You are on page 1of 15

Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Module I: Basics of Credit and Credit Process

Chapter 5: Credit Appraisal for Term Loans

Dr. M. Manickaraj

Objectives
The objective of this chapter is to provide a foundation for appraisal of business
projects and to explain how to decide on term loans for projects.
Structure
5.1 Introduction
5.2 Types of Projects
5.3 Appraisal of Projects
5.3.1 Technical
5.3.2 Commercial
5.3.3 Management
5.3.4 Legal
5.3.5 Environmental
5.3.6 Financial
5.4 Viability and repayment capacity
5.5 Determining repayment Schedule
5.6 Sensitivity analysis
5.7 Scenario analysis
5.8 Summary and conclusion

5.1 Introduction
Business firms normally need two different types of credit facilities – term loan and
working capital loan. While working capital is used for financing day to day operations of
the business, term loans are used for financing projects. Term loans are used to purchase
fixed assets such as machinery used in production of goods. Fixed assets will have a
certain useful life and hence the term loan provided for purchasing and setting up assets

Page 1 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

should be recovered fully before the end of their life. As such, the main character of term
loan is that it will have a specified repayment schedule.
5.2 Types of Projects
Business projects can broadly be classified into industrial and infrastructure projects.
Though both types of projects have common characteristics, infrastructure projects are
large in size and more complex in nature and require specially trained professionals to
deal with them. Projects can also be classified into the following types:
 New Business Projects– This involves starting a new firm along with setting up
new manufacturing and other facilities. Assessing risk of such firms could be
very difficult because of lack of track record, lack of credit history and probably
the promoters are new to the business and the like.
 Green Field Projects: These are new projects entered into by existing firms such
as setting up a new factory, plant for a new line of business, or a new location.
 Brown Field Projects: These are additional investments made on existing
operations such as for expansion/modernisation of existing facilities or
replacement of existing assets with new ones.
Among the abovementioned three types of projects new business projects are the most
risky followed by green field projects and brown field projects are the least risky.
5.3 Appraisal of Projects
Project appraisal is the process of assessing projects before term loans are sanctioned.
Appraisal of projects is intended to fulfil the following three objectives:
 Choosing projects objectively and consistently. Banks and financial
institutions are huge organisations where thousands of employees handle the
business of lending. Moreover, there are layers in the organisational structure
of banks. There will be officers at different layers of the organisation involved
in making loan decisions. In order to communicate among all the officers
involved in the decision making process there is a need for doing the credit
appraisal in a structured manner so that everyone involved in the process will
be on the same page.
 Creating documentation to meet financial and regulatory requirements.
Another important objective of project appraisal is to create a record of all the
facts and findings so that it can be referred to by anyone and anytime in the
future.
 Laying foundation for lending decisions. The most important reason for doing
credit appraisal of projects is to enable decision making on loan proposals.
Project appraisal usually covers the following six areas:
 Technical
 Commercial

Page 2 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

 Management
 Legal
 Environmental
 Financial

5.3.1 Technical Appraisal


Among the various aspects of a project the following need to be studied carefully to
evaluate technical feasibility:
- Project area: The area where a project is planned to be set up should be based on
considerations such as +climatic condition, natural resources, presence of support
industries and services, availability of human resource, etc. which are necessary
for running a project are important. If an auto component manufacturing unit is
set up in a place where there are no automobile manufacturing units then the
project will not likely to be feasible. Similarly, if a cement manufacturing unit is set
up in a place where there no limestone reserves the project cannot succeed.
- Project site: The exact place where the project is being put up will also determine
the success of a business. For instance, if a manufacturing project is set up near a
school or a hospital the public may oppose the project. There were instances
where everything with the site was fine but the project site had no access to the
nearby road. Project site may also be seen from the point of view of connectivity
to inputs like electricity, water, raw material and also outlets for effluents. If
projects are established in industrial estates most of the resources like utilities,
roads, etc will be available and there would not be any objection to the project
from any quarters.
- Approvals and clearances: Business projects may need approvals from different
government authorities like the central government, state government, local
government like Municipal Corporation, pollution control board, department of
forest, registration with relevant government departments, GST number, and so
on.
- Technology: Many alternative technologies may be available for the proposed
project. Appropriate technology should be chosen based on proposed scale of the
project, quality of output, availability of maintenance service, spare parts, and the
like. The technology chosen should not be obsolete. Energy efficiency of the
machineries installed matters. When very advanced technology is used
indigenous service or support should be available.
- Installed capacity and operating capacity: The installed capacity of the project is
production capacity of plant and machinery installed and is supposed to be
decided based on the quantity of output that can be sold in the target market.
Operating capacity is the actual production to be decided on seasonality in

