the concurrent
___________________ value of its underlying asset.
3. Describes a relation between the beta and the asset’s expected rate of
return.
Summary
Gordon’s Model states that expected return to investors from
equity stock comprises of 2 components of benefits. Dividend
Receipts expected in each year till a particular time period.
Capital gain associated with the equity stock at the end of a
particular time period. In other words, it is the value of stock
(Selling price of Stock – Purchase Price of Stock).
The Capital Asset Pricing Model (CAPM) is used in finance to
determine a theoretically appropriate required rate of return
(and thus the price if expected cash flows can be estimated) of an
asset, if that asset is to be added to an already well-diversified
portfolio, given that asset’s non-diversifiable risk. The CAPM
formula takes into account the asset’s sensitivity to non-
diversifiable risk (also known as systematic risk or market risk);
in a number often referred to as beta (β) in the financial industry,
as well as the expected return of the market and the expected
return of a theoretical risk-free asset.

1. Elucidate Gordon’s model.
2. Describe the Capital Assets Pricing Model (CAPM) approach
in detail.
111
Unit 9 Notes
WACC and Equity Capital ___________________
___________________
___________________

___________________
\ Weighted Average Cost of Capital (WACC)
___________________
\ Factors affecting Cost of Capital of a Firm
___________________
\ Equity Capital
___________________
___________________
Introduction ___________________
Another component of the cost of capital is the cost of debt, the
anticipated future cost of the firm’s borrowing. This unit explains
how to calculate the Weighted Average Cost of Capital (WACC),
the appropriate discount rate for evaluation of firm cash flows.
This will lead to a better understanding of the factors affecting
the cost of capital of a firm.
Weighted Average Cost of Capital (WACC)

The WACC is used in finance to measure a firm’s cost of capital.
It has been used by many firms in the past as a discount rate for
financed projects, since the cost of the financing seems like a
logical price tag to put on it.
Corporations raise money from two main sources: equity and
debt. Thus, the capital structure of a firm comprises three main
components: preferred equity, common equity and debt (typically
bonds and notes). The WACC takes into account the relative
weights of each component of the capital structure and presents
the expected cost of new capital for a firm.
A calculation of a firm’s cost of capital in which each category of
capital is proportionately weighted. All capital sources – common
stock, preferred stock, bonds and any other long-term debt – are
included in a WACC calculation.
WACC is calculated by multiplying the cost of each capital
component by its proportional weight and then, summing:
E D
WACC = × R e + × R d × (1 − Tc )
V V
112
Where, Re = Cost of equity
Notes
Rd = Cost of debt
___________________
E = Market value of the firm’s equity
___________________
D = Market value of the firm’s debt
___________________
V = E + D
___________________
E/V = Percentage of financing that is equity
___________________
D/V = Percentage of financing that is debt
___________________
Tc = Corporate tax rate
___________________
A company’s assets are financed by either debt or equity. WACC
___________________ is the average of the costs of these sources of financing, each of
___________________ which is weighted by its respective use in the given situation. By
taking a weighted average, we can find out how much interest
___________________ the company has to pay for every dollar it finances.
A firm’s WACC is the overall required return on the firm as a
whole and, as such, it is often used internally by company directors
to determine the economic feasibility of expansionary
opportunities and mergers. It is the appropriate discount rate to
use for cash flows with risk that is similar to that of the overall
firm.
This equation describes only the situation with homogeneous
equity and debt. If part of the capital consists, for example, of
preferred stock (with different cost of equity y), then the formula
would include an additional term for each additional source of
capital.
Sources of Information
How do we find out the values of the components in the formula
for WACC? First, note that the “weight” of a source of financing
is simply the market value of that piece divided by the sum of the
values of all the pieces. For example, the weight of common equity
in the above formula would be determined as follows:
Market value of common equity/(Market value of common equity
+ Market value of debt + Market value of preferred equity)
So, let us proceed in finding the market values of each source of
financing (namely the debt, preferred stock, and common stock).
• The market value for equity for a publicly traded company
is simply the price per share multiplied by the number of
shares outstanding and tends to be the easiest component to
find.
Unit 9: WACC and Equity Capital
113
• The market value of the debt is easily found if the company
Notes
has publicly traded bonds. Frequently, companies also have
a significant amount of bank loans, whose market value is
___________________
not easily found. However, since the market value of debt
tends to be close to the book value (for companies that have ___________________
not experienced significant changes in credit rating, at least),
___________________
the book value of debt is usually used in the WACC formula.
___________________
• The market value of preferred stock is again usually easily
found on the market and determined by multiplying the cost ___________________
per share by number of shares outstanding.
___________________
Now, let us take care of the costs.
___________________
• Preferred equity is equivalent to perpetuity, where the holder
is entitled to fixed payments forever. Thus, the cost is ___________________
determined by dividing the periodic payment by the price of
___________________
the preferred stock, in percentage terms.
___________________
• The cost of common equity is usually determined using the
capital asset pricing model.
• The cost of debt is the yield to maturity on the publicly
traded bonds of the company. Failing availability of that, the
rates of interest charged by the banks on recent loans to the
company would also serve as a good cost of debt. Since a
corporation normally can write off taxes on the interest it
pays on the debt, however, the cost of debt is further reduced
by the tax rate that the corporation is subject to. Thus, the
cost of debt for a company becomes (YTM on bonds or interest
on loans) × (1 – tax rate). In fact, the tax deduction is usually
kept in the formula for WACC, rather than being rolled up
into cost of debt, as such:
WACC = [Weight of preferred equity × cost of preferred
equity + weight of common equity × cost of common equity
+ weight of debt × cost of debt × (1 – tax rate)]
Check Your Progress
Fill in the blanks:
1. ................... is used in finance to measure a firm’s cost of capital.
2. ................... is equivalent to perpetuity, where the holder is entitled to

fixed payments forever.
3. The cost of ................... is usually determined using the capital asset

pricing model.
114
Notes
Factors affecting Cost of Capital of a Firm
• Risk-free rate of interest: The risk-free rate of interest is
___________________
the minimum cost of capital that any firm encounters in the
___________________ market. It is a benchmark for all industries to evaluate their
individual cost of funds. When the risk-free rate of interest
___________________
raises, the overall cost of funds increases in the economy.
___________________ Vice versa, when the risk-free rate of interest decreases,
cost of funds in the economy is lowered and liquidity increases
___________________ in the market. The risk-free rate of interest is governed by
___________________ the government. Thus, we can state that cost of funds in any
economy (where risk free rate of interest is regulated by
___________________ government) depends on government policies and principles.
___________________ • Business risk: The business risk, to which a firm is explored
___________________
to, also plays an important role in designing its cost of capital.
If the business risk is high, its cost of capital increases and
___________________ vice versa.
• Financial risk: Financial risk is the risk of debt finance.
Higher the proportion of debt in the firm’s capital structure,
higher is its financial risk. As financial risk increases
bankruptcy risk also increases for a given firm. Higher the
bankruptcy/insolvency risk of an enterprise higher is its cost
of capital.
• Decisions of financing mix: Depending upon the decision
of the management about the proportion of different sources
of funds, the overall cost of capital of the firm is decided.
• Attitude of management: If management of the company is
aggressive, it will require fewer amounts of liquid funds
thereby decreasing its total cost. On the other hand
conservative management keeps large amount of liquid funds
thereby increasing its total cost of capital.
• Requirement of the firm: Firms requiring large amount of
funds consequently bear a higher cost compared to those
firms which require less amount of funds, because large funds
requirement leads to heavy external borrowing of funds.
• Nature of business: Firm that requires heavy investment
in fixed assets bears a high cost of funds in comparison with
those firms which require low investment in fixed assets.
The long-term maturity funds are more expensive than the
short-term maturity funds, and fixed assets are financed by
the long-term funds.
115
Fill in the blanks:
___________________
1. The .................... is the minimum cost of capital that any firm encounters
in the market. ___________________
2. .................... is the risk of debt finance. ___________________
___________________
Equity Capital ___________________
It is the primary or basic source of finance to any company. It ___________________

represents ownership capital as equity holders collectively own
___________________
the company and do not have any maturity date. They enjoy
rewards and bear the risks of ownership. Their liability is limited ___________________
to their capital contribution.
___________________
Equity capital represents ownership capital as equity shareholders
___________________
collectively own the company. They enjoy the rewards and bear
the risks of ownership. However, their liability, unlike the liability
of the owner in a proprietary firm and the partners in a
partnership concern, is limited to their capital contributions.
Authorised, Issued, Subscribed, and Paid-up Capital: The
amount of capital that a company can potentially issue, as per its
memorandum, represents the authorised capital. The amount
offered by the company to the investors is called the issued capital.
That part of issued capital which has been subscribed to by the
investors represents the subscribed capital. The actual amount
paid up by the investors is called the paid-up capital-typically
the issued, subscribed, and paid-up capital are the same.
Par Value, Issue Price, Book Value, and Market Value: The
par value of an equity share is the value stated in the
memorandum and written on the share scrip. The par value of
equity shares is generally ` 10 (the most popular denomination)
or ` 100. Infrequently, one comes across par values like ` 1, ` 2,
` 5, ` 50, and ` 1,000.
The issue price is the price at which the equity share is issued.
Generally, the issue price and par value are one and the same for
new companies. An existing company may sometimes set its issue
price higher than the par value. Sonata Software (India) Limited,
for example, set its issue price at ` 80 per share as against the
par value of ` 10 per share. When the issue price exceeds the par
value, the difference is referred to as the share premium. It may
be noted that the issue price cannot be, as per law, lower than
the par value.
116
The book value of an equity share is equal to:
Notes
Paid up equity capital + Reserves and surplus − Intangibles
___________________ Number of outstanding equity shares
___________________ Quite naturally, the book value of an equity share tends to increase
___________________
as the ratio of reserves and surplus to paid-up equity capital
increases.
___________________
The market value of an equity share is the price at which it is
___________________ traded in the market. This price can be easily established for a
company which is listed on the stock market and actively traded.
___________________
For a company which is listed on the stock market but traded
___________________ very infrequently, it is difficult to obtain a reliable market
quotation. For such a company, the market quotation may reflect
___________________
the sale of a few shares in a past period and hence may not
___________________ reflect the current market value of the firm. For a company which
is not listed on the stock market, one can merely conjecture as to
___________________
what its market price would be if it were traded. The market
price is determined by a variety of factors like current earnings,
growth prospects, risk, and company size.
Rights of Equity Shareholders

• Right to Income: The equity investors have a residual claim
to the income of the firm. The income left after satisfying
the claims of all other investors belongs to the equity
shareholders.
This income is simply equal to profit after tax minus
preferred dividend.
The income of equity shareholders may be retained by the
firm or paid out as dividends. It may be noted here that
equity shareholders are entitled to dividend that is declared
by the Board of Directors. The dividend decision is the
prerogative of the board of directors.
• Right to Control: Equity shareholders as owners of the firm
elect the Board of Directors and have the right to vote on
every resolution placed before the company. The Board of
Directors, in turn, selects the management which controls
the operations of the firm. Hence, equity shareholders, in
theory, exercise an indirect control over the operations of
the firm. How effective is such indirect control? Often such
indirect control is weak and ineffective because of the apathy
and indifference of most of the shareholders who rarely
bother to cast their votes, by post or through a proxy, let
alone attend the annual general meetings. Scattered and ill-
organised, equity shareholders fail to exercise their collective
power effectively. Usually, the management of the firm, with
117
the support of a well-organized but not necessarily a very
Notes
substantial group of shareholders is able to hold the reins of
control.
___________________
• Pre-emptive Right: The pre-emptive right enables existing
___________________
equity shareholders to maintain their proportional ownership
by purchasing the additional equity shares issued by the ___________________
firm. The law requires companies to give existing equity
___________________
shareholders the first opportunity to purchase, on pro rata
basis, additional issues of equity capital. For example, if the ___________________
company has 1,000,000 outstanding shares of equity stock
and proposes to issue 200,000 additional equity shares, an ___________________
equity shareholder owning 100 shares has the right to ___________________
purchase 20 of the 200,000 new shares before those are offered
to anyone else. The equity shareholders may, however, forfeit ___________________
this right, partially or totally.
___________________
• Right in Liquidation: As in the case of income, equity
___________________
shareholders have a residual claim over the assets of the
firm in the event of liquidation. Claims of all others debenture
holders, secured lenders, unsecured lenders, other creditors,
and preferred shareholders are settled prior to the claim of
equity shareholders. More often than not equity shareholders
do not get anything in the event of liquidation because the
liquidation value of assets is not adequate to fully meet the
claims of others.
Methods of Raising Equity Capital

When a company is formed, it first issues equity shares to the
promoters (founders) and also, in most cases, to a select group of
investors. As the company grows, it may rely on the following
methods of raising equity capital.
• Initial public coffering
• Seasoned offering
• Rights issue
• Private placement
• Preferential allotment
These are explained below:
1. Initial Public Offering: The first public offering of equity
shares of a company, which is followed by a listing of its
shares on the stock market, is called the Initial Public
Offering (IPO).
(i) Decision to Go Public: The decision to go public (or
more precisely the decision to make an IPO so that the
118
securities of the company are listed on the stock market
Notes
and are publicly traded) is a very important issue. It is
a complex decision which calls for carefully weighing
___________________
the benefits against costs.
___________________
Benefits Costs
___________________
Access to larger pool of capital Dilution
___________________
Respectability Loss of flexibility
___________________
Lower cost of capital compared to private Disclosures and
___________________ placement accountability
___________________ Liquidity Periodic costs
___________________
(ii) Eligibility for IPOs: An Indian Company, excluding
___________________ certain banks and infrastructure companies, can make
an IPO if it satisfies the following conditions:
___________________
• The company has a certain track record of
profitability and a certain minimum net worth.
• The securities are compulsorily listed on a recognised
stock exchange which means that a certain minimum
per cent of each class of securities is offered to the
public.
• The promoter group (promoters to directors, friends,
relatives, associates, etc.) is required to make a
certain minimum contribution to the post-issue
capital.
• The promoters’ contribution to the equity subject to
a certain lock-in period.
(iii) Principal Steps in a Public Issue: A public issue involves
sale of securities to the members of the public. It
involves a fairly elaborate process involving the
following steps after the proposed issue is approved by
the Board of Directors and shareholders:
• Appoint the lead manager(s).
• Appoint other intermediaries like co-managers,
underwriters, bankers, brokers and registrars.
• Prepare the prospectus and file the same with the
Registrar of Companies and SEBI.
• Print the prospectus and dispatch the same to the
brokers.
• Make the statutory announcements.
119
• Collect and process the applications.
Notes
• Establish the liability of underwriters.
___________________
• Allot shares.
• Get the issue listed. ___________________
(iv) Cost of Public Issue: The cost of a public issue is ___________________

normally between 6 and 12 per cent, depending on the ___________________
size of the issue and the level of the marketing effort.
The important expenses incurred for a public issue are ___________________
underwriting expenses, brokerage, fees for the
___________________
managers and registrars, printing and postage expenses,
advertising and publicity expenses, listing fees and ___________________
stamp duty.
___________________
2. Seasoned Offering: For most companies, their IPO is seldom
their last public issue. As companies grow, they are likely to ___________________
make further trips to the capital market with issues of debt ___________________
and equity. These issues are likely to be public issues offered
to investors at large or rights issues or private placement or
preferential allotment.
The procedure for a public issue by a listed company
(seasoned offering) is similar to that of an IPO. Hence, all
the steps involved in an IPO are applicable to a public issue
by a listed company. However, a public issue by a listed
company is subject to fewer regulations when compared to
an IPO (except when the post-issue net worth grows to more
than five times the pre-issue net worth). This is evident
from the following:
• A public issue by a company which has been listed on a
stock exchange for at least three years and has a track
record of dividend payment for at least three immediate
preceding years does not require the promoters’
contribution, provided the relevant information is
disclosed in the offer document.
• There are no pricing norms for a public issue by a listed
company.
3. Rights Issue: A rights issue involves selling securities in
the primary market by issuing rights to the existing
shareholders. When a company issues additional equity
capital, it has to be offered in the first instance to the existing
shareholders on a pro rata basis. This is required under
Section 81 of the Companies Act, 1956. The shareholders,
however, may be a special resolution forfeit this right,
partially or fully, to enable a company to issue additional
capital to the public.
120
(i) Procedure for Rights Issue: A company making a rights
Notes
issue sends a letter of offer along with a composite
___________________
application form consisting of four forms (A, B, C and
D) to the shareholders. Form A is meant for the
___________________ acceptance of the rights and application of additional
___________________
shares. This form also shows the number of rights
shares the shareholder is entitled to. It also has a column
___________________ through which a request for additional shares may be
made. Form B is to be used if the shareholder wants to
___________________
renounce the rights in favour of someone else. Form C
___________________ is meant for application by the renounce in whose favour
the rights have been renounced, by the original allottee,
___________________
through Form B. Form D is to be used to make a request
___________________ for split forms. The composite application form must
be mailed to the company within a specific period,
___________________
which is usually 30 days.
___________________
(ii) Rights Issue versus Public Issue: A rights issue offers
several advantages over a public issue: The floatation
costs of a rights issue are significantly lower than those
of a public issue. Theoretically, the subscription price
of a rights issue is irrelevant because the wealth of a
shareholder who subscribes to the rights issue or sells
the rights remains unchanged, irrespective of what the
subscription price is. Hence, the problem of transfer of
wealth from existing shareholders to new shareholders
does not arise in a rights issue.
4. Private Placement: Private placement and preferential
allotment involve sale of securities to a limited number of
sophisticated investors such as financial institutions, mutual
funds, venture capital funds, banks and so on. What is the
difference between private placement and preferential
allotment? While there does not seem to be a very clear-cut
distinction between the two in the Indian context, we find
that broadly:
(i) private placement refers to sale of equity or equity related
instruments of an unlisted company or sale of debentures of
a listed or unlisted company, and (ii) preferential allotment
refers to sale of equity or equity related instruments of a
listed company.
Private placement in India is mostly of equity or equity-
related instruments of unlisted companies and debt
instruments of listed companies.
121
5. Preferential Allotment: An issue of equity by a listed
Notes
company to selected investors at a price which may or may
not be related to the prevailing market price is referred to ___________________
as preferential allotment in the Indian capital market. A
preferential allotment is not related to a public issue and it ___________________
should not be confused with reservations that may be made ___________________
on a preferential basis for certain categories of investors in
a public issue. Preferential allotment in India is given mainly ___________________
to promoters or friendly investors to ward off the threat of
___________________
a takeover.
___________________
This is now a very popular means of raising fresh equity
capital because (a) the cost and uncertainty associated with ___________________
the public issue is high, and (b) sophisticated investors like
___________________
mutual funds and private equity investors are likely to pay
a higher price. ___________________
Regulations ___________________
Since preferential allotment is amenable to potential abuse, it is

subject to the following regulations.
• The shareholders of the company must pass a special

resolution, or the central government must grant a special
approval under Section 81(lA) of the Indian Companies Act
before a company makes a preferential allotment.
• The price at which a preferential allotment of shares is made
should not be lower than the higher of the average of the
weekly high and low of the closing prices of the shares quoted
on the stock exchange during the six months period before
the relevant date or during the two week period before the
relevant date.
• Securities issued to the promoter group by way of a
preferential allotment are subject to a lock-in period of 3
years this means that they are not transferable for that
period. However, securities issued to other categories of
investors by way of a preferential allotment are a subject to
lock-in period of only one year.
How do the Methods Compare?

The table 9.1 presents a summary comparison for an equity issue.
As far as a debt issue is concerned dilution of control is a non-
issue and the market perception is positive under all the methods.
122
Table 9.1: Comparison of the Various Methods
Notes
Public Rights Private Preferential
___________________ Issue Issue Placement Allotment
___________________ Amount that can Large Moderate Moderate Moderate

be raised
___________________
Cost of issue High Negligible Negligible Low
___________________
Dilution of control Yes No Yes Depends
___________________
Degree of under Large Irrelevant Small No
___________________ pricing
___________________ Market perception Negative Neutral Neutral Neutral
___________________
___________________
Advantages and Disadvantages of Equity Capital
___________________
An important source of long-term financing, equity capital offers
the following advantages:
• There is no compulsion to pay dividends. If the firm has
insufficiency of cash, it can skip equity dividends without
suffering any legal consequences.
• Equity capital has no maturity date and hence the firm has
no obligation to redeem.
• Because equity capital provides a cushion to lenders, it
enhances the credit worthiness of the company. In general,
other things being equal, the larger the equity base, the
greater the ability of the firm to raise debt finance on
favourable terms.
• Presently, equity dividends are tax-exempt in the hands of
investors up to a certain extent.
The disadvantages of raising finances by issuing equity shares
are as follows:
• Sale of equity shares to outsiders dilutes the control of
existing owners.
• The cost of equity capital is high, usually the highest. The
rate of return required by equity shareholders is generally
higher than the rate of return required by other investors.
• Equity dividends are paid out of profit after tax, whereas
interest payments are tax-deductible expenses. This makes
the relative cost of equity more. Partially offsetting this
disadvantage is the fact that equity dividends are tax-exempt
up to a certain extent, whereas interest income is taxable in
the hands of the investors.
123
• The cost of issuing equity shares is generally higher than
Notes
the cost of issuing other types of securities. Underwriting
commission, brokerage costs, and other issue expenses are
___________________
high for equity issues.
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. ................... represents ownership capital as equity holders collectively
___________________
own the company and do not have any maturity date.
2. The ................... of an equity share is the value stated in the ___________________

memorandum and written on the share scrip. ___________________
3. The ................... is the price at which the equity share is issued.
___________________
4. The amount offered by the company to the investors is called the
___________________
................... .
___________________
5. The ................... of an equity share is the price at which it is traded
in the market.
6. As in the case of income, ................... have a residual claim over the

assets of the firm in the event of liquidation.
7. A ................... involves selling securities in the primary market by

issuing rights to the existing shareholders.
Summary
The weighted average cost of capital (WACC) is used in finance
to measure a firm’s cost of capital. It has been used by many
firms in the past as a discount rate for financed projects, since
the cost of the financing seems like a logical price tag to put on
it. There are various factors affecting cost of capital of a firm.
Equity capital is the primary or basic source of finance to any
company. It represents ownership capital as equity holders
collectively own the company and do not have any maturity date.
They enjoy rewards and bear the risks of ownership. Their
liability is limited to their capital contribution.

1. What is “Weighted Average Cost of Capital”? Explain.
2. Explain the factors affecting the cost of capital.
3. What do you understand by equity capital? Enumerate its
advantages and disadvantages.
4. List the various methods of raising the equity capital.
125
Unit 10 Notes
Case Study ___________________
___________________
___________________
Case Study: Financing Solar Thermal Power Plants
___________________
The commercialization of concentrating solar power technology took ___________________

a major step forward in the mid-1980s and early 1990s with the
development of the SEGS plants in California. Over the years, they ___________________
have proven that parabolic trough power technologies are the most
___________________
cost-effective approach for commercial scale solar power generation in
the Sunbelt countries of the world. ___________________
Investors and bankers who make these investments are the real clients ___________________
for solar power technologies. They are not interested in annual solar
to electric efficiencies, but in risk, return on investments, and coverage ___________________
ratios. This case study discusses solar power projects from the
financier’s perspective. The challenge in moving forward is to attract
private investors, commercial lenders, and international development
agencies and to find innovative solutions to the difficult issues that
investment in the global power market poses for solar power
technologies.
Introduction to Solar Power Investments
A widespread belief among the solar community is that financing

alternatives will not affect the outcome and thus do not need to be
included in an economic analysis when comparing different
technologies. This is true when various alternatives have a similar
financial structure and are very similar in nature. On the other hand,
if one project is capital intensive and the other is not, or a grant or
low-interest rate financing is available for only one technology, then
the financing structure can have a significant effect on the conclusions
and must be included.
Whereas a conventional power plant depends on fuel that is purchased

as a continuous string of payments during the lifetime of the plant,
a solar power plant needs to finance its “fuel costs” through capital
investment at the beginning of the project. This investment for the
solar equipment must be repaid through principal and interest payments
on the loan during the operation of the plant. In a typical parabolic
trough SEGS-type plant, the solar field represents approximately 50%
of the total plant’s investment costs (Figure 10.1). Due to real and
perceived technology risk, the interest rate and financing costs for the
solar capital investment can be significant. As a result, the cost of
power from solar power projects is particularly sensitive to financing
conditions and schedules, and it can vary dramatically with a simple
change in the project ownership or financing structure.
Contd…
126
Notes The lifetime of solar plants is comparable to that of conventional
plants (i.e., 25–30 years). For fossil plants, the risk of significant fuel
___________________ price variations during this period must be also considered. However,
for a solar plant once it is built the “solar fuel” is free, resulting in
___________________ less uncertainty in the cost of power over the life of the project.
___________________ An additional barrier is that it is in developing countries where this
type of generation seems to be possible, and these countries do not
___________________
have sufficient budgetary resources to pay for the high upfront
___________________ investment characteristic of solar power plants. This lack of financial
resources and the insufficient credit rating of such countries could be
___________________ rectified by private investment – provided that the legal situation of
the specific countries allows private investors to enter the power
___________________
market. The worldwide deregulation of the power market is changing
___________________ the way new power investments are made and has significant
implications for the future development of solar power technologies.
___________________
Sources of Capital
___________________
There are three general sources of capital available for a renewable
power project: equity, debt, and grant financing. An equity investment
is to purchase ownership in the project. A debt investment is a loan
to the project. For example, in the purchase of a house, the person
buying the house is the equity investor, and the mortgage is the debt.
In addition, since most solar power projects cannot compete with
conventional fossil power technologies today, a number of organizations
have offered grant financing to help buy-down the non-economic portion
of the project. These grants typically are made available to help account
for environmental, developmental, and economic externalities that
would not otherwise be accounted for during a normal competitive
project selection.
Financing and Ownership Structures
There are two types of financing and ownership structures used for
financing power facilities:
• “Corporate finance” with investor-owned utility ownership.
• “Project Finance” with private ownership.
Corporate financing, also known as internal or equity financing, is

characterized by the use of corporate credit and general assets of a
corporation, typically a utility, as the basis for credit and collateral.
Utility ownership is potentially attractive for solar power projects
because it has a potential for cost saving due to:
• A partial offset of the specific project risk to the utility/corporate

portfolio, ignoring the variance in risks associated with different
projects. Here the overall credit rating of the company is used to
estimate debt and equity costs rather than project specific capital
costs in a standalone project finance model.
Contd…
Unit 10: Case Study
127
• A better credit standing, and hence lower interest rates, increased Notes
debt amortization periods, and less restrictive loan covenants, called
Debt Service Coverage Ratios (DSCR). However, due to high ___________________
investment costs, most of the utilities–especially those in developing
countries – are not in a position to generate sufficient corporate ___________________
finance resources regardless of the advantages of corporate financing.
As a result, the concept of project financing was developed. ___________________
Project financing can be defined as the arrangement of debt, equity, ___________________

credit enhancement for the construction of a particular facility in a
___________________
capital-intensive industry where lenders base credit appraisals on the
estimated cash flows from the facility rather than on the assets or ___________________
credit of the promoter of the facility. The impetus behind the move
toward project finance is to change the focus of financing power plants ___________________
based on the credit rating of the host country to the merit of the
project itself. The term “project financing” is defined as the financing ___________________
of a project in which a lender is satisfied to look initially to the cash ___________________
flows and the earning of that project as the source of funds from
which a loan will be repaid and to the assets of the project as collateral ___________________
for the loan.
Services Site
8% Works
BOP & Land
8% 13%
Power
Block
14%
Solar
HTF Field
System 49%
8%
Figure 10.1: Typical Cost Distribution of Parabolic

Trough Power Plant
Project finance is the primary financing structure used by all

Independent Power Producers (IPPs). Unfortunately, there exists a
widespread confusion between the terms “independent power producer”
and “project finance”: IPP represents the entire project environment,
which includes project financing, planning, construction, and operation
of the facility. However, since an IPP project is making use of the
method of Project Finance it is sometimes a difficult task to separate
them.
Contd…
128
Notes Characteristics of Project Financing
Cash Flow–Related Lending
___________________
The crucial criterion by which lenders assess the financial feasibility
___________________ and credit rating of a project is the ability of the project to cover the
annual Operation and Maintenance (O&M) costs and debt service with
___________________ enough cash flow. Therefore, a lender with a long-term credit exposure
is mainly interested in the ability of the project cash flow to service
___________________
debt over the entire loan life cycle. The lender evaluates this ability
___________________ by analysing the capital structure of the project, the major sources
and uses of funds, its profitability over the loan period, and its
___________________ projections of future profitability.
___________________ A major incentive for many investors is the fact that project financing
undertakings (e.g., IPP projects) can be made to stand alone as a self-
___________________ financing entity, so that the investor can benefit from its success and
can be isolated from its failure. Project finance allows the (potential)
___________________
investor to transfer specific risk to the lender of the debt. The purest,
___________________ but least common, method of financing offers the lender no recourse
against the project owners. Depending on the “recourse-possibilities”
of the lender against the owners “non-recourse financing” or “limited
financing” are synonyms for project finance.
Off-Balance Sheet Financing
The goal of IPP projects is to arrange a borrowing for a project which

will be beneficial for the private investor and at the same time be
completely non-recourse to the other activities of the parent company
and in no way affecting their credit standing or balance sheet. Indeed,
project financing is sometimes called off- balance-sheet financing.
However, there is a popular misconception that the project financing
means off-balance-sheet financing to the point that the project is
completely self- supporting without guarantees or undertakings by the
parent company of the investor. A short summary of the advantages
and disadvantages of the different financing ownership structures is
depicted in Table 10.1.
Table 10.1: Comparison of Corporate Finance/Utility-Owned

and Project Finance/Private–Owned Power projects
Corp. Fin. / Utility-Owned Project Fin. / IPP
Advantages
Offset of project risk Brings fresh capital
Better credit rating Introduces market force and

• lower interest rate debt competition to keep consumer
• lower equity costs prices down
Longer debt amortization period Takes risk from public entities

and distributes risk under project
sponsors.
Contd…
Unit 10: Case Study
129
Less arrays of restrictive loan Diversifies energy supply sources Notes
covenants
• high debt leverage ___________________
Disadvantages ___________________
Projects with sophisticated or Complicated contractual ___________________
new technologies will not be relationships
realized. • large transaction costs ___________________
• high legal fees
___________________
Public projects tend to be more Need to generate a decent
expensive than private ones dividend to private shareholders ___________________
___________________
Risk Management
___________________
Successful financing will continue to be a major challenge for all
renewable power projects. The key to successful project financing is ___________________
to structure the financing with as little recourse as possible to the
private investor while at the same time providing sufficient credit ___________________
support through guarantees of project investors or third parties that
the lender of the debt will be satisfied with the credit risk. Typical
applications for project financing are capital- intensive projects
associated with high risks. There are certain risks that investors and
lenders must take into consideration:
• Country risk
• Political risk
• Foreign exchange risk
• Inflation risk
• Interest rate risk
• Appraisals
• Availability of permits and licenses
• Operating performance risk
• Fuel prices
• Force majeure risk
• Legal risk
At the end, the lender will gauge the project’s ability to withstand the
risks involved, especially critical ones, by looking primarily at the
different debt service coverage ratios (DSCR). The DSCR is a function
of the specific project risk.
Debt service coverage ratios are designed to analyse the financial

charges of a project to its ability to serve them. In any project financing
the payments on the loan should correspond as closely as possible to
the ability of the project to generate cash. Lenders want to be sure
that during the entire project lifetime the generated cash always
Contd…
130
Notes
covers the required debt service. One of the most important loan
covenants is the annual debt service coverage ratio (ADSCR), which
___________________
is simply the ratio of pre-finance cash flow after tax to the amount of
interest payment and principal repayment for the period. Lenders
___________________ normally claim that during every stage of the project the ADSCR
never falls short of the minimum required ADSCR. In general, lenders
___________________ are looking for debt-service coverage ratios of 1.25 or more. In some
cases, when the economy is doing great, they might accept a ratio as
___________________
low as 1.15, but in others, when the economy is tight, they may
___________________ require a ratio of 1.35 or even 1.5.In addition to the ADSCR, other
coverage is important, including the project life coverage ratio (PLCR)
___________________ and the loan life coverage ratio (LLCR). The PLCR is the ratio of the
present value (PV) of cash available for debt service over the entire
___________________ project lifetime to the outstanding debt. The LLCR is only interested
___________________
in the financial vitality of the project for the time period of the loan
life.
___________________
The equity investors, on the other hand, will be interested in the
___________________ Internal Rate of Return (IRR) offered by the project. The minimum
acceptable rate will depend on the project’s risk as characterized by
the type and location of the project, the risk sharing arrangements
and the investor’s cost of capital. The IRR is defined as the rate of
discount which makes the net present value (NPV) zero. To calculate
the NPV, we discount expected future payoffs by the rate of return
offered by comparable investment alternatives. This rate is also
referred to as the hurdle rate, or opportunity cost of capital. It is
called the opportunity cost because it is the return foregone by
investing in the project rather than investing in securities. IRRs of
16%–20% are generally expected from IPP projects, although depending
on specific project risk, significantly higher IRR may be required.
Independent Power Producers
The concept of independent power producers (IPP) originated in the

United States in the 1970s as a result of the 1972 Public Utility
Regulatory Policies Act (PURPA). PURPA provided a mechanism to
allow for the development of the first private non- regulated power
projects.
IPPs – long-term power projects “independent” of public funds, are

gaining more and more importance in the today’s power market, not
only in developing countries but also in the industrialized countries.
The global power market has seen a record amount of new IPP projects
in recent years.
With their high investment requirements, the success of independent

renewable power projects will primarily depend on the ability to attract
private investors, commercial lenders, and international development
agencies. As a first step, the European Commission has pushed its
member countries to give renewable IPPs a market chance by incentive
laws that facilitate and reward the private generation of renewable
power.
Contd…
Unit 10: Case Study
131
IPP projects require a tailor-made financing solution that represents Notes
a major challenge for all parties involved, especially equipment suppliers
providing tailor-made financing concepts is typically a major challenge ___________________
for any equipment supplier but those who are successful gain a lead
against other players in the electricity supply industry. However, IPP ___________________
projects require the risk to be allocated among participants, especially
___________________
to the equipment suppliers. This means that equipment suppliers are
becoming equity investors in the projects and often provide some ___________________
guarantee for project performance.
___________________
Structure of IPP Models
___________________
In view of the flexibility of the IPP structure and its variants, the
legal and company structure differs from project to project. A detailed ___________________
list of different IPP models can be found in Table 10.2.
___________________
Table 10.2: Possible IPP Models
___________________
BLOT Build, Lease, Operate, Transfer
___________________
BOD Build, Operate, Deliver
BOL Build, Operate, Lease
BOO Build, Own, Operate
BOOST Build, Own, Operate, Subsidize, Transfer
BOOT Build, Own, Operate, Transfer
BRT Build, Rent, Transfer
BTO Build, Transfer, Operate
DBOM Design, Build, Operate, Maintain
DBOT Design, Build, Operate, Transfer
FBOOT Finance, Build, Own, Operate, Transfer
The most common IPP models are build, own, operate (BOO) and
build, own, operate, transfer (BOOT), hence, we will only focus on
these two approaches. Generally, IPP models such as BOO and BOOT
are essentially a concession or global service contract offered by a
government and financed and undertaken by private investors Thus,
BOO/BOOT models involve long-term relationships that require trust
between those two parties. The heart of each IPP project is the “project
company” which is normally established in the host country. It is
desirable that the equipment suppliers, the fuel supplier, the plant
operating company and the power purchaser/utility are taking a share
within the project company. In a typical IPP model the equipment
vendors and developers will typically design and construct a project
under a turnkey contract for the project owner. A BOOT project
involves a number of important contractual arrangements between
the participants, represented by the numbers (1) to (8) within the web:
Contd…
132
Notes The shareholders of the project consortium enter into a “shareholder
agreement,” which governs the relationship among them and describes
___________________ how the project will be managed. There is considerable scope for
conflict of interest to arise between the role of shareholders as investors
___________________ and as contracting parties with the company.
___________________ Shareholders attempt to maximize the stake of low-cost loan up to an

80-20 debt-to-equity ratio. A 169-MW natural gas–fired, combined cycle
___________________ merchant plant in the United States achieved a 100% debt financing
(Burr, 1998). Hence, lenders provide substantial amounts of money
___________________
through a “loan agreement.” The lender’s security is limited to the
___________________ revenues to be received by selling the electricity to the purchaser/
utility. Here, an export credit agency can facilitate to minimize the
___________________ debt cost by providing securities in terms of “guarantee agreements”.
___________________ An agreement is made between the general contractor and project

company for a fixed price design-and-build contract, called a “turnkey
___________________ contract” which implies some of the risks. Financing is facilitated if a
general contractor takes responsibility for the design risk for a longer
___________________ period than he would under a standard construction contract. The
equipment suppliers will operate as a “subcontractor” to the general
contractor during the construction period but can also enter in a
“spare part contract” during the life of the project.
The insurer can mitigate some of the project’s risk in terms of an

“insurance contract” by providing funds for some period of time if
there are machinery breakdowns or solar field failures which reduce
the available capacity.
In the “operating agreement” the lender must be assured that an

experienced operator will be available in an early stage. The operating
company can make a considerable contribution to the design process,
helping to ensure that the plant will be operated in the most efficient
way given existing cost constrains.
The “off take contract” or power purchase agreement (PPA) is the key
contract, because it addresses the concern that there will sufficient
revenues generated from the project to service the debt for the lenders
and decent dividends for the equity investors.
Lenders normally require a long-term “fuel agreement” to assure that

the plant will be operable.
In a “concession agreement” the host government will set out the

obligations and the benefits that will be received by the project company.
One major concern of the private sector parties in the BOO/BOOT

model is the high expenditures at the front end coupled with no
assurance that they will win the contract and no assurance that the
project will be built. The project sponsors/equipment suppliers,
therefore, require that the risk will be balanced by decent rewards. In
addition, the equipment supplier is exposed to a greater responsibility
for the performance of their products, extending the normal guarantee
period to the economic lifetime of the project.
Contd…
Unit 10: Case Study
133
On the other hand, a BOOT mode allows equipment suppliers additional Notes
income during the operation period through spare part and maintenance
contracts. And an early involvement in the project helps the project ___________________
developer/equipment supplier to optimize selection of plant and
equipment. ___________________
Conclusion ___________________
The deregulation of the power market in almost all countries of the ___________________
world led to the emergence of independent power producers and project
finance techniques. By means of a cash-flow model, an IPP case study ___________________
was performed and demonstrated the impact of financing on project
___________________
financial feasibility. For instance, the internal rate of return can
increase dramatically by reducing the equity share slightly. One reason ___________________
for this is an inequity between conventional power projects and
renewable power projects due to the higher up-front investment of ___________________
solar projects. As a result, the “solar community” has to open its
horizon to consider renewable energy projects not only as ___________________
environmentally friendly and high- tech, but also as cash-generating ___________________
opportunities.
On the other side, one could obviously see that IPP structures such
as BOOT contain a large cobweb of contracts and agreements, the
establishment and maintenance of which can be daunting. One of the
basic ideas of all IPP structures is an equal allocation of the project
risk among all participants which makes each IPP project a large
challenge, especially for the involved equipment suppliers.
Questions
2. Write down the case facts.
3. Write down an effective executive summary of the given case.

