D-MBA-FM-305 : Project Management

Chapter-1

Project Management: An Overview, Significance, Defining project and its setting in

context of planning

Structure

1.0 Introduction

2.0 Objectives

3.0 Presentation of Contents

3.1 Meaning of Project Management

3.2 Characteristics of a Project

3.3 Kinds of Projects

3.4 Selection of Projects

3.5 Project Planning

3.6 Project Organisation

3.7 Project Control

4.0 Summary

5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

Project Management has become an important object in the context of development

in a country. The programme of planned economic development envisages a large
number of new projects. In fact the promotion of economic development to a large
extent depends upon the quality of project management. It provides a framework for
the allocation of scarce resources and ensures their optimum utilisation.

2.0 Objectives

After reading this lesson, you should be able to

(a) Define project management and explain its features.

(b) Describe the various types of project.

(c) Explain the criteria in selection of a project.

(d) Discuss the planning and control of project.

Presentation of Contents

3.1 Meaning of Project Management

It is well known that expansion and diversification of existing organizations and

development of new projects is an ongoing process in any development economy. B
Project Management as a specific term is comparatively new in management
literature According to Encyclopaedia of Management, 'A project is an organization
unit dedicated to the attainment of a goal, the successful completion of a
development product on time within budget, in conformance with pre-determined
performance specifications Management is an activity encompassing planning,
control, supervision and the engineering or manufacturing involved in producing the
end item. Hence Project Management it general management activity similar to
functional management and administration. In that it is basically getting work done
through people, with all that implies regarding objectives incentives and
communications. But unlike functional managers, a project manager has very
specific objectives which, when achieved mean the completion of his function.
Similarly unlike functional managers, a project manager has usually no line of
authority over the organisations producing the items

During the past century, project management has come to be recognized as a

specialised branch of management which has evolved in order to co-ordinate and
control some of the complex activities of modern industry. It consists of the activities
involved in completing project deliverable items within the stipulated time, cost,
reliability standards etc. The role of project manager is one of planning, co-
ordination, controlling and motivating the project team to achieve the above
objectives.

3.2 Characteristic of Project

The characteristics of a project are as follows:

(1) Objectives: A project has a set of objectives or a mission. Once the objectives
are achieved the project is treated as completed.

(2) Life cycle: A project has a life cycle. The life cycle consists of five stages i.c.
conception stage, definition stage, planning & organising stage, implementation
stage and commissioning stage.

(3) Uniqueness: Every project is unique and no two projects are similar. Setting up
a cement plant and construction of a highway are two different projects having
unique features.
(4) Team Work: Project is a team work and it normally consists of diverse areas.
There will be personnel specialized in their respective areas and co-ordination
among the diverse areas calls for team work.

(5) Complexity: A project is a complex set of activities relating to diverse areas.

(6) Rink and uncertainty: Risk and uncertainty go hand in hand with project. A risk
free, it only means that the element is not apparently visible on the surface and it will
be hidden underneath.

(7) Customer specific nature: A project is always customer specific. It is the

customer who decides upon the product to be produced or services to be offered
and hence it is the responsibility of any organization to go for projects/services that
are suited to customer needs

(8) Change: Changes occur through out the life span of a project as a natural
outcome of many environmental factors. The changes may vary from minor changes,
which may have very little impact on the project, to major changes which may have a
big impact or even may change the very nature of the project.

(9) Optimality: A project is always aimed at optimum utilization of resources for the
overall development of the economy.

(10) Sub-contracting: A high level of work in a project is done through contractors.

The more the complexity of the project, the more will be the extent of contracting.
(11) Unity in diversity: A project is a complex set of thousands of varieties. The
varieties are in terms of technology, equipment and materials, machinery and
people, work, culture and others.

3.3 Kind of Projects

The projects are of various kinds

i) Pure expansion projects.

ii) Expansion projects utilising the same equipment but with diversification of
products.

iii) Diversification involving the abandonment of previous equipment generally and its
replacement largely by new equipment.

iv) Development Projects.

v) Foreign Projects which may be turn key projects or joint projects with an external
agency.

vi) Internal projects financed by a foreign agency in collaboration with an internal

agency.

vii) Projects involving collaboration with foreigners.

viii) New Projects within a country without involving foreign agency.

ix) Projects involving modifications and alternation to an existing plant.

The idea in specifying such typical projects is to enable the students to appreciate
that the decision rules and the emphasis in each case would be different and that
later, in considering general methodology, it would be necessary to shape it to the
particular circumstances of each project. In fact the diversity of project work is such
that hardly any project would duplicate the concepts and context of another project.
Yet the projects do fall into types and the decision rules and strategy for them would
be somewhat similar tough each would have its peculiar characteristic.

Expansion projects may be of several types. They may be undertaken to meet

"growth in demand". This is the least risky form of investment, it does not call for the
acquisition of new kind of assets, new production techniques, new marketing skills
(though new markets may have to be explored and looked after) or new technology
(though improved old technology may have to be purchased). Such expansion is
known as "Spontaneous" expansion.

Expansion may be undertaken to modernize equipment in order to reduce costs and

meet national and international competition. This involves more investment and risk
than for spontaneous expansion, new equipment; techniques and technology have
also to be acquired. Considerable care has to be taken to train manpower necessary
for the new tasks.

Expansion in the above cases involves spreading overhead on larger production and
therefore a reduction in costs provided other things are equal. They enable the firm
to meet competition with confidence.

Markets for existing produces may cease to grow or competition becomes more
intensive; both these have spontaneous expansion. Diversification is, therefore, a
natural choice in order to avoid stagnation and deterioration. Technical innovations
or changes in customer habits (or fashions) may spur diversification in case the firm
is to utilise its resources and advantages profitably.

Another terminology is also in vogue. It is known as integration. It implies new

activities. Vertical integration would either be forward integration or backward
integration. A paper manufacturer may decide to produce only wood pulp or go into
package making or printing. The former is backward integration and the latter is
forward integration. A cotton weaving company may integrate backwards into
spinning or forward into finishing or clothing manufacture. The basic aim of vertical
integration is go into new ventures of akin nature i.e., where the raw material is the
same but technology may differ. Usually such integration offers profits from the
manufacture of a single end product. Vertical integration means that either you go
back a few steps and select a saleable product for diversification (from paper to
wood pulp) or go forward to another product in which your end product can be used.
In other words, one may move forward and backward the scale of related products
using the same raw or finished material more advantageously.
Vertical integration usually arises from the problem of comparative instability in the
present position or better marketing opportunities of a profitable character in the
future or from the wrong size of the existing firm. It will be appreciated that even
though an industry, integrating backward and forward, stays in the same industry, it
moves into areas in which it has little or no experience. It diversifies its activities; it
requires new skills; it assumes new risks. A firm can integrate horizontally also as for
example a soap manufacturing firm moving on to detergents or a motor car
manufacturing firm moving on to commercial vehicles and tractor production or a
bicycle industry moving in also to scooter and motor cycle products. Horizontal
integration provides convenient expansion opportunities and allows existing
resources and skills to be more widely used though new technologies are involved
and they present readjustment problems. In such cases, more risks have also to be
faced.

Some firms prefer to be conglomerates i.e. they like to strike into new fields every
time they have investible funds; They continue to look for new opportunities.
Profitability and risk taking in such a case has to be compared to expansion in
products in which they have already achieved a measure of success.

The examples of conglomerates are many. The replacement of textiles

manufacturing in Japan by men-made fibres. The whole investment in textile was
scrapped, new technology and equipment purchased and installed and new
marketing postures were explored making the entire venture to resounding success.
It was a rare example of bold decision making and looking forward into the second
half of the twentieth century. The risk element is certainly very high Shedding of a
traditional product in which eminence and competitive advantage have been reached
is not easy but business firms are metime compelled by circumstances and far-
sighted wisdom to do it. The major task is of raising the necessary capital apart from
technological and marketing problems. Most often the task is to create new markets.
There is a great deal of work behind this exercise and certainly many anxious
movements.

Developments projects result usually from research and development activities of the
firms. In many cases they are closely connected with defence requirements or with
international competitive technological imperatives such as the national nuclear
energy or space programmes. There is more element of the unknown in those
projects. Development projects need continuing research to keep abreast of chances
in the world of science and technology. Development projects, therefore, defy correct
estimation to begin with. It is also usual for those asking for such projects to submit
low estimates of cost and higher estimates of benefits so that the funds are made
available for a start to be made, Later when it is difficult to turn back from the project,
the revised estimates show an abnormal escalation of the original cost. The
problems of developments projects have been discussed in a very interesting report
of Steering Group of UK Ministry of Technology in two volumes published by Her
Majesty's Stationery Office, London. The rules for decision making on development
projects will be materially different from those for ordinary expansion or diversion
projects

Managing engineering projects abroad has become an important activity in India as

the country shares the technologies developed by it with countries of the third world:
Every project is a unique undertaking, no two projects are alike. Specific experience
of different countries should be codified and consulted. Various organizations with
considerable experience of foreign projects, have gathered in their archive's case
studies relevant to future preparation in these matters. The information required may
be divided into four different sections namely:

i) Basic Information
ii) Tax Laws
iii) Purchase Order Commercial Terms
iv) Simplified Definition of Quotation Terms

Some ideas must be developed beforehand about subcontracting and the

manufacturing industry in the country as it is evident that the country concerned
would like the major supplies and skills to be obtained from within. This subject,
because of its importance, would be dealt with in greater detail. Joint projects with an
external agency, besides the above problem, also raise issues of mutual dealings
and accommodation, training of the host country's technical and managerial staff and
sharing of foreign markets.

Internal projects financed by a foreign agency present different set of problems. The
major issues are:

a) the use to be made of resources available in the country.

b) training of our managers, technicians and skilled workers.

c) the purchase of technology and supplies best suited to requirements in such a

way that internal development for future projects is placed on a creative basis to
reduce dependence on foreign sources and

d) the preservation of the morale of indigenous manpower which alone will

guarantee future development of the borrowed technology.

Management of new projects within the country concern themselves with the need
for borrowing technology or using technology developed by indigenous research and
development facilities. The most important aspect in new projects is market demand
and market strategy. That alone can ensure proper feasibility. This course is
concerned more with such projects than with other types mentioned above.
However, fundamental considerations are required to be worked out in the same way
in each type of project mentioned above though the circumstances will be different in
each case and, therefore, their feasibilities would need to be tested on different
considerations. For example, a steel project located on the sea coast would need
different set of conditions and facts to be worked out and therefore resultant costs
would be lower than of a steel plant located in the heart of a country with captive
mines nearby.

Projects involving modifications, alterations or replacement are in fact miniature

version of the original projects concerning specific aspects of the equipment or
process of safety or balancing equipment and other investment to improve the
economics of original projects. It is necessary to discuss the needs of such projects,
their budgeting problems and the manner of deciding about priorities among them.

3.4 Selection of Projects

The selection of a project in the first important project decision. It has two aspects.

The criteria for selection in the first instance, has to be with reference to the value of
industrial projects to the economy. If a project is not valuable to the economy, it is
normally likely to be of value to the person who tries to establish it. The second
aspect concerns the criteria for selection of such valuable project suited to the
circumstances and convenience of a particular or collegiums of people which can
legally carry out business.

Is India the choice of a project demands on the individual entity within the limitations
of policy laid down by Government for various kinds of industrial activities. One has
to conform to this policy to be able to set up projects that will also be techno-
economically desirable to the clarity concerned for which there are specific decision
rules to be applied. But if a project does not conform to the parliamentary approved
policy and legal enactment it is useless to proceed with a project.

In terms of policy objectives, they fall within the criteria normally indicated,
theoretically by various writers on the subject. It is not necessary here to refer to all
the views on the subject as we shall then be developing deep into economic theory
in its political setting. However, the views of Mr. Murray D. Bryce are interesting in
his respect. He has suggested the following criteria for selection of projects for an
economy of our character:

(a) Factor Intensity Criterion.

(b) The Plant Size and Complexity Criterion.

(c) The Foreign Exchange Benefit Criterion.

(d) The Commercial Profitability Criterion.

(e) The National Economic Profitability Criterion.

(a) Factor Intensity Criterion

Other things being equal economies like lndia should encourage projects which
make use of the factor that is available in abundance, namely Labour. There are
many situations in which other things are not equal. For example, the approach will
not pay in circumstances in which production has to compete in the international
market. However, if competition is internal, labour intensive project may be given a
price preference over a capital intensive project for the same products. In such
circumstances, the processes selected may be somewhat old and even obsolete
provided the employment generated by the project is relatively higher than in the
case of capital intensive projects. In such cases the output may be priced on the
basis of relatively higher costs at which they will be produced. In India, Government
has reserved certain products only for the small scale sector in which production
may be carried out with relatively less modern equipment than would be the case if
large viable plants were allowed to be set up.

(b) The Plant Size and Complexity Criterion

One of the important tests of suitability of projects in certain circumstances may be to

limit the size and complexity involved in a plant. This is needed in certain direction le
developing managerial skills and technology Pharmaceutical industry is an apt
example. Relatively middle level project would have more chances of success in
India owing to the limited market than large scale mass production projects. The
difficulties of the surgical plant at Madras are entirely due to the size of the plant
which is, as thing go today, disproportionate to the needs of the country. Given
another ten thousand hospitals, we might need one more such plant. This
emphasizes the importance of small and medium projects in an economy such as
India's small projects are less demanding and under developed country usually lacks
capital, management and technical skills. Generally they use more labour in relation
to capital than large projects. They can usually be built quickly and put into operation
to produce returns. They facilitate decentralisation and can raise capital easily.

Even in countries with advanced industrial base, the small projects play an important
role either by themselves or Satellites to large project. In the USA according to a
study by the Stanford Research Institute, 87% of the manufacturing concerns employ
less than 50 persons. However, such a development cannot be an alternative to the
establishment of large industries. It should be seen that it has an enduring value
particularly as a complementary to some large scale industries. In India the scope for
setting up small chemical plants, for manufacturing drugs from intermediates and for
establishing small plants for meeting the maintenance requirements of large plants,
is really good provided enough care is taken in the proper relationship between the
two scales of industries.

(c) The Foreign Exchange Benefits Criterion

This means that priority shall be given to projects which are net savers of foreign
exchange or its earners. This arises from the balance of payment position. Usually
the first effort at industrialisation places a great deal of burden on foreign exchange
resources. Capital plant is imported, raw materials, at least critical, are imported,
technology and experts are imported. They are either paid for cash down or from
loans received. The Iatter have to be discharged annually for a number of years
thereafter, thus constituting a fixed drain on foreign exchange resources. It,
therefore, becomes important to increase these resources either by saving foreign
exchange or by earning it. At the present stage in India, we are placing a great
emphasis on this criterion. In fact, it has become almost a politic-economic slogan.

(d) The Commercial Profitability Criterion

This criterion is common to even the previous criteria the sense that, whether labour
intensive projects needs simple technology and equipment or is means for saving or
earning foreign exchange, it must be profitable. These projects have additional
benefits as they have a short payoff and need relatively less complicated equipment
and skill to work them. But they are also subject to commercial profitability criteria
particularly when they are located in the private sector in case they serve a national
purpose of importing complex technology with a long payoff. The estimated
commercial profitability is the expected net profit after all costs, including
depreciation. It is usually expressed as percentage annual return on either the total
capital cost of the project or upon the share capital invested. The criterion is widely
used as an essential test of a project's prospects by financial institution. Many of time
these institutions also take into account the projects other benefits to the economy
described above. They make take than a composite view of the viability of the
project.

(e) The National Economic Profitability Criterion

None of the criteria, discussed earlier, could be regarded either severally or jointly
the measure of a project's total net value to the economy. It is possible that a number
of measurable economic costs may be ignored or incorrectly counted. A
comprehensive general measure of the project's not measurable economy value is
required for and assessment by a country for understanding the long term effects of
its policy on utilisation and allocation of inputs or in other words of industrial
investments.

While selecting a project one must also keep in view the relevance of the project on
the ordered growth of the economy and to the plans and programmes of economic
development. Though an individual is free in a planned economy the choice for
selection of projects gets restricted by the economic policy and planning.
Programmes and plans for economic development offer opportunities which
industrialization would like to exploit. It must also be kept in mind that these factors
are not static. They keep on changing. This will be evident from the history of
regulation of industry through different policy statements and laws, in the country
since 1948.

3.5 Project Planning

Projects involving few activities, resources, constraints, and inter-relationship can be

visualised easily by the human mind and planned informally.

Planning is a vital aspect of management and serves several important functions viz.

 It provides a basis for organizing the work on the project and allocation
responsibilities to individuals.
 It is a means of communication and coordination between all those involved in
the project. It induces people to look ahead.
 It in stills a sense of urgency and time consciousness.
 It establishes the basis for monitoring and control.

Element of Project Planning

Project Planning covers the following:

1. Planning the project work: The activities relating to the project must be spelt out
in detail. They should be properly scheduled and sequenced.

2. Planning the manpower and organization: The manpower required for the
project (managers, technologies, and manual labour) must be estimated and the
responsibility for carrying out the project work must be allocated.

3. Planning the money: The expenditure of money in a time phased manner must
be budgeted.

4. Planning the information system: The information required for monitoring the
project must be defined.

3.6 Project Organisation

The Traditional form of organization is not suitable for project as:

i) it has no means of integrating different departments of levels below the top

management, and

(ii) it does not facilities effective communication, coordination, and control when
severe functioning departments, with different professional backgrounds and
orientations are involved in project work under time cost pressures, which often calls
for overlap, at last partial, of development, design, requirement, construction and
commissioning work.

Hence there is need for entrusting an individual (or group) with the responsibility for
integrating the activities and functions of various departments. Such an individual
may be called as the project manager or project coordinator. Depending on the
authority that is given to the person responsible for the project, the project
organisation may take one of the following three forms

 Line and Staff Organisation

 Divisional organisation
 Matrix organisation

3.7 Project Control

Control becomes the dominant concern of the project manager. Indeed, once the
launch phase is over, planning and control become closely intervened in an-
integrated managerial process.

Project control involves a regular comparison of performance against targets, a

search for the causes of deviation, and a commitment to check adverse variances. It
serves two major functions

i) It ensures regular monitoring of performance, and

(i) It motivates project personnel to strike for achieving project objectives.

Effective control is critical for the realization of project objectives. Yet, control of
projects in practice tends to be ineffective. There seem to be three reasons for poor
control of projects.

The bar chart, developed by the industrial engineer Henry Laurrance Gantt, is also
known as the Gantt chart. The bar chart is a graphic method for planning and
controlling production quantities and times.

PERT/CPM

Some network techniques, notable PERT (Programme Evaluation and Review

Technique) and CPM (Critical Path Method) have come to be widely used in project
management. They are very useful in the basic management functions of planning,
scheduling and control. These technique can be applied in wide diverse kinds of
projects like construction of a building or a highway, planning and launching of a new
product, large maintenance projects, scheduling ship construction and repairs, end-
of-the month closing of accounting record, Large research projects etc

For the purpose of application of PERT/CPM, project is conceived as a collection of

independent activities of jobs. If one job has to be completed before another can
begin, the first job is described as an immediate predecessor of the job.

The concept of critical path indicates that if we want to reduce the total duration of a
project we should be able to reduce the time taken by activities on the critical path.
For example, if we want to complete the research project of our example earlier, we
have to reduce the time taken by any one or more of the activities on the critical
path. For example, we may reduce the time for the consumer survey by increasing
the number of people employed for this purpose. Similarly, the data processing may
also be done quickly. However critical path is the longest path in the project.

Needless to add, any delay in an activity on the critical path will lead to a delay in the
completion of the project.

Management Information System as a Tool of Control

A management information system (MIS) is a collection of date processing

equipment, procedures, software and people that integrates the sub-system of the
organisation and provides needed information in time for efficient managerial
decision making to discharge the managerial functions promptly and efficiently.

An efficient MIS plays a very important role in enabling the managers efficiently
performing the managerial functions like planning, organizing, directing and
controlling. Adequate and up to date information is an essential input for all these
functions. The MIS, therefore, is a prerequisite for efficient management.

The term management information system indicates that the collection, recording.
Storing, retrieval, processing, analysis, presentation etc., of the information required
to the management are done in the framework of system.
That is, the various elements are properly co-ordinated and integrated
systematically. A good MIS ensures adequate and up-to-date information for
managerial decision making. Planning, monitoring and controlling, therefore, become
easier.

Functional Control (e.g. Inventory Control)

There are different types of control exercised on the basis of various functions:

The aim of inventory control is to ensure adequate stock for the uninterrupted
operation of the business with the minimum possible inventory cost. This objective
calls for a compromise between two conflicting aspects of it, namely, high inventory
and Low cost

Absence of adequate inventory might interrupt the business and cause loss. The
greatest insurance against this, obviously, is maintaining huge inventory. This,
however, is very costly. Inventory entails cost due to capital tied up. There is also
storage cost. There may be further losses due to deterioration, obsolescence or
declining prices. Even record keeping and accounting become more costly as
inventors rise.

The above problems call for Limitations of inventories. However, reduced inventories
may result in increased purchasing and handling costs because of smaller lots and
may also increase the frequency of operational sales delays.

The overall objectives should, therefore, be to keep that level of inventory which
ensures uninterrupted operation and minimize the cost.

For effective control of inventories of raw materials, purchased parts etc., the

Following steps are essential:

i) Fixing minimum quantities, or ordering points and maximum quantities, or amounts

to order, on all quantities

ii) Arranging a method for allocation of material to orders which are in process or are
contemplated.

iii) Creating stores accounts, which will control the store room.

in management circles, it is common to speak of economic order quantity i.c., the

quantity minimizes cost, in relation to the first step mentioned above. It should
however, be noted that in countries like India, it is not practicable in respect of many
items.

The ABC analysis is very useful for inventory control. This refers to classification of
the items to be controlled according to the value to provide indicators to the degree
of control that can be justified. There may be hundreds of items in inventory but a
limited number of them may account for the major chunk of the value of inventory.
These items should, therefore, get more attention of control.
Control and Supervision by Financial Institutions

Financial institutions which have advanced loans to a business concern have a stake
in it. Hence it is necessary that they keep themselves informed of the functioning and
affair of the assisted concerns. They should also have powers to control the affairs of
such a concern so that they can help ensure that the concern is properly run and that
their money will not go waste.

An essential requirement for this monitoring and control is the timely availability of
information. Financial institutions, therefore, insist on the assisted concerns
submitting periodic reports providing the needed information about their progress
and functioning. Additional information, whenever required may also be called for
Inspections may also be made for more authentic information and verification.
Further, financial institutions may appoint nominees on the Board of Directors
subject to certain conditions of the assisted concerns.

Nominee directors are normally given clearly identified responsibilities in a few areas
which are important for public policy. An illustrative list of these is:

(a) Financial performance of the company.

(b) Payment of dues to the institutions

(c) Payment of Government dues, including excise and custom duty and statutory
dues. Where the company feels that a particular tax demand is unjustified, nominee
directors should satisfy themselves about the prima facie reasonableness of the
company's case.

(d) Inter-corporate investment in and loans to or from associated concerns in which

the promoter group has significant interest.

(e) All transactions in shares.

(f) The expenditure incurred by the company on the managerial group.

(g) The policies relating to the award of contracts and purchase and sale of raw
materials, finished goods, machinery etc.

The nominee directors should ensure that the tendencies of the companies towards
extravagance, Lavish expenditure and diversion of funds are curbed. With a view to
achieving this object, the institutions should seek the constitution of a small audit
subcommittee of the Board of Directors for the purpose of periodic assessment of
the expenditure by the assisted company.

The institutional nominee director will invariably be a member of these sub

committees

The basic function of Project management is to Plan and control. The control is the
least if responsibilities generated are high. A responsibility implies that a decision
maker has to be aware of the implications of what he is doing, on his colleagues, his
subordinates, and his superior and on the company as a whole. This attitude arises
from cultivating conformity exercise continuously and effectively. In other words, an
attempt has to be made to place all the vital decision makers and the entire company
staff at a wave length on which the response is the most significant and similar, at
least as near similar as practicable. This underlines the importance of the right type
of communications.

Some top management is keen on detailed control. They want that every step should
be taken with their concurrence. This is possible cither at the cost of expenditure of
time, meant for vital decisions, on details or on clogging up lines of communications,
or on reduction in the responsibility of people below or in causing exasperation and
frustration all around. In small companies this might be necessary as responsibility
levels below are comparatively low for lack of resources to afford better types of
people but in large companies this is simply possible. It would lead to chaos.
Decentralisation of responsibility in inevitable if it not given, it would be wrested if
progress is to be made.

The limits of control, therefore, depend on the size of the company's span of
activities and the training in responsibility that it can import to its employees.
Nevertheless, minimum control is required whatever the nature of arrangements for
business in any organization.

Now-a-days the expression used is "control and feedback". this comes from the
analogy of cyber matics which is the study of communication and control mechanism
is human beings. Briefly speaking, its attributes are:

a) Stimulus
b) Standard
c) Performance
d) Feedback

Perception leads to the development of a single, overall plan. This general plan is
made operational by preparing a number of requisite sub-plans. The more complex
extensive the general plan the larger the number of detailed plans. Since no one can
control everything, a number of individuals look-after sub-plans. A financial specialist
may prepare the personnel plans, a financial specialist the finance plans, an
engineering specialist the plans requiring engineering skills such as warehouse,
roads, industrial buildings etc. Co-ordinating the various sub-plans becomes the
major task of every senior manager.

Implicit in every plan is some objectives of performance. If the plan is sound the
objective is clear cut and can be reached effectively, the objective is usually within a
range of figures and not an exact figure as uncertainly is a fact of life except in the
very short run.

Actions are initiated to achieve the performance objectives. Actions need to be

checked and reported back. This is the original step. None can correct an error
unless he knows that the error is occurring. This step directly involves proper
organization and planning of control procedures. There are several devices for
control from the most rigid personalised system to management by exception or by
objectives and self-control.

The main aim of control is to detect deviations from the planned actions, then to take
action to correct deficiencies and to improve future plans taking note of what has
happened.

The better the feedback information, the better the manager can operate.

Information controls come into the picture when coordinated results of various
departments have to be viewed by top management particularly in Board of
Committees of in successive layers or management and when managers are
situated away from the centre of control or when the operations are complete and
require a coordinated report.

These processes are called fractionalizing of control and their exact identification for
particular arrangement depends on many factors of which the size of the company is
an important index.

In selecting the control subject another consideration is that the subject selected
should be one for which precise responsibility can be placed on some one. In other
words, the subject should be controllable. It should not be vague in standards and
measurement.

4.0 Summary

A project is an organized programme of pre-determined group of activities that are

non-routine in nature and that must be completed using the available resources
within the given time limit. Project management is an organized venture for
managing projects. There are various kinds of projects such as expansion projects,
development projects, foreign projects, internal projects, new projects etc. The
selection of a project is the first important project decision. In India, the choice of a
project demands on the individual entity within the limitations of policy laid down by
Government for various kinds of industrial activities. Planning the project work,
manpower and organization, money and information system are the elements of
project planning. Project control involves a regular comparison of performance
against targets, a search for the causes of deviation, and a commitment to check
adverse variances.

5.0 Suggested Readings

 United Nations, Guidelines for Project Evaluation, Oxford & IBH Publishing
Co., New Delhi
 United Nations, A Manual for Evaluation of Industrial Projects, Oxford & IBH
Pub. Co., New Delhi.
 Prasanna Chandra, Projects: Preparation, Appraisal, Budgeting and
Implementation, Tata McGraw Hill Publishing Co. Ltd., New Delhi.
 Planning Commission, Guidelines for Preparations of Feasibility Reports for
Industrial Projects, Controller of Publications, Government of India, New
Delhi.
  Frances Cherunilam, Business Environment, Himalaya Publishing House,
Bombay.

6.0 Self Assessment Questions

1. Define project management. Explain the characteristics of project.

2. Discuss the various types of project. Also explain the criterion in selection of the
project.

3. Explain the planning and control of a project

Chapter - 2

Project Development Cycle, Aspects of Appraisal, Project Intensification Scouting of

Projects ideas

Structure

1.0 Introduction

2.0 Objectives

3.0 Presentation of Contents

3.1 Idea Generation

3.2 Project Evaluation

3.3 Project Control

3.4 Project Development Cycle

3.4.1 Pre-Investment Phase

3.4.2 Implementation Phase

3.4.3 Operational Phase

4.0 Summary

5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

Project management constitutes a number of elements in a given sequence from

idea generation to project termination. The major project steps are idea generation
and processing, project evaluation, project selection, project control and project
completion and termination.

2.0 Objectives

After reading this lesson, you should be able to

(a) Explain various aspects and stages of project development cycle.

(b) Discuss the various considerations in project appraisal.

(c) Explain the different aspects of project identification.

3.0 Presentation of Contents

3.1 Idea Generation

Idea generation and processing systems are being formalized by larger firms to
provide for the generation development, submission and handling of ideas on a
continuous and consistent basis.

New sources for profitable ideas are being developed with greater frequency. In
some cases firms have developed systems, methods and procedures for searching
screening and evaluation idea. Company-developed forms provide the basis for
monitoring and controlling the idea processing system.

In general, a firm's technical and marketing personnel are the best overall sources of
ideas. On the average, a technologically based company identifies three to four
primary sources for new ideas, Among internal sources of new ideas, the research
and sales organizations account for three-fourths of the primary sources named.
Actual and prospective customers, together with contract research organizations and
consultants, accounts for one-half of the primary external sources. It is important to
improve the creativity and communication elements in the idea generation system.

3.2 Project Evaluation

Project Evaluation consists of the collection, synthesis, ad analysis of technical

economic, manufacturing and marketing date and information to provide guidelines

on which and to what extent resources ought to be committed to technical activities
Project evaluation also involves application of various quantitative methods to
identity and measures a firm's expected economic performance (Sales, profits or
return on investment).

Long-range planning, detailed short-range planning, and annual funding and

program control are becoming increasingly used by companies, where project
evaluation and review are incorporated in this process.

Project selection is concerned with the allocation of money, skills, equipment and
facilities to projects. Such decisions are import because of their impact on corporal
performance and the uncertainties and risk involved.

Interdepartmental and inter-functional teams and committees perform project

selection in most companies. However, project initiation is usually the responsibility
of the R & D organization, where the primary considerations are the potential
economic impact on the firm, the availability of R & D resources manpower, skills,
funds, equipment and facilities marketing and manufacturing capabilities and needs,
and the likelihood of success.
3.3 Project Control

Project control consists of methods and procedures used by the firm to control the
costs, rate of progress, and performances. Project control is necessary because of
the magnitude of resources committed to achieve corporate objectives and the
uncertainty in forecasting the costs.

Project control involves budgeting project activities, acquiring timely information on

the costs and progress of the technical work and analyzing the performance and
potential impact of the project.

Many companies have developed systems for performing project control involving
the use of quantitative methods such as the Gantt chart, PERT and CPM. However,
considerable management review is required to assure that these computerized
systems are in fact achieving the required degree of control.

Project control is a joint responsibility of organizational elements and committees

more extensive evaluation of complete and terminated projects is being performed
by some firms to provide the moss for estimating the impact of projects on corporate
performance and to provide needed information on proposed and continuing
projects.

Post audit of projects consists of evaluating costs, completion times, capital

investment, and results in the form of cost, savings or new-products sales and
profits. Comparisons of actual achievement with predicted performance are often
made, particularly in firms having an accurate and reliable information system. Some
companies use an annual post audit or appraisal system.

3.4 Project Development Cycle

The project development cycle consists of

(a) Pre-investment phase.

(b) Implementation phase.

(c) Operational phase.

3.4.1 Pre-Investment Phase

The pre-investment phase consists of several stages such as identification of

investment opportunity, preliminary project analysis, feasibility study, and decision-
making.

Identification of investment opportunity calls for analyzing, inter-alias, the following:

(i) plan priorities when planning is done by the Government.

(ii) demand and supply projections of various goods and services.

(iii) pattern of imports and exports over a period of time

(iv) natural resources which can serve as the base for potential manufacturing
activity

(v) scope of extending existing lines of activity by backward or forward integration,

and

(vi) Consumption patterns in other countries at comparable stages of economic

development.

Preliminary project analysis seeks primarily to determine:

i) whether the project is prime-facie worthwhile to justify a feasibility study

ii) what aspects of the project are critical to its viability and, hence call for an
in-depth investigation.

The feasibility study is more detailed the analysis in the feasibility study results in a
reasonably adequate formulation of the project in terms of location, production
capacity, production technology, and material inputs. The feasibility study contains
fairly specific estimates of project cost, means of financing, sales revenues,
production costs, financial profitability and social profitability. It aids in decision
making.

The following stages are undertaken in the feasibility study:

1) Market share of the project which also implies the share of the growing market
as well as the effect of substitutes in the present and in future. The life-span of
the product to be manufactured should be studied in detail. If it has had
already long life span, the possibilities of its loosing customer interest or
becoming obsolescent should be carefully weighed. Normally small scale
industrialists depend on national studies or proven necessity of their hunches.
Large scale industrial establishments either carry out the study themselves or
get it done from outside. The practice of outside help is slowly coming into
vogue. Specialized studies are important and funds should be spared for
them. Medium industries cannot keep specialized staff.
2) The next stage is the selection of processes involved and the equipment
required. This stage is known as Technical Feasibility of projects. It is not
merely a process of listing equipment and technologies manufacture but also
of preparing rough estimates of capital cost, capital requirements, operating
costs and tentative ideas about start-up costs. There are some decision rules
for these processes to which we will briefly refer in the next lesson.
3) These studies will indicate certain alternatives. They have to be weighed
technically and in broad economic perspective on the basis of material
gathered in (ii) above These alternatives may be altogether different projects
from which one or two may be selected for further study or they may be
choices of different routes of the same project from which one or two routes
may be selected for further work. Many projects or alternative courses of the
same project may have to be abandoned at this stage.
 4) Simultaneously, an idea will have to be formed of the cost and duration of
such studies. The time is the essence of market catry. In case it is not
possible to adhere to a time-table required for marketing of the product, the
entire expenses may be in fructuous.
5) Usually low cost estimates are got prepared in the first instance knowing well
that their accuracy may be as such as 25-30 per cent of the final estimates.
They are a useful basis of considering problems of feasibility of individual
projects or a set of projects under review. At this stage, at a comparatively
small cost, the unpromising projects are weeded out leaving attention to be
fixed on a small number of near viable projects. An examination, at this stage,
may also reveal that more fundamental work is necessary before technology
is accepted finally and that this additional cost has to be incurred. Further, it
may be necessary to conduct more detailed enquiries on material
specifications and costs for closer estimates when technical feasibility is fully
undertaken.
6) At this stage it is also necessary to outline briefly but accurately the effect of
Government regulations and taxation policies on the ultimate economics of
the project and also to make broad but significant enquiries about possibilities
of (a) foreign collaboration, (b) import of foreign equipment and (c)
possibilities of Government attaching some export obligations and thereof of
export incentives and channels. If the last condition is anticipated, further
investigations for export marketing must begin immediately in consultation
with collaborators as a bank guarantee is required by Government for fulfilling
export obligations.
7) The Second Stage of project definition starts by analyzing financial
possibilities of the project and planning of expenditure. It is at this stage that a
preliminary view is taken whether the project will go into production after fully
completing it or it could be completed by stages to enable either some
products or intermediates to be sold. In case the project can so phase as to
begin to have cash flows from outputs sales, it Marks the Task of final start-up
easy and there is some morale boosting. At least some part of overheads gets
paid for by sales and market testing becomes than would otherwise be the
case.
8) The second stage may also be utilized for planning the production of
components outside. A survey of the possible market has to be undertaken. It
is also necessary to see the type of construction abilities available in the
market so that storages of equipment and their correction may be planned on
a realistic basis. This is usually done by the consultants employed but it this
job is to be done by the company and its own staff will be investigating these
possibilities. However, whoever does it; the company management has to be
fully informed for these possibilities as they have a very important bearing on
the feasibility of the project.

These look formidable tasks on paper but when projects are taken up for measuring
their possibilities, the work comes at such speed to make them appear light and
absorbing. There is no escape from these decision rules. Some of the tasks proceed
simultaneously. Screening in the two stages (or if you like only one stage) described
above is a process which is an inevitable exercise before management address
themselves to the tasks of assessing the technical feasibility and economic viability
of valid and hopeful projects. In case such a job is undertaken for each project in the
first instance, the expenditure of time and money will be unnecessarily high.

Since the basic reason for execution of projects is to satisfy some needs of the
population, it appears logical to commence by establishing, what these needs are as
regards the goods or services concerned i.e. to commence with the market study.
Two basic points should be remembered (a) the great advantage of beginning the
presentation with a summary of the chapters, as explained above; (b) the advisability
of not overloading the text with details, arguments, statistics, analysis and partial
studies have been necessary in order to arrive at certain conclusions., An attempt
must be made to discriminate between materials which is essential to the contents
and coherent, and that which is merely auxiliary, leaving the latter to be inserted in
annexes or appendices. The presentation plan given below is not intended to set any
standard form, but only to suggest a model which would serve not only as a
presentation plan but which would also assist in the organization of the early studies,
and as a comparative guide, to check whether any points have been omitted.
Obviously, each general plan must be adopted to the type of project to which it refers
and to the circumstances of the study,

1. Summary of the Project

1 General presentation of the basic data of the project/product/service

(a) Goods or services to be produced, capacity to be installed and total volume of

demand,

(b) Location,

(c) Volume of investments

(d) Budget of expenditure and income (summarized) unit costs,

(e) Profitability.

(f) Co-efficient of social evaluations,

(g) Sources of financing considered.

2. Systematic and coherent extract of the contents. Simple and effective plans and
diagrams,

II. Market Study

1. General presentation of the market problem in relation to the specific project/

product/service (aspects of the general market study which are of special interest in
the case.)

2. Compilation of data:

(a) Uses and specifications of goods or services,

(b) Statistical series of production, imports, exports and consumption-national
income and population.

(c) Type of the consumers, customer characteristics and buying patterns describing
who buys the product and why, give average size (or range of size) of purchase and
place of purchase,

(d) Who currently supplies and market? Where are they located? What is their size?
Do they plan expansion? What is the quality of the product? Characteristics of
marketing by competitors: Do they sell item as one of a broad line? Is discontinuing
practiced? Are there standard lot sizes, etc? Do substitute products exist? Impact of
a new supplier on the market. Marketing methods-distribution channels, size of sales
forecast, packaging methods, mode of shipment,

(e) Economic policy and its effect on the goods or services being studied, tariffs,
taxes, subsidies, price control rationing etc.

(f) Possible demographic of structural change in economic development,

(g) Laws and Government Costs.

3. Establishment of the total-current, true and apparent demand.

4. Conclusions and forecasts of the study as regards marketing of the goods or

services (Point concerning sales organization and distribution methods, transport
problem, methods of presentation of the product, possible technical servicing
requirements and other aspects)

5. Conclusions and forecasts of the study relating to the incidence of economic

policy on the market.(Suggested solutions of problems of price fixing, rationing
distribution, transport, monopolies, tariff protection, tax exemption, subsidies, etc.) 6.

6. Projection of demand, (total-current, true and apparent).

III Size and Location

1. Justification of the proposed instilled capacity, covering especially the following

factor:

(a) Market, location, distribution,

(b) Production techniques, and costs at the points of distribution,

(c) Financing and adaptability to staged installation.

2. Justification of the location, considering essentially the following

(a) Minimum freights, discussion as to whether the location of the new unit will be
oriented towards the inputs or towards the market geographical points which meets
the condition on minimum freights.
(b) Availability and costs of resources, especially raw materials, labour, fuel and
electric power, water and others

(c) Other aspects of location, such as decentralization policy; administrative,

housing. health, educational and other facilities, living conditions and climate,

(d) Relation between size, location and minimum delivery costs to the user,

(e) Explanatory diagrams and plans.

IV Project Engineering

1. Preliminary research and testing, Patents, (Preliminary research and

development, consultants, costs of projects, studies etc.)

2. Technical alternatives: Technology of the industry-concise description of the input

and product materials and processing methods and including a definition of pertinent
technical terms used in their part. Production sequence-item wise the various steps
in the manufacturing and give a non-detailed flow-chart. The appendix should
contain a detailed flow chart including all pertinent (processing variables and
materials flow rate) special manufacturing problems, hazardous material pollution
problems, high purity raw material operation complexities.

3. General description of the construction and operating equipment: Machinery and

equipment requirements and specifications, rates capacity of the proposed plant, list
of machinery and equipment including description of item and specifications,
estimated costs, source of supply, freight and installation costs and totals including
power facilities and transport.

4. Buildings and their distribution Buildings and site requirements, site characteristics
size special requirements, site preparation, building description.

5. Plant layout, explanatory diagrams.

6. Complementary engineering projects, industrial and drinking water, housing for

personnel, sanitary works, miscellaneous services.

7. Assumed productivity in the use of the resources. (Estimated technical efficiency

of the process, personnel required etc.)

8. Flexibility of productive capacity (Possibility of adapting to the production of

different goods, expansion possibilities incidence of output rate on costs, relation to
the market.)

9. Work schedule, final studies, transition stage, installation, entry into operation.

10. The content will include the simpler diagram of plants. The more detailed plans
will be in the annexes together with the copies of specifications, laboratory reports
and tests, patent, details, detailed lists of personnel required and their technical
qualification, technical details on specifications of raw materials, fuels and similar.
The annexure will also contain the more detailed data which justify the adoption of
specific solutions as regards process, degree of mechanization, type of buildings,
construction materials and technical alternatives in general.

V Investment

1. Composition and volume of fixed capital investment

a) Cost of preliminary research, experiments and studies including that of the

projects;
b) Patents and similar items;
c) Payment for land and natural resources;
d) Cost of the equipment placed on site and its installation;
e) Cost of complementary building and installation;
f) Cost of organization of the enterprise;
g) Engineering and administration costs during construction,
h) Expenses of running in period;
i) Preparatory installations;
j) Contingencies;
k) Interests during construction;

2.. Estimation of working capital.

3. Composition of the investment in national and foreign currency.

4. Table of fixed investments for e.g.

A. Land.

B. Building

C. Machinery and equipment

D. Development costs.

E. Engineering

1. Total fixed investment

2. Working capital

3. Reserve for contingencies.

4 Total Capital needed

5. Investment programme

6. Amex: the detail in the mores will include freight costs, insurance, customs and
other taxing units, salaries paid for work similar to that of enterprise, lists of the cost
of installation material, final details of the calculation of working capital, copies of
quotations, date of possible price change, data of exchange rates for imported
equipment etc.

VI Budget of Expenditure and Income and the Arrangement of the Evaluation

1. Annual costs and income budget at market price.

Table of costs

A Manufacturing costs (for e.g.)

(a) Raw material

(b) Direct labour

(e) Utilities

(d) Maintenance and supplies

(e) Depreciation.

(f) Insurance

(g) Taxes

(h) Interest on borrowed funds

(i) General administration and other indirect labour

(j) Not otherwise listed, eg. rents, royalties etc.

Total manufacturing costs.

(a) Salesman’s salaries

(b) Advertising
(c) Supervision
(d) Miscellaneous

Total Sales Expenses

Total Annual Costs

2. Determination of equalization polsts with the following factors varying:

(a) Percentage of production capacity uses;

(b) Cost of some important input items;

(c) Selling prices of the products

3. Grouping and arranging of the data required to prepare the expenditure and

Income budget:

(a) Labour budget labour requirements; describe special labour requirements and
number of shifts operating, labour schedule showing time utilized for each operation.

(b) Budget of miscellaneous material required in the operations and maintenance of

the work (source of supply and prices)

(c) Budget of fuel, power and other materials required for operation and
maintenance, specifications of raw materials, sources of supply, special packaging of
transport requirement including exact grade of material and prices, freight charges
and taxes Summaries material balance, both overall and un major processing units
and item wise quantity of purchases material, unit costs and total costs.

(d) Explanations of the way in which distributions costs were obtained;

(e) Explanations and details on the on calculation for depreciation and obsolescence:
(f) other data, depending on the nature of the project and local circumstances

(g) Profitability profile.

A Income

(a) Estimated net sales of plant;

(b) Less, total expense,

(c) Estimated profit before income tax;

(d) Less income tax;

(e) Net profit after taxes:

B Measures of Profitability

(a) Net profit/net sales,

(b) Net profit/total investment;

(c) Net profit/stockholder's equity.

4. Other data which may be necessary for the social evaluation of the project

(a) Foreign exchange balance of the project in one year's normal operation relating
to the project itself (not including possible indirect effects) and data on possible
indirect effects.
(b) Data required modifying market prices which affect the project in terms of
subsidies and taxes

(c) Data relating to the pricing of the factor at opportunity costs: (1) employment
situation (i) relating to natural resources (ill) alternative uses of the resources in
general (iv) rates of interests;

(d) Significant relationships between the projects and other existing enterprises or
projects (input output tables, plans of sources and uses, other relationships).

(e) Enumeration of intangible benefit of the project, and advantages which are
difficult to determine.

5. Annexes

The details of the calculations, the studies and auxiliary calculations will be inserted
in the annexes.

VII Evolution

There are two main methods of evaluating a project depending upon whether it is to
be from the social or the private entrepreneur’s point of view. The private evaluations
will be necessary in any case to solve the project's financial problems. The social
evaluation require varying types of information coding to the criteria to be applied. 1

1. Break even-paint calculation and chart.

2. Net return on capital invested in the project.

(a) on the total capital involved in the enterprise

(b) on the entrepreneur's equity capital 3. Value added per unit of capital

4. Rate of turnover of capital.

5. Capital intensity,

6. Labour employed per unit of capital

7. Marginal social productivity of the capital, 8. Labour productivity.

9. Benefit-costs ratio.

10. Value added per unit of total input.

Annexes: Details of the calculations will be given here and explanations of the
special research which might have been necessary in order to compute coefficients.
Financing and Organisation

1. Financing

(a) Dates on which the capital contributions must be available according to the
investment programme.
(b) Sources of financing (i) Equity capital; fixed and working capital (ii) Credits; their
sources and conditions and types of credit, form of repayment: type of interest.
Guarantee etc.
(c) Financing in the national currency and in foreign exchange.
(d) Table of sources and uses of funds (outline of figures relating to the investment

programme, sources of financing, income and expenditure budget, amortization of

credit and dividend policy, comparison between the amount involved in servicing
credits and the annual cash availability to meet it).

Payment calculations

(a) Cash flow-net profit after taxes, plus depreciation

(b) Pay-out period in years (Total investment) (cash flow);

(c) Coefficients reflecting the sum of the future enterprise's financial structure or of

2. Organisation

(a) Type of enterprise which it is proposed to create, and the reasons for this
decision, general structure of the enterprise

(b) Legal and institutional problems relating to the execution of the projects, patents,
Permits or other similar items.

(c) Administration and legal arrangements related to projects in the public sector.

(d) Decision as to whether to construct the work by contract or administration, type of

organization recommended and reasons for these recommendations.

(e) Forecasts for additional studies for (i) completing the preliminary projects and
converting it into a final project (ii) request for tenders and awards of contracts
equipment (iii) requests for bids and awards to contractors;

(f) Forecast of the transition period, between the study phase and the execution of
the project (s) Forecast of work related to the project but which must be carried out
by other public or private entities;

(g) Forecast regarding the obtaining and training of technical and administrative
personnel but for assembly and for operation of the project:

(i)Other forecasts regarding organization running period and operation of the

enterprise.
3.4.2 Implementation Phase

The implementation phase for an industrial project involves setting up of

manufacturing facilities, consists of several stages; (i) project and engineering
designs (ii) negotiations and contracting (u) construction (iv) training and (v) plant
commissioning

What is done in these stages is described below:

(a)Site probing and prospecting, preparation of blue prints and plant designs, plant
engineering, selection of specific machineries and equipment.

(b)Negotiating and drawing up legal contracts with respect to project financing,

acquisition of technology, construction of buildings and civil works, provision of
utilities, supply of machinery and equipment, marketing arrangements, etc.

(c) Site preparation, construction of buildings and civil works, erection and
installation of machinery and equipment.

(d) Training of engineers, technicians and workers (This can proceed simultaneously
with the construction work).

(e) Start up of the plant (This is a brief but technically crucial stage in the project
development cycle).

3.4.3 Operational Phase

The operational phase is the longest phase in terms of time span which begins when
the project is commissioned and ends when the project is wound up. In the short run,
the concern from the operational point of view is on smooth and uninterrupted
operation of machinery and plant, development of stable norms of productivity,
establishment of a good quality for the product, and securing the market acceptance
of the product. In the long run, the concern from the operational point of view in on
the realisation (or even betterment) of the projections with respect to sales,
production, cost and profit as estimated in the feasibility report

The purpose of examining technical feasibility soon after the origin of the project is to
make sure that it is workable before its economics is worked out and parameters for
action are established. If a project is technically not feasible, it has to be discarded
straight away

Technical feasibility takes two forms usually. It places an obligation on management

for formulating the decision rules for a preliminary appreciation of the basic
technological issues of the project. The second stage to work out sufficient details so
as to appreciate comparatively the merits of alternative technologies and equipments
available or likely to be available for the project and the position regarding raw
materials, their beneficiations to accord with manufacturing specifications and
services. The latter include power, water, gas, fuel, transport, material handling,
steam, compressed air etc.
Many a time both the processes go on simultaneously particularly when the firm is
racing against time. Whatever the juxtaposition of the two processes in terms of time,
they are meant to achieve distinct decisions. In the stage of proving technical
feasibility, we look eventually for the decision to undertake detailed techno-economic
feasibility study. In the latter stage, we are set for selecting the alternative which is
techno-economically the most suitable for taking action to establish a project. Unless
the first stage is carefully attempted, we thight be skirling around the problem. Some
expenditure on this exercise is unavoidable but prudent firms try to minimize it by
taking care to work out technical feasibility of a project quickly and effectively.

The first process in the preliminary formulation of the project after its origin is the
determination of the demand for its products. The following aspects are usually
examined:

() Pattern of Demand. (b) Effect of Price on Demand.

(c) Location of Demand. (d) Phasing of Demand.

(1) Export Markets:

This is a very vast area of study. Many aspects of it get examined economically and
managerially. The job may be done by the marketing department of a project or a
specially set up agency for this purpose or marketing research organization. Usually
large companies have their own organizations but medium and small companies and
firms depend on market research organization. The latter have considerable
experience which is docketed with them and can carry out this work with skill and
speed. There is also virtue in having an independent assessment by a competent
outside agency even in larger company outside their very bust marketing staff.

How dose demand determinations affect the technology of the project? Why
economic condition be the beginning of a technological study?

In the first place, the size of the project depends on the demand. Secondly, the size
determines the order of quantities of new materials and their specifications required
for the project. Thirdly, the order of quantities and the nature of services required
become clearer, for example, power, fuel, compressed air, sten etc. Fourthly, the
pattern of demand and its location make decision on the location of the project to be
taken intelligently. Fifthly, the type of technology needed can be appreciated more
clearly than before. Sixthly problems of quality are visualised both in term of
customer requirements, particularly in the foreign markets and the possibilities of
achievement with the raw materials and the technology available. The technology
itself could therefore be selected with care and would condition in turn, the scope of
procurement of equipment with in the country and outside.

We can therefore appreciate in this context. Why a demand study is inherently a

must if a proper and accurate technical feasibility study is required. It reduces the
cost aimlessly wandering round with a portfolio of hopeful and expected projects
when what is really required to work out, after demand study, parameters for
according priority for discarding projects considered unsuitable from the start. The
technical feasibility of the project requires consideration of the following issues:
(a) Size of the project.

(b) Orders of quantities of raw materials required and their specifications,

requirements of local and foreign materials.

(c) Appreciation of lead-time for procuring raw-materials.

(d) Beneficiation required before raw materials are made suitable for use in the
project.

(e) Choice of technology.

(f) Type of equipment needed for technology considered feasible.

(g) Breakdown of equipment into that locally and externally available as well as
Possibilities of import substitution.

(h) Types of services required and their order of quantities separately for each
service such as power, water supply, compressed air steam, gas transportation etc.

(i) Problems of location of the project.

A number of examples can be cited in which these consideration were omitted and
the success of the project set up was jeopardized. Usually, projects are entrusted to
foreign or Indian consultants but the management in charge of the project has to be
alive itself to all the possibilities of the above items of the work. It should concern
itself with detail and should consider nothing as too trivial not to be attended to. For
example, one project was

Located on river to provide for delivery of raw materials and supplies and removable
a products by large bat low water in certain season made essential transportation
almost impossible. In other cases project was located on a important river for w
supply. The temperature of the river water was favourable from Economic angle, but
the effect of floods on the water system was ignored. The result was that the project
was immobilized during the floods

The technical requirements of the plant will show whether any single or combination
of factors in so rigid that it is of controlling importance and has an overwhelming
influence on location and costs. For example, some industry need large amount of
chop power or water or feel that only the site and size, responsive to much
requirements, can fulfil. The best choice of the site may depend upon minimizing the
combined cost of transporting raw materials and fuel to the factory and moving the
finished goods to the market. In other worlds, these costs may be overwhelmingly
large in comparison to the costs of materials and labour. Some industries are
referred to as "weight losing" because; the finished goods weigh a fraction of the raw
material. Such plans have to be located near the source of new materials as the
transport cost will become prohibitive

The size of the plant itself depends on many complicated factors line demand is one
of them; the availability of equipment is another, cost of production is a third reason
as a plant set up most be able to break even in adverse circumstances also, Cost of
production self is influenced by the type of technology and equipment selected. It
therefore becomes necessary for examining technical feasibility even at the
preliminary stage to be aware of cost of production, 1or different plant sizes at
different sites. The source and the availability of finance also affect the size of the
plant. However, there is no fun in going in for a small plant because of ck of finance if
it is not techno-economically faible at first sight. As far as practicable, t.: fixed costs
of the plant i.e. depreciation and servicing of debt, should be kept as low as
practicable and hence a great deal of care is necessary in estimating the Impact of
the investigations suggested earlier.

The choice of technology has an abiding influence on the technical and economic
feasibility of a project.There are two situations that one meets. Experience already
exists in the country about the technology or it has to be imported for the first time. In
the former case, two further situations may arise. Either the technology is to be
adopted as it is or as a result of innovations whether imported from abroad or
discovered by Research and Development to which the project authorities has
access. It may also be a technology evolved for the first time by indigenous
research. Great care and investigation are required for technology imported from
abroad. The parties have to le selected on the basis both of situation we the working
experiences of the technology in almost similar conditions u in India. It is necessary
to avoid being guinea pigs of foreign research and development inless fool proof
evidence could be gathered from laboratory and pilot test made by the

innovators. The last is a job which only an expert can perform. Similarly, we should
also avoid obsolescent technology though we may have a long record of its working
as it will not help us build up a competitive industry internally and externally.

The problems of a protected markets are in favour of short circuiting modernization

process as profit can be made from any venture by changing prices relevant to
demand and supply. In case outside imports are stopped of the same commodity,
artificial shortages will push up the prices. The incentive, if it can be called, would be
to produce less and earn more profit from a unit of the product concerned. It is,
however, fatal to fall into this error in the long run no country has been able to
maintain a protective wall for ever. Sooner no other than later, it has to compete in
the world market and therefore the project must be so established as to be
competitive from the start but several factors militate against it such the need for
labour intensive technology to maintain employment in the country. The need to build
up capital resources for expansion from the first phase of the project and lack of
sophistication in the home market consumer relative to the foreign consumer.

The centre of technical feasibility is a view on the type and availability of equipment
required. The size of the plant determines also the size of the principal units. In most
industries standard units are available. In other units are custom made, i.e. for the
special case. The project authorities have to work out the types and sizes of
individual units and match capacities of units inter se to get the integrated plant. If
capacities ordered of different units do not match, the plant will be unbalanced and
its total capacity will be determined by the weakest unit in a chain of operations. The
requirements of equipment for service units have similarly to correspond with the
stage production capacity. In other words it becomes necessary even at the
preliminary stage to work out the possible standard and norms for the plant, raw
materials and yields.

It is usual for project authorities immediately; the size of the plant is determined, to
address all possible suppliers for preliminary quotations, specifications and delivery
periods. This is done without the obligation to purchase. It is, however, a very vital
step in expediting feasibility analysis later.

For purpose of selecting a process, it will be necessary to prepare material flow

tables. It will also be necessary to have usage, utilization and yield charts of raw
materials and intermediates.

This assist in selecting equipment at each stage and, therefore, in appreciating the
kind of efforts that is required in obtaining raw materials improper specification for
achieving the least cost for the inputs the industry. Finally, a process chart is
prepared which specifies the required sequence of operations. It also serves to
summarize the final process selected and to facilitate and selection of equipment.
Equipment Selection

The best suited type make and size of machine and equipments to be use for each

Operation is very important and requires careful and detailed analysis. The main
factors upon which such-specific machine /equipment selections are based are as
follows:

1 The type of operations required as indicated by the process charts.

2. The quality and degree of precision to be attained in the product.

3 The anticipated future changes in the design of the product.

The volume of production to be attained determined by a short run and long rung

fort of demand.

