Project cost estimation & working capital requirements,

➢ Project cost estimating is the process of predicting the total cost

of the tasks, time, and resources required to deliver a project's
scope of work.
➢ Cost estimation accounts for each element required for the
project from materials to labor and calculates a total amount that
determines a project’s budget.
Elements of cost estimation in project management
There are two key types of costs addressed by the cost estimation
process:
➢ Direct costs: Costs associated with a single area, such as a
department or the project itself. Examples of direct costs
include fixed labor, materials, and equipment.
➢ Indirect costs: Costs incurred by the organization at large,
such as utilities and quality control.
 Methods of Cost Estimation in Projects
➢ Expert Judgement
➢ Analogous Estimating
➢ Parametric Estimating
➢ Bottom-up Estimating
➢ Three-point Estimating
➢ Data Analysis (Alternative analysis/Reserve
analysis)
Methods of Cost Estimation in Projects
 Methods of Cost Estimation in Projects
➢ Expert Judgement
Expertise should be considered from individuals or groups with
specialized knowledge or training in team and physical resource
planning and estimating. Expert judgment, guided by historical
information, provides valuable insight about the environment and
information from prior similar projects.
➢ Analogous Estimating
Analogous cost estimating uses the values such as scope, cost,
budget, and duration or measures of scale such as size, weight, and
complexity from a previous, similar project as the basis for estimating
the same parameter or measurement for a current project. It is most
reliable when the previous projects are similar in fact and not just in
appearance, and the project team members preparing the estimates
have the needed expertise.
➢ Parametric Estimating
Parametric estimating uses an algorithm or a statistical relationship
between historical data and other variables (e.g., square footage in
construction) to calculate resource quantities needed for an activity,
based on historical data and project parameters.
 Methods of Cost Estimation in Projects
➢ Bottom-up Estimating
In the Bottom-up estimating method, team and physical resources
are estimated at the activity level and then aggregated to develop the
estimates for work packages, control accounts, and summary project
levels. Bottom-up estimating is a method of estimating a component
of work. The cost of individual work packages or activities is
estimated to the greatest level of specified detail. The detailed cost is
then summarized or rolled up to higher levels for subsequent
reporting and tracking purposes.
➢ Three-point Estimating
The accuracy of single-point activity cost estimates may be improved
by considering estimation uncertainty and risk and using three
estimates to define an approximate range for an activity‘s cost:
✓ Most likely (M): The cost of the activity, based on realistic effort
assessment for the required work and any predicted expenses.
✓ Optimistic (O): The activity cost based on analysis of the best-case
scenario for the activity.
✓ Pessimistic (P): The activity cost based on analysis of the worst-
case scenario for the activity.
 Methods of Cost Estimation in Projects
➢ Data Analysis (Alternative analysis/Reserve analysis)
A data analysis technique used in this process includes but is not limited to
alternatives analysis. Alternatives analysis is used to evaluate identified options
in order to select the options or approaches to use to execute and perform the
work of the project. Alternatives analysis assists in providing the best solution to
perform the project activities, within the defined constraints.
 Working Capital Requirements
➢ The Working Capital Requirement (WCR) is a financial metric showing the
amount of financial resources needed to cover the costs of the production
cycle, upcoming operational expenses and the repayments of debts. In other
words, it shows you the amount of money needed to finance the gap between
payments to suppliers and payments from customers.
➢ The key components of the working capital requirement formula are accounts
receivable (measured through the DSO, for Days Sales Outstanding), inventory
(measured through the DIO, for Days Inventory Outstanding) and accounts
payable (measured through the DPO, for Days Payable Outstanding). Logically,
the working capital requirement calculation can be done via the following
formula:
WCR = Inventory + Accounts Receivable – Accounts Payable.
➢ Working capital is the lubricant that keeps your company’s finances running. In
accounting terms, it is current liquid assets - such as cash, inventories and
accounts receivable - minus current liabilities, such as accounts payable. Too little
working capital can signal liquidity problems; too much working capital suggests
you are not using your assets efficiently to increase revenues.
 Working Capital Requirements
➢ A rise in WCR usually means companies are spending a lot of their financial
resources just running the business and therefore have less money to pursue
other objectives such as new product development, geographical expansion,
acquisitions, modernization or debt reduction. The higher your working capital
requirement, the more constraints you face in making forward-looking
investments. So monitor any change in working capital requirement closely
➢ Another metric showing the ability of your company to pay for its current
liabilities with its current assets is the working capital ratio.
➢ A good working capital ratio is considered to be 1.5 to 2, and suggests a
company is on solid financial ground in terms of liquidity. Less than one is taken
as a negative working capital ratio, signaling potential future liquidity problems.
An exception to this is when negative working capital arises in businesses that
generate cash very quickly and can sell products to their customers before
paying their suppliers
➢ The biggest drain affecting your working capital requirement is payment delays.
Late payments can force many companies to draw on their working capital to
pay the bills in the best of times, and in fact payment delays are the leading
cause of insolvencies.
➢ “Cash is king; cash flow is and will remain the sinews of war,” says Philippe.
