Chapter 4 Revised

CHAPTER 4
PROJECT PREPARATION (FORMULATION)
Feasibility Study: Dimensions and Reporting
A project feasibility study is a key process that justifies whether to go ahead with a
certain project idea or to disregard it. As the name implies, a feasibility study is an
analysis of the viability of an idea from different parameters. The feasibility study
focuses on helping answer the essential question of “Should we proceed with the
proposed project idea?”
Feasibility studies can be used in many ways but primarily focus on proposed
business ventures. Determining early that a business idea will not work saves time,
money and heartache later.
A feasible business venture is one where the business will:
 generate adequate cash-flow and profits,

 Withstand the risks it will encounter.
 Remain viable in the long-term and meet the goals of the founders.
The venture can be a new start-up business, the purchase of an existing business,
an expansion of current business operations, or a new enterprise for an existing
business. Feasibility study is only one step in the business assessment and
development process. The feasibility study helps to “frame” and “flesh-out”
specific business scenarios so they can be studied in-depth.
During this process the number of business alternatives under consideration is

usually quickly reduced. During feasibility process you may investigate variety of
ways of organizing the business and positioning your product in the market place.
Project Analysis and Management By Mesfin Abiye. Page 1

It is like an exploratory journey and you may take several paths before you reach
your destination. There is often some confusion between a feasibility study and a
business plan. A feasibility study is not a business plan.
The business plan outlines the actions needed to take the proposal from “idea” to
“reality.” The feasibility study outlines and analyzes several alternatives or
methods of achieving business success. So the feasibility study helps to narrow the
scope of the project to identify the best business scenarios. The business plan deals
with only one alternative or scenario. The feasibility study helps to narrow the
scope of the project to identify and define two or three scenarios or alternatives.
The consultant conducting the feasibility study may work with the group to
identify the “best” alternative for their situation. This becomes the basis for the
business plan.
The feasibility study is conducted before the business plan. A business plan is
prepared only after the business venture has been deemed to be feasible.
REASONS TO DO A FEASIBILITY STUDY
Conducting a feasibility study is a good business practice. Examination of

successful business organizations indicates that they do not go into new business
venture without first thoroughly examining all of the issues and assessing the
probability of business success.
A feasibility study will:
 Narrow business alternatives and give focus to the project

 Surface new opportunities through the investigative process
 Identify reasons not to proceed

 Enhance the probability of success by addressing and mitigating (to lessen)
factors early on that could affect the project.
 Provide quality information for decision-making.
 Help to increase investment in the company: Investment will be enhanced by
companies through wise use of resources.
 Provide documentation that the business venture was thoroughly
investigated.
 Help in securing funding from lending institutions and other monetary
sources.
The feasibility study is a critical step in the business assessment process. If

properly conducted, it may be the best investment one ever makes.
REASONS GIVEN NOT TO DO A FEASIBILITY STUDY
Project leaders and sponsors may find themselves under pressure to skip the
“feasibility analysis” step and go directly to building a business. Individuals from
within and outside of the project may push to skip this step. Reasons given for not
doing a feasibility analysis include the following;
 We know that it is feasible as an existing business is already doing it

 Why do another feasibility study when one was done just a few years ago:
previously conducted feasibility studies will not be useful to make an
investment decision currently because as time passes several changes are
encountered in the political, economical, social, and technological (PEST)
environments. Hence recent data shall be gathered for the project idea at
hand.
 Feasibility studies are just a way for consultants to make money

 The market analysis has already been done by business that is going to sell
us the equipment: feasibility study of the equipment manufacturer or
distributor doesn’t help other next parties in the channel through transitivity.
Hence, a computer assembly is feasible doesn’t mean a computer training
center will be feasible any time.
 Why not just hire a general manager who can do the study: a general
manager is always hired after a feasible business idea has been obtained and
is in the process of being implemented or is in operation.
 Feasibility studies are a waste of time: though feasibility studies will take
time to complete, reversing a wrong decision that was undertaken without
feasibility studies will require more time and the incurrence of other scarce
resources.
The reasons given above should not discourage business people from
conducting a meaningful and accurate feasibility study because, once decisions
have been about proceeding with a proposed business, they are often difficult to
change. However, some aspects of the feasibility study may even require
special attention through support or functional studies.
SUPPORT (FUNCTIONAL) STUDIES)
Support or functional studies cover specific aspects of an investment project,

and are required as prerequisite for, or in support of, pre feasibility and
feasibility studies, particularly large scale investment proposal. Support or
Functional studies are also a part of project preparation stage and are usually
conducted separately, for later incorporation in the prefeasibility or feasibility
studies.
Examples of such studies are as follows:

 Market studies of the products to be manufactured, including demand
projections in the market to be served together with anticipated market
penetration.
 Raw material and supply studies, covering current and projected
availability of raw materials and inputs basic to the project, and the
current and projected price trends of such materials and inputs.
 Laboratory and pilot-plant tests, which are carried out to the extent
necessary to determine the suitability of particular raw materials or
products.
In most cases, the results of a support study, when undertaken either before
or together with a feasibility study, form an integral part of the latter and
lessen its burden and cost. The last outcome of the feasibility study is the
final appraisal and report.
PROJECT APPRAISAL (APPRAISAL REPORT)
When a feasibility study is completed the various parties involved in the project
will carry out their own appraisal of the investment project in accordance with their
individual objectives and evaluation of expected risks, costs and gains. A formal
project appraisal report is usually required at the end of a feasibility study. The
better the quality of the project feasibility study made, the easier will be the
appraisal work to be performed. The techniques applied to appraise a project may
revolve around technical, commercial, market, managerial, organizational,
financial and economic aspects of the project under consideration.
The findings of a feasibility study will be summarized in what is called the

executive summary.
EXECUTIVE SUMMARY
The feasibility study should begin with a brief executive summary outlining the
project data (assessed and assumed) and the conclusions and recommendations
which would then be covered in detail in the body of the study. However, any
supporting material such as statistics, results of market surveys, detailed technical
descriptions and equipment lists, plant layouts etc should be presented in a separate
annex of the study.
The executive summary should concentrate on and cover all critical aspects of the
study, such as the following:
 The degree of reliability of the data on the business environment.

 project inputs and outputs
 the margin of error (uncertainty and risk) in forecasts of market,
supply and technological trends, and
 The project design.
The executive summary should have the same structure as the body of the
feasibility study and cover, but not limited to, the following areas:
1. Summary of the project background and history:

 project background
 Name and address of project promoter
 Project objective and outline of the proposed basic project strategy
including geographic area and market share.
 Project location : orientation towards the market or towards resources
(raw materials)
 Economic and industrial policies supporting the project.
2. Summary of market analysis and marketing concept:

 Summarize results of marketing research: business environment,
target market and market segmentation, channels of distribution,
competition.
 List annual data on supply and demand
 Indicate projected marketing costs, elements of the projected sales
programs and revenues
 Describe impacts on raw materials and supplies, location, the
environment, the production program, plant capacity and technology
3. Raw materials and supplies:
 Describe general availability of raw materials, processed industrial
materials and components, factory supplies, spare parts, supplies for
social and external needs.
 List annual supply requirements of material inputs
 summarize availability of critical inputs and possible strategies
4. Location, site and environment:
 Identify and describe location and plant site selected, including
ecological and environmental impact, socio economic policies,
infrastructural conditions and environment
 summarize critical aspects and justify choice of location and site
 Outline significant costs relating to location and site
5. Engineering and technology:
 Outline of production program and plant capacity
 Describe and justify significant advantages and disadvantages and
disadvantages as well as life cycle and transfer of technology,
training, risk control, costs, legal aspects etc.
 Describe the layout and scope of the project
 summarize main plant items, their availability and costs

 describe required major civil engineering works
6. Organizational and Overhead costs:
 Describe the basic organizational design of the project
 Indicate management and measures required
7. Human resources:
 describe the socioeconomic and cultural environment as related to
significant project requirements as well as human resources
availability, recruitment and training needs, and reasons for the
employment of foreign experts, to the extent required for the project
 Indicate key points (skills) required and total employment numbers
and costs
8. Project implementation Schedule:
 Indicate duration of plant erection and installations
 Indicate duration of production start up and running period
 Identify actions critical for the timely implementation of the project
9. Financial analysis and investment appraisal:
 Summary of criteria governing investment appraisal
 Total investment costs: major investment data showing local and
foreign components for land and site preparation; structures and civil
engineering works; plant, machinery and equipment; preproduction
expenditures and costs, net working capital requirements
 Total costs of products sold such as operating costs, depreciation
charges, marketing costs, finance costs
 project financing: sources of finance, impact of cost of financing and
debt servicing on project proposal, and public policy on financing
 aspects of uncertainty including critical variables, risks and possible
strategies and means of risk management

 national economic evaluation
 Conclusions concerning: major advantages of the project, major
drawbacks of the projects and chance of implementing the project.
4.1 MARKET AND DEMAND ANALYSIS:
Market analysis is a process of assessing the level of demand for the product or
service to be produced from the project. This in other words means determining the
marketability of the product or the service of the project under consideration.
Different techniques of demand forecasting are used in analyzing the availability of
market for the products and assessing the level of demand.
Objective of the study:
The study of market and demand analysis, being the first in project preparation, has
the following main objectives:
 To systematically assess the market and the market environment to

generate pertinent data.
 To collect, analyze, and report data about a specific market situation
 To obtain insight about the target market structure
 To identify customers needs and behavior in the market.
 To design the marketing mix fit in the context
 To identify available distribution channels
 To identify competitors and their characteristics in the target market
 To determine the socio-economic aspects relevant to the preparation
and evaluation of the project’s market strategy
 To identify the existing strengths and weaknesses in the internal
environment of the firm
 To project the level of demand expected
 To delineate marketing opportunities and threats
 To decide on subsequent aspects of a project
 To develop sales program of the firm.
IMPLICATIONS FOR PROJECT ANALYSIS:
In most cases, the first step in project analysis is to estimate the potential size of
the market for the product proposed to be manufactured (or service planned to be
offered) and get an idea about the market share that is likely to be captured. Put
differently, market and demand analysis is concerned with determining the:
 Likely aggregate demand for the product, and