Block–III
Detailed Contents
UNIT-11: SOURCES OF FINANCE–I
UNIT-12: SOURCES OF FINANCE–II
UNIT-13: RISK MANAGEMENT
UNIT-14: RISK IDENTIFICATION, ANALYSISAND CONTROL
UNIT-15: CASE STUDY

137
Unit 11 Notes
Sources of FFinance–I
inance–I ___________________
___________________
___________________
After completion of this unit, the students will be able to explain: ___________________
\ Preference Capital ___________________
\ Internal Accruals
___________________
\ Term Loans
___________________
___________________
Introduction
___________________
There are various sources of finance such as equity, debt,
debentures, retained earnings, term loans, working capital loans,
letter of credit, euro issue, venture funding, etc. These sources
are useful under different situations. They are classified based
on time period, ownership and control, and their source of
generation.
Sources of finance are the most explored area especially for the
entrepreneurs about to start a new business. It is perhaps the
toughest part of all the efforts. There are various sources of finance
classified based on time period, ownership and control, and source
of generation of finance.
Choosing the right source and right mix of finance is a key
challenge for every finance manager. The process of selecting
right source of finance involves in-depth analysis of each source
of finance. For analysing and comparing the sources of finance, it
is required to understand all characteristics of the financing
sources. There are many characteristics on the basis of which
sources of finance are classified.
Preference Capital
Preference capital represents a hybrid form of financing – it
partakes some characteristics of equity and some attributes of
debentures. It resembles equity in the following ways:
(i) preference dividend is payable only out of distributable
profits;
138
(ii) preference dividend is not an obligatory payment (the
Notes payment of preference dividend is entirely within the
discretion of the directors); and
___________________
(iii) preference dividend is not a tax-deductible payment.
___________________
Preference capital is similar to debentures in several ways: (i)
___________________ the dividend rate of preference capital is usually fixed; (ii) the
___________________ claim of preference shareholders is prior to the claim of equity
shareholders; and (iii) preference shareholders do not normally
___________________ enjoy the right to vote.
___________________
Features of Preference Capital
___________________
The important features of preference capital are as follows:
___________________
• Barring a few exceptions, preference shares in India carry a
___________________ cumulative feature with respect to dividends. This means
that unpaid dividends are carried forward and are payable
___________________ in the future. It may be noted that a company cannot declare
equity dividends unless preference dividends are paid with
arrears.
• Preference shares are typically redeemable after ten to
fifteen years.
• Preference shares do not carry voting rights. A preference
shareholder, however, is entitled to vote under certain
circumstances, if preference dividend is skipped.
Advantages and Disadvantages of Preference Capital

Preference capital offers the following advantages:
• There is no legal obligation to pay preference dividend. A
company does not face bankruptcy or legal action if it skips
preference dividend.
• There is no redemption liability in the case of perpetual
preference shares. Even in the case of redeemable preference
shares, financial distress may not be much because
(i) periodic sinking fund payments are not required, and
(ii) redemption can be delayed without significant penalties.
• Preference capital is generally regarded as part of net worth.
Hence, it enhances the credit worthiness of the firm.
• Preference shares do not, under normal circumstances, carry
voting rights. Hence, there is no dilution of control.
• No collateral is pledged in favour of preference shareholders.
Hence, the mortgageable assets of the firm are conserved.
Unit 11: Sources of Finance–I
139
Preference capital, however, suffers from some serious
Notes
shortcomings:
• Compared to debt capital, it is a more expensive source of ___________________
financing because the dividend paid to preference
___________________
shareholders is not, unlike debt interest, a tax-deductible
expense. ___________________
• Though there is no legal obligation to pay preference ___________________

dividends, skipping them can adversely affect the image of
the firm in the capital market. ___________________
• Compared to equity shareholders, preference shareholders ___________________

have a prior claim on the assets and earnings of the firm.
___________________
• If a firm skips preference dividends for three years, it has to
___________________
grant voting rights to the preference shareholders, on
matters affecting them. ___________________
___________________
Check Your Progress
Fill in the blanks:
1. .................... represents a hybrid form of financing, it partakes some

characteristics of equity and some attributes of debentures.
2. Preference shares do not carry .................... rights.
3. There is no .................... liability in the case of perpetual preference

shares.
Internal Accruals
The internal accruals of a firm consist of depreciation charges
and retained earnings. Depreciation represents the allocation of
capital expenditure to various periods over which the capital
expenditure is expected to benefit the firm. Suppose a machine
costs ` 100,000 and has an economic life of 5 years at the end of
which its expected salvage value is zero. If the machine is
depreciated using the straight-line method, the annual
depreciation charge will be ` 20,000. Each year a depreciation
cost of ` 20,000 is shown in the profit and loss account. This cost
merely represents a periodic write off of a capital cost incurred
in the beginning. Put differently, it is a non-cash charge. Hence,
it is considered an internal source of finance.
Retained earnings are that portion of equity earnings (profit after

tax less preference dividends) which are ploughed back in the
firm. Because retained earnings are the sacrifice made by equity
shareholders, they are referred to as internal equity. Companies
normally retain 30 per cent to 80 per cent of profit after tax for
140
financing growth. If you look at a sample of corporate balance
Notes
sheets, you will find that reserves and surplus (other than share
___________________
premium reserve and revaluation reserve), which essentially
represent accumulated retained earnings, are an important source
___________________ of long-term financing. Even this is an understatement of the
___________________
contribution of retained earnings to long-term financing because
a portion of reserves and surplus would have been capitalised by
___________________ the firm if it had issued bonus shares.
___________________
Advantages and Disadvantages of Internal Accruals
___________________
Internal accruals are viewed very favourably by most
___________________ corporate managements for the following reasons:
___________________ • Internal accruals are readily available. Management does not

have to talk to outsiders (shareholders or lenders).
___________________
• Use of internal accruals, in contrast to external equity,
___________________
eliminates issue costs and losses on account of under- pricing.
• There is no dilution of control when a firm relies on internal
accruals.
• The stock market generally views an equity issue with
scepticism. Internal accruals, however, do not carry any
negative connotation.
The disadvantages of internal accruals include the
following:
• The amount that may be available by way of internal accruals
may be limited.
• The opportunity cost of retained earnings is quite high as it
is equal to the cost of equity-remember that retained earnings
represent dividends foregone by equity shareholders.
• The opportunity cost of depreciation generated funds is equal
to the weighted average cost of capital of the firm.
• Many firms do not fully appreciate the opportunity costs of
retained earnings and depreciation-generated funds. They
tend to impute a low cost to internal accruals. Comforted by
the easy availability of internal accruals and the notion that
they have a low cost; managements may invest in sub-
marginal projects that have a negative impact.
141
Fill in the blanks:
___________________
1. The ................. of a firm consist of depreciation charges and retained
earnings. ___________________
2. ................. earnings are that portion of equity earnings (profit after tax ___________________
less preference dividends) which are ploughed back in the firm.
___________________
3. Use of internal accruals, in contrast to ................., eliminates issue
___________________
costs and losses on account of under-pricing.
___________________
Term Loans ___________________
Firms obtain long-term debt mainly by raising term loans or ___________________

issuing debentures.
___________________
Historically, term loans given by financial institutions and banks
___________________
have been the primary source of long-term debt for private firms
and most public firms. Term loans, also referred to as term finance,
represent a source of debt finance, which is generally repayable
in less than 10 years. They are employed to finance acquisition of
fixed assets and working capital margin. Term loans differ from
short-term bank loans which are employed to finance short-term
working capital need and tend to be self-liquidating over a period,
usually less than one year.
Features of Term Loans

1. Currency: Financial institutions give rupee term loans as
well as foreign currency term loans. The most significant
form of assistance provided by financial institutions, rupee
term loans are given directly to Industrial concerns for
setting up new projects as well as for expansion,
modernization, and renovation projects. These funds are
provided for incurring expenditure for land, building plant
and machinery, technical know-how, miscellaneous fixed
assets, preliminary expenses, preoperative expenses, and
margin money for working capital.
Financial institutions provide foreign currency term loans
for meeting the foreign currency expenditure towards import
of plant, machinery and equipment, and payment of foreign
technical know-how fees. The periodical liability for interest
and principal remains in the currency/currencies of the loan
and is translated into rupees at the prevailing rate of
exchange for making payments to the financial institutions.
2. Security: Term loans typically represent secured borrowing.
Usually assets, which are financed with the term loan,
142
provide the prime security. Other assets of the firm may
Notes
serve as collateral security.
___________________ All loans provided by financial institutions, along with
interest, liquidated damages, commitment charges, expenses,
___________________
etc, are secured by way of:
___________________ (a) First equitable mortgage of all immovable properties of
___________________ the borrower, both present and future; and
___________________
(b) Hypothecation of all movable properties of the borrower,
both present and future, subject to prior charges in
___________________ favour of commercial banks for obtaining working capital
advance in the normal course of business.
___________________
3. Interest Payment and Principal Repayment: Interest and
___________________
principal repayment on term loans are definite obligations
___________________ that are payable irrespective of the financial situation of the
firm. To the general category of borrowers, financial
___________________ institutions charge an interest rate that is related to the
credit risk of the proposal, subject usually to a certain floor
rate.
Financial institutions impose a penalty for defaults. In case
of default of payment of interest, the borrower is liable to
pay further interest on interest (compound interest) at the
document rate. For default in repayment of instalments of
principal, the borrower is liable to pay by way of liquidated
damages, additional interest at the rate of 2 per cent per
annum for the period of default on the amount of principal
in default. In addition to interest, lending institutions levy
an upfront fee on the sanctioned loan amount usually at the
rate of one per cent.
The principal amount of a term loan is generally repayable
over a period of 4 to 7 years after an initial grace period of
1 to 2 years. Typically, term loans provided by financial
institutions are repayable in equal semi-annual instalments
or equal quarterly instalments.
Note that the interest burden declines over time, whereas
the principal repayment re-mains constant. This means that
the total debt servicing burden (consisting of interest
payment and principal repayment) declines over time. This
pattern of debt servicing burden, typical in India, differs
from the pattern obtaining in western economies where debt
is typically a mortised in equal periodic instalments.
The latter pattern is relatively more acceptable to borrowers
because it does not result in a heavy debt servicing burden
in earlier years. However, presently, financial institutions
in India do not follow the scheme of equal periodic a
143
mortisation. Yet they try to ensure, by suitably modifying
Notes
the debt repayment schedule, within limits, that the debt
servicing burden is not very onerous.
___________________
4. Restrictive Covenants: In order to protect their interest,
___________________
financial institutions impose restrictive condition on the
borrowers. While the specific set of restrictive covenants ___________________
depends on the nature of the project and the financial
___________________
situation of the borrower, loan contracts often require that
the borrowing firm: ___________________
(a) Broad base its Board of Directors and finalise its ___________________
management setup in consultation with and to the
satisfaction of the financial institutions; ___________________
(b) Make arrangements to bring additional funds in the form ___________________

of unsecured loans/deposits for meeting overruns/
___________________
shortfalls;
(c) Refrain from undertaking any new project and/or ___________________
expansion or make any investment without the prior

approval of the financial institutions;
(d) Obtain clearances and licenses from various government
agencies;
(e) Repay existing loans with the concurrence of the financial
institutions;
(f) Refrain from additional borrowings or seek the consent
of the financial institutions for additional borrowings.
Further, loan agreements impose restrictions on the transfer of
shareholdings by promoters/associates.
Term Loan Procedure

The procedure associated with a term loan involves the following
steps:
1. Submission of Loan Application: The borrower submits
an application form that seeks comprehensive information
about the project. The application form covers the following
aspects:
• Promoters’ background.
• Particulars of the industrial concern.
• Particulars of the project (capacity, process, technical
arrangements, management, location, land and buildings,
plant and machinery, raw materials, effluents, labour,
housing, and schedule of implementation).
144
• Cost of the project.
Notes
• Means of financing.
___________________
• Marketing and selling arrangements.
___________________ • Profitability and cash flow.
___________________ • Economic considerations.
___________________ • Government consent.
___________________ 2. Initial Processing of Loan Application: When the
application is received, an officer of the financial institution
___________________
reviews it to ascertain whether it is complete for processing.
___________________ If it is incomplete, the borrower is asked to provide the
required additional information. When the application is
___________________ considered complete, the financial institution prepares a
___________________ ‘flash report’ which is essentially a summarisation of the
loan application. On the basis of the ‘Flash Report’, it is
___________________ decided whether the project justifies a detailed appraisal or
not.
3. Appraisal of the Proposed Project: The detailed appraisal
of the project covers the marketing, technical, financial,
managerial, and economic aspects. The appraisal memo-
randum is normally prepared within two months after site
inspection. Based on that a decision is taken whether the
project will be accepted or not.
4. Issue of the Letter of Sanction: If the project is accepted,
a financial letter of sanction is issued to the borrower. This
communicates to the borrower the assistance sanctioned and
the terms and conditions relating thereto.
5. Acceptance of the Terms and Conditions by the
Borrowing Unit: On receiving the letter of sanction from
the financial institution, the borrowing unit convenes its
board meeting at which the terms and conditions associated
with the letter of sanction are accepted and an appropriate
resolution is passed to that effect. The acceptance of the
terms and conditions has to be conveyed to the financial
institution within a stipulated period.
6. Execution of Loan Agreement: The financial institution,
after receiving the letter of acceptance from the borrower,
sends the draft of the agreement to the borrower to be
executed by authorised persons and properly stamped as
per the Indian Stamp Act, 1899. The agreement properly
executed and stamped, along with other documents as
required by the financial institution must be returned to it.
Once the financial institution also signs the agreement, it
becomes effective.
145
7. Creation of Security: The term loans (both rupee and foreign
Notes
currency) and the deferred payment guarantee assistance
provided by the financial institutions are secured through ___________________
the first mortgage, by way of deposit of title deeds, of
immovable properties and hypothecation of movable ___________________
properties. As the creation of mortgage, particularly in the ___________________
case of land, tends to be a time-consuming process, the
institutions permit interim disbursements. The mortgage, ___________________
however, must be created within a year from the date of the
___________________
first disbursement. Otherwise the borrower has to pay an
additional charge of 1 per cent interest. ___________________
8. Disbursement of Loans: Periodically, the borrower is ___________________

required to submit information on the physical progress of
___________________
the project financial status of the project, arrangements made
for financing the project, contribution made by the promoters, ___________________
projected funds flow statement, compliance with various
___________________
statutory requirements, and fulfilment of the pre-
disbursement conditions. Based on the information provided
by the borrower, the financial institution will determine the
amount of term loan to be disbursed from time to time.
Before the entire term loan is disbursed, the borrower must
fully comply with all terms and conditions of the loan
agreement.
9. Monitoring: Monitoring of the project is done at the
implementation stage as well as at the operational stage.
During the implementation stage, the project is monitored
through: (i) regular reports, furnished by the promoters,
which provide information about placement of orders,
construction of buildings, procurement of plant, installation
of plant and machinery, trial production, etc. (ii) periodic
site visits, (iii) discussion with promoters, bankers,
suppliers, creditors, and others connected with the project,
(iv) progress reports submitted by the nominee directors,
and (v) audited accounts of the company.
During the operational stage, the project is monitored with the

help of (i) quarterly progress report on the project, (ii) site
inspection, (iii) reports of nominee directors, and (iv) comparison
of performance with promise.
The most important aspect of monitoring, of course, is the recovery

of dues represented by interest and principal repayment.
146
Fill in the blanks:

___________________
1. Term loans are also referred to as ....................... .
___________________
2. ....................... are employed to finance acquisition of fixed assets and
___________________ working capital margin.
___________________ 3. Term loans typically represent ....................... borrowing.
___________________ 4. In order to protect their interest, financial institutions impose ..................
condition on the borrowers.
___________________
___________________
Summary
___________________
Preference capital represents a hybrid form of financing-it partakes
___________________ some characteristics of equity and some attributes of debentures.
It resembles equity in the following ways:
___________________
(i) preference dividend is payable only out of distributable profits;
(ii) preference dividend is not an obligatory payment (the payment
of preference dividend is entirely within the discretion of the
directors); and (iii) preference dividend is not a tax-deductible
payment.
The internal accruals of a firm consist of depreciation charges
and retained earnings. Depreciation represents the allocation of
capital expenditure to various periods over which the capital
expenditure is expected to benefit the firm.
Historically, term loans given by financial institutions and banks
have been the primary source of long-term debt for private firms
and most public firms. Term loans, also referred to as term finance,
represent a source of debt finance which is generally repayable
in less than 10 years. They are employed to finance acquisition of
fixed assets and working capital margin. Term loans differ from
short-term bank loans which are employed to finance short-term
working capital need and tend to be self-liquidating over a period
of time, usually less than one year.

1. What is Preference Capital? Explain its features.
2. Explain the advantages and disadvantages of term loans.
3. Enumerate the features of internal accrual.
147
Unit 12 Notes
Sources of FFinance–II
inance–II ___________________
___________________
___________________
\ Debentures ___________________
\ Advantages and Disadvantages of Debt Financing
___________________
\ Working Capital Advances
___________________
\ International Sources of Funds
___________________
___________________
Introduction
There are several sources of finance/funds available to any
company. An effective appraisal mechanism of various sources of
funds available to a company must be instituted in the company
to achieve its main objectives. Some of the parameters that need
to be considered while choosing a source of fund are:
• Cost of source of fund.
• Tenure.
• Leverage planned by the company.
• Financial conditions prevalent in the economy.
• Risk profile of both the company as well as the industry in
which the company operates.
Each source of fund has some advantages as well as disadvantages.
Debentures
For large publicly traded firms, debentures are a viable alternative
to term loans. Akin to promissory notes, debentures are
instruments for raising debt finance. Debenture holders are the
creditors of a company. The obligation of a company towards its
debenture holders is similar to that of a borrower who promises
to pay interest and principal at specified times. Debentures often
provide more flexibility than term loans as they offer greater
choice with respect to maturity, interest rate, security,
repayment, and special features.
148
Features
Notes
The important features of debentures are as follows:
___________________
• When a debenture issue is sold to the investing public, a
___________________ trustee is appointed through a trust deed. The trustee,
usually a bank or financial institution or insurance company,
___________________
is supposed to ensure that the borrowing firm fulfills its
___________________ contractual obligations.
___________________ • Debenture issues in India are typically secured by mortgages/
charges on the immovable properties of the company and a
___________________ floating charge on its other assets (subject to prior charges
___________________ created in favour of the company’s bankers over the current
assets). However, the order of priority of mortgages/charges
___________________ may vary across different debenture issues. Occasionally,
___________________
companies issue unsecured debentures. These are debentures
that are not backed by specific assets of the firm, but by its
___________________ general credit.
• Corporate debt may be short-term, medium-term or long-
term. Short-term corporate debt of less than one year is called
commercial paper. Medium-term debentures may have a
maturity of 1 year to 5 years. Long-term debentures typically
have a maturity period of 5 to 12 years.
• Publicly issued debentures that have a maturity period of 18
months or more have to be compulsorily credit rated.
• Debentures are typically redeemable in nature. For all
debenture issues with a maturity period of more than 18
months, a Debenture Redemption Reserve (DRR) has to be
created. The company should create a DRR equivalent to at
least 50 per cent of the amount of issue before redemption
commences.
• Debentures may carry a fixed rate of interest or floating
rate of interest or zero rate of interest.
• Debentures may carry a ‘call’ feature that provides the
issuing company the option to redeem the debentures at a
certain price before the maturity period. Sometimes
debentures may have a ‘put’ feature that gives the holder
the right to seek redemption at specified times at
predetermined prices.
Innovations in Debentures
1. Deep Discount Bonds: A deep discount bond does not carry
any coupon rate but is issued at a steep discount over its
face value. It is also referred to as a ‘zero interest (coupon)
bond’ or just a zero. For example, in 1992, the Small Industries
Unit 12: Sources of Finance–II
149
Development Bank of India (SIDBI) issued deep discount
Notes
bonds. Each bond having a face value of ` 100,000 was issued
at a discounted price of ` 2500 with a maturity period of
___________________
25 years from the date of allotment (i.e., February 1, 1993).
The investor as well as SIDBI have the option to withdraw ___________________
or redeem the bond respectively at the end of 5, 9, 12, 15, or
___________________
20 years from the date of allotment at the deemed value of
` 5300, ` 9600, ` 15,300, ` 25,000, and ` 50,000 respectively. ___________________
Deep discount bonds appeal to issuers interested in ___________________

conserving their cash flows during the life of the bonds. On
the other side of the market, they appear attractive to ___________________
investors who want to protect themselves against the ___________________
reinvestment rate risk. Remember that the imputed interest
on a deep discount bond is automatically reinvested at a ___________________
rate equal to its yield to maturity.
___________________
2. Convertible Debentures: A convertible debenture, as the
___________________
name suggests, is a debenture that is convertible, partially
or wholly, into equity shares. As per SEBI guidelines the
provisions applicable to Fully Convertible Debentures (FCDs)
and Partially Convertible Debentures (PCDs) are as follows:
• The conversion premium and the conversion timing shall
be predetermined and stated in the prospectus.
• Any conversions, partial or fault will be optional at the
hands of the debenture holder, if the conversion takes
place at or after 18 months but before 36 months from the
date of allotment.
• A conversion period of more than 36 months will not be
permitted unless conversion is made optional with “put”
and “call” options.
• Compulsory credit rating will be required if the conversion
period for fully convertible debentures exceeds 18 months.
Convertible debentures are commonly used all over the world
and are gaining currency in India as well. Why are they
popular? The conventional explanations for their popularity
are: (a) Convertible debentures are a cheaper source of
finance because interest rate on them is typically lower than
that on straight debentures, (b) Convertible debentures
enable a company to effectively issue equity shares at a
premium because the conversion price associated with a
convertible debenture is typically higher than the price at
which equity shares can be issued currently.
The conventional explanations have a “free lunch” flavour.
So, one should be suspicious of them.
150
Modern finance theory offers better explanations:
Notes
(a) Convertible debentures improve cash flow matching.
___________________ Firms prefer financing instruments that can be comfortably
serviced. A growing but risky firm may find convertible
___________________
debentures appealing because of a lower initial burden,
___________________ though they may entail expensive dilution later;
(b) Convertible debentures generate financial synergy. They
___________________
make sense when it is very costly or difficult to assess the
___________________ risk characteristics of the issuing firm. Remember that these
instruments have two components, the straight debenture
___________________ component and the call option component. If the company
___________________
turns out to be risky, the debenture instrument will have a
low value, but the call option component will have a high
___________________ value. On the other hand, if the company turns out to be
relatively risk-free, the debenture component will have a
___________________
high value but the call option component a low value. Given
___________________ this compensating behaviour of the two components, the
required yield on the convertible debenture will not be very
sensitive to default risk.
3. Floating Rate Bonds: Conventional bonds carry a fixed
rate of interest. Floating rate bonds, on the other hand,
earn an interest rate that is linked to a benchmark rate
such as the Treasury bill interest rate. For example, in 1993
the State Bank of India came out with the first ever issue
of floating interest rate bonds in India. It issued 5 million
(1000 face value) unsecured, redeemable, subordinated
floating interest rate bonds in the nature of promissory notes
carrying interest at 3 per cent per annum over the bank’s
maximum term deposit rate.
Floating rate bonds have been essentially a response to
inflation risk. They make sense to a borrower whose assets
earn returns that fluctuate with interest rates. Financial
institutions and banks which give variable rate interest loans
find such bonds appealing. Who is interested in buying
floating rate bonds? Investors concerned about the stability
of their principal find floating rate bonds attractive. The
prices of these bonds tend to be fairly stable and close to
par value as compared to fixed interest bonds.
4. Secured Premium Notes: In 1992, the Tata Iron and Steel
Company Limited issued Secured Premium Notes (SPNs) of
` 300 each. The principal amount of the SPN is to be repaid
in four equal annual instalments of ` 75 each from the end
of the 4th year to the end of the 7th year, together with an
equivalent additional amount of ` 75 with each instalment.
No interest or repayment of principal will become due or
151
accrue on the SPN during the first three years after
Notes
allotment. The additional amount as mentioned above will
represent interest and/or premium on redemption, in such
___________________
forms as may be in the interest of the SPN holders according
to the then prevailing regulations. The company will offer, ___________________
before the end of the third year, specific options (e.g., full
___________________
interest or premium or combination thereof) to the SPN
holders, which would have to be exercised at the end of the ___________________
third year. Each SPN will have a detachable warrant against
___________________
which the holder can get one equity share for ` 80.
5. Structured Notes: A debt obligation which is derived from ___________________
another debt obligation is called a structured note. Perhaps ___________________
the first structured notes were created in the early 1980s
when investment bankers in the US bought large blocks of ___________________
30-year non-cancellable Treasury bonds and stripped them
___________________
to create a series of zero coupons (zeroes). The shortest zero
was backed by the first interest payment on the T-bond issue, ___________________
the second shortest zero was backed by the next interest
payment, so on and so forth.
Another important type of structured notes is securitized
debt instruments. These are securities backed by a
designated pool of assets (mortgage loans, consumer loans,
hire purchase receivables, and so on). There are two major
types of securitized debt instruments: Pass Through
Certificates (PTCs) and Collateralised Mortgage Obligations
(CMOs). PTCs represent an undivided interest in a portfolio
of assets whereas CMOs are prioritised in terms of their
right to interest as well as principal repayment.
6. Indexed Bonds: The payoff of a typical indexed bond consists
of two parts. The first part represents a fixed amount and
the second part represents a variable component whose value
is dependent on some index.
Consider two investors, one purchases a regular bond and
another buys an index-linked bond. Both bonds are issued
and purchased for ` 100 during July 2019, having the same
terms – 4% coupon rate, 1 year to maturity, and ` 100 face
value. The CPI level at the time of issuance is 204.
The regular bond pays an annual interest of 4%, or ` 4 (` 100
× 4%), and the principal amount of ` 100 is repaid at
maturity. At maturity, the principal and the interest payment
due, that is, ` 100 + ` 4 = ` 104, will be credited to the
bondholder.
Assuming the CPI level in July 2020 is 207, the interest and
principal value must be adjusted for inflation with the index-
152
linked bond. Coupon payments are calculated using an
Notes
inflation-adjusted principal amount, and an indexation factor
is used to determine the inflation-adjusted principal amount.
___________________
For a given date, the indexation factor is defined as the CPI
___________________ value for the given date divided by the CPI at the original
issue date of the bond. The indexation factor in our example
___________________
is 1.0147 (207/204). Therefore, the inflation rate is 1.47%,
___________________ and the bondholder will receive ` 105.53 (` 104 × 1.0147)
when it matures.
___________________
The annual interest rate on the bond is 5.53% [((` 105.53 –
___________________ ` 100)/` 100) × 100%]. The investor’s approximate real return
___________________
rate is 4.06% (5.53% – 1.47%), calculated as the nominal rate
less the inflation rate.
___________________
7. An indexed bond appeals to investors who are looking for
___________________ an assured return along with capital appreciation that is
linked to some index.
___________________
Private Placement of Debentures

Private placement of debentures, particularly by listed companies,
has become very popular in India in recent years. The principal
buyers of privately placed debentures are mutual funds, financial
institutions, insurance companies, Army Group Insurance, Navy
Group Insurance, Air Force Group Insurance and so on.
The phenomenal growth of private placement of debt may be
attributed to the following reasons:
1. Accessibility: Almost every company, irrespective of
whether it is a public limited company or a private limited
company, or whether it is a listed company or an unlisted
company, can access the private placement market. Further
the private placement market can accommodate issues of
smaller size whereas the public issues market does not
permit an issue below a certain minimum size.
Informed observers of the private placement market for debt
feel concerned about its unregulated character. They feel
that institutional investors have taken a very liberal approach
to lending as they do not often insist on credit rating or
robust loan contracts.
2. Flexibility: In a private placement, there is greater
flexibility in working out the terms of the issue. For example,
when a non-convertible debenture issue is privately placed,
a discount may be given to institutional investors to make
the issue attractive. The absence of such freedom in a public
issue combined with interest rate ceilings (which applied
153
till recently) appears to be the primary reason for the
Notes
phenomenal growth of private placement of non-convertible
debentures in India. In addition to greater flexibility at the ___________________
time of structuring the issue initially, there may be more
latitude to renegotiate the terms of the issue subsequently ___________________
and even roll- over the debt. This is because the issuer has ___________________
to deal with one or few institutional investors in the private
placement market. ___________________
3. Speed: The time required for completing a public issue cycle ___________________
is usually 3 months or more because of several formalities
___________________
that have to be gone through. On the other hand, a private
placement requires lesser time, perhaps a month or two, as ___________________
the elaborate procedure followed in a public issue is largely
___________________
bypassed. Of course, it also means fewer hassles.
___________________
4. Lower Issue Costs: A public issue entails several statutory
and non-statutory expenses associated with underwriting, ___________________
brokerage, printing, mailing, announcements, promotion, and
so on. These costs can be quite high. As against this, the
issue cost for a private placement is substantially less.
Given the above advantages of private placement, companies are

likely to prefer private placement wherever feasible. Of course,
if an issue is large in size it will have to be made in the public
issues market. This is because institutional investors would like
to limit their exposure of individual companies.
Institutional investors, before participating in a private placement,

look into a number of factors like the net worth of the company,
the interest cover, the level of profit before tax, the asset cover,
the debt equity ratio, the dividend record, the percentage of
unsecured deposits/borrowings, the price history of the company’s
stock, and the existence of carried forward loss.
Some of the important conditions that a company should

ordinarily satisfy in order to be acceptable to institutional
investors are:
• The net worth of the company should be at least ` 1 crore.
• The interest cover should be at least two times, as per the
latest balance sheet. If not, the average interest cover for
the preceding three years should at least be two times.
• The asset cover should be at least 1.25.
• The company must have paid dividend for at least two years
in the preceding three years.
• In the case of a listed company, the stock price should be
above par for six months prior to the issue.
154
Fill in the blanks:

___________________
1. Debenture holders are the .................. of a company.
___________________
2. Debentures are typically .................. in nature.
___________________
3. A debt obligation which is derived from another debt obligation is called
___________________ a .................. .
___________________ 4. In a private placement, there is greater .................. in working out the

terms of the issue.
___________________
___________________ Advantages and Disadvantages of Debt Financing

___________________
Term loans and debentures are two important ways of raising
___________________ long-term debt.
___________________ The advantages of debt financing are as follows:

• Interest on debt is a tax-deductible expense, whereas equity
and preference dividend are paid out of profit after tax.
• Debt financing does not result in dilution of control because
debt holders (term lending institutions and debenture-
holders) are not entitled to vote.
• Debt holders do not partake in the value created by the
company as payments to them are limited to interest and
principal.
• If there is a precipitous decline in the value of the firm,
shareholders have the option of defaulting on debt obligations
and turning over the firm to debt holders. Issue costs of debt
are significantly lower than those on equity and preference
capital.
• The burden of servicing debt is generally fixed in nominal
terms. Hence debt provides protection against high
unanticipated inflation.
Debt financing is not an unmixed blessing. It has serious
disadvantages associated with it:
• Debt financing entails fixed interest and principal repayment
obligation. Failure to meet these commitments can cause a
great deal of financial embarrassment and even lead to
bankruptcy.
• Debt financing increases financial leverage, which according
to CAPM, raises the cost of equity to the firm.
• Debt contracts impose restrictions that limit the borrowing
firm’s financial and operating flexibility. These restrictions
155
may impair the borrowing firm’s ability to resort to value-
Notes
maximizing behaviour.
• If the rate of inflation turns out to be unexpectedly low, the ___________________
real cost of debt will be greater than expected.
___________________
1. Interest on debt is a ................... expense, whereas equity and preference ___________________

dividend are paid out of profit after tax.
___________________
2. ................... entails fixed interest and principal repayment obligation.
___________________
Working Capital Advances ___________________
___________________
Working capital advance by commercial banks represents the
most important source for financing current assets. ___________________
Forms of Bank Finance

Working capital advance is provided by commercial banks in three
primary ways: (i) cash credits/overdrafts, (ii) loans, and (iii)
Purchase/discount of bills. In addition to these direct forms,
commercial banks help their customers in obtaining credit from
other sources through the letter of credit arrangement.
1. Cash Credits/Overdrafts: Under a cash credit or overdraft
arrangement, a predetermined limit for borrowing is
specified by the bank. The borrower can draw as often as
required provided the outstanding does not exceed the cash-
credit/ overdraft limit. The borrower also enjoys the facility
for repaying the amount, partially or fully, as and when he
desires. Interest is charged only on the running balance, not
on the limit sanctioned. A minimum charge may be payable
irrespective of the level of borrowing, for availing of this
facility.
This form of advance is highly attractive from the borrower’s
point of view because while the borrower has the freedom of
drawing the amount in instalments as and when required,
interest is payable only on the amount outstanding.
2. Loans: These are advances of fixed amounts to the borrower.
The borrower is charged with interest on the entire loan
amount, irrespective of how much he draws. In this respect,
this system differs markedly from the overdraft or cash credit
arrangement wherein interest is payable only on the amount
utilized. Loans are payable either on demand or in periodical
instalments. When payable on demand, loans are supported
156
by a demand promissory note executed by the borrower.
Notes
There is often a possibility of renewing the loan.
___________________ 3. Purchase/Discount of Bills: A bill arises out of a trade
transaction. The seller of goods draws the bill on the
___________________
purchaser. The bill may be either clean or documentary (a
___________________ documentary bill is supported by a document of title to goods
like a railway receipt or a bill of lading) and may be payable
___________________
on demand or after a usance period which does not exceed
___________________ 90 days. On acceptance of the bill by the purchaser, the
seller offers it to the bank for discount/purchase. When the
___________________ bank discounts/purchases the bill, it releases the funds to
___________________
the seller. The bank presents the bill to the purchaser (the
acceptor of the bill) on the due date and gets its payment.
___________________
4. Letter of Credit: A letter of credit is an arrangement
___________________ whereby a bank help its customer to obtain credit from its
(customer’s) suppliers. When a bank opens a letter of credit
___________________
in favour of its customers for some specific purchases, the
bank undertakes the responsibility to honour the obligation
of its customer, should the customer fail to do so.
Application and Processing

A customer seeking an advance is required to submit an
appropriate application form. There are different types of
application forms for different categories of advances. The
information furnished in the application covers, inter alia, the
following: the name and address of the borrower and his
establishment; the details of the borrower’s business; the nature
and amount of security offered. The application form must be
supported by various ancillary statements like the financial
statements and financial projections of the firm.
The application is processed by the branch manager or his field
staff. This primarily involves an examination of the following
factors: (i) ability, integrity, and experience of the borrower in
the particular business, (ii) general prospects of the borrower’s
business, (iii) purpose of advance, (iv) requirement of the borrower
and its reasonableness, (v) adequacy of the margin, (vi) provision
of security, and (vii) period of repayment.
Sanction, and Terms and Conditions