5. Capacity of the machine

6. Ease of reintenance and reliability of operation.

7. The operation of machine should be safe and should not endanger worker's
safety.

8. Low cost and durability.

9. Resale value

10. Low operating costs i.e costs of power, fuel, lubricants, running maintenance etc.
Planning Capacity

A factor to be considered in selecting any one piece of equipments is the extent to

which it coordinates and fits into the entire production process. It will be bad planning
to select any one equipment in isolation without considering it in relation to the
remainder of the equipments to the selected. The individual units of equipments
should be selected only after the manufacturing process as a whole has been
surveyed, organized and designed. Proper selection of equipments achieves a
balance in the various units of equipments, thus obtaining a uniform flow of work.
Over capacity is unproductive as it creates an overhead charge from which the
company receives no benefit. Each equipment arranged haphazardly and not
according to the requirements of product line, creates bottlenecks which hamper
production and reduce productivity and increases cost of production.

At this stage a preliminary estimate is made of the following (a) Foreign exchange
required for capital equipments, technology, designs and detailed drawings.

(b) Foreign exchange required for raw materials. (c) Foreign exchange needed for
securing collaboration from abroad, the nature of Collaboration and its duration have
also to be settled. Careful investigation is required in terms of the current policies of
Government included in the Intest guidelines. (d) Foreign exchange for patent and
other rights, if any. If it is an internal patent, rupee expenditure has to be incurred.

(c) Rough capital and production costs should be worked out. These are very
tentative estimates and would undergo drastic revision later but it is necessary to
make them early in order to appreciate the amount of financial effort required later
and the lead time for it.

The stage has now come to work out a system on the basis of which decision rules

Could be made for jettisoning alternatives not considered technically feasible. Four
details will be jointly responsible for this kind of exercise. These include the size of
the plant, technology available and acceptable equipment available for various units
of matching character and foreign exchange requirements.

After a view is takes on these, the projects need various clearances from
Government before further details are worked out. The availability of any raw
materials under production and distribution has to be ascertained as curtain with
clarity, a discussion should be held with the Director General Technical Development
on the size of the plant, the needs of foreign raw materials and equipments, a
discussion is required with the Ministry of Industrial Development on the possibility of
sanction for collaboration. If these approaches yields positive results the age of
further development of the project namely of techno-economic feasibility has arrived.

The discussions with these Ministries and organs of Government are needed for
large projects failing within the licensing policy, For small and medium scale project it
is alto get the state authorities for industry interested and to obtain their good will for
supply of raw materials and on assistance for obtaining foreign exchange etc. The
assistance is forthcoming in varying degrees depending upon personalities and
situations. It will be a truism to state that the success of this type of projects depends
a great deal on the goodwill of Government authorities and it is no exaggeration to
say that it is best to keep on their right side and even if you consider that you know
all the ropes.

Here the types of organization required for this preliminary work are explained. Large
sized companies have separate project cells. Medium sized companies may appoint
special project officers and existing official may carry the additional burden in small
companies. The detailed work is so much that whatever your arrangements you
always feel you are short hundred. It is best to obtain expert help from outside early
when investigations point a clear enough way or when alternatives are such that it is
difficult to isolate the most desirable one.

Four types of appraisal may be conducted while evaluating an investment proposal:

a.Market appraisal.

b. Technical appraisal.

C.Financial appraisal,

d Economic appraisal.

a) Market Appraisal

Market appraisal is concerned with

(i)What would be the aggregate demand of the proposed product/service in future?

What would be the market share of the project under apprainal? The kinds of
information required are:

(ii)Consumption trends in the past and the present consumption level.

Past and present supply position.

Structure of competition. Constraints.

Elasticity of demand.

Commor behavince, intentions, motivations, attitude, preferences and requirement

Distribution channels and marketing policies in use.

Administrative, technical and legal constraints.

b) Technical Appraisal

Appraisal of the technical and engineering aspect of a project needs to be done

continually when a project is formulated. Technical appraisal seeks to determine
whether the prerequisites for the successful commissioning of the project have been
considered and reasonably good choices have been made with respect to location,
size, process etc. The important issues in technical appraisal are:

Whether the preliminary tents and studies have been done or provided for?

Whether the selected scale of operation is optimal?

Whether the availability of raw materials, power, and other inputs has been

Established?

Whether the production process chosen is suitable?

Whether the equipment and machines chosen are appropriate?

Whether the auxiliary equipments and supplementary engineering works have been

Provided for? Whether provision has been made for treatment of effluents?

Whether the proposed layout of the site, buildings and plant is sound?

Whether work schedules have been realistically drawn up?

Whether the technology to be employed is appropriate from the social point of view?

(e) Financial Appraisal

Financial appraisal seeks to ascertain whether the proposed project will be

financially viable in the sense of being able to meet the burden of servicing debi and
whether the proposed project will satisfy the return expectations of those who
provide capital. The aspects looked into while conducting financial appraisal is:

Investment outlay and cost of project. The means of financing.

Cost of capital.

Projected profitability.

Break-even point.

Cash flows of the project.

Investment worthwhileness judged in terms of various criteria of merit. Projected

financial position and flows.

Level of risks.

(d) Economic Appraisal

Economic appraisal, also referred to as social-cost benefit analysis, is concerned
with judging a project from the larger social point of view. In such an evaluation the
focus is on the social costs and benefits of a project which may often be different
from the monetary costs and benefits to the firm. The significant issues are:

*What are the direct economic benefits and costs of project measured in terms of
shadow (efficiency) prices and not in terms of market prices? What would be the
impact of the project on the distribution of income in the society?

*What would be the impact of the project on the level of savings and investment in
the society?

*What would be the contribution of the project toward the fulfilment of certain merit
wants like self-sufficiency, employment, social order?

4.0 Summary Project management includes a number of elements in a given

sequence from idea generation to project termination. Project evaluation involves
application of various quantitative methods to identify and measure a firm's expected
economic performance. Project control consists of methods and procedures used by
the firm to control the costs. Project development cycle consists of three phase’s
namely pre-investment phase, implementation phase and operational phase. Pre-
investment phase consists of several stages such as identification of investment
opportunity preliminary project analysis, feasibility study and decision-making. The
implementation phase involves setting up of manufacturing facilities consists of
project and engineering designs, negotiations and contracting, construction, training
and plant commissioning. The operational phase begins when the project is
commissioned and ends when the project is wound up. Market appraised, technical
appraisal, financial appraisal and economic appraisal may be conducted while
evaluating an investment proposal.

5.0 Suggested Readings

United Nations, Guidelines for Project Evaluation, Oxford & IBH Publishing Co., New
Delhi. United Nations, A Manual for Evaluation of Industrial Projects, Oxford & IBH
Pub.Co., New Delhi.

Prasanna Chandra, Projects: Preparation, Appraisal, Budgeting and Implementation,

Tata McGraw Hill Publishing Co. Ltd., New Delhi.

Planning Commission, Guidelines for Preparations of Feasibility Reports for

IndustrialProjects, Controller of Publications, Government of India, New Delhi.

Frances Cherunilam, Business Environment, Himalaya Publishing House, Bombay.

6.0 Self Assessment Questions

1. Explain Project Development Cycle. Also explain its various aspects and stages.
2. Explain the different consideration in project appraisal.

3. Explain the various aspects of project identification.

Market Appraisal: Information Required and Sources of Information Demand

Analysis

Structure

1.0 Introduction 2.0 Objectives

3.0 Presentation of Contents

3.1 Information Required for Market Appraisal

3.2 Market Information and Research

3.3 Sources of Information

3.4 Market Survey 3.5 Demand Forecasting

3.6 Market Penetration for the Product

3.7 Uncertainties in Demand Forecasting 3.8 Coping with Uncertainties

4.0 Summary

5.0 Suggested Readings 6.0 Self Assessment Questions

1.0 Introduction

The exercise of project appraisal often begins with an estimation of the size of the
market. Before a detailed study of a project is undertaken, it is necessary to know, at
least roughly, the size of the market because the viability of the project depends
critically on whether the anticipated level of sales exceeds a certain volume. Many a
project has been abandoned because preliminary appraisal revealed a market of
inadequate size.

2.0 Objectives

After reading this lesson, you should be able to

(a) Discuss the type of information required for market and demand analysis.

(b) Describe the various sources of primary and secondary information.

(c) Explain the procedure for conducting a market survey.

(d) Highlight the different methods of demand forecasting.

(e) Explain how to cope with uncertainties in demand forecasting.

3.0 Presentation of Contents & Information required for Market Appraisal

The first step in this direction is to identify the market by finding out:

a) Who are the customers?

b) Where are our customers located?

c) What are our customers in terms of economic and social characteristics Viz
salaried people, traders, agriculturists, industrialists and the like?

d) What do our customer need, require and expect?

Since the market consists of buyers and sellers, information will have to be gathered
about the rival sellers also. We may like to know:

a) Who are the other sellers?

b) Where are they?
c) What are they?
d) How are they organized?
e) What do they offer?
f) What are their strengths and weaknesses?
g)What are their activities?)

How much of the market does each command? After identifying the market and
gathering the basic information about it, the next is to decide upon the instruments
and the strategy for meeting the needs of the customer and the challenge of the rival
sellers. The major instruments of marketing in the hands
Management are:
1 Product Its shape, design, characteristics, utility etc.
2 Promotion Methods of communicating with consumers through personal selling
Social contract, advertising, publicity etc.
3. Price Policies regarding pricing, discounts, concessions etc.
4 Place Policy regarding outlets for sales, channels of distribution, location and
Layout of stores, etc.

The four Ps' are the weapons in the armoury of management with which it fights out
its rivals in the market for larger share of sales and greater goodwill. The
effectiveness of marketing effort will depend upon the decision made in each of the
'P' areas indicated above and their combination to effectively meet the needs of
consumers. The combination of the PS (Product, Promotion, Price and Place) is the
marketing mix of the firm. It is the which enables the management to take care of the
needs, requirements and expectations of the identified consumers.

3.2 Market Information and Research

The concept of 'marketing research' is related to the 'consumer-oriented' modern
concept of marketing. If marketing consists in finding out and satisfying consumer
needs through the right product, at the right place, and time, it calls for systematic
effort on the part of the management of the firm. Marketing research is part of such
effort. Research

involves the definition of problems and the rigorous application of logical methods to
find out solutions to them. Marketing research, therefore, "means the careful and
objective study of product design, markets and such transfer activities as physical
distribution and warehousing, advertising and sales management." In a broader and
more general way, the American Marketing Association defined marketing research
as "the gathering, recording and analysis of all facts about problems relating to the
transfer and sale of goods and services from producer to consumer". In a general
sense, marketing research consists in the use of the logical method of scientific
enquiry for the identification and solution of any marketing problem.

While taking a marketing decision, a manager will be advised to take the following
Steps which constitute the process of marketing research
a) Recognizing and defining the problem.
b) Developing alternative courses of action.
c) Gathering data or generating information necessary for problem-solving, and
d) Evaluating alternative courses of action against the data collected with a view to
arriving at the course of action that will give the maximum or best results over a
period of time.
Since marketing appraisal refers to research or systematic investigation into any
area of marketing management, it may take any or all of the following forms:

a) Research on products and services: This include research leading to the

development of new products in keeping with the needs, convenience and demand
of the consumers, development of proper packaging, product line simplification on
the Basis of feedback from the market, etc.

b) Research on markets: This involves investigation into the size and character of
Market, profitability of different markets, shifts in the nature of markets, economic
Factor’s operating on markets, territorial sales opportunities, etc. Business
forecasting particularly sales forecasting is based on such research.

c) Research on sales methods and policies: This type of marketing research takes
the form of examination of price policies, discount structure, distribution costs,
effectiveness of les.noa and advertising effort, sales compensation and advertising
media selection etc.

Production under the modern industrial set-up is carried on in anticipation of

consumers demand. The success of an industrial venture, therefore, depends a
great deal on the extent to which the producer is able to grasp the condition of the
product market and forecast the demand for his product. For a long time, producers
banked on their own network and foresight to esteem the possible size of demand
for their products. This means the use of hit-and miss methods for such a crucial
function as the forecast of demand and conditions in the market. Quite often it
resulted in failure of business concerns.

With the present-day complexity of markets, no amount of unscientific guesswork

can do There has to be systematic and scientific attempts at the discovery of the
capacity of the market to absorb a particular kind of product. Such attempts to
forecast the future of the market of a product or a service are collectively called
'Market Research'. While "Marketing Research is the systematic, objective and
exhaustive search for and study of the facts relevant to any problem in the field of
marketing". Market research is restricted to the study of actual and potential buyers,
their location, their actual and potential volume of purchases, and their motives and
habits. From this it emerges that market research is narrower term relative to
marketing research and is one type of marketing research. 3.3 Sources of
Information

Marketing research involved the collection and analysis of data or information

bearing on the different aspects of the marketing effort of a firm. Methods of
marketing research are, therefore, essentially methods of data collection. Information
as to the market and the effectiveness the marketing instruments of that firm can be
collected broadly from two types of sources:
(a) Internal sources, and

(b) External sources.

(a) Internal Sources It is commonly assumed that marketing research consists

entirely of data collection from the external sources particularly from the field.
However, this is a mistaken view for often a problem can be solved without recourse
to the much more expensive method of field research by analyzing the data already
available within the firm. Good use can be made for marketing research purposes of
the accounting information and the salesmen's reports, etc., which accumulate to the
firm in the normal course of business transaction. For example, sales turnover
statistics can be analysed by lines, areas, salesmen etc. Similarly statistics of sales
turnover, expenditure, advertising expenditure, transport costs, etc., can be analysed
to get useful information for securing an understanding of the marketing Problem’s of
the firm.

(b) External Sources

Generally internal sources of information provide clues to problems which need a

more thorough investigation. At this stage, the need for the use of external sources
of information arises. The external sources of data for marketing research fall into
two broad sub-categories (a) Primary data, and (b) Secondary data. Since the
primary data have to be collected from the field through expensive investigation, the
firm tries to extract the required information first from the secondary sources of data
on markets and their trends and problems.

(1) Secondary Sources

The secondary sources include all those agencies which gather and disseminate
Information of use to firms from the marketing point of view. The data from these
sources is generally in a printed form. The principal sources of secondary data for
marketing research are:

a) Trade Press.
b) Published Surveys.
C)Trade Associations

e) Government and International Publications.

a) Trade Press: This includes trade journals, economic and financial periodicals and
the papers and reports published by some business houses and banking companies,
etc. In India, the Economic Times, Commerce, Capital, Tatas Quarterly, etc., are
some useful publications giving data on the state of market in general and
commenting on the trends in specific trades

b) Published Surveys: Another useful source of data for marketing research is the
reports of the survey of markets for specific lines of products or specific regions
made by business houses or independent research organisations (like the NCAER
or the IPO, etc.). These reports can be consulted in libraries or procured direct from
the source for the firm's own library.

c) Trade Association: Trade Associations representing specific trade interests and

the Chambers of Commerce both in the States and as the Centre conduct industrial
and market research and collect and disseminate a considerable amount of
information and statistical data pertaining to different trades, industries and markets.
A researcher can benefit a great deal by tapping this source of information.

d) Government and International Publications: The Government is releasing a virtual

stream of useful economic data which can be analysed and used for chalking out an
effective marketing strategy for the firm. The periodic reports, journals and bulletins
issued by the Planning Commission and Ministries of Agriculture, Commerce,
Industry and Labour contain a wealth of information of use to the researcher.
International publications issued by the U.N. Agencies and the I.M.F-and the World
Bank etc., can prove useful particularly in research in international marketing.
Limitations of Secondary Data

The secondary data collected from the above-noted sources may suffer from the
following limitations which must be borne in mind by the users: The bases for the
data collected by different agencies may not be comparable.

1) The data may be based on incomplete returns.

2) The bias of the collecting agency (trade or governmental) may be reflected in the
Data.

3) The data collected by different agencies may overlap.

4) The data is generally collected for purposes different from marketing research
The definitions of terms may not be uniform in all kinds of such data.
Primary Sources The primary sources of data for marketing research are from
those agencies persons from whom the company collects the desired information
directly for its own specific purposes and through its own staff. Generally, survey
techniques have to be used to gather information from the primary sources. The
primary sources of market information are:
a)Salesman: If a firm employs salesmen to conduct and promote the sale of
products, then salesmen can be asked to give their assessment of the consumers or
dealer reaction of the various features of the firm's marketing effort, e.g. price,
design, size packaging, etc. They can also provide useful feedback regarding the
working of the marketing machinery of the firm and the problems arising in this
connection. The use of salesman for collecting data for marketing research has the
advantage of utilising the firs hand knowledge of the market conditions and
distribution system without additional expense and motivating them to still greater
effort by giving them a sense of importance However, salesmen are not trained for
marketing research and their reports may not be unbiased, accurate and pointed. i

b) Dealers: Another source of primary data for marketing research is the dealer in
products of the firm. The retail distributors may be contacted to find out percentage
of the sales of the manufacturer's product to the total sales of that kind of products
made by them over a certain period. The dealers can also give some useful
feedback about the consumer's reaction to the firm's products and marketing policies
as compared to the products of rival firms. However, the sources may not always
yield reliable information either because the retailers do not have a well-organized
system of record-keeping or because they do not feel sufficiently interested in the
firm.

c) Consumers: The ultimate test of the quality of a product and its marketability lies
in the consumer's opinions and attitudes. Representative samples of consumer-
actual or present and prospective or potential-may, therefore, be selected so that a
thorough investigation can be made of their buying habits and behavior in general
and their opinion on the quality, price, packaging, availability, etc. of the firm's
product can be ascertained. This will naturally necessitate some kind of field survey.
Such research is also called' consumer research.

The primary data collected by the firm from the above source is of more direct utility
for the firm because it is collected by the firm's own staff for the specific purpose of
forming objective judgments about the firm's marketing effort.

3.4 Market Survey

Next comes the question of using proper techniques and procedures for collecting
data from the above-noted sources. No special techniques are required for
abstracting

Information from the secondary sources. However, the collection of primary data
calls for the employment of special methods which are taken up for discussion here.

In order together information relating to the marketing effort of the firm from the
primary sources enumerated above, surveys have to be conducted by the firm
through it’s or specially appointed investigators. A survey is an enquiry conducted to
information from a number of respondents. It is called a census survey if all the
regular staff collect persons concerned are covered by it. However, this is extremely
expensive, time consulting and wasteful particularly if the respondents are scattered
far and wide. Due to mentioned limitations of the census survey the market survey,
in practice, is the above man typically a sample survey. In a sample, a certain
number of informants are picked out of the total lot at random or according to some
other arrangement on the assumption that the responses consumers. of the sample
informants will be representative of the total population of the in a sample survey

Typically, a sample survey consists of the following steps: Definition of the target
population - In defining the target population the important should be carefully and
unambiguously defined. The target population may be divided terms to various
segments which may have differing characteristics. For example, all television
owners may be divided into three to four income brackets.

2 Selection of sampling scheme and sample size - There are several sampling
schemes- simple random sampling, cluster sampling, sequential sampling, stratified
sampling, systematic sampling, and non-probability sampling. Each scheme has its
advantages and limitations. The sample size, other things being equal, has a bearing
on the reliability of the estimates- the larger the sample size, the greater the
reliability.

3. Preparation of the questionnaire - The questionnaire is the principal instrument for

eliciting information from the sample of the respondents. The effectiveness of the
questionnaire as a device for eliciting the desired information depends on its length,
the types of questions, and the wording of questions. Developing the questionnaire
requires thorough understanding of the product/service and its usage, imagination,
insights into human behaviour, appreciation of subtle linguistic nuances, and
familiarity with the tools of descriptive and inferential statistics to be used later for
analysis. It also requires knowledge of psychological scaling techniques if the same
are employed for obtaining information relating to attitudes, motivations, and
psychological traits. Industry and trade market surveys, in comparison to consumer
surveys, generally involve more technical and

Specialized questions. Since the quality of the questionnaire has an important

bearing on the results of market survey, the questionnaire should be tried out in a
pilot survey and modified in the light of problems/difficulties noted.

Recruiting and training of field investigators must be planned well since it co be time-
consuming Great care must be taken for recruiting the right kinds of investigators
and imparting the proper kind of training to them. Investigators involved industry and
trade market survey need intimate knowledge of the product and technical
background particularly for products based on sophisticated technologies.

Obtaining information as per the questionnaire from the sample of respondents -

Respondents may be interviewed personally, telephonically or by mail for obtaining
information Personal interviews ensure a high rate of response. They are, however,
expensive and likely to result in biased responses because of the presence of the
interviewer. Mail surveys are economical and evoke fairly candid responses. The
response rate, however, is often low, Telephonic interviews, common in western
countries, have very limited applicability in India because telephone tariffs are high
and telephone connections few

6. Scrutiny of information gathered-Information gathered should be thoroughly

scrutinized to eliminate data which is internally inconsistent and which is of dubious
validity For example, a respondent with a high income and large family may say that
he lives in a one-room tenement. Such information, probably inaccurate, should be
deleted. Sometimes data inconsistencies may be revealed only after some analysis.

7. Analysis and interpretation of data - Data gathered in the survey needs to be

analysed and interpreted with care and imagination. After tabulating it as per a plan
of analysis, suitable statistical investigation may be conducted, wherever possible
and necessary. For purposes of statistical analysis, a variety of methods are
available. They may be divided into two broad categories: parametric methods and
non-parametric methods. Parametric methods assume that the variable or attribute
under study conforms to some known distribution. Non-parametric methods do not
presuppose any particular distribution

Types of Surveys
Having selected the sample of informants, the next step is to elicit information from
them.The methods employed for this purpose are broadly of the following types:

1)The Personal Interview Method: It is a direct form of investigation in which skilled

interviews solid information from selected individuals. A formal questionnaire is
usually used for the interview. Generally information are interviewed in their homes.
2)The Focused Interview Method: In this type of interview, the respondents are
encouraged to talk freely, while the interviewer reports word for word. Sometime,
guiding questions may be given to the interviewers to help them to keep the
interview to the point.
3) The Telephone Interview Method: In this method, contact is established with the
informants by telephone and the informants are asked a set list of questions relevant
to the study. The questions may be modified or the informant may be asked to talk
freely for some time. This method is can be used only for telephone subscribers.
4.The Panel Method: A consumer panel is a group of persons or families selected for
getting information on the product and different aspects of the firm's marketing
strategy. The panel selected after personal interviews may be given diaries in which
the member enters all their purchases of the commodity being surveyed. The diaries
may be examined periodically. Alternatively to this the panel may be interviewed
periodically regarding ideas relevant to the survey. An adaptation of this method is
the the use of the panel for collecting reactions to a new product through port or
personal interviews or by inviting the members at one place

5) The Mail Survey Method: For such a survey the respondents are approached
through the medium of postal service. Letters are sent to a group of individuals,
selected at random, including a questionnaire to be completed and returned. After a
certain period of time has collapsed, one or more follow-up letters may be sent
including the same questionnaire to those who have not replied. Sometimes the
questionnaire is enclosed in newspaper advertisement or a periodical or attached to
consumer product.

6) Observational Method: In this method, the observer does not rely on information
given to him by a respondent which may be biased in some way. He records what he
actually observes in the field. There can be many variations of this method. Some
examples are:

Stock audits- checking up of the stock with samples of retailers to establish sales

Trends for certain commodities or brands.

Pantry checks - recording of the products in a house wife's kitchen or pantry to see

what brands are bought.

c) Dust-bin checks - recording of the tins, wrappers and packages found

Subject’s dust-bin.

d) Passenger or car counts for poster research.

e)in the Behaviour research - particularly in self-service stores or department stores.

Market survey offers the following advantages:

c). Advantages

1. Facilitates planned production: Planning of production is facilitated by forecasts of

probable sales in the coming years.

2) Correction of defects: It reveals defects and makes corrective action possible on

the part of the manufacturer. 3) Discovery of causes of consumers' resistance: It
helps in the discovery of reasons for resistance on the part of the consumers.

4) Effectiveness of existing channels of distribution: It reveals whether the existing

Channels of distribution are effective. In the case of fans, for example, it may be

Discovered that after sales service is not satisfactory, arrangements for repairs then
be made on that basis

5)Reveals the nature of demand: It reveals whether the product is in constant

demand throughout the year or has a seasonal demand.
6)Enquiry into the utility of the product: It indicates why exactly the product being
purchased by the people and what exact service do they get out of T manufacturers
of Horlicks, for example, discovered through market research Horlicks was being
used as a breakfast food by many people. Similarly, make was research conducted
by condo Hindustan Lever Ltd. revealed that Sunlight Soap, original intended to
serve as a washing soap, was being used toilet soap by many people

7)New uses of the product: It may reveal certain new uses for existing products.
Italian manufacturer of small tyres of airplanes during the war found large stocks
lying with him at the end of the war. He then developed a small vehicle, scooter, to
mause of these tyres. At first scooters were used only by tradesmen. Now they used
by all shades of people as substitute for the motor-cycle.

8) Discovery of new lines of production: It helps in the discovery of supplementar

Godrej and Remington producing a wide variety of products lines of products. God
India have progressed largely on this basis.

9) Discovery of potential market: It helps in the discovery of potential market.

10) Market Information: It affords complete information about the market and t
changes that are likely to occur in demand for a certain product.

The importance of market survey beginning to dawn upon the producers of good and
services in India. Some of the big and well known manufacturers like the Hindustan
Lever Ltd. and the Delhi Cloth and General Mills Ltd. have been using the
techniques, market research on a fairly extensive scale. It will, however, take some
time before t smaller firms also take to it.

3.5 Demand Forecasting Demand forecasting is an essential part of operation

planning. It is a basis f planning cash capital expenditure, pricing policy and costing
policies, depreciation policy and the income tax reserves etc.

Demand forecasting means projections of future demand, taking into consideration

the factors affecting the size of business profits. It demands a thorough study
including proper estimation of both economic and non-economic variables by the firm
to projected sales volume, costs and consequently the profits in future.
The signs of healthy business include making a demand consistent with the various
Risks that it has to face. A firm is faced with a number uncertainty. These
uncertainties created by the dynamic nature of consumer needs, the diverse nature
of competition th uncontrollable nature of most elements of cost, and the continuous
technological development

So far as demand is concerned, say for the basic needs essential for survival,
consumer preferences are highly subjective and, therefore, most unpredictable. The
uncertainty about the pattern and quantum of consumer demand for a particular
product increases the degree of risk faced by the firm. The nature of competition
may be related to either product or price or to both simultaneously. Product
competition is more important till the product reaches the stage of maturity. Price
competition begins after the product is established and reaches a maturity stage.
During the growth stage, the risk of product obsolescence and hence shortening of
the product life cycle is great. Again, if the scope of market segmentation and
product differential is great, the risk of product obsolescence; if such a scope is less,
the risk of price competition increases. In period of continuously rising prices, no firm
can be certain of its own internal cost structure, for it does not have any control-over
the prices of raw material, the wages it would have and the prices of other input
including the elements susceptible to indirect taxation.

Continuous technological improvements may make today's established commercial

production completely obsolete in course of time. If an improved process is available,
a firm can limit its risk by discarding its fixed investment. However, if it does not have
access in the improved process, it may have to go out of business altogether.

Unless a firm is prepared to face the uncertainties created by these risks, its profits
would be left to chance. Naturally, the firm will have to plan for profits. In this respect,
a thorough understanding of the relationship of costs, price and volume is extremely
helpful to business executives for profit forecasting. Approaches to Demand
Forecasting

1. Spot Projection

Spot Projection is a conjectural income statement for specific future period.

Forecasts are made of sales volume and prices and costs of producing the
anticipated sales. The profit forecast is no more than the residual of these
projections. The completeness and accuracy of the information in this kind of
forecast depends on the quality of the parent forecasts, that is, on the sophistication
and care with which all future conditions in the company can be forecasted.

2. Environmental Analysis

Environmental analysis is a broad-gauge approach to forecasting through empirical

Relations of demand of variable external to the business firm.

Factors that control demand have a tendency to move in regular and related
patterns. Among these factors the important ones are: rate of output, prices, wages,
material costs, and efficiency. All of these factors are interrelated by their
connections with the national markets and their interactions in the aggregate
business economy. These interrelations raise the possibility that profits of a business
firm can be forecasted directly

By finding a relation to key variables in the economy that either control or combine
the movements of the myriad of direct forces that are felt in the income statement.

3.Consumption Level Method

This method estimates consumption level on the basis of elasticity coefficients, the
important ones being the income elasticity of demand and the price elasticity of
demand

If other factors remaining the same, with the change in income, the demand
changes, it is called Income Demand. Generally, for normal or superior goods,
demand increases with the increase in income and falls with the fall in income. In
order to measure income demand relationship, we use the concept of income
elasticity of demand. It is denoted as (By to El).
YT DT D

Where Y-Income, D- Demand.

Income elasticity of demand is the rate or ratio or proportion at which the quantity
demanded changes as the income changes. Thus income elasticity measures the
extent of change in quantity demanded due to change in income alone, other factors
remaining the same. In words, income elasticity of demand measures the degree of
sensitiveness or responsiveness of demand for a commodity due to change in
income. According to Lipsey. "The responsiveness of demand to change in income is
termed as Income Elasticity of Demand".

Proportionate change in quantity demanded

Ey=
Proportionate change in income

Proportionate change in quantity demanded

Change in quantity demanded

=
Original quantity demanded

Proportionate change in income

Change in income
=
Original Income

Ey=

In notational form:

AqY AY Aq x Y AY x q EY AY Y

Where

Aq AY -Change in the quantity demanded.

-Change in income - Original quantity demanded

- Original income.

4. Price Elasticity of Demand Elasticity of demand is the rate or proportion at which

the quantity demanded changes with the change in price. The quantity demanded
increases with a fall in price and falls with a rise in price. In other words, elasticity of
demand measures the sensitiveness or responsiveness of demand to the changes in
price. Thus, ceteris paribus, price elasticity of demand measures the extent of
responsiveness of demand to a given change in price. The elasticity of demand can
be defined mathematically as a ratio of the percentage change in the quantity
demanded to a percentage change in the price. In coefficient of price elasticity of
demand (Ed or Ep) can be measured as under: (% change in quantity demand)

Ed

(% change in price)

A minus sign is given to the coefficient of elasticity of demand to make it positive

number. The aim is to neutralise the effect of the negative slope of demand curve
which means that demand changes inversely with price. So minus sign should be
ignored. If this sign is not ignored, it would lead to wrong conclusions e.g. -3 in one
case and-2, in other case.

Mathematically-3 <-2. But in case of price elasticity of demand it is 3>2. But it is

done only for convenient. With positive signs, we can make comparisons easily.

Three possibility of elasticity of demand arise:

(a) If percentage change in price is 10 whereas percentage change in quantity

demanded is 20, in that case the elasticity of demand is:

20%

10%

ic. Ed>1.

Ed

(b) If percentage change in price is 10 whereas percentage change in is also 10, in

that case the elasticity of demand is :

10%

10%

Ed

L. c. Ed-1

(c) If percentage change in price is 10 whereas percentage change in demanded is

5, in that case the elasticity of demand is:

Ed

5% =0.5
10%

ie. Ed-<1.

5.

Econometric Method

An econometric model is a mathematical representation of economic relationship(s)

derived from economic theory. T. e primary objective of econometric analysis is to
forecast the future behaviour of the economic variables incorporn.ed in the model.
Two types of econometric models are employed: the single equation model and the
simultaneous equation model. The single equation model assumes that one variable,
the dependent variable (also referred to as the explained variable), is influenced by
one or more independent variables (also referred to as the explanatory variables). In
other words, one way causality is postulated. An example of the single equation
model is given below:

D= a0 +alpt + a2Nt

Where D- demand for a certain product in year Pt-Price for a product in year t

Nt Income in year t

The simultaneous equation model portrays economic relationship in terms of two or

more equations. Consider a highly simplified three-equation on metric model of
Indian economy. GNPI

Gt+It+Ct

LD+ at GNPt b0 + bt GNPt CI

Where GNP

GI

Ct

-Gross national product for year t

Governmental purchases for year t

Gross investment for year t

- Consumption for year t

Quantity demand The quantity

 1.6 Market penetration for the product Once a reasonably good handle over
the aggregate demand is obtained, the next logical question is: What will be
the likely demand for the product of the project under examination? The
answer this question depends on
1. Aggregate potential
2 Nature pf Competition
3. Consumer preferences
4. Sales promotion efforts

Supply Nature of competition

If the aggregate potential domestic supply is likely to be significantly less than the
aggregate potential domestic demand, the demand for the product of the project
under examination is likely to be very strong, provided liberal imports which may hurt
domestic manufacturers are not allowed. The nature of competition and market-
sharing arrangement (if any) has a bearing on the demand for the product of the
project under examination.

Consumer preferences for competing products and the sales promotional efforts of
various competitors obviously influence the relative market shares enjoyed by them.
3.7 Uncertainties in Demand Forecasting Demand forecasts are subject to error and
uncertainty which arise from three principal sources: Data about past and present
market

The analysis of past and present market, which serves as the springboard for the
projection exercise, may be vitiated by the following inadequacies of data: Lack of
standardization - Data pertaining to market features like product, price, quantity,
cost, income etc. may not reflect uniform concepts and measures. Few observations
Not enough observations may be available to conduct Meaningful analysis.

Influence of abnormal factors - Some of the observations may be influenced by

abnormal factors like war or natural calamity.

(ii)Methods of forecasting
Methods used for demand forecasting are characterized by limitations. Inability to
handle unquantifiable factors- Most of the forecasting methods, Quantitative in
nature, cannot handle unquantifiable factors which sometimes can be of Immense
significance,

Unrealistic assumptions - Each forecasting method is based on certain assumptions.

For example, the trend projection method is based on the 'mutually compensation
effects' premise and the end-use method is based on the constancy of technical
coefficients. Uncertainty arises when the assumptions underlying the chosen method
tend to be unrealistic and erroneous.

Excessive data requirement - In general, the more advanced a method, the greater
the data requirement. For example, to use an econometric model one has to forecast
future values of explanatory variables in order to project the explained variable. Co
predicting the future value of explanatory variables is a difficult and uncertain
exercise

(ii) Environmental changes The environment in which a business functions is

characterized by numerous uncertainties. The important sources of uncertainty are
mentioned below:

Technological change - This is a very important but hard-to-predict factor which

Influences business prospects. A technological advancement may create a new
product which performs the same function more efficiently and economically, thereby
cutting into for the existing product. For example, electronic watches have
encroached on market for mechanical watches

Shift in Governmental policy, which may be difficult to anticipate, may ha a telling

effect on business environment, e.g. granting of licenses to new companies
particularly foreign companies, may alter the market situation significantly.; banning
the import of a certain product may create a sheltered market for the existing
produced liberalizing the import of some product may lead to stiff competition in the
market place relaxation of price and distribution controls may widen the market
considerably.

Developments on the international scene - Developments on the international scene

may have a profound effect on industries. The most classic example of recent time is
the OPEC price hike, which led to near-stagnation in the Indian automobile industry.
Discovery of new sources of raw material - Discovery of new sources of raw
materials, particularly hydrocarbons, can have a significant impact on the market
situation of several products.

Vagaries of monsoon - Monsoon, which plays an important role in the Indian

economy, is somewhat unpredictable. The behaviour of monsoon influences, directly
or indirectly, the demand for a wide range of products.

3.8 Coping with Uncertainties

Given the uncertainties in demand forecasting, adequate efforts, along the following
lines may be made to cope with uncertainties.

1. Conduct analysis with data based on uniform and standard definitions.

2. In identifying trends, coefficients, and relationships, ignore the abnormal or out-of
the-ordinary observations.

3. Critically evaluate the assumptions of the forecasting methods and choose a

method which is appropriate to the situation.

4. Adjust the projections derived from quantitative analysis in the light of a duc
consideration of unquantifiable, but significant influences.

5. Monitor the environment imaginatively to identify important changes.

6. Consider likely alternative scenarios and their impact on market and competition.
1. Conduct sensitivity analysis to assess the impact on the size of demand for
unfavourable and favourable variations of the determining factors from their most
likely levels. 4.0 Summary

An estimation of the size of the market is the first step in project appraisal. In many
cases, a project has been abandoned because preliminary appraisal revealed a
inadequate size of market. The information required for market and demand analysis
relate to effective demand in the past and present, breakdown of demand, price,
consumers, methods of distribution and sales promotion, government policy and
supply and competition. The information required for demand and market analysis is
generally obtained partly from secondary sources and partly through a market
survey. The important sources of national sample survey reports, plan reports, India
year book, and statistical abstract of the Indian Union. Sometimes, secondary
information does not provide a comprehensive basis for demand and market
analysis. It needs to be supplemented with primary information gathered through a
market survey. After collecting information about various aspects of the market and
demand from primary and secondary sources, it is essential to make an estimate of
future demand. The various methods of demand forecasting include trend projection
method, consumption level method, end use method, leading indicator method
econometric method. Given the uncertainties in demand forecasting adequate efforts
are to be made to cope with uncertainties.

5.0 Suggested Readings 1) Prasanna Chandra, Projects; Preparation, Appraisal,

Budgeting and Implementation,

Tata McGraw, Publishing Co. Ltd, New Delhi. 2) Planning Commission, Guidelines
for Preparation of Feasibility Reports for Industrial Projects, (Controller of
Publications, Govt. of India, New Delhi). 3) United Nations, Guidelines for Project
Evaluation, Oxford & IBH Publishing Co.,

New Delhi.

S.C. Kuchhal, Financial Management, Chaitanya Publishing House, Allahahbad.

5) Prasanna Chandra, Financial Management, Tata McGraw Publishing Co. Ltd.,

New

Delhi.

6.0 Self Assessment Questions

1. Describe the information required for market and demand analysis.

2. Discuss the method of demand forecasting in the marketing appraisal of the

project. 3. Describe the significance of market survey in marketing appraisal of the
project? 4. "Often secondary information is not adequate for market and demand
analysis" Comment.
MBA-Project Management

Paper: MBA-711

Updated by: Dr. M. C.Garg

LESSON NO. 4

MBAFM-205

Technical Appraisal: Material and Inputs, Production Technology, Product Mix, Plant
Capacity, Location etc.

Structure

1.0 Introduction 2.0 Objectives

3.0 Presentation of Contents 3.1 Location and Site

3.2 Selection of Site

3.3 Plant Capacity 3.4 Production Technology and Plant and Machinery

3.5 Structures and Building

3.6 Plant Layout

3.7 Effluent Treatment 3.8 Work Schedule

3.9 Choice of Technology

3.10 Product Mix

3.11 Government Policies

3.12 Project Charts

4.0 Summary

5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

The purpose of the project appraisal is to ensure that the project is sound in its
financial, technical and socio-economic aspects. Analysis of technical aspects is
done continually when a project is being examined. Technical analysis is concerned
primarily with material inputs and utilities, production technology, product mix, plant
capacity, location and site machineries and equipments structure: and civil works,
project charts and layouts and work schedule.

2.0 Objectives After reading this lesson, you should be able to

(a) Explain the various aspects to be considered for technical analysis of the project.
(b) Discuss the factors influencing the choice of location of a project. (c) Describe the
factors influencing the choice of technology.

3.0 Presentation of Contents 3.1 Location and Site

The choice of location and site follows an assessment of demand, size and input
requirements. Location refers to a fairly broad area like a city, an industrial zone, or a
coastal area; site refers to a specific piece of land where the project would be set-up.

The choice of location is influenced by a variety of considerations: proximity to raw

materials and markets, availability of infrastructure, Governmental policies and other
factors. An industrial feasibility study should define the evaluation and site suitable
for the project. Selection of location refers to the selection of a geographical area
where the project should be located. The first step, therefore, is the selection of the
location and site Selection comes only after location is finalised. There are a number
of important factors that influence industrial location. It is very important to carefully
consider all the relevant factors, while deciding about the location because the
location may significantly influence the cost of production and distribution,
distributional efficiency, operating environment etc.

The important factors that influence industrial location are:

1. Raw Material certain industries tend to be located near the source of raw material.
This is particularly true in case of industries based on gross localised materials.

Industries with a high Material Index (the proportion of the localised material to the
final product) tend to locate near the source of raw material. For example, iron and
steel mills are usually located near the ore deposits and sugar mills in the sugarcans
cultivating regions.

Industries using perishable raw materials also tend to be located in closer proximity
to the raw material sources.

2.Closer to Markets
Certain categories of industries tend to be located near the market. This is
particularly true of the Industries with the manufacturing process that involves an
increase in weight and/or bulk. In such cases, the transport and distribution costs
can be minimised by being closer to the market. Industries with fragile and
perishable output also have a tendency to be located closer to the market.
3. Water

Certain industries like the paper industry by their very nature require large quand of
water. The properties of the available water are as important as the quantity of
available and the stability of the supply. A number of industries also use the water so
for effluent disposal.

4. Power and Fuel Power and fuel supply have an important bearing on industrial
location. Cheap power or fuel and its uninterrupted supply is an important attraction
for industries, especially in the area of energy crisis. In the past certain industries
tended to be located near deposits. But the electricity has greatly changed the
industrial location patterns. Now, not very difficult to take power supply to the
location of raw material supply so that weight losing materials may be processed at
their location.

5. Manpower The economic, social and political aspects of labour supply have
important influence on industrial locations. Not only the quantity but also the skill
levels of the manpower important. In certain regions abundant cheap labour may be
available; but if the labour d not possess the required skill, the industry will have to
incur expenditure on trainings labour.

6. Natural and Climatic Factors Natural and climatic factors also play an important
role in the location of certain industries. In the absence of favourable natural and
climatic conditions, necessitate additional expenditure will be incurred to create
favourable condition artificially.
7. Incentives

There are certain incentives which may affect industrial location: For instance, State
Governments offer a number of fiscal, monetary and physical incentives for
industries in notified backward regions. Other factors

8.Other factors have to be assessed before reaching a location decision: ease;

coping with environmental pollution, labour situation, climatic conditions, and general
living
Conditions.

A project may cause environmental pollution in various ways: it may throw gascon
emission; it may produce liquid and solid discharges; it may cause noise, heat, an
vibrations. The location study should analyse the costs of mitigating environmental
pollution to tolerable levels at alternative locations.

The labour situation at alternative locations may be assessed in terms of: (i) the
availability of labour, skilled, semi-skilled, and unskilled; (ii) the past trends in labour
rate the prevailing labour rates, and the projected labour rates; and (iii) the state of
industrial relations judged in terms of the frequency and severity of strikes and
lockouts and the attitudes of labour and management.

The climatic conditions (like temperature, humidity, wind, sunshine, rainfall, snowfall,
dust and fumes, flooding, and earthquakes) have an important influence on location.
They have a bearing on cost as they determine the extent of air-conditioning, de-
humidification, refrigeration, special drainage, etc., required for the project. General
living conditions, judged in terms of cost of living, housing situation, and facilities for
education, recreation, transport, and medical care, need to be assessed at

Alternative locations.

3.2 Selection of Site There are a number of important factors to be considered in the
selection of the site. These include the load bearing capacity of the site, flood and
earthquake hazards, access to transport facilities, facilities for water supply, facilities
for effluent discharge, ecological factors, etc.

3.3 The size of the plant or scale of operation is an important factor that determines
the economic and financial viability of the project. In many industries there are
certain technological sizes which are economical. If the size is sub-optimal, there
will, therefore, be diseconomies of scale.

The uneconomic size is one of the important reasons for the poor performance of
many industrial units in India. The uneconomic size results in high cost and makes
survival in a competitive market, particularly in the international market, very difficult.

An important aspect of the technological size is the available process technology and
Equipments are often standardized at specific capacities in production sectors.

Plant capacity (also referred to as production as capacity) refers to the volume or

number of units that can be manufactured during a given period. Several factors
have a bearing on the capacity decision. Technological requirement - For many
industrial projects, particularly in process type industries, there is a certain minimum
economic size determined by the technological factor. For example, a cement plant
should have a capacity of at least 300 tonnes per day in order to use the rotary kiln
method; otherwise, it has to employ the vertical shaft method which is suitable for
lower capacity.

(i) Input constraints - In a developing country like India, there may be constraints on
the availability of certain inputs. Power supply may be limited; basic raw materials
may be scarce; foreign exchange available for imports may be inadequate.
Constraints of these kinds should be borne in mind while choosing the plant
capacity. (iii) Investment cost - When serious input constraints do not obtain, the
relationship between capacity and investment cost is an important consideration.
Typically, the investment cost per unit of capacity decreases as the plant capacity
increases. This relationship may be expressed as follows:

C₁ = C₂

CI-derived cost for Q1 units of capacity C2-known cost for Q2 units of capacity

a a factor reflecting capacity-cost relationship.

This is usually between 0.2 and 0.9. (iv) Market conditions - The anticipated market
for the product/service has important bearing on plant capacity. If the market for the
product is likely to be strong, a plant of higher capacity is preferable. If the market is
likely to be unseen it might be advantageous to start with a smaller capacity. If the
market, starting f a small base, is expected to grow rapidly, the initial capacity may
be higher than initial level of demand- further additions to capacity may be affected
with the go of market. v) Resources of the firm - The resources, both managerial and
financial, available a firm define a limit on its capacity decision. Obviously, a firm
cannot choose a of operations beyond its financial resources and managerial
capability.

vi)Governmental policy - The capacity level may be constrained by governmen

policy. Given the level of additional capacity to be created in an industry, within
licensing framework of the government the government may decide to distribute
additional capacity among several firms. 4 Production Technology, Plant and
Machinery

The feasibility study should consider the adequacy and suitability of the plant
equipments and their specifications, plant labour, balancing of different sections of
the proposed arrangements for procurement of plant and equipments, reputation of
machinery suppliers, etc. The feasibility study should define the technology required
for a particular project: valuate technological alternatives and select the most
appropriate technology in termaptimum combination of project components. The
various implications of the acquisition of such technology should be assessed.

Proper evaluation of alternative technologies is essential for selection of ppropriate

one. This evaluation should be related to plant capacity and should comment vith a
quantitative assessment of output, production build-up and gestation period and
qualitative assessment of product quality and marketability. The selection of
technology b › be related to the nature of the inputs that may be available for a
project and to a appropriate combination of factor required for both short and long
periods.

The selection of equipment and technology are interdependent. In certain projects,

such as a cement plant, production and operational technology is a part and parcel
of the supply of equipment and no separate arrangement for technology acquisition
are necessary. The equipment required for the project may be classified into the
following types:

i) Plant (process) equipment, ii) Mechanical equipment, iii)Electrical equipment,

iv) Instruments v) internal transportation system, and Other machinery and
equipment.

vi 4.2.2 Production technology For manufacturing a product/service often two or

more alternative technologies

Check the document Available. For example: Steel can be made either by the
Bessemer process or the open hearth process.
. Cement can be made either by the dry process or the wet process. Soda can be
made by the electrolysis method or the chemical method.

Paper, using biogases as the raw material, can be manufactured by the Kraft
process or the soda process or the simon cusi process. Vinyl chloride can be
manufactured by using one of the following reactions: acetylene on hydrochloric acid
or ethylene or chlorine.

Constraints in selecting machinery and equipment- In selecting the machinery and

equipment, certain constraints should be borne in mind: (i) there may be a limited
availability of power to set up an electricity intensive plant like, for example, a large
electric furnace; (ii) there may be difficulty in transporting a heavy equipment to a
remote location; (iii) workers may not be able to operate, at least in the initial periods,
certain sophisticated equipment such as numerically controlled machines; (iv) the
import policy of the government may preclude the import of certain types of
machinery and equipment.

3.5 Structures and Building

The operative efficiency of an industrial project also depends on the layout. Layout
Refers to the arrangement of physical facilities. The site, factory and plant layouts
are Important. All these layouts shall ensure that the operations are carried out
smoothly and efficiently. They shall also ensure safety. The location and layout of the
buildings also should be given due attention. The design and type of the buildings
should be given due attention. The design and type of the buildings should suit the
requirements of the work carried out and shall confirm the safety, health and
convenience standards.

Feasibility reports should incorporate project charts and layouts, which define the
Scope of the project and serve as a basis for detailed engineering work to estimate
the investment and production costs. The types of charts and layouts and the degree
of details depend on the size and technical sophistication of the project.

Buildings and structures may be divided intoFactory or process buildings; Ancillary

buildings required for stores, warehouses, laboratories, utility, supply centres,
maintenance services, and others; Administrative buildings; Staff welfare buildings,
cafeteria, and medical service buildings; and Residential buildings.

Outdoor Works

Outdoor works cover: D Supply and distribution of utilities (water, electric power,
communication, stearn and gas);

i) Handling and treatment of emissions, wastages, and effluents;

Transportation and traffic arrangements (roads, railway tracks, paths, parking areas,

Sheds, garages, traffic signals, etc.);

iv) Outdoor lighting: V) Landscaping; and

 v) Enclosure and supervision (boundary wall, fencing, barriers, gates, doors,
security posts, etc.)

. 3.6 Plant Layout

Plant layout is concerned with the physical layout of the factory. In certain industries,

Particularly process industries, plant layout are dictated by the production process
adopted. In manufacturing industries, however, there is much greater flexibility in
defining the plant layout. The important considerations in preparing the plant layout

a) Consistency with production technology. b) Smooth flow of goods from one stage
to another.

c) Proper utilisation of space. (d) Scope for expansion.

c) Minimization of production cost.

f) Safety of personnel. 3.7 Efferent Treatment

Disposal of effluent is a major problem for a number of industries like chemical

industries, paper industry etc. Industrial pollution has become a serious ecological
problem and causes severe problems for civic life.

Heavily polluting industries should pay particular attention to the location.

They should be located in places where the social impact of pollution will be
minimum. Projects which produce effluents should have proper facilities and
arrangements for treatment and disposal of the effluents harmlessly. The feasibility
report should effluent provide relevant details about the plan for effluent treatment
and disposal. It may be mentioned here that while evaluating the application for
industrial licence, Government considers the arrangements proposed to ensure the
safe disposal of effluents and gases into air, water and soil.

3.8 Work Schedule

The work schedule reflects the plan of work concerning installation as well as initial
operation. The purpose of the work schedule is: Plan of investments taking into
account availability of finances.

To develop a plan of operations covering the initial period.

An important aspect of material required is concerned with defining the materials and
inputs required, specifying their properties in some detail, and setting up their supply
programme Materials may be classified into four broad categories: Raw materials,
Processed industrial materials and components, Auxiliary materials and factory
supplies, and N) Utilities 19 Choice of Technology
The choice of technology is influenced by a variety of considerations Principal inputs
- The choice of technology depends on the principal inputs available for the project.
In some cases, the raw material available influences the technology chosen. For
example, the quality of limestones determines whether the wet or dry process should
be used for a cement plant. It may be emphasized that a technology based on
indigenous inputs may be preferable to one based on imported inputs because of
uncertainties characterizing imports, particularly in a country like India.

Investment outlay and production cost - The effect of alternative technologies of

Investment outlay and production cost over a period of time should be carefully
assessed. () Use by other units - The technology adopted must be proven by
successful use by other units, preferably in India.

iv)Product mix - The technology chosen must be judged in terms of the total product
mix generated by it, including saleable by-products.

v) Latest developments - The technology adopted must be based on latest

development in order to ensure that the likelihood of technological obsolescence in
While carrying out planning as to production, there is need to have some flexibility
regarding product mix. This type of flexibility helps the firms to change the product
mix keeping in view the changing market conditions and gives strength to survive
and compete in the market. In this regard, the additional investment requirements
need to be kept in mind Soap to the users falling in upper middle class.
In the newly developing countries, there may be constraints as to the availability of
various inputs, basic raw materials may 1 scarce, power supply may be quite limited
and foreign exchange may be quite inadequate, market may be limited, the adequate
finances may not be available from the market and the different financial institutions.
Hence, the constraints of these types should be kept in mind while selecting the
capacity of plant and the product infix.

3.11 Government Policies

Government policy guidelines have a bearing on the industrial site and location in the
various industrial areas. In the case of public sector enterprises, such a decision is
taken directly by the Government which may be based on the policy as to wide
dispersion of industries, there as in case of private sector, Government restrictions,
incentives and whereas incentives play an important role. The Government may ban
the setting up of the units in which suffer from urban congestion and pollution.
Hence, the incentive is to set up the industry in the backward areas. Various
incentives may be relating to making available the finance at the low rate of interest,
various tax concessions, subsidies and large number of other benefits. The
requirement of plant and machinery is dependent on the plant capacity and
production technology. In case of process type of industry, the machinery required
should be such that the various stages are matched properly. In case of
manufacturing units, the choice as to plant and machinery is wider, since different
type of machines can perform different types of functions with different degrees of
accuracy.

While selecting plant and machinery certain key variables should be kept in view:
1) Limited availability of power,
2) Difficulty in transporting equipment to different locations,

3Lack of availability of skilled labour,

4) The import policy of the Government may restrict the import machinery and
equipment,

5) Various other inputs for running the plant may not be available. Hence the various
equipments required for the project may be classified

Plant equipments,

Electrical equipments,

Mechanical equipments,

Of certain type of into:

Equipments,

iv) Various instructions, S Other type of machinery and

vi) Various control measures, vil) Internal control measures,

viil) Spare parts and tools,

b) Other equipments required for operational wear and tear.

3.12 Project Charts

Once the information is available as to different variables of the project like capacity,
technology, civil works equipments, supply of inputs to the project, the chart and
layouts are prepared thereafter. These help in defining the scope of the and provide
the basis for estimation of production cost, investments and planning Control. The
important charts and layouts are:

i) Functional layouts, ii) Material flow diagrams

ili) Production line diagrams

iv) Transport layouts

v) Utility consumption layouts vi) Communication layout

vii) Organisational layout

viii) Physical layout of the factory while preparing the project charts and layouts the
main emphasis is on smooth
Economical movement of material, work in progress and finished goods. The
information needed for technical appraisal is presented in the form of a feasible
Report which includes the following:

1) Examination of public policy with respect to the industry. 2) Broad specification of

outputs and alternative techniques of production in term

Process choice, plant size and raw materials. 3) Listing and description of alternative
locations. Product patterns and product prices.

5) Raw material investigation. 6) Estimation of material and energy flow balances.

7) Listing of major equipments by type, size and cost.

8) Listing of building and other structures. 9) Preparation of layout.

10) Water supply and power. 11) Labour requirements.

12) Transportation services.

(vi)Ease of absorption - The case with which a particular technology can be ab the
near future, at least, is minimized. can influence the choice of technology.
Sometimes high-level technologies beyond the absorptive capacity of a developing
country which may lack trail Personnel to handle that technology. The technology
may be acquired from other companies by way of Technology Licensing

D Outright Purchase. Joint Ventures.

The technology contract as to its licensing should be examined with reference to

1. 2. s technology to be acquired, Types of Cost of technology licensing. Guarantee

provided by the licensor,

3. Duration of technology licensing, and Purchase of intermediate products,

components and other inputs. Purchase of technology and decision making as to
acquiring technical know upon the nature of industry. It is proper when there is hardly
any need depends technological support from the seller of technology, and when
there is less possibility

4. Improvement in technology in the future period. The people who act as suppliers
of technology have the leverage of participating the project, technically as well as
financially. The financial participation is in the form equity holding and it is hoped that
such a financial participation may give motivation to supplier of technology to transfer
the new developments and recent improvements qui quickly.

The technology need to be appropriate to the methods of production being used ocal
economic, social, cultural and political conditions. The technology needs to b
evaluated in this regard: 1) whether the technology makes use of local labour and
other technical expertise?
2) Whether the technology makes use of raw material available locally?

3) Whether the services provided and the goods produced meet the basic
requirements?

Whether the technology ensures environmental balance?

5) Whether the technology is in harmony with economic, social and cultural

conditions 3.10 Product Mix

The decision as to product mix is guided by the market forces. While carrying
production of different type of items, variations in size and quality are aimed at
meeting the requirements of different types of customers. For example a soap
manufacturer by making in or changes in raw material, sales promotion and
distribution, offers a high profit margin

(vi)Ease of absorption - The case with which a particular technology can be ab the
near future, at least, is minimized. can influence the choice of technology.
Sometimes a high-level technology beyond the absorptive capacity of a developing
country which may lack trail

Personnel to handle that technology. The technology may be acquired from other
companies by way of Technology Licensing

D:- Outright Purchase. Joint Ventures.

