Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

PROJECT ANALYSIS & EVALUATION

CHAPTER- 6 PROJECT FINANCING, COST, SOURCES OF FUNDS AND CONTROL

I. COST

 Operational Cost
 Factors to be considered:
The cost structure of the proposed project must enable it to realize an acceptable profit with a
price. The following should be examined in this regard:
 Cost of material inputs
 Labor costs
 Factory overheads
 General administration expenses
 Selling and distribution costs
 Service costs
 Economic of scale, etc.

 Cost of Capital
Lending means a long medium or short-term commitment reducing the liquidity of the lender and
would also imply uncertainty concerning the full return of the funds lent. To obtain finance, an
investor must, therefore, pay a charge, the cost of capital or finance for the funds lent. This charge
comprises an interest rate, usually expressed as a percentage per annum, as well as certain fixed
charges (commitment fee, charge on capital not drawn, commissions etc.). Interest is usually
computed for the outstanding balance of the corresponding liabilities of a firm, for example, interest
payable on current account.

II. PROJECT FINANCING AND SOURCES OF FUNDS

The allocation of financial resources to a project constitutes an obvious and basic prerequisite for
investment decisions, for project formulation and pre-investment analysis, and for determining the
cost of capital (without which the decision to accept or reject a project on the basis of the NPV and
IRR cannot be made).

A feasibility study would serve little purpose if it were not backed by reasonable assurance that
resources are available for a project. The capital outlay of a project can be appropriately determined
only after plant capacity and location have been decided, together with estimates of the costs of a
developed site, buildings and civil works, technology and equipment.
Determining the financial requirements of a project at the operational stage in terms of working
capital is equally necessary. The determination of working capital can be only done once estimates
are made of production cost, on one hand, and sales and income, on the other. These estimates
should cover a period of time and be reflected in a cash flow analysis. Unless both estimates are
available and unless the available resources are sufficient to meet the fund requirements, both in
terms of initial capital investment and working capital needs over a period of time, it would not be
prudent to proceed to the financing decision and project implementation.

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 1
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

 Sources of Finance
A) Equity
A generally applied financing pattern for an industrial project is to cover the initial capital
investment by equity and long-term loans to varying extents, and to meet working capital
requirements by additional short and medium term loans from national banking sources.

The minimum net working capital requirements should be financed from long-term capital. In
situation where institutional capital is scarce and available only at high cost, equity capital covers
the initial capital investment and net working capital. Anyway, a balance needs to be struck
between long-term debt and equity.
1. The higher the proportion of equity the less the debt service obligations and the higher
the gross profit before taxation.
2. The higher the proportion of loan finance, the higher the interest payable on liabilities.

Therefore, in every project, the implications of alternatives patterns and forms of financing must
be carefully assessed. A financing pattern should be determined to be consistent with both
availability of resources and overall economic returns.

Issuing two types of shares can raise equity: ordinary shares and preference shares. Preference
shares usually carry a dividend at least partly independent from profit, without or with only
limited voting rights.

They can be convertible to common shares; they can be cumulative or non-cumulative in terms
of dividend or can be redeemable or non-redeemable, with the redemption period varying
between 5 and 15 years. Dividends on ordinary shares with full voting rights, however, depend
on the profitable operation of the company.

B) Loan Financing
Since it is relatively easy for a sound project to obtain loans, the process of project financing may
well start by identifying the extent to which loan capital can be secured, together with the interest
rate applicable. Such loan capital needs to be separately defined.
 Short and medium term borrowings from commercial bank for working capital or
suppliers credit and
 Long-term borrowings from national or international development finance institutions

 Short Term Loans:-

Short-term loan from commercial banks and local financial institutions are available
against hypothecations or pledging of inventories. Bank borrowing for working capital
can be arranged on a temporary basis. If the cash flow suggests that sufficient liquid funds
are available, such bank borrowings should be reduced or entirely eliminated, without
harming the liquidity of the project.

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 2
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
 Working capital needs should even be partly net out of long-term fund, since the
largest portion of working capital is tied in inventories (raw material, work
progress, finished goods and spare parts).

 Long Term Loans:

Loan financing is usually subject to certain regulations (convertibility of shares and
declaration of dividends). Certain ratios in the capital structure of the company need to be
maintained. Investment may also be financed partly by issues of bonds and debentures.

An important source of finance is also available at government-to-government level in

developing countries. This can be a bilateral credit or tied credit, which may be related to
the purchase of machinery and equipment from particular country or sources.

In addition to share capital and loan finance, an important financial category at the
operational stage is the internal cash generated by the project itself. This can take the
form of accumulated reserve (retained profits and depreciation).

C) Supplier Credits
Imported machinery and spares can often be financed on deferred credit term. Machinery
suppliers in developed countries are willing to sell machinery on deferred – payment terms with
payments spread over 6 to 10 years.