Once the application is duly processed, it is put up for sanction
to the appropriate authority. The sanctioning powers of various
officials like Branch Manager, Regional Manager, General
Manager, etc. are defined by virtue of the position they occupy.
157
If the sanction is given by the appropriate authority, along with
Notes
the sanction of advance, the bank specifies the terms and conditions
applicable to the advance. These usually cover the following:
___________________
1. The amount of loan or the maximum limit of the advance,
___________________
2. The nature of the advance,
___________________
3. The period for which the advance will be valid,
___________________
4. The rate of interest applicable to the advance,
___________________
5. The primary security to be charged,
___________________
6. The insurance of the security,
7. The details of the collateral security, if any, to be provided, ___________________
8. The margin to be maintained, and ___________________
9. Other restrictions or obligations on the part of the borrower. ___________________
It is a common banking practice to incorporate important terms ___________________

and conditions on a stamped security document to be executed by
the borrower. This helps the bank to create the required charge
on the security offered and obligates the borrower to observe the
stipulated terms and conditions.
Security
For working capital advances, commercial banks seek security
either in the form of hypothecation or in the form of pledge.
1. Hypothecation: Under this arrangement, the owner of the
goods borrows money against the security of movable
property, usually inventories. The owner does not part with
the possession of property. The rights of the lender
(hypothecatee) depend upon the arrangement between the
lender and the borrower. Should the borrower default in
paying his dues, the lender (hypothecatee) can file a suit to
realise his dues by selling the goods hypothecated.
2. Pledge: In a pledge arrangement, the owner of the goods
(pledgor) deposits the goods with the lender (pledgee) as
security for the borrowing. Transfer of possession of goods
is a precondition for pledge. The lender (pledgee) is expected
to take reasonable care of goods pledged with him. The
pledge contract gives the lender (pledgee) the right to sell
goods and recover dues, should the borrower (pledgor) default
in paying debt.
Margin Amount
Banks do not provide hundred per cent finance. They insist that
the customer should bring a portion of the required finance from
158
other sources. This portion is known as the margin amount. The
Notes
margin amount tends to vary from asset to asset.
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. Under a ................. arrangement, a predetermined limit for borrowing
___________________ is specified by the bank.
___________________ 2. ................. are advances of fixed amounts to the borrower. The borrower
is charged with interest on the entire loan amount, irrespective of how
___________________ much hedraws.
___________________ 3. Once the application is duly processed, it is put up for sanction to the
................. .
___________________
4. Under ................., the owner of the goods borrows money against the
___________________ security of movable property, usually inventories.
___________________
International Sources of Funds
Thanks to the globalization of capital markets, Indian firms can
raise capital from Euromarkets or from the domestic markets of
various countries or from export credit agencies.
Euromarkets
The term Euromarkets seems to be a misnomer because they do
not have a physical location. Euromarkets refer to a collection of
international banks that help firms in raising capital in a global
market which is beyond the purview of any national regulatory
body.
An Indian firm can access the Euromarkets to raise a
Eurocurrency loan or issue a Eurobond or issue global depository
receipts.
1. Eurocurrency Loans: Subject to certain terms and
conditions, the Government of India permits Indian firms to
resort to external commercial borrowings for the import of
plant and machinery. The most common instrument of
external commercial borrowing is the Eurocurrency loan.
A Eurocurrency is simply a deposit of currency in a bank
outside the country of the currency. For example, a
Eurodollar is a dollar deposit in a bank outside the US.
Likewise, a Euro yen is a yen deposited in a bank outside
Japan. How do Eurocurrency deposits arise? This may be
explained with an example. Suppose an American oil
company buys oil from a Sheikh in the Middle East and pays
159
US $ 10 million drawn on the Chase Manhattan Bank and
Notes
the Sheikh deposits the cheque in his account with a Swiss
bank. The dollar deposit placed outside the United States,
___________________
the country of the dollar currency, is a Eurodollar deposit.
The Swiss bank can use this deposit for granting Eurodollar ___________________
loans.
___________________
The main features of Eurocurrency loans, which represent
___________________
the principal form of external commercial borrowings, are:
• Eurocurrency loans are often syndicated loans, wherein a ___________________
group of lenders, particularly banks, participate jointly in ___________________
the process of lending under a single loan agreement. The
syndicate of lenders is represented by the lead bank. The ___________________
borrower is required to pay a syndication fee, which is a
___________________
front-end payment usually ranging between 0.5 percent
and 2 per cent to the lead bank. This represents the ___________________
management fees payable to the lead bank, participation
___________________
fee to the other banks, and other charges.
• The rate of interest on Eurocurrency loans is a floating
rate. It is usually linked to London Inter-Bank Offer Rate
(LIBOR) or Singapore Inter Bank Offer Rate (SIBOR).
The spread over the LIBOR or SIBOR rate is mainly a
function of the creditworthiness of the borrower and size
of the loan. Air India International, for example, obtained
a Eurodollar loan of US ` 88 million in 1982, at an interest
rate of 3/8 per cent above the LIBOR. While the rate is
determined at the beginning of each interest period, the
interest is payable at the end of each period.
• The interest period may be 3, 6, 9, or 12 months in duration.
It is largely left to the option of the borrower.
• The borrower often enjoys the multi-currency option which
enables it to denominate the interest and principal in the
new currency opted for. This option is exercisable at the
end of each interest period.
• The Eurocurrency loans are repayable in a bullet payment
or in instalments, which are typically equal, over a period
of time as agreed to by the parties. The borrower may
prepay the loan after giving due notice to the lead bank.
When prepayment is done, some premium is payable. The
lender may also reserve the right to recall the outstanding
loan under certain circumstances.
Evaluation: Overseas debt, particularly in the form of
Eurocurrency loans offers the following advantages:
• Participating institutions have deep pockets and a very
professional approach.
160
• There is a great deal of flexibility in structuring these
Notes
loans.
___________________ • Tenors up to 10 years are easily available.
___________________ The disadvantages of overseas debt are:
___________________ • It is not economical for small projects due to high appraisal

and syndication costs.
___________________
• Pricing of loans depends on risk perception.
___________________
• It may be difficult to negotiate changes with investors.
___________________
2. Eurobonds: Firms using the Euromarkets for debt financing
___________________ can take out loans (called Eurocurrency loans) or sell bonds
(referred to as Eurobonds). The important features of a
___________________ Eurobond are:
___________________ • It is issued outside the country in whose currency it is
denominated. For example, Eurodollar bonds are sold
___________________
outside the US and Euro yen bonds are sold outside Japan.
• It is usually managed by a syndicate of investment banks
and offered to investors in many countries.
• It is a bearer bond. This means that it is unregistered and
payable to the person who carries it.
• The interest on it is usually paid annually or half-yearly.
While the Eurocurrency loan is the most popular form of
external commercial borrowing, some firms have raised
money by issuing Eurocurrency bonds (or Eurocurrency
notes). Power Finance Corporation, for example, raised
overseas debt by issuing Euro notes in 1997 that had the
following features:
Note that the lending rates in the Euro debt market tend to
be lower than those in the domestic markets. Why? There
are several reasons. First, on Euro deposits banks have no
reserve requirements. Second, borrowers in Eurocurrency
market are typically large, reputed companies with good
credit ratings. Third, banks price these loans aggressively
as there are no regulators.
3. Global Depository Receipts: From the early 1990s, Indian
companies have issued Global Depository Receipts (GDRs),
which represent indirect equity investment, in the
Euromarkets.
In the depository receipts mechanism, the shares issued by
a firm is held by a depository, usually a large international
bank, who receives dividends, reports, etc. and issues claims
against these shares. These claims are called depository
161
receipts in Euromarkets they are called GDRs with each
Notes
receipt being a claim on a specified number of shares. The
underlying shares are called depository shares. The GDRs
___________________
are denominated in a convertible currency-usually US
dollars. GDRs may be listed and traded on major stock ___________________
exchanges or may trade in the Over-the-Counter (OTC)
___________________
market. The issuer firm pays dividends in its home currency
which is converted into dollars by the depository and ___________________
distributed to the holders of GDRs. This way the issuing
___________________
firm avoids listing fees and onerous disclosure and reporting
requirements which would be obligatory if it were to be ___________________
directly listed on the stock exchange. Holders of GDR can
convert them into the underlying share by surrendering the ___________________
depository receipts to the depository. ___________________
A company planning a GDR issue must obtain the approval from ___________________
the ministry of finance as well as the Foreign Investment
Promotion Board (FIPB) since GDR issues are deemed to be a ___________________
foreign direct investment. The government periodically issues
guidelines for GDR issues. These guidelines set out the criteria
a potential issuer must satisfy the permissible uses of the funds
raised, and the manner in which the funds are to be deployed till
the issuing company is ready to use them. The custodian is
required to be an Indian institution.
Foreign Domestic Markets

A second way to raise money internationally is to sell securities
directly in the domestic capital markets of foreign countries. This
is referred to as direct issuance. For example, a British firm may
issue dollar-denominated equity stocks in the US capital market
or a German firm may issue yen-denominated bonds in the
Japanese capital market. A foreign issuer has to satisfy all
regulations applicable to the domestic firms. In addition, it may
be required to fulfil certain special obligations applicable to
foreign issuers.
Indian firms can also issue bonds and equities in the domestic
capital market of a foreign country. Reliance Industries Limited,
for example, issued bonds in the US domestic capital market.
Such bonds are referred to as Yankee bonds. Incidentally, bonds
issued in the UK domestic market are called Bulldog bonds and
those issued in the Japanese domestic market are called Samurai
bonds. In recent years, Indian companies like Infosys Technologies
and ICICI have successfully tapped the US equity market by
issuing American Depository Shares (ADSs). Like GDRs, ADSs
represent claims on a specific number of shares. The principal
difference between the two is that the GDRs are issued in the
162
Euromarket whereas ADSs are issued in the US domestic capital
Notes
market.
___________________
Export Credit Schemes
___________________
Export credit agencies have been established by the governments
___________________ of major industrialised countries for financing exports of capital
goods and related technical services. The prominent export credit
___________________
___________________
agencies are US EXIM, JEXIM, HERMES, and COFACE. These
agencies follow certain consensus guidelines for supporting exports
___________________ under a convention known as the Berne Union. As per these
guidelines, the interest rate applicable for export credits to Indian
___________________
companies for various maturities is regulated. Two kinds of export
___________________ credit are provided: buyer’s credit and supplier’s credit.
___________________ Buyer’s Credit: Under this arrangement, credit is provided

directly to the Indian buyer for purchase of capital goods and/or
___________________
technical services from the overseas exporter. The buyer’s credit
facility operates as follows:
• The overseas exporter and the Indian buyer negotiate a
contract.
• An application for the buyer’s credit facility is made of the
export credit agency of the exporter’s country along with
relevant details (like the types of goods/services to be
exported, approximate value of the contract, terms of
payments, schedule of projected shipment of goods or
provision of services, percentage of financing required, etc.).
• The buyer’s credit facility is approved by the export credit
agency of the exporter’s country.
• A loan agreement delineating the terms and conditions of
the buyer’s credit is negotiated between the overseas
exporter’s bank, the Indian borrower, and where applicable
the Indian guarantors.
Supplier’s Credit: This is a credit provided to the overseas
exporters so that they can make available medium-term finance
to Indian importers. The supplier’s credit facility operates as
follows:
• The overseas exporter notifies his bank and the export credit
agency of a potential export order of an Indian buyer who
requires medium-term finance.
• The export credit agency communicates to the bank its
willingness to provide the facility.
• The terms of the facility are incorporated in the contract
between the overseas exporter and the Indian buyer.
163
Salient Features
Notes
The salient features of finance provided by export credit agencies
are: ___________________
• The finance is tied to import of goods and services. ___________________
• Up to 85 per cent of the value of imports is available as ___________________

finance.
___________________
• The finance is available for long tenors at reason able cost.
___________________
• Export credit agencies insist on a bank guarantee.
___________________

1. The term ................. seems to be a misnomer because they do not
___________________
have a physical location.
___________________
2. ................. is usually managed by a syndicate of investment banks and
offered to investors in many countries.
3. ................. Is away to raise money internationally is to sell securities

directly in the domestic capital markets of foreign countries.
4. Under ................., credit is provided directly to the Indian buyer for

purchase of capital goods and/or technical services from the overseas
exporter.
Summary
For large publicly traded firms, debentures are a viable alternative
to term loans. Akin to promissory notes, debentures are
instruments for raising debt finance. Debenture holders are the
creditors of a company. The obligation of a company towards its
debenture holders is similar to that of a borrower who promises
to pay interest and principal at specified times. Debentures often
provide more flexibility than term loans as they offer greater
choice with respect to maturity, interest rate, security,
repayment, and special features.
Term loans and debentures are two important ways of raising
long-term debt. There are several advantages of debt financing.
Working capital advance by commercial banks represents the
most important source for financing current assets. Working
capital advance is provided by commercial banks in three primary
ways:
(i) cash credits/overdrafts, (ii) loans, and (iii) purchase/discount
of bills.
164
Thanks to the globalization of capital markets, Indian firms can
Notes
raise capital from Euromarkets or from the domestic markets of
various countries or from export credit agencies.
___________________
___________________ Questions for Discussion

___________________ 1. What is the difference between fully convertible debentures
and optionally convertible debentures?
___________________
2. Explain in brief the international sources of funds.
___________________
___________________
___________________
___________________
___________________
___________________
165
Unit 13 Notes
Risk Management ___________________
___________________
___________________
\ What is Risk? ___________________
\ Risk Management
___________________
\ Functions of Risk Management
___________________
___________________
Introduction ___________________
Risk is a very common word and liberally used. Risk may be
thought of as a concept that describes uncertainty in achieving
goals and drivers of uncertainty include lack of information,
knowledge, judgment and care to maintain a few. Risk is the
most fundamental factor that influences financial behaviour and
it would be fairly a simple job to allocate and manage resources
in the absence of risk.
Managing risk has acquired greater dimensions in the wake of
the structural changes that has come about the international
financial world. Mergers and alliances, coupled with growth in
size, competition deregulation, product innovation, new business
initiatives have substantially altered the behaviour of this world.
What is Risk?
A simple definition of a “risk” is a problem that could cause some
loss or threaten the success of our project, but, which hasn’t
happened yet. (And we’d like to keep it that way.) These potential
problems might have an adverse impact on the cost, schedule, or
technical success of the project, the quality of our software
products, or project team morale. Risk management is the process
of identifying, addressing, and eliminating these potential
problems before they can damage our project.
Risk is a problem whose probability can be find out whereas
uncertainty is a problem whose probability cannot be known.
Risk management is the process of identifying, addressing, and
eliminating the potential problems before they can damage our
project.
166
We need to differentiate risks, as potential problems, from the
Notes
current problems facing the project, because different approaches
are taken for addressing these two kinds of issues. For example,
___________________
a staff shortage because you haven’t been able to hire people with
___________________ the right technical skills is a current problem, but the threat of
your top technical people being hired away by the competition is
___________________
a risk.
___________________
Current, real problems require prompt corrective action, whereas
___________________ looming risks can be dealt with in several different ways. We
might choose to avoid the risk entirely by changing our project
___________________
approach or even cancelling the project. Or, we could elect to
___________________ simply absorb the risk and take no specific actions to avoid or
minimize it. More often, though, we’ll want to contemplate actions
___________________ that will either minimize the likelihood of the risk turning into
___________________ a problem, or reduce the negative impact of that problem on our
project.
___________________
A risk is something that may happen and if it does, will have an
adverse impact on the project. A few points are here. “That may
happen” implies a probability of less than 100%. If it has a
probability of 100% – in other words it will happen – it is an
issue. An issue is managed differently to a risk and we will handle
issue management in a later white paper. A risk must also have
a probability something above 0%. It must be a chance to happen
or it is not a risk.
The second thing to consider from the definition is “will have an
adverse impact”. If it will not have an adverse impact, it is not
a risk. Suppose we said a risk was that we would find the project
less complicated than we thought, and could finish early. Unless
finishing early has an adverse effect on the project, it is not a
risk.
Risk Management
The principles of project risk management can be stated very
simply. Any project organization is subject to risks. One which
finds itself in a state of perpetual crisis is failing to manage risks
properly. Failure to manage risks is characterized by inability to
decide what to do, when to do it, and whether enough has been
done. Risk Management is a facet of Quality, using basic
techniques of analysis and measurement to ensure that risks are
properly identified, classified, and managed.
In order to manage risks we have to understand what a risk is.
The official definition by Professor James Garven, University of
Texas at Austin is from the American Risk and Insurance
Association:
Unit 13: Risk Management
167
Risk management is the systematic process of managing an
Notes
organization’s risk exposures to achieve its objectives in a manner
consistent with public interest, human safety, environmental ___________________
factors, and the law. It consists of the planning, organizing,
leading, coordinating, and controlling activities undertaken with ___________________
the intent of providing an efficient pre-loss plan that minimizes ___________________
the adverse impact of risk on the organization’s resources,
earnings, and cash flows. ___________________
___________________
Minimising Risk
in Projects ___________________
___________________
___________________
Constraints
___________________
___________________
Uncertainty
Figure 13.1
The most helpful definition is that given by Larry Krantz, Chief

Executive of Euro Log Ltd. here in the UK. Larry says that ‘A
risk is a combination of constraint and uncertainty’. We all face
constraints in our projects, and also uncertainty. So we can
minimise the risk in the project either by eliminating constraints
(a nice conceit) or by finding and reducing uncertainty.
Risk Management Paradigm

The Risk Management Paradigm is depicted below. The paradigm
illustrates a set of functions that are identified as continuous
activities throughout the life cycle of a project.
• Risk assessment is the process of examining a project and
identifying areas of potential risk. Risk identification can be
facilitated with the help of a check list of common risk areas
for software projects, or by examining the contents of an
organizational database of previously identified risks and
mitigation strategies (both successful and unsuccessful). Risk
analysis involves examining how project outcomes might
change with modification of risk input variables.
• Risk prioritization helps the project focus on its most
severe risks by assessing the risk exposure. Exposure is the
168
product of the probability of incurring a loss due to the risk
Notes
and the potential magnitude of that loss. This prioritization
___________________
can be done in a quantitative way, by estimating the
probability (0.1 – 1.0) and relative loss, on a scale of 1 to 10.
___________________ Multiplying these factors together provide an estimation of
___________________
the risk exposure due to each risk item, which can run from
0.1 (don’t give it another thought) through 10 (stand back,
___________________ here it comes!). The higher the exposure, the more
aggressively the risk should be tackled. It may be easier to
___________________
simply estimate both probability and impact as High, Medium,
___________________ or Low. Those items having at least one dimension rated as
High are the ones to worry about first.
___________________
• Risk avoidance is one way to deal with risk: don’t do the
___________________
risky thing! You may avoid risks by not undertaking certain
___________________ projects, or by relying on proven rather than cutting edge
technologies.
___________________
• Risk control is the process of managing risks to achieve the
desired outcomes. Risk management planning produces a plan
for dealing with each significant risk, including mitigation
approaches, owners, and timelines. Risk resolution is
execution of the plans for dealing with each risk. Finally,
risk monitoring involves tracking your progress toward
resolving each risk item.
Check Your Progress
Fill in the blanks:
1. A .................... is a combination of constraint and uncertainty.
2. The .................... illustrates a set of functions that are identified as

continuous activities throughout the life cycle of a project.
3. .................... involves examining how project outcomes might change

with modification of risk input variables.
4. .................... is the process of managing risks to achieve the desired

outcomes.
The functions of Risk Management are introduced below. Each

risk nominally goes through these functions sequentially, but the
activity occurs continuously, concurrently (e.g., risks are tracked
in parallel while new risks are identified and analyzed), and
iteratively (e.g., the mitigation plan for one risk may yield another
risk) throughout the project life cycle.
Unit 13: Risk Management
169
Table 13.1: Elements of Risk Management
Notes
Function Description
Identify Search for and locate risks before they become ___________________
problems.
___________________
Analyze Transform risk data into decision-making information.
Evaluate impact, probability, and timeframe, classify ___________________
risks, and prioritize risks.
___________________
Plan Translate risk information into decisions and actions
(both present and future) and implement those ___________________
actions.
___________________
Track Monitor risk indicators and mitigation actions.
Control Correct for deviations from the risk mitigation plans. ___________________
Communicate Provide information and feedback internal and ___________________

external to the project on the risk activities, current
risks, and emerging risks. ___________________
___________________
Note: Communication happens throughout all the functions of risk
management.
There are two stages in the process of Project Risk Management,

Risk Assessment and Risk Control. Risk Assessment can take
place at any time during the project, though the sooner the better.
However, Risk Control cannot be effective without a previous
Risk Assessment. Similarly, most people tend to think that having
performed a Risk Assessment; they have done all that is needed.
Far too many projects spend a great deal of effort on Risk
Assessment and then ignore Risk control completely.
1. Risk Assessment has three elements:
• Identify Uncertainties: Explore the entire project plans
and look for areas of uncertainty.
Effective Risk Management
Plan for Measure and

Mitigate Risks
Emergencies Control
Risk Control
Identify Analyse Risks Prioritise Risks

Uncertainties
Risk Assessment
Risk Management
Figure 13.2
• Analyze Risks: Specify how those areas of uncertainty can

impact the performance of the project, either in duration,
cost or meeting the users’ requirements.
170
• Prioritize Risks: Establish which of those Risks should be
Notes eliminated completely, because of potential extreme
impact, which should have regular management attention,
___________________ and which are sufficiently minor to avoid detailed
management attention.
___________________
2. In the same way, Risk Control has three elements, as follows:
___________________ • Mitigate Risks: Take whatever actions are possible in
___________________
advance to reduce the effect of Risk. It is better to spend
money on mitigation than to include contingency in the
___________________ plan.
• Plan for Emergencies: For all those Risks which are
___________________
deemed to be significant, have an emergency plan in place
___________________ before it happens.
• Measure and Control: Track the effects of the risks
___________________ identified and manage them to a successful conclusion.
___________________
Check Your Progress
1. There are two stages in the process of Project Risk Management,
................... and ................... .
2. Risk Control cannot be effective without a previous ................... .
Summary
Risk management is a discipline for dealing with the possibility
that some future event will cause harm. It provides strategies,
techniques, and an approach to recognizing and confronting any
threat faced by an organization in fulfilling its mission. Typically,
Risk Management facilitates the consolidation of insurance related
information, such as claims from multiple sources, property
values, policy information, and exposure information, into one
system. Often, Risk Management applies primarily to “casualty”
claims/loss data systems. Such casualty coverage’s include Auto
Liability, Auto Physical Damage, Workers’ Compensation, General
Liability and Products Liability. Risk management is very
important to all the companies throughout the whole world
because of the fact that the companies have to face troubles in
different fields. The prioritizing of all the risks is one of the main
things that have to be taken care of. Among all the risks that are
parts of the whole running methods of the companies some are
critical and they should be taken to the priority at the very first
hand. Otherwise the company may fall into irreparable trouble.

1. What is the difference between risk and uncertainty? Why
risk evaluation is important for any project?
2. What is Risk Management paradigm? What are the activities
that need to be monitored throughout the life cycle of a
project?
171
Unit 14 Notes
Risk Identification, Analysis and ___________________
___________________
Control ___________________
___________________
\ Risk Identification
___________________
\ Risk Analysis
___________________
\ Risk Contol
___________________
___________________
Introduction
Risk is defined as an event that has a probability of occurring,
and could have either a positive or negative impact to a project
should that risk occur. A risk may have one or more causes and,
if it occurs, one or more impacts. For example, a cause may be
requiring an environmental permit to do work, or having limited
personnel assigned to design the project. The risk event is that
the permitting agency may take longer than planned to issue a
permit, or the assigned personnel available and assigned may not
be adequate for the activity. If either of these uncertain events
occurs, there may be an impact on the project cost, schedule or
performance. All projects assume some element of risk, and it’s
through risk management where tools and techniques are applied
to monitor and track those events that have the potential to
impact the outcome of a project.
Risk management is an ongoing process that continues through
the life of a project. It includes processes for risk management
planning, identification, analysis, monitoring and control. Many
of these processes are updated throughout the project lifecycle
as new risks can be identified at any time. It’s the objective of
risk management to decrease the probability and impact of events
adverse to the project. On the other hand, any event that could
have a positive impact should be exploited.
The identification of risk normally starts before the project is
initiated, and the number of risks increase as the project matures
through the lifecycle. When a risk is identified, it’s first assessed
to ascertain the probability of occurring, the degree of impact to
172
the schedule, scope, cost, and quality, and then prioritized. Risk
Notes
events may impact only one or while others may impact the
project in multiple impact categories. The probability of
___________________
occurrence, number of categories impacted and the degree (high,
___________________ medium, low) to which they impact the project will be the basis
for assigning the risk priority. All identifiable risks should be
___________________
entered into a risk register, and documented as a risk statement.
___________________
Risk Identification
___________________
Risk Identification ascertains which risks have the potential of
___________________
affecting the project and documenting the risks’ characteristics.
___________________ Risk Identification begins after the Risk Management Plan is
constructed and continues iteratively throughout the project
___________________
execution. The Risk Identification process naturally progresses
___________________ into the Qualitative Risk Analysis or the Quantitative Risk
Analysis Process. Sometimes, it is wise to include the
___________________ identification of a risk and its response in order for it to be
included in Risk
At the beginning of the Risk Identification process it is a good
idea to have gathered all of the inputs you and your team will
need. The inputs to the Risk Identification Process are:
• The Project Management Plan: The Project Management
Plan is used in gain an understanding of the project’s mission,
scope, schedule, cost, Work Breakdown Structure (WBS),
quality criteria, and other elements.
• Risk Management Plan: The Risk Management Plan
provides the blueprint of overseeing risk management
throughout the project describing who, what, when, where,
why, and how. The Risk Management Plan provides the
following four critical inputs to Risk Identification:
– Assignment of roles and responsibilities: Identifying the
who of risk management by assigning the handling of
specific tasks and roles to specific individuals.
– Budget provisions for risk-management activities: The
approved funds available for risk-management activities.
You will need to track your actual costs against these
approved budget numbers.
– Schedule for risk management: The revised schedule
including the time needed for risk-management activities
over the duration of the project’s lifecycle.
– Categories of risk: The risk categories are used during
Risk Identification to organize and prioritize risks as they
are identified. Alternatively, the Risk Breakdown
Structure (RBS) may be the source of risk categories.
Unit 14: Risk Identification, Analysis and Control
173
• Project Scope Statement: The project scope statement
Notes
defines the project boundaries and assumptions. During Risk
Identification, risks to boundaries must be identified in order
___________________
to mitigate scope creep, and assumptions must be reassessed
to identify risks associated with them. ___________________
• Organizational process assets: Organizational process ___________________

assets provide information from prior projects including
___________________
historical information and lessons learned.
• Enterprise environmental factors: These factors include ___________________
any and all external environmental factors and internal ___________________
organizational environmental factors that surround or
influence the project’s success, such as organizational culture ___________________
and structure, infrastructure, existing resources, commercial
___________________
databases, market conditions, and project management
software. ___________________
After gathering all necessary inputs, it is tie to employ the ___________________

recommended tools and techniques of risk identification. The tools
and techniques are:
• Documentation reviews: Documentation reviews involve
comprehensively reviewing the project documents and
assumptions from the project overview and detailed scope
perspective in order to identify areas of inconsistency or
lack of clarity. Missing information and inconsistencies are
indicators of a hidden risk.
• Information gathering techniques: Information gathering
techniques are used to develop lists of risks and risk
characteristics. Each technique is helpful for collecting a
particular kind of information. The five techniques are:
– Brainstorming: Brainstorm is employed as a general data-
gathering and creativity technique which identifies risks,
ideas, or solutions to issues. Brain storming uses a group
of team members or subject-matter experts spring boarding
off each other’s ideas, to generate new ideas.
– Delphi technique: The Delphi technique gains information
from experts, anonymously, about the likelihood of future
events (risks) occurring. The technique eliminates bias
and prevents any one expert from having undue influence
on the others.
– Interviewing: Interviewing in a face-to-face meeting
comprised of project participants, stakeholders, subject-
matter experts, and individuals who may have participated
in similar, past projects is a technique for gaining first-
hand information about and benefit of others’ experience
and knowledge.
174
– Root cause identification: Root cause identification is a
Notes
technique for identifying essential causes of risk. Using
data from an actual risk event, the technique enables you
___________________
to find out what happened and how it happened, and
___________________ understand why it happened, so that you can devise
responses to prevent recurrences.
___________________
– Strengths, weaknesses, opportunities, and threats (SWOT)
___________________
analysis: A SWOT analysis examines the project from the
___________________ perspective of each project’s strengths, weaknesses,
opportunities, and threats to increase the breadth of the
___________________ risks considered by risk management.
___________________ • Checklist analysis: Checklists list all identified or potential
risks in one place. Checklists are commonly developed from
___________________
historical information or lessons learned. The Risk
___________________ Breakdown Structure (RBS) can also be used as a checklist.
Just keep in mind that checklists are never comprehensive,
___________________
so using another technique is still necessary.
• Assumptions analysis: All projects are initially planned on
a set of assumptions and what if scenarios. These assumptions
are documented in the Project Scope Document. During Risk
Identification, assumptions are analysed to determine the
amount of inaccuracy, inconsistency, or incompleteness
associated with them.
• Diagramming techniques: Diagramming techniques, such
as system flow charts, cause-and-effect diagrams, and
influence diagrams are used to uncover risks that aren’t
readily apparent in verbal descriptions.
– Cause-and-effect diagrams: Cause and effect diagrams or
fishbone diagrams are used for identifying causes of risk
– System or process flow charts: Flow charts illustrate how
elements and processes interrelate.
– Influence diagrams: Influence diagrams depict causal
influences, time ordering of events and other relationships
between input variables and output variables.
The tools and techniques used for the Risk Identification process
are designed to help the project manager gather information,
analyse it, and identify risks to and opportunities for the project’s
objectives, scope, cost, and budget. The information gathered is
entered on the Risk Register, which is the primary output of
Risk Identification.
• Risk Register: The Risk Register containing the results of
the Qualitative Risk Analysis, Quantitative Risk Analysis,
and Risk Response Planning. The Risk Register illustrates
175
all identified risks, including description, category, and cause,
Notes
probability of occurring, and impact on objectives, proposed
responses, owners, and current status. While the risk register
___________________
will become the comprehensive output, Risk Identification
process results in four entries in the Risk Register: ___________________
– Lists of identified risks: Identified Risks with their root ___________________

causes and risk assumptions are listed.
___________________
– List of potential responses: Potential responses identified
here will serve as inputs to the Risk Response Planning ___________________
process. ___________________
– Root causes of risk: Root causes of risk are fundamental
___________________
conditions which cause the identified risk.
___________________
– Updated risk categories: The process of identifying risks
can lead to new risk categories being added. ___________________
___________________
Check Your Progress
Fill in the blanks:
1. .................... ascertains which risks have the potential of affecting the

project and documenting the risks’ characteristics.
2. The .................... statement defines the project boundaries and

assumptions.
3. .................... is a technique for identifying essential causes of risk.
4. .................... are commonly developed from historical information or

lessons learned.
Risk Analysis
Once risks have been identified, they must then be assessed as
to their potential severity of loss and to the probability of
occurrence. These quantities can be either simple to measure, in
the case of the value of a lost building, or impossible to know for
sure in the case of the probability of an unlikely event occurring.
Therefore, in the assessment process it is critical to make the
best educated guesses possible in order to properly prioritize the
implementation of the risk management plan.
The fundamental difficulty in risk assessment is determining the
rate of occurrence since statistical information is not available on
all kinds of past incidents. Furthermore, evaluating the severity
of the consequences (impact) is often quite difficult for immaterial
assets. Asset valuation is another question that needs to be
addressed. Thus, best educated opinions and available statistics
are the primary sources of information. Nevertheless, risk
176
assessment should produce such information for the management
Notes
of the organization that the primary risks are easy to understand
and that the risk management decisions may be prioritized. Thus,
___________________
there have been several theories and attempts to quantify risks.
___________________
The chart plots Probability of occurrence of a risk, which is another
___________________ way of saying how uncertain the success of the task would be,
against the Impact. By Impact we mean the severity of the effect
___________________ on the budget, the timeliness of project completion, or the ability
___________________ of the project to meet the users’ requirements. Whether the
severity of Impact or the Probability is high or low is a matter for
___________________ the judgement of the Risk Assessor and the Project Manager –
even with rational method involved we are still talking of an art!
___________________
The four sectors of the graph may be classified as:
___________________
___________________
4
___________________ Medium Critical
3
Probability
2
Low High
1
1 2 3 4
Impact
Figure 14.1
Tigers
• High Probability, High Impact
These are dangerous animals and must be neutralised as
soon as possible.
Alligators
• Low Probability, High Impact.
These are dangerous animals which can be avoided with care.
Puppies
• High Probability, Low Impact.
We all know that delightful pup will grow into an animal
which damage, but a little training can do will ensure that
not too much trouble ensures.
Kittens
• Low Probability, Low Impact.
The largest cat is rarely the source of trouble, but on the
other hand a lot of effort can be wasted on training it.
177
List each of your identified Risks, decide on the probability
occurrence of each, and define the expected impact on schedule, Notes
budget, and ability to meet the users’ requirements. Tigers have
___________________
to be neutralised i.e., the risks must be mitigated early on.
Alligators have to be watched, and there must be an action plan ___________________
in place to stop them from interfering with the project. Puppies
similarly have to be watched, but less stringently and with less ___________________
urgent containment plans. Kittens can be ignored at the peril of ___________________
the project manager.
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. Once risks have been identified, they must then be assessed as to their
...................... of loss and to the probability of occurrence. ___________________
2. The fundamental difficulty in risk assessment is determining the rate of ___________________

...................... since statistical information is not available on all kinds
___________________
of past incidents.
Risk Control
1. Mitigate Risks: You would do this for all those risks
categorised above as Tigers. We can mitigate risks by
reducing either the probability or the impact. Remember
that we identified the risk by seeking uncertainty in the
project. The probability can be reduced by action up front to
ensure that a particular risk is reduced. An example is to
employ a team to run some testing on a particular data base
or data structure to ensure that it will work when the
remainder of the project is put together around it. The
technique of building a pilot phase of the project is an
example of risk mitigation. Unfortunately it often fails,
because the team works closely with the pilot user group,
and then thinks that all the problems are solved for the roll
out. This is rarely the case.
Elements of Risk Control
Mitigate Risks
Plan for
Risk Control Emergencies
Measure and
Control
Figure 14.2
178
2. Plan for Emergencies: By performing the risk assessment,
Notes
we know the most likely areas of the project which will go
___________________
wrong. So the project risk plan should include, against each
identified risk, an emergency plan to recover from the risk.
___________________ As a minimum, this plan will name the person accountable
___________________
for recovery from the risk, the nature of the risk and the
action to be taken to resolve it, and the method by which
___________________ the risk can be spotted. A risk which has been mitigated
may still be a significant and dangerous risk – it is rare for
___________________
a tiger to be converted to a kitten by action before the event.
___________________ These will require emergency plans as well as alligators
and puppies. Kittens can probably be allowed to play at
___________________
will; provided we are satisfied they really are kittens!
___________________
3. Measure and Control: The owner of each risk should be
___________________ responsible to the project manager to monitor his risk, and
to take appropriate action to prevent it from going on, or to
___________________
take recovery action if the problem does occur.
Nothing can be controlled which cannot be measured. In a project

there are three things which can always be measured – the
schedule, the cost, and the users’ satisfaction. For some more
detailed thoughts on this topic see Elements of Project Success.
If, when you get to this point, you realize that you cannot measure
a particular risk, then back you go into Risk Assessment.
Check Your Progress
Fill in the blanks:
1. The technique of building a pilot phase of the project is an example of

........................ .
2. Nothing can be ........................ which cannot be measured.
Summary
Risk Identification ascertains which risks have the potential of
affecting the project and documenting the risks’ characteristics.
Risk Identification begins after the risk management Plan is
constructed and continues iteratively throughout the project
execution. The risk identification process naturally progresses
into the qualitative risk analysis or the quantitative risk analysis
process. Sometimes it is wise to include the identification of a
risk and its response in order for it to be included in Risk
Once risks have been identified, they must then be assessed as

to their potential severity of loss and to the probability of
179
occurrence. These quantities can be either simple to measure, in
Notes
the case of the value of a lost building, or impossible to know for
sure in the case of the probability of an unlikely event occurring. ___________________
Therefore, in the assessment process it is critical to make the
best educated guesses possible in order to properly prioritize the ___________________
implementation of the risk management plan. ___________________
A risk control is a mechanism or process that minimises the risk ___________________
of the hazard becoming actual so protects people, property or the
environment from the identified hazard. ___________________
___________________
___________________
1. What are the steps involved in risk analysis?
___________________
2. What is Risk Control? Write all the important steps involved
in that. ___________________
___________________
181
Unit 15 Notes
Case Study ___________________
___________________
___________________

After analysing this case, the student will have an appreciation of the concept ___________________
of topics studied in this Block.
___________________
___________________
Case Study: Raising Finance for SMEs – Beeson
___________________
Gregory
___________________
Introduction ___________________
It was the European Commission that first coined the term ‘small and
medium enterprise’ (SME) to describe businesses which employ less
than 500 workers.
This case study focuses upon the role of Beeson Gregory, a City based
corporate adviser and stockbroker, which specialises in serving the
needs of entrepreneurial and growing companies within the SME sector.
The study examines the source of finance and the way SMEs find
access to it.
Beeson Gregory is a service driven business providing solutions tailored

to the needs of its individual clients. In recent years, it has benefited
from its niche position as adviser to European small and medium
sized growth companies. The firm’s objective is to inform small and
medium sized European companies on all aspects of corporate advice.
Beeson Gregory’s key areas of expertise are divided into:
• Corporate advice: Beeson Gregory provides advice on various forms
of finance, including floating companies on the stock market through
offering shares to the public, as well as secondary issues, i.e. providing
further finance to existing public companies. Advice is also provided
on buying and selling companies through acquisitions, disposals,
take-overs and mergers.
• Broking: The Beeson Gregory team provides a range of stock broking
services that includes identifying clients’ investment requirements,
opportunities for investment and maintaining a regular flow of
information between the company and investors.
• Market-making: Market-making involves finding buyers and sellers
for corporate stocks and shares. Beeson Gregory acts as market-
maker for clients on the central securities market of the London
Stock Exchange (known as the official list), the Alternative
Contd…
182
Notes Investment Market (AIM – the market for firms that are too young
or too small to be quoted on the full exchange), as well as EASDAQ
___________________ (the European Association of Securities Dealers Automated Quotation
– a pan – European market for medium-sized technology companies).
___________________
The importance of SMEs is now recognised by government as the
___________________ principal source of economic growth as well as employment
opportunities. Access to finance is critical to the development of this
___________________ sector of the economy. Recent investment trends, both in the UK and
world-wide, have focused on larger companies which have created
___________________
obvious difficulties.
___________________
SMEs
___________________ The European Commission divided SMEs into three sectors:
___________________ • Micro enterprises: Those with between one and nine employees.
___________________ • Small enterprises: Those with ten to 99 employees.
___________________
• Medium enterprises: Those with 100–499 employees.
The European Commission argued that the significant difference

between SMEs and large organisations is that they operate in a
business environment of greater uncertainty. A further difference is
their role in innovation. SMEs play a vital role in the way they
innovate quickly in niche markets – such as technology – and supply
alternatives to the standardised products and services provided by
large organisations. As a result, they are a breeding ground for new
industries and, as the ‘seedbed’ for tomorrow’s companies, they provide
key investment opportunities.
Many would claim that the key role and contribution of small and
medium sized enterprises to the economy in the UK is undervalued.
For example, if a number of people on the street were asked to name
any ten businesses, the chances are they would identify the well-
known corporate giants whose names appear constantly across the
media. Yet there are more than 3.4 million self-employed people in
the United Kingdom and over half the people in commercial and
industrial employment in the UK work for small or medium-sized
businesses.
Nowhere is the difference between large and small businesses more

distinct than on the London Stock Exchange, the UK’s stock market
for securities. Like Tokyo and New York, this is one of the biggest
markets in the world with an annual turnover of over one thousand
billion pounds. It plays a unique role in providing opportunities for
business organisations to raise the funds they require for investment.
Market capitalisation is the term used to describe the value placed

upon a company by the stock market – it is the number of shares
issued by each company multiplied by its market price. On the London
Stock Exchange more than 95% of market capitalisation is in the top
100 companies. This means 5% of the worth of the corporate sector
Contd…
Unit 15: Case Study
183
remaining contains 95% of the remaining companies listed on the Notes
stockmarket.
Investing in SMEs ___________________
The MacMillan Committee report, in 1931, examined the financing of ___________________

small firms and discovered it was extremely difficult to raise long-
___________________
term finance in amounts of less than £ 200,000. This became known
as the ‘MacMillanGap’. ___________________
Though, over the years, there have been a number of changes and ___________________
opportunities in the ways that SMEs are financed, it is still the case
that many smaller business owners feel that they are penalised by ___________________
markets because of their size. The concept of the ‘gap’ therefore still
exists and it is still more difficult to raise finance for small rather ___________________
than large businesses. ___________________
It has been said that a small firm is as different from a large firm as
___________________
a ‘caterpillar is from a butterfly’. As SMEs only have a small share of
the marketplace, they tend to be price-takers rather than price-makers. ___________________
However, unlike large organisations where management may often
be about control and organisation, SMEs have considerable flexibility,
mainly because the relationship between the business and the main
investor is very close.
Although the risks involved in investing in SMEs are greater than for
those of established companies, there is always the opportunity of
larger overall returns. SMEs also by their very nature have far greater
growth potential. Many of the corporate giants today were, only a few
years ago, SMEs themselves. For example, Seton Healthcare plc was
floated by Beeson Gregory in 1991 with a value of £20 million and has
today through acquisition and growth progressed into a one and a half
billion pound company, manufacturing and supplying branded healthcare
and consumer products.
There is a clear link between the growth of smaller businesses and

the arrival of new technologies. In recent years, the growth of
information industries has been fuelled by some spectacular successes,
particularly in the area of high technology. Large institutional investors
are frequently attracted to the high growth of SMEs. Although the
bulk of their investment portfolio is in large steady companies known
as ‘blue chips’, they often invest in SMEs in order to provide a more
balanced range of investments, which have potential for higher growth.
Trends in the provision of finance
One recent trend – management buyouts (MBOs) – has led to the

search for better ways of financing SMEs. This is where the
management of the business is given the opportunity to buy ownership
and control of a firm, in the hope they can improve the productivity
of the business. This has been a key reason for the growth of venture
capital.
Contd…
184
Notes Venture capital is risk capital, usually provided in the form of a package,
to provide investment for SMEs. Venture capital companies look for
___________________ good returns as companies build and then provide themselves with an
exit mechanism. This is particularly useful for a business that is
___________________ expanding rapidly but is not yet ready for the stock market.
___________________
Another area of growth, particularly for companies that require either
start-up or early development capital, is that of corporate venturing
___________________ – large companies seeking to invest funds in SMEs. For example,
Reuters, as a large company, set money aside to create a ‘greenhouse
___________________ fund’ that invests in high tech companies. By spreading its investments
across a range of exciting businesses, some of its investment will be
___________________ in companies that move on to become significantly larger and very
successful.
___________________
There is also a real desire by many businesses to ‘go public’ and
___________________ launch their shares on one of the markets of the London Stock
Exchange, particularly the AIM or secondary market.
___________________
Advice in Action
___________________
Beeson Gregory works with SMEs as both a corporate adviser and a
broker. This enables a close relationship with shared objectives based
upon mutual support and trust. On the one hand, Beeson Gregory
wants to make sure the company makes the right decisions, while on
the other acting as a broker through which it identifies and satisfies
the investment requirements of its client.
For example, Beeson Gregory’s role might involve:
• advising a client on a whole range of issues such as the appointment
of non-executive directors or the wording of public announcements.
• helping to create a link between investor and client by organising
site visits.
• producing a prospectus or public documents and advising on
regulating requirements.
• raising capital and placing shares.
• creating a market for shares through its broking and market- making
facilities.
• advising upon secondary issues or take-overs.
• advising companies on a flotation and the new issue market.
• after-sales servicing, which encourages investors to invest in client
companies and keep companies’ stock liquid.
• working with other advisers in helping to take companies to the
next stage of their development. A key element of this process is
for Beeson Gregory to help in building shareholder confidence.
Beeson Gregory also advises on and project manages private placements
which occur away from the London Stock Exchange. Beeson Gregory
is active in linking venture capital companies and corporate venturing
Contd…
Unit 15: Case Study
185
companies with investment opportunities in SMEs. It also links Notes
companies with ‘business angels’ – high net worth individuals, family
trusts, entrepreneurs and enterprises who wish to invest in SMEs. ___________________
Investor relations are also a key role of the broker. This links the
___________________
investment with institutional investors which may involve arranging
meetings for clients, visiting companies and managing the share ___________________
register. The following show examples of how Beeson Gregory helps
clients. ___________________
Cammell Laird Holdings plc
___________________
Cammell Laird Holdings plc is a leading UK company in the ship
conversion and general ship repair market. It operates from a 47 acre ___________________
freehold site in Birkenhead in the North West of England.
___________________
Beeson Gregory’s involvement with the placing of Cammell Laird was
influential in funding the expansion of its business. This raised the ___________________
profile of the company and its reputation with customers, suppliers
___________________
and communities. The placing also provided Cammell Laird with the
working capital necessary to finance increased levels of activity and ___________________
facilitate its future growth through acquisition.
Baltimore Technologies plc
Baltimore Technologies plc was formed by the merger between Zergo
Holdings plc and Baltimore Technologies Limited in January 1999.
Baltimore is a global leader in E-commerce and enterprise security
solutions and is one of the leading international providers of information
security products and services for E-business through its public key
infrastructure products (PKI). Security is one of the fastest growing
areas of IT spending. Beeson Gregory has acted as broker and adviser
to the company through its development as an AIM company valued
at under £20 million to a company on the Official List valued at over
£ 300 million.
Conclusion
Beeson Gregory helps SMEs to overcome the difficulties involved in
raising funds to finance business activities by developing partnerships
that lead to a variety of key investment opportunities for its clients.
In a world where the external environment is constantly changing,
Beeson Gregory assists its clients by providing them with stability and
certainty. At the heart of this process is an element of trust which
enables Beeson Gregory to work with other organisations towards
shared objectives.
Questions
Source: http://businesscasestudies.co.uk/beeson-gregory/raising-finance-
for-smes/intr.html#axzz2RNdD3Cms.
Block–IV
Detailed Contents
UNIT-16: RISK PLANNING
UNIT-17: INCENTIVE FOR NON-CONVENTIONAL PROJECTS
UNIT-18: FINANCING NON-CONVENTIONAL PROJECTS
UNIT-19: IREDA AND ITS ROLE
UNIT-20: CASE STUDY