The technology contract as to its licensing should be examined with reference to

1. 2. Technology to be acquired, Types of Cost of technology licensing. Guarantee

provided by the licensor,

3. Duration of technology licensing, and Purchase of intermediate products,

components and other inputs. Purchase of technology and decision making as to
acquiring technical know upon the nature of industry. It is proper when there is hardly
any need Depends technological support from the seller of technology, and when
there is less possibility

4. Improvement in technology in the future period. The people who act as suppliers
of technology have the leverage of participating the project, technically as well as
financially. The financial participation is in the form equity holding and it is hoped that
such a financial participation may give motivation to supplier of technology to transfer
the new developments and recent improvements qui quickly.

The technology need to be appropriate to the methods of production being used ocal
economic, social, cultural and political conditions. The technology needs to b
evaluated in this regard: 1) Whether the technology makes use of local labour and
other technical expertise?

2) Whether the technology makes use of raw material available locally?

3) Whether the services provided and the goods produced meet the basic
requirements?

Whether the technology ensures environmental balance?

5) Whether the technology is in harmony with economic, social and cultural

conditions 3.10 Product Mix

The decision as to product mix is guided by the market forces. While carrying out
production of different type of items, variations in size and quality are aimed at
meeting the requirements of different types of customers. For example a soap
manufacturer by making in or changes in raw material, sales promotion and
distribution, offers a high profit margin

MBA - Project Management

Paper: MBA-71 Updated by: Dr. M. C. Ga

LESSON NO. 5

MBAFM-205

Financial Estimate:

Cost of Project and Means of Financing Profitability Appraisal

Structure

1.0 Introduction 2.0 Objectives

3.0 Presentation of Contents 3.1 Cost of a Project

3.2 Means of Financing

3.3 Profitability Appraisal

4.0 Summary 5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

To judge a project from the financial angle, the information about cost of project
means of financing, cost of production, estimation of production and sales, working
capital requirements and its financing break-even point estimates of working results,
project cash flow statements and projected balance sheet is required.
2.0 Objectives

After reading this lesson, you should be able to

(a) Discuss the components of cost of a project. (b) Describe the various means of
financing a project.

(c) Explain the items that are considered in profitability appraisal.

3.0 Presentation of Contents 3.1 Cost of a Project

The cost of a project is determined by the physical facilities provided by th

management to operate a business enterprise. The nature and size of the company
will decide the production facilities required for a project including land, building, plan
machinery and equipment and other necessary services such as electric power, fuel
an water. Conceptually, the cost of project represents the total of all items of outlay
associate

With a project which are supported by long-term funds. It is the sum of the outlays on
the following:
Land and site development Buildings and civil works

Plant and machinery

Technical know-how and engineering fees

Expenses on foreign technicians and training of Indian technicians abroad

Miscellaneous fixed assets

Preliminary and capital issue expenses

Pre-operative expenses Provision for contingencies

Margin money for working capital

Initial cash losses Land and Site Development

The promoters of the project must acquire a plot of land sufficient to meet its current
requirements and also provide for expansion in future. The cost of land must be
carefully estimated and all components of this cost such as cost of land development
must be included

The cost of land and site development is the sum of the following: Basic cost of land
including conveyance and other allied charges Premium payable on leasehold and
conveyance charges Cost of levelling and development Cost of laying approach
roads and internal roads Cost of gates Cost of tube wells
The cost of land varies considerably from one location to another. While it is very
high in urban and even semi-urban locations, it is relatively low in rural locations. The
expenditure on site development, too, varies widely depending on the location and
topography of the land. Building and Civil Works

The decisions made in factory planning have a significant effect on building costs..
Important considerations are the size of the module, the shape of the building the
number of building and the number of internal partition walls. The principal factors
affecting the layout of the factory are: material flow, building policy, administrative
convenience and later expansion.

The project needs a number of buildings to house all the manufacturer facilities.
They can be classified as under for the estimation of cost: Factory building for the
main plant and equipment. Auxiliary services like water supply, steam

(i) Factory building for workshop etc.

(ii) Administrative building. (v) Miscellaneous non-factory buildings like canteen,

guest house, s

(iv) Godown’s and warehouses. Parking shed-etc.

(vi) Staff and labour.quasters.

(vii) Cost of sewers etc as a percentage the cost of building.

(viii) Architects fee etc. as a percentage of the cost of building. and machinery
selection

Plant and Machinery

The principal factors which affect plant

(a) Accuracy The accuracy of a machine can be specified by quoting the tolerance
which it will produce consistent results. This tolerance gets wider as the wears, and
eventually becomes too wide to produce products to the limits g design specification.
When this happens the machine must be overhauled or Machines of high accuracy
tend to have a longer life to overhaul than machine accuracy chosen.

(b) Purchase Price Purchase price is very unreliable criterion for plant selection, if
used alone. value of the machine can only be judged if purchase price is considered
in relation factors, such as output capacity, operating cost, life and resale value.
(c) Production Capacity It is not sufficient, when determining the production capacity
of a mad consider only the output rate when running. The true capacity is only found
allowances are included for setting up, for clearing and maintaining the mach for the
level of operating efficiency which can be maintained by the available force.

(d) Erection Cost

Machines differ widely in the provisions made for rapid setting-up in com which make
a large number of different products in small quantities. It is not uncommon find that
a machine, which would be ideal in all other respects, cannot be used be excessive
setting time which reduces its capacity and makes it uneconomic. The o expedient of
increasing batch sizes to raise the capacity level is generally uncommon to the
induced rise in the investment in stocks and in carrying cost.

(e) Resale Value

The prices for which the machines can be sold when they reach the end of their
useful time must also be estimated in order to compare their values. It should be
noted that a machine which has finished its useful life with one company making an
accurate product may still have a further life with another company making a less
accurate product, and that in any case it can always be rejuvenated by overhaul.

(g) Running Cost Power costs, wages of operations, lubrication, maintenance and
other related expense should also be considered when determining which plant to
acquire. In general the problem of plant selection is one of choosing the best from a
number of alternatives. There is no satisfactory alternative to technological
knowledge and experience for selecting the list of possible machines to carry out the
known process. The problem in process planning is first to decide which special
types should be used, and second which of the makes available in the market should
be chosen. For example, in the case of spinning in the textile industry, it is obvious
that the general type of machine required is a spinning machine. There is a choice of
special types including mules and ring frames. For each of these types there will be
a selection of makes, varying in first cost, output rate, accuracy and other qualities.

The general principle of plant and machinery selection is that the chosen plant must
produce at the required output rate and level of product quality and that within this
limitation, the plant should be selected which gives the highest rate of return on the
capital investment. The decision to acquire a plant not only requires large amount of
funds and commits the company to maintenance and preservation of the asset, but
also precludes the company from utilising the same resources for other purposes.
The promoters must consider all aspects of investment decision, for example,
measurement and time pattern of cash flow, net present value, rate of return, cash
payback, depreciation, income-tax, Inflation etc. For the purpose of cost estimation
the plant and machinery be divided into:

(0) Imported. (i) Indigenous.

(1) The cost of imported plant and machinery shall be accumulated under the
following heads:

a) F.Q.B. (Free on Board). b) Provision for price rise.

Shipping freight and Insurance at a % of (a) + (b).

d) c) Import duty % of c.i.f. cost (cost, insurance and freight) [a+b+c].

e) Clearing, loading, unloading and transport charges upto factory site at a % of (a) +
(b) + (c) + (d).
The indigenous plant and machinery would include the following costs shown their
respective heads
F.O.R cost (Free on mil cost)

Provision for price escalation. Sales tax, octori and other taxes, if any. C)

Railway freight and transport charges upto factory sito. III Installation charges on
both imported and indigenous plant and equipment. on drawings etc. payable

IV. Technical know-how fees and expenses Salaries and allowances, traveling
expenses etc. payable to foreign collaborators.

b) Salaries, travelling expenses etc. of technical personnel to be engaged on the pro

and I to be trained abroad.

personnel during erection and initial testing period.

V Miscellaneous fixed assets.

VL Pre-operative expenses (start-up). VII. Preliminary and capital issue expenses,

VIII. Provision for contingency. IX Margin money for working capital.

While great care exercised by the promoters in estimating the cost of a project,
estimates do prove inadequate in numerous cases. Delay in the implementation of a
project due to various factors is a major cause of actual capital costs overshooting
The factors for cost over-runs in project are:

1) Delay in Implementation.

2) Price escalations of equipment, material etc. 3) Changes in scope and

specifications of project the estimate

4) Modifications, inclusion of additional equipment capacity not envisaged earlier.

5) Increased requirements of utilities.

6Increase in duties, taxes, and transport charges.

7) Underestimation of cost during appraisal.

8) Exchange rate fluctuations. 9) Lack of infrastructural facilities at site.

10) Additional expenses incurred. 11) Defects in original machinery.

12) Change in consultants, increase in their fees.

13) Requirement of more working capital.

14) Cash losses after commencement of production. Pre-operative Expenses

Expenses of the following types incurred till the commencement of commercial

project Pre-operative expenses incurred point plant and machinery are may,
however, treat revenue above which is already incorporated in the cost estimates

To estimate the provision for contingencies the following procedure may followed: (i)
Divide the project cost items into two categories, viz., 'firm' cost items and 'non-firm'
cost items (firm cost items are those which have already been or for which definite
arrangements have been made). (ii) Set the provision for contingencies per cent of
the estimated cost of non-firm cost items. Alternatively, make provision of for all
items (including the margin money for working capital) the implementation period is
one year or less. For every additional one year, make an additional provision of per

3.2 Means of Financing

Financing is an important aspect of project. Efficient and effective performance the

finance function is a pre-requisite condition for the effective performance of project.
The makes vital contribution to the achievement of the main objective undertaking by
helping it to manufacture and market goods and services desired by the society at
reasonable profit economically and efficiently. Capital the life blood of unit and as
such no undertaking can prosper until it has got sufficient capital its disposal.

A project requires funds for a variety of purposes: for land and building: for plant and
for wages and salaries; for insurance and taxes and all kinds of sundry expenses.
From the view point of time or the period, for which funds are required, sources of
finance may be divided into short-term, intermediate and long-term. Funds needed
for period of up to one year are generally termed as short term funds whereas those
required for a period between 3 to 5 years are usually known as intermediate funds.
Long-t funds are required for a period of above five years. To study this problem on
time be simple and is familiar to both the users and suppliers of funds. The problem
of selecting appropriate sources of finance is very closely linked with the period for
which fund needed. This fixed capital and permanent working capital requirements
should be finance out of long-term sources, while seasonal working capital can be
met out of short sources of raising funds.

The means of financing long-term capital requirements of a unit are:

1) Preference shares, 2) Equity shares,

3) Debentures,

4) Ploughing back of profits, 5) Financial institutions.

Share capital of a company is also known as its owned capital. Share capita divided
into certain parts of equal denomination "which are known as shares and the pe who
buys these shares is known as share-holder. Every share-holder receives a divide
Payment of dividend is not compulsory. Rate of dividend is recommended by the
Boa Directors but is declared by the share-holders in the Annual General Meeting. A
pub company can issue only two types of shares, i.e., preference shares and equity
share

(1) Preference Shares

Preference shares are those which carry a preference in regard to: (a) Payment of
dividend so long as company is in existence. (b) Return of capital in case of winding
up of the company.

The rate of dividend on preference shares is fixed and this must be paid before
paying any dividend on other shares. A company can also issue redeemable
preference shares when it undertakes to pay back the amount paid on such shares
under cert conditions. The intention to return the money should be made clear at the
time of issue shares. These shares can be redeemed only if they are fully paid, and
out of profit available for dividend or out of the proceeds of a fresh Issue of shares
made for this purpose. Which shares are redeemed out of profits, that part of the
profits which is not used must b transferred to Capital Redemption Reserve
Account?

(2) Equity Shares:- Shares which are not preference shares are equity shares. The
dividend on these shares is paid after distributing a fixed rate of dividend on
preference shares. The rated dividend on these shares is dependent upon
availability of divisible profits and the initial of Directors. In case of winding up of the
company, equity capital will be repayable only after all other claim including those of
preference share-holders have been settled. Equity share-holders control the
company by virtue of their entitlement to vote at the general meetings of the
company unless meetings affect the rights of other share-holders. These shares
have the chance of earning good dividends and also face the risk of earning nothing.
Equity shares are preferred by those who are prepared to bear the risk to earn
better. Because of the risk involved in it, equity share capital is also known venture
capital. (3) Debentures

Another form of raising funds in a company is by issuing debentures. A debenture is

issued to allow a large number of investors in subscribing to the total amount of loan
being raised by a company. The total loan is raised by inviting the public to buy as
many debentures, each bearing a certain par-value, or face value, as an individual or
institution desires. In most respects a debentures is like a share. It can be purchased
or sold in the stock market like shares; the market value of a debenture can be used
by the holders as collateral security to temporary loans.

(4) Ploughing back of profits A new company has no choice between external and
internal sources of funds. However an existing company may withhold the
distribution of profits by way of cash dividends and decide to reinvest the whole or a
part of it in the business and their utilization to meet its fixed and working capital
requirements is also known as the ploughing back of profits. Internal financing is also
described as self-financing because it is generated by the company itself.

Retained earnings and depreciation are the two most important components of
internal financing. For a large number of companies internal financing is more
important than financing through external sources of funds. A number of small units
find retained earnings to be the only significant source of funds.

Large numbers of businesses adopt a sound dividend policy and set aside their
Earnings specifically for re-investment in the business. They prefer to grow gradually
and finance from the inside. Such growth effected through retained earnings in the
business is considered as the best method in company finance. When a company
retains a portion of the distributable profits in the form of free reserve and utilizes this
amount for further expansion, it is called ploughing back of profits. Profits of any one
year are channelled by the enterprise into three main directions:

1) Taxation-Government share through corporation tax;

2) Ploughing back of profits-amount retained in business which is called earned

surplus

3) Dividend payments-portion of profits paid to the owners as dividend when the

earnings are sufficiently large to pay normal dividends and still retain substantial
sums in business, there need not be any objection from the share-holders to the
procedures of ploughing back of profits. If, however, earnings are so small that the
re-investment of a considerable amounts cuts the dividend to a very low percentage

or cause it to be passed altogether, share-holders naturally will have a serious

objections and they may even compel the management to change this policy
ploughing back of profits within the business.

Need for Re-Investment of Earnings

Retained earnings can be used to improve efficiency of the plant and equipment.
The cost structure can be lowered and competitive position can be strengthened.
The company is able to survive recession without much difficulty.
ii) Unreliability of account statements also compels management to retain
substantial Profits. Profits on paper may be over-stated whereas actual earnings
may be lower than those on paper.

Depreciation as a source of fund

Depreciation does not represent valuation but allocation only. Funds are generated
by operating profit and not by making any provision for depreciation. As a non-cash
expense depreciation does not represent any cash outlay with the result that port of
profit adjusted for depreciation can be used by management to increase any of the
current assets, pay taxes or dividends etc.

Various methods are used to calculate annual depreciation on any fixed asset,
however, use of accelerated method of depreciation is particularly desirable from the
view point of tax considerations since it enables management to claim maximum
depreciation allowance in the early years of the useful life of the asset. There is also
the problem of depreciation finds accumulated by the management proving
inadequate to replace a worn out asset. This problem may be resolved by creating a
supplemental depreciation allowance as an item of appropriation of profits or by
charging depreciation on replacement cost basic. Dividend Policies

Decision regarding allocation of company's after tax profits between retention in the
business and their distribution to share-holders as cash dividends rests with its board
of directors. The decision, though by no means an easy one, is of prime concern to
the investors and also to the company. The investors are interested in earning the
maximum returns on their investments in the shares of the company, and in no case
less than the rate of interest they obtain by taking to an alternative investment. A
successful company on the other hand while realizing the need for distributing a part
of its pet profit as dividend must make adequate provision for meeting the fixed
charges interest payments on the funded obligations, taxes etc. and for additions to
surplus as well as.

Internal financing is mainly dependent upon a suitable dividend policy adopted by the
management. The ownership objective of a business enterprise is fulfilled by the
distribution of a satisfactory rate of dividend to share holders. But a dividend policy
can be regarded as satisfactory only when it permits distribution of regular dividends
at a gradually increasing rate. The objective should, therefore, be establishment of
stable dividend policy. This will help the company to raise necessary capital,
increase its reputation, and enhance the value of its securities. To maintain stable
rate of dividend the management of new companies are often advised and justified
not to pay any dividend during the first few years of their existence as they need
funds for developing and stabilizing their business.

Like many countries of the world a number of special financial institutions have also
been established in India to provide financial help to business concerns. Industrial
Finance Corporation of India (1. F.C. I), Industrial Credit and Investment Corporation
of India Ltd. (L.C.L.C. L.), State Finance Corporation (S.F.C.), Refinance Corporation
of India (R.F.C.). National Industrial Development Corporation (N.I.D.C.), State
Industrial Development Corporations (S.I.D.C.), National Small Industries
Corporations (N.S.I.C.), Industrial Development Bank of India (I.D.B.1), Unit Trust of
India (U.T.I.), Life Insurance Corporation of India (LIC) are some such special
financial institutions working in India. These institutions meet the financial
requirements of new companies as well as the going concerns. Purchases of
securities of companies, granting of loans, guaranteeing of loans and deferred
payments and underwriting of new security issues are the chief forms in which
financial help is rendered to different business units.

Means of Short Term Financing A part of the working capital needs, usually the
margin money, is also financed through long-term sources. The seasonal working
capital requirements of a project are generally financed through short-term sources.
The important short term sources of financing working capital requirements are:

Trade Credit; (i) Commercial Banks;

() Public Deposits;

(iv) Business Finance Companies; (v) Provisions for Income Tax;

(vi) Accrued Expenses;

(vii) Borrowing from Indigenous Bankers; (vii) Advances from customers; and

(ix) Miscellaneous sources

3.3 Profitability Appraisal

Cost of production and profitability are the means by which the profitability viability of
the project is established and hence, they should be prepared on a realistic basis.
The selling prices assumed for the end-products and the costs of raw materials and
other Inputs may be arrived at after due consideration of the existing market prices,
seasonal fluctuation in prices, likely competition expected etc.

Another crucial figure in deciding the profitability is the capacity utilisation capacity
76 build-up. It would not be advisable to assume high capacity utilization in the first
year of operation.

Estimates of Operating Costs

A. Total Material Materials

Power

Water

Fuel

B. Total utilities

Labour and Plant overheads Wages Factory Supervision Salaries

Bonus

Provident Fund

C. Total Labour

Repairs and maintenance

Light

Rent and taxes on Factory assets Insurance on factory assets

Miscellaneous factory expenses Contingency at 5%

D. Total Factory overheads

E. Estimate of cost of manufacture

(A+B+C+D) Estimates of Working Results

A. Cost of Production as per statement B. Total Administrative Expenses

C. Total Sales Expenses

D. Royalty-and Know-how Payable E. Total Cost of Production

(A+B+C+D)

F. Expected Sales

G. Gross Profit before Interest (F-E)

H. Total Financial Expenses I. Depreciation

J. Operating Profit (G-H-I)

K. Other Income, if any (Give Details) L. Preliminary Expenses written off.

Cost

M. Profits /Loss before Taxation (J+K-L)

N. Provision for Taxation 0. Profit after Tax (M-N).

Material Costs

Material costs average sixty per cent of the total manufacturing costs of the products
of all industries. Furthermore, the complexity of manufacturing operations tends to
produce losses and waste in materials as the articles pass through the plant in the
course of production. It is, therefore, necessary that the cost of material be carefully
estimated. There are two broad classifications of materials:

@Direct Indirect

(Direct materials: Direct materials are those which actually enter into and become
part of the finished product.

(i) Indirect materials: Indirect materials are those which are used in the operation of
the business but not directly in the product itself such as consumable stores (oil.
grease, and cotton waste), consumable tools, packing material etc. Sale of scrap
resulting from manufacturing operations and purchase discounts would be deducted
from the invoice cost of materials.

Utilities

Consumption of power, water and fuel may be arrived at on the basis of the
consumption norms of the industry or the norms indicated by the collaborators,
consultant etc. whichever is higher. Cost of power should include only cost of bought
out power and it may be calculated on the basis of the existing power tariffs of the
concerned electricity board. The cost of power generated in the company itself would
be automatically included under the costs of water, fuel etc. Cost of water would
represent the water charges payable to the local authorities. Cost of fuel such as
furnace oil, coal, firewood used in the factory is to be estimated.

Annual wages and salaries, including those of the administrative and sales staff at
maximum capacity utilisation may be worked out. Factory Overheads

Repairs and maintenance expenses would depend upon the state of the machinery.
Usually such expenses may be lower in the initial years and higher in the later years.
Rent, taxes, insurance, etc. may be provided at the prevailing rates. A suitable
provision may be made for meeting miscellaneous factory expenses which are not
included under any other head.

Administrative Expenses

Administrative salaries may be taken from the statement as given under the head of
labour after making due allowances for lower capacity utilisation in the initial year 78
Administrative salaries may also be increased at the rate of 5% per annum to take
care of annual increment etc. Professional fees relate to fee payable to outside
consultants, experts etc., who are not in the regular employment of the company
Reasonable provision may be made for other items of expenditure under their head
including miscellaneous expenses..

Sales Expenses

The expenses under this head should include

1) Commission payable to dealers.

2) Packing and forwarding charges. 3.Salary of Sales staff.

4.Sales promotion and advertising expenses, 5) Other miscellaneous sales

expenses.

Royalty and know-how

Royalty and know-how fees payable to foreign/Indian know-how supplier’s m be

carefully estimated. The rate at which royalty etc. has been calculated may indicated.

Expected Sales

The details of sales revenue have to be worked out as given below. In case project
envisages the manufacture of more than one product, particulars of each prod have
to be given separately. These projections have to be made for five years.

Estimates of Production and Sales

1) Installed Capacity (quantity per day/annum).

2) No. of working days.

3) No. of shifts.
4) Estimated production per day (quantity).

5) Estimated annual production (quantity).

6) Estimated output as a % of plant capacity. 6739
7) Sales (quantity) (after adjusting stocks).
8) Value of Sales (in rupees)
9) Unit selling price.

Production in the initial period should be assumed at a reasonable level of utilisation

capacity increased gradually to attain full capacity In subsequent years.

Financial Expenses

Financial expenses would include interest on term loans, interest on working cap
loans, guarantee commission and bank charges: Rates of interest on term loan
working capital loans may be assumed at the prevailing rates.

Depreciation
Depreciation may be calculated on the straight line method. However, for a the
income tax liability, depreciation would have to be calculated on written down value
basis.

Break Even Analysis This device involves determining the breakeven point, the
volume at which the operations of the enterprise will result in neither net income nor
net loss. This simple approach is usually referred to as break even analysis. As we
expand the applications of this technique to answer other questions regarding the
effects of cost and volume upon net income, however, the term cost volume profit
(CVP) analysis is more appropriate.

The C.V.P. analysis is used to answer many of the questions faced by the
management. As profits are affected by the inter play of costs, volume and selling
price, management must have at its disposal analysis that can allow reasonably
accurate presentation of the affect a change in any one of these factors would have
on the profit performance. When plans are formulated, certain questions of the
following type have to be answered. Should emphasis be place on increasing the
selling price or the sales volume? If so, to which of the many products marketed
should it be applied? Should the selling price be raised even at the cost of
decreasing the sales volume? If cost is to be reduced, should pressure be exerted to
reduce the variable or fixed cost? Cost volume profit analysis is of great assistance
in obtaining answers to the above questions.

Break Ever Chart Once the total fixed cost, the variable cost and the contribution is
known, it is easy to find out the relationship between cost, volume and profit. The
effect of a given change in cost or volume over the profit can be predicted with a fair
degree of accuracy. It can be depicted either on a break even chart or through the
mathematical calculations.

Break even chart,

the volume is indicated along the x-axis as number of units produced and sold. The
costs and revenue are indicated on the y-axis in terms of value (rupees). The total
cost (Y) at any volume Q equals a fixed component (F) plus
a variable component (a) times the number of units of volume (X) i.e. Y=F+aQ

T.C..

Profit Ares

Stargn of Safety

V.C..

F.C.

Charte

Break Even Chart

The breakeven point can be determined mathematically with the following formula
F.C. Q=

SP-VC

Where

FC Fixed Cost

SP=Selling Price VC Variable Cost

Assumption underlying Break Even Chart The following are the assumption of
breakeven point

1) All costs can be separated into fixed and variable costs.

2) Fixed costs will remain constant and will not change with the change in level of
output.
3) Variable costs will fluctuate in the same proportion in which the volume of output
varies. In other words, prices of variable cost factors i.e. wage rates, price of material
etc. will remain unchanged.

4.Selling price will remain constant even though there may be competition or change
in volume of production.
5) The number of units produced and sold will be the same so that there is no
opening or closing stock.

6) There will be no change in operating efficiency. 7) There is only one product or in

the case of many products, product mix will remain unchanged.

Uses of Break Even Analysis

The advantages of break even analysis are as follows:

1) Information provided by the break even chart can be understood by the

management more easily than contained in the Profit and Loss Account and the cost
statements because a break even chart is the simple presentation of cost, volume
and profit structure of the company. It summaries a great mass of detailed
information in a graph in such a way that its significance may be grasped even with a
cursory glance.

2) A break even chart is useful for studying the relationship of cost, volume and
profit.
Chart is very useful for taking managerial decisions because it shows the effect
on profits of changes in fixed costs, variable costs, selling price and volume of sales.
3.Chart is very useful for forecasting profits at various volumes of sales.

4) A break even chart is a tool for cost control because it shows the relative
importance of the fixed costs and the variable cost. Profitability of various products
can be studied with the help of these charts and a

5)most profitable product mix can be adopted. Profits at different levels of activity
canalso be ascertained.

6) The profit potentialities can be judged from a study of the position of the
breakeven point and the angle of incidence in the break even chart. Low breakeven
point and large angle of incidence in the break even chart indicate that fixed costs
are low and margin of safety is high. It is a sign of financial stability. In such a case,
some monopolistic conditions prevail and high profits are earned over a large range
of production activity. Low breakeven point and small angle of incidence show that
fixed costs are low and margin of safety is high, but rate of profit is not high because
of absence of monopolistic conditions. High breakeven point and large angle of
incidence show that fixed costs are high and margin of safety is low. A small fall in
volume may put the business into losses and a small increase in volume may give a
high profit because of large angle of incidence.

7) Profitability of various products can be compared with the help of break even
of and a most profitable mix can be adopted.
8) It is helpful in knowing the effect of increase of reduction in selling price.
Limitations

The various limitations of break even analysis are as follows: 7 1. A break even chart
is based on a number of assumptions which may not hold well. Fixed costs vary
beyond a certain level of output, variable costs do not vary proportionately if the law
of diminishing or increasing returns is applicable in the business. Sales revenues do
not vary proportionately with changes in volume of sales due to reduction in selling
price as a result of competition or increased production.
In the break even chart, the total cost line and the sales line look straight lines charts
cost line and the sales line are not straight lines because the assumptions do not
hold good different of activity.
2.A limited amount of information can be shown in a break even chart. A number of
charts will have to be drawn up to study the effects of changes in fixed costs

3.The effect of various product miles on profits cannot be studied from a single break
4.A break even chart does not take into consideration capital employed which is very
important factor in taking managerial decisions. Therefore, managerial decisions In
spite of the above limitations,

the break even chart useful management device for analysing the problems, if it is
constructed and used those who fully understand its

The financial resources available any business limited. Shortage may place serious
restrictions en management's freedom of action. Therefore, there is a vital need to
conserve the resources. Implies that investment in business assets economically
capital purposes within an organisation.

it may be represented can therefore Making proper and balanced available funds the
In accounting practice the excess current assets the working capital. The term
current assets are synonymous explained in economics. Current expected to be
converted into cash or consumed during the normal operation of the
Inventories such as finished goods, goods in process materials, operating supplies
and ordinary maintenance materials and parts

d) Current liabilities are short term debts due and payable normally within
Liabilities payable within the short-term but for which provision has been made for
payment from other than current resources are normally excluded from this category.
Examples of current liabilities are:

a)Accounts payable;

b) Notes and acceptances payables,

C) Loans payable;
d) Accruals,

f) Deposits repayable;
g) Advance payments;

g) Resources for current taxes: Unpaid dividends; and

h) Current maturity of long-term debt not provided for payment from other than
current resources.
4.0 Summary

The information about cost of project means of financing, cost of production, working
capital requirements and its financing break-even point and estimates of sales and
production is required to judge a project from the financial angle. The cost of project
represents the sum of all items of outlay associated with a project which are
supported by long-term funds. It is the sum of outlays on land and site development,
building and civil works, plant and machinery, miscellaneous fixed assets. The
means of financing long-term capital requirements of a unit are preference shares,
equity shares debentures, ploughing back of profits and financial institutions. The
starting point for profitability projection is the forecast for sales revenue. Break-even
point refers to the level of operation at which the project neither makes profit nor
incurs loss. 5.0 Suggested Readings

1. Prasanna Chandra Projects: Preparation, Appraisal, Budgeting and

Implementation Tata McGraw Publishing Co. Ltd., New Delhi.

Vasant Deasi, Project Management, Himalaya Publishing House, New Delhi.

2. 3. LM. Pandey, Financial Management, Vikas Publishing House, New Delhi. 4.

B.M. Patel, Project Management, Vikas Publishing House, New Delhi.

6.0 Self Assessment Questions 1. What are the components of cost of Project?
Explain them in detail.

2. Describe the various means of financing a project.

3. Explain the items that are considered in estimating the working results. 4. What is
the break-even point? How is it calculated for a new project? 5. Discuss the
advantages and limitations of break-even point.

MBA-Project Management

Paper:

Updated by:

Break Even Analysis and assessing tax burden project management

LESSON NO.6

MBAFM-205

Structure

Introduction 2.0 Objectives

3.0 Presentation Contents

3.1 Framework deriving Taxable

3.2 Important Provisions Relevant Deriving Taxable Income

3.3 Set off, Carry forward and Orders deduction Computing Income Business.
3.4 Break Even Analysis
4.0 Summary

5.0 Suggested Readings

6.0 Self Assessment Questions

For preparing profitability projection, expected burden forecast period, which usually
eight years, figured this calls familiarity with the provisions Income those determining
magnitude timing the burden new project. This lesson seeks provide respect
discusses broad framework deriving the taxable income, important provisions
relevant computing taxable process determination burden payment and finally,
comprehensive illustration purpose. Should emphasize here taxation a complex
specialized field, which handled experts. Purpose here build basic understanding
framework relevant financial appraisal projects provide detailed exposition field.
Objectives after reading lesson, should explain framework deriving taxable income.
Discuss relevant provisions relating carry computing income from business.forward
order deduction

(4) Define breakeven point and calculate the breakeven point. 3.0 Presentation of
Contents Framework for Deriving

Income tax is a charge calculated by applying the rates prescribed annually in the
Finance Act on the base called the total income. The total income, also known as
taxable is computed with reference to a period defined as the previous year. A figure
shows the schematic diagram for determining the total income of a corporate
assesses income, r the Income Tax Act. As a part of rationalization and simplification
process, the lacome Tax Act is being amended by doing away with many of the
incentive schemes, and under at the same time reducing the overall corporate
income tax rates. By the way, the Government hopes to reduce the complexities
involved in the calculation of tax and administration of tax law would become easier.

Taxable Figure B.1: Diagram for Determining the Total Taxable Corporate Assesses
Income for income from Business

Income from Other Heads under Tax Law

Gross Total Income

Deductions u/s 80 from Gross Total Income

Total Taxable Income

Plus

Equal to

Minus

Equal to
Income from Business

This broadly consists of receipts less deduction associated with activities, which can
be attributed to the character of business/profession. The principal sources of
receipts are sale proceeds, professional fees, and labour charges.

The deductions can be classified as follows: Actual business expenses incurred. The
major items included under this head are: (1) rent, rates, taxes, insurance, repairs
and maintenance in respect of premises used for business (section 30); (ii) repairs,
maintenance and insurance in respect of plant and machinery (section 31); (iii)
expenditure on scientific research not being in the nature of capital expenditure
related to the business of the assesses (section 35); (iv) expenditure on scientific
research by certain notified businesses get weighted deductions; (v) insurance
premium paid in respect of insurance of stock or stores of the business; bad debt
etc. (section 36); (vi) any other expenditure (not being in the nature of capital
expenditure or personal expenses of the assessee) laid out expended wholly and
exclusively for the purposes of the business/profession Amortization of certain
expenses. Certain expenses are incurred at one time and percentage of such
expenses is allowed to be deducted against the income over number of years by
way of amortization. These include: (i) outlays on fixed assets which are depreciated
at the rates prescribed under rule 5 of the Income Tax R (section 32); (ii) expenditure
on patents and copyrights (section 35A); ( expenditure for acquiring know-how
(section 35 AB); (iv) preliminary expenses (section 35D); (v) expenditure on
prospecting of minerals (section 35A); ( expenditure incurred by an Indian Company,
for amalgamation or demerger of company (section 35 DD) and (vii) capital
expenditure on family planning employees (section 36).

Capital expenditures of certain types. Though capital expenditures are a normally

allowed as a deduction in computing the business income, the following capital
expenditure can be deducted by virtue of certain provisions of the Ac (i) capital
expenditures on scientific research related to the business carried by the assessee
[section 35 (1) (iv)]; (ii) capital expenditure incurred connection with the business
consisting of prospecting for or extraction production of mineral oils (section 42). (iii)
capital expenditure incurred in connection with acquiring any rights to operate
telecommunication service (section 35 ABB). Certain contribution. Payments made
to (a) certain recognized scientific research institutions to be used for scientific
research [section 35 (1) (ii)]; (b) certain recognized institutions to be used for
research in social science or statistical research [section 35 (1) (iii)]; (c) approved
public sector companies and institutions for promoting the social and economic
welfare of, or the uplift of, the public (section 35 AC): and (d) certain associations
and institutions for carrying out programmes of conservation of natural resources
(section 35 CC B) can be deducted for ti purposes.

In respect of contributions made to approved National Laboratories or a University or

an Indian Institute of Technology with a specific direction that the amounts be used
for scientific research undertaken under an approved programme, an amount equal
to 125% of she contribution is allowed as deduction (35 2AA) Carried forward losses
and allowances. In computing the business income, losses and allowances carried
forward from the previous year can be deducted subject tocompliance with certain
conditions. Income from other Heads under Tax Law The various other heads, the
nature of income, and the deductions allowed under these

Heads by the Act are shown below

Nature of Income

Head Income from house

Property

Capital gains

Income arising from

Building and land under Appurtenant there to action on transfer of capital assets

Owned by the assessee Full value of consider

Interest and other

Incomes, which cannot be taken under any other

Deduction Allowed

Deductions are specified Sections 23 and 24 of the Act

(a) Indexed cost of acquisition (b) Indexed cost of improvements

(c) Expenses on transfer (d) certain exemptions

Expenses incurred to earn the income and depreciation where applicable head

Income from other Sources

Gross Total Income

This represents the summation of income from business and income from other
heads under the Act as described above. This aggregation process involves setting
off negative figures in the manner as prescribed in the Act. Such set off is done at
two levels as follows:

(a) Setting off negative figures under any source against positive figures under any
other source within the same head of income; and

(b) Setting off negative figures under any head of income against positive figures
under any other head of income. Exemptions/Deductions from Gross Total Income
Certain incomes enjoy special
1. Exemptions under Chapter III, and do not form part of the total income. The
important exemptions are
2. Exemption of such profits or gains from the export of articles or things or computer
Software established in a Free Trade Zone etc. (Section 10A)

2. Exemptions of such profits or gains from the export of articles or things or

computer software from 100% export oriented unit (Section 10B).

Deduction from Gross Total Income

Chapter VI A of the Act deals with various deductions that are allowed from the
gross total income. The deductions under this chapter are allowed irrespective of the
source of income and are akin to incentives. They are different from other deductions
discussed earlier, which are related to a specific head of income. If the gross total
income is negative than no deduction under chapter VI A is allowable. These
deductions cannot make a gross total negative.

The important deductions under chapter VI A are as follows: Deduction in respect of

profits and gains from projects or execution

1. India (Section 80 HHB).

2. Deduction in respect of profits and gains from housing projects in certain areas

3. which are aided by World Bank (Section 80 HHBA). Deduction in respect of export
of goods or merchandise outside India subject

Certain conditions. (Section 80 HHC) 4. Deduction in respect of earnings in

convertible foreign exchange from the business hotel and tour operators (Section 80
HHD)

5. Deduction in respect of profits from export of computer software etc. (Section HHE

6. Deduction in respect of profits from export or transfer of film software,

Software etc. (Section 80 HHF)

7. Deduction in respect of profits and gain from new industrial undertaking providing

infrastructure facility after a certain date (Section BOIA) Deduction in respect of

profits and gain of business from new industrial other than infrastructure facility as
mentioned above (Section 80JJ)

8. Undertaking

9. Deduction in respect of profits and gain from business of collecting and processing
bio-degradable waste (Section 80JJ)

10. Deduction in respect of employment of new workmen (Section 80JJAA) 11.

Deduction in respect of royalties etc received from certain foreign enterprise
(Section 800)

(Deduction under Section 80HHB, 80HHBA, 80HHE, 80HHD, 80HHE, 80HHF, 88

are being phased out in a gradual manner such that no deduction will be available
for the assessment years commencing on 1.4.2005 and subsequent years).

Total Taxable Income This represents the difference between the gross total income
and the deductions from the gross total income and is the base on which the tax rate
is applied to arrive at the tax liability.

3.2 Important Provisions Relevant for Deriving Taxable IncomeIn applying the
framework for deriving the taxable income, discussed in the preceding

Section, certain provisions and considerations relating to the following must be borne
in mind Expenses incurred during construction period

Depreciation

Deduction in respect of expenditure on scientific research

Deduction in respect of

Deduction in respect of profits from export Deduction in respect of profitsin respect of

profits of computer software and other in respect of profits and gains of newly set up
industrial undertakings

Deduction respect of profits and newly set up industrial undertakings

in infrastructure gains from certain industrial undertakings other of deduction for

computing income from business

Expenses incurred during Construction Period: The first question that needs to
construction is or what is the data from which the computation the business should
be reckoned for the purpose of income tax. ith the definition of previous year (the
period with reference computed) provides a clue in the matter. According to this
Section, in respect of any business commences from the date on which it is 'set case
of factory, the date of 'set up' will be the date on which the unit is 'ready commence
production after trial run, etc, though the actual commercial production may not start
due various reasons such as non-availability of raw material, power supply etc. of
'set up the cut off date and all the expenditures incurred after this date is to treated
revenue expenditure deductible in computing the income from business. It may
matter this stage whether the unit effecting sales or not for computing income under
head Profits and Gains of Business or Profession' for the purposes of income tax.
Once the date of 'set up' business determined, the treatment of various expenses
incurred the setting up of the unit (other than direct expenses relating to
construction) may discussed. During the construction stage of project, new company
incurs various expenses. These expenses can broadly classified as: (a) direct
expenses relating to construction other than direct expenses. The expenses, which
are directly related construction, are considered as part of plant, machinery, building
etc. The treatment other expenses needs some consideration. These expenses
(other than direct) may classified follows: preliminary expenses, indirect expenditure
relating construction, (iii) indirect expenditure not relating to construction, (iv)
expenditure relating to technical know-how, (v)

expenditure relating new project of an existing company, and (vi) income earned
during the construction with Preliminary Expenses: Preliminary expenses consists of
following: (a) expend in connection with preparation of feasibility report, preparation
of project rep engineering services, market survey or any other survey necessary for
the business o assessee; (b) legal charges for drafting any agreement between the
assessee and any o person for any purpose relating to the setting up or conduct of
the business of the me (c) legal charges for drafting the memorandum and articles of
association, fees registration of the company under the provisions of the Companies
Act, cost of is public subscription of shares and debentures of the company; (d) such
other items expenditure (not being expenditure eligible for my allowance or
deduction under any o provision of this Act) as may be prescribed

According to Section 35D of the Act, 20 percent of the preliminary expenses can
claimed as deduction for each of the five successive previous years beginning with
previous year in which the business commences or the extension of the industry
undertaking is completed. The maximum amount of preliminary expenses that can
authorise is five percent of the cost of the project or capital employed (as defined,
Section 35D) whichever is more.

Indirect Expenditure Relating to Construction: These consist of expenses financial

charges, remuneration of various personnel engaged in construction activity
travelling and other expenses incurred for the purpose of implementing the project
depreciation on various assets used for the purpose of construction and trial
production expenses. These expenses are allowed to be capitalized, i.e., added to
the value of various assets set up by allocating them over the items of plant,
machinery, buildings, etc., on some reasonable basis. The unit is permitted to claim
depreciation on the enhanced value of these assets arrived at after such allocation
and this value is referred to as the actual co of the assets. Such actual cost is
reduced by that portion, if any, as has been met direct ar indirectly by any other
person or authority [Section 43 (1)].

Indirect Expenditure not Relating to Construction: There are several expense

incurred during the construction period, which are not in any way related to
construction Examples: expenses on the marketing department, expenses incurred
due to the corporate status of the unit. Such expenses are not allowed to be
capitalized nor are they allowed to be deducted from the income of the subsequent
years. From the point of view of financial accounting, these expenses are treated as
deferred revenue expenses and are written off over a period of time. From the
income tax point of view, however, the company does not derive the benefit of
charging these expenses against revenue. Hence, it is preferable that such
expenses are incurred, as far as possible, after the date of setting up of the unit.
Expenditure on Technical Know-how : Capital Expenditure incurred on technical
know-how, incurred after In April, 1998 can be capitalized as direct expenditure
related to construction or can be by itself treated as an intangible asset, on which
depreciation can be claimed under section 32. Revenue expenditure on technical
know how can be claimed as expenses under section 37 (1).
Expenditure relating to a New Project of an Existing Company: When an existing
company with ongoing business activities sets up a new project, expenses that are
directly relatable to the construction of the project is capitalized. Other indirect
expenses earned from other existing activities of the company. However, this does
not construction period are allowed to be claimed as a deduction from the incurred
during the incomes e preclude the company from capitalizing all indirect expanses
without claiming it as a deduction from other claiming it all indirect expenses relating
to construction without incomes as previously mentioned.

Income Earned during Construction Period: Income earned during construction

period, which is attributable to construction activity, can be reduced from the
construction cost of the asset itself. Examples of such income are sale of products
produced during trial run, sale of packing material used for machinery, hire charges
received for plant and machinery which was given to the sub contractor, sale of
packing material used of machinery etc. Other types of incomes like interest received
and share transfer fees received are normally treated as income for the purpose of
Income Tax Act

Depreciation According : According to Section 31 (1) of the Income Tax Act,

depreciation at prescribed rates on the actual cost (as determined in the manner
stated in the preceding heading) in respect of (i) buildings, plant and machinery and
furniture and fittings being tangible assets and (ii) know-how, patents, copyrights,
trademarks, licences, franchises or other business other business or commercial
rights being intangible assets used for business/professional purposes is a tax
deductible expenses. For claiming the depreciation allowance, the assets should be
owned and used for the purpose of business by the assessee.

When a capital asset is imported, by incurring a liability in foreign exchange and the
rupee equivalent of such liability is outstanding at the end of each year or at the time
of repayment increases/decreases due to fluctuation in rates of exchange then such
increases/ decreases are adjusted against the actual cost (Section 43 A). The actual
cost so adjusted at the end of each year is treated as if it was the actual cost from
the date of acquisition of the asset. This necessitates adjustment toward
depreciation in each year in respect of earlier years.

Depreciation is charged on blocks of assets, which represent a group of assets,

within the broad class of assets, of buildings, plant, machinery, and furniture, for
which a common rate of depreciation is applicable. Depreciation will be calculated by
applying the prescribed rate (which varies between 5% and 100 %) on the written
down value (WDV) of the entire block. When an asset is sold the amount realized
from the sale of such asset

(after deducting expense on sales) will simply be deducted from the WDV of that
block the amount realized is greater than the WDV of the block, the difference will be
treated short term capital gain. In a case where all the assets in the block are
disposed off t there is still a balance in the account of the block, such amount will be
treated as short-t capital loss?
To illustrate the above provisions, let us consider an example. A block of consisting
of 10 items acquired during 2000 to 2005 has a written down value of Ra million as
on 1st April 2005. During 2004-2005, the assessee sells an asset for Ra million (on
which an expense of Rs.0.1 million is incurred on sale) and acquires an asset Rs.0.5
million.

The net block of assets for depreciation purposes at the end of 2004-2005 will
Opening WDV Rs.2 million

Value of addition during the year

Less

Rs.0.5million

Rs.2.5million

Sale proceeds (after deducting selling expense) Rs. 1.9 For the asset sold Net block
for purposes

depreciation In the above example, if the sale proceeds (after deducting selling
expense) had be Rs.5 million, the difference between this amount and Rs.2.5 million
should be short-term capital gain and the net block for purposes of depreciation will
be zero Suppose, all the assets in the block (including the assets acquired during the
year) are sold for Rs.2.2 million (after deducting selling expense), the balance of
Rs.0.3 million remaining in the block amount will be treated as short-term capital
loss.

In may be noted that when any asset is acquired and put to use during the previous
year for a period less than 180 days then depreciation will be allowed only to the
extent of 50 percent of the prescribed rate for that asset in respect of the year of
acquisition. Deduction in Respect of Expenditure on Scientific Research: Under
Section 35, the following expenses relating to scientific research incurred during the
previous year are allowed as deduction in computing the income from business: All
expenses, both revenue and capital (other than cost of land) incurred on scientific
research relating to the business of the assessee. Such expenditures incurred within
three years before the commencement of business shall also be deemed to be
incurred in the year of commencement of business and accordingly deductible in that
year.

Contributions to approved scientific research associations/institutions, University

College, and to be used for scientific research are eligible for deduction of 125% of
the contribution made [section 35 (1)(ii)]. Rs.0.6 million
In respect of contributions made to approved National Laboratories or University or
Jadian Institute of Technology, with a specific direction that the amounts be used for
scientific research undertaken t the under an approved programme, an amount equal
to 125% of contribution is allowed as a deduction. [section 35 (2AA))]. Contributions
to approved institutions to be used for research in social science or all research
whether related to business or not ere eligible for a deduction of 125% of the
contribution (section 35 (1)(iii)] of the com Section 35 (2 AB) allows a weighted
deduction of one and one half times, on venue and capital expenditure (other than
land and building) incurred on approved in but research and development, of
companies engaged in manufacturing and production of drugs and pharmaceuticals,
telecommunication equipment, chemicals, bio-technology. Computers and others
notifies from time to time. This deduction is available up to March

11, 2005. [section 35(2AB)]. Expenditure in the nature of capital expenditure incurred
for acquiring any right to operate telecommunication services, either before the
commencement of business or thereafter. Deduction can be claimed under section
35 ABB, starting from the year in which the payment is made (or the business had
commenced), in equal instalments and in the year in which the licence ending comes
to an end. Deduction in Respect of Profits Derived from Export Business: Section 30
HHC allows deduction of a certain percentage out of the profits derived from export
business of a resident business entity or an Indian company. Various conditions
governing the grant of this deduction are as follows. The assessee should be
engaged in the business of export out of India of any goods and merchandise.
Exports of mineral oils and minerals and ores (other than processed minerals and
ores specified in the twelfth schedule to the Income Tax Act) do not qualify for this
deduction.

2. The sale proceeds from exports of such goods are receivable by the assessee in
convertible foreign exchange within a period of six months or such extended time
given by the Appropriate Authority from the end of the previous year in which the
export took place. 3. The profits derived from export business (hereinafter referred to
as exempted profits) is determined under 3 cases, viz. where the exported goods are
manufactured or processed by the assessee, where the exported goods are trading
goods and where the exported goods consist of both types.

Case 1: Export of manufactured goods

Eligible profit=Profit of the business x Export turnover of Manufactured goods

Total turnover of the business

Case 2: Export of trading goods

Eligible profit Export turnover of trading goods-Direct and indirect attributable to

export of such goods.

Case 3: Export of both manufactured and trading goods

(a) For manufactured goods:

Eligible profit -Adjusted profit of the business

(b) For trading goods:

Adjusted export turnover Adjusted total turnover

and indirect attributable to export of such goods. The percentage rate of deduction of
the eligible profits shall be an amount equal 70, 50 and 30 percent for the financial
year beginning from April 1, 2001, 2002 and respectively.

Eligible profit - Export turnover of trading goods Direct

No deduction is allowed from the assessment year beginning 1.4.2005. Note: For
purposes of making the above computations various expressions there under have
the meanings as stated below:

(a). Total Turnover does not include freight, insurance and export incentives; (b)
'Export Turnover' means the sale proceeds received or brought into India convertible
foreign exchange within six months of the previous year or such ext

time limit but does not include freight and insurance (beyond customs limit)

(c) 'Profits of the Business' means the amount computed under the head Profit

Gains of Business or Profession' and reduced by (i) 90% of the export incentive
brokerage, commission, interest, rent or receipt of similar nature included in profit
and (ii) the profits of any branch office, warehouse or any other establish of the
assessee situated outside India; (d) 'Direct Costs' means costs directly attributable to
the exported trading go including the purchase price of such goods; (e) 'Indirect
Costs' means costs, not being direct costs, allocated in the ratio of export turnover of
trading goods to the total turnover;

(1) 'Adjusted Total Turnover' means the total turnover of the business as reduced by

export turnover of trading goods; (8) 'Adjusted Export Turnover' means the export
turnover as reduced by the export turnover of trading goods. (h) 'Adjusted Profits of
the Business' means the profits of the business as reduced by

profits derived from the business of export of trading goods. 4. An assessee selling
the eligible goods to an Export/Trading house holding a valid certificate issued by the
Chief Controller of Imports and Exports is entitled to the

Deduction in Respect of Profits and Galas Projects Outside India (Sec. 80 HHB):
This deduction is applicable to and to Indian companies or to persons resident in
India, executing foreign projects like construction of buildings, dams, roads, the
engaged or installation of plant or machinery etc., for which compensation is payable
in convertible foreign exchange (Section 80 HHB).

The conditions governing the deduction are as follows: Separate books of accounts
are to be maintained for such projects The accounts must be audited and a report
prepared in the prescribed format
The assessee is required to credit the Foreign Projects Reserve Account the
specified percentage of profits. The amount credited to the 'Reserve Account' is
required to be utilized by the assessee before the expiry of a period of five years
following the previous year in which the amount was credited which must be used for
the purpose of the business and not for distribution as dividends. The specified
percentage of profits is also required to be remitted to India in convertible foreign
exchange

The amount that can be claimed is specified percentage of the profits and gains of
such business. The specified percent is 30% for the assessment year commencing
from 1.4.2002 and there after this deduction is reduced by 10% each year. No
deduction is allowed from the assessment year beginning 1.4.2005.

Profits from the Export of Computer Software and Other Related Technical Service
(Section 80 HHE): The deduction is allowed for an Indian Company or a person
other than company resident in India, and is a Software developer, and has export
Out of India of computer software or its transmission from India to a place outside
India by any means or has providing technical services outside India in connection
with the development or production of computer software. For the purpose, profit
derived from the business specified above is determined as follows:

Eligible Profits =

Export turnover

Total turnover

x Profit of the business

The deduction allowable is 60% of eligible profits for the assessment year 20th 2003,
reduced to 40% and so on in the subsequent assessment years, and is being pha
out in a gradual manner such that no deduction will be available for the assessment
you commencing on 1.4.2005 and subsequent years.

The terms export turnover, total turnover and profit of business have been
specifically in the section. In order to claim the deduction, the assessee is required to
furnish an audit reporting in specifically in the section

the prescribed form along with the Exemptions in Respect of Profits and Gains of
Newly Set Up Industrial Undertaken in Free Trade Zones (Section 10A]: Newly
established industrial undertakings in free t return of income. zones, electronic
hardware technology parka, software technology parks, or specific economic zones,
can claim exemption of 100% of their profits and gains derived from exports for a
period of ten years beginning with assessment year relevant to the previous year in
which the industrial undertaking begins to manufacture or produce articles or things

Sale proceeds must be brought into India in convertible foreign exchange within
specified period. The exemption will not go beyond assessment year 2009-2010.
amount of profit that is eligible for deduction is calculated in the ratio of die export
him to total turnover of the business. This section applies to Kandla Free Trade Z
Santacruz Electronics Export Processing Zone or any other free trade zone as
prescribe by the central government by notification in the Official Gazette or the
technology parks up under a scheme notified by the central government, for the
purposes of this section

Newly Established Hundred Per Cent Export Oriented Undertakings (Sect oft 10B):
This provision extends the same type of benefit as allowed for the Indus
undertakings set up in a free trade zone or technology park, to newly established
undertakings recognized as 100% Export Oriented Undertaking. For the purposes of
g section, "hundred per cent export oriented undertakings" means an undertaking,
which been approved as a hundred per cent export oriented undertaking by the
Central Government. All the other provisions are similar to the above Section 10 A.

Deduction in Respect of Profits and Gains from Newly Set up Industrial Undertakings
Engaged in Infrastructure Development: Section 80 1A, allow certain deduction in
respect of profits and gains of an industrial undertaking, being Indian company or a
consortium, carrying on the business of developing, or maintaining a operating, or
developing, maintaining and operating.

(a) Infrastructure facility like roads, bridges, airports, inland waterways, ports,
highway projects water supply projects, irrigation sanitation and sewerage treatment
systems

(b) Telecommunication service (c) Industrial parks

(d) Generation, distribution and transmission of power

The allowable deductions are as follows: Infrastructure Facility started after 1.4.95
The deduction will be hundred percent (from assessment year 2002-03) of profits
and gains derived from such business for ten consecutive years beginning from the
initial assessment year and falling within the fifteenth (twenty in some cases)
assessment year from the year in which the enterprise begins operating and
maintaining the infrastructure facility.

Telecommunication Services
Telecommunication services are services that include basic or cellular services
including radio paging, domestic satellite services, network of trucking and
broadband network and Internet services.

These services should have started or starts providing telecommunication service

after a 1st April 1995 but before 31.2.2003;

The deduction will be hundred percent for the first five years and thirty percent
thereafter (next five years) for ten consecutive year starting from the initial
assessment year and falling within fifteen years from which the enterprise begins
operations.

Industrial Park An undertaking which develops and operates industrial parks or (or
special Economic zones from the assessment year 2002-2003) on or after 1 April
1997 but before 31.3.2006
The amount of deduction is 100 percent of profits from the assessment year 2002-
2003 for ten consecutive years starting from the initial assessment year and falling
within fifteen years from which the enterprise begins operations

Generation and Distribution of Power

An undertaking, which is set up in any part of India for, generation or generation and
distribution of power or transmission or distribution by laying network of new lines.
begins on the 1st April, 1999 but before 31.3.06.

Splitting up or reconstruction of a business does not form the industrial undertaking

already in existence. However, if the business is re-established or revived by the
assessee which was discontinued due to damage of building machinery etc. on
account of floods, earthquake typhoon etc. or riots and civil disturbances or by fire or
explosion or act of war etc. the business will be treated as a new industrial
undertaking. Amount of deduction will be 100 percent from the assessment year
2002-2003. For ten consecutive years starting from the initial assessment year and
falling within fifteen

Years from which the enterprise begins operations. The amount of profits eligible for
deduction will be limited to the activities under by the undertaking for example: If the
undertaking is engaged in generation power, then profits generation of power is
eligible.

Additional conditions that need to be fulfilled by the business are: (0) For calculating
the amount of deduction, such industrial undertaking or eligible business is treated
as if it was the only source of income. () Goods and services transferred by the
eligible business or those transferred to t eligible business by any other business
carried on by the assessee has to be at market value, In addition, the assessing
officer has the right to recomputed the profit and gains as be may deem fit.

Deduction in Respect of Profits and Gains from Certain Industrial Undertakings

Other than Infrastructure Development Undertakings 1 Section 20 allows a certain
deduction in respect of the profits and gains derived from any newly set industrial
undertaking, other than infrastructure development undertaking referred to eligible
business which must have commenced operation before 31.3.2002.

The allowable deductions are as follows: In the case of industrial undertakings

located in an industrially backward state for

district as specified or set up in any part of India for the generation, or generation
and distribution, of power which begins to manufacture or produce articles or things
or operate its cold storage plant or plants or to generate power at any time during the
period from 1st April, 1994 to 31st March, 2002, the deduction will be 100% for the
first five years and 30% for the next 5 years. An undertaking refining mineral gets
100% deduction for initial seven assessment years. Other small scale Industrial
undertakings manufacturing or things or operating its cold storage plants, for initial
assessment year and nine succeeding assessment years the deduction allowed is @
30% of profits and gains derived from such industries. For purposes of computing
the amount of deduction, such industrial undertakings me treated as if it was the only
source of income.