 Possible market share expected for the product.
The first stage in preparing the feasibility study comprises the estimation of size,
composition and development trends of demand for the product or products,
careful analysis of determining variables and their market environment, demand
forecast and the ultimate goal of the procedure: sales volume and revenue
projections. the extensive and careful analysis of past, present and future demand
for the product to be produced, together with market, institutional, and political
forces influencing demand and sales of the product in question, is of crucial
importance to the success of the entire project.
Estimates of Sales revenue, at a later stage of feasibility study, will be the basis for
evaluation of alternatives and final decisions regarding:
 Production program
 plant capacity
 material and input choice
 Location

 Financial evaluation
 Ultimate marketing strategy.
Given the importance of market and demand analysis, it should be carried out in an
orderly and systematic manner, which, in other words, emphasizes the necessity of
a marketing research.
The key steps in such analysis/research could broadly be stated as follows:
 Situational analysis and specification of objectives

 Collection of secondary information
 Conducting market survey (primary information)
 Characterization of the market
 Demand forecasting
 Market planning.
Market and Marketing Concepts:
1. A market is an institution set up by society as an important means to

allocate scarce resources in the economy.
 It is a locus of all potential customers involving in exchange of values
to satisfy their needs.
 It channels/transfers resources from one unit to another unit (entity) in
a given context.
2. Market participants may be described as :
 Producers of inputs/outputs
 Sales agents, distributors (wholesalers and retailers), and commission
brokers.
 Transportation agents (distribution channels)

 Competitors and partners
 consumers
 regulators
3. Marketing is the process by which solicit members in the society obtain
what they need through creating and exchanging goods and services with
others for identifiable economic return. Nowadays, the definition of
marketing is broadened to include even the exchange of ideas between social
and political entities, (for example, election campaigns).
4. The Marketing Mix, (often referred to as the 4Ps), are mixture of
controllable marketing variables that could be used by a marketer to achieve
the desired sales level in the target market. These 4 Ps are product, price,
promotion, and Place.
5. Marketing Strategy is a specific weapon, tool, or approach, composed of
basic variables in the marketing process. It is the action plan that the
company uses in order to achieve its marketing objectives. It encompasses:
 Marketing expenditures: Amount, frequency, significance to be
obtained, ability to provide competitive advantage.
 Marketing mix: the degree of combination (proportion) of the
controllable and measurable marketing variables in order to give the
firm unique competitive posture in the market.
 Competitive strategy: such as low cost leadership, high quality and
differentiation, delivery performance (fast delivery and reliability in
delivery), and flexibility and customer service.
6. Elements of the Commercial dimension in project preparation:

 Market Research: the first & basic task in any market and demand
analysis is to generate relevant information useful for doing the
subsequent tasks.
 Marketing Plan and Budget: A plan of action and budget prepared
on the basis of the results of the marketing research.
Projection of Sales Revenue
The projection of sales revenue is essentially an extension of marketing research,

(i.e. it is made in light of the outputs in the market and demand analysis). on the
basis of which, the project’s sales will be developed in terms of specific sales
volume expected during the different periods after the project goes into production.
1. Factors to be considered in Forecasting sales:

The following items affect the size of sales revenue:
 Plant capacity and production program
 marketing strategies
 Expenditure
 Mixes (4Ps)
 Competitive strategy (Cost, quality, delivery performance, and
flexibility and customer service)
 Production technology : capital Vs labor intensive, computerized Vs
manual, etc.
 project life : estimated economic life
 market price of product(s): expected selling price
 Export/import sales by competitors
 Export/local sales by the project
2. Sales Value(Revenue):

The alternative in determining the amount of sales revenue should be
identified as follows:
 Gross sales value
 Sales tax amounts
 Sales value net of taxes.
In this regard, while estimating the level of sales revenue and/or developing the
sales program, it must be decided in advance whether to include the sales tax,
which can become a rather important cost item.
3. Marketing Costs:
In addition to sales revenue, the associated marketing costs should be estimated

and accounted for in terms of the following components:
 Variable-advertisement, promotion, salesperson salaries etc.

 Fixed
The classification of the marketing costs in to variable and fixed portions has its
own significance in analyzing the relevant costs and making sensitivity analysis for
the project.

In sum, the sequence of activities/steps in arriving at sales projection should run as
follows:
Demand Estimates
Supply Potential Estimates
Project’s marketing Strategy
Expected Competitors’ Strategies (if any)
Sales Projection
TECHNIQUES OF DEMAND FORECASTING:
After gathering information about various aspects of the market and the
marketing environment from primary and secondary sources, attempt may be
made to estimate future demand. A wide range of forecasting methods is
available to the market analyst. These may be classified in two categories as
shown below:

I. Qualitative methods: These methods rely essentially on the judgment of
experts to translate qualitative information into quantitative estimates.
Examples in these groups are :
a) Expert opinion method: this method calls for the pooling of views of
group of experts on expected future sales and combining them into a
sales estimate. The major advantage of this method is the pooling of
expertise knowledge in the forecasting process. However, the
accuracy of the forecast will depend on the care and experience of the
people providing the inputs. The reliability of this technique is
questionable.
b) Delphi method: this method involves converting the views of a group
of experts, who do not interact face-to-face, into a forecast through an
iterative process; it is used for eliciting the opinions of a group of
experts with the help of a mail survey.
The processes may include the following steps:
 A group of experts is sent a questionnaire by mail and asked to
express their view.
 The response received from the experts are summarized without
disclosing the identity of the experts, and sent back to the
experts, along with a questionnaire meant to probe further the
reasons for extreme views expressed in the first round.
 The process may be continued for one or more rounds till a
reasonable agreement emerges in the view of the experts.
Delphi method appeals to many organizations for the following reasons:
 It is intelligible to users

 It seems to be more accurate and less expensive than the traditional
face-to-face group meetings.
 However, it may be time taking for reaching on common
consensus and hence, the final estimate.
II. Quantitative methods: uses a formal mathematical method to fit cost
functions to past data observations, Examples include Time series
analysis, Regression (correlation) analysis, moving average, exponential
smoothing etc.
A. TREND PROJECTION METHOD (TIME SERIES ANALYSIS):
Time series analysis forecasts based on an analysis of how variables of
interest have moved historically over the past periods. It doesn’t make a
real attempt to analyze why the variables has changed as they did in the
past, the change is only related to time. It helps to forecast about the future
based on what has happened in the past. It is more suitable when changes
have a certain pattern and the same pattern is expected in the future too.
Time series analysis is becoming a very simple task with advancement of
computer spreadsheet technologies. When the trend projection method is
used, the most commonly employed relationship is the linear relationship,
Y=a + bx
Y= demand for the year (dependent variable)

x=time variable (independent variable)
a=intercept of the relationship
b=Slope of the relationship
b= ∑xy - nxy

∑x2 – nx2
a= y – b(x)
Illustration:
Consider the following sales data for product A for the past 14 years.
Yea Demand/ Yea Demand/Sales Yea Demand/sales

r Sales r r
199 10,000 200 18,000 200 22,000
5 0 5
199 13,000 200 19,000 200 24,000
6 1 6
199 14,000 200 20,000 200 24,000
7 2 7
199 17,000 200 22,000 200 25,000
8 3 8
199 18,000 200 23,000
9 4
Required:
a) State the sales forecast equation/demand function.

b) Forecast sales for the next 7 years.
c) Draw the sales forecast diagram.