189
Unit 16 Notes
Risk Planning ___________________
___________________
___________________
___________________
___________________
\ Potential Risk Treatment
___________________
\ Create Risk Mitigation Plan
___________________
\ Types of Risk
\ Financial Feasibility ___________________
\ Risk Management and Insurance Planning ___________________
Introduction
As a part of documenting a risk, two important items need to be
addressed:
1. Mitigation steps that can be taken to lessen the probability
of the event occurring.
2. Contingency plan, or a series of activities that should take
place either prior to, or when the event occurs.
Mitigation actions frequently come at a cost. Sometimes, the cost
of mitigating a risk can exceed the cost of assuming the risk and
incurring the consequences. It is important to evaluate the
probability and impact of each risk against the Mitigation Strategy
Cost before deciding to implement a contingency plan.
Contingency plans implemented prior to the risk occurring are,
pre-emptive actions intended to reduce the impact or remove the
risk in its entirety. Contingency plans implemented after a risk
occurs, can only lessen the impact.
Identifying and documenting events that pose a risk to the
outcome of a project is just the first step. It is equally important
to monitor all risks on a scheduled basis by a risk management
team and reported on in the project status report.
190
Notes
Potential Risks Treatment
Ideal use of these strategies may not be possible. Some of them
___________________
may involve trade-offs that are not acceptable to the organization
___________________ or person making the risk management decisions.
___________________ Risk Avoidance

___________________ It includes not performing a risky activity. An example would be,
not buying a property or business to avoid the liability that comes
___________________
with it. Another would be, not flying in order to not take the risk
___________________ of hijackacking. Avoidance may seem an answer to all risks, but
avoiding risks also means losing out on the potential gain that
___________________
accepting (retaining) the risk may have allowed. Not entering a
___________________ business to avoid the risk of loss also avoids the possibility of
earning profits.
___________________
___________________
Risk Reduction
It involves methods that reduce the severity of the loss. Examples
include, sprinklers designed to put out a fire to reduce the risk
of loss by fire. This method may cause a greater loss by water
damage and therefore may not be suitable. Halon fire suppression
systems may mitigate that risk but, the cost may be prohibitive
for a strategy.
Modern software development methodologies reduce risk by
developing and delivering software incrementally. Early
methodologies suffered from the fact that they only delivered
software in the final phase of development. Hence, any problems
encountered in the earlier phases meant costly rework and often
jeopardized the whole project.
By developing in iterations, software projects can limit effort
wasted to a single iteration. A current trend in software
development, spearheaded by the Extreme Programming
Community, is to reduce the size of iterations to the smallest size
possible, sometimes as little as one week is allocated to one cycle.
Risk Retention
This involves accepting the loss when it occurs. True self-insurance
falls in this category. Risk retention is a viable strategy for small
risks where the cost of insuring against the risk would be greater
overtime than the total losses sustained. All risks that are not
avoided or transferred are retained by default. This includes,
risks that are so large or catastrophic that they either cannot be
insured against or the premiums would be infeasible. War is an
example since most property and risks are not insured against
war. So, the loss attributed by war is retained by the insured.
Unit 16: Risk Planning
191
Also, any amount of potential loss (risk) over the amount insured
Notes
are retained risk.
This may also be acceptable if the chance of a very large loss is ___________________
small or if the cost to insure for greater coverage amounts is so
___________________
great it would hinder the goals of the organization too much.
___________________
Risk Transfer
___________________
It means, causing another party to accept the risk. Typically, this
done by contract or by hedging. Insurance is one type of risk ___________________
transfer that uses contracts. At other times, it may involve contract ___________________
language that transfers a risk to another party without the
payment of an insurance premium. Liability among construction ___________________
or other contractors is very often transferred this way. On the ___________________
other hand, taking offsetting positions in derivatives is typically
how firms use hedging to financially manage risk. ___________________
Some ways of managing risks fall into multiple categories. Risk ___________________
retention pools are technically retaining the risk for the group
but spreading it over the whole group involves risk transfer among
individual members of the group. This is different from traditional
insurance. Here, no premium is exchanged between members of
the group up front instead, losses are assessed to all members of
the group.
Outsourcing is another example of Risk transfer. Here, companies
outsource, IT, BPO, KPO, jobs. In IT, some companies outsource
only development work and the product is made offshore.
Whereas, business requirements are handled onshore/ at client
site.
This way, companies can concentrate more on business
development rather than managing a large group of IT
development team.
Check Your Progress
Fill in the blanks:
1. ................. includes not performing an activity that could carry risk.
2. ................. involves methods that reduce severity of loss.
3. ................. involves accepting loss when it occurs.
Create a Risk Mitigation Plan

Select appropriate controls or counter-measures to measure each
risk. Risk mitigation needs to be approved by appropriate levels
of management. For example, risks concerning the image of the
192
organization requires top management decision whereas, IT
Notes
management would have the authority to decide on computer
virus risks.
___________________
The risk management plan should propose applicable and effective
___________________
security controls for managing risks. For example, an observed
___________________ high risk of computer viruses could be mitigated by acquiring
and implementing anti-virus software. A good risk management
___________________
plan should contain a schedule for control implementation and
___________________ responsible persons for those actions.
___________________ According to ISO/IEC 27001, the stage immediately after

completion of the Risk Assessment phase consists of preparing a
___________________
Risk Treatment Plan. This should document the decision how
___________________ each of the identified risks should be handled. Mitigation of risks
often means, selection of Security Controls. This should be
___________________ documented in a Statement of Applicability. This identifies which
___________________ particular control objectives and controls from the standard have
been selected and, why.
Implementation
• Follow all the planned methods for mitigating effects of risks.
• Purchase insurance policies for identified risks to be
transferred to an insurer.
• Avoid all risks that can be avoided without sacrificing the
entity’s goals, reduce others and retain the rest.
Review and Evaluation of the Plan

Initial risk management plans will never be perfect. Practice,
experience and actual loss will necessitate changes in the plan
and contribute information to allow possible different decisions
to be made in dealing with the risks being faced.
Risk analysis results and management plans should be updated
periodically. There are two primary reasons for this. These are,
to evaluate:
1. Whether the previously selected security controls are still
applicable and effective.
2. The possible risk level changes in the business environment.
Information risks are a good example of rapidly changing
business environment.
Whenever an activity takes place, there will be an outcome that
will either be success or failure. In undertaking the activity, there
will be a number of factors that need to be achieved. These will
determine whether the activity is a success or not.
193
In other words, there are a number of risk factors which, if they
Notes
are not managed properly, will result in failure rather than
success.
___________________
In all organizations, risk management is now expected to be a
___________________
part of the governance structure. The governing bodies are
expected to adopt a holistic approach to risk management that ___________________
builds the simple concepts discussed earlier, into the structures
___________________
and processes of the organization. The key elements of these best
practices are: ___________________
1. The governing body establishes an overall risk policy that ___________________

sets the organization’s acceptable appetite for risk and the
___________________
roles and responsibilities for identifying and managing risks
throughout the organization. ___________________
2. The governing body maintains an overall risk register, ___________________
identifying the main risks to the organization’s goals and
objectives. Substantial sub-organizations should also maintain ___________________
a risk register.
3. Individuals will be assigned responsibility for ensuring that
each risk is being properly managed (both the risk itself and
the contingency plan if the risk materializes).
4. Risk assessment becomes a part of the decision-making
process of the organization.
5. Risk assessment becomes an integral part of the planning
and budgeting processes.
6. Risk assessment becomes part of the operational activities.
7. Managerial and internal controls reflect the identified risks.
8. A Risk Management Committee is formed to inform the
Governing Body of Risk Management issues and to ensure
effective operation of risk management processes.
9. Internal Audit activity can focus more on areas of risk as
identified in the Risk Register(s).
10. The Governing Body establishes processes for, reporting,
reviewing and auditing risks. This enables satisfaction that
throughout the organization, the key risks are being managed
properly and the internal control framework is effective.
Limitations
If risks are improperly assessed and prioritized, time may be
wasted in dealing with risk of unlikely losses. Spending too much
time assessing and managing unlikely risks can divert resources
that could be used profitably. Unlikely events do occur but, if the
194
risk is unlikely enough to occur it may be better to simply retain
Notes
the risk and deal with the result if the loss does in fact, occur.
___________________ Prioritizing too highly, the risk management processes could keep
an organization from ever completing a project or even getting
___________________
started. This is especially true if other work is suspended until
___________________ the risk management process is considered complete.
___________________ It is also important to keep in mind the distinction between risk
and uncertainty. Risk can be measured by impacts ‘x’ probability.
___________________
___________________ 1. .................... needs to be approved by an appropriate level of

management.
___________________
2. Initial risk management plans will never be .................... .
___________________
3. Risk analysis results and management plans should be updated
.................... .
4. Internal Audit activity can focus more on areas of risk as identified in the
.................... .
Types of Risk
The general types of risk faced by all businesses can be grouped
into five broad categories:
• Market Risk (unexpected changes in interest rates, exchange
rates, stock prices, or commodity prices).
• Credit/Default Risk.
• Operational Risk (Equipment Failure, Fraud).
• Liquidity Risk (inability to pay bills, inability to buy or sell
commodities at quoted prices).
• Political Risk (new regulations, expropriation).
In addition, the financial future of a business enterprise can be
dramatically altered by unpredictable events such as, depression,
war or technological breakthroughs. Their probability of
occurrence cannot be reasonably quantified from historical data.
Businesses operating in the petroleum, natural gas and electricity
industries are particularly susceptible to market risk — or more
specifically, price risk — as a consequence of the extreme volatility
of energy commodity prices.
195
To a large extent, energy company managers and investors can
Notes
make accurate estimates of the likely success of exploration
ventures, refinery failures or, performance of electricity
___________________
generators. Diversification, long- term contracts, inventory
maintenance and insurance are effective tools for managing such ___________________
risks. Such traditional approaches do not work well, however, for
___________________
managing price risk.
___________________
With the onset of domestic market deregulation in the 1980s,
stable administered prices for petroleum products and natural ___________________
gas gave way to widely fluctuating spot market prices. Similarly,
___________________
in the late 1990s, deregulation of wholesale electricity markets
revealed that electricity prices, when free to respond to supply ___________________
and demand, can vary by factors of more than 100 over periods
of days or even hours. Spot prices for natural gas and electricity ___________________
can also vary widely by location. International crude oil prices ___________________
have long been volatile.
___________________
When energy prices fall, so do the equity value of producing
companies. As a result, ready cash becomes scarce and it is more
likely that contract obligations for energy sales or purchases may
not be honoured. When prices soar, governments tend to step in
to protect consumers.
Thus, commodity price risk plays a dominant role in the energy
industries. Thus, the use of derivatives has become a common
means of helping energy firms, investors and customers manage
the risks that arise from the high volatility of energy prices.
Derivatives are particularly useful for managing price risk. Their
use in the energy arena is not surprising. They have been used
successfully to manage agriculture price risk for more than a
century. Deregulation of domestic energy industries has shown
price risk to be greater for energy than for other commodities. In
a sense, energy derivatives are a natural outgrowth of market
deregulation. Derivatives allow investors to transfer risk to others
who could profit from taking the risk. This has become a popular
way for investors to isolate cash earnings from price fluctuations.
Energy price risk has economic consequences of general interest
because it can decisively affect whether desirable investments in
energy projects are actually made. Investments in large power
plants run from ` 200 million to over ` 1 billion, and the plants
take 2 to 7 years to construct.
Following general discussions of Risk Management without and
with the use of derivatives, descriptions of various kinds of
derivative contracts and a brief analysis of energy price volatility,
this unit presents an illustration of the potential impact of price
196
volatility on the economics of investment in a natural-gas-fired
Notes
combined-cycle electricity generator.
___________________ Combined-cycle generators are of particular interest because the
Energy Information Administration (EIA) and other forecasters
___________________
expect them to be the dominant choice for investments in new
___________________ generating capacity over the next decade. The example shows
that an economically efficient investment - one that is in society’s
___________________
interest to undertake - could generate large cash losses that must
___________________ be managed.
___________________
Financial Feasibility
___________________
Financial feasibility study analyses total facility costs, including
___________________ construction and operating expenses and potential facility revenue
that could vary from rental fees, ticket sales, and/ or other forms
___________________
of participant contributions. A business plan that measures the
___________________ adequacy of potential revenues to meet operating, debt service
and replacement costs is developed. Options for Capital financing
are analysed and recommended.
Financial Feasibility Analysis provides decision-makers with the
information as to whether or not they can afford to take up a
project and operate it successfully once constructed.
Financial feasibility involves the capability of the project
organization to raise the appropriate funds needed to implement
the proposed project. Project financing can be a major obstacle in
large multi-party projects because of the level of Capital required.
Loan availability, credit worthiness, equity, and loan schedule
are important aspects of Financial Feasibility Analysis.
To determine the extent to which toll revenues can support debt
retirement, it is instructive to compare the current value of the
project’s cashflow to its Capital cost. The cashflow in this case
refers to the annual stream of toll revenues remaining after paying
for current O&M costs. This is referred to as Net Revenue. This
long-term future cashflow is discounted back to present year rupee
valuation to allow a rupee-to-rupee correlation. The present value
(or discount) rate is used to simulate the project owner’s cost of
Capital.
Check Your Progress

Fill in the blanks:
1. ................. are particularly useful for managing price risk.
2. A ................. analysis provides decision-makers information on whether

or not they can afford to take up the project and operate it successfully
once constructed.
197
Risk Management and Insurance Planning Notes
Risk management has become an integral part of “Corporate
___________________
Governance” and Business Strategy. By definition, risk must have
two attributes: ___________________
• Uncertainty in outcome ___________________
• Impact on utility ___________________
Risk is an event where there is enough information to assess ___________________

both the probability and the consequences. These probabilities
are converted into financial terms. That is why, it is often said ___________________
that Risk management is commonly associated with financial ___________________
markets and financial intermediaries.
___________________
Risk management is not new and it has been in practice in
Banking and Investment sector among others. Now, Risk ___________________
Management has become relevant to management, governance
___________________
and profession as well. In present the business environment, risks
are increasing and that is why Business and Risk are treated as
synonyms of each other.
This is primarily because of the fact that every organization is
exposed to various risks. While many of them are pure risks like,
fire, explosion, chemical release and so on, some are speculative.
Pure risks are handled as operational and safety issues by
professionals and finance personnel. They have to address the
risks arising from failure of operational and safety measures
discussed earlier.
Together, they need to ensure that the organization is able to
withstand any risk or failure of systems and yet continue its
operations without struggle. Risk Management and Insurance
Planning are required for any organization to review their Risk
Management Strategies and to opt for risk transfer measures
like, availing insurance cover.
Many a times, the coordination between the technical or
operational departments and finance department is difficult.
However, an unbiased study on technical risk management
measures adopted and insurance practices followed will help the
management to manage risks effectively and profitably.
In other words, “Risk Management is the Identification, Analysis
and Economic Control of those “risks” which can threaten the
Assets (Property, Human) or the Earning Capacity of an
Enterprise”.
Broadly, Risk Management Studies are conducted with the
following objectives:
198
• To carry out a systematic, critical appraisal of all potential
Notes
risks involving personnel, plant, services and operations (risk
identification, assessment and control).
___________________
• To review the insurance coverage and identify areas of
___________________
coverage to optimize the risk exposure.
___________________
Classification of Risk
___________________
There are various classifications of risk:
___________________
• Financial and Non-financial Risk: Risk may involve
___________________
financial loss in some cases. In others, there is none.
___________________ • Static and Dynamic Risk: Dynamic risks are those resulting
___________________ from changes in the economy. Changes in price level,
consumer tastes, income and output, and technology may
___________________ cause financial loss to members of the economy. Static risks
involve those losses that occur even if there were no changes
___________________
in the economy. For example, perils of nature and dishonesty
of other individuals.
• Fundamental and Particular Risks: Fundamental risks
are caused by conditions more or less beyond an individual’s
control. As a result, they suffer the losses. Examples of such
risks are, earthquakes, floods, etc. Particular risks involve
losses due to events that are felt by individuals rather than
by an entire group. Example of such risks are, car thefts,
accidents, etc.
• Pure and Speculative Risks: Pure risk is used to designate
those situations that involve only the chance of loss or no
loss. Speculative risk describes situations in which though
there is a possibility of loss, but, there’s also a possibility of
gain. Gambling is an example of a speculative risk.
Risk and Insurance

Insurance is the most common method used for transferring risks.
It shifts the risk from an individual to a group. It also provides
a means to pay for losses. Insurance provides an important means
of preventing risk to interfere with a client’s financial objectives.
Hence, insurance is an important tool in risk management.
Getting an insurance ensures that an insurance company/s takes
over risks from customers. Insurers consider every available
quantifiable factor to develop profiles of high and low insurance
risk. Level of risk determines insurance premiums. Generally,
insurance policies involving factors with greater risk of claims
are charged at a higher rate.
199
With such information at hand, insurers can evaluate risk of
Notes
insurance policies with much higher accuracy. To this end, insurers
collect a vast amount of information about policy holders and
___________________
insured objects. Statistical methods and tools based on data mining
techniques can be used to analyse or to determine insurance ___________________
policy risk levels.
___________________
The following types of risks are insurable:
___________________
1. Property Risks or Damage to Physical Assets
___________________
• Acts of God
___________________
• Accidents
___________________
• Breakdown
___________________
2. Financial Risks or Monetary Loss from,
___________________
• Theft and Burglary
• Business Interruption ___________________
• Bad Credit
3. People Risks or Loss to Employees
• Ill Health and Accident
• Death
• Overseas Travel
4. Liabilities Risks or Loss from Operations
• Product liabilities
• Public liability
• Directors and Officers liabilities
5. Errors and Omissions liabilities
Insurance Risk Analysis and Risk Measurement

As with any insurance, the precise scope of coverage is governed
by the terms of the insurance policy. Hence, the analysis of Risk
is very important for the insurer. Following methods are used for
insurance risk analysis:
• Insurance Risk Modelling
• Insurance Scoring
• Scenario Analysis
• Decision Tree
• Simulation
200
Insurance Risk Modelling
Notes
If the past has any guide for predicting future events, Predictive
___________________ Modelling is an excellent technique for Insurance Risk
___________________
Management. Predictive Models are developed from past historical
records of insurance policies, containing financial, demographic,
___________________ psychographic, geographic information, along with properties of
insured objects.
___________________
From the past insurance policy information, Predictive Models
___________________
can learn patterns of different insurance claim ratios and can use
___________________ that to predict risk levels of future insurance policies. It is
important to note that statistical processes require a substantially
___________________
large number of past historical records (or insurance policies)
___________________ containing useful information. Useful information is something
that can be a factor that differentially affects insurance claims
___________________
ratios.
___________________
Insurance Risk Scoring
Insurance risk scoring is a numerical rating of insurance policies.
It measures the level of risk of being claimed.
Scenario Analysis
Various steps are involved in scenario analysis. These include to:
• Determine factors around which scenarios can be built.
• Determine the number of scenarios to be analysed for each
factor.
• Estimate asset cash flows under each scenario.
• Assign probabilities to each scenario.
The most useful information from scenario analysis is the range
of values across different scenarios that provide a snapshot of
the riskiness of the asset. To be effective, the outlined scenarios
must be realistic and cover the spectrum of possibilities. Scenario
analysis is ideally suited for dealing with risk that takes the firm
of discrete outcomes.
Decision Trees
This technique is useful when risk is not only discrete but, also
sequential. The following steps are involved in this process:
• Divide analysis into risk phases.
• Estimate the probabilities of outcome in each phase.
• Define decision points.
201
• Compute cash flows/value at end nodes.
Notes
• Fold back the tree.
___________________
By linking actions and choices to outcomes of uncertain events,
decision trees encourage firms to consider how they should act ___________________
under different circumstances. Since they provide a picture of
___________________
how cash flow unfolds over time, they are useful in deciding what
risks should be protected against and the benefits of doing so. ___________________
Risks that affect an asset concurrently cannot be easily modelled
___________________
in a decision tree.
___________________
Simulation
___________________
Simulations provide a way of examining the consequences of
continuous risk. Simulations allow for more flexibility in the way ___________________
we deal with uncertainty. The steps involved include:
___________________
• Determine the variables
___________________
• Define probability distributions for these variables
• Check for correlation across variables
• Run the simulation
Running a simulation is simplest for firms that pick up same
kind of projects repeatedly. These firms can use their experience
from similar projects already in operation to estimate expected
values for new projects.
Profiling Risky Segments

Profiling insurance risk factors is very important. The Pareto
Principle, (also known as, the 80-20 Rule and the Law of the Vital
Few) states that, for many events, roughly 80 percent of the effects
come from 20 percent of the causes.
Profiling these 20 percent causes that may cause 80 percent of
the risk in the project has to be identified critically. Insurance
rules suggest that 80 percent–90 percent of the insurance claims
may come from 10 percent–20 percent of the insurance segment
groups.
To access the risk and premium, insurance providers often collect
a large amount of information on insured entities. Policy
information such as, automobile insurance, life insurance, general
insurance, etc. often consists of dozens or even hundreds of
variables, involving both categorical and numerical data with noisy
information.
202
Notes
Benefits of Insurance
Insurance offers many benefits. Some are:
___________________
• Indemnification of Loss
___________________
• Reduction of Anxiety
___________________
• Source of Investment Funds
___________________
• Loss Prevention
___________________
• Enhancement of Credit
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. Risk management has become an integral part of .................. and
___________________ .................. .
___________________ 2. .................. Risk may involve financial loss in some cases. In other
cases, there is no financial loss.
3. .................. Risks are those resulting from changes in the economy.
4. Gambling is an example of a .................. Risk.
5. Provide a way of examining the consequences of continuous risk.
Summary
1. Ideal use of strategies to mitigate risk may not be possible.
Some may involve trade-offs that are not acceptable to the
organization or the person taking the risk management
decisions.
2. Select appropriate controls or countermeasures to measure
each risk. Risk mitigation needs to be approved by
appropriate level of management. For example, risk
concerning organizational image should have top management
decision behind it. Whereas, IT Management would have the
authority to decide upon computer virus risk scenarios.
3. General risk types faced by all businesses can be grouped
into five broad categories:
• Market Risk (unexpected changes in interest rates,
exchange rates, stock or commodity prices).
• Credit/Default Risk.
• Operational Risk (equipment failure, fraud).
• Liquidity Risk (inability to pay bills, inability to buy or
sell commodities at quoted prices).
• Political Risk (new regulations, expropriation)
203
4. The object of a financial feasibility study is to analyse total
Notes
facility costs, including construction and operating expenses
and potential facility revenue that could vary from rental
___________________
fees, ticket sales, and/or other forms of participant
contributions. ___________________
5. Risk Management and Insurance Planning are required for ___________________

any organization to review their Risk Management Strategies
___________________
and to opt for risk transfer measures like, availing insurance
cover. ___________________
Questions for Discussion ___________________
1. Name the different types of possible risks in a project. ___________________
2. Write short notes on: ___________________
(i) Decision Tree ___________________
(ii) Risk and Insurance ___________________

205
Unit 17 Notes
Incentive for Non- conventional

Non-conventional ___________________
___________________
Projects ___________________
___________________
___________________
Learning Objectives:
\ Non-conventional Projects ___________________
\ Hydro Power and Biomass Power Projects ___________________

\ MNEs/ GoI Incentives
___________________
___________________
Introduction
Availability of cheap and abundant energy with minimum
environmental and ecological hazards associated with its
production and use is one of the most important factors for
economic growth and improvement in the quality of life of people
living in the developing countries.
In the past, the countries that took the lead in making proper
use of abundant supply of fossil fuels not only overcame the
subsistence threshold, but, were also able to enter the mass
consumption of energy phase.
Moreover, to their advantage, the global environment was able to
act as a vast sink and adverse effects of energy extraction,
conversion and utilization from fossil fuels were not observed.
India started rather late in its infrastructure development
activities and could not benefit from this phase. Along with other
oil importing countries, India suffered a big jolt as a consequence
of the first international oil crisis of 1973.
Development and dissemination of renewable energy technologies
has been actively pursued in India for over 20 years now. The
Indian government took an important initiative in establishing a
Department of Non-Conventional Energy Sources (DNES) in 1982.
It was later upgrading it into a full-fledged Ministry of Non-
Conventional Energy Sources (MNES) in 1991.
Policy makers and researchers have estimated a large potential
for renewable energy utilization in India. There is no doubt that
renewable energy technologies will be increasingly used in the
206
future. However, these are presently facing severe competition
Notes
from conventional fossil fuel-based energy supply systems.
___________________ To make matters worse, many renewable energy systems are
characterized by the sporadic nature of the availability the
___________________
resources and large sizes.
___________________
On the other hand, increasing prices of fossil fuels and of course,
___________________ limited reserves and associated environmental hazards of their
excessive production and utilization have made the renewable
___________________
energy options more attractive.
___________________
It is therefore crucial to optimize the allocation of scarce funds
___________________ by concentrating on those applications which are financially/
economically more rewarding besides being socially acceptable
___________________
and environmentally sustainable.
___________________
So, the Government of India (GoI) is continuously encouraging
___________________ investors into the renewable energy space by providing lots of
incentives and, financial assistance under various schemes.
Generation-based Incentives (GIB) for Grid Connected

Wind Power Projects
The Ministry of New and Renewable Energy (MNRE) has
announced a scheme on GBI for grid connected wind power
projects. The broad aspects of the scheme are:
Objectives
The main objectives of the scheme are:
• Generation of electricity from grid connected wind power
projects through GIB.
• To encourage IPPs, registered companies, NGOs, Trusts,
academic and research institutions, SNAs and such, who will
not avail of accelerated depreciation under the IT Act for
making investments in wind power projects.
• To encourage actual energy generation rather than just
capacity addition. This results in optimum utilization of wind
resources.
• To augment flow of power to the grid to add to grid
stabilization.
Eligibility
The GBI scheme is applicable only for those power producers
who do not avail of the accelerated/enhanced depreciation benefits
under the Income Tax Act. Those power producers who avail of
Unit 17: Incentive for Non-conventional Projects
207
the benefits of the scheme are required to furnish documentary
Notes
proof to this effect. The scheme is applicable only for independent
power producers with minimum installed capacity of 5 MW that
___________________
are commissioned for sale of power to the grid upon announcement
of the scheme. ___________________
The scheme is not applicable to those who set up capacities for ___________________
captive consumption, third party sale, merchant plants among
___________________
others.
___________________
Implementation Arrangements
___________________
The Wind power producers submit application in the prescribed
___________________
format in accordance with the procedure. They also deposit
` 10,000 per MW capacity that they intend to set up as registration ___________________
fee by Demand draft to the IREDA.
___________________
The IREDA assists the Ministry in organizing business meets,
___________________
awareness programs and other related activities, as considered
necessary for promotion of the scheme.
Generation-based Incentives
The Indian government offers accelerated 80 % depreciation on
renewable energy projects to attract investors, however,
Independent Power Producers (IPPs) and Foreign Direct
Investment (FDI) have not been able to avail the accelerated
depreciation provision. In order to increase the investor base of
wind energy projects, the Ministry of New and Renewable Energy
has announced a scheme for Generation Based Incentives (GBI)
of INR 0.5 (1 INR = € 0.015) per kWh of electricity fed into the
grid from wind power projects subject to a maximum of INR 6.2
million per MW installed capacity. The scheme is applicable for
projects set-up before March 2012.
The GBI is above the tariff fixed by the State Regulatory
Commissions for purchase of electricity from wind power projects.
The GBI scheme is applicable for projects up to 4,000 MW only.
The Indian Renewable Energy Development Agency (IREDA)
implements the GBI scheme.
IREDA has created a comprehensive database of wind turbines
availing the GBI and of those availing accelerated depreciation.
A registration process has been put in place for all the wind
turbines, which is a mandatory requirement for claiming the above
incentives.
For solar power utilities fix, the tariff for solar power during the
period for which the Ministry is providing incentive, the utilities
208
offer a minimum of that tariff to the solar thermal grid interactive
Notes
power projects in their respective states.
___________________ In absence of such tariff orders, the utilities offer the highest
tariff for purchase of power to the solar thermal power project
___________________
developers that is being offered by the utilities for purchasing
___________________ power in their respective states on medium term or the highest
tariff being provided for purchase of power from any other energy
___________________
source for which orders/guidelines are already issued for that
___________________ State.
___________________ The PPA draws reference to the orders of the State Electricity
Regulatory Commission’s directive in this regard. Enclose copies
___________________
of the same are given with the proposal. The Ministry does not
___________________ consider proposals that do not follow these guidelines on the
power purchase agreement.
___________________
The maximum amount of generation based incentive applicable
___________________ for a project is determined after deducting the power purchase
rate for which PPA has been signed by the utility with a project
developer. This can vary from a notional amount of ` 13 per kWh.
In all cases, the maximum amount of GBI should not exceed Rs
10 per kWh. In case the project developer has submitted an
application to the State Electricity Regulatory Commission or
the Utility or to the Ministry, where a lower power purchase
price or sale price of power from the proposed grid interactive
solar thermal power plan has been sought, then, the GBI is
determined with that amount as the base and a lower rate of
incentive is approved by the Ministry.
The project developers are required to submit documentary proof
and give an undertaking about correctness of this information.
• Any project that is commissioned after 31st December, 2009
is eligible for a maximum incentive with a 5% reduction and
ceiling of ` 9.50 per kWh.
The GBI will continue to decrease, as and when the utility
signs a PPA for power purchase at a higher rate. The
proposed annual escalations agreed with the utility, as in
force, should be reflected in the PPA.
• The GBI approved for a grid interactive solar thermal power
generation project may be available for a maximum period of
10 years from the date of approval and regular power
generation from that project, provided the utility continues
to purchase power from that grid interactive solar thermal
power plant.
209
• The Ministry may, at any given time, even before 31st March,
Notes
2010, announce a new GBI and guidelines. This will be
applicable to all such proposals/ projects that have not been
___________________
approved by that time.
___________________
• The incentive is released by the IREDA to the eligible solar
thermal power project developer on quarterly basis. This is ___________________
only announced upon the receipt of certified information
___________________
about the net electricity fed to the grid from the solar thermal
power project during the period of claim. The concerned ___________________
utility provides such information to the project developer on
periodic basis. The solar thermal power project developers ___________________
are required to produce a certificate from the concerned ___________________
utility about the solar thermal power purchase rate granted
by the utility for eligible projects, each time they seek funds ___________________
from the IREDA towards generation-based incentive.
___________________
Table 17.1: Incentives for Small hydro power ___________________
projects provided by GOI/MNES
Head Incentives
For assessment ` 15.00 lacs for identification up to 50 new sites

of potential and
preparation of ` 22.50 lacs for identification of more than 50
perspective plan new sites.
Incentives for ` 1.25 lacs upto ` 2.00 lacs ` 3.00 lacs above
preparation of 1 MW above 1 MW 10 MW and upto
DPR and upto 10 MW 20 MW
Subsidy for 20% of the project 20% of project 20% of the project
commercial cost limited to cost limited to cost limited to
small hydro ` 10,000/- KW ` 10.00 lacs + ` 75.00 lacs +
projects by upto 100 KW ` 7200/- per KW ` 12.5 lacs per
private, joint projects. for 101 KW to MW for 1 MW
sector and 999 KW projects. upto 25 MW
others. projects.
For power 40% of the project 40% of project 40% of the project
projects in cost limited to cost limited to cost limited to
Govt. sector. ` 20,000/- KW ` 20.00 lacs + ` 150.00 lacs +
upto 100 KW ` 14,425/- per KW ` 25.00 lacs per
projects. for 101 KW to MW for 1 MW
999 KW projects. upto 25 MW
projects.
210
Table 17.2: Incentives for Wind Power
Notes
Projects Provided by MNES
___________________ Type of project Capital subsidy
___________________ Land Based Demonstration 60% of the cost of wind electric generator
Project including spare with maximum of ` 3.5
___________________
crore per MW.
___________________
Wind Hybrid Project Cost of wind turbine and control equip-
___________________ ment, spares and erection/commissioning
subject to a ceiling of ` 70 lacs per 100 KW
___________________
+ 90% of cost of laying new or upgrading
___________________ existing lines.
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. The ..................... has a scheme on GBI for grid connected wind
power projects.
2. The proposed annual escalations agreed with the utility, as in force, is

reflected in the ..................... .
Biomass Power Projects

The Ministry of Non-conventional Energy Sources (MNES),
Government of India, has been actively promoting utilization of
Biomass through technologies such as, briquetting, gasification,
combustion and cogeneration. The combustion and cogeneration
routes are meant for generation of power in Megawatt scale.
Installation of large projects necessitates a reliable assessment
of availability of Biomass material.
As is well known, a large proportion of Biomass generated in the
country during agricultural operations is utilized for some or
other activity in the rural economy. Use of biomass for power
generation applications may deprive the poorest sections of the
society of cheap fuel. Hence, more than an assessment of total
biomass availability, it is necessary to assess the amount of
surplus Biomass that can be used without affecting the present
lifestyle of the people.
Accordingly, the MNES/GOI introduced a scheme, “National
Biomass Resource Assessment Programme” as a first step in the
selection - the block level. Biomass Assessment Studies are
attended to establish the quantity of surplus biomass available in
a taluka with the following objectives:
211
• Identification of Biomass source in the block and assessment
Notes
of their availability in terms of quality and quantity.
• Estimation of quantum of biomass consumed for various ___________________
activities in the block.
___________________
• Estimation of surplus biomass available after accounting for
the present utilization. ___________________
• Ascertaining biomass availability, season and mode of ___________________

procurement, storage and so on. ___________________
• Preparation of economics of the proposed Biomass Power
___________________
Plant.
___________________
These findings become a tool for planning of different biomass
power plants by the respective State governments in different ___________________
regions. This in turn, brings down the regional disparities in
___________________
availability of power to a certain extent.
___________________
Table 17.3: MNES/GoI Incentives for Bagasse
Co-generation power project
Sr. Bagasse Cogeneration Pressure Interest

No. Configuration Subsidy
1 Projects by Cooperative/Public/ 40 bar and above 3%

Joint Sector Sugar Mills.
60 bar and above 4%
80 bar and above 5%
80 bar and above 6%
2 Projects in IIP Mode in Co- 60 bar and above 2%

operative/Public Sector Sugar
80 bar and above 3%
Mills.
100 bar and above 4%
3 Projects by Private Sector 60 bar and above 1%