For computing the profits of the eligible business as previously mentioned, past loss
and unabsorbed allowances relating to such business is deducted even though such
pat losses, etc., have already been absorbed by other incomes in the past. For both
Sections 801A and 80 IB the following conditions apply:

The splitting up, or reconstruction, of a business already in existence, does not form
it The transfer does not form it to a new business of a machinery or plant previously
used for any purpose.

industrial undertaking other than a small scale industry or an industry set up in a

backward state, it manufactures or produces any articles or In the case of an things
other than articles or things specified on the list in the Eleventh Schedule; employs
ten or more workers in a manufacturing process carried on with the aid of power or
employ twenty, or more workers in a manufacturing process carried on without the
aid of power.

Disallowances: The Income Tax Act provides that though certain expenses are
incurred by the assessee during the previous year, they will not be allowed as a
deduction partly or fully) in computing the income under the head Profits and Gains
of Business or profession under certain circumstances. The more important of these
items are mentioned Advertisement expenditure in the material published by any
political party is disallowed in full [Section 37 (2B)).

Any expenditure incurred by the assessee who is prohibited by law will not be
allowed as deduction. (Section 37). Expenditure because supply of goods, services,
or facilities by certain specified related persons/organizations, which is in the opinion
of the assessing officer, is excessive or unreasonable can be disallowed [Section
40A (2)].

Expenditure in respect of which payment is made in a sum exceeding Rs.20,000/-, t

a time, otherwise than by crossed cheque or bank draft (except in certain exempted
cases) is disallowed in full [Section 40A (3)]. Contributions to unapproved gratuity or
other funds of employees are disallowed in full [Section 40 A (7 and 9)].
Expenditures of the following kinds are allowed if they are not paid for within the
previous year or within a stipulated time after the previous year: (a) expenses on
account of tax, duty, or fees, (b) contributions to any provident/superannuating/
gratuity/other welfare fund of employees, (c) payment of bonus or commission to
employees, and (d) interest on any loan or borrowing from public financial institution

(e) Interest on term loan from scheduled banks (1) provision made for amount
payable as in lieu of any leave (leave encashment) (as defined in Section 4A of the
Companies Act, 1956) (Section 43B).

1 Set Off, Carry Forward, and Order of Deduction For Computing Income From

Business
Various deductions and allowances are considered in computing the income from
business as discussed in the previous section. If the result after providing for such
deductions and allowances is a negative figure in any year, this is allowed to be set
off against income from other heads and the remaining unabsorbed amount, if any,
can be carried forward to the next year and set off against the income of that year
and so on. The

Provisions relating to set off negative income and aggregation and the order of
deduction for computing income from business are as follows:

The first step in the aggregation process is the determination of income under bead
by setting off losses against incomes under different sources. The rules for set off
are as follows:

(a) Losses from any source under a given head of income' can be set off only sp
income from any other source under the same head of income' with exceptions in (b)
below, (b) Losses from speculation business (which falls under the head of income
'profits gains of business or profession) can be set off only against profits from
speculation business. Likewise, losses from owning and maintaining racehorses can
be set against profits from similar activity. Setting off losses does aggregation of
income from all heads of income from one he of income against income from other
head/s. The rules regarding set off against forward are as follows:

(a) Subject to (i) above losses under any head of income other than the head capital
gains can be set off against the income under any other head of income. Lose under
the head house property to the extent it relates to the interest on loan taken f
construction, purchase or repair of such property can be set off against income from
any other head. In the subsequent year, the carried forward loss should be set off
against income from house property and the balance loss can be carried forward for
a period of eight subsequent years from the year in which the loss was firm
Computed. (b) Losses that remain under the head capital gains can be carried
forward and set off against income under the head capital gains of subsequent years
and so on. Such carry forward can be done for a period of eight subsequent years
from the year end which the loss was computed.

Unabsorbed business loss (other than speculation business loss) of any year can be
carried forward and set off against income under the head of business of subsequent
years. Such carry forward can be done for eight subsequent years from the year in
which the loss was computed. (d) Unabsorbed loss from speculation business can
be carried forward and set off against income from speculation business. Such carry
forward can be done for eight Subsequent years. Unabsorbed depreciation can be
carried forward and set off against the income from any other head of subsequent
years without any limitation as to the number of years. Capital expenditure on
scientific research, which is not absorbed by available current

Profits, is treated in the same way as unabsorbed depreciation. Order of Deduction

for Computing Income from Business For the purposes of carry forward and set off,
the unabsorbed benefits from an earlier year are divided into various categories and
are considered for set off, along with certain current allowances, in the order given
below in computing the income from business of the current year. Current scientific
research capital expenditure

.
Current depreciation

Carried forward business loss

Unabsorbed depreciation and unabsorbed capital expenditure on scientific research

A loss cannot be carried forward unless the return of Income Tax is filed within the
time allowed under Section 139 (1) of the Act.

3.4 Break Even Analysis Earning profits is a target of any project management. The
profits with help of different techniques can be planned before hand. One of such
techniques is break even analysis. It is a technique which relates costs, selling price
and volume of sales to highlight profit earning capacity at different levels of activities.
The basic exercise in the analysis is computation of breakeven point (BEP), the point
where there is neither any loss nor any profit. This technique by identifying BEP
helps to determine the lowest production and/or sales level at which the project has
to operate in order to keep out of financial problem. The sales level above BEP
represents profit earnings and below BEP losses are inevitable. Besides this, the
technique explains another concept 'Margin of safety'. These all are explained in this
part of lesson. To appreciate the real worth of break even analysis it is necessary to
be aware of its assumptions. Assumptions

Break even analysis is based on the following fundamental assumptions: (1) It is

assumed here that total cost of product can be splitted into either fixed cost or
variable cost. Fixed cost remains constant irrespective of the quantum of output. The
examples are rent, insurance charges, supervisor's salary etc. It remains constant
per unit of time. But as the production increases or decreases per unit fixed cost
decreases or increases respectively (see fig. 1).

Per unit Fixed Cost

Total Fixed Cost

Fc

Output

Output

Total Fixed Cost

Fc

Cost Rs.
Total Variable Cost

Output

Output

On the other hand variable cost is the cost which varies in direct proportion te output.
These increase or decrease in the same proportion in which the output increases om
decreases. Example of this cost is material, labour, power etc. This cost remains
constant per unit of output (See Fig. 2) In case there are some semi-fixed or semi-
variable costs all efforts are to be made to

split up them into their variable and fixed component. (ii) Selling price remains
unchanged with changed volume of sales.

(i) The behaviour of both costs and revenues is linear over the (iv) General price
level remains unchanged.

(There is only one product. If a fem produces more than one product, its remain. (v)
Efficiency and productivity of all factors of production remain constant (vi) Whatever
has been produced is sold and there is neither opening stock and nor clothing mock

Technique of Break Even Analysis The concept of break even can be explained
graphically as well as through Mathematical formulae Graphical Analysis of Break
Even Chart

The graphic presentation of break even explains break even analysis. This graph or
chart can be prepared differently as per the requirements. How to prepare a simple
break even chart is explained by drawing chart for different components of Break
Even Chart and finally these are combined.

In Fig. 3, FC shows the fixed cost curve. Total fixed cost is same irrespective of

volume of production, thus its line is parallel to volume line. Variable cost per unit
increases by same amount with increase in production so its line slopes upward. VC
is variable cost curve. If we draw a line parallel to variable cost line from the point
fixed cost curve starts,

we get total cost curve TC.

Sales line takes a slope depending on selling price. Higher the selling price steeper

the sales curve. It also starts from zero level. SP is sales line.

Since Break Even Point is the point where sales and total cost equate, point P

Identifies the breakeven point where SP and TC intersect each other.

Breakeven point can be explained in terms of rupees as well as number of physical
units produced. To know breakeven point in terms of rupees draw a perpendicular on
Y axis from point P. Thus OYI breakeven level is in terms of rupees. To calculate
breakeven point in terms of volume, draw a perpendicular on X axis from point P
thus OX is breakeven level in terms of number of units. This simple break even chart
gives a narrow sense break even analysis whereby we come to know breakeven
point.

For cost volume profit analysis, the break even chart is to be labelled further to give
a boarder look. Have a look on the figure-3.

V.C

-MS

Cen & Sales

FC

Output

Figures 3

All the terms except margin of safety and angle of incidence have been explained
earlier. Margin of Safety is the difference, either in rupee terms or in terms of
physical unit between the breakeven level and actual sales level if the latter exceeds
the former. We ca say that sales over and above breakeven point denotes margin of
safety. The bigger the margin, the higher the degree of safety. As the margin shrinks,
it indicates to the organisation that reduction in sales will curtail profits. Thus margin
of safety makes the organisation cautious of its profitability and its change pattern.
When margin of safety is below satisfaction, any of the following steps may be taken
to improve it:

Increase in D Increase in selling price in volume of sales

1) Reduce fixed cost iv) Reduce variable cost

Angle of Incidence is the angle formed at the intersection of total sales curve and
total cost curve to the right of the break even point. In our Fig. 3 Q is angle of
incidence this angle denotes the rate of profits. Wider the angle higher the rate of
profitability and narrow angle indicates low profitability. The management aim would
be to have as wider an angle as possible since it indicates high quantum of profit
once the fixed overheads are recovered.
(b)Profit Volume Chart Profit volume chart is another graphical exercise to study cost
volume profit relationship. This chart portrays the profit or loss at different levels of
sales as well as different sales prices of an item. It is prepared on the basis of same
information is required for the break even chart. Fig. 4 illustrates profit volume chart.
Its construction is different from break even chart as following steps are involved
therein:

(2) Fixed cost is presented in left vertical axis. is presented on right vertical axis.

(b) Profit (c) Sales are shown on horizontal axis. Horizontally and vertically. Ares

(d) Sales line divides P/V graph into two segments both above the horizontal line
represents 'profit area and below the line is loss area.

(e) Points are plotted for the given level of profits and fixed cost. Points as at stage
(e) are connected by a diagonal line which represents total marginal contribution of
the business.

(g) The diagonal line intersects horizontal sales line at break even point.

Profit Area

Sales Line

Profit

(Rs)

BEP

-MS

F. Cost Rs.

Loss Area

Figure 4

P/V chart can prepared showing effects or break even points for different products in
one chart where a business produces two or more products. In such situation P/V-
chart takes the shape as in Fig. 5.

Product

Profit of

1 Product z

Profit of 2
Profit

BEP (3)

DEPU

Loss of Y

Mited Cost

Product

Figure S

Analysis

Mathematical formulae for Break

Basically the break even charts are prepared to show cost volume profit relationship
in a simple manner. But to have detailed analysis of this relationship, calculating
break even level and other associated component with mathematical formulac is
desirable.

Break Even Point (In units) Total fixed cost

Sale Price-Variable cost

F C per unit (contribution)

S-V

(Per unit)

Fixed Cost X Sales

Break Even Point (in rupee value) = Sales-variable cost

FxS

S-V

It is simple to establish this relationship with the help of marginal we know S-V-F+P
(1) since at BEP, P is zero thus equation (1) reduces to S-V-F... (ii)

Cost equation.
Multiplying both sides by S we get equation (ii) as S(S-V) -F XS

FXS

S-V

or S

Example

A firm proposed to submit a project report to Haryana Financial Corporation for Joan.
The Corporation desires the details of costs and sales to estimate profit earnings of
the company. The firm submits the following data:

Production capacity working capacity

Variable Costs (Per unit)

Material Cost

Consumable stores Power charges

Selling charges Fixed Costs

Salary

Rent

Administrative

Selling price (after trade discount of 5%)

You are to compute:

(a) Break even point for first five years (b) Profits if sales are 10% above break even
point (c) Break even point if fixed cost is reduced by

20%.

Solution

First of all compute contribution (C)-SP-VC

C= Rs. 63- Rs. 43

(a)

Fixed cost BEP (units)

Rs. 15 lakh

Rs. 20

Rs. 20 per unit

Rs. 15 lakh Fixed Cost

= 0.75 lakh units

cost

3 lakh unit

60 per cent for first five years and then 80%

Rs. 30

Rs. 5

Rs. 3 Rs. 5

Rs. 5 lakh

Rs. 3 lakh

Rs. 7 lakh

Rs. 63

-0.75 lakh X Rs. 63- Rs. 47.25 lakh (b) New Sales (units) -75,000+ 10%-82,500

BEP (Rs.)

C for 82,500 units

Profits

-82,500 x Rs. 20- 16.50

-C-FC

lakh
-Rs. 16.50 lakh-Rs. 15 lakh -1.5 (c) New Fixed Cost - Rs. 15 lakh-20% -Rs. 12 lakh

New BEP

Rs 12 lakh 60,000 units

Rs. 20

A company may not be having only one product to be sold. It may have a well
defined sales mix of few products. In such case if BEP is to be calculated the basic
principle remains the same:

FC

BEP Contribution per unit

But here contribution per unit will be weighted contribution per unit for the sales mix
Say a firm has four products A,B, C and D be sold in 4:3:2:1 ratio having contribution
respectively as Rs20, Rs15, Rs10 and Rs5 per unit. Here weighted contribution will
be 0.4 X 20+0.3 x 15+ 0.2 x 10+ 1x 5=Rs. 15.30

If the fixed cost is Rs. 30.60 lakh the BEP for the mix will be

Rs. 30.60 lakh

Rs. 15.30

- 2 lakh units

Break even sales each type of product is: Product A=2 lakh units x 0.4-80,000

Product B=2 lakh units x 0.3= 60,000 Product C=2 lakh units X 0.240,000

Product D=2 lakh units X 0. I=20,000

4.0 Summary

After the calculation of taxable income of a company, the next step is the
determination of the tax burden and its payment. For this purpose, the information
about tax rate of companies, calculation of minimum alternative tax, provisions for
payment of advance tax and provision for payment of tax along with the filing return
is required. Incomes and taxed at rates mentioned in the income Tax Act. Income
from business broadly consists of receipts less deduction associated with activities
which can be attributed to the character of business. Gross total income represents
the summation of income from business and income from other heads. The
deductions under Chapter VIA of Income Tax Act are allowed irrespective of the
source of income of income and are akin to incentives.
In applying the framework for deriving the taxable income, certain provisions and
considerations must be taken into consideration. Break even point is a technique
which relates costs, selling price and volume of sales to highlight profit earning
capacity at different levels of activities. 50 Suggested Readings

1. Prasanna Chandra Projects: Preparation, Appraisal, Budgeting and

implementation - Tata Mcgraw Publishing Co. Ltd., New Delhi. B.M. Patel, Project
Management, Vikas Publishing House, New Delhi.

2.

V.K. Singhanin, Income Tax Law and Practice, Taxman Publishing, New Delhi. Self
Assessment Questions 6.0

1. Discuss how income tax Act permits depreciation as a tax planning instrument

2 What are the main concessions for establishing a new industrial undertaking as
incorporated in Income Tax Act? Write a detail notes on Break Even Analysis.

Discuss the provisions relating to set off and carry forward of losses under Income

Tax Act. What is the relevance of such provisions in case of a new project?

MBA-Project Management

Paper: M

Updated by: Dr. M.

Financial Projection in Project Management

LESSON NO.7

MBAFM-205

Structure

1.0 Introduction 2.0 Objectives:

3.0 Presentation of Contents 3.1 Sales Forecast

3.2 Cash Forecast

3.3 Projected Income Statement 3.4 Projected Balance Sheet

3.5 Quality Financial Forecasting

3.6 Projected Cash Flow Statement 4.0 Summary

5.0

Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

Every project is launched with a target that over its life, financial position will be
sound enough. Such aspiration of sound financial position is to be converted into a
statement when the project is to be evaluated. Such statement is prepared on the
basis of financial projections of expected actions of management. This forecasting is
an outcome of coordinated outlook of the project. All aspects affecting financial
position are considered to work out the projections. Forecasting besides assessing
financial strength of project can be used as a control device for evaluating
performance of related segment of the project Preparing such statements gives an
insight of the whole working of the project, thus to justify procurement of funds
becomes easier and convincing. It certainly helps in improving the utilization of
resources. This exercise enables to pre-test financial viability of project

Financial forecasting is not a one time job. It is a continuous programme. Of course,

when project is being planned at its initial stage evolving financial variables, forming
basis of financial forecasting is a ticklish job. Financial forecasting, if is to be done for
a running business it is comparatively simpler since reliable base is available on
which forecasting are developed.

A comprehensive system of financial forecasting has the following major elements:

Sales forecast Cash forecast

Projected Income Statement

Projected Balance Sheet

Projected Cash Flow Statement

2.0 Objectives

After reading this lesson, you should be able to (a) Explain the importance of
financial forecasting.

(b) Discuss the procedure of cash forecasting. (e) Develop the projected income
statement and balance

(d) Prepare a projected cash flow statement.

3.0 Presentation of Contents

3.1 Sales Forecast Sales are the most crucial factor on which whole financial
forecasting is based. It is sales which determine the level of operations or capacity
level of the business. Most of the financial variables are projected in relation to the
estimated level of capacity utilization. The sales may be forecasted by adopting rule
of thumb method or after making use of detailed analysis of competitive firms,
market research and professional economic surveys. If period of forecast is long,
breakdown of the expected sales by months is useful to forecast inventory
requirements. Although sales forecast is the job of marketing executive, financial
managers play significant role because he is to provide required finance. These
forecasts are made for long term say for next five years as well as for short term say
for next six to twelve months. Long term forecasting also helps in investment
planning. Short term sales forecasting is of immense use for preparing cash budgets
and also for estimating other variables of current assets like stock, bills receivables,
debtors etc. Based on sales is material procurement which helps in determining the
quantum of bills payable and sundry creditor’s items of current liabilities. Long term
forecasting of sales gives indication of capacity, thus size of fixed asset is also
influenced by the size of expected sales. Sales forecast, thus, gives direction to
balance sheet contents. Similarly sales budget influences the income statement.
Variable expenses are in proportion to production and sales. Sales proceeds are
obviously reflected by sales forecast.

3.2 Cash Forecast

Cash acts as lubricant in business transactions. Easier the cash position better is
financial position in short run at least. Cash forecasting is preparing cash budget. It
identifies the volume and timings of inflow and outflow of cash in future. Matching of
cash inflows and outflows to overcome the situation of cash surplus or shortage.
Cash flows can be on account operating activities, financing activities, investment
activities and miscellaneous activities. This break up of activities makes it easy to
identify the sources of information for the budget. Cash flow from operating activities
can be compiled from estimated or project income statement. Cash inflow can be
estimated on the basis of sales budget after taking into account the credit policy
being allowed to customers. Cash outflows on procurement of raw material etc. are
determined on basis of procurement schedule. Payments creditors depend on credit
policy offered by the creditors. Financing activities refer w raising long term funds,
say, through issue of share capital, debentures, bonds, fixed deposits etc. It also
covers redemption of preference shares, debentures, bonds and fixed deposits.
Returns on these sources of funds are also covered in this set of activities. This
actually depends on long term strategy evolved by the firm. Investment activities
refer how the funds raised are invested especially in fixed assets and marketable
securities. A sale of these assets is also covered in this category of cash flows.

For project planning, long term cash forecasting is very important. These forecasts
are generally prepared for a period ranging from two to five years. It gives a broad
picture of a firm's financing needs and availability of investible surplus in future. Such
forecast facilities appraising and planning capital investments. Requirement of long
term borrowing is also projected in long term cash forecasting. It will also disclose
whether sufficient ca will be generated internally to meet the working capital
requirements. No hard and fast rule is prescribed for the format of long range cash
forecasting but normally adjusted net income method is adopted for preparing
statement of such forecasts.
Long term cash forecasting is certainly a typical exercise to undertake. The reliability
of such forecasts depends on the accuracy of the expected trends on which cash
position of the firm depends. To ensure accuracy in term-cash forecasting it is better
to revise the forecasted figures at reasonable intervals.

Cash forecasting for short period is most popular for working capital estimation Such
an exercise is of not much use in project evaluation but still to gather financial
strength position of the project in initial year this forecasting is worth. Traditionally
this forecasting is based on 'Receipt and payment method'. All expected receipts and
payments over the period of forecasting are included. The information useful for such
detailed forecasting are cash sales, payments from debtors, cash purchases,
payment to creditors, raising bank overdraft, repayment of loans, sale of capital
assets, receipt of returns on investment e.g. interest or dividend. This forecasting
may be done for sub period also like daily, weekly, monthly, half yearly etc. The
length of sub period depends on the quality of control to be exercised on cash. When
problem of cash is very crucial, daily forecast is resorted to. As cash also costs, a
short period of forecasting has its justification.

Projected Income Statements

Projected income statement is also very useful statement while evaluating a project
since this statement gives a reasonable estimate of expected sales, expenses,
profits. Dividends, depreciation etc. Such statement is normally prepared on the
basis of budgeted sales. The main heads for which forecasts are made are cost of
goods sold, selling cost administrative expenses and other items.

Viewing the fact that income is outcome of sales, projected income statement can be
prepared on percentage basis of sales. This assumes that all items of income
statement have defined relationship with sales. This relationship has to be defined in
clear terms. For computing cost of sales forecast is to be made for material used,
conversion cost, purchases, closing stock etc. Detailed forecast may be required at
initial stage to get this data of operations. Per unit estimate of these items can also
be used. Sometimes ratio of gross profit and sales is used to get idea about cost of
goods sold. Similarly for selling and distribution expenses a percentage to sale can
be evolved keeping in mind what type of infrastructure is envisaged for the project.
Administrative expenses which are more of a fixed nature are to be handled
carefully. Policy regarding charging of depreciation is also to be decided but again it
hardly has a relation with sales. These all forecasts give us the net result of
operating profit. Depending on financing alternatives resorted to, provision for
interest etc. are to be made. For projecting dividends, again sales cannot be suitable
base. It more depends on policy of management. After providing all these data a
Projected Income statement is ready.

Performa Income Statement for 20x1 and 20x2 (as a percentage of sales)

Net Sales
Cost of sales Gross profit

Admn. Expenses Selling Expenses

Operating Profit

Interest on borrowing Earnings before tax

Tax

Earnings after tax Dividend

Retained earnings

Average per cent of sales 100

60

40 10

25

20

12

For sale of Rs.

50 crores 50

30

20

2.5

12.5

2.5
10

2.5

1.5

For sale of Rs. 60 crores

60

30

24

15

12

4.8

7.2

1.8

The exercise undertaken to compute projected income statement as per cent of is

simple to operate but has limitations too in its approach. Limitations are its rigidity.
decided percentage is to be followed even if its weightage differs. Complete variable
expenses with sales can easily be challenged. Here budgeted expense method is as
the situation changes the budgeted estimate is varied. Thus it is advisable total
percent of sales method with budgeted method to prepare Performa income
statement expenses which are fixed in nature or can hardly be defined in relation to
sales, but figures may be incorporated. Such expenses can be interest charges,
depreciate administration expenses, income tax, appropriations of profits etc. to com

Performa income Statement for 2011 and 2012 (as per cent of sales and budgeted
figures)

Basis
20x1 Sales of Rs. 50 crores

Rs. In crore

50.00

30.00

20.00

2.50

2.50

3.60

11.40

2.00

9.40 4.70

4.70

1.88

2.82

Average % of sales

100

60

40

Budgeted

Budgeted

As per EBT

Company EAT

Balancing
rates

Particulars

2012 Sales Rs. 60 cror

Rs.In crore

60.00 36.00

24.00

3.00

2.70

3.60

14.70

2.00

12.70

6.35

6.35 2.54

3.81

Net sales

Cost of sales

Gross Profit

Admn expenses selling Expense

Fixed

Operating profit Interest on debentures

EBT Tax

EAT Dividends

Retained earnings

3.4 Projected Balance Sheet

A projected balance sheet reports the effect of the plan of operations on the
assessee liabilities and capital of the firm. To assess the requirements of these
elements of balm sheet, projected income statement is prepared Capital investment
schedules, statement

Policy

50%

40%

of

of

of finance, cash forecasting statement, working capital projections etc. provide

formation. Projected income statement has been discussed earlier. Let us have a
look on means specimen of capital investment schedule.

Particulars

New building

(Phase-1) Land

Power motor Machinery

Unit 1

Unit 2

(Attaining Furniture

New Building

(Phase II

Tech. Known-how

Machinery Unit III

Unit IV

Total

40% capacity)
1 year Rs.120 lakh

Rs.900 lakh Rs. 20 lakh

Rs. 40 lakh

Rs. 40 lakh

3rd year

4th year

Rs. 3 lakh

Rs.17lakh

Rs 20lakh

Rs. 181akh

Rs 2 lakh

Rs.6 lakh

Rs.26 lakh

Rs. 20 lakh

Rs.21akh

Rs.10lakh Rs. 18lakh

Ra 33 lakh

Rs.1140 lakh

Rs.82 lakh

Capital investment schedule gives estimates of fund requirements for acquiring nxed
assets. The schedule shown above is for a new unit. For existing units there may be
situations like sale of old assets, additions of new models etc. Working capital
projections provide information about current assets and current liabilities which may
be incorporated in balance sheet. In working capital projections we forecast stock of
raw material, stock of finished goods, debtors, cash in hand, prepaid expenses,
investments, loans and advances etc. for current assets and for current liabilities
items like sundry creditors, trade advances, borrowings from banks, expenses
outstanding, tax liability etc. These items are forecasted on basis of sales, purchase,
credit policy, payment policy etc. of a firm. of finance, cash forecasting statement,
working capital projections etc. provide formation. Projected income statement has
been discussed earlier. Let us have a look on means specimen of capital investment
schedule.

Particulars

New building

(Phase-1) Land

Power motor Machinery

Unit 1

Unit 2

(Attaining Furniture

New Building

(Phase II

Tech. Known-how

Machinery Unit III

Unit IV

Total

40% capacity)

1 year Rs.120 lakh

Rs.900 lakh Rs. 20 lakh

Rs. 40 lakh

Rs. 40 lakh

3rd year

4th year

Rs. 3 lakh

Rs.17lakh
Rs 20lakh

Rs. 181akh

Rs 2 lakh

Rs.6 lakh

Rs.26 lakh

Rs. 20 lakh

Rs.21akh

Rs.10lakh Rs. 18lakh

Ra 33 lakh

Rs.1140 lakh

Rs.82 lakh

Capital investment schedule gives estimates of fund requirements for acquiring nxed
assets. The schedule shown above is for a new unit. For existing units there may be
situations like sale of old assets, additions of new models etc. Working capital
projections provide information about current assets and current liabilities which may
be incorporated in balance sheet. In working capital projections we forecast stock of
raw material, stock of finished goods, debtors, cash in hand, prepaid expenses,
investments, loans and advances etc. for current assets and for current liabilities
items like sundry creditors, trade advances, borrowings from banks, expenses
outstanding, tax liability etc. These items are forecasted on basis of sales, purchase,
credit policy, payment policy etc. of a firm.

We combine projected investment schedule working capital forecast and tentative

means of financing statement the projected balance sheet for two years 20X1 and
20X2 will be as under.

Projected Balance Sheets

Applications of funds fixed assets:

20x1

900

120
40

20

40

20

20x2

900

137

85

20

40

40

290

80

80

50 15

15

50

1802

Land

Building

Machinery

Power motor

Furniture

Technical knowledge

Stock (raw material) Finished inventory

Accounts receivable

(a) Domestic

(b) Foreign

Unexpired insurance Marketable securities

Cash and bank

Total

Current Assets

260

80

40

30

10

25

50

1635

Sources of funds Current liabilities

Account payable

Trade Advance

Interest Payable

Tax liability

Bank overdrafts

160

140

8 20

16
180

160

12

26

Long term liabilities

Loans (secured)

Fin. Inst.

Bank

Unsecured loans

Share capital

Retained earnings

Total

Projected Balanced Sheet as present of Sales Method A simple approach to forecast

balance sheet ingredients is to use sales as foundati for forecasting. Each item of
balance sheet is computed in terms of percentage of anna sales. For a new project a
study can be made of similar unit. To illustrate it let us take example. Following is the
average balance sheet of a unit for making a sale of Rs. 50 lakhs

Rs. In lakhs

Liabilities Capital

Loans

Bills payable Bank overdraft

Rs. 20.0

7.0

5.0

2.5

34.5
Assets

Fixed Assets Stock in hand

Sundry debtors

Cash

Ro.

15.0

10.07

B.S 1.0

34.5

To develop projected balance sheet from the normal balance sheet first we are to
identify the items that can have association with sales. If we have higher sales our
working capital requirements will increase. Thus on asset side we require more stock
in hand, sundry debtors and cash. On current liabilities there will be simultaneous
increase in bills payable and bank overdraft. Of course capital is not to change as
sales increase whereas additional fixed assets may be required.

If our company desires to have a sale of Rs. 80 lakhs what should be the funds
required. We can take help of the following equation to assess our requirements:

Additional

Total assets

Total sales

Funds needed -

(Change in sales) -

100

100

91

1000

1635

200
100

118

1000

Capital & Reserves

1802

Liabilities

Sales

34.5 ---(30).

50

-20.7-4.5 -16.2

Thus, projected Balance sheet for our project will be as under:

Rr.

36.2

7.0

8.0

4.0

55.2

Liabilities

Capital

(Balancing figure)

Loan

Bills payable

Bank overdraft
Assets

Fixed assets

Stock in hand

Sundry debtors

Cash

Rs.

24.0

16.0

13.6 11.6

55.2

(Assuming all additional funds is to be raised in form of capital only)

15 Quality Financial Forecasting

Every finance executive is made responsible to arrange the required funds and to
show best results thereof at least as envisaged in his financial forecasting. It is
understandable but one point needs to be appreciated that all activities of business
are not controlled by finance executive. Thus top management has to create an
environment wherein financial executive for his forecasting exercise gets necessary
and quality bound data. Forecasting of other departments to a very great extent
influence projected statement of income and balance sheet. To make forecasting
more understandable, it is necessary that key factors and significant assumptions
are to be spelled out clearly. It is necessary since we cannot consider forecasting
unchangeable. Business is very dynamic so is its environment. As it changes
forecasting needs to be changed. Provisions for revisions always have to be
provided otherwise forecasting will always be a bitter pill to swallow.

Long range forecasting is a good strategy but it should be value based and logical.
Projected statements should not be made resembling to actual statements content

(Change in sales)

7.5

50

(30)
120 wine. It means that all details required say in actual income statement and
balance may not be compiled in projected statements detailed workings make
forecasting tedious task and time consuming. Forecasting by other organisations
should not adopted as such, as it may not suit every organisation.
3.6 Projected Cash Flow Statement The financial institutions which provide finance
for project, normally ask for projected cash flow statement. This statement gives an
idea about the main sources and applications of cash. It is different from cash budget
in the sense that in projected costs statement cash forecast we do not provide for
notional cash items or items like depreciation. Further profit element is not presented
in cash forecasts. This statement is compiled on the basis of projected income
statement and projected balance sheet. Its specimen format is give as statement.

Cash Flow Statement

20X 1

Cash outflow

New Plant and Machinery New Buildings etc. or additions

Increase in working capital

Repayment of loans Redemption of debentures

Interests on loans Increase in investments Increase in investments

Taxation

Dividends-Equity

- Preference

Cash Inflow
Sale of fixed assets

Sales of investments

Short term borrowings

Long/medium loans Profits after tax

+Depreciation

+Interest

Issue of Share capital

Equity

Preference
Issue of Bonds/debentures

Financial institutions have their specific formats which applicants for loans are to fill

20 X2

20X3
And file with all required details. In general to prepare projected cash flow statement
the basic principle to be followed is estimating how cash flow streams for the firm will
be affected, if the project is accepted. Thus the receipts and payments assuming that
the project has been accepted have to be taken into account. Further, cash savings
on account concessions must be considered. After tax cash flow should be the basis.
A peculiarity in cash flow statement desired by lending institution is that interest m
obligation of tax debt (presuming it has been granted) is not to be considered as an
expense. The logic for this feature is that interest is a transfer payment. To avoid its
double counting it is excluded. This implies that if profits are given after interest then
along with depreciation. Interest will also be added back. Suppose there is project
with proposed financing pattern of debt-equity ratio of 3:2 with total funds needs of
Rs. 56 lakh, projected sales are Rs. 90 lakhs, projected material cost is Rs. 25 lakh,
conversion cost is Rs. 27 lakh, depreciation Rs. 5 lakh, administrative and selling
expenses Rs. 10 Inkh, interest is payable at 10 per cent if tax rate is 40 per cent,
what will be its projected cash flow:

Rs in lakh

90

Sales Less

Material expenses

Conversion expenses Depreciation

Admn. &selling expenses

25

27

10

Interest @ 10% on Rs. 30 lakhs 3

Profit before tax Tax@ 40%

Profit after tax

Cash flow:

Profits Rs. 12 lakh + Depreciation Rs. 5 lakh + Interest Rs. 3 lakh = Rs. 20 lakh. This
Rs. 20 lakh is cash inflow for the project of Rs. 50 lakh. Illustration

A project is to be submitted to HSIDC for a loan proposal of Rs. 250 lakhs. The
projects will a cost Rs. 600 lakh including working capital requirements of Rs. 160
lakh. Public offer will be for Rs. 125 lakhs. Loan at 10% is to be raised in two
instalments of Rs. 150 lakh in first year and Rs. 100 lakh. A plant for Rs. 370 lakh is
to be bought in first year and payment is to be made in two equal yearly instalments.
Buildings will be raised in

70

20

12

First year for Rs. 275 lakhs. Total depreciation for one year will be Rs. 30 lakhs.
Payment on interest on loan outstanding will start by paying at end of 3rd year.
Profits after tax is expected to be Rs. 5 lakh in first year, Rs. 40 lakh in second year
and Rs. 50 lakh in 3rd year. Loan repayment of Rs. 20 lakh starts in 3rd year.
Prepare projected cash flow for the project.

Solution Projected Cash flow statement for 3 years

Ist year (Rs.)

185

275

160

520

2 year (Rs.)

185

(Rs. in lakh) 3rd year (Rs.)

20

20

(Rs. In lakh)
Particulars

Cash Outflow

Plant

Building

Working

Loan repayment

Cash in flow

Share capital-public

Promoters

Loans

Profit after tax

Working

Loan repayment

85

125

200

150

100

(5)

(30) 35

510

(40) (30)

(50)

(30) (15)

70
95

95

Financial forecasting by percentage of sale method has some critical assumptions.

These are critical in the sense that these may not fit a real world context. This is of
course simple to operate but risky to rely. If this method is followed viewing the
following features, it can serve better purpose:

The strategic changes, which a company may resort to be meaning, acquiring or

diverting a business or if it changes its financial structure, makes forecasting mere
difficult. Altogether new plan may have to replace the existing plan.

Unforeseen changes in the economic set up may significantly affect the accuracy of
the forecast, Streams of revenue and or expenses may change thus, Performa
statement may not be reliable. It is desirable that for different economic situations
different plans may be prepared. Fixed assets hardly change with sales. Firms
cannot add in small amount of fixed assets. We must forecast the level of fixed
assets needed for each year of the
Planning horizon to support the estimated level of revenues. We normally ignore the
fact that over a period of time we enjoy economies of scale. This feature is not
reflected in forecasting process. To accommodate this feature, financial planner
must forecast new parameters for items like production cost, profit margin etc. over
the planning horizon. In situations where such relation of sales with other variable is
at a simple, variable linear regression method may be adopted. This method is seen
to be superior for

Forecasting financial requirements particularly for long term forecasts when a firm is
likely to have base stock of inventories or fixed assets. The ratio of items to sales
declines as sale increases. Thus large error sets in under percentage to sale
method. A more sophisticated method for forecasting used may be multiple
regression method. In simple regression sale is assumed to be a function of only one
variable whereas in multiple regression, sales are recognised to depend upon a
number of variables.

4.0 Summary

A comprehensive system of financial forecasting has the elements of sales forecast,

cash forecast projected income statement, projected balance sheet and projected
cash flow statement. The sales may be forecasted by adopting a rule of thumb
method or after making use of detailed analysis of competitive firms, market
research and professional economic surveys. Cash forecasting in preparing cash
budget. Cash budget identifies the volume and timings of inflow and outflow of cash
in near future. Projected income statement gives a reasonable estimate of expected
sales, expenses, profits, dividends, depreciation etc. and is prepared on the basis of
budgeted sales. A projected balance sheet reports the effect of the plan of operation
on the assets, liabilities and capital of the firm. Projected cash flow statement gives
on idea about the main sources and applications of cash.
5.0 Suggested Readings

(1) Project Preparation Appraisal Budgeting and Implementation by Prasanna

Chandra (2) Project Management by B.M. Naik.

(3) Project Management by P. Gopal Krishnan & V.E. Ram Moorthy

(4) Financial Management by I.M. Pandey

(5) Financial Management by Prasanna Chandra

6.0 Self Assessment Questions 1. How does forecasting financial requirements in

advance of need assist the financial

manager to perform his responsibility more effectively?

2.How percentage to sale method is useful in financial forecasting?

3. What is the procedure of cash forecasting? Explain.

4.How should you develop Performa balance sheet and income statement?

5.Their procedure with examples.

Prepare a projected cash flow statement with imaginary figures.

Explain

DIRECTORATE OF DISTANCE EDUCATION

KURUKSHETRA UNIVERSITY KURUKSHETRA - 136 119

MBA-III

Paper-MBAFM-205 Lesson No.8

1. Introduction

2. Objective

Writer: Ajay Solkhe

PROJECT FINANCING: Means of Finance, Institutional Finance, Incentives and
Subsidies

3. Presentation of the Contents

3.1. What is Project Financing?

3.2. Characteristics of Project Financing 3.3. Difference between Conventional

Financing and Project Financing

3.4. Requirements for Project Financing 3.5. Structuring of Project Finance

3.5.1. Functional or Hierarchical Organization

3.5.2. Task Force Organization

3.5.3. Matrix or Horizontal Organization

3.6. Ideal candidates for Project Financing

3.7. Rationale for Project Financing

3.7.1. Need for Special Purpose Vehicle

3.7.2. Need for Contractual bundling

3.7.3. Free cash flow conflict

3.7.4. Efficient structuring of debt contracts

3.7.5. Reducing asymmetry information and signalling cost

3.7.6. Project Finance Versus Corporate Finance

3.7.7. Project Finance Arrangement: Stages in Project Finance 3.8. Risk

identification, assessment, and mitigation in Project

3.8.1. Finance deal structuring 3.8.2. Completion risk

3.8.3. Technological risk

3.8.4. Raw material supply risk 3.8.5. Operation and maintenance risk

3.8.6. Economic risk

3.8.7. Financial risk

3.8.8. Currency risk

3.8.9. Political risk

3.8.10. Environmental risk

3.8.11. Force Majeure risk

3.8.12. Implications for Project Financing

3.8.13. Project Finance Risk and their allocation

3.9. Means of Finance

3.9.1. Equity Share

3.9.2. Preference Share

3.9.3. Debentures/Bonds/Notes

3.94. Term Loans

3.9.4.1. Advantages and Disadvantages

3.9.5. Promoter's Contribution to Projects

3.9.6. Others

3.9.6.1. Deferred Credits

3.9.6.1.1. Suppliers Credits 3.9.6.1.2. Buyers' Credits

3.9.6.2. Lease Financing

3.9.6.3. Unsecured Loans

3.9.6.4. Internal Accruals

3.9.6.5. Bridge Loans

3.9.7. Disbursements of Loans/Loans Arrangement 3.9.7.1.Terms/Conditions for

granting term loan for projects

3.9.7.2. Procedure

3.9.7.3. Monitoring and Follow-up

Institutional Finance

3.10.

3.10.1. History
3.10.2. Financing by all FI-An Overview

3.10.2.1.

3.10.2.2.

3.10.2.3.

3.10.2.4.

Overall Position of Sanctions and Disbursements

Institution Wise assistance

Sector wise assistance

Forms of Assistance

3.10.3. Certain Special Scheme of Fls

3.11.

Incentives provided by 3.11.1. Incentives for Export Oriented Units the Government

3.11.2. Incentives for Units in Industrially Backward Area 3.11.3. Incentives for Small
Scale Industries

3.12.

3.12.1. Areas Subsidy

Subsidies provided by the Government

3.12.2. Product Subsidy

Financial Modelling

3.13.1. Cash flows to equity & Cost of equity valuation Approach 3.13.2. Monte Carlo
Simulation approach to assess risk

3.14.

Case Study of Noida Toll Bridge

3.14.1. The Project history

1.14.2. The Sponsors of the Project 3.14.3. Project Cost

3.14.4. Project Financing

3.14.5. Fiscal benefits to SPV

3.14.6. Risk Identification, Assessment & Mitigation

4. Summary

5. Suggested Readings/Reference Material & Self Assessment Questions(S.A.Q.)

1. Introduction

Project finance is a vehicle to raise funds through loans for mega projects is power,
telecommunications, roads, railways, theme parks, airbus, oil & gas and other
infrastructure sector. It is based on lending against project cash flows rather than on
the strength of the sponsors' or promoters' balance sheet. The debt ratio in case of
project finance is very high in order to discipline the management and reduce agency
cost. It ranges from 60% to 95%.

To use the concept of project finance, a special purpose vehicle (SPV) created. For
example, in case of Konkan Railway project, Konkan Railway Corporation Limited
was created under the Companies Act, 1956. Similarly, in case of Noida Toll Bridge,
Noida Toll Bridge Company Limited has been created.

The project assets and project cash flows are segregated from the sponsors There
are agreements between the SPV and the lenders, sponsors, raw material suppliers,
off-take parties, government, Operation & maintenance (O&M) contractor and
engineering, procurement & construction (EPC) contractor. It is termed as
contractual bundling. The transaction cost in project finance is as high as in case of
mergers & acquisition deals.

3.4.3. Availability of Raw Material

The raw materials and other inputs required to manufacture desired level of output
over the life cycle of the project should be available. The project SPV may enter into
an agreement with the raw material suppliers to share the input risk. If the project
uses natural resources such as oil reserves in case of oil & gas project, bauxite
reserves in case of aluminium project, the project SPV may enter into an agreement
with the Government for use of natural resources over the life of the project.

3.4.4. Competent Management

The project entity must have competent management in place in order to ensure
successful execution of the project. If it is not there, then Project SPV must enter into
an agreement with the engineering firms. For example, in case of Hong Kong
Disneyland Project, the project has to be operated by Disney against a management
fee.
3.5. Structuring of Project Finance

A Project firm is responsible for completing an assigned task an schedule within

coast and according to established standards. Project structures can take various
forms, exemplified by functional, matrix or task force. They can be clinched or
severed depending on the need of the firm. The classic structures fundamentally
prevail in project:

3.5.1. Functional or Hierarchical Organization Reportedly the most common type of

organisation in the world is pyramid shaped, with stratified management levels
subordinated by distinct horizontal tiers. Work activities are divided functionally by
specialists and disciplines.

3.5.2. Task Force Organization

Under this type of structure human resources are pooled for a project team are
largely repeated from other personalities, and centralized project management
directs the project efforts

3.5.3. Matrix or Horizontal Organization The matrix organisation is a hybrid structure

aimed at optimizing strengths and minimizing weaknesses of functional structure in
which extended lateral mobility exits. This type can accomplish complex or different
projects. It is better to have a completely

Autonomous organisation called "completely projected organisation" rather partially

projected organisation." In a project, the organisation team working is important
whatever the structure of the firm be. The project teams are not static groups. The
team should be an aligned and energetic. Line organisation, line and staff
organisation and functional organisation are generally suitable to firms wave
activities are stereotypes and continuous. The above three types are suitable for
capital intensive projects.

3.6. Ideal candidates for Project Financing The ideal candidates for the project
financing are those projects that

i. are capable of being operated as independent economic units in a company form

of organization

ii. Could be successfully completed without any uncertainty are positive NPV projects
to the sponsors

A few examples of these projects are:

i. Rs. 1400 crore Konkan Railway Project: Construction of 768 Kros long
railway line between Roha in Maharashtra to Mangalore.
ii. Rs 408.2 crores Delhi Noida Road Bridge
 iii. $13 billion Airbus A380 project of Airbus: World's largest commercial jet
iv. $2.4 billion Oil-field development Petrozuata project in Venezuela
v. $1.4 billion Mozal Project in Mozambique: Aluminium smelter
vi. $4 billion Chad-Cameroon Petroleum Development & Pipeline Project
vii. $2 billion Petrochemical Plant in Kuwait known as Equate Petrochemicals
Project
viii. Euro 934 million Poland's A2 Motorway

3.7. Rationale for Project Financing When a firm is undertaking a capital investment
project, the issues before it are

Should the project be taken on firm's balance sheet or as a separate strategic

business unit be having a separate legal entity? What should be the debt on the
balance sheet of separate legal entity?

How should the loan agreements be structured? Should the lenders have full
recourse or no-recourse to the sponsors' balance sheets for their claims?

3.7.1. Need for SPV (Special Purpose Vehicle)

When a company has multiple projects on its balance sheet, the ability of sponsors
to control the operations of the company gets affected. In case of company form of
organization, there is separation of ownership from the management. The
management may use free cash flows to maximize sales and assets through
unrelated diversification, which may not necessarily create shareholders' wealth. The
management may pay themselves the high salaries and perquisites.

To discipline the management, a separate organizational entity is created. The

management of SPV enters into an agreement with the sponsors to pay all free cash
flows to equity as dividends. The project has a finite life so does the SPV. The SPV
ceases to exist at the end of the project life or concession period. In case of
corporate finance, the assumption is going concern. The entity has neither the
necessity nor the intentions to discontinue its operations in the near future.

3.7.2. Need for Contractual bundling Project finance deal structuring involves
agreements between the SPV and all the stakeholders i.e. lenders, sponsors,
providers of raw materials and other inputs, engineering, procurement & construction
contractor, operation & maintenance contractor, customers & off-take parties, and
the government. The project financing arrangement will be successful if it is in the
best interest of all the stakeholders i.e. "commonality of interests" must be there.

In the case of Petrozuata Project, the Conoco (oil & gas subsidiary of El Du Pont &
Company and one of the sponsors of the Petrozuata project) wanted assured supply
of crude oil for 35 years for one of its refinery. The Venezuelan government wanted
to develop its oil & gas sector. Venezuela is rich in terms of availability of heavy,
extra heavy crude oil. They required US$65 billion for developing the sector. Hence,
they want foreign participation in this sector. Hence, the Petrozusta project was
taken up in joint venture with PDVSA, the oil & gas PSU of Venezuela.
3.7.3, Free cash flow conflict In a corporate finance each project is though separate
SBU but not a distinct Hence, all projects appear on the balance sheet of the
company. The board of directors determine as to how the free cash flows will be
used, whether for distribution dividends amongst the shareholders or for
reinvestment for growth and diversification The free cash flows are cash flows
generated by the operations of the company meeting all operating expenses
including taxes and normal capital expenditure and working capital needs. There is
growing concerns that management may not use the in for free cash flows in the
best interest of the shareholders. They may go in diversification either through
green-filed projects or through mergers & acquisitions. T unrelated diversification
may destroy shareholder value, though it may ensure perquisites and long-term job
contracts for the management.

In project finance, each project is a separate legal entity. The management of SPV
enters into an agreement with the sponsors to distribute all free cash flows to enquiry
as dividends. Hence, project finance creates value by avoiding free cash flow conflict

3.7.4. Efficient structuring of debt contracts

There is inherent conflict of interests between the shareholders and lenders. The
Lenders. The management may act in the interest of the shareholders at the
expense of Tender The management may go in for high-risk negative NPV projects
or may reject low-d positive NPV projects and in the process value migration from
lenders to shareholder may take place.

In project finance SPV enters into an agreement with the leaders wherein certain
covenants restricting the freedom of the management are provided. These
covenants pertain to cash waterfall, dividend policy, debt ratio, maintaining a
particular level of working capital and diversification programme.

The cash waterfall covenant is like maintaining an escrow account, where all
revenues are deposited. The trustees manage this account. They first meet the
operating expenses and keep reserve for three months for operating expenses.
Then, claim of the lenders is met and reserve for next six months for debt service is
maintained. Thereafter, the residual cash flows are distributed as dividends. This
arrangement gives a lot of confidence to the lenders. The debt ratio covenant is that
debt ratio will not exceed agreed upon level. In project finance, it will be very high in
the beginning say 60% to 90% in year 1 and then reduce gradually every year, loan
is paid off. It will reduce to zero by year 12 or 15, as by that time the entire loan will
be paid off. The dividend policy covenant is that only residual cash flows after
maintaining reserves for operating expenses and debt service will be paid to
sponsors as dividends. If in a particular year, the dividend payment amount exceeds
the debt service, the dividend Payment amount will be restricted and excess cash
flows will be used for retiring the
debt

The working capital covenant is that SPV will maintain a particular level of Working
capital by bringing in sponsors contribution. The SPV will not diversify; as project
finance deal is for a particular project. The entity will come to exist, once the
concession period is over. In case of Petrozuata project, by structuring the debt
contract more efficiently, they were able to get BBB credit rating as against B rating
of Venezuela government and PDVSA, one of the sponsors of the project. By doing
so, there were able to raise debt a 200 basis point lower that what was the rate for B
credit rating

3.7.5. Reducing asymmetry affirmation and signalling cost

There is information asymmetry regarding future performance of the project between
the Management and the capital market. Further sharing information with the market
on project may result in losing competitive advantage. In project finance, when SPV
raises a bage debt, it provides a signal to the market that the project is expected to
generate efficient cash to service the debt in a timely manner. In case of debt, SPV
has agreed upon to make contractual payments. Thus, issuing debt instead of equity
in case of high risk projects provides a positive signal to the market and reduces
information asymmetry.

3.7.6. Project Finance versus Corporate Finance Project Finance Corporate Finance
Criterion Organization

Each business separates SBU but not a separate legal entity. Hence all projects
assets & cash flows are reported together in the balance sheet

The cash flows of each project are mixed up together The Board of 135

Each project is a separate legal

Entity. • Project specific cash flows and assets are thus segregated and reported
separately

• The agreements between SPV

Monitoring and Control

Debt Ratio

Risk Sharing

Directors of the company monitors and control the overall performance generally it is
very Low. The lenders have recourse sponsors NO the balance sheet if a particular
project fails, since the failed project part of company's balance sheet.

The leaders consider the company's assets and cash flows while deciding whether to
fund a particular project or not.

The company raise can finances quickly. as debt capacity may ΠΟΙ have been fully
exhausted, since a large number of projects are there on its balance sheet

The internally generated funds could be used for new projects

The company is a going concern and the different stakeholders guide and rather
disciplines the Board of Directors to monitor and control the performance Generally it
is very high in Order to reduce the agency co . The lenders have no recourse to the
sponsor’s balance sheet once the project has been successfully implemented. The
lenders have recourse the project assets and project cash flow for meeting their
claims

The lenders decide on the strength of the project assets and future cash flows
expected to be generated by the project

The financing arrangements are highly structured and involve lot of transaction cost
No new debt can be raised once financial closure has been reached.

. The residual cash flows are to be distributed as dividends and cannot be ploughed
back

The SPV has a finite life and comes to an end once the concession period is over.

Structure of Debt Contracts

Financial Flexibility

Life| Free Cash

The Board of Directors of the company has to decide how much of the free cash
flows to be paid 13 dividends and how much reinvested. to be

The management of SPV has no choice because of the MOU It has to pay all equity
cash flows as dividends

3.7.7. Project Finance Arrangement: Stages in Project Pinance

A Project passes through following stages

1) Project feasibility

2) Project finance

3) Project Implementation 4) Project Evaluation

The typical structure of project finance is as follows: A single purpose project

company is formed to build and operate the project. The shares in the project
company are owned by the project sponsors who enter into a shareholders or joint
venture agreement between themselves governing their rights and duties as
participants.

A syndicate of banks or financial institutes enter into a credit agreement to finance

the construction of the project. The banks are paid out of the proceeds of the project
after completion. These are several classes of lending banks eg foreign banks, local
banks, export credit guarantee agencies and international

Agencies like world banks. . The balance of finance needed is provided by the
sponsors, either by way of
Equity subscriptions or subordinated debt or both.The project sponsors may
guarantee the loans under full or limited guarantees during the high risk pre-
completion period.

>The Major Sources of Finance tapped for project can be classified according to
maturity of the project i.e, Short Term, Medium Term (called term loans) and Long
Term.

> Projects can be financed either by Equity, or by Bonds or by Loans and Credits.
Firms may also obtain finance through Internally Generated Funds (Reserves and
Surpluses), Public Deposits Commercial Paper, Supplier's Credit, Foreign Currency
Funds and External Commercial Borrowing.
> Projects are also financed through Lease Financing and Venture capital. These are
many financial institutions helping project finance at all India level, IDBI, EXIM Bank,
NABARD, UTI, LIC, ICICI, HUDCO, STCI, REDA, DFHI and so on.

3.8. Risk identification, assessment, and mitigation in Project be lenders will identify
the various risks associated with the project and look at the uality of assessment on
the same and strategies followed to mitigate them by the management of the SPV.
The nature of collateral offered for the loan is also evaluated. they are comfortable
with the process of exercise and its outcome, they may decide to fund the project.
Otherwise they may refuse to fund the project.

Risk identification, assessment and mitigation is essential because the project does
not have prior established credit record. The risks associated with the project to both
business risks and the financial risks.

3.8.1. Completion risk be completion risk means that project may not be completed
within time and cost framework. Further, the project may turn out to be technically
not feasible and environmental unfriendly. The lenders will be the most sufferers, if
the project does not get completed, since the sponsors of the SPV have a limited
liability.

The SPV enters into a fixed price agreement with the EPC contractor to mitigate he
completion risk. The agreement has bonus clause for early completion and penalty
clause for delay in completion. Besides that, the sponsors of the SPV give
guarantees for successful implementation of the project. The lenders have full
recourse to the sponsor’s balance sheet, if project is completed within stipulated time
and cost framework.

3.8.2. Technological risk A project's use of complex or untested technology may lead
to cost and time Even if the proposed technology may be the state-of-the-art
technology but the industry may be such which is fast evolving. Further the project
may not meet the desired quality pacifications, at the projected capacity utilization
level. The consultants' report on the technology risk and sponsors' past track record
in the use of technology and their completion guarantees will provide comfort level to
the lenders.

3.8.3. Raw material supply risk

The quality and quantity of resource (natural resource, material, parts supply)
availability is critical to the project success. The quantity of resource availability must
Support the planned life of the project. The quality of resource availability has to
ensure

Smooth operation of the technology. The Independent consultant’s estimate of

reservoir availability & its quality and an agreement between the SPV and the
resource provider Av Assured supply will provide comfort level to the lenders 3.8.4.

Operation and maintenance risk

The ability of the management of the SPV to successfully operate and maintain the
plant after its implementation is important for the project to be successful. For this
purpose, the SPV may enter into an agreement with the specialized agency against
a minimum level of fixed fee and a variable fee linked with its operating profits. The
economic risks pertain to market demand for the project output, td its market price.

3.8.5. Economic risk

The demand for the product may not be sufficient to service the debt and to provide
adequate returns to the sponsors. Further the prices may be very competitive,
making the project margins very low for sustaining such a huge debt. The off-take
agreement with the customers over the life of the project for its entire output and low-
cost operation & maintenance agreement with the specialized agency will make
lenders feel comfortable. 3.8.6. Financial risk there is a generally very high debt ratio
in case of project finance. If most of the debt is floating-rate, there is a possibility that
rising interest rates may impair the ability of the firm to service the debt. It is termed
as interest rate risk. The SPV may hedge the internet rate risk either by entering
interest rate cap contract or interest rate swap agreement.

3.8.7. Currency risk

The currency risk arises when the project cost and revenue flows are in different
currency ay cost flows in USS and revenues flows are in home currency. In such a
situation, a change in exchange rate will impact the project profitability & cash flows
and its ability to service the debt. The SPV may hedge the currency risk by opting for
currency forwards or futures agreement.

3.8.8. Political risk

The domestic government due to political and social pressure may seize the MNC's
project assets (known as direct expropriation), seize project cash flows (diversion) or
change tax rates & royalty rates (creeping expropriation) and thus affect the project
cash flows and returns to lenders and sponsors. Full expropriation was common
during the mid 1970s. In today's world of globalization full expropriation rare but
creeping expropriation possible. The SPV may involve the domestic government one
of the sponsors and also enter into long-term agreements on royalty rates. As far tax
laws concerned, they are more or less stable most the emerging economies.

Environmental
The environmental risk present when the environmental impact of the project causes
delay project completion necessitates an expensive project redesign. The case
Konkan Railway Corporation highlights various environmental, political well
controversies the choice alignment Goa faced the SPV. The case argues for
integration of environmental assessment in project formulation.