Solution:
For purpose of time series analysis, the actual year (time) is converted into year for analysis
Actual Year Year for Actual Year for Yea Year for
analysis Year analysis r analysis
1995 0 2000 5 200 10

5
1996 1 2001 6 200 11
6
1997 2 2002 7 200 12
7
1998 3 2003 8 200 12
8
1999 4 2004 9
Computation:
X Y XY X2
0 10,000 0 0
1 13,000 13,000 1
2 14,000 28,000 4
3 17,000 51,000 9
4 18,000 72,000 16
5 18,000 90,000 25

6 19,000 114,000 36
7 20,000 140,000 49
8 22,000 176,000 64
9 23,000 207,000 81
10 22,000 220,000 100
11 24,000 264,000 121
12 24,000 288,000 144
13 25,000 325,000 169
∑X=9 ∑Y=269,00 ∑XY=1,998,00 ∑X2=81
1 0 0 9
X= ∑x/n = 91/14=6.5
Y = ∑y/n =269,000/14 = 19,214.29
b= ∑xy – nxy = 1,998,000-14(6.5)(19,214.29) = 1,096.7
∑x2 – nx2 819-14(6.5)2
a= y-bx = 19,214.29 – 1,096.7(6.5) = 12,085.74
a) Sales forecast equation : y=a+bx
y=12,085.74 + 1,096.7x
b) Sales forecast for the next 7 years
y=12,085.74 + 1,096.7x
Yea Year Demand/

r for sales
analysi forecasts
s

200 14 27,440
9
201 15 28,536
0
201 16 29,633
1
201 17 30,730
2
201 18 31,826
3
201 19 32,923
4
201 20 34,020
5
c) Sales forecast diagram:
27
2009 2015

B. HIGH-LOW METHOD: It uses only the highest and lowest observation
values of the dependent and independent variables. The demand function is
estimated by using these two points to calculate the slope coefficient and
the constant or intercept.
Slope coefficient (b) = difference between the highest demand and the
lowest demand in the past divided by the difference between the highest and
the lowest of the independent variable.
To compute the constant (a), we can use either the highest or the lowest
observation of the data. Both calculations yield the same answer because the
solution technique solves two linear equations with the two unknowns, the
slope coefficient and the constant because;
y=a+bx
a= y-bx
Illustration:
The following observations were extracted from 12 years data.
Highest Lowest
Sales (Y) 220,000 50,000
Income level (x) 4,000 800
Required: Estimate the demand function using High-Low method.

Solution:
y=a+bx
b=yb-yl/xb-xl = 220,000-50,000/4,000-800 = 53.125
a = y-bx = 220,000-53.125 (4,000)= 7500
y=a+bx
i.e. y=7500+53.125x

C. REGRESSION ANALYSIS: is a very popular demand forecasting tool in
practice. It involves extrapolating the past trend of demand with identified
factor affecting the demand such as income to project the future
consumption.
It measures the average amount of change in the dependent variable associated

with a unit change in one or more independent variables. There are two types of
regression analysis : simple regression (using one independent variable) and
multiple regression analysis (that uses several independent variables). It involves
 Determining the trend of consumption by analyzing past consumption

statistics and
 Projecting future consumption by extrapolating the trend.
The results should be interpreted with diligence:
 Explanatory variable must make sense.

 The right model must be selected.
 Results should be interpreted with due care.
 Outliners, observation that is very far from the majority observation, may
be disregarded in order to avoid their effect on the regression results.
D. EXPONENTIAL SMOOTHING METHOD: In exponential smoothing

forecasts are modified in the light of observed errors.
 If the forecast value for year t, i.e. Ft, is less than the actual value for year t,
i.e. St, the forecast for the year t+1, i.e. Ft+1, is set higher than Ft.
 If Ft> St, Ft+1 is set lower than Ft.
In general, Ft+1 =Ft + αet

Where, Ft+1 = forecast for year t+1
α = smoothing parameter (which lies between 0 and 1)
et= error in the forecast for year t= St -- Ft
How should the first forecast (F1) and the smoothing parameter (α) be chosen?
 A simple and reasonably satisfactory rule of thumb is to choose F 1 as the

mean of the warm-up sample (the warm-up sample consists of several
observations preceding the period for which the forecasting exercise is
began).
 For choosing α, consider several values in the range of 0 to 1 and choose the
value that minimizes the MSE (mean squared error) in the warm-up period.
the mean squared error is defined as :
1/n = ∑ (Si – Fi)2
Where Si= actual actual value of sales in period i
Fi = forecast of sales in period i
n= number of periods in the “warm-up” sample.
For simplicity of using the exponential smoothing method, in this text, it is

assumed that we know the value of Ft and α.
E.MOVING AVERAGE METHOD:
According to this method, the forecast for the next period represents a simple
arithmetic average or a weighted arithmetic average of the last few periods.
In symbols,
Ft+1 = St +St-1 +St-2+………St-n+1

n
Where, Ft+1= forecast for the next period
St = sales for the current period
n= period over which averaging is done
F. CONSUMPTION LEVEL METHOD:
This method estimates consumption level based on elasticity coefficients, the

important ones being the income elasticity of demand and the price elasticity of
demand. It is useful for a product that is directly consumed.
1. Income Elasticity of demand: It reflects the responsiveness of demand to

variations in income. It is measured as follow:
EI= Q2-Q1 X I1+I2
I2- I1 Q2+Q1
Where EI = income elasticity of demand
Q1 = quantity demanded in the base year
Q2= quantity demanded in the following year
I1= Income level in the base year
I2= Income level in the following year.
Then, demand is computed as follows:
Per capital change in demand= per capita change in income level

(percentage) X EI
Projected per capita demand for year n= present per capita demand X 1+per
capita change in demand

Total demand projection for year n= projected per capita Projected
population
demand for year n X level in the
country for
year n
2. Price Elasticity of Demand: It measures the responsiveness of demand to

variations in price. It is computed as:
EP= Q2-Q1 X P1+P2

P2- P1 Q2+Q1
Where EP = Price elasticity of demand
Q1 = quantity demanded in the base year
Q2= quantity demanded in the following year
P1= Price per unit in the base year
P2= Price per unit in the following year.
Expected change in Expected percentage change
quantity demand due = in price per unit X EP
to a change in price
Projected demand = Current level of 1+ Expected change in

quantity
quantity demand X demand due to a change in
price

Assignment Questions:
Solve the following problems:
1. You are given the following demand data:
Year 199 199 199 199 200 200 200 200 200 200 200 200 200 2
6 7 8 9 0 1 2 3 4 5 6 7 8 9
Demand 10 13 14 17 18 18 19 20 22 23 22 24 24 2
(000
units)
Required: Develop the linear equation from the data and forecast the
demand for the year 2010 (Use Trend Projection Method)
2. Assume that the actual sale of a given product in period 1 is 28,000 units
while the forecasted sale is 29,000 units for the initial period. assume
further that the actual sales value for the next ten periods is the
following:
Period 2 3 4 5 6 7 8 9 10 11
Sales 2 28. 3 34. 32. 33. 31. 31. 34. 35.
(000 9 5 1 5 7 5 8 9 3 2
units)
Given α=0.2, derive the forecast of sales for the next 10 periods.
(Use Exponential Smoothing Method)
3. Consider the following time series (figure in ‘000 of units) :

Year 1 2 3 4 5 6 7 8 9 10 11 1
2
Sale 2 2 28. 3 34. 32. 33. 31. 31. 34. 35. 3
s 8 9 5 1 2 7 5 8 9 3 2 6
Assuming the forecaster has set “n” to be equal to 4, make a forecast of sales
for the periods 5 through 12. (Use Moving Average Method)
4. Consider the following observations extracted from 10 years data
X Y
Highest observation 9 145
6 6
Lowest observation 4 71
6 0
Calculate the slope coefficient, constant and the demand function.
(Use High-Low Method).
4.2 RAW MATERIALS & SUPPLIES STUDY
General

An important aspect of technical analysis is concerned with defining the materials
and supplies required, specifying their properties in some detail, and setting up
their supply program.
 There is close relationship between the study of raw materials and supplies
required and other project formulation stages, such as definition of plant
capacity, location, and selection of technology and equipment, as these
inevitably interact with each other.
 The main basis for selection of materials and inputs is, however, the demand
analysis, the production program and finally the plant capacity.
Therefore, issues relating to material and input requirements should be covered in

the feasibility study.
Objectives of Input Study:
 To determine
 types of raw materials and supplies required
 Availability of basic raw material suppliers
 quantity of raw materials needed for the plant
 quality of raw materials and suppliers available and needed
 To estimate the cost of raw materials and supplies needed
 To develop supply programs and devise supply marketing schemes.
UNIDO Approach in the study:
The approach followed by UNIDO in the study of raw materials and supplies is as
follows:
Step 1: Classification of raw materials:

1. Raw materials (unprocessed and semi processed.
 Agricultural products
 livestock and forests products
 marine products, and
 mineral products
2. Processed Industrial materials and components
3. Factory supplies: Auxiliary materials, utilities, and spare parts.
Step 2: Specification of requirements:
 Product characteristics and material inputs

 Requirements of raw materials and factory supplies.
Step 3: Check Availability and supply of the raw materials
Step 4: Supply marketing and supply program:
 Supply Marketing, with the objective of :

 Cost minimization
 Risk minimization (reliable supplies sources)
 Cultivating relations with the suppliers
 supply program
Step 5: Estimate costs of raw materials and supplies
 Unit costs, annual costs, and overhead costs.
The approach followed by the UNIDO is adopted and each of the aspects indicated
in the above five steps is explained next.