Sugar Mills.
80 bar and above 2%
100 bar and above 3%
Biomass Co-generation Projects (Non-bagasse) in

Industry
Under this programme, co-generation projects (excluding baggase
co-generation is promoted in the industry with at least 50% of
power for captive use and in the provision for surplus power to
be exported to the grid. Use of conventional fuel up to maximum
25% is allowed in such projects. To meet the requirement of
212
captive power and thermal energy, the installation of biomass co-
Notes
generation projects (excluding bagasse co-generation) is to be
promoted in industry, with at least 50% of power of captive use,
___________________
and a provision for the surplus power to be exported to the grid.
___________________ This will increase the use of New & Renewable Energy sources
and conserve the use of fossil fuels such as coal, oil and natural
___________________
gas. Use of maximum of 255 conventional fuels would be allowed
___________________ in such projects.
___________________ The Ministry provides central financial assistance (CFA) to the

tune of, ` 20 lakh per MW to the promoters for installation of
___________________
biomass co-generation (non-baggase) projects.
___________________
The Capital subsidy is calculated on the basis of the installed
___________________ capacity and CFA is limited to a maximum capacity of 5 MW
irrespective of the installed capacity.
___________________
___________________ Co-generation Projects based on Conventional Fuels

and their Rejects
Under this programme, cogeneration projects based on
conventional fuels such as, coal, oil, lignite, gas and un/semi-
utilized waste/rejects like, dolochar, coal rejects and refinery muds
among others, is to be encouraged in the industry for meeting
power and energy requirements.
Under this programme, only promotional incentives at the rate
of, ` 1.00 lac/- MW subject to maximum of, ` 5.00 lacs/- project for
professional technical services is provided to consultancy firms
for helping to bring a project to financial closure including,
preparation of DPR.
Implementation Procedure
The projects discussed here are implemented by private and public
sector industries including, Energy Service Companies (ESCOS).
The IREDA/other financial institutions or commercial banks
forward the DPR received from the promoter to the Ministry
along with their appraisal notes indicating the techno-economic
viability of the project.
After the receipt of DPR and appraisal note and copy of loan
sanction order, the proposal is examined by the Ministry and a
sanction is issued by providing Capital subsidy. The entire Capital
subsidy is released directly to the FI for the purpose of offsetting
the loan amount after the successful commissioning of the project
as per DPR norms.
The condition of successful commissioning of the project, inter
alia implies, operation of the project for three months, including
213
at least 72 hours of continuous operation at minimum 80 per cent
Notes
operated capacity.
The concerned State Nodal Agencies closely monitor the execution ___________________
of the project and ensure their timely completion.
___________________
Waste to Energy ___________________
The increasing industrialization, urbanization and changes in the ___________________

pattern of life, which accompany the process of economic growth, ___________________
give rise to generation of increasing quantities of wastes leading
to increased threats to the environment. In recent years, ___________________
technologies have been developed that not only help in generating
___________________
substantial quantity of decentralized energy but also in reducing
the quantity of waste for its safe disposal. ___________________
The Ministry is promoting all the Technology Options available ___________________

for setting up projects for recovery of energy from urban wastes.
___________________
In developed countries, environmental concerns rather than
energy recovery is the prime motivator for waste-to-energy
facilities, which help in treating and disposing of wastes. Energy
in the form of biogas, heat or power is seen as a bonus, which
improves the viability of such projects. While incineration and
biomethanation are the most common technologies, pyrolysis and
gasification are also emerging as preferred options. A common
feature in most developed countries is that the entire waste
management system is being handled as a profitable venture by
private industry or non-government organizations with tipping
fee for treatment of waste being one of the major revenue streams.
The major Advantages for adopting technologies for recovery of
energy from urban wastes is to reduce the quantity of waste and
net reduction in environmental pollution, besides generation of
substantial quantity of energy. Energy recovery from waste is the
conversion of non-recyclable waste materials into usable heat,
electricity, or fuel through a variety of processes, including
combustion, gasification, pyrolization, anaerobic digestion and
landfill gas recovery. This process is often called waste to energy.
Every year, about 55 million tonnes of municipal solid waste
(MSW) and 38 billion liters of sewage are generated in the urban
areas of India. In addition, large quantities of solid and liquid
wastes are generated by industries. Waste generation in India is
expected to increase rapidly in the future. As more people migrate
to urban areas and as incomes increase, consumption levels are
likely to rise, as are rates of waste generation. It is estimated
that the amount of waste generated in India will increase at a
per capita rate of approximately 1-1.33% annually. This has
significant impacts on the amount of land that is and will be
needed for disposal, economic costs of collecting and transporting
214
waste, and the environmental consequences of increased MSW
Notes
generation levels.
___________________
Why Waste to Energy is Important
___________________
Most wastes that are generated, find their way into land and
___________________ water bodies without proper treatment, causing severe water
pollution. They also emit greenhouse gases like methane and
___________________ carbon dioxide and add to air pollution. Any organic waste from
___________________ urban and rural areas and industries is a resource due to its
ability to get degraded, resulting in energy generation.
___________________
The problems caused by solid and liquid wastes can be significantly
___________________ mitigated through the adoption of environment-friendly waste-
___________________
to-energy technologies that will allow treatment and processing
of wastes before their disposal. These measures would reduce
___________________ the quantity of wastes, generate a substantial quantity of energy
from them, and greatly reduce environmental pollution. India’s
___________________
growing energy deficit is making the government central and
state governments become keen on alternative and renewable
energy sources. Waste to energy is one of these, and it is garnering
increasing attention from both the central and state governments.
While the Indian Government’s own figures would suggest that
the cost of waste to energy is somewhat higher than other
renewable sources, it is still an attractive option, as it serves a
dual role of waste disposal and energy production.
India Waste to Energy Potential

According to the Ministry of New and Renewable Energy (MNRE),
there exists a potential of about 1700 MW from urban waste (1500
from MSW and 225 MW from sewage) and about 1300 MW from
industrial waste. The ministry is also actively promoting the
generation of energy from waste, by providing subsidies and
incentives for the projects. Indian Renewable Energy Development
Agency (IREDA) estimates indicate that India has so far realized
only about 2% of its waste-to-energy potential.
MNRE has promoted the national programme for the recovery of
energy from industrial and urban wastes. Since this programme
seeks to promote setting up of waste-to-energy plants, various
financial incentives and other eligibility criteria have been
proposed by the MNRE to encourage the participation in waste-
to-energy projects.
These are listed below:
• Financial assistance is provided by way of interest subsidy
for commercial projects.
215
• Financial assistance is provided on the capital cost for
Notes
demonstration projects that are innovative in terms of
generation of power from municipal/industrial wastes.
___________________
• Financial assistance is provided for power generation in
___________________
STPs.
• Financial incentives are given to municipal corporations for ___________________
supplying garbage free of cost at the project site and for ___________________
providing land.
___________________
• Incentives are given to the state nodal agencies for promotion,
co-ordination and monitoring of such projects. ___________________
• Financial assistance is given for carrying out studies on waste ___________________

to energy projects, covering full costs of such studies.
___________________
• Assistance is given in terms of training courses, workshops
and seminars and awareness generation. ___________________
___________________
Demonstration Projects for Power Generation from MSW through
New Technologies
With the objective of developing indigenous capabilities as well
as, for demonstration of various new and emerging technologies,
financial assistance is provided to the extent of 50 percent of the
project cost, subject to maximum of ` 3.0 crore/ MW for setting up
demonstration projects based on gasification/ pyrolysis and plasma
arc technologies.
Power Generation at Sewage Treatment Plants

Financial assistance at the rate of 40 percent of the project cost
subject to a maximum of, ` 2 crore/ MW is provided for projects
for generation of power from biogas being produced at Sewage
Treatment Plants. Project cost will include the cost of engine
genset, H2S removal plant and other related equipment.
Power Generation from other Urban Wastes

Financial assistance to the tune of, 50 per cent of the project cost
- subject to upper limit of ` 3.0 crore/ MW is provided for setting
up projects based on Biomethanation Technology for power
generation. This is derived from, cattle dung, vegetable market
and slaughterhouse waste generated in urban areas.
For cattle dung based projects, eligible project capacity needs to
be, 250 kW and above. In case of projects for generation of only
biogas for thermal applications, the FA is limited to ` 1.0 crore/
M.Weq (i.e., biogas production of 12000 cu.m./ day).
216
Notes
Other Provisions
Any waste of renewable nature or biomass can be mixed to the
___________________
extent of 25 percent with MSW.
___________________
Financial assistance provided for any single project is limited to
___________________ ` 8.0 crore for projects in different categories.
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. Combustion and co-generation routes are meant for generation of power
___________________ in .................. scale.
2. Any waste of renewable nature or biomass can be mixed to the extent of

___________________
.................. with MSW.
___________________
___________________ Promotional Incentives

The programme for fast track promotion of projects for power
generation from MSW involves, development of a project document
for specific cities for determining the Capital subsidy required as
viability gap funding through a process of competitive bidding.
It is expected that the State Nodal Agencies, HUDCO, IREDA,
IL&FS, TCOs and others, will develop the projects with the help
of consultants, as necessary, for the Municipal Corporations and
Urban Local Bodies. A Project Development Assistance of ` 10
lac per project is provided for this activity involving the following:
• Analysis of MSW and assessment of quantity.
• Identification of project site.
• Preparation of MSW collection and transportation plan.
• Finalization of tie-up with the ULBs for land lease and supply
of waste.
• Finalization of power purchase agreement.
• Development of a bankable project with feasibility report
and the DPR.
• Preparation of the bid document for inviting bids for viability
gap funding.
• Firming up the of means of project finance.
• Assistance in the entire bidding process .
• Obtaining all statutory clearances for the project.
• Providing assistance and supervision during execution and
commissioning.
217
In case of other projects, financial assistance of 50 percent of the
Notes
cost of preparation of Detailed Project Reports - subject to a
maximum of ` 1 lakh per project - is provided. This assistance is
___________________
released at the time of sanction of financial assistance for the
project. ___________________
CFA Provided Renewable Energy Schemes/ ___________________
Programmes ___________________
Grid Interactive Programme ___________________
• Off-grid Renewable Energy Programmes ___________________
• Remote Village Electrification Programme ___________________
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. The programme for fast track promotion of projects for power generation
from MSW involves development of a .................. for specific cities.
2. It is expected that State Nodal Agencies, HUDCO, IREDA, IL&FS, TCOs

and others, will develop projects with the help of ..................... .
Summary
• In India, non-conventional energy sources consist of those
sources that are infinite, natural and restorable.
• Non-conventional energy sources include, tidal energy, solar
energy and wind energy.
• The application of tidal and wind energy was operational in
the form of energy sources long before mineral oil, coal and
natural gas were not introduced as conventional sources of
energy.
• In the beginning, windmills were utilized for taking out
water and pounding grains. Running water and wind were
applied for direction finding.
• Currently, some of the important and widely used non-
conventional sources of energy are, tides, wind, solar
geothermal heat and biomass, comprising animal and
agricultural waste and human body waste. Disposals from
big metropolitan areas can work as a source for producing
biogas.
• All these non-conventional energy sources are unlimited or
restorable and are essentially economical.
218
Notes
1. What are the objectives of generation-based incentives for
___________________ grid connected wind power projects?
___________________ 2. Write a note on biomass power projects.
___________________ 3. Why is waste to energy important?
___________________
___________________
___________________
___________________
___________________
___________________
___________________
219
Unit 18 Notes
Financing Non- conventional

Non-conventional ___________________
___________________
Projects ___________________
___________________
___________________
Learning Objectives:
\ Power Generation Projects ___________________
\ Types of Lease ___________________

\ Joint Venture Financing in Public and Private Sector
___________________
\ Research and Development Partnerships
___________________
Introduction
Financing power generation projects in developing countries has
for the past several decades been based on public budgets and
public borrowing. Since the mid-1980s, governments of developing
countries have been receptive of private sector investment in
building new generating capacity.
Initially, proposals were made for Build-Operate-Transfer (BOT)
model. This meant that the Private Sector’s Capital and efficiency
was utilized to build the power plant, but, after some years of
operation, the plant would be transferred to the Public utility to
be integrated into the rest of the country’s power generating
capacity.
As the ideas and proposals were further developed, it was
recognized that the eventual transfer of the plant to the public
utility was not necessary. The proposals then changed to what
became known as, Build-Own-Operate (BOO). This new
arrangement is of course nothing but a straightforward Private
Sector investment. The company is referred to as an, Independent
Power Producer (IPP).
Financing Power Generation Projects

Renewable or non-conventional energy systems have a huge
potential for meeting energy demands of the society in an
environmentally friendly manner. However, renewable energy-
based technologies are yet to gain market acceptance and face
220
many barriers - technical, financial, institutional and socio-cultural
Notes
- against their large-scale dissemination.
___________________ High Capital cost of renewable energy systems as compared to
their conventional alternatives is the foremost barrier to their
___________________
large-scale dissemination.
___________________
So, availability of easily accessible financing is the key to
___________________ overcoming the initial cost-barriers.
___________________ Financing in renewable energy systems has, in principle, been
considered since the early 1980s and a variety of approaches and
___________________
strategies have been proposed since then.
___________________
Prior to describing the elements and parties likely to be involved
___________________ in renewable energy financing, it may be pertinent to point out
some basic disadvantages of renewable energy systems which
___________________
makes it difficult to obtain finance at reasonable cost as compared
___________________ to conventional energy options. These include:
• Higher Project Risk
• Very Small Project Size
• Small Size of Renewable Energy Industry
• Uncertain Policies of the Government
Banks
A bank is normally the first (supporting) party to be considered
while looking for debt financing. Besides commercial banks, other
financial institutions such as, savings and loan institutions, credit
unions and mutual savings organizations can also be grouped
under this category.
Banks normally fund low-risk projects and accept commensurately
lower rates of interest. Loans in varying sizes (small to large) can
be obtained from banks. Banks normally do not prefer to
participate in the management and control of projects financed
by them.
Most existing banks are not fully aware of the merits and
limitations of renewable energy technologies and hence have
rather low propensity to provide funds for renewable energy
systems.
Both Private and Public Sector banks can be approached for
financing and all of them have taxable status. As banks usually
lend others’ deposits, they have to follow several regulations on
their functioning, particularly on interest rate and loan-to-asset
ratio. Transaction costs associated with bank loans are relatively
low.
Unit 18: Financing Non-conventional Projects
221
Finance Companies Notes
In contrast to banks, finance companies loan their own funds.
___________________
Finance companies can support projects with higher risk and
consequently, they expect higher rate of return compared to banks. ___________________
Finance companies may restrict financing to moderate-size loans. ___________________

They may not usually participate in the management of projects
financed by them. Owing to very little knowledge of renewable ___________________
energy technologies, the finance companies have rather low ___________________

propensity to invest in renewable energy system.
___________________
Similar to the case of banks, transaction costs of obtaining a loan
from them is low. Financing companies are organizations with ___________________
taxable status. ___________________
Probable elements involved in financing of renewable energy ___________________
projects include:
___________________
• Debt
• Grants
• Insurance
• Tax Incentives
• Regulation
While a Public organization can finance through one or more of
all these six elements, by definition, the Private Sector can neither
provide tax incentives nor issue regulations.
Some details of the potential supporting parties in financing
investments on renewable energy systems are given next. In each
case, broad information on the above characterizing parameters
has also been provided.
Individual Investors and Investor Groups

Individuals or groups of individuals may often provide funds that
can be used to finance projects with higher levels of risk. The
expectation is to therefore, provide commensurately higher rates
of return than that available from commercial banks.
Obviously, the size of financing available from an individual would
normally be lower than that available from a group of investors.
However, large variations are possible here. Some individuals/
groups may desire participation in the ownership and management
of the project.
It is relatively higher propensity to invest in renewable energy
systems (of course, restricted by the availability of other better
222
investment options). Transaction costs are expected to be very
Notes
low while dealing with an individual investor and are increased
only moderately for groups. Individuals/ groups of individuals
___________________
fall under the category of private individuals who usually have
___________________ taxable status.
___________________
Limited Partnerships
___________________
In a partnership, more than two individuals or groups share the
___________________ ownership of a project. A limited partnership is a special type of
partnership in which at least one is a general partner. The general
___________________
partner’s entire assets are pledged to support the partnership.
___________________ The others are limited partners who pledge only their investments
in the partnership.
___________________
The general partner should normally be an established industry/
___________________
organization whereas, limited partners could be individuals or
___________________ groups of individuals or even other organizations.
Limited partnerships may be able to accept relatively higher
levels of risk with expectation of higher rates of return and can
finance projects of varying sizes - depending on the resources put
into the partnership.
Interest in ownership and management may also vary from
partnership to partnership.
Limited partnerships are expected to have high propensity to
invest in renewable energy systems. The transaction costs of
obtaining finances from limited partnerships should be quite low.
Limited partnerships are usually private groups with taxable
status.
Research and Development (R&D) Partnerships

These are a special category of limited partnerships. Here, an
agreement is made solely for the purpose of conducting research
and development in a pre-specified area. The R&D partnerships
have high propensity to provide moderate to large-scale financing
with an acceptance for high levels of risk.
Such R&D partnerships would normally participate in the
ownership and management of the project and would fall under
the category of private groups/ organizations with a taxable status.
Industrial and Commercial Users of Electricity and Heat

By definition, this category of parties may include all industrial
and commercial organizations undertaking energy-intensive
223
activities. The basic idea is to involve large-scale users of
Notes
electricity and heat (in industrial and commercial activities) to
finance renewable energy systems.
___________________
However, users of grid electricity and relatively cheap fossil fuels
___________________
may not accept higher levels of risk and may, at the most, finance
small to moderate-scale projects. Both public and private ___________________
organizations - with a possibility of both taxable and tax-exempt
___________________
status - can participate in such financing arrangements with low
transaction costs. ___________________
Manufacturers of Equipment for Renewable Energy ___________________
Systems ___________________
The manufacturers of equipment/components finding use in ___________________

renewable energy systems may consider financing development ___________________
and dissemination of renewable energy technologies for
applications that gain high visibility. ___________________
Though they may have a high propensity to invest in such

renewable energy projects, the level of financing would normally
be limited by their own manufacturing capacity. These are private
taxable organizations willing to accept reasonable levels of risk
with expectations of commensurately higher rates of return.
Energy Management Companies

Companies/ institutions engaged in the business of providing
energy to users in the form of, electricity, heat, and so on, may
also be potential parties for financing renewable energy
investment.
Being knowledgeable about energy technologies and systems as
well as the likely energy scenario(s) in the future, some of these
companies may have a very high propensity to invest in renewable
energy systems.
They are likely to accept higher levels of risk with expectations
of higher rates of return in the future. Such companies can finance
varying sizes of projects at very low transaction costs.
Organizations Engaged in Power Generation, Transmission and

Distribution
Organizations presently involved in the generation, transmission
and distribution of electricity may also be motivated to finance
renewable energy systems for centralized and/or decentralized
power generation. Such organizations can provide funds for
varying sizes of projects but, are not likely to accept high risks.
The transaction cost of securing finances from such organizations
224
may be moderately higher because of a variety of regulations
Notes
involved in their operation.
___________________
Insurance Companies
___________________
Insurance companies are large diverse investors who can accept
___________________ high levels of investment risk for commensurately higher rates of
return. They can in principle, support projects of varying sizes
___________________
(from very small to very large) without much interest in ownership
___________________ and management of the projects.
___________________ However, limited knowledge of the future potential of renewable

energy systems makes their propensity to invest in such systems,
___________________
very low. The transaction cost of dealing with insurance companies
___________________ are expected to be low. Both Public and Private Sector insurance
companies have a taxable status.
___________________
___________________ Venture Capital Firms

These, by definition, provide financing for new, high-risk
enterprises that promise very high returns on being successful.
Thus, they can finance any size of renewable energy projects
provided that high rates of return are gained.
Venture Capital firms have a high propensity to invest and the

associated transaction costs are likely to be very low.
But unfortunately, so far, high risks in renewable energy projects

are not matched by high returns as compared to those offered by
other alternative investment opportunities with comparable risk.
Venture Capital firms are Private, taxable organizations with an

occasional interest in the ownership and management of projects
financed by them.
Leasing Companies
A leasing company is essentially involved in the buying of
equipment or system from a manufacturer/ supplier and leasing
it to user(s). Leasing companies may also have high propensity to
get involved in renewable energy systems if they are, relatively
portable, re-usable and reliable technologies that are readily
available. Usually only low to moderate levels of risks are
acceptable.
The size(s) of investment made by leasing companies may vary

from very small to very large depending on the status of the
company itself. Leasing companies are private taxable
organizations.
225
Fill in the blanks:
___________________
1. A ................. is normally the first (supporting) party to be considered
while looking for sources for debt financing. ___________________
2. Finance companies may restrict financing to ................. loans. ___________________
3. In a ................., more than two individuals or groups share the ownership ___________________
of a project.
___________________
4. ................. provide financing for new, high-risk enterprises that promise
very high returns on being successful. ___________________
___________________
Combination of Parties and Elements for Renewable ___________________

Energy Financing ___________________
A wide variety of combinations of parties and elements may ___________________
provide finance for renewable energy projects. Some potential
combinations are briefly described next.
Ordinary Sale Directly to the End User

In an ordinary sale, the user receives the renewable energy
equipment/ system directly from the manufacturer in exchange
for the purchase price.
Renewable energy
equipment or system
Manufacturer of
End
renewable energy
system User
Purchase price
Figure 18.1: Schematic arrangement for Ordinary Sale of Renewable Energy

Equipment/System Directly to the End User
Except for small-scale domestic gadgets, such arrangements are

extremely unlikely as:
• Huge Capital is required to be invested in a renewable energy
system project.
• The level of risk apprehended on their performance-related
aspects are high.
• Relatively low rates of return are projected for renewable
energy system projects.
Sale with Borrowed Financing from a Bank

In the case of sale of a renewable energy system with borrowed
financing, a bank would be involved as a third party (Figure 18.2).
226
In this arrangement, the end user is able to take a loan from a
Notes
bank to help finance the purchase of the renewable energy
equipment/ system from a manufacturer.
___________________
A major fraction (as high as 80 percent) of the initial Capital and
___________________
the installation cost of the systems can be obtained as loan from
___________________ the bank. This has to be repaid with interest according to the
guarantees and recourse measures stipulated in the loan contract.
___________________
Providing loans to end users for the purchase of renewable energy
___________________
systems puts the ownership of the system directly in their hands.
___________________ This may encourage them to properly manage the system (with
best possible care and maintenance).
___________________
In such an arrangement, the ownership of the renewable energy
___________________
equipment/system is usually transferred to the end user at the
___________________ point of sale.
___________________ Renewable energy

equipment or system
Manufacturer of
renewable energy End
system User
Purchase price
Repayment
Loan with
interest
Bank
Figure 18.2: Schematic arrangement for Sale of Renewable Energy

Equipment/system with Borrowed Financing from a Bank
Leasing
A lease is essentially a rental agreement in which the end user
of a renewable energy equipment/system (lessee) promises to make
a pre-specified number of periodic payments to the manufacturer/
supplier (lessor).
Usually, the equipment/system remains the property of the lessor
until the full cost of the system is repaid. Hence, the lessor can
obtain tax benefits of ownership during the lease terms. Of course,
if agreed upon, the lessor can pass these savings (due to tax
benefits) to the lessee through lower lease payments.
At the end of the repayment period, the ownership of the system
passes on to the end user. If the end user (lessee) fails to provide
the loan repayments, the lessor would normally have the option
to repossess the system.
227
Leasing of renewable energy equipment (system) may offer several
Notes
advantages to both lessor and lessee. The potential advantages
available to the lessor include:
___________________
(i) Availability of accelerated depreciation to amortize the cost
___________________
of the system.
(ii) Applicable investment and energy tax credits (and also any ___________________
other State/local tax benefits applicable on renewable energy ___________________

investments).
___________________
(iii) The residual value of the equipment (as per the lease
contract). ___________________
Similarly, the advantages which may be availed of by the lessee ___________________

are:
___________________
(i) No Capital requirements as 100 percent financing provided
___________________
by lessor.
(ii) A possibility of lower payments in the repayment plan (as ___________________
compared to those expected for a bank loan) if the tax

benefits to the lessor are passed on to the lessee.
(iii) Flexibility in selecting the repayment schedule and the
amount of each instalment.
Ordinary Lease
It involves only two parties as it operates directly between the
manufacturer of renewable energy equipment/ systems and the
end user (Figure 18.3). The end user agrees to make regular
(periodic) lease payments to the manufacturer in return for the
use of renewable energy equipment/ system as per the lease
agreement.
However, such an arrangement is very unlikely for renewable
energy systems and a third party may often be involved.
Renewable energy
equipment / system
Manufacturer of
User
system
Lease payments
Figure 18.3: Schematic Diagram of Ordinary Lease
Third Party Lease

In this arrangement (Figure 18.4), the owner purchases the
renewable energy system from the manufacturer and then lease
it to the end user in return for regular lease payments. The
owner (in this case lessor) would receive available tax credits
including depreciation, the investment tax credit and the energy
228
tax credit among others. Such tax benefits can be passed on to
Notes
the end user (lessee) in the form of reduced lease payments.
___________________
Manufacturer of
___________________ User
system
___________________
___________________
Renewable energy
equipment/system
___________________
Purchase Price Lease Payments
___________________
___________________
Owner
___________________
___________________ Figure 18.4: Schematic Diagram of Third-Party Lease
___________________ Leveraged Leasing

It combines investors and lenders with third party leasing. In
leveraged leasing, a part of the total cost of the renewable energy
system is financed through equity investments and debt from
lenders. The debt is secured by the renewable energy system and
lease payments.
The lessor, who is the owner of the renewable energy system,

issues debt and equity claim against the system (as an asset) and
lease payments.
As shown in Figure 18.5, the owner (lesser) is the intermediary

among all the parties involved. He may raise the majority of the
Capital needed to purchase the renewable energy equipment/
system by taking loan(s) (which may comprise a major part of the
Capital cost.
The remaining Capital is contributed by investors in the form of

equity. After purchasing the system, the owner/s make a lease
agreement with the end user to receive regular lease payments.
The lease payments received by the owner would then be used to

make a repayment of loan(s) with interest. The amount left over
after a repayment of loan(s) would be distributed among the
investors of equity. The tax benefits availed by the owner (lessor)
can also be passed on to the investors (both equity and debt
providers).
229
End
Notes
Manufacturer
user
___________________
Renewable energy
___________________
Equipment system/system
Purchase price ___________________
Renewable energy
Lease payments
Equipment system ___________________
___________________
Owner
___________________
___________________
Equity Repayment plus interest
___________________
Loan
___________________
Return on equity
___________________
Investors Lenders
Figure 18.5: Schematic Diagram of Leveraged Leasing
Sale-leaseback Approach
This approach is primarily suggested for those parties who cannot
normally take advantage of the investment tax credits. In the
sale leaseback method, such a company/organization would sell
the renewable energy equipment/system to another company/
organization that can benefit from such credits.
The buyer company/organization would then give the system back
to the first party under a lease agreement. The lessor (the
renewable energy equipment/system owner) and the lessee (the
end user of the system) can thus, share the tax benefits available
to the lessor.
Obviously, the sale-leaseback arrangement reduces the risk to
the lessor substantially as the lessee invests in the renewable
energy system and is therefore, accountable for most of the risk
involved (as compared to the conventional lease arrangements
where lessor makes the investment).
A sale-leaseback arrangement for renewable energy financing
would involve the basic steps shown in Figure 18.6.
In the first step, the first party procures the necessary equipment/
system. Another party rich in Capital but, needing tax reductions
would then buy the system from the first party by paying a certain
part of the Capital as down payment.
In the second step, the second party leases the plant back to the
first party ensuring that the remaining purchase payments to the
230
first party in step 1, are offset by the lease payments (to be made
Notes to the second party).
___________________ Thus, normally there would not be any further exchange of cash
between the parties involved.
___________________
The first party can make arrangements to sell the energy
___________________ (provided by the leased renewable energy system) to another end
___________________ user to receive payments.
___________________ In the sale-lease back approach, the second party is able to take
advantage of all the tax benefits while the net cost of the system
___________________ to the first party is reduced by the amount that the second party
paid as the down payment (essentially for the tax benefits).
___________________
Moreover, the lease payments being equal to the debt payments,
___________________
the second party may not have any tax liability due to this deal.
___________________ It is also worth pointing out that in this arrangement the amount
of money at risk for the second party is very small as the first
___________________ party has accepted most of the risk in the investment.
Manufacturer of
renewable energy
RES system(RES)
Party 1 Purchase price

RES
Party 2
Down payment
Figure 18.6: Schematic Diagram of Sale-leaseback Approach
Joint Venture Financing

It facilitates partnership of a variety of parties which may include
Public/Private Sector organizations involved in generation,
transmission and distribution of electricity, leasing companies,
banks, equity investors, manufacturers and suppliers of renewable
energy systems, energy management companies, government
bodies, non-profit organizations and so on.
It offers the benefits of combining the skills and experience of
different organizations through cooperative agreements.
Further, financing mechanisms not normally available with
traditional arrangements may be developed, making use of the
resources and expertise of different parties involved.
Research and Development (R&D) Partnerships

In this arrangement, a general partner (normally an existing
manufacturer, organization or an inventor) would seek limited
231
partners to obtain funds required to undertake research and
development work on a particular renewable energy equipment/ Notes
system.
___________________
Limited partnership are made available to prospective investors in
___________________
exchange for contribution of a minimum amount (and upwards). It
can provide creative and appropriate opportunities for financing the ___________________
necessary research and developmental work in the field of renewable
energy. ___________________
Each limited partner would normally be eligible for the deduction ___________________
of all of the expenses of the partnership and also have a chance at
___________________
a proportional share of the returns if the research and development
work is successful. ___________________
A majority of the limited partners in the R&D partnership would ___________________

prefer to spend all of the partnership money within the initial few
years to benefit from the allowable deduction(s) from taxable income. ___________________
The general partner on the other hand, is interested in attracting ___________________

equity investors without getting involved in the regulations and
requirements of raising Capital through sale of shares and such
other methods.
Knowledge Renewable
and labour energy system
General End
Partner user
Funds Purchase price
Funds Royalties and share of proceeds from

Sale
Limited partner
Figure 18.7: Schematic Diagram of Research and Development Partnership
A possible arrangement of partnership for financing renewable

energy research and development is shown schematically in
Figure 18.7. As indicated, the general partner, usually the
manufacturer, would seek limited partners to contribute to the
research and development on well-defined, goal-oriented topics
under the framework of research and development partnerships.
Each one of the limited partners would be benefited by available
tax deductions on their contributions to research and development.
The general partner would use the funds along with knowledge
and labour to develop and manufacture appropriate renewable
energy, equipment/ systems. The product(s)/ technique(s)
developed within the partnership may then be licensed and sold
to manufactures/ users of renewable energy systems.
232
The limited partners would receive a pre-specified share of the
Notes
royalties or the purchase price of the renewable energy
Equipment/system.
___________________

___________________ 1. In an ......................., the user would receive the renewable energy

equipment/ system directly from the manufacturer in exchange for the
___________________ purchase price.
___________________ 2. In ....................... the owner would purchase the renewable energy
system from the manufacturer and then, lease it to the end user in return
___________________
for regular lease payments.
___________________
3. ....................... is primarily suggested for those parties who cannot
___________________ normally take advantage of the investment tax credits.
___________________
Summary
• In India, non-conventional energy sources consist of those
energy sources that are infinite, natural and restorable. Some
examples of non-conventional sources of energy are, tidal
energy, solar energy and wind energy.
• Application of tidal and wind energy were operational as
energy sources long before mineral oil, coal and natural gas
were introduced as conventional sources of energy.
• In the beginning, windmills were utilized for taking out
water and pounding grains. Running water and wind were
applied for direction finding.
• Currently, some of the important and widely used non-
conventional sources of energy are, tides, wind, solar
geothermal heat and biomass comprising animal waste,
agricultural waste and human body waste. For example,
disposals from big metropolitan areas can work as a source
of producing biogas.
• All these non-conventional energy sources are unlimited or
restorable and economical.

1. What are the major hurdles in the path of non-convention
energy projects?
2. Write short notes on:
1. Sale-leaseback Approach
2. Research and Development (R&D) Partnerships
233
Unit 19 Notes
IREDA and its R

IREDA ole
Role ___________________
___________________
___________________
\ Indian Renewable Energy Development Agency (IRDA) Ltd. and its
___________________
objectives
\ Small Hydro Development Program ___________________
\ Eligibility Criteria for Financing Loan ___________________
\ Security for Loan ___________________
___________________
Introduction
Energy is a basic requirement for economic development. Every
sector of the national economy be it, agriculture, industry,
transport, commercial and domestic, needs energy. The economic
development plans implemented since Independence have
necessitated increasing amount of energy inputs. As a result,
consumption of energy in all forms has been steadily rising all
over the country.
The growing consumption of energy has also resulted in the
country becoming increasingly dependent on fossil fuels such as
coal, oil and gas. Rising prices of oil and gas along with future
shortages are raising concerns about the security of energy supply,
which is needed to sustain our economic growth. Increased use
of fossil fuels also causes environmental problems both on local
and global scales.
With this background, there is urgent need for the country to
develop a sustainable path of energy development. Promotion of
energy conservation and increased use of renewable energy
sources are twin planks of sustainable energy.
Renewable Sector in India

The Ministry of New and Renewable Energy (MNRE) has been
implementing comprehensive programmes for the development
and utilisation of various renewable energy sources in the country.
As a result of efforts made during the last several years, a number
of technologies and devices have been developed and have become
commercially available.
234
India has 83.37 GW of renewable energy capacity as on October
Notes
2019 which includes 31.69 GW from Solar & 37.09 GW from Wind
power. India is set to cross 100 GW renewable energy capacity
___________________
mark in 2020. Solar capacity has increased by eight times between
___________________ FY14-18.
___________________ India is one of the countries with the largest production of energy
from renewable sources. As of 2019, 35% of India’s installed
___________________
electricity generation capacity is from renewable sources,
___________________ generating 17% of total electricity in the country. In the Paris
Agreement India has committed to an Intended Nationally
___________________
Determined Contributions target of achieving 40% of its total
___________________ electricity generation from non-fossil fuel sources by 2030.
___________________ The country is aiming for even more ambitious target of 57% of
the total electricity capacity from renewable sources by 2027 in
___________________ Central Electricity Authority’s strategy blueprint. According to
___________________ 2027 blueprint, India aims to have 275 GW from renewable energy,
72 GW of hydroelectricity, 15 GW of nuclear energy and nearly
100 GW from “other zero emission” sources. In the quarter ending
September 2019, India’s total renewable electricity capacity
(including large hydro) was 130.68 GW. This represents 35.7% of
the total installed electricity generation capacity in the country,
which is around 366 GW.
India has a strong manufacturing base in wind power with 20
manufactures of 53 different wind turbine models of international
quality up to 3 MW in size with exports to Europe, the United
States and other countries. Wind or Solar PV paired with four-
hour battery storage systems is already cost-competitive, without
subsidy, as a source of dispatchable generation compared with
new coal and new gas plants in India.
Indian Renewable Energy Development Agency

(IREDA) Ltd.
The IREDA was incorporated as a Public Limited Government
Company in 1987 and is under the administrative control of the
Ministry of New & Renewable Energy (MNRE), Go I.
Its Mission is to:
“Set a pioneering, participant-friendly and competitive institution
for financing and promoting self-sustaining investment in energy
generation from Renewable Sources, Energy Efficiency and
Environmental Technologies for sustainable development”.
The IREDA mainly provides financial support to specific projects
and schemes for generating electricity and energy through new
Unit 19: IREDA and its Role
235
and renewable sources and conserving energy through energy
Notes
efficiency.
Improvement in the efficiency of services provided to/ customers ___________________
through continual improvement of systems, processes and
___________________
resources. Capacity building by strengthening Human Resource
Development. ___________________
By giving the financial support and revolving funds the IREDA ___________________
is working for development and deployment of New and
___________________
Renewable Sources of Energy (NRSE).
___________________
The objectives of IREDA are to:
___________________
• Provide financial support to specific projects and schemes
for generating electricity and/ or energy through new and ___________________
renewable sources and conserving energy through energy
___________________
efficiency.
• Maintain its position as a leading organization to provide ___________________
efficient and effective financing in renewable energy and

energy efficiency/ conservation projects.
• Increase IREDA’s share in the renewable energy sector by
innovative financing.
• Improve the efficiency of services provided to customers
through continual improvement of systems, processes and
resources.
• Strive to be a competitive institution through customer
satisfaction.
Check Your Progress
Fill in the blanks:
1. The IREDA was incorporated as a Public Limited Government Company

in the year, ................ .
2. By providing financial support and revolving funds, the IREDA is working

for the development and deployment of ................... .
Small Hydro Development Program

India is the 7th largest producer of hydroelectric power in the
world. As of 30 April 2017, India’s installed utility-scale
hydroelectric capacity was 44,594 MW, or 13.5% of its total utility
power generation capacity.
Additional smaller hydroelectric power units with a total capacity
of 4,380 MW (1.3% of its total utility power generation capacity)
have been installed. Small hydropower, defined to be generated
236
at facilities with nameplate capacities up to 25 MW, comes under
Notes
the ambit of the Ministry of New and Renewable energy (MNRE);
whilst large hydro, defined as above 25 MW, comes under the
___________________
ambit of Ministry of Power.
___________________
Of all the renewable energy sources, small hydro represents the
___________________ “highest density’ resource and stands in the first place in
generation of electricity from such sources throughout the World.
___________________
Emanating from environment consciousness, there is an increased
___________________
thrust on Small Hydro Development in India which has an
___________________ estimated potential of 15000 MW.
___________________ The Go I has stimulated considerable enthusiasm for private sector

participation through suitable policy initiative and guidelines for
___________________
speedy development of Small Hydro Power. The Electricity Act
___________________ 2003 has paved the way for setting up of State Electricity
Regulatory Commissions (SERCs) for providing conducive
___________________ atmosphere for the rapid development of power generation in
the country through all sources including renewable energy.
The IREDA has been in the forefront to promote, support and
accelerate the development of power generation through
renewable energy projects in India. It does this by providing
financial and technical assistance to the prospective developers
in setting up of commercially viable renewable energy projects
including, utilization of hydro energy.
Ministry of New and Renewable Energy has been vested with the
responsibility of developing Small Hydro Power (SHP) projects
up to 25 MW station capacities. The estimated potential for power
generation in the country from such plants is about 20,000 MW.
Most of the potential is in Himalayan States as river-based
projects and in other States on irrigation canals. The SHP
programme is now essentially private investment driven. Projects
are normally economically viable and private sector is showing
lot of interest in investing in SHP projects. The viability of these
projects improves with increase in the project capacity. The
Ministry’s aim is that at least 50% of the potential in the country
is harnessed in the next 10 years.
Power generation through small hydro projects is gaining attention
of prospective entrepreneurs due to its reliability, proven
technology which is non-polluting and environmentally benign.
The sector is also considered to be having good potential for
claiming Clean Development Mechanism (CDM) benefits under
the Kyoto Protocol.
Hydro power projects are generally categorized in two segments
i.e. small and large hydro. In India, hydro projects up to 25 MW
237
station capacities have been categorized as Small Hydro Power
Notes
(SHP) projects. While Ministry of Power, Government of India is
responsible for large hydro projects, the mandate for the subject
___________________
small hydro power (up to 25 MW) is given to Ministry of New and
Renewable Energy. ___________________
Small hydro power projects are further classified as: ___________________
Class Station Capacity in kW ___________________
Micro Hydro Up to 100 ___________________
___________________
Mini Hydro 101 to 2000
___________________
Small Hydro 2001 to 25000
___________________
Small Hydro Power Programme is one of the thrust areas of ___________________
power generation from renewable in the Ministry of New and
Renewable Energy. It has been recognized that small hydropower ___________________
projects can play a critical role in improving the overall energy
scenario of the country and in particular for remote and
inaccessible areas. The Ministry is encouraging development of
small hydro projects both in the public as well as private sector.
Equal attention is being paid to grid-interactive and decentralized
projects.
An estimated potential of about 20,000 MW of small hydro power
projects exists in India. Ministry of New and Renewable Energy
has created a database of potential sites of small hydro and 6,474
potential sites with an aggregate capacity of 19,749.44 MW for
projects up to 25 MW capacity have been identified.
There are about 28 Equipment Manufacturers (As on 28.02.2018)
of Small Hydro Power Turbine who fabricate almost the entire
range and type of SHP equipment listed in MNRE. Manufacturers’
capacity is estimated at about 400 MW per year.
Eligibility Criteria for Financing