Page 3 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

operations, number of shifts of operation and so on. While assessing a term loan
it has to be kept in mind that the capacity of the project is selected keeping in mind
the total outlay from the promoter and the desired level of output envisaged
depending on the market. Installation of over capacity would increase the cost of
capital. Similarly there should be optimal utilisation of the installed capacity.
Underutilisation may reduce profitability.
- Implementation schedule: The length of time needed for completion of the
proposed project including milestones and timeline must be studied. The schedule
should be feasible such that it shall not be too ambitious that it cannot be
completed within the scheduled time nor it will take too long a time. While the
implementation schedule is important for the promoters it is also important for
the banks providing loan for the project for determining the loan release schedule.
When a Project Loan is given, Banks monitor the progress of the project with
reference to the implementation schedule. The Date of Commencement of
Commercial operations (DCCO) is of importance to the Banker since delay in DCCO
beyond the RBI permitted period can render the Loan as an NPA.
- Availability of inputs: Availability and accessibility to inputs including raw
material, energy, water, and human resource are critical for running projects.
They may also affect profitability.
- Quality of input/output: Quality of inputs will determine the quality of output.
Therefore, if a certain quality product is planned to be produced the choice of
input should be chosen accordingly. Tie ups for procurement of inputs of desired
quality may have to be made beforehand.
5.3.2 Commercial Appraisal
Commercial feasibility is highly critical for success of any business. The factors that would
determine the commercial feasibility include the following:
- The Industry outlook, whether the industry is a sun rise industry / sun set
industry and the prospects of the product proposed to be manufactured. The
degree of health or sickness prevalent in the industry to be scrutinised.
- Market size: Number of potential consumers, expected quantity of consumption
and frequency of consumption will determine the size of the market. Larger the
size of the market better would be the prospects for a company.
- Demand-Supply Gap: This is a critical factor that will determine the profitability
of business firms. Positive demand-supply gap (demand is greater than supply) is
an indicator of growth potential and also will enable the companies to enjoy higher
bargaining power. Players in a sector with positive demand-supply gap will
generally enjoy higher profitability.
- Competition: Nature and intensity of competition are the two other factors that
will determine the success of firms. If competition is cut throat all players are

Page 4 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

likely to suffer losses or very low profitability. The price assumed by the Borrower
should be realistic and in tune with the market.
- Substitution: If the product can be easily substituted the risk of failure will be high.
Apart from the above three factors arrangements for marketing the product and
necessary logistics are also necessary for making a project commercially successful.
5.3.3 Management Appraisal
Appraisal of management should consider three major elements including the promoters,
the management and the executive team.
Promoters are the owners of the project who invest money in the project. The promoters’
credentials, experience, competence, and resources should be studied.
Top management (board of directors) of a firm is another element to be analysed as part
of management appraisal. Competency of members on the board of directors should
therefore be assessed.
Executive team is the key persons who will head the various functions like production,
technology, marketing, human resource, and finance. In today’s world business projects
are highly technology and knowledge intensive and hence persons of relevant
competency are supposed to be chosen for the various functions.
For small businesses all the three elements of management may be handled by the same
person or team. In case of large businesses all the three may be made up of different set
of people.
5.3.4 Appraisal of Legal Matters
Legal aspects to be verified before committing funds in a project include regulations
governing the business, approvals from government authorities, viz., Factory licences,
Building approvals from competent authority, PCB approvals, EPR registration, title
deeds etc. Besides, contractual arrangements between the project/company and other
stakeholders like suppliers, customers, contractors, service providers and so on should
also be studied.
5.3.5 Environmental Analysis
Impact of the proposed project on the environment and the society need to be assessed
and one should verify if the project is violating any law governing environment and
society. In case of big projects Environmental Impact Analysis (EIA) is supposed to be
done and clearances from the ministry of environment and forests or state pollution
control board or the national green tribunal as the case may be should be obtained.