Step 1 .CLASSIFICATION OF RAW MATERIALS AND SUPPLIES
1. Raw materials (Unprocessed and Semi-processed)
Agricultural products: If the basic material is an agricultural product, first the

quality of the product must be identified. Assessment of the quantities currently
and potentially available may be a cardinal and/or functional feature in pre-
investment studies involving the use of agricultural products. In food processing
industries, only the marketable surpluses of agricultural produce should be viewed
as raw materials, which are the residue remaining after the quantities required for
consumption and sowing by producers been subtracted from the total crop
production. In case of commercial crops, the marketing surplus is the total
production minus sowing (seeds) requirements.
Livestock and Forest Products: In most cases of livestock produce and forest
resources, specific surveys are called for to establish the viability of an industrial
project. However, general data from official sources and local authorities that is
only sufficient for opportunity studies is required.
Marine Products: The major problem in marine-based raw materials is to assess

the potential of availability, the yields, and cost of collection. Availability of
marine products may not only depend on ecological factors, but also on national
policies and bilateral or multilateral agreements. (Fishing Quotas)
Mineral Products: For mineral products detailed information on the proposed

exploitable deposits is essential, and proven reserves are needed. The availability
of opencast or underground mining; location, size, depth, and quality of deposits;
and the impurities and the need for beneficiation should be qualified. A detailed
analysis of physical, chemical, and other properties of the mineral is required.

2. Processed Industrial materials and Components:
Processed industrial materials and goods constitute an expanding category of basic

inputs for various industries in developing countries. Such inputs can generally be
classified under:
 Base metals
 Semi-processed materials, and
 Manufacturing parts: components for assembly type and engineering goods
industry.
3. Factory Supplies
a) Auxiliary Materials: All manufacturing projects require various auxiliary
materials and utilities summed to be factory supplies. it is not always easy to
distinguish between auxiliary materials such as chemicals, additives,
packaging materials, paints, and varnishes and factory supplies such as
Maintenance materials, oils, greases, and cleaning materials, since these
terms are used interchangeably.
b) Utilities: A detailed assessment of the utilities required (electricity, water,
steam, compressed air, fuel, and their efficient disposals) can only be made
after analysis and selection of location, technology and plant capacity.
However, the general assessment of these is a necessary part of the input
study. An estimate of utilities consumption is essential for identifying the
existing sources of supply, any bottlenecks, and shortages that exist or are
likely to develop, so that appropriate measures can be taken to provide for
whether internal or external addition supplies in good time.
c) Spare Parts: All machinery and equipment will finally break down after a
certain lifetime. Various spare parts will be required to keep a plant in

operation. The importance of correctly identifying essential spare parts, the
quantities required, and available suppliers cannot be overemphasized.
Usually, the initial investment includes spare parts for the first one or two
years of plant operations under the heading of the initial net working capital
requirement (current assets). The consumption of spare parts during plant
operation is a part of the annual production costs (which is a manufacturing
overhead cost).
Step 2. DETERMINATION/SPECIFICATION OF REQUIREMENTS:
In order to estimate the requirements of materials and supplies during the future
operation of the plant, the requirement should be identified, analyzed, and
specified in feasibility study, both quantitatively and qualitatively. A number of
factors such as Socio-economic, financial, and technical should be considered. The
specification of raw materials and factory supplies, as required for the envisaged
production technologies, is the basis for the assessment and analysis of the
availability of the project inputs.
 Project characteristics and material Inputs: For a given industry, the

envisaged plant can be capital or labor intensive, computerized or
mechanized, complex or fairly simple. The nominal and feasible plant
capacity will have to be defined on the basis of varying supply condition.
Any significant dependencies on raw materials and factory supplies of the
product mix and production target will be identified in view of market
potential, expected sales, transport facilities, and production capacity.
 Requirements of Raw Materials and Factory Supplies: The
determination of requirements of raw materials and factory supplies forms

the basis for the supply program and subsequent cost estimates. The
specifications of requirements should be made in view of (or include):
a) User Demand: Users of the produced finished goods have their own
expectations and demand that will have implications over not only on the
choice of technology, machinery, and equipment, but also on the type and
quality of materials and inputs used.
b) Quantity Required: The quantities required can be expressed in terms of
units produced (items, tones, cubic meters); section of the production
process (auxiliary materials, utilities, spare parts); machine or labor hours
(factory supplies, spare parts); and number of employees (medicine,
social costs, etc).
c) Qualitative Properties: These include Physical properties (size,
dimension, form, state, etc); Mechanical properties (formability,
elasticity, fatigue, and hardness); Chemical properties (form, composition
policy, oxidizing, etc); and Electrical and magnetic properties
(magnetization resistance).
Step 3: AVAILABILITY AND SUPPLY OF RAW MATERIALS:
A number of projects are conceived either to exploit available raw materials or to

utilize basic materials that become available from other production process. A
feasibility study must show how the materials and inputs required will be provided.
General availability, data about materials, potential users, and supply sources and
programs are aspects that should be analyzed and described. at the initial stage of
the study, the quantity of basic material inputs that may be required should be
assessed principally for the purpose of determining availability, sources, and long
term needs. Final input requirement will be determined only after the plant
capacity, technology, and equipment to be used are defined.

Step 4: SUPPLY MARKETING AND SUPPLY PROGRAM:
An enterprise acts as a buyer on supply markets when purchasing required raw

materials and factory supplies and a seller in the markets for finished
goods/services.
a) Supply Marketing:
The objective of supply marketing are basically cost minimization, risk

minimization (by identifying reliable suppliers), and creating better relationships
with suppliers.
 Cost Minimization: Input costs can be reduced by selecting appropriate

suppliers and by choosing a proper volume and frequency of the orders,
( Economic order quantity/size).
 Risk Minimization and reliability of suppliers: reliability with regard to
quantity, quality, deadlines (schedule), and prices is significant for the entire
manufacturing process. (Late deliveries, lack of quality, or poor maintenance
services negatively influence the projects activities).
 Cultivating relations with suppliers: Purchases should be focused not only
on acceptable prices, but also on establishing smooth, productive, and long-
term relations with the suppliers. Purchasing prices and conditions largely
depend on the bargaining power of the project and its management. It is
essential to identify possible supply alternative, suppliers, and the quantities
to be purchased from each should be determined in the study.
b) Supply Program:

Supply program is needed to show how supplies of materials and inputs will be
secured. Evidence should be presented to justify the assumptions and suggestions.
Cost estimates should be based on the supply program presented. A supply
program should deal with:
 Identification of supplying sources and suppliers

 Agreement and regulations
 Quantities and qualities
 Consignments
 Means of transport
 Storage
 Risk assessment.
In the identification of supplier, consideration should be given to geographic

location, ownership, main activities, financial strength and profitability, production
capacity, and business experience with the product. The types of agreement, such
as long term contracts and license agreements should be presented. Letters of intent
regarding supply contract and obligation; and agreements such as period of
validity, payment terms, currency conditions, and guarantees should be outlined.
Step 5: COST OF RAW MATERIALS AND SUPPLIES:
Unit costs: Not only the availability but also the unit costs of basic materials and
factory supplies have to be analyzed in detail, as this is a critical factor for
determining project economies. In the case of domestic materials, current prices
have to be viewed in the context of past trends and future projection of the
elasticity of supply.