Eligibility includes:
• Public, Private Limited companies, NBFCs and registered
societies.
• Individuals, Proprietary and Partnership firms (with
applicable conditions).
• Restructured State Electricity Boards or those in the process
of restructuring.
These organizations are all eligible to borrow from the REC/PFC.
238
General Eligibility Criteria for Applicants
Notes
• Profit making companies with no accumulated losses.
___________________
• Debt Equity Ratio not more than 3:1 (5:1 in case of NBFCs
___________________ - Conditions Apply).
___________________ • No default to IREDA and other FIs/Banks.
___________________ • No erosion of paid-up Capital.
___________________
Note: Applicants who are loss making or not meeting the criteria relating
to accumulated losses/ debt equity ratio are eligible for financing if a Bank
___________________ Guarantee is provided as security for the entire loan.
___________________
Eligible Projects
___________________
• Projects demonstrating techno commercial viability.
___________________ • Small Hydroelectric projects developed at existing irrigation
___________________ canals as Canal Based schemes, as Dam-Toe schemes and as
Run-of-River schemes with maximum station capacity up to
25 MW.
• Projects above 25 MW capacity may be considered under co-
financing or consortium financing arrangements.
• Refinancing of projects not commissioned earlier than 1 year
from the date of application to IREDA.
The companies eligible as per the criteria laid down by the IREDA
can apply for loan and get the loan disbursed without any hassle
as the Go I is doling concessions and incentives to promote energy
generation in the Renewable Sector.
The detail procedures are subject to change from time to time
and are available on the official website of the IREDA for
convenience of promoters in the area of renewable energy.
Check Your Progress
Fill in the blanks:
1. The IREDA has been operating a line of credit from the World Bank for
development of .................. Projects.
2. The companies eligible as per the criteria laid down by .................. can
apply for loan and can get the loan disbursed without any hassle.
Summary
The main objective of the IREDA is to provide financial support
to specific projects and schemes for generating electricity or
energy through new and renewable sources and conserving energy
239
through energy efficiency. The IRDA, needs to maintain its
Notes
position as a leading organization providing efficient and effective
financing in renewable energy and energy efficiency/ conservation
___________________
projects. It needs to increase its share in the renewable energy
sector through innovative financing. The IREDA is the ___________________
implementation agency for finance schemes for off- grid projects
___________________
under the JNNSM.
___________________
___________________
1. Explain the role of IREDA in financing of Hydropower and
___________________
Wind-power projects.
2. Explain the eligibility criteria for financing loan to small ___________________
Hydropower and Wind Power projects. ___________________
3. Write short notes on:
___________________
(a) Front-end fee
___________________
(b) Security for loan
241
Unit 20 Notes
Case Study ___________________
___________________
___________________
Case Study: Project Financing – Coimbatore Bypass ___________________
Road Project ___________________
___________________
Project Background
Coimbatore is a prosperous and industrial city in Tamil Nadu. It is ___________________
well connected by National and State highways. The National Highway
___________________
No.47 connecting Salem with Kanyakumari via Trissur, Ernakulam
and Thiruvananthapuram in Kerala, passes through the city. ___________________
Congestion within the city was causing traffic delays and so there was ___________________
a need for a bypass. An alignment traversing a length of 28 km was
finalized and the land for a width of 40-45 m was acquired for this
purpose in 1974. However, construction was delayed due to lack of
funds.
The Coimbatore Bypass was the first road project to be implemented

in South India on BOT basis. The project was a pioneering initiative,
which incorporated Private Sector participation and levy of toll on
users to ensure sustainability in the long run. The road ran between
Neelambur, on the Salem side of NH-47, Tamil Nadu, and in Kerala,
Madukkarai on the Palghat side.
The project involved the construction of a 28-km long two-lane bypass

road, the 32.2 m new Athupalam bridge across the river Noyal, the
railway overbridge at Chettipalayam and the maintenance of the old
bridge at Athupalam, all in Tamil Nadu.
The Larsen and Toubro (L&T) company’s, L&T Transportation

Infrastructure Ltd (LTTIL), the BOT operator, was authorized to collect
and retain the fee from users of the new and old Athupalam bridges.
The bypass was expected to ease the traffic congestion in Coimbatore

city, and the Salem-Cochin national highway running between Tamil
Nadu and Kerala. The shippers, mostly export-oriented units relying
on the Cochin port for shipments, were the other major beneficiaries
as transportation time would be saved by using the new road.
The construction started in January 1998 and was completed in 22

months 1. The Athupalam Bridge was opened for traffic in December
1998 and the bypass became operative from January 19th, 2000.
The project cost was about ` 1.04 billion. The project concession
period was 12 years and was expected to set a precedent for assessment
of traffic risk patterns in the country for toll-based roads.
Contd…
242
Notes However, the project ran into problems when users refused to pay the
toll for the old Athupalam Bridge. They argued that the old bridge
___________________ already existed. As for the bypass and the new Athupalam Bridge,
they felt that the toll rates were high. They also complained that L&T
___________________ had not taken them into confidence before fixing the toll rates.
___________________ The bid was discussed in detail with the State Government. Based on
the argument that the 27.67 km bypass road, linking the southern
___________________ (Coimbatore–Kanyakumari) segment of NH 47 with the northern
(Coimbatore–Salem) segment of the same NH, was not viable on its
___________________
own.The State government agreed to enlarge the scope of the project.
___________________ It would now include the construction of an additional bridge (to make
the two-lane into a four-lane right of way) near the old Athupalam
___________________ Bridge, across the Noyyal river.
___________________ The ROB on NH 209 was not considered. Subsequently, a tripartite

concession agreement was signed between MoST, the Tamil Nadu
___________________ State Government and LTTIL on 13 October 1997.
___________________ Scope of Project
The scope of the project thus included two distinct segments:

• Construction of a bypass.
• Construction of a two lane, Athupalam Bridge across Noyyal river
on the NH 47.
A map indicating the location of the Coimbatore Bypass and its

adjoining road network is shown here (Figure 1).
Figure 20.1: Map indicating the location of the Coimbatore Bypass Project
Contd…
Unit 20: Case Study
243
This project was the first to be executed on a BOT basis in the state. Notes
Coimbatore Bypass: Construction of the bypass for a length of 27.67

___________________
km, having a two lane 7.5 m carriageway with paved shoulders
configuration. The alignment of the bypass intersected two major ___________________
roads which had since been notified as national highways, namely, the
Coimbatore Pollachi Road (NH 209) and CoimbatoreKarur Road (NH ___________________
54A).
___________________
The bypass component included construction of two ROBs, one major
bridge (across river Noyyal, called Noyyal Bridge), 10 minor bridges ___________________
and other cross drainage structures.
___________________
Athupalam Bridge: Construction of two additional lanes to the
___________________
existing bridge over river Noyyal on NH 47 at km 161/8 was proposed
as part of the bypass project to ease congestion on the existing bridge. ___________________
The cost of the project was estimated at Rs 90 crore (` 87 crore for ___________________
the Coimbatore Bypass and ` 3 crore for the Athupalam Bridge). The
recovery of this was proposed through collection of toll on both the ___________________
bypass and the bridge.
As per the agreement, LTTIL was given a concession to levy toll for
a period of 20 years on the Athupalam Bridge and 30 years on the
Coimbatore Bypass. The agreement clearly specified that while the
traffic risk was with LTTIL, the risk due to non-payment of toll would
be with the State Government.
Financing of the Project
In the 1970s, the Tamil Nadu government planned the Coimbatore

Bypass Road to ease the traffic congestion in Coimbatore and the NH-
47 between Salem and Cochin. However, due to paucity of funds, the
project had to be dropped.
In 1995, the Government of India (GoI) liberalized its policies and

opened up the road sector for private investments. In September
1995, the GoI through its Ministry of Surface Transport (MoST) invited
tenders from the private sector to finance and implement the
construction, operation and maintenance of the Coimbatore bypass
road project under BOT scheme.
As the project was not viable on its own, the GoI after studying the
various options, widened the scope by including the construction of an
additional two-lane bridge on river Noyal on the NH-47.
A concession agreement for the integrated project of bypass and a

bridge at Athupalam on NH-47 was signed on October 3, 1997 between
the MoST, the government of Tamil Nadu and L&T.
L&T set up a Special Purpose Vehicle (SPV) – L&T Transportation

Infrastructure Ltd. (LTTIL), to implement the project. It held 100
percent equity in LTTIL. LTTIL implemented the project under BOT
scheme, with the revenue accruing directly to it.
Contd…
244
Notes The project was constructed by L&T-ECC (Engineering Construction
Corporation) group, the largest construction organization in India.
___________________
For quality control supervision and review of the critical pavement
design, L&T-Ramboll Consulting Engineers, a joint venture between
___________________ L&T and Ramboll of Denmark, was employed.
___________________ The project was financed by a share Capital of ` 416 million and a
term loan of ` 620 million, with a debt equity ratio of 1.5:1. As per
___________________ the agreement with the Tamil Nadu government, L&T had to hold a
minimum equity of 26% at the end of 30 years.
___________________
The debt financing was done by the State Bank of India (SBI), L&T
___________________ Finance, Housing and Urban Development Corporation (HUDCO),
Housing Development Finance Corporation (HDFC), and Industrial
___________________ Development Bank of India (IDBI). IDBI had sanctioned Rs 300 million
for the project in the form of infrastructure bonds. The loan was given
___________________
in two tranches of ` 150 million each at, 15 percent interest each.
___________________ Principal repayment was to begin from the eighth year onward.
The SBI loaned ` 300 million to the project. Infrastructure Development

___________________
Finance Corporation (IDFC) had structured a “liquidity support”
arrangement to help SBI in any emergency situation. This support
enabled the SBI to approach IDFC for refinancing in case it failed to
raise the money from other sources.
For IDFC, liquidity support was different from the take-out financing
since it was lending on condition that the bank was unable to raise
the money. Moreover, IDFC would not take project risk even after
lending to the bank. IDFC would only be carrying the bank risk as it
had given the money to the bank and not the SPV.
Table 1: Financing Options Matrix
Sr. Characteristics Projects Issues(s)

No. of Infrastructure
1. Capital Intensive Scarcity of • Multilateral financing

Resources • Consortium/Syndication
• Federal Govt. Guarantee
with financial support
2. Long Gestation Asset Liability • Take out financing

Period Mismatch • Long Term Borrowing
• Securitisation of receivables
3. Working Capital Overlapping of • Flexible financing delinking

Requirements Project construction stage from post-
based on Project Implementation construction phase
Phasing Schedules • Cash flow financing
4. Inadequate High Cost of • ‘Take or Pay’ Agreements

returns and Funds • Escrow Accounts
uncertainty on • Tax Incentives
returns • Priority Sector Lending
• Sub-ordinate debt finance
• Firm tariff policy
• Sinking funds
Contd…
Unit 20: Case Study
245
Revenue Generation Notes
L&T pointed out that the project helped vehicles save fuel, time and
vehicle operating costs due to reduction of distance by, 2.5 km and ___________________
allowed free flow traffic. Other benefits to the bypass users included, ___________________
less pollution, pleasant drive, good wayside amenities and safety.
___________________
L&T put special emphasis to safety aspect of the road. Crash barriers
were provided on the high embankments of the road along with thermo ___________________
plastic road markings.
___________________
Traffic signals were erected at the junctions of Neelambur (Tamil
Nadu), Madukkarai (Kerala), Trichy Road (Tamil Nadu), and Pollachi ___________________
Road (Kerala). Speed breakers were erected at suitable locations on
the major district roads crossing the bypass to regulate the speed of ___________________
vehicles. ___________________
Retro reflective signboards were also provided to illuminate junctions
___________________
for better visibility at night.
___________________
L&T also set up a trauma care facility with ambulance at the bypass.
Table 2: Toll Charges for using the Coimbatore bypass Road
Type of Vehicle Toll Charged (`

`)
Car, Jeep and Van 19
Light Commercial Vehicles 28
Heavy Commercial Vehicles 56
Multi-axle Vehicles 84
The Indian Railways had requested L&T to build a rail overbridge

instead of a crossing for the bypass. However, L&T successfully argued
that it was not part of the original project. In order to recover the
additional cost, an alternative funding method had to be selected to
keep low, the fixed costs to be recovered from the project. Hence,
with the consent of the State Government, L&T decided to toll the old
Athupalam Bridge, which did not come within the route of the bypass.
(Refer Table 3)
Table 3: Toll Charges for using the old Athupalam Bridge
Type of Vehicle Toll Charged (`

`)
Car, Jeep and Van 5
Light Commercial Vehicles 15
Heavy Commercial Vehicles 15
Multi-axle Vehicles 2
Contd…
246
Notes L&T also intended to provide necessary amenities for travellers such
as, petrol pumps, parking, service stations, restaurants, drinking water
___________________ facility, public telephone booths and so on. The development of the
real estate was to start soon. Toll plazas of international standards
___________________ were another attraction.
___________________ Challenges
___________________ As can be seen from the traffic profile, trucks and buses were the
most important in order to increase toll revenues. However, in India,
___________________ a typical problem that is faced is the mentality of the truck drivers to
avoid toll. Car drivers tend to be much more flexible because they
___________________
value time. It was hoped that over a period of time, the mentality of
___________________ truck drivers would change, and they would pay more attention to the
vehicle operating cost and also the opportunity cost of time.
___________________
The challenges faced by LTTIL included:
___________________
Project Structuring: Only one private party bid for the project. This
___________________ was mainly due to the deficiency in project structuring, both scope
wise and financially. LTTIL bid for the project with the condition that
the Athupalam Bridge segment should be bundled with the bypass
segment to make it financially viable.
Public Consultation: Neither any demand or willingness to pay

surveys were carried out nor any initiatives taken towards preparing
the users for a high-class facility that saved on operational cost like,
time, fuel, wear and tear among others. There was no prior public
consultation or discussion with opinion makers before deciding to levy
toll on the bridge.
Biased Revenue Analysis: Revenue projections were expected in

the ratio of 40:60 from the bypass and the bridge, whereas the
investment towards the construction was in the ratio of, 87:3. The
bridge users were supposed to cross-subsidize bypass users.
Delays Due to Queuing: The tolling on the bridge had attendant

queuing and waiting time. The public looked upon this as a hindrance
instead of improved levels of service.
Local Traffic: The Athupalam Bridge was located close to the city
limits of Coimbatore. The volume of local traffic was very high. There
was an unwillingness to pay toll, especially since they had not paid
toll for the bridge crossing prior to the construction of the new two-
lane bridge.
Multiple Trips: The agreement provided for collection of tolls only

on the basis of single trips made across the bridge. It ignored the
users that made multiple trips per day. Such users found trip-wise toll
charges expensive.
Toll on Existing Bridge: The agreement provided for toll collection

on the existing two-lane bridge. After the construction of the new two-
Contd…
Unit 20: Case Study
247
lane bridge, each bridge was being used unidirectionally. Public objected Notes
to the toll being levied on the existing bridge for which LTTIL had not
made any additional investment. ___________________
Enforcement: Local taxi, bus and commercial fleet operators formed ___________________
associations to protest against the toll collection and refused to pay
the toll. Despite public protest, toll collection continued but, with ___________________
poor/ low compliance. LTTIL appealed to the government to suitably
___________________
amend the Motor Vehicles Act to empower a private entrepreneur to
enforce toll collection and regulate traffic flow for users refusing to ___________________
pay toll charges.
___________________
L&T faced more problem with the tolling of the old Athupalam Bridge,
which did not come within the route of the bypass. This bridge was ___________________
an already existing facility being used by the incoming traffic from
___________________
Kerala to Tamil Nadu. Transport operators had initially refused to
pay the toll. The bulk users of the bridge including, the State Transport ___________________
Corporations of Tamil Nadu and Kerala refused to pay the toll.
___________________
The Tamil Nadu State government too backtracked and sought
concessional tariff for State Transport buses on the plea that the
transport department was in the red. The Tamil Nadu government
was willing to pay only ` 50 per bus for making more than three trips
a day instead of the originally planned ` 15 per bus per trip. L&T
agreed to the subsidized toll rate on the condition that the State
government compensate the revenue losses sustained by the company.
The Coimbatore District Bus Owners Association (CDBOA) and the

Lorry Owners Association refused to pay even the subsidized tariff.
The CDBOA even took the issue to the Madras High Court against
the tariff but, the Court directed the private operators to pay toll
charges. But they refused to comply with the court’s orders.
From December 1998, L&T was unable to collect toll from road users
and this resulted in a loss of ` 74.1 million as of June 2000. This
included, ` 11.4 million due from the Tamil Nadu government towards
reimbursement of losses incurred out of the subsidized toll payment
for the State Transport buses.
L&T’s GM (Developmental Projects), N R Naramsimhan, felt that

unless the State government gave L&T the power to deal strictly with
the non-payers, it would be impossible to recover the investment. He
felt that L&T might even request the State government to take over
the project.
Then, L&T contemplated on invoking the force majeure clause and

pulling out of the project. L&T was also under tremendous pressure
from the various financial institutions, which had lent money, to create
additional securities. MoST had asked the State government to take
a quick decision as a delay would have an adverse impact on other
BOT projects in the State.
Contd…
248
Notes Key Takeaways of the Coimbatore Bypass Case Study
In the Coimbatore Bypass case, in spite of the government being

___________________
responsible for the payment risk, but, did not fulfil its role by taking
___________________ action towards ensuring toll compliance or compensating for the losses.
If the response from the government remains so, future public private
___________________ road projects would be in jeopardy, as already feared for the forthcoming
BOT bridge projects in Kuzhithurai on NH-47, Vaniyambadi and
___________________
Pachakupam on NH-46 in Tamil Nadu [Financial Express, 2000].
___________________ There is no clarity between the government and the developer on the
resolution of the problems, if the project gets into unanticipated
___________________
problems. This would be a major deterrent for private players to
___________________ invest in road development projects. Other fundamental deterrents
are perceived risk due to problems in estimating traffic demand and
___________________ public’s willingness to pay.
___________________ Tolls based road projects are demand sensitive. This is more so in
urban roads where the willingness to pay is almost none. Also, the
___________________ extent of homework to identify various user segments, like, single
trip versus multiple trip users, and to develop an appropriate tolling
structure is significant.
The consequence would be that the construction and maintenance of

city roads would be ignored under the toll-based road development
concept.
Source: http://www.larsentoubro.com/lntcorporate/pmiv/pdf/
ProjectFinancing-ACasestudyo nCoimbatore BypassRoadProject.pdf
1. Discuss the implication of the state government’s poor support to

the project, on the future investment in the concerned state. Give
reasons.
2. What is the role of an innovative financial instruments like, takeout

financing, in the infrastructure sector?
3. Discuss project-financing options for similar future projects of L&T.

Block–V
Detailed Contents
UNIT-21: PROJECT ECONOMICS AND VIABILITY–I
UNIT-22: PROJECT ECONOMICS AND VIABILITY–II
UNIT-23: ELECTRICITY SECTOR IN INDIA–I
UNIT-24: ELECTRICITY SECTOR IN INDIA–II
UNIT-25: CASE STUDIES

251
Unit 21 Notes
Project Economics and Viability–I ___________________
___________________
___________________
\ Cash Flow
___________________
\ Capital Costs
___________________
\ Break-Even Analysis
___________________
___________________
Introduction ___________________
When we start a business, its economics that is cash flows,

expenses and income, should be assessed systematically both from
an optimistic perspective as well as from a pessimistic perspective,
to assess the viability of the project.
Cash Flow
Cash flow is the movement of cash into or out of a business,
project, or financial product. Projecting cash flow is a vital aspect
of managing a business. Many new and small businesses implode
because as they develop their business models, they forget to
consider when money is actually going to be available. It can
refer to actual past flows, or to projected future flows. It can
refer to the total of all the flows involved or to only a subset of
those flows. Subset terms include ‘net cash flow’, ‘operating cash
flow’ and ‘free cashflow’.
The (total) net cash flow of a company over a period (typically a
quarter or a full year) is equal to the change in cash balance over
this period. It is positive if the cash balance increases (more cash
becomes available) and is negative if the cash balance decreases.
The total net cash flow is the sum of cash flows that are classified
in three areas:
1. Operational cash flows: Cash received or expended as a
result of the company’s internal business activities. It
includes cash earnings plus changes to working capital. Over
the medium term this must be net positive if the company
is to remain solvent.
252
2. Investment cash flows: Cash received from the sale of long-
Notes
life assets, or spent on capital expenditure (investments,
acquisitions and long-life assets).
___________________
3. Financing cash flows: Cash received from the issue of debt
___________________
and equity, or paid out as dividends, share repurchases or
___________________ debt repayments.
___________________ Measurement of cash flow can be used for calculating other

parameters that give information on the companies’ value and
___________________
situation. Cash flow can be used for calculating parameters:
___________________ • To determine a project’s rate of return or value: The time of
___________________
cash flows into and out of projects are used as inputs in
financial models such as internal rate of return and net
___________________ present value.
___________________ • To determine problems with a business’s liquidity: Being
profitable does not necessarily mean being liquid. A company
___________________
can fail because of a shortage of cash, even while profitable.
• As an alternate measure of a business’s profits when it is
believed that accrual accounting concepts do not represent
economic realities. For example, a company may be notionally
profitable but generating little operational cash (as may be
the case for a company that barters its products rather than
selling for cash). In such a case, the company may be deriving
additional operating cash by issuing shares or raising
additional debt finance.
• To evaluate the ‘quality’ of income generated by accrual
accounting: When net income is composed of large non-cash
items, it is considered low quality.
• To evaluate the risks within a financial product: For example,
matching cash requirements, evaluating default risk,
reinvestment requirements etc.
How to Project Cash Flow

A projected cash flow statement can be constructed using
information from a comparative or projected balance sheet and
income statement. It is very useful to help plan a business in
such areas as the recruitment of new employees, whether to issue
new stock, and/or acquisitions of long-term assets. Or simply to
estimate whether the bills can be paid, or a loan will be needed.
There are two methods that companies use to prepare a cash
flow statement. They are the direct and indirect method. The
indirect method is the chosen method for most companies. It
begins with the net income reported on the income statement
Unit 21: Project Economics and Viability–I
253
and adjusts accrual amounts for any items that do not affect the
Notes
cash flow, such as depreciation.
The following are the steps to prepare a projected cash flow ___________________
statement:
___________________
1. Based on historical information (comparative statements),
___________________
an estimate must be projected of the percentage of the
increase/decrease of sales for the new period. ___________________
2. Determine the change in cash including cash equivalents. ___________________

This is determined by analysing the change in operating,
___________________
investing and financing activities and then, arriving at a
total sum. ___________________
3. Convert the income statement from an accrual basis to a ___________________
cash basis by analysing the changes in all operating assets
and liabilities and making the adjustments. ___________________
4. Analyse the long-term debt and stockholder’s equity accounts ___________________

in the investing and financing activities to determine cash
flow effects.
5. Prepare the statement of cash flows, reconciling the
beginning and ending balances. If the total of the operating,
investing and the financing doesn’t total the change in the
cash from step 2, then something is wrong and will need to
be fixed.
6. Disclose any significant non-cash activities pertaining to
investing or financing transactions.
Example of a simplified cash flow projection: For example,
let’s say that you are thinking of purchasing a new machine that
will allow you to offer a new product to your customers. The
machine will cost ` 100,000 to purchase and install, and after five
years (when you plan to sell it) the machine will be worth about
` 10,000. Your facility has plenty of room, so you won’t have any
additional rental costs for space, and you can piggyback
advertising for the new product on to your existing advertising
budget. You will, however, have to pay for insurance, personal
property taxes, and a part-time employee to operate the machinery
(these items are included in your fixed costs, which will total
` 12,000 in the first year). Also, there will be costs for materials,
supplies, and electricity that will vary depending on the volume
of production. These variable costs will amount to about 60 per
cent of the sales revenues.
The following is a simplified example of a projected cash flow
statement for the project:
254
Notes Current Year 1 Year 2 Year 3 Year 4 Year 5
(`
`) (`
`) (`
`) (`
`) (`
`)
___________________
Price/Unit 80 84 88 93 97
___________________
Multiplied by: 1000 1150 1323 1521 1749
___________________ Units Sold
___________________ Net Sales 80,000 96,600 116,424 141,453 169,653
___________________ Variable Costs 48,000 57,960 69,854 84,872 101,792
___________________
Fixed Costs 12,000 12,600 13,230 13,892 14,586
Depreciation 14,290 24,490 17,490 12,490 8,930

___________________
Gain/Loss - (12,310)
___________________
Equip. Sale
___________________
Pre-tax 5,710 1,550 15,850 29,591 32,034
___________________ Income
Tax Expense 1,941 527 5,389 10,060 10,892
Net Income 3,769 1,023 10,461 19,531 21,142
Adjustments
Add Back 14,290 24,490 17,490 12,490 8,930

Depreciation
Asset 100,000 10,000

Purchase
Salvage
Value
Net Cash (100,000) 18,059 25,513 27,951 32,021 40,072

Flow
The table makes several assumptions:

• The average price of the product will increase by 5 per cent
a year, while the volume sold will increase by 15 per cent a
year.
• Depreciation is computed using the IRS’s tables for 7-year
property, using the half-year convention under MACRS. Tax
depreciation is used because it affects the outflow of cash in
the form of tax payments.
• Fixed costs will increase by an inflation factor of 5 per cent
a year.
• The tax rate is calculated at 34 percent.
255
Fill in the blanks:
___________________
1. ................ is the movement of cash in too rout of a business, project
or financial product. ___________________
2. ................ is very useful to help plan a head in a business in such ___________________

areas as the recruitment of new employees, whether to issue new stock
___________________
and/or acquisitions of long-term assets.
___________________
Capital Costs ___________________
In business terms, the word capital refers to money. Capital costs ___________________
are the fees associated with the initial setup of a plant or project. ___________________
Capital costs will usually occur at the beginning of a project, as
the operational costs cover reoccurring business expenses. It may ___________________
take a wide array of resources to begin a business, so capital
___________________
costs may finance a number of expenses.
The cost of capital will vary depending on the type and size of
the business being established. In order to build an entire plant,
capital costs may need to cover the expense of materials and
labour to create the new structure. Capital costs tend to mostly
cover costs incurred as the result of buying land and building a
plant or structure for business use.
In order to account for these expenses, they are capitalized and
added to the cost of the asset. If the expenses were deducted in
one large sum, it could be potentially devastating to a new
business. These costs are instead capitalized and deducted over
time from depreciation or depletion.
Most capitalized costs are considered to be fixed assets. Since
fixed assets are not included in current net income, they tend to
affect net income slowly, over several financial periods.
Capitalized costs may be considered fixed assets since they include
any facility the company constructs for its own use, such as a
wind or power plant. Other costs that may be considered fixed
assets are real estate developments that may be leased or sold,
large office buildings and ships.
Being categorized as a fixed asset makes the company’s funds
both an equity and a debt. Eventually, for a business to remain
intact,

the return on the capital must reach a higher point than the cost
of capital. The company typically needs to make enough money,
256
so investors receive at least their original return on the initial
Notes
investment of capital costs.
___________________
Operating Costs
___________________
For a commercial enterprise, operating costs fall into two broad
___________________ categories:
___________________ • Fixed costs, which are the same whether the operation is
closed or running at 100% capacity.
___________________
• Variable costs, which may increase depending on whether
___________________
more production is done, and how it is done (producing 100
___________________ items of product might require 10 days of normal time or
take 7 days if overtime is used. It may be more or less
___________________ expensive to use overtime production depending on whether
___________________ faster production means the product can be more profitable).
___________________ Fixed Costs

Fixed costs are those business costs that are not directly related
to the level of production or output. In other words, even if the
business has a zero output or high output, the level of fixed costs
will remain broadly the same. In the long term, fixed costs can
alter, perhaps as a result of investment in production capacity
(for example, adding a new factory unit) or through the growth
in overheads required to support a larger, more complex business.
Examples of fixed costs:
• Rent and rates
• Depreciation
• Research and development
• Marketing costs (non- revenue related)
• Administration costs
Variable Costs
Variable costs are those costs that vary directly with the level of
output. They represent payment output-related inputs such as
raw materials, direct labour, fuel and revenue-related costs such
as commission.
A distinction is often made between “Direct” variable costs and
“Indirect” variable costs.
Direct variable costs are those that can be directly attributable
to the production of a particular product or service and allocated
to a particular cost centre.
257
Indirect variable costs cannot be directly attributable to
Notes
production, but they do vary with output. These include
depreciation (where it is calculated related to output, for example,
___________________
machine hours), maintenance and certain labour costs.
___________________
Semi-Variable Costs
___________________
Whilst the distinction between fixed and variable costs is a
___________________
convenient way of categorising business costs, in reality, there
are some costs that are fixed in nature but increase when output ___________________
reaches certain levels. These are largely related to the overall
___________________
“scale” and/or complexity of the business. For example, when a
business has relatively low levels of output or sales, it may not ___________________
require costs associated with functions such as human resource
___________________
management or a fully resourced finance department. However,
as the scale of the business grows (for example, output, number ___________________
people employed, number and complexity of transactions), more
resources are required. If production rises suddenly, some short- ___________________
term increase in warehousing and/or transport may be required.
In these circumstances, it is said that part of the cost is variable,
and part of the cost is fixed.
Check Your Progress
Fill in the blanks:
1. .................... are the fees associated with the initial setup of a plant or
project.
2. .................... are those business costs that are not directly related to the
level of production or output.
3. .................... are those costs that vary directly with the level of output.
4. .................... are those that can be directly attributable to the production

of a particular product or service and allocated to a particular cost
centre.
Break-Even Analysis
Break-even analysis is a technique widely used by production
management and management accountants. A break-even
analysis is used to determine how much sales volume your
business needs to start making a profit. The break-even analysis
is especially useful when you’re developing a pricing strategy,
either as a part of a marketing plan or a business plan.
It is based on categorising production costs between those which
are “variable” (costs that change when the production output
changes) and those that are “fixed” (costs not directly related to
the volume of production).
258
Total variable and fixed costs are compared with sales revenue
Notes in order to determine the level of sales volume, sales value or
production at which the business makes neither a profit nor a
___________________
loss (the “break-even point”).
___________________
The Break-Even Chart
___________________
In its simplest form, the break-even chart is a graphical
___________________
representation of costs at various levels of activity shown on the
___________________ same chart as the variation of income (or sales, revenue) with the
same variation in activity. The point at which neither profit nor
___________________ loss is made is known as the “break-even point” and is represented
on the chart below by the intersection of the two lines:
___________________
___________________ E
A
___________________
___________________ C
P
Variable
Break-Even Costs
point
B
Loss Profit
Fixed
Costs
Q
O
Output
Figure 21.1: The Break-even Chart
In the figure 21.1, the line OA represents the variation of income

at varying levels of production activity (“output”). OB represents
the total fixed costs in the business. As output increases, variable
costs are incurred, meaning that the total costs (fixed + variable)
also increase. At low levels of output, costs are greater than
income. At the point of intersection, P, costs are exactly equal to
income, and hence, neither profit nor loss is made.
Understanding Break-even
The break-even analysis is not considered to be favourite because:
• It is frequently mistaken for the payback period, the time it
takes to recover an investment. There are variations on
break- even that make some people think we have it wrong.
The one we do use is the most common, the most universally
accepted, but not the only one possible.
• It depends on the concept of fixed costs, a hard idea to
swallow. Technically, a break-even analysis defines fixed costs
259
as those costs that would continue even if you went broke.
Instead, you may want to use your regular running fixed Notes
costs, including payroll and normal expenses.
___________________
• It depends on averaging your per-unit variable cost and per-
unit revenue over the whole business. However, whether ___________________
we like it or not, this table is a mainstay of financial analysis. ___________________
You may choose to leave it out, but really, a business plan
would not be complete without it. And, although there are ___________________
some other ways to do a break-even analysis, this is the
___________________
most standard.
___________________
The break-even analysis depends on three key assumptions:
1. Average per-unit sales price (per-unit revenue): This is ___________________
the price that you receive per unit of sales. Take into account ___________________
sales discounts and special offers. Get this number from
your Sales Forecast. For non-unit-based businesses, make ___________________
the per-unit revenue ` 1 and enter your costs as a per cent
___________________
of a dollar. The most common questions about this input
relate to averaging many different products into a single
estimate. The analysis requires a single number, and if you
build your Sales Forecast first, then you will have this
number. You are not alone in this, the vast majority of
businesses sell more than one item and have to average for
their break-even analysis.
2. Average per-unit cost: This is the incremental cost, or
variable cost, of each unit of sales. If you buy goods for
resale, this is what you are paid, on average, for the goods
you sell. If you sell a service, this is what it costs you, per
dollar of revenue or unit of service delivered, to deliver that
service. If you are using a Units-based Sales Forecast table
(for manufacturing and mixed business types), you can project
unit costs from the Sales Forecast table. If you are using the
basic Sales Forecast table for retail, service and distribution
businesses, use a percentage estimate, e.g., a retail store
running a 50% margin would have a per-unit cost of .5, and
per-unit revenue of 1.
3. Monthly fixed costs: Technically, a break-even analysis
defines fixed costs as costs that would continue even if you
went broke. Instead, we recommend that you use your regular
running fixed costs, including payroll and normal expenses
(total monthly operating expenses). This will give you a better
insight on financial realities. If averaging and estimating is
difficult, use your profit and loss table to calculate a working
fixed cost estimate. It will be a rough estimate, but it will
provide a useful input for a conservative break-even analysis.
The break-even analysis depends on assumptions made for average
per-unit revenue, average per-unit cost, and fixed costs. These
260
are rarely exact. The break-even analysis shall be done twice -
Notes first, with educated guesses for assumptions, as part of the initial
assessment, and later on, using your detailed Sales Forecast and
___________________
Profit and Loss numbers. Both are valid uses.
___________________
Check Your Progress
___________________
Fill in the blanks:
___________________
1. A .................. is used to determine how much sales volume your
___________________ business needs to start making a profit.
___________________ 2. .................. is the price that you receive per unit of sales.
___________________ 3. ............. is the incremental cost, or variable cost, of each unit of sales.
___________________
Summary
___________________
It is important to distinguish between the economic evaluation of
___________________ alternative physical facilities and the evaluation of alternative
financing plans for a project. The former refers to the evaluation
of the cash flow representing the benefits and costs associated
with the acquisition and operation of the facility, and this cash
flow over the planning horizon is referred to as the economic
cash flow or the operating cash flow. The latter refers to the
evaluation of the cash flow representing the incomes and
expenditures as a result of adopting a specific financing plan for
funding the project, and this cash flow over the planning horizon
is referred to as the financial cash flow.