5.3.6 Financial Appraisal

Page 5 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

The last and most critical step in project appraisal is the appraisal of the project’s
financials. The various aspects about a project’s financials that need to be carefully
studied are discussed hereunder.
- Project cost: Estimation of project cost will determine the amount of capital
required for the project. Accordingly, project promoters should make necessary
arrangements for raising the required capital. Under estimation as well as
overestimation of project cost are possible. Under estimation of project cost will
lead to not being able to complete the project. It will also result in choosing non-
viable projects for investment. On the other hand, overestimation may lead to
rejection of viable projects. Banks therefore shall check every item in the project
cost estimation thoroughly. Wrong estimation of project cost could also be due to
omission of certain items. Project cost may generally have the following heads:
S No Items
1 Land and Site Development
2 Buildings
3 Plant & Machinery
4 Engineering & Consultancy fees
5 Miscellaneous Fixed Assets viz., Furniture, equipments,
vehicles etc.,
6 Preliminary & pre-operative expenses including interest
during construction (IDC)
7 Provision for contingencies
8 Margin money for working capital

Working capital margin: One item that is commonly underestimated or even


ignored is the margin for working capital. It is the amount of equity capital for
financing current assets. The need for working capital will arise once the
construction of the project is completed and commercial operations start.
However, as the margin for working capital is supposed to be equity capital
adequate provision for the same should be made in the project cost. Otherwise it
may so happen that the project promoters approach the bank for working capital
but may not bring the equity capital for working capital. This will put the bankers
in a tight spot that they cannot say no to working capital support because the term
loan provided can be recovered only if the operations of the project start and
continue. Simply put each and every item of project cost and also working capital
margin should be checked.
- Once the project cost is accepted the next question will be the means of financing
the project. Banks do not fund expenses and margin money, generally. The

Page 6 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

promoters will have to bring margin as stipulated by the Banks for funding other
assets as well.
- Means of finance and source of equity capital: After checking the project cost
the sources from where capital for the project are planned to be raised should be
examined. While banks may decide on the amount of loan to be provided for the
project they should also check the source of equity capital and the feasibility of
raising equity capital. Net worth of promoters may give an indication about their
ability to bring in the necessary amount of equity capital. If raising capital from
the market is proposed, market conditions should also be studied.
- Break Even Analysis :
- The repayment of the Term Loan is proposed to be made from the profits to be
generated from the project. Hence studying and accepting profitability estimates
and cash flows projected is a crucial role of the Banker.
- For this, it is necessary to estimate the cost of production and projected sales so
as to arrive at the profitability estimates. Therefore, analysing what level of sales
will cover the cost and from where the unit will start making profit becomes
important.
- So it is necessary to ascertain the minimum level of production and sale at which
the unit will run on "no profit no loss" basis. This is known as Break Even Point
(BEP).Bankers are keen that the unit achieves this level at the earliest and
operates well above this level to sustain profitability and ensure repayment.
To calculate the BEP, as a first step, the total cost has to be bifurcated into fixed
and variable items.

Fixed costs refer to those costs which are incurred regardless of the operation
and/or level of activity of the unit e.g., rent, taxes, insurance, depreciation,
maintenance of building, machinery, etc.

The variable costs or marginal costs on the other hand are expenses which vary
directly in proportion to level of activity or sales or production e.g., raw materials,
power & fuel, consumables etc.

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝐸𝑃 (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦) = (𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡

(Or)

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝐸𝑃 (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦) = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑃𝑒𝑟 𝑈𝑛𝑖𝑡

- Sale Price per unit – Unit variable cost per unit is also known as contribution

Breakeven point (in value) = BEP in quantity (units) X Selling price per unit

Page 7 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

In Breakeven analysis, the measure of profitability is Margin of Safety


Margin of Safety = Actual sales - Break even sales (in units)

Margin of safety can also be measured as a % of actual sales.


Profit = Margin of safety (units) X Contribution

- The size of the margin of safety is an indicator of company’s financial health,


i.e. low margin of safety is indication of higher risk and vice versa.