3.8.10. Force Majeure risk

The Force Majeure events are those events that are beyond the control these events
may political non-political such acts God. The political events war, strikes lockouts,
and terrorism. The acts God are earthquakes, floods, and hurricanes. The Force
Majeure risk loss suffered the project because these

3.8.11. Implications for Project Financing The various types project risks can
classified the basis ability control and nature risks. R.Stulz has discussed these risk
along with generic risk management strategies his paper titled "Rethinking risk
management" published the Journal Applied Corporate Finance (Vol. pp.8-24)

3.8.12. Project Finance Risk and their allocation before project, financial institution
caries out project appraisal study. These studies relate market feasibility, financial
profitability, economic viability, managerial ability and social amenability. basis five
'P's the feasibility norms are:

Purpose

Prospects growth

Payment loans

People's expertise

Protection and surety.

The prediction financial analysis project definitely relies overall feasibility study, large
extent, this universally ascribed flow operations and funds position project. The
capital role financial among team monitor keep tract various operations marketing.
Costing, procurement duty payment which affect routine cash mid 1970s. In today's
world of globalization full expropriation rare but creeping expropriation possible. The
SPV may involve the domestic government one of the sponsors and also enter into
long-term agreements on royalty rates. As far tax laws concerned, they are more
less stable most the emerging economies.

Environmental

The environmental risk present when the environmental impact of the project causes
delay project completion necessitates an expensive project redesign. The case
Konkan Railway Corporation highlights various environmental, political well
controversies the choice alignment Goa faced the SPV. The case argues for
integration of environmental assessment in project formulation.
3.8.10. Force Majeure risk

The Force Majeure events are those events that are beyond the control the These
events may political non-political such acts God. The political events war, strikes
lockouts, and terrorism. The acts God are earthquakes, floods, and hurricanes’. The
Force Majeure risk loss suffered the project because these

3.8.11. Implications for Project Financing The various types project risks can
classified the basis ability control and nature risks. R Stulz has discussed these risk
along with generic risk management strategies his paper titled "Rethinking risk
management" published the Journal Applied Corporate Finance (Vol. pp.8-24)

3.8.12. Project Finance Risk and their allocation before project, financial institution
caries out project appraisal study. These studies relate market feasibility, financial
profitability, economic viability, managerial ability and social amenability. basis five
'P's the feasibility norms are:

Purpose

Prospects growth

Payment loans

People's expertise

Protection and surety.

The prediction financial analysis project definitely relies overall feasibility study, large
extent, this universally ascribed flow operations and funds position project. The
capital role financial analyst among team is to monitor and keep tract various
operations viz marketing. Engineering costing, procurement duty payment which
affect routine cash

These credits are mainly backed by bills of excharige drawn on the buyer or his
banker. 3.9.6.1.2. Buyers' Credits by the supplier

When the banker of the buyer gives a guarantee to the deferred payments by either
securing unconditional guarantee or by accepting or co-accepting the bills drawn on
the buyer it is called as buyer's credit. When a bank gives financial guarantees
beyond 12 maths it is called a deferred payment guarantees. The following: payment
guarantees can be classified into Expressed in Foreign currencies Favouring foreign
lenders for financing plant and machinery. o Favouring Foreign lenders for financing
raw material and stores Favouring Indian financial institutions. Expressed in Indian
currency o such deferred payment guarantees were very common in the past under
a special scheme formulated by the IDBI in order to enable the indigenous
machinery suppliers to sell the machine on credit terms.

3.9.6.2Lease Financing
Lease as a source of project financing is mainly suitable for expansion projects. This
is because of the reason that repayment of lease rentals start immediately after
acquisition of the leased asset by the lessee. New projects will take time for
generating cash for repayment whereas existing projects that go for expansion can
start repaying. Immediately out of their cash generation from their existing facilities.

3.9.6.3. Unsecured Loans

If there is some shortfall in the mean-of-finance, the promoters/directors can mobilize

funds from their friends, relatives and well-wishers. Such loans are always
unsecured i.e.. the lenders cannot have any charge over the assets of the company.
Banks and finance institutions stipulate the following conditions if unsecured loan is
to form part of the means-of-finance.

• The promoters shall not repay the unsecured loan till the term loan persists
Interest if any payable on unsecured loan shall be paid only after meeting the term
loan re-payment committees.

The rate of interest payable on unsecured loan shall not be higher than the rate of
interest applicable for term loans. Normally unsecured loan component is expected
not to exceed 50% of the equity capital.

3.9.6.4. Internal Accruals Internal accruals form a part of the source of finance in
respect of expansion project

Depreciation which is not cash expenditure and profits retained after payment of
dividends are the main sources of internally generated funds. As existing company
that foes for an expansion/diversification/modernization project may opt to finance a
portion of the capital Investment out of internal cash accruals.

39.6.5. Bridge Loans

Temporary loan meant for tying up the capital cost of project. The for bridge finance
arises in situations where finance from particular source delayed. However, the
availability of finance from that source is certain.

This is a Ex.1: The project cost of a new project is estimated at Rs.100 lakhs. The
promoters able to bring in a capital of Rs. 30 lakhs. The project is eligible for an
investment subsidy of Rs.10 lakhs. The financial institution that has appraised the
project a ready to sanction a term loan ofRs.60 lakhs. Means of finance for project
com as under:

Promoter's contribution-

Investment subsidy

Term loan

Rs. 30 lakhs Rs. 10 lakhs

Rs. 60 lakhs

Rs.100 lakhs

Though the eligibility of investment subsidy of Rs. 10 lakhs for the projects certain, t
here maybe certain procedural formalities involved in getting it. E.g.2 Food
processing industries that are eligible for special product subsidy can avail f only
their product gets ISV/Agmark certification which is possible only after the project is
completed and production taken out. That if the availability of subsidy though
ensured, is likely to be delayed, the banks/financial institutions come the rescue of
the project promoters by sanctioning a bridge loan to the extent of the subsidy.

3.9.7. Disbursements of Loan/Loans Arrangement 3.9.7.1.Terma/Conditions for

granting term loan for projects

Terms loans are granted subject to the following terms and conditions. 1. Clear title
to land as security.

2. Insurance of assets, building and machinery separately.

3. Scrutiny of Articles of Association to ensure that it does not contain any restrictive
clause against covenants of the financial institutions.
4. Lien on all fixed assets. 5. Personal and corporate guarantees of major
shareholders and associates concerns.

6Approval of appointment of managerial personnel by DFT. 7. Payment of dividend

and issue of bonus shares subject to the approval of financial institution. &
Undertaking for non-disposal of promoters shareholding for a period of 3 years.
before the loan is disbursed, documents have to be executed and submitted. Stamp
duty and registration fees have to be paid, 3.9.7.2.Procedure

After the loan has been sanctioned, the security documents should be obtained and
charge on the assets present and future-created in favour of the bank. Thereafter,
suitable disbursements may be made, keeping in view the following aspects:

The bank should verify the status of implementation of the project. If no progress at
all has been made the reasons should be ascertained and satisfactory answers
obtained.

As far as possible, disbursement should be made direct to the supplier of machinery

or other services in order to ensure that the proceeds of the term loan are not
diverted for unauthorized purposes.

It is preferable to disburse the loan in instalments instead of in one lump sum. Lump
sum disbursement of the entire loan will be permitted if the project or scheme
involves one-time acquisition of machinery. It should be ensured that the projected
debt-equity ratio of the project is maintained at all stages of disbursement.

If the loan is sanctioned by a number of lenders to the project, the concerned bank's
disbursement should be in proportion to its share in the loan. After the disbursement
of one instalment, the next instalment should be disbursed only after verifying
whether the earlier instalment had been properly utilized.. Sometimes the borrower
would request for interim loans or bridge loans, before the security and other
formalities are completed. Such requests may be acceded to by granting interim
advances for short periods of, say, 3 months, provided the bank is satisfied that the
requisite formalities would be completed within a short period. After these
requirements are complied, disbursements are made on the basis of assets created
at site. There has to be security matching, every disbursement starting with land and
buildings. As machines arrive, term loan is disbursed at 75% of their value, the

cheque being made in the name of the supplier. In case of large projects,
disbursement is need based. In such cases, promoters have to bring in their entire
contribution. The most important and yet quite difficult part of any loan is to monitor
proper utilization 33.7.3.Monitoring and Follow-up of the loan and follow-up the
borrower's performance and working results, so that the borrower does not default
on his financial commitments to the lender. The follow-up can split into

• follow-up during the implementation stage of the project,

-follow-up after commencement of commercial production.

The objectives of the follow-up during the implementation stage are:

- To ensure that the borrower mobilizes the various sources for the project in time -
To ensure that the physical progress of the project is in accordance with theproject
implementation schedule, and - To ensure that, in the event of an escalation in the
cost of the project, due to reasons beyond the control of the borrower, the promoters
bring in the proportionate share. The above follow-up could be done by obtaining
periodical reports from the borrower the progress-both physical and financial of the
project.

3.10.

3.10.1. History

Institutional Finance

Financial Institutions (Fls) popularly known as Development Banks have started

engaging the attention of the people in the industry as early as in 1822, when the
Socials General de Belgique was founded in Belgium. This was followed by the
establishme of the French Credit Mobilier in 1852. By the turn of the century, there
was great interes generated in this exercise and almost every country followed suit.
In 1902, Japan founde the Industrial Bank of Japan. England started its effort with
the setting up of "Carterhou Industrial Development Company in 1934 and Industrial
and Commercial Finance Corporation ce Corporation for Industry in 1945. Germany
set up its firm development bank in 1949 for the purpose of supplying long term
loans to the industry Encouraged by the success of 'Credit Mobilier', countries like
Austria, Netherlands Italy, Switzerland and Spain have also floated financial
institutions of the French kind. A review of the experiences of the various countries
reveals the fact that almost all the countries realised the need for creating separate
machinery for financing industrial development. As a matter of fact, though there
were attempts at founding a congenial agency for financing industrial development,
the real impetus for the development of Fla took place only after the Second World
War. The economies in the west shattered by the

followed by the Depression found it a necessity to innovate on the industrial front

including the financing of it. This even led to the founding of the International Bank
for Reconstruction and Development (IBRD). Though there is lot or diversity in the
structure, objectives and methods of financing across the globe, the core activity
fencing industrial units-low ever remained common to all Fls. Developing economical
which happen to be the colonies of the West, always looked to their rulers for
innovation in fostering development Indies, being no exception to this kind of a
tendency, alike emulated the experiments of the West and founded its first financial
institution - Industrial Finance Corporation of India (IFCI) in 1948 to cater to the
medium and long term credit needs of industrial units. The constitution of IFCI was
changed in 1993 from a statutory corporation to a company under the Companies
Act, 1956 to ensure greater flexibility in the operations and to cope up with the
changing financial system of the country. IFCI provides financial assistance by way
of rupee and foreign currency loans, underwriting, direct subscription to shares,
debentures, guarantees, suppliers credit and equipment leasing. It provides a variety
of merchant banking services which include project counselling, i project e
management, loan syndication, financial restructuring, mergers, acquisitions and
debenture trusteeship. The IFCI has now been merged with Punjab National Bank.
The IFCI followed by the setting up of the Industrial Credit and investment
Corporation of India (ICICI) Limited in 1955 as a public limited company. The primary
objective of establishing ICICI was to promote industries in the private sector and to
meet their foreign currency requirements. The next agency that was set up in this
network for the provision of industrial finance was the Refinance Corporation for
Industry Limited (RC) in 1958. This institution was promoted jointly by the RBI, LIC
and some leading commercial banks. The RCI was intended primarily to provide
refinance facilities commercial bank respect of their medium term lending to medium
sized borrowers in the private sector. However, The RCI was merged with the
Industrial Development Bank of India (IDBI) in September 1964. During the same
time, several state governments have floated a variety of Financial Corporations and
Industrial Development Corporations. Thus, the SFCa and SIDCs came into
existence during 1950s. Further, in 1955 the Government of India set up an
exclusive agency for t development of small industry in the name of National Small
Industries Corporation Limited (NSIC). Financing through Fls, however, took a sharp
turn with the establishment of the IDBI in July, 1964 under an Act of Parliament as a
principal financial institution to provide credit and other facilities for the development
of industry in the country. The main objective of IDBI was to provide term finance
and financial service for the establishment of new projects as well as for expansion,
diversification, modernization and technology up gradation of existing industrial
projects. As a premier organisation, IDBI was al vested with the responsibility of
coordinating the activities of the other financial

Institutions engaged in the promotion and development of the industry. The activity
establishing some more specialised agencies for taking care of financial and non
needs of the industries is continuing till now. As at present, the structure of Fi
Institutions catering to the needs of Indian Industry comprises of 6 All-India level
specialized financial institutions, 3 investments. 18 SFCs, 28 SIDCs, besides
NABAR Export Import Bank and many other technical consultancy organisations.

3.10.2. Financing by all Fla-An Overview 3.10.2.1. Overall Position of Sanctions and
Disbursements

As indicated earlier, Financial institutions have been instrumental in providing

finance to industry. Responding to the emerging needs of the industry, these
invitations have developed and introduced a variety of products and diversified into
newer a Starting with the operations of IFCI, the Financial Institutions today have
been advance finance in sizeable amounts. Ia retrospect, the sanctions and
disbursements of during 1949-50 stood at only Rs. 2.90 and Rs. 2.08 crore
respectively. The network spread now to 13 institutions at the national level and 46
at the state level. All institutions could sanction and disburse an amount of Rs.
6181747 crore and Rs. 435 crore respectively слоге registering an annual growth
rate of over 40 percent with the end of March 2000 (See Table 8.1). One particular
financial lacks.com sanctioned by these Fls is that it lacks consistency. This would
be evident from th growth rates of sanctions and disbursements. These rates varied
from the lowest of percent to the highest of 18.3 per cent in case of sanctions and
between 4.9 and 43 cent in case of sanctions during 1980-96. The individual record
of the Fls during the same period presents diversity of a still higher magnitude. In
case of some of the there is even negative growth in the finance extended by them
to the industrial units. of 25

3.10.2.2

Institution Wise assistance

Among the FIs, highest amounts were sanctioned by IDBI. It sanctioned an amount
of Rs. 1,73,978 crore and disbursed Rs. 1,17,687 crores by the end of March 2000.
This followed by the IFCI and UTI (See Table 8.2). Though IFCI was the first to be
set up it could not excel in sanctions for want of limited funds available at its
disposal, compared to the fund base of IDBI. While IDBI had Rs. 69849 crores at its
disposal by the end of March 2000, IFCI had only-Rs. 22,974 crore at its command.
The differences that could be noticed in the figures (Table 13.2) mainly account for
this reason.

3.10.2.3.

Sector wise assistance

To whom assistance should be sanctioned is always a matter of concern. Some Fls

concentrated in financing the public sector projects while others were engaged in the
task of promoting the private sector. Similarly, the size and nature of activities also
varied depending upon the peculiar conditions under which Fls were constituted and
operated. of fact, development banks in the un derdeveloped countries in the initial
years were required to a banks execute for government i investment projects. Some
were even authorised to formulate plans development. But the objective of setting up
Fls in India was stated to be of private sector enterprises. While piloting the bill for
the setting up of FCI, the then Finance Minister was reported to have observed that
the IFCI was not the intended to meet the financial requirements of nationalised
industries; but only to provide finance for the needs of private industry. However,
these restrictions are not followed now and by following the rules and regulations any
industrial enterprise can get sanction from the Fls; although private sector is the
major recipient of their assistance. Of the cumulative sanctions made so far by all the
Fls in India, 84.2 per cent went to private sector, 9.4 per cent to public sector and 6.4
per cent to joint sector.

3.10.2.4.

Forms of Assistance

These Fls are mainly set up to finance long-term operations of the industrial units.
This may be in the form of equity. loans and guarantees. To a great extent, they
sanction assistance in the form of loans at specified rates of interest. Their
participation into the equity was once very limited. It is only after the constitution of
IDBI in 1964., Fis started providing direct finance in

the form of subscription to shares and debentures of industrial concerns. Altogether

a new dimension is added after the establishment of UTI in 1964, since the very
objective of is Trust was to channel household sector savings for investment in risk
bearing industrial securities. Above all, underwriting of new issues of companies has
been the continuous activity of FIs since their inception. The intention of these
institutions in extending underwriting support was not merely to ensure that the
financing of the project was fully tied up,but also to indicate that the project was
support-worthy and that investors could take the risk of investing in such securities.

Further, the form in which assistance in sanctioned by the Fls.is also dependent on
the

specific provisions incorporated in their legislations. besides the financial standing of

the promoter, financing pattern, and the agreements already entered into by the
promoter. For stance, under section 23 of the IFC Act, the Corporation was
authorised to carry on and transact the following kinds of business: i) guaranteeing
loans raised by industrial concerns; ii) underwriting the issue of stock, shares, bonds
or-debentures by industrial concerns: ii) granting loans or advances to or subscribing
to debentures of industrial concerns.

iv) acting as agent for the central government and/or with its approval, for the IBRD
in respect of loans sanctioned by them to industrial concerns; and v) extending
guarantee in respect of differed payments by imports who are able to make such
arrangements with foreign manufactures. The powers given under section 23 of the
Act were widened in 1960 through an amendment to the Act to enable the
Corporation to guarantee:

(i) loans raised by industrial concerns from scheduled banks or state co-operative
banks (ii) deferred payments in connection with the purchase of capital goods
manufactured in India; and (iii) with the prior approval of the central government,
loans raised from or credit
Arrangement made by industrial concerns with any bank or financial institution
outside India in foreign currency. The Corporation was also empowered to subscribe
directly to the stock or shares of any industrial concern. much the same way, the
SFCs were authorised to provide financial assistance of the following types to small
scale and medium sized industries: i) granting loans or advances or subscribing to
debentures of industrial concerns:In

ii) Guaranteeing loans raised by industrial concerns on such terms and conditions as
may be mutually agreed upon; and iii) underwriting the stock, shares, bonds and
debentures.

These restrictions on the form of assistance have started losing their significance
after the setting up of IDBI in 1976 with a considerable measure of operational
flexibility. The Bank has been empowered to finance all types of industrial concerns
in whatever form it prefers to. There are no restrictions as regards nature and type of
security that may be accepted from the industrial concerns. The financial sector
liberalisation initiated in early nineties has also led to a structural transformation in
the business of Fls. They are now expected to respond to the challenges imposed by
the new competitive and deregulated financial environment. The Fls are now
diversifying into both project and non-project lending and fee-based services.

Table 8.3 provides the details regarding the different forms of assistance sanctioned
by diverse Fls by the end of March 2000. It is evident from the table that loans
forming part of the direct assistance are occupying the prime place. Their
significance seems to be more pronounced in case of SIDCs. As indicated earlier.
Underwriting and direct subscription to the securities of industrial units is also a
preferred activity of the Fls. Nearly, one-fifth of their money is remarked for this
purpose. 3.10.3. Certain Special Scheme of Fis Yet another glaring feature of the
assistance of Fls is that they have launched diverse schemes to cater to the special
needs of the industrial units. As a matter of fact, the list of

such schemes is quit exhaustive; however specific mention may be made of the
following:

Development Assistance Fund of IDBI: This fund was set up by the IDBI in 1965 with
its own resources and from the resources of the central government. The fund is
intended to provide assistance to those industries which, for various reasons like
heavy investment involved or low anticipated rate of return, may not be able to obtain
funds in the normal course. Assistance from the fund requires prior approval of the
central government. The government, in turn, is to be satisfied that the proposed
project is necessary in the of industrial development of the country. The IDBI is
supposed to inter separate accounts for this fund and also to submit a report on the
operations of the fund to the Central Government. .

Risk Capital Foundation Scheme of IFCI: This scheme was started by IFCI in June
1976 with initial money of Rs.1crore. The objective of this scheme was to meet the
seed capital requirements of entrepreneur the new entrepreneurs to contribute their
share of promoter's meant to s who have other abilities but no finance to launch a
project. This was equity. The loans from the foundation were granted on liberal term
such as no interest, limited service charge and repayment in 15 years. These loans
were be to repaid by the promoters out of their own income. This scheme was similar
to the Seed Capital Scheme of IDBI. This scheme was merged with the Risk Capital
and Technology Finance Corporation (RCTFC) from January 1988. The RCTFC Ltd.,
extended the operation of this scheme to include innovative technologies. products,
processes, control of environmental pollution, energy conservation and other venture
capital schemes. • Soft Loan Scheme of IDBI: This scheme is meant to finance
traditional industries such as cotton, jute, textiles,cement, sugar and some
engineering industries towards modernisation.replacement, renovation of their old
and obsolete plant and machinery. Though this scheme was originally introduced by
IDBI in November 1976. the same is now operated jointly by IDBI, IFCI and ICICI.
The scheme is named as such because of a number of concessions offered by the
Fls to industrial units such as low interest rates. less promoters contribution, high
debt equity ratios, long repayment periods, etc. Further, a liberal view is taken in
respect of imposing margins and security.

Seed Capital Assistance Scheme of IDBI In order of encourage new entrepreneurs

having technical and other skills, In has introduced this scheme in 1976. Under this
scheme, entrepreneurs provided with necessary finance upto Ita. 3 crore as seed
money. This money granted of charge. This scheme is intended to induce and
encourage the setting up of small and medium industrial units The assistance is also
extended for the projects which have been appraised by the IDBI or any other all
India F1 The scheme is operated through the SPCs and SIDCs. These state level
Fis expected to make a thorough evaluation of the entrepreneur as to his capability o
and run the project successfully establish on the basis of appraisal, the technical,
financial, economic and feasibilities of the project and continuously monitor the
progress of the unit at various stages. This scheme has bee liberalised to make it
more worthwhile and effective. Now that not only technically qualified persons, but
also anyone who has a worthy project can approach IDDI for this assistance.
Similarly, the scheme is no longer restricted to projects in backward regions or
priority sectors.

- Suppliers' Line of Credit Scheme of ICICI This scheme was introduced by ICICI to
help indigenous machinery manufacturers to offer deferred payment facilities to the
buyers so as to increase the sales. Under this scheme, payment is made by ICICI
directly to the supplied of equipment without involving banks. The facility under this
scheme is available only to actual users of equipment. The supplier will get around
80-90 per cent of the invoice value much early. The purchaser is provided with a
deferment period varying between 5 and 7 years.

Industry-wise Assistance:

Though there are some restrictions at least in the initial years, regarding the grant of
assistance different sectors, and in different forms, the Fls are relatively free to
choose the industry of their choice. Perhaps, they are obliged to look into the
priorities indicated in the Five-Year Plans regarding the encouragement to be given
to a particular type of industry. As one can observe

from the operations of the Fls, there is a general preference towards the funding of
projects promoted by new entrepreneurs and technologists, those located in
backward areas, those having foreign exchange caring potential, those based on
indigenous technology and those that are designed to fulfill the increased demand
for man consumption goods like medicines, textiles, sugar and other food products
and those paged in the creation of necessary infrastructure for the development of
Indian industry

Table 8.4 provides the relevant statistics pertaining to the allocation of Fis istance to
different industrial sectors. It is clear from the table that the industries such as
textiles, chemicals, electricity generation and services have got major share of the
istance from Fls. Each of them have got around 10 per cent of the total assistance
Compared to over fifty categories of industries considered by them for assistance,
the above industries certainly had a better preference.

3.11. 3.11.1. Incentives for

Incentives provided by the Government Export Oriented Units

Government of India offers various incentives for setting up export oriented projects
as a assure for export promotion and for improving the balance of payments position
foreign change. The following are some of the incentives for export-oriented units

Liberal import facilities are allowed depending on actual import content of product
and value of product. • Customs and Central Excise duties paid on raw material used
for manufacture of export products are reimbursable.

Raw materials are supplied at controlled prices for specified export products.

Priority is accorded by Railways for transport of goods meant for exports.

Export Credit Guarantee Corporation (ECGC) offers special assistance by way of

protecting from credit risk Insurance against loss in export of goods and services.
ECGC also provides guard to banks and financial institutions to enable exporters to
obtain better facilities from them.

Financial facilities at special concessional rates of interest are given by Commercial

banks. 100% foreign equity participation is allowed but the company should be an
Indian Co. Imports of capital goods I components and raw material are exempted
from Import Duty.

• Single point clearance with simplified procedures. Relaxations are allowed in

respect of sales tax, property tax, octroi etc. Tax holiday is available for 100% export
oriented units.

3.11.2. Incentives for Units in Industrially Area To promote balanced regional

development, of India has announced since for industries established in selected
backward district These incentives are in the form Central outright grant or subsidy
scheme . Concessional finance scheme Transport subsidy scheme Besides, the
central governmens scheme, many state governments have also schemes for

promoting industries in the backward areas in their States. The incentives offered in
setting up units in these areas are primarily of waiver /reduction in Sales tax 3.11.3.
Incentives for Small Scale Industries To promote the development of small scale
industries in the country, several

has been Small scale units need not obtain industrial licenses for certain category of
items

• Numbers of products and services have been exclusively reserved for small scale

Government provides comprehensive assistance to small entrepreneurs through

various organisations like Small Industries Development Organisation.

• Priority and assistance is provided in allotment of land.

State Financial Corporations provide long and medium term loans to small industries
at concessional rates. 3.12. provided by the Government

Government provides subsidy for setting up of types:

Area Subsidy (1) Product Subsidy 3.12.1. Area Subsidy

industries. The subsidy offered is of two

This is available for projects set-up in notified backward areas. Government notifies
backward areas from time to time based on the industrial activity prevailing in
different parts of the country. It will be between 15%-20% on the investment on fixed
assets. Government also extends subsidy to projects coming up in Industrial estates.

3.12.2. Product Subsidy

This is available for projects that manufacture specified products. These products
that are eligible for subsidy are identified by the government by keeping in view the
potential for the economic development of the country in such sectors of industries
and notified by the government. It ranges from 10% 20%for different types of notified
products. A project can avail only one subsidy. For example if food processing is
eligible for 20% product

subsidy and if the project is going to be located in a notified backward area that is
eligible for 15% area subsidy, the project promoters can choose only one, who will
obviously choose 20%product subsidy.

Financial Modelling

The first step in an economic analysis of a project is to calculate the projected cash
flows. 3.13. To do that one has to understand the business model, revenue model
and the cost model of the project. One has to make precise forecast of cash flows to
arrive at meaningful results. One can use sensitivity and scenario analysis for this
purpose.

3.13.1. Cash flows to equity & Cost of equity valuation Approach la project finance
the valuation approach suggested use of free cash flows to equity and
the rate of discount as cost of equity. The equity cash flows for each year of project
life has to be worked out. The cost of equity will vary every year as the firm's debt
ratio is very high in the beginning and is close to year by the end of year 12 to 15,
when the entire loan will be fully paid off. The equity cash flows are worked out from
cash available for debt service. The computation process is illustrated below with the
help of numbers for a particular year of

project operation:

Sales revenues

Less:

Operating

cost

including

manufacturing,

administration, marketing & distribution overbeads (other than depreciation)

Earnings before depreciation, interest & taxes

(EBDIT)

Less: Depreciation

Earnings before interest & taxes (EBIT)

Less: Actual cash taxes

Less: Incremental normal capital expenditure Less: Incremental Net working capital

Less: Incremental Reserves for 3-months operating

expenses

Less: Incremental

service

Reserves for next 6-months debe

Add: Depreciation being non-cash item

100
43

57

8 49

35

-Cash available for debt service (CADS)

Less: Interest on loan funds Lea: repayment of loan principal amount Add: Fresh
loan raised during the year if any

Free Climb Flows to Equity

be lenders look at the debt service coverage ratio (DSCR). The average DSCR of
greater than 2 over the project life is considered to be very good. It is worked out
under:

SCR=CADS/(Interest +Loan Principal repayment) he internal rate of return to

sponsors (also known as equity IRR) is worked out and is compared against required
rate of return to sponsors each year. If equity IRR is greater than required rate of
return during all the years of project life, then the project is positive

IPV to the sponsors. The process of computation of equity IRR and NPV to the
sponsors

& as under:

Equity IRR-EFCFE₂/(1+r) zero

Where is unknown.

NPV to Sponsors = FCFE₂/(1+k)'

Where:

FCFE-Free cash flows to equity shareholders or sponsors in Period t r-Internal rate

of return required rate of return to sponsors in period t t-life of the project in years
Besides above the lenders also take into consideration the payback period and
discounted payback period. The credit rating agencies do consider the above
parameters in their evaluation studies.

3.13.2. Monte Carlo Simulation approach to assess risk The evaluation of project risk
depends on the analysts' ability to identify and understand the nature of uncertainty
surrounding the key project variables and also on having the tools and methodology
to process its risk implications on the return of the project. The steps required to use
Monte Carlo Simulation for assessing project risks are as under.

25

Preparation of a model capable of predicting reality Selection of key project variables

Selection of probability distribution & definition of Generation of random scenarios
Values based on assumption set Setting of relationships for correlated variables

. Analysis of output of simulation The simulation results will indicate the probability
that project will generate positive NPV. The Crystal Ball software can be used for
applying Monte Carlo Simulation. The areal version of the software can be
downloaded from www.decisioneering.com 3.14. Case Study of Noida Toll Bridge

The Noida Toll Bridge being the first project of its kind on build, own, operate and
transfer (BOOT) basis as a toll bridge. The construction of the bridge would reduce
traffic congestion besides providing a shorter alternative to a large percentage of
population in south/east Delhi and Noida, leading to significant benefits in terms of
time and cost. 3.14.1. The Project history

Over the last twenty years Delhi has grown and spread in all the directions.
Formerly, the river Yamuna formed the eastern boundary of Delhi. In the last few
years, Delhi has expanded rapidly beyond the natural boundary and now 30% of the
population of the city is located on the eastern side of the river. New Okhla Industrial
Development Authority (Noida) was established in 1976 by the UP government. It
being contiguous to East Delhi, Noida has communication and

Transportation links, which are continuous between Noida & Delhi. Noida's
population is expected to touch 1.5 million by the year 2011. Bridges across the
Yamuna at Nizammudin and Okhla barrage served the road transport needs of the
Noida area. The unprecedented rapid growth of Delhi, more so in the areas across
the river Yamuna and that of Noida has increased the pressure on existing bridges,
where the traffic far exceeds the capacity during peak hours. The main components
of the project are Yamuna river main bridge, the toll plaza, the approach roads
including the grade separated interchanges and the Ashram flyover with
interchanges.

3.14.2. The Sponsors of the Project

The sponsors of the project are IL&FS Limited, NOIDA, IFCI Limited, and Intertoll
(0&M contractor). IL&FS is a financial services company with a strategic focus on
development of infrastructure project. Noida Toll Bridge Company Limited (NTBCL)
was created as a separate legal entity to implement the project. A concession
agreement range limits for variable
NTBCL and Noida Administration was entered to implement, operate and uaintain
the project and to determine, levy and collect fees from the users during the 30 years
concession period.

3.14.3. Project Cost

The time frame for completion of the project was set at 29 months from the date of
the start of the construction. The construction was to commence in January 1999
The base construction cost of Delhi-Noida Toll Bridge is estimated to be Rs.2120
millions based on the negotiations with the bidders. In addition to the project cost,
there are other expenses incurred including Ashram flyover cost, pre-operative
expenses, financing, insurance and contingencies. The landed project cost is
estimated at Rs 4082 millions

3.14:4. Project Financing

The project has a debt component of Rs 2857 million and equity component of Rs
1225 million based on debt-equity ratio of 70:30. The debt instrument has been
structured on the basis of the toll revenue pattern of the project. Lenders will be
secured by recourse to the project assets and revenues stream from the project. The
most of debt has been raised at floating rate linked to PLR

3.14.5. Fiscal benefits to SPV

An enterprise carrying on the business of developing, maintaining and operating any

infrastructure facility gets the tax holiday of 100% of the profits and gains derived
from such business for initial period of five years and thereafter, 30% of such profits
and gains. The benefits is available or any 10 consecutive assessment years falling
within a period of 12 assessment years in which the company begins operating and
maintaining the

Infrastructure facility. 3.14.6. Risk Identification, Assessment & Mitigation The Delhi
Noida Bridge project is characterized by a long payback period requiring huge

Capital investment

Land acquisition

Project cost risk

Obligation of Noida Administration to provide requisite land within 180 days from
signing of

concession agreement Significant detailing in the Project report Adequate

contingencies provision

30

Project Completion risk

Reputed EPC contractor with adequate track record

EPC contract structured on a fixed time contract with stiff liquidated damages for non

Compliance

Comprehensive all risk insurance during construction

IL&FS to cover shortfall due to cost overruns

Performance bond from the EPC contractor post

Construction for 12 months

O&M contractor have to meet operation & maintenance requirements

Monitoring by independent engineer

Provision to extend concession agreement in case of non-achievement of 20%

return over 30 years period development rights to the NTBCL at the discretion of
Noida and upon certification by independent auditor / independent engineer, in case
of inadequacy of Project revenues from tolls. O&M contract is proposed to be a fixed
price Concession agreement provides for land contract with the risk of cost-overrun
to be borne by the O&M contractor Comprehensive insurance coverage heet

8.

Technology risk

Risk of shortfall in

Traffic

Risk of O&M cost

being higher than

anticipated

Force Majeure risks

The case is based on the detailed case analysis developed by the Kapil Singhal,
Anoop Pabby and Subhash Bana, PTPGPM participants of Management
Development Institute, Gurgaon under the guidance of Dr Manoj Anand. Here, the
case facts have been presented in brief only. 3.16 Tables and Charts

Table 8.1 Assistance Year

1964-65 1970-75

1975-80

1980-81

Sanctioned Sanctions

118.1

1916.7

7102.4

2934.0

and Disbursed by all Fis

Growth

rate %

Disbursements

90,5

1296.7

4623.4

1847.9

Growth rate %

2352.0

2468.4

3138.4

3618.0 4937.7

5708.9

7061.3 7713.0

9640.4

12810.1 16259.9
23258.7

266293 33528.7

38442.6

684804.2 4354065.1

1981-82

1982-83

1983-84

1984-85

1985-86

1986-87 1987-88

1988-89

1989-90

1990-91

1991-92

1992-93

1993-94 1994-95

1995-96

1999-2000

Cumulative Up to end

March 2000

3281.0 3366.9

4195.1 5578.7

6548 2

6348

8138.9
9576.0

113866

14429.1

19254.7 22443.7

33282.0

41010.8

59663.1

67618.0

1043407.6 6181747.2

Source: Report on Development Banking in India, 1999-2000 Mumbai ID01

Table 8.2 Institution-Wise Assistance Sanctioned and Disbursed by All Fls Institution

Cumulative

Sanctions up to March 2000

1988112.9

430141.9

1914572.6

554084.9

100898.1 4969637-3

1546.6

Cumulative

Disbursements upto March 2000

1348938.1

390042.0

1141987 3

399505.1
72525.6.

All-India Development

Banks

IDBI IFCI

SIDBI

Sub-Total

Specialised Financial

Institutions

IVCF

2.6

24.6

13.0

174

24.3

17.7

18.9

26.7

334

16.6

48.3

23,2

45.5

13.3

15.5

27.3 49
27.1

153 36.5

15.6

23.7

9.2

25.0

32.9

26.9

43.0

145

25.9

14.7

63.5

1474.3

ICICI Venture TFCI

Sub-Total

Investment Institutions

LIC UIT

GIC

Sub-Total

State-level Institutions

SFCs

SIDC's
Sub-Total

Grant-Total

4710.2

19435.4

25692.2

330343.1

623900.1

109361.6

1063606.8

323282.1

207940.1

531222.2

6181747.2

4080.3

11561.6

17116.2

297323,3

476699.2

86695.4

860787.9

265950.7

167998.2

433948.9

4354065.1

Including assistance to small scale sector up to end-March 1990.

Source: Report on Development Banking in India, 1999-2000. Mambal, IDAL.Table
8.3 Form Wise Assistance (Cumulative) Sanctioned by Fls by the end of March 2000

All-India Dev. Banks

3531949.8

(71.1)

616149.2

(12.4)

(Rs. in crore)

investment

Form of Assistance Rupee Loans

Foreignency

Underwriting

cal direct subscription

Guarantees

Total

506914.1 (10.2)

314384.2

(6.3)

4969637.3(100.0)

Figures in the brackets indicate percentages to total assistance.

State-

Level Institutions 5046498 (95.0)

307723.5 (38.9)

23309.3

(4.4)

58746 755883.3
(18.4)

(61.1)

14339 3263.1(0.6)

(4.5)

531222.2 (100.0)

1063506.8 (100.0)

Source: Report on Development Banking in India, 1999-2000 Mumbal, IDBI.

The growth of project finance over the last 20 years been process of deregulation in
public utilities and infrastructure. Project finance structure is unique o such thing as
"standard project finance". In project finance, is treated to achieve the project goals.
There is high ratio future expected cash flows to be generated by the project.
Lenders sponsors' balance sheet only if the project successfully ost framework. The
project has finite Corporate Finance. There are large number PV and different
stakeholders. The haring amongst the different stakeholders of the and IRR to equity
sponsors is relevant decision risk identification, assessment and mitigation could be
used to know what the probability that project NPV to the sponsors. Project finance
deal structuring involves use of financial creativity and innovation.

With the entry of commercial banks into the term finance area, latter be the
prerogative of term-lending institutions. The increasing presence commercial banks
this area has further radicalised the scene industrial finance. pertaining the lending
norms such project appraisal, security, interest rate, repayment schedule, disbursal
procedures

Conversion option and post sanction monitoring are also discussed this unit. matter
of fact, Fls are criticised industrial units mainly because these norms and
cumbersome procedures they are following disbursing the loan applications.
Financing

by Fis has also assumed significance in the total financing position of companies.
Nearly one-fifth of the external resource requirements are being met now by the Fls.
However, is importance has diminished remarkably in recent years. Nevertheless,
there is lot ground yet to be covered by our Fls, In view of increasing competition in
the financial sector, pressure on the availability of concessional finance and
progressive deregulation of interest rates, Fls are required to become more and
more competitive, efficient, profitable and operationally flexible,

& Suggested Readings/Reference Material L Chong Yee Yee and Evelyn May
Brown (2000). Managing Project Risks: Business Risk Management for Project
Leaders, Financial Times - Prentice Hall. Esty, Benjamin C (1999) "Improved
Techniques for Valuing Large Scale
Projects", The Journal of Project Finance, spring, pp. 9-25.

Finnerty, John D (1996). Project Financing: Asset Based Financial

Engineering, John Wiley & Sons, Inc.

Nevitt, Peter K and Frank J Fabozzi (2000). Project Financing, London, Euromoney
Books, seventh edition Prasanna Chandra (2002). Projects: Planning. Analysis,
Financing.

Implementation & Review, New Delhi, Tata McGraw-Hill Publishing Company

Limited, fifth edition. Yescombe, E R (2002). Principles of Project Finance, Academic
Press

R.M. Srivastava Management of Indian Financial Institutions. Himalaya Publishing

House, Mumbai, 2001 Prasad. G.. Corporation Finance in India, Guntur. Sai
Publications, 1987. vill

Ravi M Kishore. Financial Management, Taxmann Publications. New Delhi

IM Pandey, Financial Management, Vikas Publications. New Delhi

Khan and Jain. Financial Managernent, Tata McGraw Hill New Delhi.

& Self Assessment Questions(S.A.Q.)

Give an overview of Project Finance and distinguish it from corporate finance. ii.
Discuss the criteria for successful project financing. Hi. Why use Project Finance?
Discuss its significance.

IV.

Discuss the process of carrying out financial analysis while structuring the deal.

Discover the process of risk identifications, assessment and mitigation while

structuring the project finance deal.

vi. Briefly highlight the procedures and norms followed by the Fls in credit Can you
suggest any modifications to the existing procedure? vii. Bring out the significance of
term lending organisations in the financing of industries. Extending lii. What are the
recent trends in the financing of industrial units? Are they healthy direction? In the
present day scenario, should there be restrictions on the form and type of assistance
sanctioned by Fls in the country? What are the latest incentives and subsidies being
offered by the government of leafier financing of Projects? Discuss. X.
ix.

xi. What are the major sources and means of financing a project? Describe in detail.

MBA-Project Management

Paper: MBA-711 Updated by: Dr. M. C. Garg

LESSON NO. 9 MBAFM-205

Cost & Benefits from the Financial Angle, Appraisal Criteria,

Cost of Capital Analysis

Structure

1.0 Introduction 2.0 Objectives

10 Presentation of Contents 3.1 Cost of Capital

3.2 Cost and benefit from Financial 3.3 Appraisal Criteria of a Project

4.0 Summary

5.0 Suggested Readings 6.0 Self Assessment Questions

1.0 Introduction

In the competitive economy, selection of the best investment project out of numerous
alternatives or ranking them in order to economic and social profitability is an
upheaval task. Simply stated, a project would be most suitable if there is maximum
difference between the stream of benefits and costs associated with various choices.
A project affording highest amount of benefits for the same cost or the same amount
of benefits at the least cost is deemed to be the best one. A project has, therefore, to
be judiciously, cautiously and intensively appraised by application of a host of
quantitative techniques to identify, enumerate and measure costs/benefits emanating
from it.

2.0 Objectives

After reading this lesson, you should be able to (a) Define cost of capital and
calculate the specific source of capital.

(b) Determine the costs and benefits are relation to a project. (c) Discuss the various
methods of appraisal criteria of a project.

3.0 Presentation of Contents 3.1 Cost of Capital

It may be defined as cost to the firm for obtaining funds or equivalently as the
average rate of return that an investor would expect for supplying capital. From firm's
Angle point of view it is the minimum rate of return that a project must yield to
maintain the value of the firm intact. The minimum rate of return tantamount to cost
of capital. Cost of capital is always expressed in term of percentage. Appropriate
allowance is to be made for tax factor so that the cost of capital may be compared
with rate of return on capital investments that are based on cash benefits after tax. In
project management relevance of cost of capital is two way. First, it facilitates
evaluating the net present value of investments and second assists determining the
attractiveness of internal rate of return. A project to be viable has to be in excuses of
financing the project before it can be considered acceptable. Say in a company
source of financing provides funds at an effective rate of 10 per cent. The company
wishes to expand its business: First, it should undertake the expansion project only if
its rate of return on the expansion is in excess of 10 percent Second, the size of
capital budget influences the cost of capital and is in return affected by it. Thus,
estimation of cost of capital becomes important to understand evaluation of projects.

A firm can finance its projects by utilizing various sources of funds. Each fund has
different features, thus, has different cost. It can raise funds by issuing new common
stock, preference shares, convertible and non-convertible debentures and by raising
term loans. The following paras discuss how to compute cost of different avenues of
funds: (a) Cost of Debt (Kd)

When the debt is repayable after definite period of time, the explicit cost of debt is
Calculated symbolically: C(I-T) + (F-P) (1-T) N

Kd

(P+F) 2

Where P-net amount realised on debt issue (after floatation costs etc.), C-Annual
debt interest payment, T=Tax rate applicable to the firm, N-Maturity period of debt,
Kd =discount rate which equates the present value of post-tax interest payment and
principal repayments with the net proceeds of debt issue, F-Redemption Value. But
when the debt capital of the company has an infinite maturity i.e. the debt capital is
perpetual, then

C (I-T) P Kd=>

Example
A firm issued 1000, 10% debentures each at Rs. 100. The debenture is to be
redeemed at 5 per cent premium at the beginning of eleventh year. The tax rate for
the company is 40%. Compute the cost of capital.

Selation Kd-(10500 (0.60)/1025100- 6.1 percent If the debeature has an infinite

maturity, then:

Kd-10% X (1-T)-10% X.60-6% (b) Cost of term Loans (Kd) Term loans from financial
and commercial banks are considered as debt capital and are repayable
Within 8 to

11 years. The post-tax cost of a term loan is:

Interest payable on loan X (1-1)

(c) Cost of Preference Capital (Kp) P-Net amount realised per share If redeemable,
then Kp is to be found out like the cost of debt. In short

If irredeemable, then Kp (cost of preference capital) D/P Where, D-Dividend for

share payable annually and

D+ E-P N

(P+F)

(d) Cost of Equity Capital (Ke)

Rate of return required by the equity shareholders is not governed by any contract or
fixed rule. It is very difficult to measure the same. However, there are different
approaches to estimate the rate of return. We are concerned here only with the
dividend forecast approach because the shareholders are concerned with the stream
of dividends receivable from any firm and the value of an equity share is equal to the
present value of dividends associated with it.

Symbolically, Ke (rate of return required by the equity share holders) is equal, to

D where 'f is floatation cost. PO (1-f)

When the shareholders expect a constant dividend then

D Ke=

P But when the equity shareholders expect the dividend to grow out at a constant
rate g' per cent per year, then

Kp

DI

Ke PO

Floating cost dividend

Expected

Rate of growth of dividend.

Net current market price of each equity share.

DI-DO (1+g)

F DI

PO Last year dividend. Market price per equity share before deducting any expenses
i.e. gross

price. Example: Market price of shares of Dena Industries is Rs. 240. The expected
divided year hence is Rs. 24 per share and dividend is expected to grow at a
constant rate of pr cent. What will be the cost of equity capital?

Solution

DI

Ke + g = 24/240 +0.9 19 per cent

PO

Cost of Retained Earnings

In the notion of cost of capital it has been stated that the cost of retained an
opportunity cost. It is identical to cost of capital excepting for floatation costs
earnings is There is peculiarity of retained earnings that brokerage is saved by
investors to get retained earnings portion and then reinvest in share of the same
firm. Further in hand of investor it is taxable if we take these two situations: Kr Ke (1-
t) (1-B)

Example

For Excel industries cost of equity capital is 12.5 per cent. The average tax slab of
the investors of the company is 30 per cent. Brokers charge 3.5% flat rate
irrespective of size of investment. What will be the cost retained earnings?

Solution: Kr Ke (1-1) (1-B) as Ke= (DI+g)

P%

Kr= 12.5% (1-0.3) (1-0.035) 12.5% (0.7) (0.965)

8.44%

Weighted Cost of Capital

When cost of the whole capital structure is to be calculated, costs of all the
components are to be combined. It is referred as combined cost or weighted cost of
Here weights refer to the proportions of equity, debt and preferred stock utilized to
raise capital. These weights may be at the face value of the components or the
market price of the components. Let us refer to the following table:

Source of funds

Book Value

(Ra. In lakch)

250

200

300

750

Percentage (weights)

33.3

26,7

40.0

100.0

Market value (Rs. in lalch)

450

180

270 900

Percentage (Weights)

50.0

20.0

30.0 100.0

Equity shares

8% Preference
Shares

12% Debentures

Total

Once weights have been assigned or identified for all sources of funds, weighted
average cost of capital can be calculated as follows:

KO-Wd Kd+ We Ke + WrKr + WPKP Where KO= Weighted average cost

W = refers to respective weights

K = refers to respective cost

refers to debt

= refers to equity

r =refers to retained earnings

P = refers to preference equity The weighted average costs which can be used to
calculate combined rate can be in

any of the following three forms: Historical Average cost of capital

Incremental average cost of capital Marginal average cost of capital

Historical average cost of capital is the cost associated with the firm's already
existing financing. Since this is based on historical facts such cost does not
necessarily reflect the current cost of financing that would be incurred to take up a
new project.

Incremental average cost of capital is an improvement over the historical rate. The
new funds rose, (whether internally or externally) provide incremental amount to
invest in projects. These costs associated with rising or generating these incremental
funds are incremental costs. On basis of these incremental costs, weighted average
cost can be

Compiled. Average cost of capital is the weighted average cost associated raising
the last rupee of an imaginary new budget. It is different from incremental capital due
to difference in cost of retained earnings and cost of new issue.

Let the cost of a project be as under:

Capital Cost Working Capital

Sources of Financing
8% Preferences Share capital

Equity Capital 10% Term Loan

12% bank Retained Earnings

The opportunity costs of equity and Weighted Average Cost of Capital

10% Term Loan

12% Bank overdraft 8% Preference Capital

10% Equity Capital 10% Retained earnings

Weighted Average Cost after tax

1,00,000/

3.00,000/-

Rs. 7 lakhs

Rs. 10 lakhs

Rs. 2 lakhs

Rs. 3 lakhs

Rs. 1 lakhs

Rs. 3 lakhs

1 lakhs

Rs. 10 retained

Earnings is 10%, tax rate being 50%

10 x 30 x

20 x 8-160

3,00,000/-

10, 00,000/

30 x 10-300 10 x
100

790

Tax rate being 50%, the costs of Term loan and Bank overdraft have been taken as
5 and 6 respectively.

In order that the expectation of each source of finance may be satisfied, the
company must earn at least 7.9% from the project so that value of the equity shares
in the market may be saved from falling.

3.2 Cost and benefits from financial angle

Cost and benefit analysis is an appraisal technique which facilitates selection

process by offering decision rule or criterion for selection. From financial angle, it
facilitates selection of financially viable and remunerative projects to be
implemented. Every project is to use up some financial resources termed as cost of
project and contributes output to the organisation in form of cash flow. A project
merits choice only if benefits exceed cost of project. Thus, cost and benefits of
project in financial terms are measured in terms of cash outflows and cash inflows
respectively. The basic calculations of cash flows (CF) for new project determines
the changes in the cash inflows and outflows of the firm in each period t' as a result
of taking on the project CFt-CFt with project. Why Cash is not income?

The benefit of a project is better reflected in the profit as shown in books of But a firm
needs to evaluate cash flow impact of the project in order to determine acceptability
because cash is what is central to all decisions of the business, Cash is invested
with a view to generate more cash which can further be reinvested in the business its
or paid to shareholders in form of dividends. Thus, cash, not accounting income, is
relevant. In accounting incomes adjustments for non-cash items is required. In
simple terms h flows associated with a project for a period based on accounting data
is follows:

CFt-[(IPt-It)- (CPt-C)- (dPt-dt] (1-T) + (dpt -dt)] CFI=Cash flow generated by the
project during period t.

IP-Income with project.

CP-Cost of operating with project.

C=Cost of operating without project. dP-depreciation with project

d=depreciation without project

T-Tax rate of the company

Cash after tax only

Depreciation is added back to after tax operating income a it represents a non-cash
expense. Like depreciation, amortization as permissible by tax statute, also needs
similar treatment. As the non-cash expense is deducted from the cash flow before
tax it shelters cash flow from the effect of taxes. So, to measure cash flow
accurately, it is necessary to add the depreciation and amortization back into the
equation, not accounting income. Thus, it is clear that cash flows needed in 'cost and
benefit analysis' should be on an after tax basis.

Tuning of Cash

When cash flow occurs, it is another important aspect to look into since cash also
has a time value cost. The analyst in ideal situation should take cash flows into
account at the moment they were either paid or received. But due to complexity in
such situation, cash flow is assumed to be taking place at the end of accounting
period. This approach is of course not nearly reality. In such situation measuring and
considering cash flows monthly, quarterly or half yearly is advisable. To decide the
frequency of cash how, we certainly have to compare cost of this extensive exercise
with the expected profits. In the age of computers of course such detailed exercise
may not be a costly affair. Incremental cash flow

As mentioned earlier, information about cash flow should be on an incremental basis

involving foreign exchange, inflow like EOUs, the statutory concessions naay also te
considered. Elements of Cash Flows Cash flows to be considered are broadly
categorised in three phases:

During investment phase

During operational phase during terminal phase

Investment Phase: Cash flow mainly constitute cash outflow as investment in the
infrastructure installation. The cost of plant and equipment, cost of the building and
facilities, cost incurred for planning this infrastructure e.g. feasibility studies or project
office expenses are the main cash flow. Cash flow at this stage is proportional to
capacity creation. Few examples of cash outflows at this stage are: site acquisition
and preparation cost, building erection and alteration costs, plant cost and its
transportation cost, plant installation and affection costs, capitalized research and
expenditure costs, design etc. Sometimes investments (additional) are also made in
between the project life to

Increase its capacity or efficiency. Such cost is also added. Operational Phase: Cash
flows constitute cash outflow as well as cash inflows. Cash outflows may be required
to operate and make productive use of the infrastructure created. All operating costs
which constitute cash outflow need to be considered. Some of these are: raw
material conversion facilities cost like fuel, power, labour packing and warehouse
cost. insurance, rent, rates etc. distribution cost. administrative costs.

So cash flows in operating phase are post investment phase cash flow where
commercial production starts and dynamic interactions between cost-volume-profit
manifest themselves posing many problems for management main being cost
control. Cost control is not only for variable costs but also for fixed cost of period
costs which are to be minimized per unit.

Cash inflow for project is associated mainly in this phase. It refers to the income
which is the eventual out-come we envisage from a project. Income is function of any
variables like quality of product, market share of product, cost pattern of product,
project mix proposed, selling and distribution costs etc. Cash inflow is representing
these benefits are contemplating. These benefits are influenced to a great extent by
factors like consumer's preference, demand and supply situation, customers
bargaining strength. government regulations say for pricing and general economic
conditions.etc.

Terminal phase of a project also has an impact on cash flows. In terminal phas
generally there is a cash inflow. A part of cash inflow in investment phase is released
at stage in form of scrap value of the project machine etc. The scrap realization, as
me earlier, should be tax adjusted. Another component of cash inflow is release of
investment in working capital components like inventory levels, work in progress
values, debtor’s receivables etc.

Cost and Benefit Estimates

A firm is proposing to have a new project wherein machine worth Rs. 30 lakh
required besides a working capital budget of about Rs. 5 lakh. The machine is in
transported by road paying cartage Rs. 28000 besides insurance charges Rs. 12000
proposed to get it installed by supplier for Rs. 60000. The company proposes that
increase its capacity new attachments to machine for Rs. 42 lakh will be acquired te
three years. Company raised a loan of Rs. 10 lakh at 9%. At the end of 10 years its
so is expected to realise Rs. 2.20 lakh.

Illustration

Income tax authorities permit straight line method of depreciation and exempt to
salvage value. The product to be marketed at Rs. 18 per unit will require material of
as per unit with conversion cost excluding depreciation Ra. 4 per unit. First three
years it w sell 80000 units per year and subsequently 1,00,000 units per year. Tax
slab for company is 50%. Estimate the cost and benefit (from financial angle) the
project.

(n) Investment Phase

Machinery

(30+28+12+6) (31.00)

Working Capital

(5.00)

(b) Operating phase

a) Revesses

(Operating cont

i) Material

il) Conversion

ill) Depreciation

v) Int on Deb.

To al

012

10

(4.2)

14.4

14.4

18.0

18.0

18.0

18.0

18.0

18.0

18.0

4.8

3.2

3.1

0.9
12.0

4.8

3.2

3.1

0.9

12.0

4.8

3.2

3.1

0.9

12.0

6.0

4.0

3.7

0.9

14.6

6.0

4.0

3.7

0.9

14.6

6.0

4.0

3.7

0.9
146

6.0

4.0

3.7

0.9

14.6

6.0

4.0

3.7

0.9

14.6

6.0

4.0

3.7

0.9

14.6

6.0

4.0

3.7

0.9

63

17

13

146 14
34

1.7

7.55

Pre before

2.2

2.2

1.1

5.75

1.1

75

34

1.7

7.55

34

1.7

14

1.7

14

1.7

14

1.7

14

1.7

14

1.7
1.7 1.7 1.7 1.7 1.7 1.7

7.55

7.55

7.55

755

TAR

(Develop) Profit 1.1 after Ax

Operating cash

in flow (c + W() (10)

Terminal Now

(w.cap. + scrap) Cast and Benefit

7.20

7.55

5.73

5.75

.75

(4.2)

3.3 Appraisal Criteria of a project

After considering cost benefit analysis and cost of capital it is appropriate to

introduce appraisal criteria which may be employed to examine the financial viability
of a project. The important appraisal criteria are classified into following broad
categories

A) Non Discounting Criteria (a) Pay back period, (b) Accounting rate of return.

B) Discounting Criteria (c) Net Present Value, (d) Present Value Index, (e) Internal
Rate

of Return. a) Pay back period

It refers to the period in which project will generate the necessary cash to recoup the
initial outlay on the project. For example if outlay of a project is Rs. 2 lakh and the
project generates cash Rs. 50,000 every year. In this case pay back period will be
== Rs. 2 lakh/Rs. 50,000-4 years

If cash generation is uneven, say in first year it is Rs. 30,000, second year it is Rs.