For imported/ material inputs: C.I.F prices (including costs, insurance, and
freight) should invariably be adopted together with clearing charges (including
loading, port charges, tariffs, local insurance, and taxes), and cost of internal
transport to the plant. the prices of imported inputs generally fluctuate and depend
on international market situations.
Annual costs: Estimates of annual costs for materials and supplies are to be made.
the price basis for the estimates, (price level, quotations from suppliers, world
market prices, comparisons with similar inputs in other projects, etc), should be
stated in order to enable the reader to check their reliability.
The feasibility study should also determine key factors affecting prices, state
whether a monopolistic or oligopolistic situation exist; identify possibilities for
obtaining preferential prices; and specify government or other administrative price
controls. Cost estimates are to be divided into foreign and local currency
components according to UNIDO procedures. The currencies most likely to be
used and the exchange rates applied for the cost estimates should be identified.
This will help in making sensitivity analysis.
At whatever level, it is possible to carry out sensitivity analysis for different levels
of production and capacity utilization in the financial calculation. In estimating
costs, the following information should be presented:
 Type of material and input

 Unit of measurement (barrels, cubic meters, etc)
 Number of input units consumed/used per unit of output produced
 estimated cost per input unit
 Estimated cost per unit of output produced

 Estimated cost per unit produced divided into direct (which are mostly
variable costs) and indirect (predominately fixed and comprised of
overheads) cost components.
 Direct cost per unit of output produced divided into foreign and local
currency components.
 Indirect costs per unit of output produced divided into foreign and local
currency components.
In order to arrive at the total operating cost by product as well as the total costs
per year, the total number of units to be produced should be multiplied by the
estimated cost per unit. Costs are projected over the production period.
Overhead Costs of Suppliers: When estimating material and input

requirements by project components, the project planner has to plan not only at
the level of production cost centers, but also at the level of service,
administration and finance, and sales cost centers. Thus, estimation of suppliers
and their costs should be made.
4.3. Location, site, and environmental impact assessment
GENERAL:
Location and site are often used synonymously; but must be distinguished to
properly address the relevant issues requiring assessments.
Location refers to a fairly broad area like a city, an industrial zone, or a coastal
area; whereas site refers to a specific piece of land where the project would be set
up.
Objective of location and site study:

To identify a location and site suitable to the industrial project
Dimensions for Location and Site selection:
 Traditional:
Accessibility to market
Accessibility to raw material sources
Availability of infrastructure services (like transportation) and
Utilities
 New Dimensions Added (Public policies):

Level of urbanization and implications to bring balanced development
among localities
Regionalization and Decentralization policy
Investment policy and Incentives
Population concentration and impacts on Migration
Environmental impacts and pollutions due to over concentration
I. Location and Site Selection Aspects:
In Location and site selection, the following considerations should be made:
The choice of location should be made from a fairly wide geographical area,
within which several alternative sites can be considered.
An appropriate location could extend over a considerable area, such as along
a river bank or 15 kilometer radius around an urban area in a particular
geographic district.
Within a recommended location one or more specific project sites should be
identified and assessed in detail.

For each project alternative, the environmental impact of erecting and
operating the industrial plant should be assessed.
The main criteria or key requirements for selecting proper location and sites should
always be identified at early stage of the study. Qualitative analysis of these key
requirements would then allow the assessment of a number of potential locations
and sites, and the rejection of those not fulfilling the key requirements. The
remaining alternatives are then subject to a more in-depth qualitative analysis of
technical, financial, social environmental and economic aspects of location and site
selection.
The most important or critical requirements include, among others:
 The Natural Environment (climatic conditions and Ecological requirements.

 Environmental Impacts
 Socio economic policies (Role of public policies and Fiscal and legal
aspects)
 Infrastructural Conditions (Infrastructure dependence, factory supplies,
Human resources, Infrastructural services, and Effluent and waste disposal
facilities)
 Final choice of location (resource or market orientation)
In site selection, the requirements and relevant factors are:
 Site requirements (cost of land, construction requirements, local condition,

Infrastructure, effluent and waste disposal, Human resources)
 Final site selection and cost estimates.
II. Location Analysis

Location analysis has to identify locations suitable for the industrial project under
consideration. A project can potentially be located in a number of alternative
regions, and the choice of location should be made from a fairly wide geographic
area within which several alternative sites may have to be considered.
The study should also indicate on what grounds alternative locations have been
identified and give reasons for leaving out other locations that were suitable but not
selected.
The choice of suitable locations require an assessment of, among others,
 Market and marketing aspects

 The availability of critical project inputs, such as:
 Raw materials
 Factory supplies
 Technical projects requirements
 The type of industry
 Technology and process
 Characteristics of products or outputs
 Size of the plant
 Organizational requirements and management structure.
As key aspects vary from industry to industry, the project analyst will have to use
their professional skills to identify those key criteria, which are relevant for each
specific project. The identification of key requirements helps to reduce the number
of potential locations and sites at an early stage.
The Natural Environment
Climatic Conditions:

Climate can be an important factor for choice of location. Apart from the direct
impact on project costs of such factors as dehumidification, air conditioning,
refrigeration, or special drainage, the environmental effects may be significant.
Thus, information should be collected on temperature, rainfall, flooding, dust,
fume and other factors for different locations.
Ecological requirements:
Some projects may not have negative environmental impacts by themselves, but
would rather be sensitive to such effects. Agro industrial projects clearly depend on
the use of raw materials that have not been degraded by contaminated water and
soil. Management and labor may be reluctant to work in a factory located in a
polluted area with health risk.
Environmental Impact Assessment (EIA)
EIA is an assessment which aims at ensuring that development projects are

environmentally sound (friendly).The feasibility study should include a thorough
and realistic analysis of the environmental impact of the industrial project. The
impact is often of crucial importance for the socio-economic, financial, and
technical study of the project.
Objectives of Environmental Impact Assessment:
General:
 To ensure the project under consideration is environmentally sound.

 To incorporate in the project design any existing regulatory requirements,
emission standards, and guidelines
 To identify measures for mitigation of adverse environmental impacts that
land for.

 To enhance the likely beneficial impacts of the project.
 To determine environmental merits of alternative projects.
In principle, environmental impacts should be assessed on the basis of legal

regulations and emission standards and guidelines established in the country. In
countries where no regulations and standards are defined, it may be advisable to
anticipate a future tightening of environmental impact control measures. if trends
are properly considered during the project planning stage, unexpected costs for
later plant adaptations, conversions, rehabilitations, or even the shut down of
operations may be avoided or minimized.
Socio Economic policies
A. The Role of Public Policies:
Government regulations and restrictions may be critical for the location of a

project. Projects with certain characteristics (particularly industries) may be
allowed only in a certain regions. In a number of developed and developing
countries, there is a considerable pressure for the decentralization of industries, the
main objective of industrial decentralization being to reduce the external
diseconomies of urban industrial concentration.
Knowledge of public policies with regard to location aspects is necessary to enable

the various concessions and incentives that may be part of such policies to be
adequately considered. Among others,
 Specific geographical zones often are setup in some countries and varying
patterns of financial incentives have been determined for them.
 In some developing countries, direct subsidies are given to industries located
in particular areas or regions (for instance, in marginalized areas).

 Financial and other incentives are given for projects located in under
developed regions.
Therefore, the impact of these incentives on the economics of a proposed project

should be analyzed. The growth of public sector enterprises has been significant
for industrial growth in many developing countries, in which wider policies such as
regional, industrial, and disposal aspects tend to play a part in the location
decisions.
B. The fiscal and Legal Aspects:
The fiscal and legal regulations and procedures applicable for alternative locations
should be defined. The various national or local authorities to be contacted in
respect of power and water supplies, building regulation, fiscal aspects, security
needs, etc, should be listed. The corporate and individual incomes taxes, excise
duties, purchase taxes and other national or local taxes should be ascertained for
different locations, together with the incentives and concessions available for new
industries.
Infrastructural Conditions
The availability of a developed and diversified economic and social infrastructure

is often of key importance for a project. Quantitative and qualitative requirements
for energy, utilities, labor, land, etc, may be met in only a few locations if the
project is relatively big.
i. Technical Infrastructure
ii. Transport and Communications
iii. Factory supplies
 Water

 Electricity
 Fuel
iv. Human resources
v. Effluent and water Disposal techniques
Final Choice of Location
The optimal location is where the total cost (i.e., the cost of raw material
transportation cost plus production cost plus distribution cost for final product) is
minimized.
The best choice of location would be the one where the costs of products sold
(production costs and marketing costs) are a minimum.
In a nutshell, critical to location selection are the impacts on a particular project of

factors such as:
 The availability of raw materials and inputs,

 The proximity of centers of consumption, and
 The existence of basic infrastructure facilities.
III. Site Selection
The study should analyze and assess alternative sites on the basis of key aspects
and site-specific requirements, and the analysis should result in a selection of a
specific site.
For sites available within the selected area, the following requirements and
conditions are to be assessed:
 Ecological conditions on site (soil, site hazards, climate)

 Environmental impact (restrictions and standards)
 Socio-economic conditions (restrictions, incentives, requirements)
 Local infrastructure at site location (existing industrial infrastructure,
economic and social infrastructure, availability of critical project inputs such
as labors and factory supplies)
 Strategic aspects (extension, supply, and marketing policies)
 Cost of land
 Site preparation and development requirements and costs.
The selection of plant location and site does not have to be undertaken in two
stages; rather it should be made in an integrated manner.
Site Selection main considerations: The following factors determine the selection
of the final site:
Cost of land
Site preparation cost
Cost of utility lines extension
Environmental considerations
Size and shape of the available area
Suitability for future expansion
Nature of goods (products) produced (perishables or not)
Proximity of centers of consumption (market orientation)
Infrastructure facilities (transport network, houses, power supply, etc)
Availability of labor in the area (skilled and unskilled)
Socio-economic factors
 Water disposal
 Environmental factors