1. What is break-even analysis? How is that useful in evaluating
the financial viability of a project?
2. Following information is given for an electronic item:
Selling Price Per Unit: ` 17
Fixed Expenses
Selling & Administrative: ` 130,000
Interest Expense: ` 10,000
Variable Expenses
Cost of Goods Sold: ` 4
Selling & Administrative: ` 3
(a) What is the company’s contribution margin?
(b) What is the break-even point in units?
(c) If the company wants to earn a profit of ` 42,000 instead
of breaking even, what is the number of units the
company must sell?
261
Unit 22 Notes
Project Economics and Viability–II ___________________
___________________
___________________
\ Stochastic Modelling
___________________
\ Monte Carlo Simulation
___________________
___________________
Introduction ___________________
There is not a single definition of Monte Carlo method, but they ___________________
have in common that they make use of random sampling to
compute the result. The algorithms typically rely on pseudo
random numbers, computer-generated numbers mimicking true
random numbers, to generate a realization, one possible outcome
of a process. All outcomes do not have to be equally probable, and
by repeating the procedure with different random numbers as
input, one gathers data corresponding to the modelled process.
On this data, one may then perform a statistical analysis in order
to answer different questions about the process.
Stochastic Modelling
A method of financial modelling in which one or more variables
within the model are random. Stochastic modelling is for the
purpose of estimating the probability of outcomes within a forecast
to predict what conditions might be like under different situations.
The random variables are usually constrained by historical data,
such as past market returns.
Sensitivity Analysis
For any new project we invest in, the future is uncertain, and we
may like to know what will happen to the viability of the project
when some variable like sales, raw material cost, tax laws etc.
deviate from its expected value. In other words, we may want to
do “what if” analysis or sensitivity analysis.
Sensitivity analysis involves calculating cash flows under the best
estimate of input variables, and then calculating the consequences
of limited changes in the value of these inputs. It assists the
evaluator to identify the variables that significantly affect the
262
outcome and correspondingly needs more information and
Notes
investigation. Sensitivity analysis is carried out during every
financial and economic evaluation of projects. It is simple and
___________________
informative. It is a review of the impact that changes in selected
___________________ project inputs, costs or benefits, or a combination of these, can
have on the project’s net present value or IRR.
___________________
In this case, one or more variables are changed independently or
___________________
collectively, within reasonable limits (10-20 per cent) to see the
___________________ likely effect of the change on the net present value of the project
and its likely IRR. Alternatively, the aim may be to calculate the
___________________
change in one variable, like the selling price per unit or project
___________________ cost that will reduce the net present value of project benefits to
zero. This will indicate the selling price per unit or project cost
___________________ below or above which respectively, it is not worthwhile pursuing
___________________ the project.
___________________ Another alternative may be break-even analysis, to work out

values of inputs and outputs that will reduce the project benefits
to below the cut-off rate, which is a rate established as a
‘threshold’ below which projects should not be accepted. The cut-
off rate depends to a large extent on the riskiness of the project.
A project with a high volatility in some inputs will therefore
need a much higher acceptable cut-off rate than a project with
almost sure estimates. One of the most important exercises in
sensitivity analysis is to review the impact of the discount rate
on the project’s net present value and its profitability. In this
case, and if there is no single film discount rate, more than one
discount rate is tried and the outcome with each discount rate is
described.
Sensitivity analysis is, therefore, an essential and easy means of
evaluating the vulnerability of the project to likely future deviation
from best-input estimates. It can also help in assessing the extent
of risk in the project, and the particular inputs that significantly
affect the project outcome. Once these are identified, then a more
careful study should be undertaken of these particular items to
enable better estimates and a firmer calculation of the net present
value and the project’s IRR.
For the electrical power ‘industry, the most important items
affecting a project’s financial performance are the electrical tariff
and fuel prices. With the increasing availability of electronic
calculating facilities, it has become easier to undertake many
sensitivity analysis scenarios and to analyse the effect of various
parameters on the project’s financial and economic feasibility.
One of the major weaknesses of sensitivity analysis is that the
changes are, most of the time, ad hoc (10 per cent change in price
Unit 22: Project Economics and Viability–II
263
of fuel or 10 per cent change in demand etc.), without regard to
Notes
the expectancy and probability of these happening. Such ad hoc
assumptions do not assist decision makers to examine the
___________________
likelihood of the event. Fuel price changes, in the future, may be
much more likely to occur than other operational costs. Therefore, ___________________
dealing with these two on equal terms can lead to wrong
___________________
impressions and conclusions. What is important is not only the
prospect of change of a fundamental input assumption but also ___________________
the probability of this happening and its extent, and also the
___________________
interrelationship between variation in one variable and other
inputs. Such prospects can only be adequately evaluated by proper ___________________
risk analysis.
___________________
To demonstrate this, consider a 100 MW CCGT set, firing LNG,
that consumes 6000 BTU per kWh generated, at a cost of ` 208 ___________________
per million BTU. The set will cost ` 4,000 million at commissioning ___________________
and is expected to act as a base load generating unit at full load
for 7,000 hours annually. There is a fixed annual cost of ` 80 ___________________
million.
With a 10 per cent discount rate, over 20 years, the equivalent
annual cost of investment is equal to
Investment ` 4,000
= = ` 469.8 million
20 - year annuit 8.5
The fixed annual cost of capital and operation will equal to

469.8 million + 80 million = ` 549.8 million,
with an annual generation of
100 MW × 7000 h = 700 GWh.
The fixed annual cost per kWh will be
` 549.8 million ÷ 700 GWh = 78.54 paise/kWh
Fuel cost per kWh is
(` 208 × 6000)/106 = 124.8 paise
Total cost of generation is
78.54 + 124.8 = 203.8 paise/kWh.
Consider the case of a sensitivity analysis of a possible increase
in fuel cost by 20 per cent, then the fuel cost will become 149.8
paise kWh−1 and the total cost of generation 228.34 paise kWh−1.
With such a fuel price and operational cost, the set most likely
will not remain a base load set and correspondingly the energy
output of the set and its cost per kWh will be higher. Sensitivity
264
analysis fails to capture such correlation between fuel cost, energy
Notes
contribution of the set and correspondingly system cost. It is only
simulation that can give the generation cost, capture the system
___________________
effect and evaluate the true economics of investing in such a
___________________ plant compared with other alternatives firing other fuels.
___________________ Sensitivity analysis has certain merits:
___________________ • It shows how robust or vulnerable a project is to changes in
values of the underlying variables.
___________________
• It indicates where further work may be done. If NPV is highly
___________________
sensitive to changes in some factor, it may be worthwhile to
___________________ explore how the variability of that critical factor may be
contained.
___________________
• It is intuitively a very appealing as it articulates the concerns
___________________ that project evaluators have.
___________________ Notwithstanding its appeal and popularity, sensitivity analysis
suffers from several shortcomings:
• It merely shows what happens to NPV when there is a change
in some variable, without providing any idea of how likely
that change will be.
• Typically, in sensitivity analysis only one variable is changed
at a time. In the real world, however, variables tend to move
together.
• It is inherently a very subjective analysis. The same sensitivity
analysis may lead one decision maker to accept the project
while another may reject it.
Check Your Progress
Fill in the blanks:
1. .................... is a method of financial modelling in which one or more

variables within the model are random.
2. .................... is a review of the impact that changes in selected project

inputs, costs or benefits, or a combination of these, can have on the
project’s net present value or IRR.
Monte Carlo Simulation

Monte Carlo simulation is an example of a stochastic model used
in finance. When used in portfolio evaluation, multiple simulations
of the performance of the portfolio are done based on the
probability distributions of the individual stock returns. A
statistical analysis of the results can then help determine the
probability that the portfolio will provide the desired performance.
265
What is Simulation?
Notes
Simulation is emulation of reality using mathematical model. A
simulation model allows to examine system behaviour under ___________________
different scenarios in virtual computational world. It can be used ___________________
to identify bottlenecks in a process, provide a safe, and relatively
very cheap (in term of both cost and time) test bed to evaluate ___________________
the side effects and to optimize the performance of the system
___________________
before transferring them to real world.
___________________
Risk analysis is a part of every decision we make. We are
constantly faced with uncertainty, ambiguity, and variability. And ___________________
even though we have unprecedented access to information, we
___________________
can’t accurately predict the future. Monte Carlo simulation lets
you see all the possible outcomes of your decisions and assess the ___________________
impact of risk, allowing for better decision making.
___________________
Monte Carlo simulation is a computerized mathematical technique
___________________
that allows people to account for risk in quantitative analysis
and decision making. The technique is used by professionals in
such widely disparate fields as finance, project management,
energy, manufacturing, engineering, research and development,
insurance, oil & gas, transportation, and the environment.
Monte Carlo simulation furnishes the decision-maker with a range
of possible outcomes and the probabilities they will occur for any
choice of action. It shows the extreme possibilities - the outcomes
of going for broke and for the most conservative decision along
with all possible consequences for middle-of-the-road decisions.
The technique was first used by scientists working on the atom
bomb; it was named for Monte Carlo, the Monaco resort town
renowned for its casinos. Since its introduction in World War II,
Monte Carlo simulation has been used to model a variety of
physical and conceptual systems.
There is no single Monte Carlo method; instead, the term describes
a large and widely used class of approaches. However, these
approaches tend to follow a particular pattern:
1. Define a domain of possible inputs.
2. Generate inputs randomly from the domain using a certain
specified probability distribution.
3. Perform a deterministic computation using the inputs.
4. Aggregate the results of the individual computations into
the final result.
For example, the value of ð can be approximated using a Monte
Carlo method:
266
1. Draw a square on the ground, then inscribe a circle within
Notes
it. From plane geometry, the ratio of the area of an inscribed
circle to that of the surrounding square is ð/4.
___________________
2. Uniformly scatter some objects of uniform size throughout
___________________
the square. For example, grains of rice or sand.
___________________ 3. Since the two areas are in the ratio ð/4, the objects should
___________________ fall in the areas in approximately the same ratio. Thus,
counting the number of objects in the circle and dividing by
___________________ the total number of objects in the square will yield an
___________________
approximation for ð/4.
4. Multiplying the result by 4 will then yield an approximation
___________________
for ð itself.
___________________
Notice how the ð approximation follows the general pattern of
___________________ Monte Carlo algorithms. First, we define a domain of inputs. In
this case, it’s the square that circumscribes our circle. Next, we
___________________
generate inputs randomly (scatter individual grains with in the
square), then perform a computation on each input (test whether
it falls within the circle). At the end, we aggregate the results
into our final result, the approximation of ð.
The two other common properties of Monte Carlo methods are
the computation’s reliance on good random numbers, and its slow
convergence to a better approximation as more data points are
sampled. If grains are purposefully dropped into only, for example,
the centre of the circle, they will not be uniformly distributed,
and so our approximation will be poor. An approximation will
also be poor if only a few grains are randomly dropped into the
whole square. Thus, the approximation of ð will become more
accurate both as the grains are dropped more uniformly and as
more are dropped.
Monte Carlo simulation performs risk analysis by building models
of possible results by substituting a range of values - a probability
distribution, for any factor that has inherent uncertainty. It then
calculates results over and over, each time using a different set
of random values from the probability functions. Depending upon
the number of uncertainties and the ranges specified for them, a
Monte Carlo simulation could involve thousands or tens of
thousands of recalculations before it is complete. Monte Carlo
simulation produces distributions of possible out come values.
By using probability distributions, variables can have different
probabilities of different outcomes occurring. Probability
distributions are a much more realistic way of describing
uncertainty in variables of a risk analysis.
267
Random Numbers on [0, 1] Notes
ξ1, ξ2, ξ3, ...

___________________
The Sun Probability ___________________
density
f(x) functions (pdf’s) ___________________
π which describe
Results of Simulation the Sun
___________________
Radiance, solar wind influence,
___________________
Physical System evolution of Sun ......................
___________________
Statistical Simulation
___________________
Figure 22.2: Monte Carlo Simulation of Physical System
___________________
Common probability distributions include: ___________________
1. Normal Or “bell curve”: The user simply defines the mean ___________________
or expected value and a standard deviation to describe the
variation about the mean. Values in the middle near the
mean are most likely to occur. It is symmetric and describes
many natural phenomena such as people’s heights. Examples
of variables described by normal distributions include
inflation rates and energy prices.
2. Lognormal: Values are positively skewed, not symmetric
like a normal distribution. It is used to represent values
that don’t go below zero but have unlimited positive
potential. Examples of variables described by lognormal
distributions include real estate property values, stock prices,
and oil reserves.
3. Uniform: All value shave an equal chance of occurring, and
the user simply defines the minimum and maximum.
Examples of variables that could be uniformly distributed
include manufacturing costs or future sales revenues for a
new product.
4. Triangular: The user defines the minimum, most likely and
maximum values. Values around the most likely are more
likely to occur. Variables that could be described by a
triangular distribution include past sales history per unit of
time and inventory levels.
5. PERT: The user defines the minimum, most likely, and
maximum values, just like the triangular distribution. Values
around the most likely are more likely to occur. However,
values between the most likely and extremes are more likely
to occur than the triangular; that is, the extremes are not as
emphasized. An example of the use of a PERT distribution
268
is to describe the duration of a task in a project management
Notes
model.
___________________ 6. Discrete: The user defines specific values that may occur
and the likelihood of each. An example might be the results
___________________
of a lawsuit: 20% chance of positive verdict, 30% change of
___________________ negative verdict, 40% chance of settlement and 10% chance
of mistrial.
___________________
During a Monte Carlo simulation, values are sampled at random
___________________
from the input probability distributions. Each set of samples is
___________________ called an iteration, and the resulting outcome from that sample
is recorded. Monte Carlo simulation does this hundreds or
___________________ thousands of times, and the result is a probability distribution of
___________________ possible outcomes.
___________________ In this way, Monte Carlo simulation provides a much more

comprehensive view of what may happen. It tells not only what
___________________ could happen, but how likely it is to happen.
Monte Carlo simulation provides a number of advantages over
deterministic, or “single-point estimate” analysis:
• Probabilistic results: Results show not only what could
happen, but how likely each outcome is.
• Graphical results: Because of the data a Monte Carlo
simulation generates, it’s easy to create graphs of different
outcomes and their chances of occurrence. This is important
for communicating findings to other stakeholders.
• Sensitivity analysis: With just a few cases, deterministic
analysis makes it difficult to see which variables impact the
outcome the most. In Monte Carlo simulation, it’s easy to
see which inputs had the biggest effect on bottom-line results.
• Scenario analysis: In deterministic models, it’s very difficult
to model different combinations of values for different inputs
to see the effects of truly different scenarios. Using Monte
Carlo simulation, analysts can see exactly which inputs had
which values together when certain outcomes occurred. This
is invaluable for pursuing further analysis.
• Correlation of inputs: In Monte Carlo simulation, it’s
possible to model interdependent relationships between input
variables. It’s important for accuracy to represent how, in
reality, when some factors go up, others go up or down
accordingly.
An enhancement to Monte Carlo simulation is the use of Latin
Hypercube sampling, which samples more accurately from the
entire range of distribution functions.
269
Some of the Monte Carlo applications are as follows:
Notes
• Nuclear Reactor Design
___________________
• Quantum Chromo Dynamics
___________________
• Radiation Cancer Therapy
• Traffic Flow ___________________
• Stellar Evolution ___________________
• Econometrics ___________________
• Dow Jones Forecasting ___________________
• Oil Well Exploration ___________________

• VLSI Design ___________________
Advantages ___________________
• Monte Carlo simulation is simple to use as long as the ___________________

convergence can be guaranteed by the theory.
• Monte Carlo simulation may provide statistical sampling for
numerical experiment using computer.
• For optimization problems, Monte Carlo simulation often
can reach global optimum and overcome local extreme.
• Monte Carlo simulation provides approximate solution to
many mathematical problems.
• The method can be used for both stochastic (involve
probability) and deterministic (without probability).
Disadvantages
• Monte Carlo simulation was originally developed to study
properties of equilibrium system. It is not universally
acceptable whether this method can also be used to simulate
system that is not in equilibrium (i.e., transient state)
• To use Monte Carlo simulation, you need to generate large
number of sampling. This can be time consuming to reach
the desired results.
• You cannot generate only single sample and use it as the
result of simulation. You need to generate many samples
and get the average (or any other statistics) as the results.
• The results of Monte Carlo simulation are only an
approximation of the true value, not exact.
• Large Variance may be produced by the simulation.
270
Fill in the blanks:

___________________
1. The .................. is an example of a stochastic model used in finance.
___________________
2. .................. is emulation of reality using mathematical model.
___________________
3. .................. is part of every decision we make.
___________________
4. In .................. values are positively skewed, not symmetric like a normal
___________________ distribution.
___________________
___________________
Summary
___________________ In general, economic evaluation and financial evaluation are
carried out by different groups in an organization since economic
___________________ evaluation is related to design, construction, operations and
maintenance of the facility while financial evaluations require
___________________
knowledge of financial assets such as equities, bonds, notes and
mortgages. The separation of economic evaluation and financial
evaluation does not necessarily mean one should ignore the
interaction of different designs and financing requirements over
time which may influence the relative desirability of specific
design/financing combinations. All such combinations can be duly
considered. In practice, however, the division of labour among
two groups of specialists generally leads to sequential decisions
without adequate communication for analysing the interaction of
various design/financing combinations because of the timing of
separate analyses.

1. Write a short note on Stochastic Modelling.
2. What is simulation? Explain Monte Carlo simulation in detail.
3. Enumerate the common probability distributions.
4. List the advantages and disadvantages of Monte Carlo
simulation.
271
Unit 23 Notes
Electricity Sector in India–I ___________________
___________________
___________________
\ Power Generation Projects
___________________
\ Various Types of Lease
___________________
\ Joint Venture Financing in Public and Private Sector
___________________
\ Research and Development Partnerships
___________________
___________________
Introduction
India has a deficit in power generation and dynamic growth
witnessed by the economy has not been matched by the power
sector in India. In fact, experts believe the deficit in power supply
has been the biggest infrastructure constraint.
The government came up with the Accelerated Power Sector
Development and Reform Programme in 2001 to restructure the
power sector. The Electricity Act 2003 was passed to make the
state governments introduce reform to bring in competition and
efficiency in the sector. The post reforms, various state
governments have chalked out strategies to overcome the power
crisis. In spite of all these measures, the power scenario has not
witnessed any dramatic change. Investment into the sector has
not been up to the expectation.
Electricity Sector in India: An Overview

The electricity sector in India is predominantly controlled by the
Government of India’s public sector undertakings (PSUs). Major
PSUs involved in the generation of electricity include National
Thermal Power Corporation (NTPC), Damodar Valley Corporation
(DVC), National Hydroelectric Power Corporation (NHPC) and
Nuclear Power Corporation of India (NPCI). Besides PSUs, several
state-level corporations, such as Tamil Nadu Electricity Board
(TNEB) in Tamil Nadu, Maharashtra State Electricity Board
(MSEB) in Maharashtra, Kerala State Electricity Board (KSEB)
in Kerala, in Gujarat, MGVCL, PGVCL, DGVCL and UGVCL
four distribution companies and one controlling body GUVNL,
272
and one generation company GSEC, are also involved in the
Notes
generation and intrastate distribution of electricity.
___________________ While the power sector in India is predominantly controlled by
PSUs owned by central/state governments, private players have
___________________
a significant presence in the areas of gas-fired power plants and
___________________ power generated from renewable sources.
___________________ The Power Grid Corporation of India is responsible for the
interstate transmission of electricity and the development of
___________________
national grid. The Ministry of Power is the apex body responsible
___________________ for the development of electrical energy in India.
___________________ India’s energy demand outpaced global demand growth in 2018

according to the International Energy Agency. The higher energy
___________________
demand was driven by a global economy that expanded by 3.7 per
___________________ cent in 2018, a higher pace than the average annual growth of 3.5
per cent seen since 2010.
___________________
According to the IEA’s Global Energy & CO2 status report, India
saw primary energy demand increase 4 per cent or over 35 million
tons of oil equivalent. This accounts for 11 per cent of global
demand growth.
Energy consumption in India has grown at a compound annual
growth rate of about 6% during the last decade. BP Energy
Outlook 2035 expects India to achieve the fastest energy
consumption growth among all major economies, despite rapid
increases in non-fossil fuel production. The total energy
consumption is expected to grow by 128% by 2035. Demand for
gas is expected to expand by 155%, followed by coal (121%) and
oil (118%), while demand for renewables, nuclear and hydro are
estimated to rise by 656%, 334%, and 99%, respectively.
The growth in India was led by coal for power generation and oil
for transport. Indian oil demand grew 5 per cent in 2018 compared
to 2017, a year when demand was lower due to the impact of the
implementation of the Goods and Service Tax and demonetisation.
The total wind potential in the country is estimated to be over 30
times the current installed capacity of 27 gigawatts (GW), while
our solar potential is expected to grow by about 90 times the
current installed capacity of 8 GW. Already, the government has
an aggressive target of 60GW of wind capacity and 100 GW of
solar capacity by 2022.
India is the world’s third largest producer and third largest
consumer of electricity. The national electric grid in India has an
installed capacity of 368.79 GW as of 31 December 2019. Renewable
power plants, which also include large hydroelectric plants,
constitute 34.86% of India’s total installed capacity.
Unit 23: Electricity Sector in India–I
273
Notes
installed capacity of 368.79 GW as of 31 December 2019. Renewable
___________________
power plants, which also include large hydroelectric plants,
constitute 34.86% of India’s total installed capacity. During the ___________________
2018-19 fiscal year, the gross electricity generated by utilities in
___________________
India was 1,372 TWh and the total electricity generation (utilities
and non-utilities) in the country was 1,547 TWh. The gross ___________________
electricity consumption in 2018-19 was 1,181 kWh per capita. In
___________________
2015-16, electric energy consumption in agriculture was recorded
as being the highest (17.89%) worldwide. The per capita electricity ___________________
consumption is low compared to most other countries despite
India having a low electricity tariff. ___________________
India’s electricity sector is dominated by fossil fuels, in particular ___________________

coal, which during the 2018-19 fiscal year produced about three- ___________________
quarters of the country’s electricity. The government is making
efforts to increase investment in renewable energy. The ___________________
government’s National Electricity Plan of 2018 states that the
country does not need more non-renewable power plants in the
utility sector until 2027, with the commissioning of 50,025 MW
coal-based power plants under construction and addition of
275,000 MW total renewable power capacity after the retirement
of nearly 48,000 MW old coal-fired plants.
The total installed capacity stated is after subtracting retired
capacity (if any). Nearly 40,000 MW is in various stages of
construction as on 31 March 2019.
The total installed utility power generation capacity as on 31
July 2019 by sector and type is given below:
Thermal (MW) Renewable (MW)

Nuclear
Sector Total (MW) %
Sub-Total (MW) Other
Coal Lignite Gas Diesel Hydro
Thermal Renewable
State 64,736.50 1,290.00 7,118.71 363.93 73,509.13 0.00 26,958.50 2,349.98 102,817.61 29
Central 56,340.00 3,140.00 7,237.91 0.00 66,717.91 6,780.00 15,046.72 1,632.30 90,176.93 25
Private 74,733.00 1,830.00 10,580.60 273.70 87,417.30 0.00 3,394.00 76,650.52 167,461.82 46
All India 195,809.50 6,260.00 24,937.22 637.63 227,644.34 6,780.00 45,399.22 80,632.80 360,456.37 100
Figure 23.1: Total installed utility power supply by sector and type
Power distribution comes at the end of the supply chain and

mainly controlled by state-run governments. These state-owned
distribution companies (DISCOMs) are the weakest link in the
entire power sector value chain. The reason for this lies in the
deteriorating finances of the state-owned power distribution
companies. They are reeling under losses as they hardly ever
274
pass on the cost of their operation to consumers. The average
Notes
cost of supply (ACS) of electricity is higher than the average
revenue realised (ARR) on it, making them financially unviable.
___________________
Lower tariffs are mainly set to serve the poor domestic and
___________________ agricultural sector. They have high aggregate technical and
commercial losses (AT&C), that is, losses due to electricity theft
___________________
and deficiencies in billing and revenue collection. A high AT&C
___________________ means lower operational efficiency and higher cost of doing
business. It stood at 20.23% in FY17.
___________________
In the past few years, India has made important progress towards
___________________
the goal of supplying uninterrupted, clean and affordable power.
___________________ However, the goal remains unreached due to the constraints in
the transmission and distribution system. The precarious financial
___________________ health of the state-run DISCOMs is a significant hurdle for India
___________________ in meeting its electricity demand. Furthermore, electricity
demand is expected to increase by nearly two-folds by 2027. Adding
___________________ generating capacity to meet the expected demand increase,
strengthening transmission system and removing bottlenecks
impeding financial viability of DISCOMs are necessary to meet
the growing demand for power.
According to the World Bank estimates, power theft reduces
India’s GDP by 1.5 %. According to a recent survey, it was found
that 40% of electricity remains unpaid and around one-fourth of
electricity produced is either lost in transmission or is stolen.
During the 2018-19 fiscal year, the gross electricity generated by
utilities in India was 1,372 TWh and the total electricity
generation (utilities and non-utilities) in the country was 1,547
TWh. The gross electricity consumption in 2018-19 was 1,181 kWh
per capita. In 2015-16, electric energy consumption in agriculture
was recorded as being the highest (17.89%) worldwide. The per
capita electricity consumption is low compared to most other
countries despite India having a low electricity tariff.
India’s Ministry of Power launched Deen Dayal Upadhyaya Gram
Jyoti Yojana (DDUGJY) as one of its flagship programmes in July
2015 with the objective of providing round the clock power to
rural areas. The programme focused on reforms in the rural power
sector by separating feeder lines for rural households from those
for agricultural applications and strengthening transmission and
distribution infrastructure. A previous scheme for rural
electrification, Rajiv Gandhi Grameen Vidyutikaran Yojana
(RGGVY) was subsumed into the new scheme. As of 28 April
2018, 12 days ahead of the target date, all Indian villages (a total
of 597,464 census villages) were electrified.
275
India has also achieved close to 100% electrification of all rural
Notes
and urban households. As of January 2019, 211.88 million rural
households were provided with electricity, close to 100% of the
___________________
212.65 million total rural households. As of January 2019, 42.937
million urban households are provided with electricity, close to ___________________
100% of the 42.941 million total urban households.
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
Figure 23.1: Installed capacity by source in India as

on 31 January 2020
Thermal Power
India’s electricity sector consumes about 72% of the coal produced
in the country. Coal consumption by utility power was 608 million
tons in 2017-18. A large part of the Indian coal reserve is similar
to Gondwana coal: it is of low calorific value and high ash content,
with poor fuel value. On average, Indian coal has a gross calorific
value (GCV) of about 4500 Kcal/kg, whereas in Australia, for
example, the GCV is about 6500 Kcal/kg. The result is that Indian
power plants using India’s coal supply consume about 0.7 kg of
coal per kWh of power generation, whereas in the United States
thermal power plants consume about 0.45 kg of coal per kWh. In
276
2017, India imported nearly 130 Mtoe (nearly 200 million tons) of
Notes
steam coal and coking coal, 29% of total consumption, to meet the
demand in electricity, cement and steel production.
___________________
The Centre for Science and Environment has assessed the Indian
___________________
coal-based power sector as one of the most resource-wasteful and
___________________ polluting sectors in the world, in part due to the high ash content
in India’s coal. India’s Ministry of Environment and Forests has,
___________________
therefore, mandated the use of coals whose ash content has been
___________________ reduced to 34% (or lower) in power plants in urban, ecologically
sensitive and other critically polluted areas. The coal ash reduction
___________________
industry has grown rapidly in India, with current capacity topping
___________________ 90 mega tonnes.
___________________ • Current installed capacity of Thermal Power is 106,517.98

MW which is 64.6% of total installed capacity.
___________________
• Current installed base of Coal Based Thermal Power is
___________________ 87,943.38 MW which comes to 53.3% of total installed base.
Current installed base of Gas Based Thermal Power is
17,374.85 MW which is 10.5% of total installed capacity.
• Current installed base of Oil Based Thermal Power is
1,199.75 MW which is 0.9% of total installed capacity.
The state of Maharashtra is the largest producer of thermal power
in the country.
Coal is the most important resource for power generation in India,
taking care of half of the primary energy needs and a third of
total energy needs. Coal reserves in India are substantial high
but low in quality. Because of economic and security reasons,
coal would play a vital role as a raw material for power generation.
Most of the coal-based power plants use conventional sub critical
pulverized coal technologies and below par in converting coal to
electricity. The reasons for the bad performance of the coal-based
power plants are due to:
• Challenges in the coal supply industry.
• Not having clear-cut performance standards.
• Negligible incentive for continual performance improvement
due to negligible competition.
• Insufficient investments in R&D.
• Substandard operational and management practices.
• Not having sufficient facts and accountability.
Controls to check the negative impact on the eco system due to
the usage of coal is not sufficient. The trend of relying on imported
gas over the past decade raises concern with respect to security
277
and continuity of supply. There is not much initiative to upgrade
Notes
current technology and to come up with new technology for
generating power based on coal.
___________________
Table 23.2: Total Installed Capacity (As on 31.01.2020) ___________________
Fuel MW % of Total ___________________

Total Thermal 2,30,701 62.8% ___________________
Coal 1,98,495 54.2% ___________________
Lignite 6,760 1.7% ___________________
Gas 24,937 6.9%
___________________
Diesel 510 0.1%
___________________
Hydro (Renewable) 45,399 12.4%
___________________
Nuclear 6,780 1.9%
___________________
RES* (MNRE) 86,321 23.4%
Total 368,690
Hydro Power
India was one of the pioneering countries in establishing hydro-
electric power plants. The power plant at Darjeeling and Shimsha
(Shivanasamudra) was established in 1898 and 1902 respectively
and is one of the first in Asia.
India’s potential for hydro power has been assessed to be about
125,570 MW at 60% load factor. India is ranked fourth globally by
underutilized hydro power potential. The estimated amount of
viable hydro power varies with improved technology and the cost
of electricity generation from other sources. In addition, there is
an estimated 6,740 MW of potential for small, mini, and micro-
hydro generators, and 56 sites for pumped storage schemes with
an aggregate installed capacity of 94,000 MW have been identified.
In 2020, the power tariff from Solar PV clubbed with pumped
storage hydro have fallen below the coal based power plant tariffs
in offering base load and peak load power supply.
The installed hydro power capacity as of 31 March 2018 was
approximately 45,293 MW, 13.17% of total installed utility capacity
at the time. Small, mini, and micro-hydro generators add another
4,486 MW capacity. The share of this sector operated by public
companies is 97%. Companies engaged in the development of
hydroelectric power in India include the National Hydroelectric
Power Corporation (NHPC), Northeast Electric Power Company
278
(NEEPCO), Satluj Jal Vidyut Nigam (SJVNL), Tehri Hydro
Notes
Development Corporation, and NTPC-Hydro.
___________________ Pumped storage schemes offer the potential for centralized peak
power stations for load management in the electricity grid. They
___________________
also produce secondary /seasonal power at no additional cost when
___________________ rivers are flooding with excess water. Storing electricity by
alternative systems such as batteries, compressed air storage
___________________
systems, etc. is more costly than electricity production by standby
___________________ generator. India has already established nearly 4,785 MW pumped
storage capacity as part of its installed hydro power plants.
___________________
___________________ Nuclear Power

___________________ As of 31 March 2019, India had 6.78 GW of installed nuclear
power generation capacity or nearly 2% of total installed utility
___________________
power generation capacity. Nuclear plants generated 37,812
___________________ million kWh at 63.67% PLF in 2018-19.
India’s share of nuclear power plant generation capacity is 1.2%
of worldwide nuclear power production capacity, making it the
15th largest nuclear power producer. India aims to supply 9% of
its electricity needs with nuclear power by 2032 and 25% by 2050.
India’s government is developing up to 62 additional nuclear
reactors, mostly using thorium fuel, which it expects to be
operational by 2025. It is the “only country in the world with a
detailed, funded, government-approved plan” to focus on thorium-
based nuclear power.
Renewable Power
Renewable power plants, which also include large hydroelectric
plants, constitute 34.86% of India’s total installed capacity. During
the 2018-19 fiscal year, the gross electricity generated by utilities
in India was 1,372 TWh and the total electricity generation
(utilities and non-utilities) in the country was 1,547 TWh.
India’s renewable energy sector has been growing vigorously for
the last decade. As of 31 March 2018, India had grid-connected
installed electricity generation capacity of about 69.02 GW from
non-conventional renewable technologies and conventional
renewable power or major hydroelectric power capacity of 45.29
MW.
Bids have been invited for installation of a further 115 GW, to
achieve a total of 175 GW total installed capacity of non-
conventional renewable power by 31 March 2022. The government
has set up a fund of US$350 million to finance solar projects.
279
Fill in the blanks:
___________________
1. The electricity sector in India is predominantly controlled by the Government
of India’s ..................... . ___________________
2. Electricity losses in India during transmission and distribution are extremely ___________________
high and vary between ..................... to ..................... .
___________________
3. ..................... reserves in India are substantial high but low in quality.
___________________
___________________
Privatisation in Power Sector
___________________
Privatization and regulatory reform of electric utilities has been
taken off worldwide as electricity in developing countries is ___________________
crucial for sustainable economic growth. In the early 1980s the ___________________
world’s national electric utilities were, in general, vertically
integrated, centralized and publicly owned. Since the late 1980s ___________________
many countries have seen a transition of their electric power
industries from public ownership to private and private/public
ownership.
In many developing countries, high growth in the demand for
electricity, plus limited capital for power plant construction, has
led to consideration of independent private power generation.
Two of the most popular ways of structuring private power projects
are: build-own-transfer (BOT) or build-own-operate (BOO).
Projects structured this way allow countries to develop new power
plant capacity without major capital investment by the
government. Industrial growth in developing countries is the
major reason for electricity demand growing at 10 per cent to 15
per cent or more per year.
Under BOT a plant is constructed and operated for a
predetermined period of time by a private electric power company.
At the end of a specified period the plant is transferred to the
country’s electricity generating authority at no cost. Usually, a
power plant has approximately another 10 years of life when it
is handed over. A BOO developed power plant, on the other
hand, is built and operated by the private electric power company
for the life of the plant.
Whether a plant is a BOT or BOO, the local electric generating
authority generally pays the company, the plant’s builder and
operator a fixed capital recovery and operating fee. In addition,
they are paid a variable operating fee.
How a country’s electric power industry is privatized depends to
a large extent on how it is structured. It defines the jurisdictions,
280
rights, obligations, regulations and responsibilities of public and
Notes
private electric utilities.
___________________ The Unites States electric power industry is very diverse and is
a conglomeration of investor and public-owned utilities,
___________________
government agencies, co-generators and independent power
___________________ producers. In general, the electric power industry in the United
States is regulated by federal, state and local governments. The
___________________
Federal Electric Regulatory Commission (FERC) has overall
___________________ authority in regulating the electric industry in the United States.
This agency issues regulations and guidelines for pricing,
___________________
transactions of electricity and coordination of the operations of
___________________ interconnected electric systems.
___________________ The privatized electric supply industry in England and Wales

consists of one distribution company, National Grid Co., and two
___________________ electric generation companies, National Power and Power Gen.
___________________ National Grid Co., a holding company owned by 12 regional supply
companies, inherited all of CEGB‘s transmission assets and a
2,000-MW pumped storage plant in Wales upon privatization. The
National Grid Co. is responsible for dispatching all of the electric
generating plants while the regional supply companies have the
responsibility for the distribution and supply of electricity in
their particular areas.
A Director General of Electricity Supply, the regulator, allows
the price of electricity to increase by set amounts relative to
inflation. It is not based on any rate of return.
Day-to-day commercial operation of the system centres on the
“pool” into which all major generators of electricity sell their
output. Each day generators make offers for the following day by
unit availability and price. Based on the daily offers, and National
Grid’s estimate of demand, National Grid produces a generation
schedule ignoring any constraints which the transmission system
may impose on actual generation.
India’s Central Electricity Authority is responsible for the
country’s national power policy and overall planning and
development on the national level. At the state level in India,
state electricity boards are responsible for the generation,
transmission and distribution of power. The Power Grid Corp.,
an Indian government enterprise, is responsible for the
construction and operation of the central transmission system.
Its goal is to establish and operate regional and national power
grids in India. In addition, the Power Grid Co. is taking the
initiative to develop the overall coordination procedures for the
government and private companies connected to the national grid.
281
Fill in the blanks:
___________________
1. Under ................ a plant is constructed and operated for a predetermined
period of time by a private electric power company. ___________________
2. A ........................, the regulator, allows the price of electricity to increase ___________________

by set amounts relative to inflation.
___________________
___________________
Developing Private Hydroelectric Power
___________________
To keep up with its fast-growing economy, Asia is looking at
private power to help it meet the need for additional electric ___________________
generation capacity. While most of the private power projects ___________________
developed in Asia have been thermal power plants, hydroelectric
power projects should not be overlooked. ___________________
Hydroelectricity is electricity produced from hydropower. In 2015, ___________________

hydropower generated 16.6% of the world’s total electricity and
70% of all renewable electricity and was expected to increase by
about 3.1% each year for the next 25 years.
Hydropower is produced in 150 countries, with the Asia-Pacific
region generating 33 percent of global hydropower in 2013. China
is the largest hydroelectricity producer, with 920 TWh of
production in 2013, representing 16.9% of domestic electricity
use.
The technical potential for hydropower development around the
world is much greater than the actual production: the percent of
potential hydropower capacity that has not been developed is
71% in Europe, 75% in North America, 79% in South America,
95% in Africa, 95% in the Middle East, and 82% in Asia-Pacific.
Due to the political realities of new reservoirs in western
countries, economic limitations in the third world and the lack of
a transmission system in undeveloped areas, perhaps 25% of the
remaining technically exploitable potential can be developed
before 2050, with the bulk of that being in the Asia-Pacific area.
Some countries have highly developed their hydropower potential
and have very little room for growth: Switzerland produces 88%
of its potential and Mexico 80%.
The ranking of hydroelectric capacity is either by actual annual
energy production or by installed capacity power rating. In 2015
hydropower generated 16.6% of the world’s total electricity and
70% of all renewable electricity. Hydropower is produced in 150
countries, with the Asia-Pacific region generated 32 percent of
global hydropower in 2010. China is the largest hydroelectricity
producer, with 721 terawatt-hours of production in 2010,
282
representing around 17 percent of domestic electricity use. Brazil,
Notes
Canada, New Zealand, Norway, Paraguay, Austria, Switzerland,
Venezuela, and several other countries have a majority of the
___________________
internal electric energy production from hydroelectric power.
___________________ Paraguay produces 100% of its electricity from hydroelectric dams
and exports 90% of its production to Brazil and to Argentina.
___________________
Norway produces 96% of its electricity from hydroelectric sources.
___________________
Asian Development Bank Loans
___________________
ADB offers the public sector different types of financial products,
___________________
which includes loans, grants, technical assistance, guarantees,
___________________ and debt management products. Energy demand is projected to
almost double in the Asia and Pacific region by 2030. There is an
___________________
urgent need for innovative ways to generate power in a socially,
___________________ economically, and environmentally sustainable manner.
___________________ The Asian Development Bank (ADB) will invest over $1 billion
worth of energy projects in the Pacific from 2019 to 2021 to
increase renewable energy generation and improve access to
affordable and sustainable electricity in the subregion. Between
2007 and 2018, ADB-financed projects in the Pacific installed 62
megawatts (MW) of renewable energy generation capacity,
constructed or refurbished 1,600 kilometers of power lines, and
connected 10,000 households to electricity grids. ADB is currently
supporting 14 active energy projects in 10 countries in the Pacific
worth $371 million.
For example, up until 2008, the state of Madhya Pradesh was
losing more than a third of its power within the distribution
system. Voltage fluctuations were common. Farmers and small
businesses were among those most affected as motor pumps would
malfunction and electrical equipment often prematurely damaged.
To enhance the reliability of the distribution network, reduce
losses, and improve the overall quality of the power supply,
Tranche 2 of the ADB-funded Madhya Pradesh Power Sector
Investment Program supported the installation of modern
systems—including a high-voltage distribution system and remote
metering—that improved efficiency and helped reduce system
losses.
As a result of the program, power losses declined from 38% in
2008 to 24% in 2014, and further to 22% in 2015. Power availability
improved to 10 hours in rural areas and 24 hours in cities, with
fewer interruptions, improved voltage, and fewer surges.
ADB is committed to achieving a prosperous, inclusive, resilient,
and sustainable Asia and the Pacific, while sustaining its efforts
283
to eradicate extreme poverty. In 2018, it made commitments of
Notes
new loans and grants amounting to $21.6 billion. Established in
1966, it is owned by 68 members.
___________________
The following are the key results of ADB-supported operations
___________________
in the energy sector from 2010-2017:
___________________
• 22,751,325 tCO 2 equivalent per year in greenhouse gas
emission reduction. ___________________
• 4 TWH equivalent per year of energy saved. ___________________

• 5,699,950 new households connected to electricity. ___________________
• 3,820,138 new households connected to electricity, rural.
___________________
• 1,879,812 new households connected to electricity, urban.
___________________
• 20,581 MW installed energy generation capacity.
___________________
• 5,382 MW installed energy generation capacity, renewable.
___________________
• 12,518 kilometers transmission lines installed or upgraded.
• 108,530 kilometers distribution lines installed or upgraded.
Electric transmission systems and hydroelectric plants will
continue to be owned by electric utilities. However, the utilities
might be privatized and existing thermal power plants will be
privatized. Although the private sector is expected to develop
most of the new thermal power plants they would most likely be
jointly owned by the private sector and the utility.
India is privatizing the generation of electricity by offering a
range of incentives and guarantees to local and foreign investors
who wish to set up new power generation units. China also is
allowing construction of privately owned power generating
facilities.
The World Bank, the United States Agency for International
Development (USAID) and the International Finance Corp.
support a major role for the private sector in the supply of electric
power. Policies were adopted by the World Bank in 1992 that
encourage private participation in the power sectors of developing
countries. Not only is the private sector more efficient in operation
they are able to tap resources for financing power projects.
Because the electric industry in many developing countries has
always been government run the concept of private ownership of
electric power is not always accepted with open arms. However,
no country can privatize its electric industry without also changing
the regulations and laws governing its operation.
Privatization of electricity can accelerate the economic growth
and social development of a country by helping to meet the energy
needs of its agriculture, industrial and commercial sectors.
284
Notes
Role of Private Sector
The government has set in reforms to allow the entry of private
___________________
sector in power generation. But the process has been hampered
___________________ by the fact that the ultimate purchase of power is the state
governments. At present the private sector accounts for about
___________________ 15% of the total capacity, mostly in the renewable energy sector.
___________________ Reliance Power Limited (R-Power), formerly Reliance Energy
Generation Limited (REGL) is a part of the Reliance Anil
___________________
Dhirubhai Ambani Group. The company is the sole distributor of
___________________ electricity to consumers in the suburbs of Mumbai. but in 2017
they sold Mumbai operation to Adani Power. It also runs power
___________________
generation, transmission and distribution businesses in other
___________________ parts of Maharashtra, Goa and Andhra Pradesh. With its
subsidiaries, it is developing 13 medium and large-sized power
___________________ projects with a combined planned installed capacity of 33,480
___________________
MW.
Essar Energy Plc is an Indian-focused energy company with
assets in the existing power and oil and gas businesses. Essar
Energyhas an installed power generation capacity of 3,910 MW
across six plants.
GMR Energy is a part of GMR Group, which is one of the
largest diversified Infrastructure Conglomerates in India. With
an operating capacity of over 4400 MW, it has a balanced fuel mix
of coal, gas, LSHS as well as renewable sources of wind and solar
energy. Apart from this, plants of over 2300 MW generation
capacity are under various stages of development in India and
Nepal.
Tata Power has a strong portfolio of 1388 MW of solar generation
capacity. It has recently commissioned a 100 MW solar plant at
Anantapur Solar Park, Andhra Pradesh. It has also commissioned
150 MW in Pavagada, Karnataka, 30 MW at Palaswadi in
Maharashtra and 25 MW in Charanka, Gujarat in 2017. The
Company had set up its first solar power plant of 110 kW, way
back in 1996 at Walwhan in Lonavla. A 60.48 kWp solar power
plant has been installed on the rooftop of one of the Company’s
offices in Mumbai in 2010 and the power generated by these solar
panels takes part of the lighting load of the entire building
announced the synchronisation of its 15 MW solar plant at
Belampally in Telangana, thereby starting its commercial
operations.
Tata Power has an installed capacity of 1161 MW and plants
spread across seven states of Maharashtra, Gujarat, Tamil Nadu,
Karnataka Rajasthan, Andhra Pradesh and Madhya Pradesh
leading in promoting wind power generation in India.
285
Cennergi is a Joint Venture (JV) between Tata Power and Exxaro
Notes
Resources, a South Africa-based diversified resources company.
Based in South Africa, Cennergi will focus on the investigation of
___________________
electricity generation projects in South Africa, Botswana and
Namibia., Cennergi Limited, achieved commercial operations of ___________________
134.4 MW Amakhala Emoyeni Wind Farm and 95.17 MW
___________________
Tsitsikamma Wind Farm.
___________________
Recently, Tata Power’s subsidiary, TPREL has commissioned 21
MW Vagarai wind Farm in Tamil Nadu, 100 MW in Nimbagallu, ___________________
Andhra Pradesh, and 26 MW in Gujarat.
___________________
1. In 2015, hydropower generated ............% of the world’s total electricity ___________________

and 70% of all renewable electricity. ............. is one of the leading
groups in the private sector for power generation. ___________________
Summary
Energy consumption in India has grown at a compound annual
growth rate of about 6% during the last decade. BP Energy
Outlook 2035 expects India to achieve the fastest energy
consumption growth among all major economies, despite rapid
increases in non-fossil fuel production. The total energy
consumption is expected to grow by 128% by 2035. Demand for
gas is expected to expand by 155%, followed by coal (121%) and
oil (118%), while demand for renewables, nuclear and hydro are
estimated to rise by 656%, 334%, and 99%, respectively.