D) Leasing
Instead of borrowing financial means it is sometimes possible to lease plant equipment or even
complete production units, which is productive assets, are borrowed. Leasing (borrowing of
productive assets) requires usually a down payment and the payment of an annual rent, the
leasing fee. These are, however, contained in balance sheet of the lessor and not in the lessee –
which is off balance sheet financing.
 The problem is basically to decide which alternative should be preferred, leasing or
purchasing of capital assets. To evaluate the two alternatives, the discounted cash flow
should be applied.
 The initial down payment, the current leasing fees and additional payments under the
leasing agreements are part of the cash outflow (replacing the investment costs).
 Since the duration of leasing contracts is in general much shorter than the technical and
economic life of an asset, it is necessary to include the residual value (cash inflow) of the
leased asset when comparing with loan financing.
 The inflow for the lessee would usually not be the book value, but either the book value or
the market value (minus the lessors cost of setting the used items) which ever is lower.
 If the investor has a choice between loan and leasing financing, he would compare the
discounted cash flow for both flow arrays to determine which alternative would bring the
higher yield (IRR, NPV).

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 3
 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
III. PROJECT CONTROL

Once the project is launched, control becomes the dominant concern of the project manager. 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: (1) It
ensures regular monitoring of performance, and (2) It motivates project personnel to strive for
achieving project objectives.

 Cost Control Tools

Reliable and accurate data and information are the keys for controlling. The master budget is the
most important tool for the cost control. The master budget has to be broken down into various
components of cost such as material, equipment, labour, office expenditure, technology acquisition,
sundry costs etc. These schedules of cost serve as the basic for controlling cost.

In addition to the schedules of costs, output information is used in cost control. At different
operating levels, important data are collected and converted into management information. Progress
reports, cash flow statements, and reports on cost trends, cost status, and bottlenecks or constraints
etc. are the important pieces of information required for controlling costs. A number of ratios, such
as ratios of total project cost and individual activity costs, are also used for cost control.

 Control Functions
 The Control Function Includes:
1. Check on activities
2. Measure the qualitative output
3. Compare the results with the budgeted figures
4. Based on the present performance, predict the future costs
5. Ascertain and analysis the past and the predicted variances
6. Investigate and trace the causes of variances to their roots
7. Offset the adverse variances and correct the root causes of the variances to prevent their
recurrence.

 Performance Analysis
Effective control over a project requires systematic performance analysis. This calls for answering
the following questions:
1. Is the project as a whole on scheduling, a head of schedule or behind schedule?
2. Has the cost of the project been as per budget estimates or different?
3. What is the trend of performance? What would be the final cost for completion of the project?

Performance analysis may be done for individual components of the project. In performance
analysis, we consider the value of work that has been done. This enables us to know systematically
whether the expenditure incurred was commensurate with progress.

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 4
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
 Control of Contingency & Changes

Contingency control and changes control are often used interchangeably. Unless an effective control
is exercised on contingencies and changes, the budget and schedule will be thrown out of control.
Project cost control to be effective, should have two streams of accounting, one for the estimated
definitive budgeted cost and the other for the potential contingencies or changes. Approved and
accrued contingency amounts shall get added on to the cost.

Contingency controlling or change controlling is done through a system of continual trending, and
predicting changes, and brining down the level of contingency. The system should identify changes
form the original scope, estimate their impact on the cost budget, evaluate their benefits with
reference of to cost, and provide the management with sufficient information on these variables for
making decisions on giving effect to the changes. There are optional changes like modifications and
additional facilities being incorporated, and inescapable changes like statutory, regulatory, and
inflationary changes.

If approved, the changes shall be implemented as if they were parts of the original scope, with an
additional contingency budget or add on budget. Price escalations may also be combined with
contingency.

The project manager must try to reduce the impact of contingencies and changes through trending
and predicting. They are simple forecasting exercised through which the future performance of
work and cost are predicted.

 Corrective & Preventive Actions

Variances identified or predicted shall form the basis for management actions of correction and
prevention. In project implementation, there are controllable and uncontrollable factors of variance
either existing at the present time or likely to occur in the future. The manager should always be
alert and be in contact with the external and internal environment to be able to predict the potential
deviations and take preventive measures in times.

As for the past variances and the existing situation, urgent corrective actions must be taken on
controllable factors. A revision of budget is necessary for uncontrollable factors.
 Controllable variance factors include wrong resource assessment, poor productivity, etc.
 Among Uncontrollable factors we usually find errors in design, un-envisaged events,
statutory changes, wrong selection of equipment, etc.

Management action in variance control shall be aimed at reducing further adverse variance, and
simultaneously accelerating the pace of activities to put the project back on schedule. Preplanning,
rescheduling, closer monitoring, change in project team to induct more number of committed people,
faster decision making, deletion of some work packages, etc. are among corrective measures.