 Taxes and duties
 Public policies (fiscal and legal regulations)
Distance to seaport (import or export)
IV. Cost Estimates
The cost estimates at the site are:
£ Acquisition of land
£ Taxes
£ Legal expenses
£ Railway connections
£ Site preparations and development.
IV.4. PRODUCTION PROGRAM AND PLANT CAPACITY
Production Program: basis and Aspects
Sales program as a basis
Sales program shows the level of sales forecast to be realized during the specified
life of the envisaged plant (showing local sales, export sales, total revenues over
project life0.
1. Sales program is projected under market analysis

 Market requirements and market structure identified
 Marketing strategies will be defined & the implications broadly in terms of:
 Product pricing
 Production program
 Promotional efforts
 Sales & distribution mechanisms

 Marketing mix
 Demand forecasting
2. Provides inputs for financial analysis
After projecting sales for different stages of production, a feasibility study

should define and come up with the detailed production program. A production
program defines the level of output to be produced during specified period and,
from this viewpoint, we can say that it should be directly related to the specific
sales forecasts.
Aspects in Production Program
The demand and market analysis specify the sales program, which should be
transformed into the plant production program, taking into account losses of
production within the production plant site, in storage, transportation, and by
warranty service. It indicates the level of output to be produced during specified
period.
Objectives:
 To determine the type and range of products to be produced over the life
of the envisaged plant.
 To show the level of capacity utilization expected and the quantity of
production.
Considerations:
 Determine capacity utilization

 Determine the type of products or range of products
 It is related to the sales program (sales forecast)

 The determinants of a production program during the initial
production years vary considerably from project to project.
 Thus, different approaches would have to be adopted for different
industries. Below are cases illustrating this:
Single Product Case: Cement factory, coal factory, tea factory, Sugar factory
Multiple Products Case: Electronics factory, machine tools, leather products,

food complex, Oil Refinery.
Case 1: Single-product-continuous process manufacturing as in cement production
Case 2: Multiple-products-continuous process production as in an oil refinery;
Case 3: Batch/Job orders production such as in an engineering workshop; and
Case 4: Assembly/mass manufacturing as for the production of motor cars.
In the first case, the growth of sales may not be a great problem unless production
capacity is in excess of local demand. However, production problems may be more
critical. In the second case, both production and sales problems may arise. In the
third case, though production aspects may present difficulties, obtaining
satisfactory orders would be critical. In the fourth case, the sales aspects in
relation to price would be dominant.
The production program changes over time during the project’s life with respect to
capacity utilization. Initially, the production may not be higher than 40% to 50% of
the overall design capacity for the first one or two years of operation. This is
because market may not be ready to acquire large amount of new product or
technological difficulties may obstruct the full-capacity operation of the
equipment. Full production capacity is being reached usually towards the third or

fourth year and stabilizes for about 10 to 15 years. The growth of the demand and
continuous improvement in technology usually encourages modernization of a
project, which enables the production growth. After certain period (probably 30 or
more years), the project is terminated due to the low market competitiveness, de-
capitalization of the equipment or sometimes, environmental reasons (i.e., an old
plant often results in more environmental pollution).
Therefore, while planning a production program, the various production stages

should be considered in detail, both in terms of production activities and timing.
Within the overall plant capacity, there can be various levels of production
activities during different stages that are determined by various factors in different
projects as discussed above. It would be prudent to recognize that the full
production may not be practicable for most projects during the initial production
operations. In general,
 Even if full production were to be achieved in the first year, marketing and
sales might prove a bottleneck.
 At the initial years, production may be programmed at well below the full
capacity in order to adjust a gradual growth of demand for a particular
product.
 Growth of skills in operations can also be a limiting factor in a number of
industries and hence, production has to be tailored to the development of
such skills and productivity. Extraction rates and operating ratios should be
effectively determined and adequately planned.
The input requirements and costs have to be assessed for:
 Basic materials such as raw materials, semi-processed items, bought-out

items, etc.

 Auxiliary materials and factory supplies,
 Major utilities, and
 Direct labor requirements.
Detailed estimates in this regard should be prepared for the stages of initial
production and full production.
Factors considered in setting the Production Program
1. Production level (capacity utilization):

 Production may not be full capacity during the initial period due to:
 Production and technological difficulties
 Skill and productivity to be learned
 Lack of marketing experience
 Market forecast needs testing
 Plant is new for competition-time to cope up with the
competitive environment.
 A level of 40-50% of overall capacity utilization in the first year may
not be too low.
 In later years, capacity utilization might increase due to learning and
effect of experience/improvement in skill.
2. Production problems:
 Machine breakdowns and problems of line balancing in operations;
raw material shortages or materials may not be up to the standard;
utilities shortage, etc.
3. Wastage and spoilage:
Try to avoid abnormal spoilage & wastage (only anticipate normal ones). Note
that abnormal spoilages and wastages can be eliminated through efficient

operations and thus, are controllable/avoidable. However, normal spoilages and
wastages are not controllable or unavoidable.
4. Price Vs Quantity sales:

Sales might be affected by the price established. That is, higher prices
may have impacts reflected over lower sales volume/quantity.
Which in turn affect production program
Determination of Plant Capacity
The term “plant capacity” can generally be defined as the volume or number of
units that can be produced during a given period. This definition implies the output
expectation from the production plant.
Objectives:
 To identify factors affecting capacity decisions

 To examine alternative capacity levels in view of sales, profitability,
technology, and so on.
 To determine the feasible normal level of plant capacity
 To provide a basis for determining capacity costs (investment costs in
capacity)
Factors Affecting Capacity decisions
1. Technological requirements:
 Minimum economic size determined by the technological factor.

 For many industrial projects, 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 tones per day in order to
use the rotary kilos method, or else it has to employ the vertical shaft
method, which is suitable for lower capacity plants.
2. Input constraints:
 In developing countries, there may be constraints on the availability of
certain inputs, such as:
 Power supply may be limited
 Basic raw materials may be scarce
 Foreign exchange available for imports may be inadequate.
3. Investment costs:
 Investment cost per unit of capacity decreases as the plant capacity
increases (i.e. capacity costs increases at a decreasing rate). That is,
some capacity costs remain the same regardless of the size of the plant
(for instance, installation costs, technicians charges, etc); and the rest
often increase still at a lesser proportion.
 Capacity Vs Investment cost: In general, as capacity increases, the
investment cost per unit of capacity decreases.
The capacity-cost relationship could be defined by the following
equation:
α
C2 = C1 X Q2
Q1
Where,

C1 is the known cost for Q1 units of capacity
C2 is the derived cost for Q2 units of capacity
α (alpha) which is the factor reflecting capacity-cost relationship. Alpha is usually

set in between 0.2 to 0.9. If α=0, means there is no relationship between cost and
capacity; and If α =1, it means that capacity cost increases in the same proportion
with the increase in the level of capacity.
Example, Assume that C1 = Br. 1,000,000 represents the investment cost in

capacity level Q1
Q1 = 5000 units per annum at the normal capacity level, and
α = 0.6 reflecting the capacity-cost relationship. How much will be the investment
cost in the new capacity (C 2) for a level of production (Q2) equal to 10,000 units
per annum?
Solution: Apply the formula given above and C2 = Br.1, 516,000
The implication here is that although capacity has doubled, the investment cost in
capacity has increased by a less than double cost of earlier capacity.
4. Market conditions:
 The anticipated market for the product has an important bearing on plant
capacity
 If the market for the product is likely to be very strong, a plant of higher
capacity is preferable.
 If the market is likely to be uncertain, it might be advantageous to start with
a small capacity.

 If the market starting from a small base, but is expected to grow rapidly, the
initial capacity may be higher than the initial level of demand. Further
addition to capacity may be effected with the growth of market.
5. Resources of the firm:
 The following resources define a limit on a firm’s capacity decisions:
 Managerial infrastructure,
 Finance, and
 Availability of skilled employees to a firm.
6. Government policy:
 Minimum Economic Capacity Policy in several industries:
 Economic use of raw materials and other resources (like land, human
resources, etc)
 Economies of scale and subsequent low prices to consumers
 Optimum investment in imported machinery & equipment (to save
foreign exchange)
 To minimize fragmented investments and encourage long-term
investments in large capacity plants.
Feasible Normal Capacity (FNC)
Once the marketing concept and the corresponding sales volume are defined, other
components have to be assessed to determine the feasible normal plant capacity.
This capacity should in fact represent the optimum level of production as may be
determined by the relative interactions of various components of the feasibility
study such as : technology, availability of resources, investments and production
costs, raw materials and supplies (auxiliary & utilities), human resources, etc.