Illustration for Break Even Point :

Ramu is an entrepreneur who has put a small tailoring shop in Ranganathan street, for
stitching readymade shirts and selling in bulk to number of established textile shops in
the market. 5 textile shops have agreed to buy 1000 pieces per month at a selling price of
Rs 70. The shop proposes to work for 25 days and on an average each can stitches 40. The
costs per month are as follows :

Fixed Costs (Rs) Variable costs per unit (Rs)

Salary for tailors on 21000 Raw material cost 50


fixed pay basis

Rent 10000 Threads and other 4


consumables

Machinery maintenance 3000 Power required for 1


running the machinery per
shirt

Other fixed expenses of 1000


the shop

Total Fixed Expenses 35000 Total variable expenses 55

Page 8 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

- Selling Price per unit = Rs 70

- Variable costs per unit = Rs 55

- Therefore Contribution = Rs 70 – Rs 55 = Rs. 15

- Breakeven point (Quantity) = 35000 / 15 = 2334units

- Margin of safety = 5000 – 2344 = 2667

- Margin of safety in % =2667 /5000 = 53.34 %

- Profit per month = 2667 X 15 = Rs 40005/-

Projection of cash flows: Cash flows for a project are drawn based on several
assumptions. Assessment of project viability and repayment capacity therefore will
largely depend on how realistic the projection of cash flows. Lenders must question each
and every assumption behind the projections, check if all the relevant items of income
and costs have been taken into account and also verify whether all the items have been
correctly estimated. The following items may be paid closer attention:
Revenue from projects would depend on:
 Installed capacity and operating capacity
 Capacity utilisation
 Seasonality and working days
 Operational efficiency
 Quantity and quality of output
 Selling Price
Omission of cost items: It is possible that some items of costs are taken into account.
Management compensation, selling and distribution expenses, and transportation cost
are the few items which are commonly ignored.
5.4 Viability and Repayment Capacity
The next step after studying the project cost and projected cash flows is to check the
viability and repayment capacity of projects. Viability of projects is tested with the
following:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Repayment capacity will be measured by using the Debt Service Coverage Ratio (DSCR)

Page 9 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

5.4.1 NPV: NPV or Net Present Value is present value of future cash flows minus the
project cost. Value of cash flows depends on time and hence time value of money needs
to be taken into consideration. Normally, all the future cash flows will be converted into
present value by discounting the cash flows with a discount rate. Mathematically, NPV
may be expressed as follows:
n
Cash Flowt
NPV    Pr oject Cost
t 1 (1  Discount Rate )
t

Where, ‘t’ refers to the relevant year and ‘n’ is the life of the project in years.
Project cash flows are the cash flows available for disbursement to the capital
providers including the lenders and the equity capital providers.
Discount rate is nothing but the cost of capital of the project in question. Cost of
capital is the minimum rate of return expected from the project.
If the NPV is greater than zero one can say that the project is offering higher return than
the discount rate and hence the project is viable. If the NPV is negative then the project is
not viable. In other words, the cash outflows and cash inflows over the entire project
period is discounted at a predetermined rate (which can be cost of capital/weighted
average cost of funds/minimum acceptable rate of return) and the net present value is
derived as a surplus of discounted inflows over discounted outflows. If the NPV is zero
the benefits derived from the project are just sufficient to cover cost of the capital.

5.4.2 IRR: Though NPV can be used to assess the viability of projects its limitation is that
it does not measure the rate of return offered by projects. Moreover, if discount rate is
changed NPV should be calculated using the new discount rate. Internal Rate of Return
or IRR is the rate of return offered by projects. It is the discount rate that will make the
discounted value of project cash flows equal to the project cost. If IRR is used as the
discount rate NPV will be zero. Viability of projects can be determined by comparing the
IRR with the discount rate. If the IRR is greater than the discount rate the project can be
said to be viable.

For the purpose of estimating NPV and IRR cash outflow will generally be the project cost
plus initial working capital requirement. Cash inflow will be calculated as net operating
profit + depreciation + interest on borrowings. Net cash flow is derived as cash inflow
minus cash outflow plus residual value of investments at the terminal year.

5.4.3 NPV and IRR: Illustration


The cost of Project X is Rs.40 million and it is expected to generate cash flow over its life
of 5 years as in the table below. The cost of capital of the project is 10%.