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 5
 Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

IV. IMPLEMENTATION PLANNING AND BUDGETING

The project implementation phase embraces the period from the decision to invest to the
start of commercial production. Implementation planning aims at determining the
technical and financial implications of the various stages of project implementation, with a
view to securing sufficient finance. A series of simultaneous and interrelated activities
taking place during the implementation phase have to be identified together with their
financial impact on the project.

When preparing the implementation plan for the feasibility study, it should be borne in
mind that, at a later stage, this plan will be the basis for monitoring and controlling the
actual project implementation.

The implementation schedule must present the costs of project implementation as well as
the schedule for the complete cash outflows (for all initial investments), in order to allow
the determination of the corresponding inflows of funds.

 Implementation planning and budgeting includes the following major tasks:

A. Determination of the type of work tasks that is necessary to implement the
project.
B. Determination of the logical sequence of events in the work tasks.
C. Preparation of a time-phased implementation schedule, allowing for adequate
time to complete each individual task.
D. Determination of the resources needed to complete the individual task along
with its cost.
E. Preparation of an implementation budget and cash flow that will ensure the
availability of adequate funds.
F. Documentation of all implementation data, allowing the implementation plan
and budget as well as the forecasts made in the feasibility study, to be
updated.

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 6
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

Stages of Project Implementation

1. Appointment of the implementation team
The main objective in the appointment of a project team is to ensure that the execution of
all work comply with the implementation plan and budget.

2. Company formation and legal requirements

The formation of a new company would be necessary if the investors are starting a new
project. In case if the investment is to take place within an existing enterprise, many of the
legal requirements for forming a new company will not be required.

3. Government approvals
Government approval may be necessary for importing machinery and materials. Adequate
time should be provided to obtain the necessary approvals.

4. Project management and organization

It is usually advisable to appoint a key person who would build up a company-internal
management team. During the stage of organizational build-up the recruitment of human
resources is initiated. The training plan that has been prepared earlier in the feasibility
study is an important planning tool for the implementation team. Recruitment is too often
left to a very late stage, and training programmes are initiated only when the plant is ready
to commence production.

5. Financial planning
After the decision to invest has been taken and once the total investment costs and their
scheduling are known, detailed arrangements for financing need to be initiated.

6. Technology acquisition and transfer

Negotiations with technology suppliers may take considerable time in certain cases. Legal
problems such as patent rights, exploitation limitations, restrictions on the trade names etc.,
have to be solved. The feasibility study should contain a projection of the time schedule
and the costs related to the technology.

7. Detailed engineering and contracting

The final plant layout as prepared in the feasibility study will be the beginning of detailed
engineering. The time required for civil works site preparation etc., and the cost of these
works have to be estimated in the feasibility study. Reasonable time must also be allowed
for rendering, evaluation of renders, contract negotiations, and award of contracts.
8. Acquisition of land
Acquisition of land may take time-consuming negotiations. Accessibility to the plant site,
climate conditions, facilities for utilities etc., should be considered in selecting the land.
The acquisition of land may require approval by the authorities of environmental
protection.

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 7
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
9. Construction and installation
Any delays during the actual construction phase will have an impact on the costs and
income projections made in the feasibility study. The sequence of civil works and
construction activities needs to be carefully defined. For scheduling the construction and
installation work, it is important to understand that such work can begin only after
designing the layout, acquiring the land, and getting approval from the authorities.

10. Supply of materials and services

It is necessary to finalize arrangements for the delivery of basic production materials during
the implementation phase. Both the domestic and foreign suppliers have to be studied to
ensure that they are capable of delivering the specified quality and quantity materials in
accordance with the supply schedule.

11. Pre-production marketing and Plant commissioning

The preparation of the sales market must start early enough to ensure that the output can be
sold as scheduled. Market preparation ranges from advertising and training of salesmen
and dealers to the organization of distribution newt work.
One of the most critical stages during the implementation period is the commissioning of
the plant. This stage normally comprises the following activities:
b) Pre-operational checks
c) Trail runs
d) Performance test
e) Acceptance and take-over

Implementation Scheduling
The implementation schedules are normally prepared in three steps. In the first step, the
planner determines the logical sequence of events in implementation without paying much
attention to the exact duration of each task. In the second step the planner will analyze how
specific tasks are to be undertaken. Some tasks will be further divided into subtasks. Finally,
the analyst established the implementation schedule showing the correct positioning and
duration of all activities, and tasks.

 The description of each task should include:

1. The resources needed for the task
2. The time required to complete the task
3. The responsibility for the task
4. Information inputs required for the task
5. Results to be produced
6. Interrelationship with other activities, etc.
Suppliers of plant and equipment will be able to provide information concerning installation
and commissioning. Shipping companies can provide valuable information on transports
times and the customs clearance procedures.

Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 8