The FNC is achievable under normal working conditions taking into account the
following conditions:
 Installed equipment:
Level of sophistication
Standard of operation
Specific characteristics
 Technical plant conditions:
Down time (a period where by the plant is not in operation or not
running due to technical requirements).
Maintenance requirement
Total checks
 Organizational and management aspects:
Normal working hours
Holidays
Normal labor strikes
Ability to manage and coordinate diverse interactions
 Availability of inputs
 Skill of employees (i.e. employee skill should fit to the technological
requirement)
The feasible normal capacity is the number of units produced during one year
under the above conditions and that should correspond to the sales projections in
the market and demand analysis. Therefore, both Human Factor and System
Engineering define Feasible Normal Capacity (FNC), which is “Plant plus
Human”.
Nominal Maximum Capacity (NMC)

This is the technically feasible capacity and frequently corresponds to the installed
capacity as guaranteed by the supplier of the plant. Nominal Maximum Capacity is
defined by system engineering, that is, the equipment installed capacity, which
includes reserve and stand-by capacity. To reach the maximum output figures,
overtime work may be needed as well as it might result in excessive consumption
of factory supplies, utilities, spare parts, and wear tear parts. This results in a
disproportionate production cost increase due to diseconomies of scale. In general;
the FNC is less than the NMC under normal condition.
Determination of feasible Normal capacity (FNC)
In feasibility study, the determination of the appropriate plant capacity is critical.

Forecasts of demand and market penetration strategies for a particular product are
the starting points. The limited availability of basic materials and inputs or
resources may be constraints for certain projects, requiring evaluation of various
alternative possibilities of plant sizes and capacity. These alternatives have to be
related to various levels of production and different levels of sales and profitability.
The steps are in short the following:
 Identify alternatives possibilities of plant size & capacity

 Determine various levels of production capacity utilization
 Examine the different level of sales & profitability expected
Once the overall constraints on demand and market forecasts are defined, other
components of the study have to be assessed to determine the feasible normal plant
capacity. This capacity represents the optimum level of production. One of the
aspects (components) can be critical for determining the feasible normal plant
capacity of a project, but the implications of all the above aspects should be taken
into account.

Finally, prior to capacity determination, the minimum economic size, availability
of production technologies, and equipment related to various production levels
should be determined. Production capacities have tended to increase rapidly in a
number of sectors in industrialized countries to take greater advantage of
economies of scales. Increased capacities give increased output resulting in lower
unit production costs. Another important factor is that the available process
technology and equipment are often standardized at specific capacities in different
production sectors.
IV.5. TECHNOLOGY AND ENGINEERING STUDY
Engineering Study:
Objectives of the study:
 To design the functional and physical layouts in order to produce the defined
outputs.
 To determine the corresponding investment expenditures
 To determine the costs arising during the operational phase
 To accomplish necessary infrastructure investments
It is the task of engineering to design the functional and physical layouts for the
industrial plant necessary to produce the defined output and to determine the
corre4sponding investment expenditures as well as the costs arising during the
operational phase. The scope of engineering also includes the plant site and all
activities required to deliver both inputs and outputs and to provide the necessary
infrastructure investments.

Technology Study:
An integral part of engineering study at the feasibility stage is the selection of an

appropriate technology, planning of the acquisition and absorption of this
technology, and the corresponding know-how.
Objectives of the study:
 To select the technological alternative most suitable to the

 Socio-economic conditions in the context
 Investment strategy chosen
 Ecological condition (natural environment)
 To acquire and absorb technology and the corresponding know-how
necessary
While the choice of technology defines the production processes to be utilized, the
effective management or technology transfer requires that the technology and
know-how are acquired on suitable terms and conditions, and the necessary skills
are available or developed. The required machinery and equipment must be
determined in relation to the technology to be utilized, the local condition, and
human capabilities. Skill development needs to be planned through training
program. The analysis must include a survey of spare parts.
After the determination of the marketing strategy, the production program, and
capacity, a preliminary project layout has to be prepared defining the physical
features of the plant such as:
 Infrastructure
 factory and other buildings and civil works
 Their relationships with utilities, material flows, and machinery installations

 Other aspects of plant construction and operations.
It is necessary to identify the necessary technologies and the implications in terms

of costs, use of local raw materials, environmental impacts, and other factors.
Technology Choice:
An important factor in determining the production program and plant capacity is

the technology and the people know-how to be utilized in the project. Therefore,
the selection of appropriate technology and know-how is a critical element in any
feasibility study.
The word “technology” or “manufacturing technique” mean a sum of patented and

unpatented knowledge, know-how, experience, and skills needed for the
transformation of raw materials into outputs. The selection of technology should be
based on a detailed consideration and evaluation of technological alternatives and
the selection of the most suitable alternative in relation to the project or investment
strategy chosen and to socio-economic and ecological condition. The choice of
technology is influenced by a variety of considerations:
 market and marketing concepts

 Plant capacity
 Principal inputs
 Investment outlays and production cost
 Use by other units
 Product mix

 latest developments
 Ease of absorption
Appropriate technology choice is directly related to the conditions of applications

in particular situations.
Appropriateness of Technology:
Appropriate technology refers to the methods of production, which are suitable to

heal economic, social, and cultural conditions. Technology should be evaluated in
terms of:
 Whether the technology utilizes local raw materials

 Whether the technology utilizes local manpower
 Whether the goods and services produced cater the basic needs
 whether the technology protects ecological balance
 Whether the technology is harmonious with social and cultural conditions
The project planner, therefore, should have a good knowledge of the present trends
in technology development and local conditions to evaluate all possible
technological alternatives.
The most common mistakes at this stage of the evaluation are:
 Choice of technology which already is or is going to become obsolete in the

near future
 Choice of new versions of existing technology not sufficiently proved and
tested

 Choice of technology heavily dependent on the supplies of special semi-
products, sub-assemblies, or additives available from a monopoly supplier
(i.e. the licensor)
 Adoption of technology incompatible with the local conditions (climate,
special raw material properties, local personnel qualifications, etc)
 Under estimation of environmental hazards
Alternative technologies should also be evaluated with regard to their

environmental impacts. Critical elements that must be considered for the selection
of suitable technologies include:
 Economic use of raw materials,

 Low emission technologies, and
 Low-waste production processes
Assessment of Technology Required:
The technology required to produce the desired products on the basis of the
resources identified for the project may be common knowledge or the property of
owners who may be willing to transfer it under certain conditions.
The primary goals of technology assessment are to determine and evaluate the
impacts of different technologies on the society and national economy, impacts on
the environment and socio economic feasibility assessed from the point of view of
the enterprise.
To allow the careful assessment of the suitability of the technological alternatives

required and available for the project under consideration, the following logical
sequence of steps should be followed:

Problem Definition
Technology description and Project

layout
Technology Market alternatives
Assessment of availability
Technology Forecast
Assessment of Local Integration
Description of the Socioeconomic Impact
Environmental Impact Assessment
Means of Technology Acquisition:
When technology has to be obtained from some other enterprise, the means of
acquisition have to be determined. These can take the form of technology
licensing, outright purchase of technology or a joint venture involving participation
in ownership by technical supplier. The implications of these methods of
acquisition should be analyzed.
1. Licensing: A license gives the right to use patented technology and provides
for the transfer of related know-how on mutually agreed terms. Technology
licensing has developed into a popular and effective mechanism for trade in
technology. In cases where technology licensing is considered necessary, it

is desirable to have the technology package disaggregated and to identify
critical contractual elements.
2. Purchase of Technology: Outright purchase is appropriate when “one-time”
technological right or know-how are to be secured, and when there is little
likelihood of subsequent technological improvements or need for continued
technological support to the prospective licensee.
3. Participation of the license-holder in the joint venture: This refers to
allowing equity participation by a technology supplier. This type of
acquisition is sometimes found important for continuing technical assistance
and supply of inputs and services is necessary over a period of time, or
access to external markets that may otherwise be difficult to operate.
4. Disaggregation: The technology packages should be disaggregated into
various component parts, such as the technology proper, related engineering
services, phasing of domestic integration, supply of intermediate products
and even the supply of equipment by licensors. A distinction should be made
between essential and technological features and others that should be
evaluated separately.
5. Technology Absorption and Adaptation: The feasibility study should
indicate the measures and actions to be taken for technological absorption
and adaptation of the acquired technology to local conditions. An essential
element in staff planning and an efficient recruitment policy has to be
combined with a comprehensive training programme for various categories
of plant personnel. Technological adaptation requires not only the
adjustment of special know-how to local factor conditions, but also the
capability to modify products and processes to suit local preferences and
requirements and to initiate a process of innovative development in a
particular field.