Page 10 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Year Cash Flow (Rs. Million)


Project Cost -40
1 10
2 11.5
3 12.5
4 10
5 12
Total cash flow 56.0

NPV of Project X: In order to find out NPV of the project its cash flows should be
discounted by its cost of capital as in table below. The present value of cash flow in year
1 is calculated as 10/(1+10%). It works out to 9.09.The present value of cash flow in year
2 works out to 9.50 (i.e., 11.5/(1+10%)2 and so on.

Calculation of NPV of Project X

Year Cash Flow (Rs. Million) Present Value (at 10%)


1 10 9.09
2 11.5 9.50
3 12.5 9.39
4 10 6.83
5 12 7.45
Total cash flow 56.0 42.3
NPV (PV of all cash flows – Project Cost) 2.3

NPV of the project = Sum of present value of all cash flows – Project Cost
= 42.3 – 40
= 2.3 million
As the NPV is positive at 2.3 million the project can be termed as viable.

IRR: As the NPV of the Project X is positive one can say that the IRR is greater than its
discount rate. Therefore, one shall discount the cash flows of the project with a higher
discount rate. The present values of the cash flows discounted by 12% are as follows:

Page 11 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Year Cash Flow (Rs. Million) Present Value (at 12%)


Project Cost -40
1 10 8.93
2 11.5 9.17
3 12.5 8.90
4 10 6.36
5 12 6.81
Total cash flow 56.0 40.16
NPV (PV of all cash flows – Project Cost) 0.16

At 12% discount rate the NPV of the project is 0.16. Therefore, one may say that the IRR
of project X is roughly 12%. The exact IRR of the project is 12.16%. It shall be noted that
if IRR should be calculated manually ‘trial and error’ method should be used.
Both NPV and IRR will give the same result. In the above illustration the NPV is positive
and the IRR is greater than the discount rate. The project hence is viable according to both
NPV as well as IRR.
Data required for calculating NPV and IRR are project cost, projected cash flows and
discount rate. The discount rate is also referred to as hurdle rate, minimum required rate
of return, cost of capital, and weighted average cost of capital (WACC). One thumb rule to
be used is higher the risk of a project higher should be discount rate and lower the risk
lower should be the discount rate.
5.4.4 Debt Service Cover Ratio (DSCR)
DSCR indicates the adequacy or otherwise of project cash flows to service term loans. It
can be calculated as follows:
(𝐸𝐵𝐼𝑇𝐷𝐴 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑇𝑎𝑥)
𝐷𝑆𝐶𝑅 =
(𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛 𝐼𝑛𝑠𝑡𝑎𝑙𝑚𝑒𝑛𝑡 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛)

Or

(𝑃𝐴𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛)


𝐷𝑆𝐶𝑅 =
(𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛 𝐼𝑛𝑠𝑡𝑎𝑙𝑚𝑒𝑛𝑡 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑇𝑒𝑟𝑚 𝐿𝑜𝑎𝑛)

Where, EBITDA is the operating profit before interest, tax, depreciation and amortization.
The above equation will be used to find out the DSCR of a project every year. In addition,
Average DSCR should be calculated. It can be calculated using the following equation:

Page 12 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Sum of all cash flows during the repayment period


Average DSCR =
Sum of all term loan instalments and interest

DSCR of greater than 1 would indicate that the cash flow is sufficient to service the loan
and if it is less than 1 the cash flow is not sufficient to service the loan. Therefore, every
year the DSCR should be greater than 1 and the average DSCR should also be greater than
1.
Generally, yearly DSCR of 1.25 and Average DSCR of 1.75 are considered to be
comfortable.
Illustration of DSCR calculation:
Let us assume that a Term Loan of Rs 50 L is proposed for Project X. The repayment is
proposed to be made in 60 instalments with a moratorium of 6 m in year I. The data on
PAT, Depreciation and interest on Term Loans are as follows:
(Rs in Lacs)
Years I II III IV V VI Total

PAT 3 8 10 15 16 18 70

Depreciation 6 8 8 8 8 8 46

Interest on TL 5.42 2.86 5.85 4.43 3.01 1.78


27.79
Instalment on Term Loan 5 10 10 10 10 5
50

DSCR will be as follows:


Years I II III IV V VI

DSCR 1.38 1.47 1.50 1.90 2.08 4.10

70 + 46 + 27.79
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑆𝐶𝑅 =
27.79 + 50

In all the years the DSCR is above 1 and the average DSCR is also 1.85 which is very
comfortable. If the DSCR or average DSCR is low, then the ability to service the loan is low.
If DSCR is less than the acceptable norms (stipulated by Banks), the loan repayment
period may be increased, provided the project is otherwise viable.
If the DSCR is high, then the repayment period should be reduced.