1. Write a short note on Electricity Sector in India.
2. Elucidate privatization in Power Sector.
3. What is the role of Private Sector? Explain.
4. Write a short note on Asian Development Bank Loans.
287
Unit 24 Notes
Electricity Sector in India–II ___________________
___________________
___________________
\ Transmission
___________________
\ Power for ALL
___________________
\ Captive Coal Mines
___________________
___________________
Introduction ___________________
For any country, the energy sector is one of the most important
sectors of its economy. For a developing country such as India,
the development of this sector is important in terms of improving
the material well-being of its population. However, in the context
of resource constraints in terms of fuel sources, water, etc. as
well as growing concerns over environmental impacts of burning
fossil fuels, there is a need to rethink strategies in this sector
and carefully evaluate the linkage between energy, environment
and the economy.
Transmission
Transmission of electricity is defined as bulk transfer of power
over a long distance at high voltage, generally of 132 kV and
above.
India’s power grid is transforming at an exceptional rate. Large-
scale integration of renewable energy to catering to new demand
loads and provide reliabile electricity is motivating transmission
utilities to redesign their grid strategies. It is estimated that an
investment of ` 2.6 trillion is required in the transmission sector
by 2021–22. While most of the future investment will be for the
expansion of physical grid infrastructure, utilities are expected
to invest significant sums in new technologies to make grids more
reliable, resilient, secure and smart. Competitive bidding has
picked up at both interstate and intra-state levels, thus offering
significant opportunities for the private sector. The sector is also
expected to immensely benefit from major policy and regulatory
reforms such as the new tariff regulations and early regulatory
approvals to transmission schemes.
288
In India bulk transmission (transmission lines 220 kv & above)
Notes
has increased from 2,20,794 ckm in 2008-09 to 4,13,407 ckm in
2018-19 [Source: Central Electricity Regulatory Commission
___________________
(CERC)]. During the period, the transmission capacity of
___________________ substations has also increased from 2,88,615 MVA to 8,77,163 MVA.
The entire country has been divided into five regions for
___________________
transmission systems, namely, Northern Region, North Eastern
___________________ Region, Eastern Region, Southern Region and Western Region.
The Interconnected transmission system within each region is
___________________
also called the regional grid.
___________________
The transmission system planning in the country, in the past,
___________________ had traditionally been linked to generation projects as part of
the evacuation system. Ability of the power system to safely
___________________ withstand a contingency without generation rescheduling or load-
___________________ shedding was the main criteria for planning the transmission
system. However, due to various reasons such as spatial
___________________ development of load in the network, non-commissioning of load
centre generating units originally planned and deficit in reactive
compensation, certain pockets in the power system could not
safely operate even under normal conditions. This had
necessitated backing down of generation and operating at a lower
load generation balance in the past. Transmission planning has
therefore moved away from the earlier generation evacuation
system planning to integrate system planning.
While the predominant technology for electricity transmission
and distribution has been Alternating Current (AC) technology,
High Voltage Direct Current (HVDC) technology has also been
used for interconnection of all regional grids across the country
and for bulk transmission of power over long distances.
Certain provisions in the Electricity Act 2003 such as open access
to the transmission and distribution network, recognition of power
trading as a distinct activity, the liberal definition of a captive
generating plant and provision for supply in rural areas are
expected to introduce and encourage competition in the electricity
sector. It is expected that all the above measures on the
generation, transmission and distribution front would result in
formation of a robust electricity grid in the country.
Distribution
The government is planing a slew of reforms for the power
distribution sector. Structural reforms in the tariff policy are
expected, besides a revamped Ujwal Discom Assurance Yojana
(UDAY). The existing distribution franchise (DF) model is also
being modified to ensure greater participation by private players.
Unit 24: Electricity Sector in India–II
289
Further, the separation of wires and supply businesses in
Notes
distribution is one of the top priorities of the government. These
policy announcements, if implemented in time and effectively,
___________________
would have a direct and significant impact on the sustainability
of the power distribution segment. ___________________
India is the world’s third largest producer and third largest ___________________
___________________
installed capacity of 368.79 GW as of 31 December 2019. During
the 2018-19 fiscal year, the gross electricity generated by utilities ___________________
in India was 1,372 TWh and the total electricity generation
___________________
(utilities and non-utilities) in the country was 1,547 TWh. The
gross electricity consumption in 2018-19 was 1,181 kWh per capita. ___________________
India’s electricity sector is dominated by fossil fuels, in particular ___________________

coal, which during the 2018-19 fiscal year produced about three-
quarters of the country’s electricity. The government is making ___________________
efforts to increase investment in renewable energy. The ___________________
government’s National Electricity Plan of 2018 states that the
country does not need more non-renewable power plants in the
utility sector until 2027, with the commissioning of 50,025 MW
coal-based power plants under construction and addition of 275,000
MW total renewable power capacity after the retirement of nearly
48,000 MW old coal-fired plants.
The sector has started receiving greater attention and investment
with the restructuring of the state electricity boards. Several
new initiatives have been introduced to reduce aggregate technical
and commercial (AT&C) losses along with a definitive regulatory
framework. Electricity Act 2003, National Electricity Policy 2005
and National Tariff Policy 2006 are important regulations
governing the sector today with an aim to bring competition in
the sector and improve the services to the end consumers.
The distribution segment continues to carry electricity from the
point where transmission leaves off, that is, at the 66/33 kV level.
The standard voltages on the distribution side are, therefore, 66
kV, 33 kV, 22 kV, 11 kV and 0.4 kV/0.230 kV, besides 6.6 kV, 3.3
kV and 2.2 kV. Depending upon the quantum of power and the
distance, lines of appropriate voltages are laid. The main
distribution equipment comprises HT and LT lines, transformers,
substations, switchgears, capacitors, conductors and meters. HT
lines supply electricity to industrial consumers while LT lines
carry it to residential and commercial consumers.
The following are the main factors in deciding the Indian power
distribution sector:
• Continued Demand for Power: The Integrated Energy
Policy predicts that in order to eradicate poverty, the
290
country’s economic growth needs to be at least 8 per cent
Notes
annually until 2032 and in that time frame, the power capacity
needs to rise to as high as around 800 GW.
___________________
• Distribution Reforms: Unbundling of the vertically
___________________
integrated SEBs into functional entities is a key requirement
___________________ of the EA 2003. While most of the States have unbundled
their utilities, the real benefit of unbundling can be derived
___________________
only through bringing in best practices and professional
___________________ management through PPP models. Given the political
sensitivity and issues on valuation of assets on transfer
___________________ together with employee reservations, states are looking at
___________________
the Distribution Franchisee as a middle path for securing
efficiencies while addressing the above political/social issues.
___________________ However, in the long run, privatization seems to be a
sustainable solution.
___________________
• Supply Codes and Performance Standards: Supply Code
___________________
lays down standards and procedures for recovery of electricity
charges, billing cycles, disconnections, and restoration of
service and metering among other things. To protect
consumer interests, the EA 2003 requires the SERCs to
specify standards of performance for distribution licensees.
The commissions also have to specify the penalty and
compensation to be paid by the licensees to the affected
parties if the former fails to meet the standards. Both supply
codes and standards of performance help in improving
efficiency in power distribution operations.
• Growing Consumer Awareness: For both SEBs and private
companies, consumer interest is becoming a high priority.
Connections are far easier to come by, bill payments are
being streamlined, and complaints are addressed more
promptly and effectively. Call centers have been set up to
address supply and billing complaints. It has put in place a
SMS based-fault management system whereby complaints are
addressed through SMS. This has resulted in increased
customer satisfaction across all segments, especially, among
urban domestic consumers, thereby, improving the customer’s
willingness to pay for better services. A virtuous cycle of
better customer satisfaction resulting in more revenues for
the discoms, who in turn are investing in better services,
seems to be finally coming into play.
• Focus on IT: All the discoms are adopting IT systems and
practices to improve operations and customer service. SCADA
is being used for better management of distribution networks.
Spot billing, call centers, remote meter reading, automated
billing, and energy accounting are some of the IT mechanisms
291
being incorporated. Advanced technologies are being deployed
Notes
particularly, in billing, fault reporting, remote metering and
substation operations, enterprise solutions involving
___________________
employees and commerce, consumer servicing through the
internet and telephones, and MIS. Energy auditing and ___________________
accounting are also being taken up assiduously.
___________________
• Move towards DSM: Realising the benefits of introducing
DSM measures in reducing overall electricity demand, ___________________
several state regulators are encouraging DSMs in their states.
___________________
Many SERCs have introduced time-of-day with differential
tariffs for usage in different times, particularly, for HT ___________________
consumers. Discoms and regulators are also encouraging the
___________________
use of energy efficient devices, including efficient pump sets
in agriculture, and efficient lighting and appliances. Farmers ___________________
are being encouraged to use electricity in non-peak hours.
They are also encouraging the use of energy efficient devices, ___________________
including efficient pumpsets in agriculture, and efficient ___________________
lighting and appliances.
• Environmental and Social Pressures: As a result of
increasing environmental pressures, both local and global,
the country’s power mix is increasingly becoming green. Since
power from renewable energy is intermittent, these require
a well interconnected grid with adequate spinning reserves
and transfer capabilities. Further, as per policy objectives,
discoms have to procure a certain percentage of their power
requirement through renewable.
• Tariff Rationalization: The tariff rationalisation will result
in commercial viability of the discoms and hence lead to
corresponding investments in related infrastructure. With
tariff rationalisation, the HT consumer, who currently bears
the burden of higher tariffs, will increasingly find it
competitive to buy power from the grid rather than through
captive generation. This will further help the discoms in
improving their consumer mix, and hence their financials.
The consumers below BPL, who consume a small quantity of
electricity, shall continue to receive special support through
cross-subsidised tariffs.
• Improving Grid Standards: The regulatory mechanisms of
the availability-based tariff (ABT) and unscheduled
interchange (UI) have created a solid base for maintaining
grid standards. These should improve further with the newly
notified draft for the amendment of the Indian Electricity
Grid Code by the Central Electricity Regulatory Commission
(CERC). Thus, the utilities will have to focus on demand
forecasting, and predict their long-term requirement of power
in order to benefit from the ABT regime.
292
• Accelerated Power Development Reforms Program: The
Notes
scheme was launched in 2002-03 as Additional Central
Assistance to the States for strengthening and up-gradation
___________________
of sub-transmission and distribution systems. 50% incentives
___________________ were given to SEBs / Utilities to reduce their financial losses
for actual cash loss reduction.
___________________
___________________ Power for All

___________________ The Government of India is committed to improving the quality
of life of its citizens through higher electricity consumption. The
___________________
aim is to provide each household access to electricity, round the
___________________ clock. The ‘Power for All’ programme is a major step in this
direction.
___________________
24×7 - Power for All (24×7 PFA) is a Joint Initiative of Government
___________________
of India (GoI) and State Governments with the objective to provide
___________________ 24×7 power available to all households, industry, commercial
businesses, public needs, any other electricity consuming entity
and adequate power to agriculture farm holdings.
Ministry of Power, India started the joint initiative with 36 states
and UTs for providing power for all. Joint initiative plans have
been arrived at by each of the states.
Objectives
The objective of this initiative was to enhance the satisfaction
levels of the consumers and improve the quality of life of people
through 24x7 power supply. This would also lead to rapid
economic development of the state in primary, secondary &
tertiary sectors resulting in inclusive development.
The initiative of 24x7 power supply to all encompasses mainly
the following:
1. Reliable and quality 24×7 power supply to the existing
consumers in a phased manner within a period of three years
from the date of commencement of the programme.
2. All unconnected households to be provided access to
electricity in a time bound manner ultimately by FY 2018-
19. States have the liberty to hasten the process by taking
accelerated steps, if required.
3. To ensure adequate capacity addition planning & tie ups for
power from various sources at affordable price to meet the
projected increase in power demand for future.
4. Strengthen the Transmission and Distribution network to
cater to the expected growth in demand of existing as well
as forthcoming consumers.
293
5. Monitoring the timely commissioning of various generating
Notes
plants, transmission and distribution infrastructure to meet
the expected growth in demand.
___________________
6. Put in place a strategy to ensure reduction of AT&C losses
___________________
as per the agreed loss reduction trajectory and methodology
and steps required to be taken at every level of distribution ___________________
in this regard.
___________________
7. Overall Power Supply Improvement to be achieved by
undertaking measures such as energy mix optimization, ___________________
reduction in power operational in efficiency of state ___________________
generation plant(s) and optimal fuel procurement policy.
___________________
8. Financial measures including investment roll out plans and
undertaking necessary balance sheet analysis to assess the ___________________
financial strength/ weaknesses in the utility finances.
___________________
9. Introduce modern technologies to monitor reliable supply
like sub-station automation, providing adequate ___________________
communication infrastructure, GIS, Reliability, Centralised
Network Analysis and Planning tools, SAP driven ERP
systems, Distribution Management Systems (DMS), Outage
Management System (OMS), etc.
10. To take essential measures for meeting the performance
standards as laid down by SERC.
Strategies
Methodology for Preparation of the Action Plan for the 24×7
Power for All
1. Projection of average per day consumption of rural and urban
households based on respective historical compounded
annual growth rates (CAGR) during the past years and
considering the aspirational growth perspectives.
2. Projection of demand of consumers encompassing commercial,
industrial, agricultural and all remaining consumers have
been carried out under others category based on past data
and historical CAGR recorded for the state during the past
years after discussing with state and factoring in the
aspirational growth perspectives.
3. Assess the power requirement of unelectrified households
and draw up a time bound plan for electrification of all
households.
4. Project the annual energy requirement and maximum
demand by aggregating the requirement of all consumer
categories and applying an appropriate load factor.
294
5. Prepare a broad plan to meet power demand in future
Notes
through additional generation capacity proposed in the state
and quantum for additional procurement required.
___________________
6. Assess the financial implications on utilities and per unit
___________________
implication on tariff for procuring additional energy to meet
___________________ the energy requirement of all segments of consumers. Assess
the adequacy of the network - both inter-state and intra-
___________________
state transmission as well as distribution so as to meet the
___________________ increased / expected / projected power requirement of all
consumer categories of the state.
___________________
7. Conduct sensitivity analysis on various parameters namely
___________________ average purchase price of energy, AT&C loss reduction, etc.
___________________ 8. Conduct sensitivity analysis on various parameters namely
average purchase price of energy, AT&C loss reduction, etc.
___________________
___________________ Rural Electrification

India’s Ministry of Power launched Deen Dayal Upadhyaya Gram
Jyoti Yojana (DDUGJY) as one of its flagship programmes in July
2015 with the objective of providing round the clock power to
rural areas. The programme focused on reforms in the rural power
sector by separating feeder lines for rural households from those
for agricultural applications and strengthening transmission and
distribution infrastructure. A previous scheme for rural
electrification, Rajiv Gandhi Grameen Vidyutikaran Yojana
(RGGVY) was subsumed into the new scheme. As of 28 April
2018, 12 days ahead of the target date, all Indian villages (a total
of 597,464 census villages) were electrified.
India has also achieved close to 100% electrification of all rural
and urban households. As of 4 January 2019, 211.88 million rural
households were provided with electricity, close to 100% of the
212.65 million total rural households.[1] As of 4 January 2019,
42.937 million urban households are provided with electricity,
close to 100% of the 42.941 million total urban households.
Subsidies
Several state governments in India provide electricity at
subsidised rates or even free to some sections. This includes for
use in agriculture and for consumption by backward classes. The
subsidies are mainly as cross-subsidisation, with the other users
such as industries and private consumers paying the deficit caused
by the subsidised charges collected. Such measures have resulted
in many of the state electricity boards becoming financially weak.
295
Captive Coal Mines Notes
Coal is a critical input for fuelling growth of major infrastructure
___________________
sectors like power, steel and cement. Coal is the dominant energy
source in India, accounting for more than half of the country’s ___________________
requirements. Around 72% of India’s coal production is used for
power generation, with the remainder being used by heavy ___________________
industry and public use. Domestic supplies satisfy most of India’s ___________________
coal demand.
___________________
India’s total coal production in the 2018–19 Indian financial year
(April to March) was an estimated 730 million tonnes. Thermal ___________________
coal accounted for 94 per cent of India’s domestic coal production, ___________________
at 683 million tonnes in the same period.
___________________
In 1993, captive coal mining was allowed, but this did not provide
the production growth that was envisaged. In more recent years, ___________________
the government has approved two major policy changes,
___________________
representing the biggest reforms to India’s coal sector since its
nationalisation in the 1970s. The policy changes aim to boost
output, and improve productivity and coal quality in the sector,
through facilitating greater competition and private investment.
The two policy changes approved by the Indian Cabinet were:
• February 2018: Allow commercial coal mining, by changing
coal mining auction rules to allow private companies to
develop new mines and sell coal in the free market without
price or end-use restrictions.
• February 2019: Allow captive producers to sell 25 per cent
of their output in the open market.
India is the world’s second largest producer of thermal coal, and
production is dominated by the state-owned company Coal India
Limited, the world’s largest coal producer.
About 88% of the total coal production in the country is produced
by various subsidiaries (a total of 390 mines) of Coal India Ltd.
which is the largest supplier of coal (and one of the largest
taxpayers) in the country. Although Coal India is currently State
controlled, efforts are being made to open the industry to Indian
private investors.
Coal India has seven coal producing subsidiary companies; viz.
Central Coal fields, Eastern Coalfields (Sanctoria), Bharat Coking
Coal (Dhanbad), Northern Coalfields (Nagpur), Western Coalfields,
Southern Eastern Coalfields (Bilaspur), Mahanandi Coalfields
(Sambalpur) and the Central Mine Planning & Design Institute
(CMPDI) at Ranchi Bihar, which is entrusted with the job of
providing total research and consultancy support to the industry.
296
South Eastern Coalfields are planning to increase production from
Notes
two of its operations, the Gevra and Dipka mines that supply
coal to power stations. The only other major producer outside of
___________________
CIL is the Singerani Collieries Company that is located in Andhra
___________________ Pradesh. Minerals & Metals Trading Corp (MMTC)’s ambitious
___________________ Coal India has ambitions to raise domestic coal production to 1
billion tonnes by 2025–26. While India has lifted growth in thermal
___________________
coal production over the last few years, it is still tracking well
___________________ short of the production levels required to meet this target.
___________________ In a bid to break the public sector monopoly over coal, the
government is seeking to introduce legislative changes allowing
___________________
for private mining, whilst liberalising norms for the allocation of
___________________ captive blocks permitting trading of coal. The government is
contemplating the allocation of captive blocks for setting up
___________________ washeries in the private sector. Captive block holders would also
___________________ be permitted to sell their coal on the open market. The current
legislative requirements permit private-sector investment only
for the limited purpose of setting up coal washeries and captive
mining for specified end-uses, including setting up power plants,
fertiliser and steel units.
Under the Coal Mines (Nationalisation) Act, 1973, coal mining
was mostly reserved for the public sector, but by an amendment
to the Act in 1976, two exceptions were made to the policy.
• The first one was that private companies producing iron and
steel were allowed to do captive mining.
• Secondly, coal mining was sub-leased to private parties in
isolated small pockets. These pockets were ones not
otherwise suited for economic development and from where
one would not have to depend on the railways to transport
the coal.
Among the reasons likely to act as major impediments for
enhancing coal production, according to the note, is the move by
the environment ministry to classify the country’s forests as Go
and No Go areas. The categorization specifies regions where coal
mining can be permitted only after stringent forest clearances
are obtained. Though this is only indicative in nature, it has
worried power project developers, as several existing and
upcoming mines now fall in areas barred formining.
Energy Conservation Act 2001

Energy conservation refers to efforts made to reduce energy
consumption. Energy conservation can be achieved through
increased efficient energy use, in conjunction with decreased
297
energy consumption and/or reduced consumption from
Notes
conventional energy sources. The Act provides for the legal
framework, institutional arrangement and a regulatory mechanism
___________________
at the Central and State level to embark upon energy efficiency
drive in the country. Measures include: pilot phase of programme ___________________
for energy efficiency in government buildings and prepare action
___________________
plan for wider dissemination and implementation, development
of energy conservation building codes, beginning a Standards and ___________________
Labelling Program to identify energy efficient appliances and
___________________
equipment, assisting 5 electric utilities to set up DSM (demand
side management) Cell, formulation of energy efficiency codes ___________________
and standards, introducing educational programs to increase
awareness regarding efficient use of energy resources, and the ___________________
introduction of the Energy Conservation Awards to nationally ___________________
recognize efforts to reduce energy consumption. It also mandates
the setting up of a Bureau of Energy Efficiency (BEE) that will ___________________
introduce stringent energy conservation norms for energy
___________________
generation, supply and consumption. The enforcement of penalties
stipulated in the Act have been kept in abeyance for five years
during which time people would be made aware of the economics
and efficacy of the conservation of energy.
Check Your Progress
Fill in the blanks:
1. .................. is a critical input for fuelling growth of major infrastructure

sectors like power, steel and cement.
2. .................. refers to efforts made to reduce energy consumption.
Summary
In India bulk transmission (transmission lines 220kv & above)
has increased from 2,20,794 ckm in 2008-09 to 4,13,407 ckm in
2018-19. During the period, the transmission capacity of
substations has also increased from 2,88,615 MVA to 8,77,163
MVA has increased from 3,708 ckm in 1950 to more than
165,000ckm today (as stated by Power Grid Corporation of India).
installed capacity of 368.79 GW as of 31 December 2019..

1. Write a short note on Energy Conservation Act 2001
2. Explain the concepts of transmission and distribution.
299
Unit 25 Notes
Case Study ___________________
___________________
___________________
Case Study 1: International Business Machines (IBM) ___________________
___________________
Raising Awareness of Energy Consumption and Opportunities
___________________
IBM, a multinational computer technology and IT consulting corporation
is a global leader in technology manufacturing, server and storage ___________________
equipment, software and IT business services andsolutions.
___________________
Around352,600 employees in over 170 countries across the globe create,
develop, and manufacture computer and storage systems, ___________________
microelectronics, and software systems and applications and provide a
wide range of professional business solutions and ITservices. ___________________
Implementing an Energy Management System
The IBM Real Estate and Site Operations (RESO) group is responsible
for energy management programs across IBM’s operations. The energy
management team has energy engineers assigned to major locations
and regions that cover all of IBM’s major operations.
To meet the company’s goal of achieving annual energy use avoidance

and reductions equivalent to 3.5% of the company’s energy use in
2007, the group implemented an Enterprise Energy Management
System (EEMS) to enable real time energy use monitoring at IBM
locations.
Seizing Opportunities for Energy Conservation
IBM’s energy conservation program provided an effective methodology

for performing ongoing optimization of building and system operations
that would utilize real-time baseline energy use from a regular, periodic
(every 15 minutes) collection of building, system and facility-level
electrical use.
Collection of electrical use over the day provides a view into two
important factors: 1. Anomalies in energy use such as short-term
transients of high electrical use, and 2. Increases in electrical use
over time against a baseline electrical use profile.
Results and Lessons Learned
This system has enabled IBM to identify more than 105 energy
conservation projects over 2005 and 2006 that resulted in a total
savings of 16,500 MWh of electricity and US$ 1.35 million for the
company.
Contd…
300
Notes The implementation of the EEMS data collection system demonstrated
that real-time collection and display of energy-use data could reveal
___________________ energy-use patterns that are not seen through a review of the monthly
utility bills. Real-time evaluation of energy use can identify intermittent
___________________ patterns or gradual changes in established baseline energy use that
indicate opportunities to reduce energy consumption.
___________________
Questions
___________________
___________________
___________________
___________________
___________________
Case Study 2: Energy Service Company (ESCO)
___________________
An energy service company (acronym ESCO or ESCo), is a business
___________________ that develops, installs, and finances projects designed to improve energy
efficiency and reduce operations and maintenance costs for its
customers’ facilities. ESCOs act as project developers for a wide range
of tasks and assume the technical and performance risk associated
with the project. What sets ESCOs apart from other firms that offer
energy efficiency improvements is the concept of performance-based
contracting. When an ESCO undertakes a project, the company’s
compensation is directly linked to the amount of energy that is actually
saved.
Mode of Operation of ESCO
The initial Energy Service Company (ESCO) started in Europe more

than 100 years ago. Over the last few years, there has been an increased
interest within Europe for the provision of energy services. This has
been driven by a restructuring of the gas and electricity sectors, and
the push to mainstream sustainable forms of energy into the market.
ESCOs offer energy services, such as:
• Energy analysis and audits

• Energy management
• Project design and implementation
• Maintenance and operation
• Monitoring and evaluation of savings
• Property/facility management
• Energy and/or equipment supply
• Provision of service (space heating/cooling, lighting, etc.)
The comprehensive energy efficiency retrofits inherent in ESCO

projects typically require a large initial capital investment and may
Contd…
Unit 25: Case Study
301
offer a relatively long payback period. The customer’s debt payments Notes
are tied to the energy savings offered under the project so that the
customer pays for the capital improvement with the money that comes ___________________
out of the difference between pre-installation and post-installation
energy use and other related costs. ___________________
With the rising cost of energy and the availability of efficiency ___________________
technologies in lighting, heating, ventilation and air conditioning
(HVAC), and building energy management, ESCO projects became ___________________
much more commonplace. The term ESCO has also become more
___________________
widely known among potential clients looking to upgrade their building
systems that are either outdated and need to be replaced, or for ___________________
campus and district energy plant upgrades.
___________________
With the enactment of Energy Conservation Act in 2001, and the
Central Government’s commitment to reduce the energy consumption ___________________
in select government organizations by 30% over the next five years,
ESCO business had got a boost. Overcoming conventional barriers to ___________________
such business and affecting a market transformation holds the key to
___________________
its further success. ESCOs provide their clients with comprehensive
services encompassing audits for energy saving performance, design
& implementation of conservation measures, maintenance, operation
and management introduces facilities and procurement of project funds.
ESCOs conduct retrofitting for energy conservation without damaging
the environment. The ESCO will guarantee the savings that would
meet or exceed the annual payments to cover up the entire project
costs usually a period of 5 to 10 years. The savings can be shared
proportionately with the institution for which the project is designed
and implemented for.
The salient features of performance contracting for energy savings

through ESCO-based business model are asunder:
• ‘Nil’ investment by customer. ESCOs typically either finance or

assist in arranging financing for the installation of an energy project
they implement by providing a savings guarantee.
• ESCO identifies Energy Efficient Measures (EEMs) to replace/modify
existing inefficient systems.
• ESCO supplies, installs and maintains the Energy Efficient Measures
(EEMs) during the contract period.
• Contract period could be 3-5 years or as mutually agreed upon.
• Energy saving is shared between ESCO and customer as per agreed
terms. Total project cost is funded by ESCO.
• Guarantee Energy savings and recover its investment including
interest and other costs out of generated energy savings. ESCOs
guarantee the energy savings and/or the provision of the Same
level of energy service at a lower cost by implementing an energy
efficiency project.
Contd…
302
Notes Hence, under an Energy Performance Contract (EPC), an ESCO
develops, implements and finances (or arranges financing for) an energy
___________________ efficiency project or a renewable energy project , and uses the stream
of income from the cost savings, or the renewable energy produced,
___________________ to repay the costs of the project, including the costs of the investment.
In EPC, ESCO remuneration is based on demonstrated performance;
___________________
a measure of performance is the level of energy or cost savings or the
___________________ level of energy service. Energy supply contracting (delivery contracting)
is focused on the supply of a set of energy services (e.g. heating,
___________________ lighting, motive power, etc.) mainly via outsourcing the energy supply.
___________________ With the enforcement of the Kyoto protocol, ESCOs can result in
additional substantial revenues through Clean Development Mechanism
___________________
(CDM) benefit to its clients. AEL ESCO has resources and expertise
___________________ to execute CDM projects.
___________________ With deregulation in the U.S. energy markets in the 1990s, the energy
services business experienced a rapid rise. Utilities, which for decades
___________________ enjoyed the shelter of monopolies with guaranteed returns on power
plant investments, now had to compete to supply power to many of
their largest customers. They now looked to energy services as a
potential new business line to retain their existing large customers.
Also, with the new opportunities on the supply side, many energy
services companies (ESCOs) started to expand into the generation
market, building district power plants or including cogeneration
facilities within efficiency projects.
An example of a project undertaken by ESCO is as follows:
Scaling up a proven mechanism to implement energy efficiency street

lighting projects in India.
Purpose
Dissemination of a proven approach to develop, implement and finance

municipal energy efficiency projects, working with private sector
(ESCOs) and carbon finance, to eliminate the barriers for such projects
in India.
Main Activities and Outputs
• Creating a steering committee to implement the concept

dissemination activities in India.
• Preparing and disseminating the required standard documents based
on the previous project including a conceptual document for internal
approval in municipalities; technical, legal, financial, and other
documents for City councils for bidding procedures; Request for
Proposals (RFP); and Monitoring and Verification (M&V) plan and
payment mechanism.
• Seeking support from local organisations.
Contd…
Unit 25: Case Study
303
• Organising and delivering dissemination and capacity presentations Notes
in different states on the concept, and provide all the needed
documents (in Hindi and English) to the interested participants. ___________________
• Supporting unicipalities in utilising the concept within their process. ___________________
Expected Impacts
___________________
• Over 100 cities exposed directly to the concept in at least five
___________________
states.
___________________
• A minimum of 10 cities entering into the process for energy efficiency
project implementation. ___________________
• Five different private sector companies (ESCOs) interested in the
___________________
concept and willing to bid (or bidding) on projects.
___________________
• Interest carbon credits buyers in the approach and enter into
partnerships with potential sellers. ___________________
Questions ___________________
Case Study 3: Japan Facility Solutions (JFS) - TEPCO

Group
Japan Facility Solutions, Inc. was founded in 2000. The Company’s
line of business includes the wholesale distribution of industrial
machinery and equipment. JFS has implemented more than 80 ESCO
projects, and in 2008, it achieved annual reductions of CO2 emissions
totalling approximately 26,600 tons. In 2007 and 2008, JFS won the
first award of excellent ESCO projects held by the Energy Conservation
Centre, Japan.
An example of a successful ESCO-project: Tokyo Metropolitan Hiroo

General.
Hospital
The project at Tokyo Metropolitan Hiroo Hospital is one of the most

successful ESCO projects proposed and implemented by JFS.
In October 2005, the hospital made a 6-year guaranteed saving contract

with JFS, which stipulated an energy consumption reduction of 28.2%
and a targeted utility cost reduction of 72 million yen per year at
construction costs for the renovation amounting to 310 million yen.
Various energy saving techniques were applied, such as optimizing

cool and reheat process in double-coil air handling units (AHUs) to
Contd…
304
Notes reduce air-conditioning load, renewing refrigerators from conventional
chiller to inverter chillers, introducing free cooling system, and
___________________ increasing the efficiency of transporting heat through various controls.
___________________ Results
___________________
The annual performance factor of the heat-source system has become
approximately twice as high as before. The achieved energy
___________________ consumption savings in the first fiscal year 2006 exceeded the targets.
114% achievement was made in primary energy consumption; 116%
___________________ achievement in CO2 emissions; and a more than 82-million-yen
reduction in the utility costs.
___________________
Questions
___________________
___________________
___________________
___________________
www.cce.upes.ac.in
ISBN: 978-81-946164-6-7
9 788194 616467

Econo-Ch 1

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Econo-Ch 1

Uploaded by

Copyright:

Available Formats

UPES

CENTRE FOR CONTINUING EDUCATION

Dr. Kamal Bansal Mr. Ashok Sahu

SLM Development Team

Mr. Tarun Batra Mr. Rahul Sharma Mr. Shantanu Trivedi

Prof. Raju Ganesh Sunder

Course Code: MBPF913D

Version: July 2019

Unit 1 Introduction to Return Concept–I ...................................................................... 3

UNIT-1: INTRODUCTION TO RETURN CONCEPTS–I

UNIT-2: INTRODUCTION TO RETURN CONCEPTS–II

UNIT-3: INTRODUCTION TO PROJECT APPRAISAL

UNIT-4: FINANCIAL ANALYSIS

UNIT-5: CASE STUDY

Introduction to Return Concept–I

Learning Objectives: ___________________

___________________ Payback Period Method

Cost of Project (or) Investment

In a widely used investment criterion, the payback period seems ___________________

___________________ The payback criterion prefers A, which has a payback period

___________________ 3. It is a measure of the project’s capital recovery not

FV consists of: ___________________

Check Your Progress

Fill in the blanks:

1. ................. in business and economics refers to the period of time

2. The ................. must be compensated for the declining spending/

Year Cash Flow (`

1,000,000 200,000 200,000 300,000 300,000 350,000

NPV = 0 the investment would neither the project could be accepted

Properties of the NPV Rule

NPV Calculation Permits Times Varying Discount Rates

Where, Ct = Cash flow at the end of year t

Where, Ct = Cash flow at the end of year t

The present value of the cash flows can be calculated as follows:

Check Your Progress

Fill in the blanks:

1. ........................ is a way of comparing the value of money now with

Introduction to Return Concept–II

Learning Objectives: ___________________

NPV = 0 the investment would neither We should be indifferent in ___________________

However, NPV = 0 does not mean that a project is only expected

___________________ Check Your Progress

___________________ 1. To some extent, the selection of the .................... is dependent on the

Cash Flow (100,000) 30,000 30,000 40,000 45,000

The IRR is the value of r which satisfies the following equation:

30,000 30,000 40,000 45,000

30,000 30,000 40,000 45,000 ___________________

30,000 30,000 40,000 45,000

Accept/Reject Rule for IRR

Graphical Explanation for IRR

• IRR: Internal Rate of Return. ___________________

• n: Last year of the lifetime of the project. ___________________

Calculating the IRR is done through a trial-and-error process ___________________

IRR function in a spreadsheet program or with a programmable ___________________

Fill in the blanks:

___________________ Advantages and Disadvantages of IRR and NPV

Why the NPV and IRR sometimes Select Different Projects

Project Size and Life

Different Cash Flows

Check Your Progress

Fill in the blanks:

2. A project selected according to the NPV maybe ................... if the IRR