45,000, third year it is 75,000 and fourth year its Rs. 1,00,000. In this case payback

Period will be assessed by taking cumulative cash inflows at end of every year or
part of the year. Cumulative cash inflow at end of Ist year is Rs. 30,000, 2nd year it is
Rs. 75,000

(30,000+45000), 3rd year it is Rs. 1,50,000 (30,000+45000+75000). Thus in fourth

year

to recover full outlay of Rs. 2 lakh we require cash inflow of only Rs. 50,000 (Rs. 2
lakh

-Rs. 1.5 lakh) and it can be recovered in 6 months of 4th year (being half of Rs. 1
lakh

cash inflow in 4th year) So in this case pay back period will be 3 years. Selection
Criterion A project whose payback period is shortest, is selected in absence of any
already laid down norm. In some situations, a cut off pay back period is determined
by taking

7.55

7.55

7.55

7.35

7.55

reciprocal of cost of capital say if cost of capital is 30% then maximum payback
period acceptable should be 100-3.3 years. Computed payback period is judged
against this pre determined period and all projects over and above it automatically
stand rejected. Worth of the Criterion

It is a very simple method of selection. In case of shortage of funds, political

instability, rapid technological development etc. this is a suitable criterion. But this
method has few limitations also. This method considers a Rupee received today
equal to a Rupee received after one year, i.e. it does not consider time value of
money. Further, it ignores cash inflows beyond pay back period and cash inflows in
post-pay back period may be substantially high. This method does not give
weightage to overall profitability of a project since it places excessive emphasis on
liquidity (cash flows).

b) Accounting Rate of Return (ARR)

This method uses the concept of Accounting Profit in place of Cash Flow. Here
profits are related to investment. Since the concept of profit and investment can be
defined in different ways, ARR may also be different. Normally we take profits after
depreciation and tax. Investments can be initial investment or average investment. It
is normally calculated in terms of percentage.

Selection Criterion: Generally a business enterprise pre-determines a minimum rate

of retune. Any project which has ARR below targeted rate of return is automatically
disqualified. Out of the qualifying projects, obviously a project with highest ARR will
be selected. Worth of the Criterion: ARR is again a criterion which is not difficult to
compute and analyze. Profits can easily be ascertained from the profit or loss
statement. It, unlike pay back period method, recognizes profits for the entire life of
the project. But on the other hand this criterion has some inbuilt limitations: Like
payback period it does not recognizes true value of money. In absence of well
accepted formula, the results may not be dependable and its interpretations may
create confusion and controversy. B) Discounting Criteria

This feature has been added in selection criteria to do away with the defect of not
recognizing time value of money. The criteria using discounting as a base have
another feature that they, unlike payback period, consider cash flows relating to
whole life span of the project. To introduce time value of money the future cash
inflow is put to adjustment using discounting rate. There is no difference in
discounting rate and interest rate. These two are same but context of time is
different. Interest rate assumes looking from the present to the future whereas
discount rate looks from the future to the present. In discounting the purpose is to
determine the present worth of future cash flow streams on the basis of discounting
rate. Present worth of present value of cash inflows and cash outflows are calculated
and matched.

Net Present Value (NPV)

It represents present value (PV) of all the cash flows of a project at a given discount t
constitutes cash inflow and outflow has already been discussed. Present value what
can be assessed with the following formula:

RI

(1+k)1

R2

(1+k) 2
R-Cash inflows from year 1 to n. -Discounting factor.

PV =

R3

(1+k) 3

R4

(1+k) 4

RS

(1+k) 5

For simplicity present values are available from Present Value Tables.

Once PV has been calculated for cash inflows, we deduct PV of cash outflows from
it. The difference is known as NPV. Say for a project of Rs. 10 lakh, cash inflows are
Rs. 1 lakh for first two years, Rs. 3 lakh for next two years and Rs. 3.5 lakh for fifth
year. Its

NPV will be as:

-10lakh PV =

(1.10) 0

=-5273

2 lakh

2 lakh

(1.10)2

(1.10) 1

3 lakh

(1.10)3

3 lakh

3.5 lakh

(1+10)4
(1.10)s

So NPV can also be negative. It is so in case when PV of cash out flow exceeds PV

Of cash Inflow. Selection Criterion

In case NPV is positive, the project should be selected. In our given example since
NPV is negative the proposal should be rejected. In case out of mutually exclusive
projects, many projects give positive NPV, select the project with highest NPV.
Worth of Criterion

It is a systematic and reliable technique since it takes into consideration the time
value of money and cash flow stream in its entirety. It clearly represents the
contribution to the wealth of stockholder by accepting a project. NPV of more than
one project can be calculating by just adding NPV of all accepted projects since NPV
is in absolute money terms. On the other hand this technique has a big limitation.
The decision depends on selected discounting rate. If this rate is biased, so will be
the selection. Further, projects with different outflows can hardly be compared
judiciously. d) Present Value Index

This criterion is also known as profitability index (PI). This method computes a
relationship between PV of cash outflows. PI = PV of cash inflow /PV of cash
outflow.

selection Criterion: Accept a project only when Pl> 1. Further, if more project have Pt
1, select the project with highest Pl. Worth of Criterion The technique is an
improvement over NPV technique. Instead of giving selection basis in absolute
figures (as in NPV), PI gives a comparative figure, PI provides ready comparison
between investment proposals of different magnitudes. .) Internal Rate of Return
(IRR) Here we are looking for a discounting rate. IRR is the rate in which the sum of
discounted cash inflows equals the sum of discounted cash outflows. It is the rate
that causes a project NIV to equal zero and PI to equal unity. The equation for IRR
would be: Where 'r' is IRR

PV (0)

In IRR we set the NPV equal to zero and then find out the discount rates (IRR) which
satisfy this condition. The above equation can also be written as:

CFO CFi

0 (1+r)0

+ ... CFn

(1+T)
(1+r)n

In this method we are to go by hit and trial method to find out IRR. Selection Criterion

Accept a project whose IRR is greater than or equal to the enterprises cost of capital
while a project whose IRR is a less than the cost of capital should be rejected. While
evaluating two or more projects, a project giving higher IRR would be preferred. This
is because higher the rate of return, the more profitable is the investment. Worth of
Criterion

IRR like NPV also considers the time value of money and whole cash flow stream.
IRR is more convenient and logical criterion for judgment as compared to NPV. But
on the other hand this rate may not be specifically defined with more than one
change in sign of cash flows there may be multiple rates of return. Illustration :
Meera Limited Company is considering investing in a project requiring a capital
outlay of Rs. 2,00,000. Forecast for annual income after depreciation but before tax
is as follows:

Year

1.

2.

3.

Rs.

80,000

80,000 40,000

Depreciation may be taken as 20% on original cost and taxation of 50% of net the
project according to each of the following method income

You are required to evaluate a) Pay-back method.

b)

c)

Rate of return on original investment method.

Rate of return on average investment method.

d) Discounted cash flow method taking cost of capital as 10%

(e)

Net present value index method. Internal rate of return method.

Solution

Pay back method

Year

STATEMENT OF NET CASH INFLOW

Profit after depreciation

100000

100000

80000

80000

40000

Add

Depreciation

40000

40000

40000

40000

40000

Deduct Tax

Profit before

Depreciation but after tax

90000

90000
80000

80000

20000

1.

2.

3.

4.

5.

50000

50000

40000

40000

20000

Pay Back period, Rs. 180000 is recovered in 2 years. The balance of Rs. 20000 will

be recovered in or 0.25 year. Hence pay back period is 2.25 years.

b) Rate of return on original investment method Year

Net profit after tax and depreciation

50000 50000

40000

40000 20000

1. 2.

3.

4.

5.
Total

200000

Average Annual Return=

Rate of return

Rs. 40000

200000

Discounted cash flow method

Rs.

-20%

d)

Present value of cash inflows

Initial Investment Excess cash inflow

(e) Net Present Value Index

Total present value of cash inflows Total present value of cash outflows

-3,08,130

x 100-154%

Internal Rate of Return Method

Since the annual cash inflows are not uniform, the factor will have to be located for
determining the approximate rate of return: I

where

F= Factor to be located I-Initial Investment

C-Average annual cash inflow

F=2,00,000 -2.5 80,000

Annuity present value table discloses at this factor rate of return in the column for 5
yours 0228%
3,08,130

1,08,130

The present value at 28% rate,

Year

Cash inflow

90000

90000

80000

80000

60000

Total present value

Initial Investment

Excess present value

At 28% discounting rate, the present value, is highest by Rs. 10,650. Hence, a
higher discounting rate should be taken. Taking it at 30%,

Year

Cash inflow

90000

90000
80000

80000

60000

Discount factor

0.769

0.592

0.455

0.350

0.269

Net cash inflow

69120

53280 36480

28000

16140

Discount factor

Net cash inflow

70290

54900

38160

29840

17460

210650
200000

10650

0.781

0.610

0.477

0.373

0.291

The preservoivalue at 30% is higher by Rs. 3,030. The internal rate of return will
therefore, be slightly higher than 30%. Though exact interpolation can be done, it
would affect much the management decision. Hence, the rate may be taken as 31
%. Judging from all angles, the investment in the new project seems to be fairly
attractive.

4.0 Summary

Cost of capital is the minimum rate of return that a project must yield to maintain the
value of the firm intact. A firm finances its projects by utilizing various sources of
funds having different cost. The cost of a specific source of fund is measured as the
rate of discount which equates the present value of expected payments to that
source of finance with the nest funds received from that source of finance. Given the
cost of specific sources of financing and the scheme of weighting the weighted
average cost of capital can be calculated by multiplying by its proportion in the
capital structure and adding the weighted values. Cost and benefit financially viable
and remunerative projects to be implemented. A project merits choice only if benefits
exceed cost of project. Cash flows for project whose involvement of foreign
considering cost benefit analysis and cost criteria to examine the financial viability of
a project. The appraisal criteria consist of non-discounting techniques and
discounting techniques.

5.0 Suggested Readings

(1) Project preparation appraisal budgeting and implementation (2) Project

Management by B.M. Naik

(3) Project Management by P. Gopala Krishana. (4) Financial Management by

M.Pandey (5) Financial Management by M.Y. Khan & P.K. Jain.

6.0 Self Assessment Questions 1,

the various methods of appraisal criteria of a project. 2. Describe the various
methods of determining the cost of capital. Also certain the technique to measure the
weighted average cost of capital. 3. Discuss the modern for determining the cost and
benefits to be incurred on a project

Critically examine

Explain with suitable example.

by Prasanna Chandra

MBA-Project Management

LESSON NO. 10 MBAFM-205

Structure

1.0 Introduction 2.0 Objectives

3.0 Presentation of Contents

3.1 Measures of Risk 3.2 Techniques to handle risk

3.2.1 Payback Period

3.2.2 Risk-adjusted Discount Rate

3.2.3 Certainty Equivalent

3.2.4 Sensitivity Analysis 3.2.5 Simulation Analysis 3.2.6 Decision Tree

4.0 Summary 5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

Risk implies uncertainty of profits or danger of loss due to some unforeseen events
in future. It refers to the chance of loss on account of unfavorable or unpredictable
happening. Risk occurs when there is an adverse deviation from desired or expected
outcome. In business, risk and return are inseparably linked with each other. "No
risk, no gain' is a fundamental principle of Business Management of every business
undertaking always strives to minimize the negative consequence of business risks.
It is faced with a multitude of risk some of which are inherent in business and
inevitable. In order to control the risks, management takes various preventive and
corrective measures. Management of risks involves the various steps such as
identification of the risk, evaluation of the risk, choice of the method of handling risk,
utilizing the selected device, evaluating the aftermath etc. The term risk with
reference to investment decision may be defined as the variability in the actual
returns emanating from a project in future over its working life in relation to the
estimated return as

Paper: MBA-711 Updated by: Dr. M. C. Garg

Risk Analysis of Single Projects

MBA-Project Management

LESSON NO. 10 MBAFM-205

Structure

1.0 Introduction 2.0 Objectives

3.0 Presentation of Contents

3.1 Measures of Risk 3.2 Techniques to handle risk

3.2.1 Payback Period

3.2.2 Risk-adjusted Discount Rate

3.2.3 Certainty Equivalent

3.2.4 Sensitivity Analysis 3.2.5 Simulation Analysis 3.2.6 Decision Tree

4.0 Summary 5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

Risk implies uncertainty of profits or danger of loss due to some unforeseen events
in future. It refers to the chance of loss on account of unfavourable or unpredictable
happening. Risk occurs when there is an adverse deviation from desired or expected
outcome. In business, risk and return are inseparably linked with each other. "No
risk, no gain' is a fundamental principle of Business Management of every business
undertaking always strives to minimize the negative consequence of business risks.
It is faced with a multitude of risk some of which are inherent in business and
inevitable. In order to control the risks, management takes various preventive and
corrective measures. Management of risks involves the various steps such as
identification of the risk, evaluation of the risk, choice of the method of handling risk,
utilizing the selected device, evaluating the aftermath etc. The term risk with
reference to investment decision may be defined as the variability in the actual
returns emanating from a project in future over its working life in relation to the
estimated return as
Paper: MBA-711 Updated by: Dr. M. C. Garg

Risk Analysis of Single Projects

Where C.V.- Coefficient of variation d standard deviation of distribution - Arithmetic

mean of variables. Major sources of risk in a project are:

Source

Government regulatory agencies founding fiscal

Definition of project

Project organization

Design

Local conditions Permanent plant supply

Construction contractors Construction materials

Logistics

Inflation

Exchange rate

force majeure Market conditions

Political uncertainty

3.2

Techniques to Handle Risk

A number of techniques to handle risk are used by managers in practice. They range
from simple rules of thumb to sophisticated statistical techniques. The following are
the popular conventional techniques of handling risk: 3.2.1 Payback Period

Payback is one of the oldest and commonly used methods for explicitly recognizing
risk associated with an investment project. Business firms using this method usually
prefer short payback to longer ones, and often establish guidelines that firms accept
only investments with some maximum payback period, say three to five years. The
merit of

payback is its simplicity. It makes an allowance for risk by:

Focusing attention on the near term future and thereby emphasizing the liquidity of
the
Example

Bureaucratic dels changes in fliegt der Clunges in Genomment funding policy fora

Between ses eral folmnders

Change in project scope

Authority of project manager, nem outside bodies

Adequacy to meet need, realism of design programme

Local customs, weather window

Degree of nevelty, damagefloss during transportation Experience, financial stability

Excessive wastage, reliability of quality Remoteness, access to site inflation

firm through recovery of capital, and (i) by favouring short term projects over what
may be riskier, longer term projects. However, this method ignores the time value of
cash flows. For example, two projects with, say four-year payback periods are at
very different risks if in one case the capital is recovered evenly over the four year.
While in the other it is recovered in the last year. Obviously, the second project is
more risky. If both cease after three years, the first project would have recovered
three fourth of its capital, while all capital would be lost in the case of second project.
Given the uncertainty element, it may well be that a four-year payback period based
on fairly certain, estimates might be preferred to a three year payback period
calculated with very uncertain estimates.

3.2.2 Risk-Adjusted Discount Rate For a long time the economic theorists have
assumed that to allow for risk, the businessman required a premium over and above
an alternative which was risk-free. Accordingly, the more uncertain the returns in the
future, the greater the risk and the greater the premium required. Based on this
reasoning, it is proposed that the risk premium be incorporated into the capital
budgeting analysis, through the discount rate. That is, if the time preference for
money is to be recognised by discounting estimated future cash flows at some risk-
free rate to their present value, then to allow for the riskiness, of those future cash
flows a risk premium rate may be added to risk-free discount. Such a composite
discount rate will allow for both time preference and risk preference and will be a
sum of the risk-free rate and the risk - premium rate reflecting the investor's attitude
towards risk. The risk adjusted discount method can be formally expressed as
follows:

NFC =Σ(1+K' NPV=

where k is a risk-adjusted rate. That is: Risk-adjusted discount rate= Risk- free rate +
Risk premium
k-kt +kr The risk-adjusted discount rate accounts for risk by varying the discount rate
depending on the degree of risk of investment projects. A higher rate will be used for
riskier projects and lower rate for less risky projects. The net present value will
decrease with increasing k indicating that the riskier a project is perceived, the less
likely it will be accepted. If the risk - free rate is assumed to be 10 per cent, some
rate would be added to it, say 5 per cent, as compensation for risk of the investment,
and the composite 15 per cent rate would be used to discount the cash flows.

Illustration: Consider an investment project costing Rs. 50,000 initially and expected
to generate cash flows in years one through four of Rs. 25,000, Rs, 20,000, Rs.
10,000 and Rs. 10,000. What is the project's NPV if it is expected to generate
certain?

cash flows? Assume a 10 per cent risk-free rate. The net present value for the
project, using a 10 per cent risk-free discount rate is -Rs.50000 Rs. 25000 Rs 20000
Rs 20000

NPV

(1+10)

10000

(1+10) (1+10) (1+10)

-=R₁3599

If the project is risky, than a higher rate should be used to allow for the perceived
risk. Assuming this rate to be 15 per cent, the net present value of the project will be:
NPV == -Rs 50000 Rs. 25000 Rs20000 Rs 20000 10000 -R&845

(1+15)

(1+15)

(1+15)

(1+15)

Thus, we observe that the project would be accepted when no allowance for risk is
granted, but it is unacceptable if a risk premium is added to the discount rate. In
contrast to the net present value method, if a firm uses the internal rate of return
method, then to allow for perceived risk of an investment project, the internal rate of
return for the project should be compared with the risk adjusted minimum required
rate of return. If the internal rate of return is higher than this adjusted rate the project
would be accepted otherwise it should be rejected.

3.2.3 Certainty Equivalent

Yet another common procedure for dealing with risk in capital budgeting is to reduce
the forecasts of cash flows to some conservative levels. For example if an investor
according to his "best estimate," expects, a cash flow of Rs. 60,000 next year, he will
apply an intuitive correction factor and may work with Rs. 40,000 to be on safe side.
In formal way, the certainty equivalent approach may defined as

· Σ NPV = a NCF, (1+K₂)'

Where NCFt= the forecast of net cash flow without risk-adjustment at the risk
adjustment factor or the certainty-equivalent coefficient

Kt-risk rate assured to be constant for all periods. The certainty equipment
coefficient, at assumes a value between 0 and 1, and varies inversely with risk. A
lower at will be used if greater risk is perceived and a higher at will be used if lower
risk is anticipated. The coefficients are subjectively or objectively established by the
decision maker. These coefficients reflect decision-maker's confidence in obtaining a
particular cash flow in period t. For example, a cash flow of Rs. 20,000 may be
estimated in the next year, but if the investor feels that only 80 per cent of it is a
certain amount, then the certainty equivalent, coefficient will be 80 i.e., be considers
only Rs. 16,000 as the certain cash flow. Thus to obtain certain cash flow multiply
estimated cash flow by the certainty equivalent coefficient.

The certainty equivalent coefficient cm be determined as a relationship betwe certain

cash flows and the risky cash flows. That is

NCE Certain Cash Flow

NCF, Risky Net Cash Flow

For example, if one expected a risky cash flow of Rs. 80,00 in period t and

Considers a certain cash flows of Rs 60,000 equally desirable, then at will be 0.75

60,000/80,000

Illustration: To illustrate the certainty equivalent approach let us consider a project

which costs of Rs. 6,000 and has cash-flows of RS. 4,000, Rs. 3,000, Rs. 2,000 and
Ra 1,000 in years I through 4. Let us assume further that the associated at factors
are estimated to be at 1.00, al-.90, a2 -.70, a3-50 and a4-30, and the risk free
discount rate is 10 per cent. The net present value will be:

NPV LO-6000), 0.90(4000) (1+.10)

0.70(3000) (1+.10)

050(2000) 0.30(1000) 2-Ra37 (1+.10)¹ (1+10)'

The projects would be rejected as it has a negative net present value. If the internal
rate of return method is used, we will calculate that rate of discount which equates
the present value of certainty-equivalent cash inflows with the present value of
certainty equivalent cash outflows. The rate so found will be compared with the
minimum required risk free rate. Project will be accepted if the internal rate is higher
than the minimum rate,otherwise it will be unacceptable. 3.2.4 Sensitivity analysis

One measure which expresses risk in more precise terms is sensitivity analysis. It
provides information as to how sensitive the estimated project parameters, namely,
the expected cash flows, the discount rate and the project life are to estimation
errors. The analysis on these lines is important as the future is always uncertain and
there will be estimation errors. Sensitivity analysis takes care of estimation errors by
using a number of possible outcomes in evaluating a project. The method adopted
under the sensitivity analysis is to evaluate a project using a number of estimated
cash flows to provide to the

Decision-maker an insight into the variability of the outcomes. The sensitivity

analysis provides different cash flow estimates under three assumptions:

The worst (i.e. the most pessimistic) (ii) The expected (i.e. the most likely) The best
(i.e. the most optimistic) outcomes associated with the project. Let us illustrate the
use of sensitivity analysis for estimated cash flows:

initial cash outlays

Cash flow estimates:

Worst

Most likely Best

Required Rate of Return

Economic Life

Solution

(11-15)

Project X -Rs. 40000

6000

10000

10%

15 years

Project Y -Rs. 40000

0
8000 16000

10%

15 years

The NPV of each project assuming a 10% required rate of return can be calculated
for each of the possible cash flows. It can be found from the annuity table that the
present value of Re. I annuity for 15 years at 10% discount is 7.666. Multiplying cach
possible cash flow by present value factor we get:

Expected cash flow

Project X

PV

NPV

Rs. 5636

20848

36060

Project Y

PV

NPV

-40000

20848

21696

Rs.

45636

60848

76060

Worst

Most likely
Best

Rs.

Nil

60848

121696

The above table demonstrates that sensitivity analysis can produce some very useful
information about projects that appear equality desirable on the basis of the most
likely estimates of their cash flows. Project X is less risky than Project Y. The actual
selection of the project (assuming projects are mutually exclusive) will depend upon
the decision maker's attitude towards risk. If the decision maker is conservative, he
will select Project X as there is no possibility of suffering loses. On the other hand, if
he is risk-taker, he will choose Project Y as it has the possibility of paying a very high
return as compared to Project X. Sensitivity analysis does provide the decision
maker with more than one estimate of the project outcome and thus, an insight into
the variability of the return. 3.5 Simulation Analysis

Sensitivity analysis allows considering the effect of changing one variable at a time.
By looking at the project under alternative scenarios, one can consider the effect of a
limited number of plausible combinations of variables. Simulation is a tool for
considering all possible combinations. It therefore enables to inspect the entire
distribution of project Outcomes. The steps involved in simulation analysis are given
below:

Mentifying the problem

Identity decision variables performance criterion and decision rules

Construct simulation model

Validate the model

Design experiments (specify values of decision variables to be lasted)

Run or conduct the simulation

Is simulation process completed?

No

Modify the model by changing the Input data Le. Values of decision variable

Illustration: The investment corporation wants to study the investment project based
on three factors: Market demand in units; Price per unit minus cost per unit

Yes
Examine the results and select the best course of action

Investment required. Three factors are felt to be independent of each other. In

analysing a new-consumer product, the corporation estimates the following
probability distribution
Annual demand

Units

20000

25000

30000

35000

40000

45000 50000

Using simulation process repeat the trial 10 times, compute the return on investment
for each trial taking these three factors into account. Approximately what is the most
likely return?

Solution: The return per annum can be computed by the following expression (Price
Cost) X Number of units demanded

Return

Investment

Building a cumulative probability distribution correspondence to each of the three

factors, an appropriate set of random number is assigned to represent each of the
three factors as shown in table A,B, and C.

Table A

Annual demand

20000

25000

30000

35000
40000

45000

50000

Probability

0.05

0.10

0.20

0.30

0.20

0.10

0.05

Cumulative probability

0.05

0.15

0.35

0.65

0.85

0.95

1.00

Random number

00-04

05-14 15-34

35-64

65-85

88-94
95-99

Probability

0.05

0.10

0.20

0.30

0.20

0.10

0.05

Price mlans cost per unit

Rs.

3.00

5.00

7,00

9,00

10.00

Probability

0.10

0.20

0.40

0.20

0.10

probability distribution:

Investment required

1750000
2000000

2500000

Probability

0.25

0.50

0.25

As shown in table D, the highest likely return is 20% which corresponds to annual
demand of 35,000 units yielding a profit of Rs. 10 per unit and investment required is
R17.50,000.

A decision tree is a graphic representation of the sequence of action event

combinations available to the decision maker. It depicts in a systematic manner all
possible sequences of decisions and consequences. Each such sequence is shown
by a distinct path through the tree. A decision tree enables the decision maker to see
the various elements of his

126 Decision Tree

Problem in proper perspective and in a systemic manner. A decision tree consists of

network of nodes, branches, probability estimates and pay-offs. Nodes are of two
types, decision nodes (designated as a square) and chance node (designated as a
circle). Alternative course of action or strategies originate from the decision node as
the main branches (decision branches). At the terminal of each derision branch,
there is a chance node where from chance events emanate in the form of sub
branches (chance branches). The respective pay-offs and the probabilities
associated with alternative courses and the chance events are shown along side the
chance branches. At the terminal of the chance branches are shown the expected
value of the outcome. The criterion on the basis of which the decisions are made in
the decision tree approach is generally the expected monetary value (EMV)
principle. One may choose the alternative that maximizes the expected profit, or the
alternative that minimizes the expected cost and so on. The key steps involved in
decision tree analysis are:

(3) Identifying the problem and alternatives.

(b) Delineating the decision tree. (c) Specifying probabilities and monetary
outcomes.

(d) Evaluating various decision alternatives.

The various decisional ternaries may be evaluated by using backward induction

procedure. The financial managers often use decision trees for analysing projects
involving sequential decisions. The decision tree model can be applied in various
fields such as introduction of a new product, marketing strategy make vs. buy
decisions, pricing, assets acquisitions, investment decision and as strange an areas
as selecting a life partner. However, the trouble with decision tree is that it becomes
very complex and cumbersome if an attempt is made to consider the myriad possible
future events and decisions. Such a decision tree is not likely to be very useful tool of
analysis. Hence an effort should be made to keep the decision trees somewhat
simple so that decision makers can focus their attention on major alternatives.
Illustration: A farm owner is considering of drilling a farm well. In the past, only

70% of the wells drilled were successful at 200 ft. of depth. Moreover, on finding no
water at 200 fl. some persons drilled it further upto 250 ft. but only 20% struck water
at 250 ft. value terms) to buy water from the neighbour.

The prevailing cost of drilling is Rs. 50 per ft. The farm owner has estimated that in
case he does not get his own well, he will have to pay Rs. 15,000 over next 10 years
(in present

The following decisions can be optimal: (1) do not drill any well

(ii) drill upto 200 ft.

(ii) if no water is found at 200 ft. drill further upto 250 ft.

Draw an appropriate decision tree and determine the farm owner's strategy under
Expected Monetary value (EMV) approach.

Solution

Monetary value (EMV) approach

Salation

Consequence of outflows (Rs)

15.000

15,000+ 250x50-27,500

250x50-12,500

15,000+

20050-25,000

200x50-10,000

Do not Drill

Struck (8)
Water ander

Spell 200 BL

There are two decision points in the indicated by 1 and 2. In order to decide.
Between the two basic alternative, we have to fold back (backward induction) the
tree from the decision point 2, using EMV as criterion.

Drill up to 250ft

water struck

Do not Drill to 250ft

195

Evaluation of decision points

State of nature

Probability

Decision st polet Dy

Cash outflows

Decision points

Expectant outflow

Rs. 2500

R24500

1.Drill upto 250

Water struck No water struck

The decision at Dy in Drill upto 250

Decision point D

3
Water struck

No water struck

Rs. 12500

Rx 27500

EMV (outflows)

EMY (outflows)

2. De not drill upto

250 A

1. Drill upto 200 ft

Rs. 7000

Rx. 14350

RA 19000

Rs. 24500 EMV (outflows)

EMV (outflows)

1. Do not drill upto

The decision at D, ir Drill up to 250

The decision at D1 is Drill up to 250 ft.

Thus the optimal strategy for the farm owner is to drill the well up to 200 ft. and if no
water is struck, then further drill it up to 250 ft. Risk analysis of capital investments is
one of the most complex areas of project management. Risk occurs when there is an
adverse deviation from the desired or expected outcome. Several measures such as
range, mean absolute deviation, standard deviation and

4.0 Summary

Coefficients of variation are used to denote risk. To assess the risk of a project,
several methods are available. Payable period, risk-adjusted discount rate, certainty
equivalent, sensitivity analysis, simulation analysis and decision tree are commonly
used to assess the risk of a project.

5.0 Suggested Readings

(1) Prasanna Chandra "Projects-Preparation, Appraisal, Budgeting &
Implementation, Tata McGraw Hill Publishing Co. Ltd., New Delhi.

(2) Vasant Desai "Project-Management", Himalaya Publishing House, Bombay.

(3) B.M. Naik, "Project Management". Vani Educational Book, New Delhi. (4) P.
Gopalkrishanan & V.E. Rama Moorthy, "Text Book of Project Management"
MacMillian India Ltd., New Delhi.

6.0 Self Assessment Questions

1. Galaxy Ltd. is considering two mutually exclusive investment A and B. Investment

A requires an outlay of Rs. 10,000 and generates a net cash flow of Rs. 3,000 for six
years. Investment B requires an outlay of Rs. 30,000 and generates a net cash flo of
Rs. 11,000 for five years. The required rates of return on these investments are 12
per cent (for A) and 14 per cent (for B). Which of the two should the firm choose?
distribution the outcome of an investment is shown below:

2. The probability

Outcome

Rs. 1,000

Rs. 2,000

Rs. 3,000 Rs. 4,000

Calculate the following

0 Range

3.

of

Probability

0.1

0.3

0.4

0.2

measures

Standard deviation what makes important

of dispersion Mean absolute deviation

(iv) Coefficient of Variation

in the selection of projects? Explain briefly the various

Methods of evaluating risky projects.

4. When would the use of tree diagrams be beneficial? When would it be impossible
use tree diagrams?

to

5. A company is considering a proposal to buy one of the two machines to

manufacture a new commodity. Each of these machines requires investment of Rs.
50,000 and is expected to provide benefits over a period of 12 years. The firm has
made pessimistic, most likely and optimistic estimates to the returns associated with
each of these alternatives. These estimates are as follows:

Machine A

Rs. 50,000

8,000

12,000

16,000

Machine B

Rs. 50,000

10,000

20,000

Cost

Cash Flow estimates

Pessimistic Most likely

Optimistic

6.0 SELF ASSESSMENT QUESTIONS 1. Critically examine the various methods of

appraisal criteria of a project.
2 Describe the various methods of determining the cost of capital. Also certain the
technique to measure the weighted average cost of capital. 3. Discuss the modern
for determining the cost and benefits to be incurred on a project.

Explain with suitable example.

MBA-Project Management

LESSON NO. 11

MBAFM-205

Paper: MBA-711

Updated by: Dr. M. C. Garg

Social Cost Benefit Analysis in Projects

Structure

1.0 Introduction

2.0 Objectives

3.0 Presentation of Contents

3.1 Difference between Commercial Calculations and Social Cost Benefit 3.2 The
Indian Context of Social Cost Benefit Analysis

3.3 UNIDO Approach

3.4 Little Mirrlees Approach 3.5 SCBA by Indian Financial Institutions

4.0 Summary

5.0 Suggested Readings 6.0 Self Assessment Questions

1.0 Introduction

Social Cost Benefit Analysis (SCBA, hereafter) also referred to as economic or social
evaluation of projects provides an answer to the problem of appraising projects in a
social context. SCBA is not a mere technique, but rather a general approach that
systematizes the selection process by offering a decision rule or criterion for choice.
SCBA is a methodology for evaluating projects from the social point of view. In the
context of planned economies, SCBA helps in evaluating individual projects within
the planning framework. Projects are judged in terms of their impact on the
economy, and this is evaluated by using parameters reflecting national goals and
social objections. Before the final decision on such socially desirable projects is
taken analysis is respect of the social cost and benefit of the project is made. Such
analysis is different to the normal financial justification for a project. The cost and
benefits involved are not like the usual monetary cost incurred or benefit earned, but
in SCBA, the assessment is made from indirect effects resulting from the
implementation of such project. For example, a project in the construction of road will
create significant benefits to the society but at the same time may lead to social cost
in acquisition of private land, removal of commercial activities from the creation of
environmental pollution etc. If the special benefit of a project exceeds its costs, it
qualifies for implementation.

Analysis

Projects emanate from various sources like individuals, firms and government.
Where government is not the owner, the commercial profitability is used as decision
criterion for selection of projects for implementation. If financial benefits are more
than financial costs, the projects merit choice. While the process of selection of
individual projects meets the profit criterion of the individual investors, the
combination of choices may not necessarily result in the most socially profitable
allocation of resources. For developing economies, this

is a crucial factor that cannot be ignored. 2.0 Objectives

After reading this lesson, you should be able to (a) Differentiate between commercial
financial appraisal and social cost benefit analysis, (b) Explain the UNIDO approach
to social cost benefit analysis.

(c) Discuss the Little-Mirrices approach

(d) Critically evaluate the integer linear programming model.

(e) Discuss the goal programming model.

3.0 Presentation of Contents 3.1 Difference between Commercial Calculations and

Social Cost Benefit

Analysis

These lies some basic differences between commercial calculations and social cost
benefit analysis. The commercial organisation can make project investment, decision
based on hard' information while the information for public investment decision tends
to be 'soft'. For example, a wine company confines its business analysis to profit and
loss accounts and the statement of assets and liabilities, whereas a national planner
has to evaluate the social costs of drinking on the health of the people.

The second major difference between commercial calculations and social cost
benefit analysis relates to the multiplicity of objectives in case of SCBA, diverse
national interests and objectives are to be considered like employment generation,
equitable income. distribution, improving consumption patterns, increasing GNP and
savings etc. While, an entrepreneur may have several objectives like increasing the
profits, volume of sales etc. but the process of satisfying these objectives is much
simpler.
Another difference relates to the choice of parameters. An example is the
determination of rates of interest. In private investment, rate of interest represents
the market cost of money. But in public investment project, the choice of rate of
return to discount future social benefits represents a compromise between different
conflicting interests. The planner has to compare the value of benefits today with that
of benefits in the future. For choosing between projects, the planner must know the
impact of the choice on

all economic and social parameters, and also have some methods of evaluating this
impact. The private entrepreneurs view taxes as the monetary costs and subsidies
as monetary gains. From the social point of view, however, taxes and subsidies

transfer and hence, considered irrelevant. There are certain goals and preferences
termed as merit wants, which expressed in the market place, but believed by policy
makers to be in the larger interest, example, promoting women education
programme. While merit wants relevant from the private point of view, they are
important from social point of view. The Indian Context of Social Cost Benefit
Analysis

Use of cost-benefit analysis in India started in the sixties, but on a very limited scale.
In the beginning it was confined to irrigation projects only. K.N. Raj's appraisal
Bhakra Nangal project in North India was one of the few systematic attempts in field.
In the last few years, Planning Commission has been insisting upon SCBA for
passing a project for public investment. In India, since the major economic decisions
centrally taken by the Government of India on the advice of Planning Commission,
the rapid economic growth is the main objective of Government activity. Cost benefit
analysis has its application for the projects which form part of development
programmes undertaken by the Long range perspective plans and the successive
five years plans determine the allocation of resources in various spheres of
economic activity but the broad strategy of growth adopted in that overall plans
leaves many questions unresolved, especially at the micro level and it is at this level
that social cost benefit analysis plays an important role.

In India, the all India term lending financial Institutions-IDBI, IFCI and ICICI appraise
project proposals primarily from the financial point of view. However, they also
scrutinize projects from the larger social point of view. ICICI was perhaps the first
financial institution to introduce a system of economic analysis as distinct from
financial profitability analysis. ICICI computes the Economic Rate of Return (ERR)
for projects assisted by it, though a low ERR is not the sole criteria for rejecting
assistance. The Project Appraisal Dept. (PAD) and the Planning Commission has
spelt out the 'Guidelines for the preparation of Feasibility Reports for Industrial
Projects'. Following are the items of information which are considered for social
profitability analysis: Information on foreign exchange content, labour content and
the requirement of

capital per unit of output for commodities that are to be procured domestically.
Information on the level of foreign trade and average foreign trade prices for the
various items of plant and equipment, raw materials, components and the outputs of
the project, detailing the sources of such information.
An analysis of the indirect effects of the project on foreign trade.

Information on the categories of labour recruited and the locations from which labour
has come. A note on the possible indirect costs and benefits of the project. In India,
the relevance and necessity for SCBA has not been fully appreciated yet. v) Proper
understanding of conceptual framework of SCBA is must for project formulator.

A comprehensive informational network is a further necessity. Multiple National

Objectives

In SCBA, the evaluation of project begins by clearly stating the relevant

and benefits. Those could be as follow:

Social aims

Better economic and social development of the region in which project is carried out

i Increased economic and social productivity.

Generation of employment and job opportunities.

iv) Distribution of benefits to large number of people. v) Provision of certain level of

per capita consumption.

vi) Production of exportable goods and services, and minimisation same.

of imports of the

vii) Reduction of environmental pollution, maintenance of ecological balance etc.

vii) Provision of certain types of collective goods or merit wants, which add to the
social welfare.

3.3 UNIDO Approach

Towards the end of sixties and in the early seventies two principal approaches for
SCBA emerged, the UNIDO approach and the Little-Mirrlees approach. It is difficult
to measure the social cost and benefit in terms of monetary unit but

UNIDO has laid down specific recommendations in carrying out the SCBA for such
project. The UNIDO recommendations are to measure the cost and benefit at
domestic prices in terms of consumption. Accordingly, the foreign exchange involved
in the project (for SCBA) is identified and adjusted by an appropriate premium
depending upon the prevalent rate of exchange to reflect the shadow price of foreign
exchange. The UNIDO approach was first published in 1972 in the Guidelines for
Project Evaluation and then in 1978 in the 'Guide to Practical Project Appraisal'. The
UNIDO method of project appraisal involves five stages. These are as follows:

(a) Stage one involves the financial profitability of the project measured at market
prices. (b) Stage two is concerned with the determination of the net benefit of the
project in terms of economic (efficiency) prices also referred to as shadow prices.
One of the important aspects of shadow pricing is the determination of numerairs,
the

Unit of account in which the value of inputs or outputs is expressed. The

specifications of

the UNIDO numerair are "net present consumption in the hands of people at the
base level of consumption in the private sector in terms of constant price in domestic
accounting rupees".

The UNIDO approach suggests three sources of shadow pricing depending on the
impact of the project on national economy. If the impact of the project is on
consumption in the economy the basis of shadow pricing is consumer willingness to
pay. How is this measured? The consumer willingness to pay can be explained with
the help of following diagram:

Price

201

S'

Quantity

DD: represents demand schedule, SS: the supply schedule, E: the equilibrium point,
0Q the quantity bought, and OP the price per unit. According to the diagram, the
consumer who buys the first unit is willing to pay OD for that unit and the consumer
who buys the last unit is willing to pay OP for that unit. Schedule DE indicates the
consumer willingness to pay for various units. So the total willingness to pay by
consumers who buy the product is measured by the area ODEQ. The pride paid by
them, however, is only OPEQ. The difference between ODEQ and OPEQ, namely
DEP, is referred to as consumer surplus.

If the impact of the project is on production in the economy, the basis of shadow
pricing is the cost of production. If the impact of project is on international trade-
increase in exports, decrease in imports, increase in imports, or decrease in exports
- the basis of shadow pricing is the foreign exchange value. For calculating shadow
pricing, taxes are taken into consideration. The UNIDO

Guidelines for taxes are following:

D) When a project results in diversification of non-traded inputs which are in fixed

Supply from other producers or addition to non-traded consumers goods, taxes

should be included. i) When a project augments domestic production by other
producers, taxes should be excluded.

For fully branded goods, taxes should be ignored. A key issue in shadow pricing is
whether a good is tradable or not. A good is fully traded when an increase in the
consumption results in corresponding increase in import or decrease in export or
when an increase in its production results in a corresponding increase in export or
decrease in import. For fully traded goods, the shadow price is the border price,
translated in domestic currency at the market exchange rate. A good is non-trade
when the following conditions are satisfied: its import (CIF price) is greater than its
domestic cost of production; and domestic cost of production.

its export price (FOS price) is less than its The value of non-traded goods should be
measured in terms of what domestic consumers are willing to pay. If the output of the
project adds to its domestic supplies or if the requirement of the project causes
reductions of its consumption by others. The value of non-traded goods should be
measured in terms of its marginal cost of production if the requirement of the project
induces additional production or if the output of the project causes reduction of
production by other units. Since SCBA seeks to consider all costs and benefits, to
whomsoever they may accrue, external effects also need to be taken to account.
The principles of shadow pricing for goods may be applied to labour as well, though
labour is considered to be a service The UNIDO method uses domestic currency as
the name. So the foreign exchange input of the project must be identified and
adjusted by an appropriate premium. This means that valuation of inputs and outputs
that were measured in border rupees has to be adjusted upward to reflect the
shadow price of foreign exchange. The shadow price and foreign exchange is
determined on the basis of marginal social value as revealed by the consumer
willingness to pay for the goods that are allowed to be imported at the margin. The
shadow price of a unit of foreign exchange is equal to:

Where F = Fraction of foreign exchange, at the margin,

Spent on importing commodity i. Q=Quantity of commodity i that can be bought with

one unit foreign exchange. (This will be equal to 1 divided by CIF value of the goods
in question) P= Domestic market clearing price of commodity.
(c) Stage three of the UNIDO method deals with adjustment for the impact of the
project on savings and investment. The gain or loss to a group within society as a
result of project is equal to the difference between the shadow price and the market
price of each input or output in the case of physical resources or the difference
between the price paid and the value received in the case of financial transaction.
UNIDO method, concerned with this stage, seeks to answer the following questions:

(1) Given the income distribution impact of the project, what would be its effect on
savings? (ii) What is the value of such savings to the society?

The saving impact of a project is equal to:

AY, MPS, Where Y change in income of group i as a result of the project.

MPSI marginal propensity to save of group i.

The shadow price (value) of a rupee of savings, given certain simplifying

assumptions, is as following:

K-ar

Where I social value of rupee of savings (investment) r marginal productivity of

capital

a reinvestment rate on additional income arising from investment

K social discount rate

The formula for the social value of savings is valid when the following conditions are

Satisfied:

the inertial productivity of capital and the reins straent rak on additional income.

(Marginal propensity to save) are constant over time. savings rate in the rociety will
not become optional in the foreseeable future. Many governments regard
redistribution of incom: in favour of economically weaker D sections or economically
backward regions as a socially desirable objective.

(d) Stage four of the UNIDO method is concerned with measuring the impact of the
impact on income redistribution. (e) Stage five decls with adjustment for the impact
of the project on merit and demerit goods, in some cases, the analysis is extended
beyond stage four to reflect the difference between the economic value and social
value of resources. This difference exists in the case of merit goods and demerit
goods. A merit good is one for which the social value exceeds the economic value.
For example, oil production inay be grown more social value than economic value by
a country because it reduces dependence on foreign supplies. In the case of demerit
goods, the social value of goods is less than its economic value. For example,
tobacco products are regarded as having social value less than economic value. The
procedure for adjusting for the difference between social value and economic value
is

As follows:

Estimate the economic value.

D) Calculate the adjustment factor as the difference between the ratio of social value
to economic value and unity. i) Multiply the economic value by the adjustment factor
to obtain the adjustment

iv) Add the adjustment to the net present value of the project.

3.4 Little Mirvlees Approach

IMD Little and J.A. Mimlees have developed an approach (L-M approach) to social
cost benefit analysis. This approach is expounded by them in two works: Manual of
Industrial Project Analysis in Developing Countries and Project Appraisal and
Planning for Developing Countries. There is considerable similarity between the
UNIDO approach and

L-M approach.

Both the approaches call for:

1. Calculating accounting (shadow) prices particularly for foreign exchange savings

unskilled labour,

2. Considering the factor of equity, and

and

3. Use of DCF analysis. Despite considerable similarities, there are certain

differences between the two approaches: 1.

The UNIDO approach measures costs and benefits in terms of domestic rupees
whereas the L-M approach measures cost and benefits in terms of international
prices, also referred to as border prices.

2. The UNIDO approach measures costs and benefits in terms of consumption

whereas the L-M approach measures costs and benefits in terms of uncommitted
social income.

3. The stage-by-stage analysis recommended by the UNIDO approach focuses on

efficiency, carvings and redistribution considerations in different stages. The L-M
approach, however, tend to view these considerations together. As per the L-M
approach, the outputs and inputs of a project are classified into the

Following categories:
D) traded goods and services, D non-traded goods and services,labour.

The shadow price of a traded good is simply its border price. If a good is exported,
its shadow price is its FOB price and if a good is imported, its shadow price is its CIF
Price.

The shadow prices of non-traded goods are defined in terms of marginal social cost
and marginal social benefit. The marginal social cost of a good is the value in terms
of accounting prices of the resources required to produce an extra unit of the goods.
The marginal social benefit is the value of an extra unit of the good from the social
point of view. When a good is not taxed and consumed by only one income group, its
marginal social benefits equal to its market price multiplied by a factor which
represents the value assigned to an increase in the income of that group vis-a-vis an
equal increase in uncommitted social income

The calculation of marginal social cost and marginal social benefit is often a difficult
tack. As a practical expedient, L-M has suggested that the monetary cost of a non-
traded item be broken down into tradable labour, and residual components. The
tradable and residual components be converted into social cost by applying suitable
social conversion factors, the Labour component's social cost can be obtained by
using social wage rate. L M has suggested the following formula for calculating the
shadow wage rate

SWRC-1/s (C-m) Where SWR shadow wage rate

C additional resources devoted to consumption. 1/s-Value of a unit of committed

resource

C=Consumption of the wage earner.

marginal product of the wage earner.

The components of SWR may be rewritten as follows: SWR m+ (C+c) + [1-1/s) (C-
m)

where marginal product of labour

(C-c) cost of urbanisation (it is the cost associated with providing consumption level
of c though it does not form part of it) (1-1/s) (C-m) = the cost of having an additional
amount (C-m) committed to

Consumption. I is the value of a unit of uncommitted resource and 1/s is the value of
unit of committed resource,

General Framework of SCBA

Different agencies have given different set of guidelines for applying SCBA. We can
develop a general framework of SCBA. A systematic application of SCBA would
generally involve the following: (a) Measuring economic, social and environmental
inputs and outputs of the

Projects Broadly economic, social and environmental benefits and costs of a project
can be classified into three categories. The three categories of benefits and costs
associated with

a project are: those which can be quantified and also translated into money terms,

D those which can be quantified but cannot be translated into money terms, and
those which can neither be quantified nor translated into money terms,Intangibles.

Called

(b) Shadow Prices The prices relevant for use in social cost-benefit analysis are
called shadow prices or social prices or accounting prices. To estimate the costs and
benefits of a project inputs are translated into cost by the use of price mechanism.
The output of the project which is measurable and convertible into money terms is
translated into prices are used for

Converting inputs into cost and output into monetary benefits, therefore, would
determine to an important extent the complexion of social cost benefit analysis.
Shadow prices express prices in terms of opportunity cost. Taking an example,

If the prevailing rate of foreign exchange is higher than the officially fixed rate, then
the price of imports into the country is understated. Here, the shadow price of foreign
exchange used in social cost benefit analysis would be higher that the official
exchange rate. Also, while determining shadow price of a commodity taxes are
removed from the market place, as these are considered to be transfer payments
and therefore, not a cost to the society.

According to the methodology of shadow pricing, those goods which can enter into
foreign trade are valued at border prices. The commodities which can be imported
from abroad are valued at their C.L.F. (cost-insurance-freight) price. Those
commodities which can be exported to other countries are valued at F.O.B. (free on
board) price.

For non-traded goods, the border prices are not relevant. Social valuing of these
goods is done on the basis of their marginal cost of production, which is broken
down into traded goods and labour. If there are non-traded goods in the cost of
production, these are further broken down and the components are reduced to
traded goods, labour and taxes. The term labour here includes all domestic receivers
of private income i.e. not government but independent interests. The traded goods
are then priced at their relevant border prices and labour at Social Wage Rate
(SWR) or social opportunity cost of labour.

(c) The Conversion Factors In order to arrive at shadow prices, as a short cut,
conversion factors may be used. There may be several conversion factors for
individual commodities or different sectors. These conversion factors are defined as
some average ratios of accounting prices to market prices, whether the reference is
to a particular commodity or a sectoral average. A general conversion factor (known
as standard conversion factor or SCF) can be prepared. This SCF is the weighted
average of the ratios of accounting prices to market prices. The formula for
calculating SCF is:

Q.AP

Q.MP

Where AP= Accounting Prices MP-Market Prices Q=Available supply

SCF =

Social Weights

Different projects yield different benefits and costs to society. The benefits accruing
section of society might be valued more and hence given certain weights than the s
accruing to other section of society. These weights reflect social preferences. a
project gives a benefit worth Rs. 50,000 to a richer section of society. The to one
benefits accruing poorer section can be multiplied by a suitable weight say 2, 3 etc.
to For example, p reflect higher preference of the decision maker for benefits to the
poor. benefit (2) Selecting Appropriate Social Rate of Interest

The social rate of interest is the social opportunity cost of capital, the rate which will
just result in all the capital in the economy being invested if all possible projects were
undertaken which yielded that ed that much or r more return. The rate should reflect
the opportunity to the society between present and future returns and the amount the
society could get from the use of savings. The choice of the rate of interest which
correctly reflects time value of money plays an important role in social appraisal.
(Determining Social Profitability of the Project

In determining SCBA, the use of decision criterion, whether Net Present Value or
Internal Rate of Return or Benefit Cost ratio has to be applied to all those benefits
and costs which could be converted into money terms. In SCBA balance sheet all
the benefits and costs should be listed, including those, which could not be
translated into monetary values. The final decision about selection of a project is
done after carefully looking at all the benefits and costs, direct or indirect, associated
with the project. Value judgments are exercised in assigning weights to non-financial
benefits and costs while selecting a project.

3.5 SCBA by Indian Financial Institutions The Development Financial Institutions

(DFLs) in India, in their economic appraisal, mal use projects also from the social
point of view. The DFIs consider the following aspects:

Economic rate of return (ERR) Effective rate of protection (ERP)

Domestic resource Cost (DRC) Economic rate of return

The calculation of economic rate of return is partially based on Little-Mirrlees
method. Like L-M approach, all non-labour inputs and outputs are converted to
international prices. For all tradable items, CIF prices are used for inputs and FOB
prices for cutouts - when such international prices are available. For all other items
social conversion factors are used to convert actual rupee cost to social cost.
() Effective Rate of Protection

Such analysis is made to measure the extent to which the project is sheltered by

Government protection in the form of import restrictions, import duties, subsidies, by

the Govt. etc. The ERP is measured in terms of percentage using the following
formula:

Value added at domestic prices-value added at world races

Value added at world prices

ERP

Where value added= Sales realisation - Total input cost

The data required for calculating ERP relates to selling price and input cost (traded,
and non-traded). This data is arranged at domestic prices and at world prices. The
domestic selling price is net of taxes and excise duties but inclusive of a reasonable
selling commission. The selling price at world price is the CIF price for imports and
FOB for exports. The data required for calculating the ERP may be arranged as
follows A domestic prices

At world prices

A. Selling price

B. Input cost Traded

C. Value added The input cost consists of the costs of following inputs:

Raw material and stores

Power, fuel and water

Repairs and maintenance

Part of administrative overhead and expenses

Selling expenses

The difference between selling price and input costs is value added. This represents
payment to labour and capital.

(ii) Domestic Resource Cost

Domestic Resource Cost indicates the cost in terms of domestic resources by which
one unit of the relevant foreign currency is earned or saved by the project.

The DRC is calculated as follows: Value added at domestic prices

x Exchange rate

Value added at world prices For calculating the DRC, data may be arranged as
below

Domestic

Imported

Selling Price

Operating Costs Raw Materials (net of duties and tax) Power, fuel, and water

Repairs and Maintenance Administrative overhead

and expenses

Selling expenses Capital Costs

(a) Charge on

Capital employed

Social Cost benefit analysis highlights the non-financial considerations, viz.

economic, (b) Depreciation social and environmental relevant to project evaluation.
Because of government's responsibility for the social welfare and supplement of
social conditions Government undertakes many projects with non-financial
justifications. Such projects are designed for the people it is intended to serve. The
private sector also undertakes many projects with ao-ficancial justifications, such as
when there is a need to build up a corporate in sponsoring projects for education or
sports and games etc. for the people in the locality.

The capital employed consists of fixed assets plus working capital. It is broken down
is to indigenous and imported components. After deducting taxes and duties from
both the components, the charge on capital employed is calculated. Capital
equipments are divided is to indigenous and imported components. After deducting
duties and taxes, depreciation on capital is taken. LO Summary

Social cost benefit analysis is a methodology for evaluating project from the social
point of view. In SCBA the focus is on social benefits and costs of a project. These
are some basic differences between commercial calculations and social cost benefit
analysis. The social cost benefit analysis started in India in the sixties on a limited
scale. The evaluation of a project begins by clearly stating the relevant social aims
and benefits in SCBA. The UNIDO method of project appraisal involves five stages
(i) calculation of financial profitability of the project measured at market prices (ii)
obtaining the net benefit of the project measured in terms of economic prices (iii)
adjustment for the impact of the project on savings and investment (iv) adjustment
for the impact of the project on income distribution and (v) adjustment for the impact
of the project on merit and demerit goods. Little Mirrlees approach has considerable
similarity with the UNIDO approach. However, these are some important differences
as well. As per L-M approach, the outputs and inputs of a project are classified into
traded goals and services, non-traded goods and services and labour. The shadow
price of a traded good is its border price. Development financial

Institutions

Economic of

Prasanna Chandra,

Parmeshwar P. Iyer and

Publishing, Ghosh, Project Management and Control, Agency,

Gopala and V.E. Ramamurthy, Text Book of Project Management,

Macmillan India Limited, 6.0 Self Assessments

1. Explain social cost-benefit analysis. How

a project? 2. Highlight some basic differences between commercial

Cost benefits analysis. When and why should we undertake analysis for project? 3.
What are the similarities and between the UNIDO approach

Mirrlees approach?

MBA-Project Management

LESSON NO. 12 MBAFM-205

Structure

Introduction

2.0 Objectives

10

Presentation of Contents 3.1 Project Constraints

3.2 Approaches to multiple projects 3.2.1 Method of Ranking

3.2.2 Mathematical Programming Approach

4.0 Summary 5.0 Suggested Readings

60 Self Assessment Questions

10 Introductions

When investment projects are considered individually any of the discounted cash
flow criteria-net present value, internal rate of return, or benefit cost ratio-may be
applied for obtaining a correct "accept or reject" signal. In an existing organisation,
however, capital investment projects often cannot be considered individually or in
isolation. This is because the pre-conditions for viewing projects individually-project
independence, lack of capital rationing, and project divisibility - are rarely, if ever,
fulfilled. Under the constraints obtaining in the real world, the so-called rational
criteria per se may not necessarily signal the correct decision.

2.0 Objectives

After reading this lesson, you should be able to (a) Explain about the project
constraints.

(b) Construct a set of projects for which there is conflict in ranking as per NPV, IRR

BCR criteria.

(c) Describe the linear programming model.

(d) Critically evaluate the integer linear programming model.

(e) Discuss the goal programming model.

Paper: MBA-711 Updated by: Dr. M. C. Garg

Multiple Project And Castraints

3.0 Presentation of Contents 3.1 Project Constraints

The following are the project constraints: (a) Capital rationing: The resources are not
normally available in unlimited quantity and have to be rationed amongst competing
demands and priorities. Capital rationing may cross because of internal limitation or
an external constraint. Internal capital rationing is caused by a decision taken by
management to set a limit to its capital expenditure outlays; or it may be caused by a
choice of hurdle rate higher than the cost of capital of the firm. External capital
rationing arises out of the inability of the firm to raise sufficient amounts of funds of a
given cost of capital. The usual supply and demand for capital will determine the cost
of capital. The usual supply and demand relationship is shown with the help of the
following diagram:
Y-axis

M1

-S

XI X

X-axis

The supply demand equilibrium at point M' gives the rate of interest (cost of capital)
OY. The project selection authority will utilize the funds 'OX' and will take up those
projects which would lie on DM segment of DD. The projects are ranked along, DD,
inversely in order of diminishing profitability. The project to the left of M has a
positive net present value when discounted at the relevant cost of capital (OY) and
the marginal project has a zero net present value of this interest. Now; suppose the
funds are rationed to the extent of OX, the projects falling on M.M will have to be
foregone.

Capital Rationing - A Linear Programming Approach: The fundamental theorem

around which the linear programming model is woven is to maximise net present
values of all investment proposals within the constraints of the availability of total
funds. A frequently used model could be written as:

Maximise

ΣΡΧ,

i-1

213

CX, SB, (1-1,2T)

- amount of funds required by the ith project in period t where projects

C= 1, 2, n, time period 1=1, 2, T. = net present value of the project i.

0

Subject to

Where,

Cit

P = absolute amount of funds to be invested in period 't'.

B XI

= integer representing the proportion of project "i' taken on. It can be either

or 1 (rejected or accepted).

In the constrained maximum form, NPV is maximised within the constraints of funds
availability and mutual exclusiveness of project (acceptance of one project to the
exclusion of another).