Page 13 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

5.5Determining Repayment Schedule


One necessary condition for determining the repayment schedule is that it must match
with the cash flow of the project. For instance, neither interest nor instalments shall be
recovered during project construction. Generally, in big projects, interest during the
construction period (IDC) is estimated and added to the project cost as well as the
principal of the loan for the project. Moratorium is the repayment holiday given i.e.,
Repayment will start after the moratorium period (which will be few months after
commercial production, generally). Moratorium may be for both interest and principal.
If the moratorium is for both principal and interest, interest will be capitalised and added
to the principal.
However, where moratorium is extended only for principal, interest should be paid
during the moratorium period. Margin for IDC should be 100%. In case of small projects
banks prefer the same after confirming that the funds are available with the promoter.
Repayment schedule shall be determined keeping in mind the following:
 Start of commercial production
 Moratorium period
 Cash flows e.g., if in the initial years the cash flow is less, ballooning repayment
schedule may be fixed.
Supposing a project is viable, then debt servicing should not be an issue. However, if the
repayment schedule doesn’t match the project cash flows or if the repayment period is
significantly shorter than the life of the project then the loan cannot be serviced.
5.6Sensitivity Analysis
Sensitivity analysis is the study of how the uncertainty in the cash flows of a project can
be apportioned to different sources. Sensitivity analysis answers the question, "if the
input variables like cost of raw material, cost of labour, tax rates, selling price, etc. deviate
from expectations, what will the effect be on cash flows or NPV or IRR or DSCR?“
Therefore, to see the impact of a particular variable the same alone will be changed
keeping other variables at the base case level. This way one can check sensitivity of a
project’s cash flows to different variables. NPV, IRR and DSCR after each change should
be noted and finally average NPV, average IRR and average DSCR should be calculated. If
the average NPV/IRR/DSCR is above the minimum required level the project will be
accepted and funding support can be provided.
Different variables that can be changed for sensitivity analysis could be the Project cost,
Capacity utilization, Quantity of sales, Selling price, Raw material cost, Labour cost,
Discount rates, etc.
5.7Scenario Analysis
Scenario analysis is a process of analyzing possible future events by considering
alternative possible scenarios. The scenarios can be base case scenario, optimistic
scenario and pessimistic scenario but not necessarily restricted to these three scenarios.

Page 14 of 15
Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune

Unlike sensitivity analysis scenario analysis allows variation in multiple variables at a


time. Rather, the entire scenario is changed and the effect of the same is studied. Under
each scenario NPV, IRR and DSCR should be estimated and the average of them should be
calculated.
5.8 Summary and Conclusion
Term loans are needed for business projects to finance fixed assets necessary for
establishing projects. The types of projects include new businesses, green field projects
and brown field projects. New business projects are the most risky and brown field
projects are the least risky. Appraisal of projects is necessary for making loan decisions.
It will help in choosing projects objectively and consistently, will provide documentation
for meeting financial and regulatory requirements and also will enable loan decisions.
Project appraisal will normally include appraisal of technical, commercial, managerial,
legal, environmental and financial aspects of projects. Financial appraisal of projects will
include checking project cost, means of finance, and working capital margin, projection
of cash flows, and ascertaining viability and repayment capacity of the project. While
viability of projects can be measured by NPV or IRR repayment capacity it measured by
DSCR. Lenders should determine the repayment schedule such that it will match with the
cash flows of the project.
As the estimates and projects are based on assumptions there is a need to carryout
sensitivity analysis and scenario analysis. Sensitivity analysis allows changing only one
assumption at a time whereas scenario analysis allows changing many variables at a time.

Page 15 of 15

You might also like