“25% of business failures are the result of suspension of payments. It is
therefore essential that companies manage their cash flow rigorously.”
 Working Capital Requirements
Is there a difference between cash flow and working capital?
The terms cash flow and working capital are used interchangeably, which causes
significant confusion in many project organizations. Cash flow is the inward and
outward movement of cash; essentially the management of income and
expenditure. However, working capital is measured by comparing a firm’s
current assets against current liabilities. It is essentially the money available to
meet your current short-term obligations.
 Sources of Funds
➢ Companies always seek sources of funding to grow their business. Funding, also
called financing, represents an act of contributing resources to finance a
program, project, or need. Funding can be initiated for either short-term or
long-term purposes. The different sources of funding include:
 Sources of Funds
Retained Earnings:
Businesses maximize their business profits by selling the product or by rendering the
services for a higher cost and to produce the goods and services. Retained earnings are
the most primitive way to channelise their funding for any company. After the profits
being generated, the company needs to decide what to do with the earned capital and
how to distribute it efficiently. With the retained earnings at hand, the company can –
distribute it to the shareholders as dividends, or reduce the company’s outstanding
loans. Yet in another way, the company can invest the money into an entirely new
project, like building a new building, factory or a machine. These retained earnings can
be used also to create a partnership with another company forming a joint venture.
Debt Capital
Companies obtain debt financing privately through bank loans. They can also source new
funds by issuing debt to the public. In debt financing, the issuer (borrower) issues debt
securities, such as corporate bonds or promissory notes. Debt issues also include
debentures, leases, and mortgages.
Companies that initiate debt issues are borrowers because they exchange securities for
cash needed to perform certain activities. The companies will be then repaying the debt
(principal and interest) according to the specified debt repayment schedule and
contracts underlying the issued debt securities.
The drawback of borrowing money through debt is that borrowers need to make interest
payments, as well as principal repayments, on time. Failure to do so may lead the
borrower to default or bankruptcy.
 Sources of Funds
Equity Capital:
Companies can raise funds from the public in exchange for a proportionate
ownership stake in the company in the form of shares issued to investors
who become shareholders after purchasing the shares. Alternatively, private
equity financing can be an option, provided there are entities or individuals
in the company’s or directors’ network ready to invest in a project or
wherever the money is needed for. Compared to debt capital funding, equity
funding does not require making interest payments to a borrower.
However, one disadvantage of equity capital funding is sharing profits among
all shareholders in the long term. More importantly, shareholders dilute a
company’s ownership control as long as it sells more shares.
Other Funding Sources:
Funding sources also include private equity, venture capital, donations,
grants, and subsidies that do not have a direct requirement for return on
investment (ROI), except for private equity and venture capital. They are also
called “crowdfunding” or “soft funding.”
Crowdfunding represents a process of raising funds to fulfill a certain project
or undertake a venture by obtaining small amounts of money from a large
number of individuals. The crowdfunding process usually takes place online.
 Sources of Funds
Sources of financing a business are classified based on the time period for
which the money is required. The time period is commonly classified into
following three
 Capital Budgeting
➢ Capital budgeting is the process of making investment decision in
long-term assets or courses of action. Capital expenditure incurred
today is expected to bring its benefits over a period of time. These
expenditures are related to the acquisition & improvement of fixes
assets
➢ Capital budgeting is used by companies to evaluate major projects
and investments, such as new plants or equipment.
➢ The process involves analyzing a project’s cash inflows and outflows
to determine whether the expected return meets a set benchmark
➢ Capital Budgeting is defined as the process by which a business
determines which fixed asset purchases or project investments are
acceptable and which are not.
➢ The purpose of capital budgeting is to make long-term investment
decisions about whether particular projects will result in
sustainable growth and provide the expected returns.
 Capital Budgeting
Capital Budgeting is characterized by the following features:
➢ There is a long duration between the initial investments and the
expected returns.
➢ The organizations usually estimate large profits.
➢ The process involves high risks.
➢ It is a fixed investment over the long run.
➢ Investments made in a project determine the future financial
condition of an organization.
➢ All projects require significant amounts of funding.
➢ The amount of investment made in the project determines the
profitability of a company.
 Capital Budgeting
How Capital Budgeting Works
It is of prime importance for a company when dealing with capital
budgeting decisions that it determines whether or not the project will be
profitable. The most common methods of selecting projects are:
▪ Payback Period (PB)
▪ Internal Rate of Return (IRR)
▪ Net Present Value (NPV)
▪ Profitability Index
Payback Period (PB)
It is the most popular and widely recognized traditional method of
evaluating the investment proposals. It can be defined, as ‘the number
of years required to recover the original cash out lay invested in a project
It refers to the time taken by a proposed project to generate enough
income to cover the initial investment. The project with the quickest
payback is chosen by the company.
 Capital Budgeting
Payback Period (PB)