Through this linear programming model, the firm will be able to select the best set of
investments from the criteria of maximising their net present values within the
constraints of the availability of a predetermined quantum of investable funds.
However, the problems associated with such model building exercise stem from the
enormous information inputs that would be needed to make use of them (present
value of all investment opportunities and constraints, etc.).

(b) Project Indivisibility: Capital projects are considered indivisible i.c. a capital
project has to be accepted or rejected into A project cannot be accepted partially.
Given the indivisibility of capital projects, and the existence of capital rationing. the
need arises for comparing projects. To illustrate this point, consider an example.

Example: A company working against a self-imposed capital budgeting constraint

of Rs.7,00,000 is trying to decide which of the following investment proposals should

be undertaken by it. All these investment proposals are indivisible as well as
independent. The list of investments along with investment required and, the NPV of
the projected cash flows are given as below:

Project

E
Initial Investment (Rs.)

2,40,000

3,20,000

2,20,000

1,80,000

NPV (Rs.)

60,000

1,80,000

Which investments should be acquired by the company?

NPV from investments D, E and D is Rs 6,80,000 with Rs. 6,40,000 utilized leaving
Rs. 60,000 to be invested income other investment outlet. No other investment
package would yield an NPV of this amount. The company is advised to invest in D,
E and projects.

(n) Project dependence: Project A and B are economically independent if the

acceptance or rejection of one does not changed the cash flow stream or does not
affect the acceptance or rejection of the other. On the other hand, a project A and B
ate commercially dependent if the acceptance or rejection of one change the cash
flow street of the other or affects the acceptance or rejection of the other.

If two or more projects are mutually exclusive, acceptance of any one project out of
the set of mutually exclusive projects automatically precludes the acceptance of all
other projects in the net. For example the alternative possible uses of a building
represent the of mutually exclusive projects. Clearly if the building is put to one me, it
cannot be put to any other use.

Another kind of dependency occurs when there is complementarily between projects.

If undertaking a project influences favourably the cash flows of another project, the
two projects are complementary projects. Complementarily may be of two type
asymmetric complementarily and symmetric complementarily. In asymmetric
complementarily, the favourable effect extends in one direction. For example, project
A favourably influences the cash flow of project whereas project B in turn, has no
influence on cash flows of project A. In symmetric complementarily, the favourable
extends in both directions: project A-bas favourable influence on the cash flows of
project B and, likewise,

Project B has favourable influence on cash flow of project A. Basically, there are two
approaches available for determining which projects to
3.2 Approaches to multiple projects

Accept and which projects to reject. (1) The method of ranking

(2) The method of mathematical programming.

3.2.1 Method of Ranking: The method of ranking consists of two steps:

(0) Rank all projects in decreasing order according to their individuals NPV's, IRR's
or BCR's.

(b) Accept projects in that order until the capital budget is exhausted. Example:
Selection of projects under capital rationing.

Consider a set of four projects A, B, C & D for which the investment outlay, expected
annual cash inflow, net present value (NPV), internal rate of return (IRR), benefit

cost ratio (BCR) and the ranking (shown in brackets) along these dimension are
shown 215

below:

Projects

Capital (Ra.

crores)

500

200 400

100

Not Income P. (Rs. crores)

300 (1 102 EA 70 to 3 yr 100 (1 to 3 yrs.)

NFV at 5% (Rs. creres)

57 (11) 103 (5)

30.3 (111)

10.0 (IV)

BCH

1:52 (1)
13% (10) 32% (

108 (14) 7% (IV)

130 (11) 15% (11)

In a situation of scarcity of a particular resource, say capital, all projects envisaged to

be undertaken may not be possible to be implemented. We have to select these
projects which would generate the largest incremental increase in share values per
unit of financial resources. Suppose the funds available are Rs.700 crores. The
following will be the procedure to select the project under capital rationing constraint:

Criteria

NPV BCR

IRR

Projects selected B and A

B, D and part of A B. D and part of A

It is clear in the above case the three criteria rank the projects differently. If there is
no capital rationing all the projects would be accepted under all the three criteria
though internal aking may differ across criteria. However, if the funds available are
limited, the set of projects accepted would depend on the criterion adopted.

However, there are some limitations to this simple ranking method. One of these is
that it breaks down whenever more than one resource is rationed. 3.2.2
Mathematical Programming Approach:

A mathematical programming model is formulated in terms of two broad categories

of equation: (i) the objective function and (ii) constraint equations.

The objective function represents the goal or objective the decision maker seeks to
achieve. The objective function is always non-negative. Constraints are the set of
restrictions imposed on the variables or some combination of few or all the variables
appearing in the objective function. These constraints or restrictions are due to
limitations of manpower, capacity of the plant, capital available, time restrictions etc.
i.e. the resources. The mathematical model seeks to optimise the objective function
subject to various constraints. Out of the wide variety of mathematical programming
models, we shall discuss three types (a) Linear programming model

(b) Integer programming model

(c) Goal programming model

(a) Formulation of linear programme leg model: The construction of 216

D function as well as the constraints is known as formulation of linear programming
problem. The following are the basic steps in formulation of LPP. Identify the
variables to be determined and then express these by some algebraic symbols,
objective

Locate the various constraints/restrictions present in the problem and express these
as linear equations/ inequalities which are some linear functions of the variables
identified in step (i).

Determine the objective of the problem and express it as linear function of the
decision variables involved in the phenomenon. Linear Programming Model of a
Capital Rationing Problem: Let us start with a simple example. The opportunity cost
of capital is 10 per cent and the company has the following opportunities

(Rs. in crores)

NPV at 10%

21

16

12

Project

AB

Cash outflow

10

Cash inflow

30

All these projects are attractive, but suppose that the firm is limited to spending
Rs.50 crores.

Suppose that we were to accept proportion XA of project in our example. Then the
not present value of our investment in the project would be 21 XA. Similarly, the net
present value of our investment in project B can be expressed as 16 XB and so on.
Our objective is to select the set of projects with the highest total net present value.
In other words, we wish to find the value of X that maximize NPV,

NPV-21X, +16x +12Xc Our choice of project is subject to several constraints. First,
total cash outflow in

period must not be greater than Rs.50 crores. In other words: 10X +5X +5X 2.50
Similarly, for obtaining a positive net present value, the cash inflows

than Rs.50 crores. In other words: 30X +6X +8X 250

Also, we cannot invest a negative amount in a project.

Therefore, we have

Collecting all we can summarize the problem as

21X, +12X Subject to constraints

+5X +5X 50 30X +6X +8X250

One way to tackle such a problem is to keep selecting different values for the noting
which combination both satisfies the constraints and gives the highest present value.
But it is smarter to recognize that the equations above constitute programming
problem. It can be handed to a computer equipped solve linear programming
problems. Other Constraints on Non-Financial Resources: Money may not be the
only scarce

Resource. Each of our projects may require services from 12 person technical
department. If project A would employ three designers, project B two, and so would
need to add a constraint like Sometimes it is appropriate to place constraints on the
total increase in physical

+8X ≤ 12

Capacity. Suppose that projects A and C produces four and three units respectively
of the same product. If the company is unable to sell more than five units, it is
necessary to add

+3X

(b) Integer Linear Programming Model In linear programming each of the decision
variables is allowed to take any real or fractional value. However, there are certain
practical problems in which the fractional value of the decision variables no
significance. For example, it is absurd to speak of 1.5 men working on a project or
1.6 machines in workshop. The rounding off the fraction values of the optimal
solution from linear programming cannot guarantee that the deviation from actual
values will be large enough to retain the feasibility of the solution. Thus, we should
try to evolve some method by which integer solution is obtained without any
unreasonable or arbitrary approximations. The method known as integer
programming. If all the variables should have integer values then known as pure
integer programming problem and if some variables can have integer values and
some can have fractional values in the solution, then known as mixed integer
programming problem. The pure integer linear programming problem its standard
Form can be stated as follows: Maximize C,X, C₂X₂

Subject to the constraints

4₁, X₁

X₁ X₂

C,

Collecting all we can summarize the problem as

21X, +12X Subject to constraints

+5X +5X 50 30X +6X +8X250

One way to tackle such a problem is to keep selecting different values for the noting
which combination both satisfies the constraints and gives the highest present value.
But it is smarter to recognize that the equations above constitute programming
problem. It can be handed to a computer equipped solve linear programming
problems. Other Constraints on Non-Financial Resources: Money may not be the
only scarce resource. Each of our projects may require services from 12 person
technical department. If project A would employ three designers, project B two, and
so would need to add a constraint like Sometimes it is appropriate to place
constraints on the total increase in physical

+8X ≤ 12

capacity. Suppose that projects A and C produces four and three units respectively
of the

same product. If the company is unable to sell more than five units, it is necessary to
add

+3X

(b) Integer Linear Programming Model In linear programming each of the decision
variables is allowed to take any real or fractional value. However, there are certain
practical problems in which the fractional value of the decision variables no
significance. For example, it is absurd to speak of 1.5 men working on a project or
1.6 machines in workshop. The rounding off the fraction values of the optimal
solution from linear programming cannot guarantee that the deviation from actual
values will be large enough to retain the feasibility of the solution. Thus, we should
try to evolve some method by which integer solution is obtained without any
unreasonable or arbitrary approximations. The method known as integer
programming. If all the variables should have integer values then known as pure
integer programming problem and if some variables can have integer values and
some can have fractional values in the solution, then known as mixed integer
programming problem. The pure integer linear programming problem its standard

form can be stated as follows: Maximize C,X, C₂X₂

Subject to the constraints

4₁, X₁

X₁ X₂

C,

Capital required year-wise by projects Year 1 Year J

Year 2

700

300

350

1200

550

150

200

700

400 350

100

460

Project

Present

value of expected

return 630
225

250

Capital available for vestment

In addition, projects 1 and 2 are mutually exclusive and project 4 is contingent on the
priot acceptance of project 3. Formulate an integer programming model t determine
which projects should be accepted and which should be rejected to maximize the
present value from accepted projects.

Model formulation:

Let

X,- 1 if project j is accepted 0 if project j is rejected.

aleger LP Model: Maximize (Total Present Value) Z-650X, +700X, +225X, +250X,
subject to the constraints:

Expenditure in year 1, 2 and 3

700 X, +850 X, +300 X, +350 X, 1200 550 X, +550 X+ 150 X, +200X, 5700

400 X, +350 X, +100X, ≤ 400

X,+X, SI X,+X, SI

X₁ = 0 or I

(c) Goal Programming Model: The goal programming model is a method for solving
an optimization problem with multiple goals. This method seeks to solve the
programming problem of minimising the absolute deviations from the specific goals
in order of the priority structure established. The distinguishing feature of goal
programming is that the goals are satisfied in ordinal sequence. That is, the solution
of the goal programming problem involves achieving some higher goals first, before
the lower order goals are considered. Since, it is not possible to achieve every goal
to the extent desired by the decision-maker, attempts are made to achieve a
satisfactory level of all his goals rather than optimum solution for a single goal.

In goal programming, instead of trying to minimize or maximize the objective function

Directly as in linear programming, the deviations from established goals within the
given ser of constraints are minimized. The deviational variables are represented in
two dimension both positive and negative deviations, from each goal and sub-goal.
The objective function then becomes the minimization of a sum of these deviations
based on the relative importance within the pre-emptive priority structure assigned to
each deviation. Goal. Programming Format: With 'm' goals, the general goal linear
programming
model may be stated as:

Minimize Z ΣΣΗ Pr(W-4,-+W, +4,+)

subject to, the linear constraints

ŻaijXj+di-di+mbi,i=1,2, H

and Xjdi - dj + 20

Where X represents a decision variable which is under the control of the decision
maker, whereas ranking coefficient Pr weights W, matrix of coefficients, a, and the
constant, b, are not under the direct control of decision-maker, d, - and d,+ are
deviational variables representing the amount of under and over achievement of its
goal respectively. The goal programming model is formulated in terms of three
principal components: (1)

The objective function; (i) The economic constraints (iii) goal constraints. The
objective function seeks to minimize the weighted deviation from the target levels of
various objectives in accordance with a priority structure. The economic constraints
represent resource limitations or restrictions emanating from the decision
environment which cannot be violated. They are referred to as 'hard constraints'. The
goal constraints represent target levels of various goals that are pursued by the
decision maker. Defined as strict equalities, goal constraints contain, in addition to
an expression showing the impact of decision variables on goal attainment, two
deviational variables denoted by d,+ und d, - d,+ indicates that the desired level of
goal i has been over-achieved, d,- indicates that the desired level of goal i has been
underachieved. When the desired goal level has been over achieved Id,+ is non-
zero, when the desired goal level has been underachieved, d,+ is zero and d,- is
non-zero; when the desired goal level is exactly achieved, both d,+ and d -are zero.
The deviational variables tie the goal constraints and the objective function. For each
goal, the appropriate deviational variables are placed in the objective function.

Illustration: An office equipment manufacturer produces two kinds of products, chairs

and lamps. Production of either a chair or a lamp requires I hour of production
capacity in the plant. The plant has a maximum production capacity of 50 hours per
week.

Because of the limited sales capacity, the maximum numbers of chair and lamps

old are 6 and 8 that can be per week respectively. The gross margin from the sale of
a chair is Rs.90 and Rs.60 for a lamp. The plant manager desires to determine the
number of units of each product that should be produced per week in consideration
of the following set of goals:

Available production capacity should be fully utilized but not exceeded. Sales of two
products should be as much as possible. (1)
Overtime should not exceed 20 per cent of available production time.

Formulate this problem as a GP model so that the plant manager may achieve his
goals as closely as possible.

Solution

Model Formulation: Let x, and x, number of units of chair and lamp produced
respectively.

The first goal pertains to production capacity attainment, with a target established at

50 hours per week. This constraint can be stated as: x₁+x,+d, -d,+ = 50 Where, d-
underutilization (idle) of production capacity

D,+=Over utilization (overtime) of production capacity If this goal is not achieved, d,-
would take on a positive value and d,+ would be

The second goal pertains to maximization of sales which have sales volume
constraint. The sales constraints can be expressed as:

x, +d,- = 6 x₂ +d, = 8

Since the sales goals are the maximum possible sales volume, d,+ and d,+ will not
appear in these constraints. Thus over achievement of sales goals is ruled out. The
third goal pertains to the minimization of overtime as much as possible. The
constraint is stated as follows: d,+ d-d, = 0.2 (50) -10

Where,

d-overtime less than 20 per cent of goal constraint

d+= overtime more than 20 per cent of goal constraint

d,+= overtime beyond 50 hours. Now the production problem can be summarized in
goal programming model form

Minimize Z=d,. +d, +d, +d₂. Subject to the constraints

x₁ + x, +d, -d,+50

z+d, -8

d+d, -d, +-10

and x,.x,,d,..d...d...d,..d.. 20 4.0 Summary

Investment projects cannot be viewed in isolation because of project constraints like

capital rationing and project indivisibility. Capital rationing exists when funds
available for investment are inadequate to undertake all projects which are otherwise
acceptable. Two approaches are available for comparing projects in order to accept
some and reject others. These are the method of ranking and the method of
mathematical programming. The method of ranking consists of two steps namely (a)
rank all project in decreasing order according to their individual NPV, IRR or BCR
and (b) accept exhausted. A mathematical programming model is formulated in
terms of two categories of equation viz. the objection function and constraint
equations. The linear programming model assumes that the objective function and
constraint equations are linear and the decision variables are continuous. The
integer linear programming model assumes that the decision variables assume a
value of 0 or 1. The goal programming model is a method for solving an optimization
problem with multiple goals. This method seeks to solve the programming problem of
maintaining the absolute deviations from the specific goals in order to the priority
structure established. 5.0 Suggested Readings

(1) Prasana Chandra, Projects - Planning, Analysis, Selection, Implementation

Review, Tata McGraw Hill, New Delhi. (2) Parmeshwar P.lyer and F.C.

and

Kohli, Engineering Project Management, Wheeler Publishing, New Delhi. (3) S.

Ghosh, Project Management and Control, New Central Book Agency, New Delhi.

(4) Krishnan Gopala and V.E. Ramamoorthy, Text Book of Project Management,

Macmillan India Limited, New Delhi.

6.0 Self Assessment Questions 1. Construct a set of four projects for which there is
conflict in ranking as per NPV, IRR, and BCR criteria. 2. What assumptions underlie
the linear programming model?

3. Critically evaluate the integer linear programming model as a tool for capital

Budgeting. 4. Discuss the following in the context of a goal programming model:

objective function, economic constraints, and goal constraints.

5.

Galaxy Limbed is considering seven projects with the following characteristica:

Project

Initial Outlay

12

14

15
16

11

23

20

Contribution to net income

Year 1

12

1.6

0.6

1.5

0.5

0.9

1.8

Year 2

1.1

1.2

1.2

1.6

1.2

2.5

2.0

Year 3

1.6

1.5

2.0
1.8

1.5

4.0

2.2

Contribution to sales growth

(Percentage)

Year

1.0

12

0.5

1.8

0.6

1.0

2.0

Year

1.5

1.0

1.2

2.0 1.4

3.0

3.0

Year

3
1.8

1.2

2.5

2.2

1.8

3.5

3.5

NPV

The capital budget constraint is 65. The goals sought by management are as follows.

(1) maximisation of NPV, (ii) contribution to net income of 6.0, 8.0, and 10.0 in years
1,2 and 3 and (iii) contribution to sales growth of 6,8 and 10 per cent in years 1,2 and
3. The

Priorities assigned to various goals are as follows

Priority 1 Net income

Priority 2 Sales growth Priority 3 NPV

At priority level 1, the relative weights attached to the net income of years 1,2 and 3
are, 3,2,1 respectively. At priority level 2, the relative weights attached to the
contribution to sales growth of years 1,2, and 3 and 4,2, and I respectively.

Formulate the above problem as a goal programming problem.

MBA - Project Management

Paper: MBA-111 Updated by: Dr. M. C. Gart

LESSON NO. 13

MBAFM-205

Structure

Portfolio Theory and Capm Approach to Risk Analysis

1.0 Introduction

2.0 Objectives 3.0 Presentation of Contents

3.1 Portfolio Theory

3.2 Capital Market Theory

3.3 Capital Asset Pricing Model 3.4 Estimation of the Key Factors

4.0 Summary

5.0 Suggested Readings

6.0 Self Assessment Questions

4.0 Introduction

A portfolio is a combination of assets. Portfolio theory shows how an individual can

reach his optimal portfolio position. According to portfolio theory the riskiness of a
portfolio is generally less than the average risk of the individual asset in the portfolio.
It describes how rational investors should build efficient portfolios. The Capital Asset
Pricing Model (CAPM) specifies the relationship between systematic risk and
required rates of return on assets when they are held in well diversified portfolios.

2.0 Objectives After reading this lesson, you should be able to

(a) Define the risk of 2-Security and n-security portfolio. (b) Explain efficient frontiers
and determine the optimal portfolio on the efficient frontier

(c) Discuss the capital Asset Pricing Model.

(d) Define the aggressive and defensive investment, security market line and beta

3.0 Presentation of Contents

3.1 Portfolio Theory

The portfolio theory answers the question that what is the incremental contribution of
a project to the risk exposure of a firm as a whole. The risk of a project is judged in
the Context of the total risk of the firm. Portfolio theory, originally proposed by Harry
larkowitz, is also referred to as mean-variance portfolio theory or the two parameter

Folio theory. I'ortiolio theory is based on the assumption that the utility of an investor
function of two factors: mean (expected) return and variance (standard deviation) of
The investor is assumed to prefer a higher mean return to a lower one and prefer a
lower variance of return to a higher one

Portfolio Return
The expected return on a portfolio is simply the weighted arithmetic average of the
Expected returns on the assets constituting the portfolio. For example, when a
portfolio consists of two securities, its expected return is R,=X, R, +(1-X,)R,
where R, expected return on a portfolio X, proportion. of portfolio invested in security
1. R expected return on security 1.
(1-X,)- Proportion of portfolio invested in security 2.

R, expected return on security 2.

Illustration

Consider a portfolio consisting of two securities, A and B. Let the expected mm on

security A is 12 per cent and on B it is 16 per cent. The proportion invested on unity
A is 0.6 and on B it is 0.4. The expected return on the portfolio will be

0.6x 12% +0.4 x 16%-13.6 % Portfolio Return: n Security Case

When a portfolio consists of n securities, the expected rate of return on the portfolio

k, = Σx, R.

Where R, expected return on portfolio X-Proportion of portfolio invested in security.

R₁ = expected return on security i.

Illustration
Consider a portfolio, consisting of four securities with the following expected returns
R, 12 per cent, R, 14 per cent, R, - 15 per cent, and R, - 16 per 41 and X,-0.4. The
expected portfolio return is: The portfolio proportions invested in these securities are:
X, -0.2, X,-0.3, X, -

R,=X,R,+X,R,+X,R,+X,R, -0.2 x 12+ 0.3 x 14+0. 1x 15 +0.4 x 16-14.5 per cent

Portfolio Risk: The 2- Security Case Standard deviation of the portfolio rate of return
is used to measure the risk of portfolio. The risk of two asset portfolio is equal to

ap=X, +a, +a,' +2X,X,P,,a,a,

aP=[X,'a, +X,'a, +2X,X,P,,a, Whereas p-standard deviation of the portfolio return

X, - proportion of portfolio invested in security!

Al-standard deviation of the return on security! X, proportion of portfolio invested in

security 2

02-standard deviation of the return on security 2

Pucoefficient of correlation between the returns on securities I and 2

It is clear from the equation that the riskiness of a portfolio is a function of (0) the
proportions invested in the components,

the riskiness of the components, and the correlation of returns on the component
securities,

GP2 may be obtained as the sum of the elements in the following 22 matrix

x₁x, P, o, a,

The entries in the boxes lying on the diagonal from the top left to the bottom right
depend on the variances of returns on securities in the portfolio. The entries in the
other boxes depend on the co variances of returns on securities included in the
portfolio.

Portfolio Risk: The a- Security Case

The variance and standard deviation of an n-security portfolio are:

op=[ΣΣ××Ρ, 0]1/2
Where

σp = standard deviation of portfolio return =proportion of portfolio invested in security

i

= proportion of portfolio invested in security j.

= coefficient of correlation between the returns of securities I and J. = standard

deviation of return on security i.

-standard deviation of return on security). The relationship depicted above in the

equation can be shown in the following

Matrix:

X,' a,'

Efficient Portfolios

The investments available to an invector may be combined into any number of

portfolios. Maximisation of utility function is the criteria on which the choice of
portfolio depends. This involves two steps:

0 Delineation of the set of efficient portfolios, and

(B) Selection of the optimal portfolio from the set of efficient portfolios.

A portfolio is efficient if there is no alternative with (i) the same Rp and a lower op or

the same op and a higher Rp or

a higher Rp and a lower ap. In figure I the available portfolios lie in the region
ABEFG. Boundary ABE may be 1 referred to as the efficient frontier i.e. the portfolios
which lie along the boundary. ABE are the efficient. All other portfolios are inefficient
risk.
MEAS

We have merely defined what is meant by a set of efficient portfolios. How can this
set be actually obtained from the innumerable portfolio possibilities that lie before the
investor? The set of efficient portfolios may be determined with the help of graphical
analysis, or calculus analysis, or quadratic programming analysis. The major
advantage of graphical analysis is that it is easier to grasp. The disadvantage of
graphical analysis is the it cannot handle portfolios containing more than 3 securities.
The calculus method can handle portfolios containing any number of securities since
mathematical analysis can grapple with the n-dimensional space. However, the
calculus method is not capable of handling constraints in the form of inequities.
Quadratic programming analysis is the most versatile of all the three approaches. It
can handle any number of securities and it can cope with inequalities as well. For
practical purposes, the quadratic programming approach is the most useful
approach. Risk-Return Preferences

Determining risk-return preferences of the investor is the next step. It can be

depicted through risk-return indifference curves.

Figure 1

Expected returns

Figure 2

The Figure 2 shows 4 risk return indifference curves I, I, I, I,. All the points lying an a
given indifference curve offer the same level of satisfaction. The indifference curve L
represents a higher level of satisfaction than the indifference curve I, and similarly I,
and 1, represent higher satisfaction level than the indifference curves 1, and L,
respectively.

Optimal Portfolio

Given the efficient frontier and the risk-return indifference curves, the optimal

Portfolio is found at the point of tangency between the efficient frontier and a utility

Indifference curve.

N₁

N₁

M₂ M₂ M₁

Std deviation of return op

Figure J.

Two investors M and N are confronted with the same efficient frontier XYZ. The
indifference curves are different for both the investors. For investor M it is
represented by M₁, M, and M, while for N it is represented by N₁. N, and N,.
Investors M and Nare achieving highest utility at points M and N respectively. These
are points of tangency between the efficient frontier and utility indifference curves.
3.2 Capital Market Theory

Capital market theory is a major extension of portfolio theory given Markowitz. It is

concerned with how assets should be priced in the capital markets, if investors
behaved in the way as portfolio theory suggested.

by Harry

All the investors should hold portfolios lying on the line R,X, The efficient frontier of
risky portfolios is AB. When a tangent is drawn from risk free rate of return to the
efficient frontier, the efficient set of portfolios get modified from AxB to Rx. This
implies that investors should hold a combination of risk free assets and risky portfolio
X. Thus all the investors should hold portfolios which lie on the line R,x Z, with
particular location of a given individual's portfolio being determined by the point at
which his or her indifference curve is tangent to the line The line R, X Z is called the
Capital Market Line (CML)

(36)

Risk

Capital Market Lins and Eicient Prontler

Figure 4

3.3 Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) developed Linter in 1960s' describes the
relationship between expected return and unavoidable risk. and the valuation of
securities based on that.

CAPM is based on the following assumptions:

1. 2. Individuals have homogeneous expectations. Individuals seek to maximise the

expected utility of their portfolios over a single period planning horizon.

3. Individuals are risk averse,

4. There are no taxes; there are no transaction costs; securities are completely
divisible; the market is competitive.
5.The quantity of risky securities in the market is given.

Individuals can borrow and lend freely at the risk less rate of interest. The Capital
Asset Pricing Model as a framework for investment projects implies that projects
should be judged with reference to their systematic risk. The thrust of Capital Asset
Pricing Model is that the required return for any project is not dependent on the firm's
present or expected earnings, but on what the market expectation is for the category
of systematic risk associated with the project. The investment projects should be
evaluated

6.On the basis of their systematic risk, and not on the basis of their total risk the
incremental risk which they contribute to the firm as a whole

For the securities held in a well diversified portfolio, the risk of each security
represented by beta which measures the risk contributed by each security to the
portfolio CAPM incorporates beta as the relevant measure of risk and relates it to the
required rate of return. According to this model, risk adverse investors higher of
return on securities with larger Risk free rate of return (R) is known with certainty.
Securities must provide the expectation of an excess return in order to investors to
forgo the risk free rate of return. Excess return is simply the expected less the risk-
free return. The excess return, also called, risk premium is necessary to compensate
the investors for risk.

Required rate of Risk the risk free return accounts for the time value of money.
According to the CAPM the risk premium consists of two parts market price of risk
and diversifiable Risk premium-Market price of diversifiable risk diversifiable risk is
measured by which is the slope of the characteristic

The characteristic line describes the historical relationship between the security and
excess return on market portfolio. Beta simply the slope of the line. depicts the
sensitivity of the security's excess return to that of indicates that a security average
non-diversifiable risk

Average non-diversifiable risk of the security equals to that of market portfolio.

Percentage changes in the prices of security tend to be same as that of the market
index. Beta greater dhan 1.0 indicates greater non-diversifiable risk than that of
market. These securities are called 'aggressive' investments. A slope less than I
indicate that security has less non diversifiable risk than that of the market. This type
of security is called 'defensive" investment,

The market price of risk is the reward per unit of risk measured in market terms. It is
measured with the required rate of return on the average risk security minus the risk
free rate of return (R). The required rate of return on the average risk security is
equivalent to the required rate of return on the collection of all securities (R). The
collection of all securities traded in the secondary market is called the market
portfolio i.e. Risk premium-Market price of risk x non-diversifiable risk

(R-R) Bp
Adding this risk premium to the risk free rate gives the required rate of return i.e. the
Capital Asset Pricing Model.

RR,+ (RR) Bj

*required rate of return on security j. = tisk free rate of return

Required rate of return on market portfolio.

Beta coefficient of security j. Greater the beta of a security, greater the risk, and
greater the expected return

Security Ma

Where

R required on a security.

R Risk free Rate of return

R required rate of return

Bj Beta coefficient of security j

Graphic Portrayal of CAPM

K,

Risk premium

R4 2

Risk tracr.rate

(Non-diversifiable risk;

Figure 6

The required rate of return (R,) is measured on the vertical axis and beta on the
horizontal axis. The relationship between the non-diversifiable risk and expected
return on security is known as security market line (SMI)

Under the assumptions of CAPM, all securities lie along this line. The figure 6 shows
that the expected return as a risky security is a combination of the risk free rate plus
a premium for risk. This risk premium is necessary to induce risk averse investors to
buy a risky security. The trade off between risk and return will determine the line's
slope i.e. to obtain a greater return, an investor must be willing to incur greater non-
diversifiable risk Added risk leads to significant increase in the required rate of
return. Slope of the Security Market Line

The Capital Asset Pricing Model suggests that when beta is zero, the required rate of
return equals the risk free return i.e.R.

R-R,+ (R.-R,B

-R₂+(R-RO

If bets of a security equals 1.0, then the security has the same non-diversifable as
the market portfolio, and the required rate of return on the security is R

- Rj = R₁ +(K-R,)B

-R+ (R-R) 1 =R₁+R-R

The slope of security market line is given by the following:

R-R₁ 10-0 Slope= =R-R₁

The slope represents the market price of risk Rm, Rf is the excess return necessary
to induce investor to buy an average security with the same risk as the market
portfolio. Figure 7 illustrate the required rate of return on a low and high risk security.
Security D represents a low risk security with beta of 0.50 and security G represents
a high risk security with beta of 1.50. The required rate of return on security D is
lower than the required rate of return on security G. The Capital Asset pricing Model
qualifies for different securities, the trade off between risk and required-rate of return.

Semalay Market Lion

Security a

Ba

security

6.5. 10 LS

Changes in Risk Aversion

The shape of the security market line reflects the extents to which investors are
averse to risk-the steeper the slope of the line, the greater the marginal investors risk
version. If the investor were indifferent to risk, there would be no risk premium and
the security market line would be horizontal. If the risk aversion increases, also
increases, thus increasing the slope of SML. e risk premium
Figure 8 examples an increase in risk aversion. If the market risk premium increases,
RI also increases to R 2. The return on other rising securities also rise. The effect of
this shift in risk aversion is more on aggressive securities (securities with beta more
than 1.0)

Capital Asset pricing Model (CAPM) helps to understand the risk return and pricing
the securities, Difficulty involved in application of the model include estimating a
reliable beta for future based on historical data, estimating the market price of risk
i.e. the risk premium. However inspite of the problems involved and so many
assumptions on which CAPM is based, it is truly of fundamental importance. It
represents the way people relationships must behave to maximize returns while
minimizing risk. 3.4 Estimation of the Key Factors

To apply the CAPM, one need estimates of the following factors that determine the

CAPM line:

Risk-free rate

Market risk premium

Beta

Risk-free Rate

The risk-free rate is the return on a security (on portfolio of securities) that is free
from default risk and is uncorrelated with returns from anything else in the economy.
Theoretically, the return on a zero-beta portfolio is the best estimate of the risk-free
rate Constructing zero-beta portfolios, however, is costly and complex. Hence, they
are often unavailable for estimating the risk-free rate.

Some practical alternatives for determining the risk-free rate are: (1) the 364-day
Treasury bill, (ii) the rate on a 10-year gilt-edged security, and (iii) the rate on a
20-year gilt-edged security.

It appears that the rate on a 20 year gild-edged security is a good choice because
the duration of a 20-year gilt-edged security is similar to that of the duration of a
stock market index portfolio (like the Bombay Exchange National Index). Hence the
rate on a 20-year gilt-edged security is consistent with the betas and market risk
premiums that are estimated in relation to the stock market index portfolio.

Market Risk Premium

The market risk premium is the difference between the expected return portfolio and
the risk-free rate. There are different ways of measuring it. One measure, that is
considered quite appropriate, is on the market

Long-run geometric average - Return on long-term gilt-edged return on a broad

market index securities.
The geometric average return on a security or portfolio is defined as: [(1+r) (1+r,
(1+r3..... (1+1)-1

where r, = return for year I return for year 2

m for year n For example, if the annual returns for years 1,2,3,4 and 5 are 15
percent, 0 percent, 354 percent, 26.7 percent and 15.7 percent respectively, the
geometric average return the 5 year project is:

((1+0.15) (1+0.00) (1+0.364) (1+0.267) (1+0.157)]1/5-1

-0.18 or 18 per cent.

The reasons for measuring the market risk premium as the difference between weg-
run geometric average return on a broad market index and the return on long-term
pledged securities are as follows:

The LA long time frame eliminates the effects of short-term aberrations and
anomalies)

The geometric average is superior to the arithmetic average as it is not biased by the
measurement period. Since the geometric average represents the compound rate of
return that equates the beginning and ending value, it is better estimate of the
expectations of investors over long period of time. Calculating the premium over
long-term return on gild-edged securities in consistent with the way in which the risk-
free rate is defined.

Beta The beta of an investment j is the slope of the following regression relationship:

R = a +b R+ c Where R, return on investment j (a project on a security) in period t R

return on the market portfolio is period t a intercept of the linear regression
relationship between

- Rjt and Rmt (a is pronounced as alpha) B-slope of the linear regression relationship
between R, and R (B is pronounced as beta) The variance of R, is:

Var (R₂) =B, +a+Var (c)

The total risk associated with investment j as measured by its variance is the sum of
two components: (i) The risk associated with the responsiveness of the return of the
investment to market index: B, +a, and (ii) the risk associated with the error term: Var
(ejt). The first component represents systematic risk and the second, unsystematic
risk. Systematic risk stems from economy-wide factors which have a bearing on the
fortune of all firms whereas unsystematic risk emanates from firm-specific factors.
While systematic risk cannot be diversified away, unsystematic risk can be. Hence,
the relevant risk, as per the capital asset pricing model, is the systematic risk. It is
also referred to as non divorceable risk.
To measure the systematic risk of a project, we have to calculate the slope of the
regression. The estimate of the slope of the regression model is:

B₁ =

Where ß-estimate of the slope in the regression model

P coefficient between the return on investment j and the return on investment m

standard deviation of the return on investment j

standard deviation of the return on market portfolio,

4.0 Summary

A portfolio is a combination of assets. Portfolio theory shows how an individual can

each his optimal portfolio position. Portfolio theory is based on the assumption that
the utility of an investor is a function of mean return and variance of return. The
investments available to an investor may be combined into any number of portfolios.
All the points lying n a given risk-return indifference curve offers the same level of
satisfaction. Given the efficient frontiers and the risk-return indifference curves the
optimal portfolio is found at the point of tangency between the efficient frontier and a
utility indifferences curve, capital market theory is concerned with how assets should
be priced in the capital markets, if investors behaved in the way as portfolio theory
suggested. CAPM describes the relationship between expected return and
unavoidable risk, and the valuation of securities based on that. The risk free rate is
the return on a security that is free from default risk and is uncorrelated with returns
from anything else in the economy. The market risk premium is the difference
between the expected return on the market portfolio and the risk-free rate,

5.0 Suggested Readings

(1) Prasanna Chandra, Projects - Planning. Analysis, Selection, Implementation and

Review, Tata McGraw Hill, New Delhi. (2) Parmeshwar P. lyer and F.C. Kohli,
Engineering Project Management, Wheeler Publishing, New Delhi.

(3) S. Ghosh, Project Management and Control, First Edition, New Central Book
Agency, New Delhi. (4) Krishnan Gopala and V.E. Ramamoorthy, Text Book of
Project Management,

Macmillan Indian Limited, New Delhi. 6.0 Self Assessment Questions 1. How is the
risk of 2-Security and n-security defined?

2. What is efficient frontier? How is the optimal portfolio on the efficient frontier?
Determined?

3. What is the relationship between risk and return as per CAPM?

4. 5. What are the basic assumption underlying the CAPM? What is aggressive and
defensive investment?
6. 7. What is the slope of security market line? What does beta mean? Describe why
beta is a useful measure of risk

MBA-Project Management

Paper: MBA-711 Updated by: Dr. M. C. Garg

LESSON NO. 14

MBAFM-205

Project Planning -Areas of Planning, Project Objectives and Policies, Tools of

Planning, Hierarchy of Plans

Structure

1.0 Introduction 2.0 Objectives

3.0

Presentation of Contents 3.1 Meaning of Planning

3.2 Steps in Project Planning

3.3 Functions of Planning 3.4 Areas of Planning

35 Hierarchy of Planning

3.6 Project Objectives and Policies

3.7 Tools of Planning

4.0 Summary

5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

Project planning is emerging as an important area of project management. Project

planning will cover all aspects relating to an enterprise. Broadly, planning implies
comprehensive and coordinated activities in all facets of an enterprise and is aimed
at the acceleration of development. Herein macro and micro-planning are blended to
ensure the success of the project. It, therefore, involves commitment at all levels to
the development ideal. Project planning is a process involving the joint effort of a
team of entrepreneurs, technicians and skilled workers. A planned project is a tool to
achieve the objectives of the project at a minimum cost.
2.0 Objectives

After reading this lesson, you should be able to

(a) Define project planning and explain the steps in project planning.

(b) Discuss the areas of planning. (c) Explain about hierarchy of plans

(d) Describe the criteria for articulation of project objectives and policies.

Highlight the various tools of planning.

Presentation of Contents Meaning of Planning

Planning is the answering of the following general questions:

What must be done? This question deals with objectives and magnitude How should
it be done? Answering this question leads to the selection of project or scope of
Strategy.

Who should do it? Roles and responsibilities can be assigned by answering this
Question. When must it be done? Scheduling is accomplished with this one. How
much will it cost? The budget is developed.

How good does it have to be? Quality levels are determined. What performance is
required? Performance specifications are generated.

What strengths do we have? How can we best take advantage of them? What
weaknesses do we have? How do we minimize the impact of those?

What opportunities does this project present us and how can we capitalize on them?
What obstacles or threats could keep us from achieving our objectives? Risk
analysis.

11 Steps in Project Planning: The basic planning steps and the resulting documents
which must be generated are as

Define the problem to be solved by the project.

Develop a Work Breakdown Structure (WBS). Work Break down structure

Provides a framework in which to accomplish the following:

(a) All tasks to be performed can be identified and resources allocated to them.

(b) Once resource levels have been allocated to tasks, estimates of task durations
can be made. (c) All costs and resource allocations can be total to develop the
overall project
Budget. (d) Task durations can then be used in developing a working schedule for
the project. (e) Performance can be tracked against these identified cost, schedule
and resource

Allocations. (0) Assignments of responsibility for each element can be made. Using
the WBS, estimate activity durations, resource requirements and costs. Prepare the
project master schedule and budget. Decide on the project organization structure-
whether matrix or hierarchical, Set up the project notebook.

Get the plan signed off by all project stakeholders. The various stakeholders and the
Performa which they are expected to sign below:

PROJECT PLAN APPROVAL

PROJECT PLAN APPROVAL

Project Code

Department

Project Description

From

Your signature below indicates that you agree with plan submitted, so for as

Interests are concerned

Signed

Approving individual

Functional

Managers

Date

Date

Return by

is shown

your

Directors

Project Manager
Customers

Comments

Functions of Planning

Planning, a vital aspect of management, serves several important functions: It

provides a basis for organizing the work on the project and allocating responsibilities
to individuals.

It is a means of communication and coordination between all those involved in the

project.

It induces people to look ahead.

is instils a sense of urgency and time consciousness. established the basis for
monitoring and control.

14 Areas of Planning Comprehensive project planning covers the following:

Planning of work: The activities relating to the project must be spelt out in detail.
They should be properly scheduled and sequenced. Planning the manpower and
organization: The manpower required for the project (manager’s technologists and
manual labour) must be estimated and the responsibility for carrying out the project
work must be allocated. Planning the money: The expenditure of money in time-
phased manner must be budgeted 3.Planning the information system: The
information required for monitoring the Project must be defined

3.5 Hierarchy of Plans A large project may consist of hundreds or even thousands of
activities. A project plan consisting of such a large number of activities cannot be
comprehended and visualized by the human mind. Hence, the plan of so many
activities may be hold in a computer memory and structured on a hierarchical and
modular basis in terms of plans of much weller sizz, consisting of say 30 to 150
activities. Thus, for a large project a hierarchy of plans, showing varying levels of
details, need to be prepared.

91 Level Plan: This is highly summarized plan, which shows the brond activities of
the project, such as engineering design, contract negotiation, procurement,
construction, and commissioning with very elementary breakdown. It may serve as
the basis for marking rough estimates for overall resources and outlays. It would
indicate the major interrelationships in the project and suggest what could be the
critical phase of the project. Such a plan is useful for strategic planning and
establishing project objectives and policies. It serves as a tool for top management

11 Level Plan: The activities in the summary plan (at the I level) are shown in greater
detail. This permits more detailed examination of various stage of the
Project so that interrelationship can be property established. This level coessentially
a tool of middle management planning, decision making and control. It plan is

(a) Identification of individuals responsible for various work packages,

(b) Aggregative manpower planning.

(0) Broad scheduling of project work. (III Level Plan: It is useful for lower levels of
management. It helps them in week to week, or even day to day, planning and
control. Such a plan is based on a very detailed estimate of resource requirements,
funds availability, project inter. relationships and time targets. 3.6 Project objectives
and policies

Before deciding on specific goals and objectives that the project team must
accomplish, it is important that team members decide on their "reason for being. This
is called the team's mission, and it may remain constant throughout the life of the
project or it may change. The mission statement should be used to set goals and
objectives, to make decisions and to provide goods and services the organization
has determined. It should be providing to meet the needs of customers. The Mission
Identification Process Identity the team's internal and external environment. List all of
the team's stakeholders. Highlight the team's customers from within the list of
stakeholders just generated. Check the three most important stakeholders-at least
one of them should be the team's major customers.

Make a list of those things your three most important stakeholders want from the
tearn. When the team has finished its job, how will members know they were
successful?

List those criterions for success which will be used to judge the team's performance.
What critical events might occur in the future that could affect the team's success
Either positively or negatively. Now write the mission and purpose

An Example of Mission Statement

Statement.

Project Management Institute is the professional society for project managers. Their
Mission is "To be the leading recognized professional and technical association in
advancing the state of the art program and project management. To be achieved
through the development and dissemination of the theory and practice of effective
management of resources in reaching project goals”. well-defined objectives and
policies serve as the framework for the decisions to be

Made by the project manager. The questions to be discussed in this context are:
What are the technical and performance objectives? What are the time and cost
goals? To what extent should the work be given to outside contractors? How many
contractors should be employed? What should be the terms of project? A clear
articulation of the priorities of management will enable the project manager to take
expeditious actions.
In every organization, there is always more work to be done than the organization
can accomplish with its limited resources. This means that priorities must be
established so that work will be done to achieve the best use of those limited
resources. These objectives are ordered based on value to the organization. The
factors that may affect the priority of an objective include customer pressures,
market forces, cost considerations and the like. Objectives s influenced by such
factors must be ranked ordered taking all such variable into consideration. Generally,
it is fairly easy to determine the most and least important objectives, but those in
between are more difficult to rank.

Kind of Project Objectives

A project may have multifarious objectives. Some of them are listed below: Develop
expertise in some area.

Become competitive. e productivity.

Improve

Quality.

Improve Reduce costs.

Modify an existing facility a new sales strategy. Develop a

Develop a new Product Criteria for Sound Objectives

By complying with the following guidelines, it should be possible to develop clear

objectives for which specific implementation steps can be worked out, and using
them should enable individuals to tell when they have achieved the desired results:

A statement of the objective should be specific. They should be measurable.

They should fit higher-level organization objectives.

They should be started in terms of deliverable its areas.

They must be comprehensible. They should be time limited.

When several objectives must be met before another can be achieved, it is useful to
prioritize them.

When appropriate, objectives should be assigned a risk factor so others in the

Organization will be aware of such risk. The objective should be attainable. Setting
unrealistic objectives only cause people to

.
Have no commitment to them. A stretch objective is fine, so long as it is not totally
out of reach. They should also specify a single end result. When multiple objectives
are combined into one statement, it becomes difficult to sort out what is being said.

3.7 Tools of Planning the oldest formal planning tool is the bar chart, also referred to
as Gantt Charts or multiple activity charts. In the last three decades, Network
Techniques have received

Considerable attention. (0) Gantt chart

Time

Insert adv. for Bride groom

Selection of Negotiation

Arrange Finance, identify place for wedding

Buy ornaments/ dresses

Conduct wedding

Couple leave for honeymoon

Over the years, people have tried to picture machine schedule, progress of work and

Project schedules on graphs and charts that Henry L. Gantt, the pioneer of Scientific
Management, used about a century ago. The value of the Gantt Chart stems from its
ability to show clearly and quickly the relationships among several variables. The
picture presented by these charts focuses attention on those situations, which need
attention. In this chart, the activities are represented by horizontal bars on the time
axis. The left hand end of the bar shows the beginning time, the right hand end the
ending time. The duration of the activity is indicated by the length of the bar. The
progress of the work may be shown by a bar or a line within the upright of the activity
symbol and its length should represent the amount of work completed.

Example2: Let there be an operation A, which should start on fifth day of a month,
finish on 14th day, and other operation should start on 9th day and finish on 20th day
of the

Jan.

Feb.

Mar.

Apr.

May
June

Same sequence. It is observed that only 50 per cent of the work is completed for A
up to 9th, day while operation B was only 30 per cent complete up to 11th day.
Represent it by a Gantt chart.

Gantt Chart

18 19 20

Up H

Scheduled

The chart clearly shows that performance of operation A is lagging behind by two
days on 11th day, whereas operation B is ahead of the schedule. Drawback of Gantt
Chart

The Gantt chart has the following drawbacks: The relationship between various
operations is not shown by the chart. It is very difficult to find the sequence of various
operations on the Gantt Chart or the most

Probable date of completion. It will be very difficult to change the length or position of
the bars on the chart along with the change in time schedule.

Instead of these limitations, Gantt Chart is used as a principal tool in project

Planning.

(b) Network Techniques

Network provides a comprehensive study of the entire project in terms of precedence

and succession of various activities as well as the resources available to perform the
activities with an object to evolve some better and quicker plan to complete the work.
It can be applied in case of complicated large-scale projects involving greater
financial and administrative problems. Some applications of networks can be in:

Construction of building, dams, factories, bridges etc. Manufacturing of shops, aero

planes etc.

Actual

Inventory control strategies. Defence operations etc.

Network study can be divided into two broad categories:

(1) Network construction (ii) Network analysis

Network construction means graphical representation of logically and sequentially

connected arrows and nodes representing activities and events of a project. After
construction of network the next step is to relate the important characteristics of the
activities it contains. The network analysis is done to:

(0)Determine the most critical sequence of activities. (1) Contract the project duration
in case of emergency i.e. time cost trade off. (ii) Evolve strategy for efficient resource
allocation. Two important techniques of Network Analysis are Critical Path Method
(CPM) and Project Evaluation Review Techniques (PERT). The critical path is the
longest path through a project, and so determines the earlier completion for the
work.

An illustrative Network Diagram

Terminology

1. Activity: In a network it is denoted by an arrow (à). The arrow can be slant, bent or
straight but should not be broken. An activity represents the efforts applied over a
period of time having a definite beginning and end. This involves expenditure of
resources as well as time. The tail of the arrow shows the start and its head
represents the completion of the activity. The description of the activity as well as its
duration is written along with arrow.

2. Event: These are denoted by circle (0) with event number enclosed in it. An event
point time indicating start involve expenditure resources

Dummy Activity: arrow which

Upon another dummy activity carries zero

Represented dashed arrow lines. Network Constructions: The following

considerations must kept while drawing network:

List activities the project. The identification and number depend upon the degree of
details desired the management. Should represent the smallest unit over which
control desired. Draw arrow for the first activity and add the corresponding

Activity/activities and continue the process till the final activity reached. The
operations, which should complete before particular should listed.

(iv)The operations can carried out simultaneously determined. (v) The operations
which are succeeding other operations should also be listed. Diagramming should
proceed from left right.

Example Network Diagram with Basic Scheduling Computations

Draw Suitable network for the following:

Activity
A

Duration (days)

Basie Scheduling Computations: Although no one is likely to do network it is

computations manually in this day of abundant scheduling software, i important to
understand how computations are made by the computer. Further, the computer
output is not easily understandable unless the computation method is understood. In
the above Thus the event following activity A is Event (2). The numbers under the
activities are diagram, the activities are labelled with letters, and events are
numbered within brackets, working durations in day. Each event is divided in half so
that the earliest time can be placed on the left side and latest time can be placed on
the right side. Other notation schemes are also there but this is very simple to
understand.

In order to locate the critical path and computer earliest and latest start times for
non-critical project activities. It is necessary to do two sets of computations. These
are called forward pass and backward pass calculations.

Forward Pass Computations: A forward pass is made through the network to

calculate the earliest achievement times for each event in the network. For an event
at the end of an activity, the earliest event time is called the earliest finish. When the
event is at the beginning of an activity, it is called the earliest start for the activity.
The project is started at time T-O. The figure given below shows the first step in the-
forward-pass computation.

75 11 days on this patt

615 days is they

event 3 can be cher

Event 2 can be achieved eight days after the project starts, because activity A has
that duration and is the only path leading to Event 2. However, there are two paths
leading to Event 3, one along activities A-C and the

Other across activity B. Since event 2 can be achieved as early as eight days into
the job. Continuing along activity C would allow achievement of event 3 on day
eleven. The duration of activity B, however, is fifteen days, so event 3 cannot be
achieved until day fifteen- the larger of the two numbers, which is based on the
longest path to the event. The remaining forward-pass computations are made the
same way, yielding the event times shown in figures given below. Note that the
earliest completion for the project is twenty-five working days.

Backward Pass Computations: A backward pass is made through the network to

compute the latest times for each event in the network. This latest time will represent
the latest finish for a preceding activity and a latest start for a succeeding one. This
computation is made by subtracting activity durations from previous event late times.
We assign a twenty-five day late time to the final event, and then do a backward
pass computation to determine the latest event times which will permit achievement
of the twenty-five day completion.

22-5-17 days on path F

(3,

10

Smallest outback 15 days to celestevant tihe

25-10-15 days along path G

In the above figure, beginning at event and working backward, subtract the three day
of activity F from twenty-five and the In the time for event is twenty-two. Now subtract
the five-day duration of activity E firm twenty-two and you get seventeen days on the
path. Note, however, that path G also leads back to event and by subtracting the ten-
days duration of G from the twenty-five-day and time of event 5, you have fifteen The
choice, then, is between fifteen or seventeen days and we take the smaller
Therefore, the latest time for event is fifteen days, which is the same as its earliest
Continuing in this way, you arrive at the late event times shown in the following

Event Slack: The difference between earliest finish and

Called slack, which

gives a measure of latitude on the event. Activity Float: Examine activity D. Based on
the beginning event, activity can
start as early as day eight, and can also end as late as day twenty-two. The distance
between those times is fourteen days. The activity itself takes days to complete. The
difference between the fourteen day distance between the two events and the seven
day working time leaves seven days in which activity can float around. This called
maximum for activities D. The equation for calculating maximum float for activity
follows

(written in terms of activity D): Max.

Similarly, floats for other activities can be calculated. The Critical Path: Examine B-
G. There no latitude on this path i.e. the float for activity zero and the same true for
activity By convention, this called the Critical Path. Since this path has no float, any
the work the path falls behind schedule, then the end date will slip accordingly.

Advantages of Network Diagram The advantages of network techniques are:

(1) They can effectively handle inter-relationships among project activities.

ii)They identify the activities which are critical to be completion of the project on and
indicate the slack (or spare time) for other activities

iii)They can be easily computerized.

(iv) They can handle very large and complex projects.

Drawbacks While the network techniques are superior tool for project planning, they
suffer from several drawbacks:

Being more complicated than the traditional bar chart, they are not easily understood

by the project personnel. They do not define an operational schedule which tells who
does what and when 4.0 Summary

A planned project is a tool to achieve the objectives of the project at a minimum cost.
A project plan consisting of a large number of activities cannot be comprehended
and visualized by the human mind. Hence, the global plan of so many activities may
be held in a computer memory and structured on a hierarchical and modular basis in
terms of plans of much smaller size. Well-defined objectives and policies serve as
the framework to the decisions to be made by the project manager. The two
important tools of planning are the bar chart and the network techniques. The bar
chart is a pictorial device in which the activities are represented by horizontal bars on
the time axis. In network techniques, the activities, events, and their inter-
relationships are represented by a network diagram. 5.0 Suggested Readings

 United Nations, Guidelines for Project Evaluation, Oxford & IBH Publishing
Co.,
 United Nations, A Manual for Evaluation of Industrial Projects, Oxford & IBH
Pub. Unite New Delhi. Co., New Delhi Co.
 Prasanna Chandra, Projects: Preparation, Appraisal, Budgeting and
Implementation, Tata McGraw Hill Publishing Co. Ltd., New Delhi.
  Planning Commission, Guidelines for Preparations of Feasibility Reports for
Industrial Projects, Controller of Publications, Government of India, New
Delhi.
 Frances Cherunilam, Business Environment, Himalaya Publishing House,
Bombay.

6.0 Self Assessment Questions? What are its advantages and limitations?

1. What is a bar chart

2. Discuss the notion of hierarchy of plans.

3. What is project planning? Discuss the significance of project planning completion

of the project?

4. What is the procedure for determining the critical path?

5. What is early start schedule and late start schedule

6. What kind of mistakes may occur in project planning?

MBA - Project Management

LESSON NO. 15

MBAFM-205

Paper:

Updated by: Dr. M. C. Garg

Project Control, Reason Ineffective Control, Modern Approaches: Analysis, Project

Management

Structure

1.0 Introduction

2.0 Objectives

3.0 Presentation of Contents

3.1 Meaning of Control

3.2 Components of Project Control System 3.3 Reasons for Ineffective Control

3.4 Variance Analysis Approach to Project Control

3.5 Modern Approach to Project Control 3.6 How to Control Overruns Costs Project

3.7 Human Aspects of Project Management

3.8 Conflicting zones Project Management 3.9 Motivation of Project Personnel

4.0 Summary Suggested Readings

Self Assessment Questions

Introduction

No sooner the project launched, control becomes the dominant concern project
manager. Indeed, once the launch phase over, planning and control become closely
intertwined the integrated managerial process.

Project control involves regular comparison performance against targets, search for
the causes deviation, and commitment check adverse variances. Serves two major
functions: ensures regular monitoring performance, motivates project personnel
strive achieving project objectives.

2.0 Objectives

After reading this lesson, you should able List out the reasons ineffective control
projects.

(b) Evaluate variance analysis approach project control. Discuss about modern
approach project control.

(d) Explain the human aspects of project management. (e) Highlight the
considerations to be kept

in mind with regard to motivation of project personnel.

3.0 Presentation of Contents

3.1 Meaning of Concept

Control is achieved by comparing where one is supposed to be, then taking

corrective action to resolve any discrepancies which exist. One of the primary
responsibilities of a project manager is to ensure that things are done as they are
supposed to be done. In other words, that control of a project is maintained. Project
control involves a regular comparison of performance against targets, a search for
the cause of deviation and commitment to check adverse variances. The central idea
in the meaning of control is that information is used to maintain satisfactory progress
toward a desired goal. This invokes that model for a basic feed back system and is
the model that should be applied to project control system. A simple feedback
system is shown below:
Input

Process

Output

Feedback

This way of looking at control in terms of information processes, rather than in

energy terms, is helpful because it leads to insight into how a manager must deal
with people. When control is thought of in terms of energy or power, it inevitably
leads to authoritarian management, in which the manager tries to achieve control by
monitoring workers and giving orders for them to follow. Such a control method is
ineffective for at least two reasons.

For one thing, the manager is burdened with having to closely monitor workers,
which does not give him much time to do anything else. Thus, planning and other
management activities tend to suffer. Further, such a method of control is not very
effective if a number of workers must be monitored, since the manager cannot easily
practice surveillance on all of them at once.

The second reason why authoritarian management does not work well is simply that
today's workers do not readily accept it. People today expect more autonomy, and
do not willingly let managers treat them like pawns. However, when they do accept
authoritarian management, they absolve themselves of responsibility for the outcome
of their efforts.

For this reason, a manager must ultimately establish a situation in which workers
achieve self-control, so that work is controlled not workers. Attempts to constrain and
Regiment workers generally lead to resentment and an atmosphere that stifles which
is just the opposite what is needed. Control should be viewed as a tool that the
creativity, worker can use to work more effectively and efficiently.

Control over the project can be divided into two parts: macro control and micro
Control. The project manager is interested in achieving macro control of the project.
That is, at the top level of the work breakdown structure, the project is supposed to
be in control. Clearly, if micro-control is not achieved, no macro control will exist,
since top-level control depends on what is happening at the lowest of the project.
The individual must be in control of his or her own work so that micro control will
exist the term most often used to designate what the manager must achieve is
empowerment. Employees must be empowered to do their jobs with minimum
supervision that consistent with the individual's capability. Enabling individual
members of a project team to achieve self-control is absolutely essential if real
project control is to be established. In order to show how this can be achieved, a
Standard Operating Procedure (S.O.P.) for empowering people is presented below:

1. The first step is to be sure that each member of the team is clear on what his or
her objective is.
2. Each team member must have a personal plan on how to do the required work. 3.
The project manager must be sure that team member has all resources needed to
do the job. This includes tools, equipment, materials, and skills etc. which are
adequate. 4. Feedback on progress which goes directly A clear definition of his or
her authority to take corrective action when there is a deviation from plan and it
cannot be zero. to the person from the work itself.

3.2 Components of Project Control System The feedback system shown previously
is a very simple one, which systems people call a first order system. It is not very
elegant, and has some serious limitations as a model on how to achieve control in
project management. Sometimes, a project may run into unexpected obstacles that
fall outside the boundaries for which the project control system was designed. For
example, if everyone is following the plan to the letter, but they are not getting the
desired result. What is needed? is to change the approach. However, a first-order
control system does not have that Capability. Something more flexible is needed.
The figure given below is another feedback system which is broader scope as
compared to earlier one:

INPUTS

PROCESS

OUTPOT

ADJUST

FEEDBACK

PLAN

COMPARE

The above system has the same basic elements of the system shown earlier.
however, this system feeds information about the system outputs to a Comparator,
who weighs them against the original plan. If there is a discrepancy, that information
is passed to an ad element, who must decide if the discrepancy is caused by
something being wrong with the process the inputs or the plan itself.

Once that determination is made, the adjust element calls for a change in the plan,
inputs or the process. Note also that the adjust element has an arrow going back to
the monitor. If a deviation is detected, the monitoring rate is increased until the
deviation is corrected, then monitoring is decreased to its original level. The real-
world analogy is that if you were monitoring progress on a project weekly and a
problem occurred you might begin to monitor daily. If the problem becomes serious
enough, your monitoring rate might increase to several times each day. Once the
problem has been solved, you would met your weekly monitoring

3.3 Reasons for Ineffective Control The following are the reasons for ineffective
control over the project Characteristics of the project: Most of the projects are large,
complex undertakings involving many organizations and people. This renders the
task of control difficult because
 Keeping track of physical performance and expenditure on hundreds or the
thousands of activities which are often non-routine is a stupendous task.
Coordination and communication problems multiply when several
organizations are involved in the project.
People problems: Most of the operational managers used to the steady rhythm of
normal operations and routine work lack the experience, training, competence and
inclination to control project.

Poor Control and Information system often there is a delay in reporting of

performance. This prevents effective monitoring of the project and initiation of timely
action to check adverse development. Unreliable and inaccurate data and
information. Often project managers receive reports which suggest that 'everything is
ok' or things are 'reasonably within control when the reality is otherwise. 3.4 Variance
analysis approach to project control The traditional approach to project control
involves a comparison of the actual con with the budgeted cost to determine the
variance. An example of variance analysis is given below:

Budgeted cost in the period

Cumulative budget to date

Actual cost in the period

Cumulative actual cost to date Variance for the period

Cumulative variance to date

Activity A

50,000

55,000

240,000

5,000 40,000

Activity B

30,000 75,0000

28,000

80,000

2,000

5,000
This approach is inadequate for project control for the following reasons:

1. It is backward looking rather than forward looking. It tells only what happened in
the past but does not answer the following question: happen in future? Is the rate of
work accelerating or decelerating?

2. It does not use the data effectively to provide integrated control. The traditional
variance analysis shows whether in the time period under analysis more or less
resources were expended than budgeted. However, it does not indicate the value of
work done. This information is vital for purposes of control.

3.5 Modern Approach to Project Control Effective control over a project required
systematic Performance Analysis. This calls for answering:

Is the project as a whole (and its individual parts) on schedule, ahead of schedule, or
behind schedule? If there is a variation, where did it occur? Why did it occur? Who

is responsible for it? And what would be its implications? Has the cost of the project
as a whole (and its individual parts) has been as per budget estimates? If there is a
variation, where did it occur? Why did it occur? Who

is responsible for it? And what would be its implications? What is the trend of
performances? What would be the likely final cost and completion date for the
project and its individual parts?

For small and simple projects, the project managers would do performance analysis
for the project as a whole, or for its major components. As the project becomes
larger and more complex, performance analysis, need to be done for individual
segments of the projects which are referred to as cost accounts. Using variance or
earned value analysis in the project control: There are three areas of the project
which the project manager is expected to control. There are good, fast, cheap
objectives. Because of the difficulty of qualifying the performance objectives (good),
variance analysis usually not applied, but only to the cost and schedule targets. In
the case, the project manager will have to monitor the quality targets, using whatever
standards can be developed, and take necessary steps to ensure that they are met
as for the schedule and cost objectives, the following terms define what is to be
monitored:

.
Cost variance: Compares deviations only from budget and provides comparisons of
work schedule and work accomplished. Schedule variance: Compare planned
versus actual work completed. This variance can be translated into rupees, so that
all variances can be specified in monetary terms

In order to make cost and schedule variance measurements, three variables are
used. (a) Budgeted cost of work schedule (BCWS): The budgeted cost of work
schedule is to be done in a given time period or the level of effort budgeted to be
performed in that period. This is the target toward which the project is headed. It is
basically the product of man hours and the labour rate that is paid during a given
period of time.

Suppose that a project is to employ two people working on the project for 40 hrs.
@Rs 30/- per hr. In addition, a third person will work on the project for 30 hrs. @
Rs.50/ -per hr. The budgeted cost of work schedule is:

40 hrs x Rs.30x2 xRs.50x1

30 hrs x BCWP: Rs.2400+Rs.1500 =

Rs.2400 Ra1500

Rs.3900

(b) Budgeted cost of work performed (BCWP): BCWP is also called earned value

e.g. the two employees who were assigned to work for 40 hrs each actually put in
that amount of effort. One worker actually gets his work complete while the other
does only 80 per cent. The third employee also completes his work.

Then the earned value of the

40 hrs x Rs.30xl

work completed Rs.1200

80% x 40 hrs x Rs.30 = Rs. 960 Rs.1500

30 hrs x Rs.50

BCWP

Rs.3660

(c) Actual cast of work performed (ACWP): It is the amount of money actually spent
in completing work in a given period. This is the amount of money paid to workers to
do

is:

the work that was completed during the time period in question. To continue, assume
that the work completed has actually cost the organization Rs.3900. If we compared
it with BCWS, the project is in good shape. However, we know that one person did
not get through with the work he was supposed to do. The value of his project, the
following formula is employed accomplishment is only Rs.960 but was supposed to
be Rs.1200.

In order to see, what this means for the BCWP-ACWP

Cost variance

Schedule variance (Rs. value)

Rs.3660- Rs.3900 -Rs.240/ BCWP-BCWS

3660-3900 -Rs.240 A negative cost variance means that the project is spending
more. A negative schedule variance means that the project is behind schedule and
and both unfavourable to the project.

3.6 How to control overruns costs in project Correct identification of the causes of
delays can help the project team to eliminate

the same. As per the adage, a problem well formulated is half solved. The most
important reason for delay in cost and time overrun: planning, organizing and
monitoring; hence, the need to plan the resources adequately and estimate the need
scientifically. Right choice of project manager, project oriented organization, project
team and delegation of authority commensurate with responsibility will go a long way
to reduce the overruns. Proper project management information system and effective
coordination with all concerned will ensure timely project completion. The other
reasons that help completing the project without delay are listed hereunder. These
are: Detailed planning and implementation schedule.Sound monitoring.Resource-
planning based on time schedules and anticipated progress.Ensuring safety
measures while preparing contracts. Reward and incentive schemes for the project
staff.selection of appropriate, feasible technology. Listing engineering parameters
designs. Mobilizing community participation in planning and implementation.
Decentralized decision-making for fast implementation.Continuity of the project
manager, at least till the start of the plant. Adequate training of the workers,
supervisors involved.Anticipating omissions, mistakes and preparing the organization
to face crisis. Minimizing managerial lapses. Identifying transport bottleneck by
proper liaison. Communication and following-up with vendors and subcontractors to
know the latest status and locution of project material. Regular follow-up with local,
national and international

Innovative attitude and skills of the project team.

Adequate project information system.

Financial agencies.

Maintaining ecological balance and avoiding environmental pollution. Clarity of scope

on project objectives.

Lucid description of team and sub-tearn tasks. Lucid financial cost estimates.

Milestone charts and project audit reports, and

Minutes of the co-ordination committees' meetings with contractors agencies.

3.7 Human Aspect of Project Managementand government

A satisfactory human relations system is essential for the successful execution of a
project. Without such a system, the other systems of project management, however
sound they may be by themselves, are not likely to work well. While technical
problems can often be solved with additional investment of resources, people's
problems may not be amendable to a satisfactory solution in the short span of the
project life. To achieve satisfactory human relations in the project setting, the project
manager must have the following attributes:

Good listener

+ Supportive + Organized

Clears road blocks

Mutual respect Team builder

> Knows own limitations

Sense of humour Give feed back

Good decision-maker

> Follows up

Shares experience + Mutual ownership

Visible leadership Technical Knowledge

Fair

Flexible + Open-minded

Delegates Honest/trustworthy

Understanding

Challenges team to do well

Knows strengths.

Weaknesses of team members

Proactiveness

Buffer to rest of organization

To maintain satisfactory human relations, the project manager must successfully

handle problems and challenges relating to the following:
(a) Group functioning: In a large complex project, many persons drawn from different
function, department, and organizations are involved. This leads to formation of
groups, formal and informal.
According to Likert, organizations may be considered as systems of interlocking
groups. Thus, in a typical project organization, many interlocking and interdependent
groups are formed. The groups formed in a project setting may be of three types: (1)
Vertical group: It consists of people drawn from different levels in the sate

department, function or company. A vertical group tends to form most naturally

because of departmental/functional/organizational affinities. However, the existence
of such groups may lead to a pronounced "we/they" attitude and accentuate
conflicts. (li) Horizontal group: It consist of people drawn from different functions,
departments and companies but occupying similar hierarchical positions. The
members of the horizontal group occupying key position in their respective fields
serve as channel of communication By their influence, they can strengthen the
commitment to the project. (i) Mixed group: It consists of people drawn from different
levels, from various functions, department and companies. The mixed group tends to
promote greater cohesion of the total project organization. However, it is difficult to
establish such a group because of the temporary nature of a project when members
of a group know that the group would be dissolved sooner or later, they retain strong
links with their parent company or department. (b) Building effective group: An
effective group consists of members who are satisfied and committed and who strive
for the attainment of project objectives without dissipating their energies in
interpersonal and inter-group conflicts. The manifest sign of an effective group are:
Esprit de corps

Pride in the project

Supportive behaviour Coordinated endeavour

Mutual respect

Open communication

Clearly this is very challenging task for a project manager.. (e) Leadership qualities

It is wrong to presume that a professional with technical expertise can fill the role of a
Project Manager. A Project Manager has to manage time, money and performance.
He has to have technical expertise and general knowledge, skills in forecasting,
planning, scheduling and estimating, and be able to establish objective, performance
criteria and standards and organize tasks. He should be flexible and adaptable,
should have aptitude to identify and solve problems and have a range to other
qualities that will enable him to relate to the greatest number of team members and
attend to the broad requirements of the project. It is said that the Project Manager
should be able to draw upon as many as required, out of the following seven-power
basis:
Coercive power: This involves use of fear tactics in dealing with subordinates and
staff. It has to be selectively used, as it inhibits creativity and may have a negative
influence on the project team morale.
2.Connection power: Ability to establish alliances with important and influential
people helps developing trust and obtaining support at critical situations.
3. Expert power: Recognition of expertise provides substantial strength and
credibility, but this should not be confined to technical aspects alone and should
combine with knowledge of the organization and understanding of the needs of the
customer.
4.Legitimate power: This is derived from the formal position in the organizational
hierarchy. The right to command, if resorted to excessively, might prove ineffective.

5. Referent power: Personal characteristics or charisma can be highly effective. It

can establish quick t rapport a and help interpersonal communications.

6.Reward power: The manager, in this case, has the authority of recognize and
recommend or sanction reward, promotion or other incentives. If fairly applied, this
can be a very positive influence in improving efficiency and productivity.
7. Information power: A manager who is perceived to be well-informed on the project
activities and related occurrences can win the confidence and respect of colleagues
and associates, provided he is not one who keeps the information to himself but
shares it with others.

The successful project manager has to identify and develop a variety of influence
and

3.8 Conflict Zones in Project Management Research affirms that conflict is a natural
phenomenon flowing from a matrix or hybrid structure adopted by complex,
multidisciplinary project teams. The following causes of conflict have been identified
as most recurrent:
1. Schedules: Where several disciplines and project activities of differing nature are
involved, disagreements crop up on timing, sequencing and scheduling or project
related tasks.

2. Project priorities: In determining the relative importance of the activities and tasks
and in assessing the trade-offs between choices and alternatives, there can be
differences of views.

3.Personnel : Where personnel of different departments or section of enterprise are

sought to be drafted Into, or utilized for providing project related services or doing
project work, there is scope for conflicts or opinion.
4. Technical opinions and performances trade-offs: In technology oriented projects,
there could be disagreements on technical issues, performance specifications on
technical trade-offs and on means to achieve performance.

5.Administrative procedures: There can be conflicts on the methods of managing the

project, on the pattern of delegation of responsibilities, project scope and other
procedural matters.
6.Cost: Cost estimates from support areas may be considered as excessive by the
main operating areas, and the resource allocating may be considered insufficient by
the support areas.
7. Personality: Interpersonal differences can also arise from personal egos of the
individuals involved in the teamwork.

Appropriate conflict resolution strategies have to be adopted by project management

depending on the needs of the situation. The strategies may revolve around denial of
the existence of conflict, suppression or playing down of the conflict, reaching
compromises, or agreeing on collaboration.

3.9 Motivation of Project Personnel

The principal behavioural factor which a project manager can influence is the
motivation of the project personnel. In this content, he should bear in the mind the
following: Human beings have a large number of needs. When those needs are
active, they are motivated to satisfy them. Abraham Maslow suggested that human
needs can be grouped into five general categories, which vary in strength,
depending on whether they have been recently satisfied. He arranged those needs
in a hierarchy, because he believed that the category at the bottom of the hierarchy
(the lower-level needs) must be satisfied before the upper level needs emerge. The
hierarchy of the needs is

i)Physiological: The biological needs including hunger, warmth, sex, shelter etc. (1)
(ii) Safety: The need to provide for unexpected happenings and to feel secure from
harm.
(iii) Social: The need to affiliate with other people.
(iv) Esteem: The need to be though well of by significant others.
(v) Self-actualization: The need to be everything one is capable of being self-
mastery. Motivation tends to be strong when the goal is challenging, yet attainable.
Difficult objectives can cause people to become frustrated, exhausted and
disenchanted. The traditional approach to management was based on the
assumption that human beings regard work as unpleasant, shirk responsibility, and
ordinarily employ inefficient and wasteful methods. Such a conception of human
behaviour suggests that a great deal of pressure has to be applied. Behavioural
research, however, has shown that while some pressure is beneficial, an excess of it
is undesirable. Beyond a certain point, pressure is dysfunctional. Expectation or
reward, rather than fear of punishment, has a greater bearing on individual
behaviour. Further, the effectiveness of reward or punishment depends om how
quickly it is administered.

In a project setting where hygiene factors (like pay, physical working conditions,
etc.) are reasonably taken care of, the principal motivators would be a sense of
Accomplishment and professional growth. In this setting, the project manager should
rely more on participative methods of management.
in order to succeed in motivating project personnel, the project manager must be a
perceptive observer of human beings, must have the ability to appreciate the
variable seeds of human beings, must have skill in several styles of management
suitable to different situations, and must be sensitive to the reactions of people so
that he can act supportively rather than threateningly. 4.0 Summary
Project control involves a regular comparison of performance against targets, a
search for causes of deviation, and a commitment to check adverse variances.
These are a number of reasons for ineffective control over the project. Variance
analysis approach to project control involves a comparison of actual cost with the
budgeted cost. The moderns approach to project control involves monitoring the
project on cont variance and schedule fiancé. To achieve satisfactory human
relations in project a setting, the project manage variance successfully handle
problems and challenges. Correct identification of the cases delays can help the
project team to eliminate the same. In order to succeed is motivating personnel, the
project managers must be a perceptive observer of human beings have the ability to
appreciate the variable needs of human needs, have a skill in several styles and
must be sensitive to the reactions of people so that he can act supportively rather
than threateningly

. 5.0 Suggested Readings

Project Planning, Scheduling and Control by James P-Lewis.

Projects: Preparation, Appraisal, Budgeting and Implementation by Presanal
Chandra
Project Management by Vasant Desai
Text Book of Project Management by P. Gopalakrishnan and VE. Rama Moorthy.
Project Appraisal Technique by R.L. Pitale by B.S.Goel.
Production and Operation Management
Project Management by B.B. Goel.

Self Assessment Questions

1. Discuss the concept of project control. What are the components of a project
control system?

2. Why does the control of projects in practice tend to be ineffective?

3. What considerations should the project manager bear in mind with respect to
Motivation of the project personnel?
Discuss and evaluate the variance analysis approach to project control?
How to control overruns costs in project? Explain.

MBA- Project Management

Paper: MBA-711

Updated by: Dr. M. C. Garg

Development of Project Schedule: Concept, Methods, Problems in Scheduling,

Measure of Variability etc.

LESSON NO. 16

MBAFM-205

Structure
1.0 Introduction

2.0 Objectives

3.0 Presentation of Contents

3.1 Concept of Scheduling

3.2 Steps of PERT/CPM Techniques 3.3 PERT System of Three Time Estimates

3.4 Measures of Variability

3.5 Project time-cost trade-off

3.6 Scheduling When Resources are Limited

3.7 Problems in Scheduling 4.0 Summary

5.0 Suggested Readings

6.0 Self Assessment Questions

1.0 Introduction

Scheduling the project is the act of producing a time-table of work for the project
showing when each activity as to begin and finish. The critical activities schedule
themselves, but it is necessary to decide when all the non-critical activities are to
take place. In other words there is no flexibility in scheduling the critical activities, but
floats available with non-critical activities provide flexibility in scheduling them.

2.0 Objectives

After reading this lesson, you should be able to (0) Define scheduling and discuss
the development of project schedules.

(b) Explain the steps involved in PERT/CPM techniques.

(c) Discuss the procedure for determining the critical path. (d) Describe the problems
in scheduling.

3.0 Presentation of Contents 3.1 Concept of Scheduling

In the words of Spriegel and Lansburg, "Scheduling involves establishing the amount
of work to be done and the time when each element of work will start or the order of
the work". and Kimball, "The determination of time that should be According to
Kimball required to perform each operation and also the time that should be required
to perform the entire series as routed is scheduling".
Development of Project Schedule: In the 20th century, Henry Gantt developed a
detailed system of scheduling using bar charts, which were subsequently called
'Gantt Charis". His system which included notation for reporting progress, has been
widely used. Sample Bar Chart

The figures shows that Bar Charts are very easy to construct and easy to read, with
one Exception. By looking at the chart, it is impossible to tell whether tasks B and
Care defenders

The figures shows that Bar Charts are very easy to construct and easy to read, with
one exception. By looking at the chart, it is impossible to tell whether tasks B and
Care dependent on the completion of task A, or if it is just coincidence that they are
planned to start at the exact time when A ends. Unless this information is available, it
is difficult to determine the impact on a project if some activity gets behind.

In other words, the bar chart does not show the interrelationship between the various
tasks being done. It was this problem that led to a search for better methods in the
late 1950s. One group working on this problem was the U.S. Navy in conjunction
with the consulting group of Booze, Allen and Hamilton. They developed the PERT
(Performance Evaluation and Review Technique) scheduling system, which was
applied to the Polaris project.

About the same time, E.I. du Pont de Nemours Company was trying to solve the
same problem and they developed CPM (Critical Path Method). The CPM system is
very similar to PERT, in that activity relationships are shown by diagrams using
arrows to show sequencing of work. The major difference between PERT and CPM
is that PERT makes 130 of probabilistic methods from statistics, whereas CPM does
not.

A project such as construction of bridge; highway; power plant; repair and

maintenance of oil refinery; or an air plane; design, development and marketing of a
new product; research and development work etc. may be defined as a collection of
inter related activities (or tasks) which must be completed in a specified time
according to a specified sequence (or order) and require resources such as
personnel, money, materials, facilities and/or space. The process of dividing the
project into these activities is called the Work Breakdown Structure (WBS). The
activity or a unit of work also called work content is an identifiable and manageable
work unit. The main objective before starting such project is: How to schedule the
required activities as to: 00 complete the given project on or before a specified time
limit.

Minimize the cost of completion of the project on or before a specified () Minimize the
total project completion time for given cost.

time limit.

Hence, before starting any project, it is essential to devise an adequate plan for
scheduling and controlling the various activities (or tasks) of the given project. This
will help in undertaking the project, possibly identifying bottlenecks and even
discovering alternate work plan for the project.

3.2 Steps of PERT/CPM Techniques

The application of PERT/CPM in particular and network analysis in general, towards

projects which require network analysis have to go through the following steps. Step
1. Project planning and construction of the network

The various steps involved during this phase are given below:

@ Identifying various activities (tasks or work elements) to be performed in the

project.

(ii) Determining requirement of resources such as men, materials, machines etc. for
carrying out activities listed above.

(i) Specifying the costs and times for various activities.

(iv) Specifying the inter-relationship (i.e. precedence relationship) among various

activities.

(v) Developing a network diagram showing the sequential interrelationships between

the various activities.

Step 2. Scheduling Once the planning phase is over, scheduling of the project i.e.
when each of the activities will be required to be performed, is taken up. The various
steps involved during this phase are listed below:

(1) Estimating the duration(s) of activities, taking into consideration the resources
required for their execution in most economic manner, Based on these time
estimates, preparing a time chart showing the start and finish times for each activity,
and hence calculation of total project duration by applying network analysis
techniques such as forward (backward) pass and float calculation, identifying critical
path, carrying out resource smoothing (or levelling) exercise for critical or scarce
resources including recasting of the schedule taking into a resource constraints (if
any).

Step 3. Project Control

Project control refers to evaluating actual progress against the plan. If significant
differences are observed then rescheduling must be done to update and revise the
uncompleted part of the project. In other words remedial or reallocation (of
resources) measures are adopted in such cases, Definitions of Network Terms

PERT/CPM network consists of two major components as discussed below. Events:

Events of the network represent project milestones, such as the start or the
completion of an activity (task) or activities, and occur at a particular instant of time
at which some specific part of the project has been or is to be achieved. Events are
commonly represented by circles (nodes) in the network diagram. The events can be
further classified into two categories, 1.

(a) Merge Event: An Event which represents the joint completion of more than one
Activity known as merge event.

(b) Burst Event: An event which represents the initiation (beginning) of more than
one activity is known as burst event.

Event

Event

(b) Burad Event

Merge Event

Events in the network diagram are identified by numbers. Each event should be
identified by a number higher than that allotted to its immediately preceding event to
indicate progress of work. The numbering of events in the network diagram must
start from

left (start of the project) to the right (completion of the project) and top to the bottom.
Care should be taken that there is no duplication in the numbering.

2. Activities: Activities of the network represent project operations or tasks to be

conducted. As such each activity except dummy consumes time and resources and
incurs costs. An arrow is commonly used to represent an activity with its head
indicating the direction of progress in the project. Activities are identified by the
numbers of their starting (tail or initial) event and ending (head or terminal) event. An
arrow (i, j) extended between two events, the tail event 'T' represents the start of the
activity and the head event represent the completion of the activity. e further
classified into the following three categories:

The activities can be f (0) Predecessor Activity: An activity which must be completed
before one

or more other

activities start is known as predecessor activity. (ii) Successor Activity: An activity

which started immediately after one or more of other activities are completed is
known as successor activity.

(15) Dummy Activity: An activity which does not consume either any resource and
time is known as dummy activity. A dummy activity in the network is added only to
represent the given precedence relationships among activities of the project and is
needed when (a) two or more parallel activities in a project have same head and tail
events, or (b) two or more activities have some (but not all) of their immediate
predecessor activities in common. A dummy activity is depicted by dotted line in the
network diagram.

Example on Network Diagram with Basic Scheduling Computations

Draw Suitable network for the following:

Activity

AB

Duration (days)

8 15

75

10

Precedence

A B,C

DE

B,C
Basic Scheduling Computations: Although no one is likely to do network
computations manually in this day of abundant scheduling software, it is important to
understand how computations are made by the computer. Further, the computer
output is not easily understandable unless the computation method is understood. In
the above diagram, the activities are labelled with letters, and events are numbered
within brackets. Thus the event following activity A is Event (2), etc. The numbers
under the activities are working durations in days. Each event is divided in half so
that the earliest time can be placed on the left side and latest time can be placed on
the right side. Other notation schemes are also there but this is very simple to
understand.
In order to locate the critical path and compute earliest and latest start and finish
times for non-critical project activities, it is necessary to do two sets of computations.
These are called forward pass and backward-pass calculations. Forward Pass
Computations: A forward pass is made through the network to calculate the earliest
achievement times for each event in the network. For an event at the end of An
activity, the earliest event time is called the earliest finish. When the event is at the
beginning of an activity, it is called the earliest start for the activity. The project is
started at time

T-O. The figure given below shows the first step in the forward pass computation:

(2)

201

(1)

(3)

834 11 days on this path

15

T 15 days on this path

15 days is the longest path, so 15 days is the earliest that event 3 can be achieved

Event 2 can be achieved eight days after the project starts, because activity A has
that duration and is the only path leading to Event 2.

However, there are two paths leading to Event 3, one along activities A-C and the

Other across activity B. Since event 2 can be achieved as early as eight days into
the job, continuing along activity C would allow achievement of event 3 on day
eleven. The duration of activity B, however is fifteen days, so event 3 cannot be
achieved until day fifteen - the larger of the two numbers, which is based on the
longest path to the event. The remaining forward pass computations are made the
same way, yielding the event

Times shown in figures given below. Note that the earliest completion for the project
is Twenty-five working days.

E
5

15

G 10

(Network with Earliest Time Show)

Backward Pass Computations: A backward pass is made through the network to

compute the latest times for each event in the network. This latest time will represent
the time to finish for a preceding activity and a latest start for a succeeding one. This
computation is made by subtracting activity durations from previous event late times.
We assign a twenty-five day late time to the final event, and then do a backward
pass computation to determine the latest event times which will permit achievement
of the twenty-five day completion.

22-5 17 days on path F-E

(4)

20 22

(3)

15 15

(5)

10

Smallest number 15 days to determine a event time

25-10-15 days along path G.

In the above figure, beginning at event 5 and working backward, subtract the three
day duration of activity F from twenty-five and the late time for event 4 is twenty-two.
Now subtract the five-day duration of activity E from twenty-two and you get
seventeen days on the path. Note, however, that path G also leads back to event 3
and by subtracting, the ten-day duration of G from the twenty-five day and time on
event 5, you have fifteen. The choice, then, is between fifteen or seventeen days and
we take the smaller number. Therefore, the latest time for event 3, is fifteen days,
which is the same as its earliest time/ continuing in this way, you arrive at the late
event times shown in the following figure:

(4)
Critical path

Event Slack: The difference between earliest finish and latest finish is called slack,
which gives a measure of latitude on the event. Activity Float: Examine activity D.
Based on the beginning event, activity D can start as early as day eight, and can
also end as late as day twenty-two. The distance between those times is fourteen
days. The difference between the fourteen day distance between the two events and
the seven day working time leaves seven days in which activity D can float around.
This is called maximum float for activity D. The equation for calculating maximum
float for an activity follows (written in terms of activity D):

Max FloatD- LFD-ESD - Duration similarly, floats for other activities can be
calculated. Free Float: To continue the analysis of the network, note that the latest
time that

Activity D can begin is day twelve and the earliest it can be completed is day twenty.
The distance between those two days is eight days. Since the activity takes seven
days to complete, it can still float around for one day between those event times.
This is called minimum float or free float. That float is more-or-less free to activity D,
so long as other activities that affect the early and late times for activity D do not slip
past their late times The free float for activity D is largely determined by the other
elements of the network. The equation for free float is as follows (again, written in
terms of activity D):

Free Float EFD- LSD - Duration Network with Dual Critical Paths Consider the
following network:

(2)

15

Critical path

Duration of G reduced to 8 days

If two critical paths exist, the total project risk has been increased. To reduce that
risk, an attempt should be made to get rid of all but one critical path. This can only be
done by changing the duration of one or more activities, by allowing the end date to
be extended, or by redrawing the network to have a new configuration. Assuming
that a choice must be made of which critical path to eliminate, the issue is how to
decide which path would be best to get off the critical path. There is no single answer
to this problem. Float is only one kind of risk involved in a project. There are also
risks from technical problems, poor estimates, weather and other uncontrollable
factors. The following table
Contains a list of factors which should be considered in making a decision. The
comments following each other explain the rationale for appropriate decision making

Factors

Number of Activities
• Skill level of people

• Technical risk

Comments

Path with most activities might be met risky

Path with least-skilled people could be montrisky.

Path with greatest technical risk should have

Give float to activities with uncontrollable

• Weathd Uncontrollable

• Cont

• Historical data

. Available backup plan

• Business Cycle

• Difficulty

Give float to activities which cost most to do.

Least historical data give flot

Give float to activities with no obvious backup

If business tends to get hectic at certain trees, give float to activities affected

Float given to activities which are most difficult

3.3 PERT System of Three Time Estimates

If the duration of activities in a project is uncertain, then activity scheduling

calculations are done by using the expected value of the durations. Three time
estimates optimistic, normal and pessimistic times are estimated for each activity to
take into account the presence of uncertainties.

Optimistic time t1: The shortest possible time to complete an activity without any
provision for any delay or set backs.

Normal time 12: This is the time most often required to perform an activity. Here it is
assumed that the situation is almost normal. Pessimistic time 13: It is the longest
time for the accomplishment of an activity under adverse conditions. This time
corresponds to abnormal situations where everything has gone wrong.

In order to combine the three estimates to calculate the expected me duration for
the activity, a formula was derived based on principles from statistics. The estimate
of average expected time to perform an activity in given by the following expression:

11 +412 +13

These values of te, also called the mean value, are used as the durations of
activities

in a'PERT network. Given those estimated durations, the network calculations are
identical as shown in the previous example.

3.4 Measures of variability

Variability in PERT analysis is measured by variance or its square root, standard

Deviation. It is estimated by the formula:

13-tl

Variance is obtained by squaring a

The variance of the critical path duration is obtained by adding variances of activities
on the critical path.

Variance

(Critical Path duration) This means:

Standard Deviation

(Critical Path duration)

Sum of variances of activity durations on the critical path

(Sum of variances of activity

Durations on the critical path

For real life projects, which have a large number of activities on the critical path we

can reasonably assume that the critical path duration is approximately normally
distributed with mean and standard deviation obtained by the method described
above. Armed with information about mean (te) and standard deviation (?) for critical
path duration, which is normally distributed, we can compete the probability of
completion by a specified data (D) as follows: D-t

(a) Find D=

(b) Obtain cumulative probability up to Z by looking at the probability distribution

standard normal variate. 3.5 Project Time - Cost Trade-off

of the

PERT/CPM in a network determines that sequence of activities which requires

maximum normal time for the completion of the work i.e. with the available resources
the

Operations of the events/activities lying on the critical path cannot be performed in

less than the required time. But every organisation wants to reduce the target times
that the surplus saved time can be used for extra work by spending extra resources.
Furthermore, every enterprise wants to accomplish the desired objective at minimum
cost. Sometimes it may be desirable to extend the project duration if there is
considerable saving in costs Thus time cost relationship is of great significance in
project management

The project cost consists of both direct and indirect costs. Direct costs are related
with the duration of the activities and include costs on inputs to perform that activity.
Indirect costs include overhead costs, the interest charges on investments and
penalty costs

for completing the work after the specified date. The duration of the project can be
shortened by systematic analysis of critical path activities, crashing costs and
corresponding affect of indirect costs. For this time relationship should be critically
examined.
The relationship can be studied with the help of following costs and time values:

(1) Normal Time: The time associated with normal resources organisation to
Perform the activity is known as normal time. (ii) Normal Cost: The expenditure
incurred on normal resources for completing here activity in normal time is known as
normal cost. (ill) Crash time: The reduced time for the completion of any activity by
using additional resources is known as crash time.

(iv)Crash cost: The total expenditure incurred on normal and additional resources for
Crashing the time is known as crashed cost.

The behaviour of normal and crashed cost/time is illustrated below)

Cost

Crash Cost

Normal cost
Time

Normal The

Actual time-cost relationship could be of any shape but with assumption of linearity
time-cost trade-off for an individual activity, the cost slope is defined as:

Crashed Cost - Normal Cost

Normal Time - Crashed Time

Cost Slope

Cost slope represents the extra cost of shortening the duration of the activity by one
time unit. For reducing the activity duration the management may agree for extra
expenditure but to keep this expenditure minimum we must concentrate only on
these activities for which cost slope is minimum.

The time-cost trade off method consists of systematic analysis of project cost and
time. It can be observed that shortening the duration leads to increase in direct costs
but decrease in indirect costs and the strategy will be justified only when it results in
net saving

3.6 Scheduling when resources are limited In every productive enterprise, resources
are always limited and the management wants to allocate these to various activities
in such a manner that there is best possible use of resources at disposal. PERT and
CPM techniques provide valuable guidelines for most systematic and economic
allocation of resources. The resource is some sort of physical variables viz., labour,
capital and equipment. The source allocation procedure consists of Two main
activities namely resource smoothing and resource levelling.

1) Resource smoothing: The time scaled version of various activities and their
resource requirement along with corresponding floats, if any, is used for resource
smoothing. The period of maximum demand for resources are located and the
activities according to their float values are shifted for balancing the resource needs
and availability. Thus intelligent utilisation of floats can smoothen the demand of
resources to a great extent. (ii) Resource levelling: There are many activities in a
project requiring varying levels of resources. The overall resources of the
organisation though are limited but these should not be below the maximum amount
of resources needed to perform an activity out of all the activities in the process,
otherwise that particular activity cannot be completed. In resource levelling process,
whenever the availability of a resource is less than its maximum requirement, the
only recourse is to delay that activity which have larger float. If two or more activities
require same resources then the activity with minimum duration is chosen for
resource allocation.

Resource levelling attempts to reduce peak resource requirements and smooth out
period to period assignment, within a constraint on project duration. 1.7 Problems in
Scheduling In real life project the activities run into hundred and there may be
several Constraints. The problem of scheduling in such cases tends to become very
complex. For solving such problems the technique of linear programming can be
used. However, when a problem has numerous activities, say, more than 100, the
technique of linear programming becomes computational unwieldy and inordinately
expensive, even with the aid of its fastest computers available.

In view of the practical difficulties in using linear programming for solving large-scale
scheduling problems, heuristic programs have been developed. A heuristic is a rule
of thumb like 'schedule critical activities first or schedule the activity which has the
largest independent float in the end. A heuristic program consists of a collection of
such heuristics. In recent years many heuristic programs have been developed -
they are formulated usually as computer programs. These programs may be usually
divided into two parts: resource levelling programs and resource allocation
programs. A resource levelling program seeks level resource requirements, given a
constraint on project duration. A resource allocation program tries to find the shortest
project schedule, given fixed resources availabilities. 4.0 Summary

The determination of time required to perform each operation and time required to
Perform the entire series as routed is known as scheduling. It is essential to devise
an adequate plan for scheduling and controlling the various activities of the given
project before starting any project. PERT/CPM network consists of two major
components namely events and activities. To locate the critical path and to compute
earliest and latest start and finish times for non-critical project activities, forward pass
and backward pass calculations are made. If the duration activities in a project is
uncertain, then activity calculations are done by using the expected value of the
durations. Variability in PERT analysis is measured by variance on its square root.
The duration of the project can be shortened by systematic analysis of critical path
activities, crashing costs and corresponding affect of indirect costs. Keeping in view
of the practical difficulties in using linear programming for solving large-scale
scheduling problems, heuristic programs have been developed.

5.0 Suggested Readings

1. Project Planning, Scheduling and Control by James P. Lewis. Projects

Preparation, Appraisal, Budgeting and Implementation by Prasanna

2. Chandra.

3 Project Management by Vasant Desai

4. Text Book of Project Management by P. Gopalakrishnan and V.E. Rama Moorthy.

5.Project Appraisal Technique by R. L. Pitale.
6.Production and Operation Management by B.S. Goel.
7. Project Management by B.B. Goel.
6.0 Self Assessment Questions. 1. What steps are involved in PERT/CPM network
analysis? Determining the Critical path?
2. 3. What is the procedure for what is scheduling. Discuss the development of
project schedules. A project consists of 12 activities and their time estimates are
shown on text page.

4.

Activity

Time in weeks

tP

10 3 7 12

569

246

6 10 20

34

15 3 7 12

245

36

2 58

26
(1-2) (1-3)

(1-4) (1-7)

(2-4)

(2-6) (2-7)

(3-4)

(4-5)

(5-6)

(3-7)

(6-7)

Draw the network diagram. (b) Determine the critical path.

(a)

(c) Calculate event slacks and activity floats.

(d) Find the standard duration of the critical path.

(e) Compute the probability of completing the project in 30 weeks.

5. Discuss the basic principle of network cost system.

MBA-Project Management

LESSON NO, 17

MBAFM-205

Paper: MBA-711

Updated by: Dr. M. C. Garg

Network Analysis: Pert and CPM

Structure

1.0 Introduction

2.0 Objectives

3.0 Presentation of Contents

3.1 Philosophical Foundation of PERT and CPM 3.2 Purpose of PERT and CPM
Models

General Framework of PERT and CPM

3,3

3.4 Development of Project Network

3.5 Rules for Network Construction 3.6 Determination of the Critical Path

3.7 Probabilistic Analysis in PERT 3.8 CPM Networks and Project Crashing

4.0 Summary

5.0 Suggested Readings 6.0 Self Assessment Questions

1.0 Introduction A network is a graphical representation of a project, depicting the

flow as well as the sequence of well defined activities (an activity defines the actual
work to be performed) and events (an event represents the beginning or end of an
activity). Developed during the 1950's, both PERT (Program Evaluation and Review
Technique) and CPM (Critical Path Method) are network models.

2.0 Objectives

After reading this lesson, you should be able to (a) Explain the philosophical
foundation and purpose of PERT and CPM Models.

(b) Discuss the working procedure of PERT and CPM.

(c) Highlight the rules for network construction.

(d) Pinpoint the procedure for determination of critical path. (e) Make a probabilistic
analysis in PERT.

3.0 Presentation of Contents 3.1 Philosophical Foundation of PERT and CPM

Planning and control are two of the most important functions of management
Planning

Involves the formulation, of objectives and goals that are subsequently translated
into specific plans and projects. The function of control is to ensure that the actual
performance is in conformity with the plans. It institutes a mechanism that can trigger
a warning signal if actual performance is deviating, in terms of cost, time or some
other measures of effectiveness, from the plan. If such a deviation is unacceptable to
the manager, he will take corrective action to bring performance in conformity with
the plans. In other cases, the manager may have to develop more realistic plans so
that a viable correspondence between plans and performance can be maintained.
This brief description of planning and control leads to two observations, first,
successful planning requires an appropriate and effective system of control. Second,
an economical and effective system of control is based on the principle of
management by exception. That is, the need for corrective action should arise only in
exceptional situations, and that in most cases performance should be in confirmity
with the plans. These two concepts, an integrated planning and control system and
management by exception, provide the philosophical foundation of PERT and CPM
Models.

3.2 Purpose of PERT and CPM Models

The purpose of PERT and CPM is to enable the manager to plan, schedule, monitor,
evaluate and control all the work activities involved in the completion of a project.
Although the concept, as well as the mechanics of PERT and CPM can be used in
any type of work, the focus of these models is on one time projects. That is, these
models are particularly suited for the coordination and control of one time projects.
Depending upon the type and nature of the business, work activities can be either
one time or repetitive, for example, the design of a new car is a one time project,
consisting of one time activities. However, the mass production of car involves
repetitive activities. 3.3 General Framework of PERT and CPM

The PERT and CPM models are extremely useful for the purpose of planning,
analysing, scheduling and controlling the progress and completion of large and
complex projects. In both PERT and CPM the working procedure consists of five
steps:
1. Analyse and break down the project in terms of specific activities and/or events.
2. Determine the interdependence and sequence of activities and produce a
network.
3. Assign estimates of time cost; or both to all the activities of the network. 4. Identify
the longest or critical path through the network;
5. Monitor, evaluate and control the progress of the project by preplanning, re
scheduling and reassignment of resources. The central task in the control aspect of
these models is to identify the longest path

through the network. The longest path is the critical path because it equals the
minimum time required to complete the project. If, for any reason, the project is not
completed in less time than the critical path time, additional resources must be
devoted to expedite one or more activities comprising the critical path. Paths other
than the critical path i.e. non critical path or slack path, offer flexibility in scheduling
and transferring resources, because they take less time to complete than the critical
path.

The PERT and CPM models are similar in terms of their basic structure, rationale,
and mode of analysis. However, in general two distinctions are made between PERT
and CPM. The first relates to the way in which activity times are estimated, and the
second concerns the cost estimates for completing various activities. The PERT
activity time estimates are probabilistic i.e. three different time estimates, based
upon the probability of completing one activity are made for each activity, while in
case of CPM the assumption is made that activity times are deterministic i.e.
specified conditions, a single time estimate is made for each activity. The sound
usual destination is that while in PERT the e e concept of activity costs are not
explicitly provided. The CPM model does give explicit of activity costs. Furthermore,
in CPM I two sets of estimates are provided. One estimates of set gives normal time
and normal cost required to complete each activity under normal conditions. The
second set gives crash time and crash cost required to complete, each activity under
conditions, that gain reduction in project completion time by expanding more money.
The purpose of this dual estimate is to enable the management to obtain a clear
picture of the cost associated with deliberate acceleration of the project completion.

3.4 Development of Project Network Basic to PERT as well as CPM is the network
diagram. The network diagram, also referred to as the project graph, shows the
activities and events of the project and their logical relationships. A simplified
network diagram for a dinner project is shown in figure 1.

Figure 1

Send Lavitation

Prepare Dianer
The network diagram is constructed in terms of activities and events. An activity is
definite task, job or function to be performed in a project, for example "prepare dinner
is an activity. An activity is represented by an arrow. The head of the arrow marks
the completion of the activity and the tail of the arrow marks its beginning. (The
"length d 'compass' direction of the arrow have no significance). An event is a
specific point in time indicating the beginning or end of one or more activities. It
represents a milestone and do not consume time resources.

Since activities are the basic building blocks of a network diagram, it is necessary fo
narrate all activities of the project. For this purpose, it is helpful to break the project in
enumerate several steps. The number of steps, of course, would depend on the
magnitude and complexity of the project. For industrial projects generally a two-step
procedure would suffice. In the first step, the major parts of the project are identified
and in the second step the activities of each major part are delineated. Activities
should be so defined that they are distinct, reasonably homogenous tasks for which
time and resource requirement can be estimated. Once the activities are enumerated
it is necessary to define for each activity, the activities which precede it, and the
activities which can take place concurrently Given this information, the network
diagram, showing the logical relationship between Activities and events may be
developed.

3.5 Rules for Network Construction The following are the rules for network
Construction

1. A network, whether it is PERT or CPM, consists of interrelated and interdependent

Activities and events. An activity refers to actual process of doing work. It involves
the expenditure of effort, time, money and other resources. An activity is denoted by
an arrow
2. An event refers to a specific, and identifiable milestone, or accomplishment of
work at a specified point of time. Events signify the start or end of activities and
therefore do not require the expenditure of effort, time, money or other resources.
Event is denoted by circle (0). The events are normally so numbered that the number
at the head of the arrow is greater than at its tail.

4. The network flows from left to right.

5. No activity can start until its start event is complete. 6. No event is complete until
all activities leading to that event are complete.

7. Loops and cycles are not permitted in networks. A situation like the one shows in

Figure 2 is not permissible.

Figures 2

Figures 2

8. In order to incorporate technological or managerial requirements it is sometimes

necessary to insert a dummy activity into one network It is donated by dash arrow. A
dummy activity does not require any time, effort or resources for its completion.
Figure 3 shows a variant of figure 2 with a dummy activity

Figure 3

A dummy activity is used to represent a constraint necessary to show one proper

relationship between activities.

Example 1

Draw simple network of a project for constructing a new chart. The project

Consists of the following eight activities:

Activity

1-2

2-3

2-4

3-5

4-5

4-6

Description

Construction of bull Engine Installation Construction of super structure

Construction of dock
Plumbing and wiring

Radar Installation

Interior finishing

Painting

5-7

6-7

The network for this project can be drawn like this:

Figure 4

T₁ - 28 5-0

T-16 5-4

Time Estimation

Once the logic and detail of the network have been established, time estimates must
be assigned to each activity. The three estimates for each activities are generally: (1)
a = Most optimistic time. This is the shortest time for completing the activities
assuming most favourable condition.

(2) m=Most likely time. This is the time in which activity is most likely to be
completed. (3) b=Most pessimistic time. This is the longest time for completing the
activity assuming

most unfavourable conditions. Once the three time estimates for each activity are
obtained, the expected value of activity is calculated. The expected time, i.e. te for
activity is usually obtained by the formula.

a+4m+b

te

expected time for completing the activity a

te

b
= optimistic time most likely time

pessimistic time

Continuing with example I three time estimates are given and we are required to
calculate i.e. te expected time for competing the project.

Example 2 Activity

(a)

1-2

24

3-5

4-5

46

5-7

6-7

Expected Time

to m

Time Estimates (Werkn

1)

Standard deviation

from Expected time

2/3
1

1-2/3

1/3

173

1 2/3

65

35

52

83

13

11 4

12

6
3

- Standard deviation of the distribution or time estimated for completing the

activity. It measures the spread or dispersion of the distribution and is calculated as

follows:

b-a

Determination of the Critical path

Once the network diagram with single time estimates has been developed, the
following procedure may be employed for determining the critical paths B, event
slacks and activity floats.

1. Calculate the Earliest Occurrence Time (EOT) for each event. An event occurs
when all activities leading to the event have been completed. In the network diagram
shown in figure 4, note that event 5 is realized only when activity (3-5) is complete
and activity 4-5 is complete. Now if we reach event 5 via 1-2-4-5 it take 15 weeks.
However if we reach event 5 via 1-2-3-5, it takes 19 weeks. Hence, the earliest
expected time i.e. TE for event 5 is 19 weeks. In other words we can say the BOT of
an event refers to the time when the event can be completed at the earliest. The
generalized procedure for calculating TE for an events is: Step 1: For each event,
identify the various paths that connect the network beginning event to that event.

Step 2:

Step 3

Proceeding forward (left to right) add te. i.e. expected time of activities along 286

each such path. The longest chain or path determines its TE

It is to be noted that TE of the network beginning event is zero.

events of figure 4 are given here:

Event 1

3
4

TE (weeks)

11

12

19 14

Another rule for calculating the TE of an event is as follows: For each event, identify
its predecessor events and their respective TE. To each predecessor TE add the
respective TE i.e. expected time of the activity that leads to the event under
consideration then the highest of such values is TE of that event.

2. Calculate the Latest Occurrence Time (LOT) for each event.

The LOT for an event represents the latest allowable time by which the event can
occur given the time that is allowed for the completion of the project (occurrence of
end event). If we want to finish the project on time; it is obvious that TL of the
network beginning event must equal its TL. Hence, by definition, TL of the network
beginning event is zero. Similarly, the TL of the network ending event must equal its
TE. Thus for event 7, T= 28 weeks.

Consider event 4, starting backward from the terminal event, we trace two paths to
event 4. One path (7-6-4) is 8 weeks and the second path (7-5-4) is 12 weeks. This
means that the latest allowable time for completing event 4 is 20 (28-8-20), in view of
path (7-6-4). However, the latest allowable time for event 4 is 16 (28-12-16) in view
of path (7-5-4). It stands to reason that event 4 must be realized by 16 weeks, and
not by 20 weeks, if the terminal event 7 is to be realized by 28 weeks.

A generalized procedure for calculating TL of an event is: Step 1: For each event,
identify various paths which connect the network ending event

to that event. Step 2: Proceeding backward (right to left) subtract te of the activities
along each such

Step 3:

path. The longest chain or path determines its TL for all the events shown in figure 4
is given below:
The EOT of all the

Event

65

TL (weeks) 28

22

19

16

11

Another rule for calculating the TL of event is as follows: For each event, identify its
successor events and their respective TL. From each

Successor TL, subtract the respective te of the activity that originates from the event
under consideration. Then, the lowest of such values is TL of that event.
3.

Calculate the Slack for each event

Associated with each event is a measure called slack. The slack of an event
represents the time by which we can delay the realization of that event without
delaying the successor events. The concept of slack is important because it
indicates a measure of flexibility for one manager in terms of scheduling activities
allocating resources and achieving a balanced rate of production. The slack of an
event is denoted by S and is calculated as follows

S=T₁ - T

We calculate the slacks of events

Event

T₁ 0

11
16 19

22

28

12

19

14

28

4. Obtain the Critical Path

The critical path starts with the beginning event, terminates with the end event, and
is marked by events which have a zero slack. This is the path on which there is no
slack, no cushion. Other paths are black paths with some cushion. The critical path
in our illustration

is 1-2-3-5-7.

5.

Compute the activity floats

Given the estimates of activity time and event slacks, activity floats can be
calculated.

shown as under. Slack

8
For illustrating the concept of float, let us consider activity (2-4) of illustrative Activity
(2-4) is shown in figure.

EOT LOT

66

EOT

12

LOT 16

project.

le='d = 6

Figure 5

The total float of an activity is the extra time available to complete the activity if it is
started as early as possible, without delaying the completion of the project. The total
float for activity (2-4) is equal to :

Lot for Event 4

EOT tor Event 2

Duration of the activity (2-4)

6-4 weeks

16

The total float represents float under most favourable conditions. This is so because
the activity can be started at the earliest (the EOT of the preceding event) and
completed at the latest (the LOT of its succeeding event). The activities on critical
path do not have these floats.

3.7 Probabilistic Analysis in PERT As described earlier, we assume that time

estimates to complete each and every

Activity in a PERT network have a probabilistic distribution. Thus, for each activity on
the critical path we have a separate distribution of time estimates. Since the critical
path 1-2 3-5-7, consists of four activities, this gives rise to four separate probability
distributions The next logical question is how can we combine these individual
distributions to obtain a single distribution that shows the time estimates for
completing the critical path and hence the entire project. The task is accomplished
by making these two assumptions:

(1) The activities are independent in terms of their variance. (2) The completion time
for each critical path is normally distributed. Based on these

assumptions, we calculate the expected time and standard deviation of the critical
path 1-2

3-5-7 as follows:

G-20

Figure 6

The expected time of the critical path is calculated by simply adding together of the
individual activities on the critical path:

'te of the critical path (1-2-3-5-7)=

6+5+2-9-28 weeks.

The standard deviation of the critical path is calculated as followed

Critical path = Project

6 of Project

+1+1+1

<<- 1.16 winks

After knowing expected completion 'te and the standard deviation? of the project.
under the assumption the time estimates of the critical path, and hence the project
on normally distributed. We can make an estimate of probability of completing the
project by certain date.

Now continuing with the same example, we can calculate the probability of
Completing project, by a specific time, say 30 weeks (D) as followed

Absolute difference from the mean

Standard deviation
I. Find Z

or

D-T

30-28

1.86

1.08 Standard deviation

Z represents the number of standard deviations by which D, the specified date

Exceeds T, the mean critical path duration. 2. Obtain cumulative probability upto Z
by looking at the probability distribution of the

Standard normal variants. In our example, it comes out to be 86 per cent. 3.8 CPM
Networks anti Project Crashing

The CPM network is deterministic. Under this approach we can assume that born
time and cost of completing various project activities are known with certainty. Two
sets of time and cost estimates are obtained for each activity (1) normal time and
normal cost, and

(2) crash time and crash cost.

We can illustrate this with the help of an example:

Example 3

- Cost

-Time

Change in Cost

Per week (rs.)

200

200

400

240

240

500
400

Time (Weeks)

Activity

1-2

1-3

2-4

2-5

3-6

4-5

5-6

Normal

10

15

20

30

14

12

Total

Cost (Rs.)

Normal

1000

2000

1800

4500
7200

5000

3300

24800

Crash

10

16

20

12

9.

Crash

1600

3000

2600

5300

9600

6000

4500

32600

20 (16)

10 (7)

15 (10) 3
14 (12)

Figure 7

30 (20)

On each bra of the network in figure we show the normal as well as the crash time
now, the analysis phase of the CPM requires three steps.

Step 1

Identify the formal critical path and the crash critical path. In our example normal
critical path is 1-3-6 (45 weeks), and the normal cost is Rs. 24,800 and the crash
critical path is 1-2-4-5-6 (34 weeks) and under crash conditions, the cost of the entire
project is Rs. 32,600.

Step 2 On the Normal critical path, identify the least expensive activity to crash.

Crash the path expensive activity, and note whether the critical path has changed. If
not, crash the most expensive activity on this critical path and so on, until a new
critical path emerges, with its own expensive activity to crash. Continue this process
until an reducible critical on which all activities are on their crash times has been
obtained.

Step 3 Examine the non-critical path and uncrash activities on such paths, beginning
with the most expensive activity, to the point after which further uncrashing will
create a longer critical path.

The final the status of the activities and their cost consequences are summarized
below.

Final Time and Cost of Activities

Time (weeks) Crash

Cost (Rs.)

1,600

Activity

1-2
10

18

24

12

3,000 2,600

4,900

8,640 6,000

4,500

31,240

3-6

4-5

5-6

Total

4.0 Summary

A network is a graphical representation of a project showing the flow as well as the

sequence of well defined activities and events. PERT and CPM are network models.
An involved planning and control system and management by exception provide the

Philosophical foundation of PERT and CPM models. The basic purpose of these
models is to enable the managers to plan, schedule, monitor, evaluate and control all
the work activities involved in the completion of a project. PERT and CPM models
are similar in terms of their basic structure, rationale and mode of analysis but these
are general two distinctions made between PERT and CPM. The network diagram
shows the activities and events of the project and their logical relationship. There are
certain rules for network construction. For determining the critical paths, steps
include calculation of the earliest occurrence time for each event, calculation of the
latest occurrence time for each event, calculation of slack for each event, obtaining
the critical path and computation of the activity floats. CPM analysis seeks to
examine the consequences of crashing on total cost.

5.0 Suggested Readings

 United Nations, Guidelines for Project Evaluation, Oxford & IBH Publishing
New Delhi.
  United Nations, A Manual for Evaluation of Industrial Projects, Oxford & IBH
Co.,Pub. Co., New Delhi.
 Prasanna Chandra, Projects: Preparation, Appraisal, Budgeting and
Implementation,Tata McGraw Hill Publishing Co, Ltd., New Delhi.
 Planning Commission, Guidelines for Preparations of Feasibility Reports for
Industrial Projects, Controller of Publications, Government of India, New
Delhi.
 Frances Cherunilam, Business Environment, Himalaya Publishing House,
Bombay.

6.0 Self Assessment Questions

1. Describe the basic procedure that is common in building CPM and PERT network.

What are the two characteristics that distinguish PERT and CPM?

Following are activities and time estimates of a project:

Activity

1-2

2-3

2-4 3-4

3-6

4-5 5-6

Time estimate

Te(HRs)

15

15

6-7 9 Design the appropriate PERT network. Calculate TPTL and S (Slack) for each

A construction company attempts to build houses according to PERT methodology.

Activity
1-2

1-3

2-4

3-5 4-5

event.

3.

The construction activities include: Description

Laying Foundation Digging Basement

Install Pumping

And wiring

Construction Frame

Insulating

5-6 Management has interviewed its foreman and has arrived at the following time

Finishing

estimated for the activities

Activity

1-2

1-3 2-4

3-5

4-5 5-6

9 6 12 9

84

9 5 15
63

7 10

Calculate (a) the expected time te, for individual activities: (b) the completion time of
project and (c) the standard deviation of project completion time. 4. Discuss the
basic principle of network cost system.