Example:
An enterprise plans to invest $100,000 to enhance its
manufacturing process. It has two mutually independent options
in front: Product A and Product B. Product A exhibits a
contribution of $25 and Product B of $15. The expansion plan is
projected to increase the output by 500 units for Product A and
1,000 units for Product B.
the incremental cash flow will be calculated as:
(25*500) = 12,500 for Product A
(15*1000) = 15,000 for Product B
The Payback Period for Product A is calculated as:
The Payback Period for Product A & B is calculated as:
Product A = 100,000 / 12,500 = 8 years

Product B = 100,000 / 15,000 = 6.7 years

This brings the enterprise to conclude that Product B has a shorter payback
period and therefore, it will invest in Product B.
 Capital Budgeting
Net Present Value Method
Evaluating capital investment projects is what the NPV method helps the
companies with. There may be inconsistencies in the cash flows created over
time. The cost of capital is used to discount it. An evaluation is done based
on the investment made. Whether a project is accepted or rejected depends
on the value of inflows over current outflows.
𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
𝑁𝑃𝑉 =
𝑟𝑛
Where : n is no. of years; r : discount rate

Example of Net Present Value (with 9% Discount Rate ):

For a company, let’s assume the following conditions:
Capital investment = $10,000
Expected Inflow in First Year = $1,000
Expected Inflow in Second Year = $2,500
Expected Inflow in Third Year = $3,500
Expected Inflow in Fourth Year = $2,650
Expected Inflow in Fifth Year = $4,150
Discount Rate = 9%
Net Present Value achieved at the end of the calculation is:
With 9% Discount Rate = $18,629
This indicates that if the NPV comes out to be positive and indicates profit.
Therefore, the company shall move ahead with the project.
 Capital Budgeting
Profitability Index:
This method provides the ratio of the present value of
future cash inflows to the initial investment. A Profitability
Index that presents a value lower than 1.0 is indicative of
lower cash inflows than the initial cost of investment.
Aligned with this, a profitability index great than 1.0
presents better cash inflows and therefore, the project will
be accepted.

Example:
Assuming the values given in the table, we shall calculate
the profitability index for a discount rate of 10%.
So, Profitability Index with 10% discount = $15,807/$10,000 = 1.5807

As per the rule of the method, the profitability index is positive for the 10%
discount rate, and therefore, it will be selected
 Capital Budgeting
Internal Rate of Return:
Internal rate of return (IRR) is the discount rate that makes Present value
(PV) of cash outflows equal to PV of cash inflows of an investment project.
The term 'Internal Rate of Return' is used in three senses. It is the rate of
growth of an investment, secondly, it is the highest rate of interest that an
investor could pay for borrowed funds to finance the investment. The third
interpretation is that the rate of discount (interest) that equates Net Present
Value of cash inflows with present value of outflows. Internal Rate of
Return= Discount rate that makes NPV=0;
implies discounted cash inflows are equal to discounted cash outflows.