Contract Terms and Conditions:
The contractual terms and conditions for technology acquisition and transfer need
ne highlighted in the feasibility study. The contract for technology licensing should
be carefully scrutinized with respect to:
definition (process, products, documentation)

Duration ( adaptation, upgrading, and renewal)
Warranty ( guarantee to technological features and know-how)
Access to improvement (access to improvement made by licensor)
Industrial property right (patents and usage rights)
Payments ( a lump sum, or royalties, or both)
Territorial sales right( exclusive and non-exclusive)
Training (in the plant of licensor or supply of expert)
Supply of imported input ( intermediate products or components)
Selection of Machinery and Equipment:
Objective:
 To choose an optimum group of machinery and equipment necessary for the

project, considering:
o the specific production capacity,
o Production techniques (technology), and
o Type of products to be produced
The selection of equipment and technology are interdependent. the requirement of

machinery and equipment should be defined on the basis of the plant capacity and
the selected production technology. Equipment selection should broadly define
optimum group of machinery and equipment necessary for a specific production

capacity by using a specific production technique. The selection of machinery and
equipment could be affected by different factors that are constraints in selecting
machineries and equipments:
 Plant capacity and technological processes

 Infrastructural constraints (the availability of electric power for a large
electric furnace, the transport of heavy equipments to remote area)
 The length of time required for training (highly sophisticated equipment)
 Investment constraints and the availability of foreign exchange
 Maintenance requirements and the availability of maintenance facilities
 Government policies such as import controls (restrict the import of certain
types of equipments)
Another important issue in equipment choice is the degree of automation that may
be required.
 Computerized equipment may be required, but the capital costs of

automation tend to be high (this could be viable in developed countries
because it replaces high-cost labor)
 The competitive nature of production may require the use of automated
equipment, thus necessary skills must be developed.
Cost estimates for imported equipment should be on the basis of C.I.F and the
landed cost, as well as internal transport, insurance, and other costs up to the plant
site. Transport and other cost of domestic equipment should be incorporated up to
the plant site. the cost of erection of equipment should be estimated, particularly
when this is undertaken as an independent operation. The lowest installation cost
ranges from 1 to 2% and the highest up to 15% depending on the equipment.

Procurement of plant and machinery could be made from different suppliers or a
turnkey contract may be given for the entire plant and machinery to a single
supplier. The factors to be considered in selecting the suppliers of plant and
machinery are:
 The desired quality of machinery

 The level of technological sophistication
 The reputation of the suppliers
 The expected delivery schedules
 The preferred payment term, and
 The required performance guarantee
Detailed Plant Layout and Basic Engineering
Project charts and layouts may be prepared once data is available on the following
principal dimensions of the project:
 market size
 Plant capacity
 production technology
 Machineries and equipments
 Building and civil works
 Conditions in the plant site
 Supply of inputs to the project
These define the scope of the project and provide the basis for detailed project
engineering and estimation of investment and production costs. The plant layout is
concerned with the physical layout of factory. In process industries, the production
process adopted dictates the plant layout; in manufacturing industries, however,
there is much greater flexibility in defining the plant layout.
The important considerations in preparing the plant layout are :
 Consistency with production technology

 smooth flow of goods from one stage to another
 proper utilization of space
 scope of expansion
 Minimization of production cost
 Safety of personnel
Detailed final plant layout needs to be prepared prior to project implementation.

The detailed plant layout and basic engineering design are required in a feasibility
study to allow the preparation of cost estimates, where detailed engineering work
would usually not start before a project enters the implementation phase.
Civil Engineering Works
The feasibility study should provide plans and estimates for the civil works related
to the project. This should cover:
Site preparation and development

Factory and other buildings
Civil engineering works related to utilities, transport, emissions and effluent
discharge, internal roads, fencing and security, and other facilities and
requirements of the plant.
The plans and estimates for civil engineering works should be detailed for cost
estimates and implementation scheduling. The estimates for building and other
constructions should be based on unit costs such as building costs per square meter
in the plant surroundings.
Maintenance and Replacement requirements

An important aspect of project engineering is the determination of critical
maintenance and replacement requirements for the project. Maintenance
requirements should be assessed in terms of both the maintenance equipment that
may be necessary for efficient maintenance of the plant and facilities and the
maintenance skills and capability that need to be developed. Replacement
requirements need to be determined for wear-and-tear parts; tools and fixtures; and
for spare parts, components, and materials for plant.
Overall Investment Costs
Once the production program and plant capacity are defined, a preliminary
estimate can be drawn up regarding the investment requirement, if a plant capacity
is set at a fairly standardized level and prices are available for plant and equipment:
 Cost estimates for various components of studies can be done by ratios of

the total costs of pre-feasibility and feasibility studies
 Often, estimates of machinery and equipment for a project would constitute
50% of the total investment cost
 Buildings and civil works are to cost 10 to 15% of the total costs.
 Similarly, percentages can be set for utilities, instrumentation, piping, and
other facilities and requirements.
These figures may be useful at the project appraisal stage when analyzing the
structure of investment cost. Based on the estimates for technology, machinery and
equipment, and civil engineering works, the study should provide an overall
estimate of the capital costs of the project. To check the reliability of cost
estimates, a detailed breakdown to the various cost items would be necessary. A
physical contingency allowance is commonly added. The precision of cost
estimates will be aided by a clear definition of the scope of the project.

IV.6. Organizational and Human Resource
This basically incorporates the socio-cultural patterns and institutions or the

population that the project is believed to serve. Does the project takes into account
the cultural setup and customs of the beneficiaries? Or will it disturb the accepted
pattern? If so how should this be included as part of the project design?
To have a chance of being carried out, a project must be related properly to the
institutional structure of the country or region where the project is to be carried.
Examples include the land tenure system, use of local institutions such as Idir or
Debbo
Similarly, managerial issues are critical for successful completion of projects.

Thus, the project analyst must examine the ability of available staff to identify
whether they have the capacity to carry out the managerial needs of the project.
Organization and Manning

A division of the company into organizational units in line with the marketing,
supply, production and administrative functions is necessary not only from the
operational point of view, but also during the planning phase, to allow the
assessment and projection of overhead costs. It is also essential for the feasibility
of a project that a proper organizational structure should be determined in
accordance with the corporate strategies and policies. The organizational set-up
depends to a large extent on the size and type of the industrial enterprise and the
strategies, polices and values of the organization.
Plant organization and management

Organization is the means by which the operational functions and activities of the
enterprise are structured and assigned to organizational units, represented by

managerial staff, supervisors and workforce, with the objective of coordinating and
controlling the performance of the enterprises and the achievement of its business
targets.
The organizational structure of an enterprise indicates the assignment of

responsibilities and delegation of authorities to the various functional units of the
company, and is normally shown in a diagram, often referred to as an organ gram.
The organizational functions are the building blocks of the company. They may be
grouped into the following organizational units in line with the specific
requirements of the individual company:
 General Management
 Finance, financial control and accounting
 Personnel administration
 Marketing, sales and distribution
 Supplies, transport, storage
 Production:
o Main plant
o Service plants
o Quality assurance
o Maintenance and repair
The organizational structure of the company can also take a number of shapes, the
most common being the pyramid shape, which has the following three
organizational levels:
 Top management
 Middle management, and
 Supervisory management

Human Resources
The successful implementation of any operation of an industrial project needs
different categories of human resources- management, staff and workers-with
sufficient skills and experiences. The feasibility study should identify and describe
such requirements and assess the availability of human resources as well as
training needs. On the basis of the qualitative and quantitative human resources
requirement of the project, the availability of personnel and training needs, the cost
estimates of wages, salaries, other personnel-related expenses and training are
prepared for the financial analysis of the project. In case an economic evaluation is
intended, the costs of unskilled labor should be shown separately.
Human resources as required for the implementation and operation of industrial

projects need to be defined by categories, such as management and supervision
personnel and skilled and unskilled workers, and by functions, such as general
management, production management and supervision, administration, production
control, machine operation and transport. The numbers, skills, and experience
required depend on the type of industry, the technology used, plant size, the
cultural and socio-economic environment of the project location, as well as the
proposed organization of the enterprise.
Since the lack of experienced and skilled personnel can constitute a significant
bottleneck for project implementation and operation, extensive training programs
should be designed and carried out as pat of the implementation process of
investment projects.
IV.7. Financial Analysis

Financial Cost-Benefit Analysis

The analysis of financial costs and benefits is a key step in the project preparation
process, which seeks to ascertain whether the proposed project will be financially
viable i.e. in the sense of being able to meet the burden of servicing debt and
whether the proposed project will satisfy the returns/expectations of those who
provide capital and/or the promoters.
Objectives of Financial cost-benefit analysis:
 To establish the project’s financial viability for the private investor

 Commercial profitability is the yardstick for selection among competing
projects.
Components of financial analysis:
 Investment cost estimation

 Revenue estimation
 Production costs & expenses
 profitability analysis
 Cash flow estimation and analysis
 Financial ratio analysis
 Uncertainty/risk analysis
 Debt repayment schedule
Technical aspects of financial analysis:
At the technical level of financial analysis, the basic activities involved are:
 Projection of cash inflows and outflows- for each period that enables
computation of net cash flows of the project,
 Setting of the cost of capital-which is a very difficult task in countries like
ours where there is no capital markets,

 Discounting of net cash flows of the project.
Why evaluate cash flows rather than profits?
 Cash is what ultimately counts-profits are only a guide to cash availability:

they cannot actually be spent.
 Profit measurement is subjective-the time period in which income and
expenses are recorded, and so on, are a matter of judgment,
 Cash is used to pay dividends-dividends are the ultimate method of
transferring wealth to equity shareholders.
Determining relevant cash Flows:
Elements of cash inflows and outflows of the project under consideration can be
described as follows:
Cash inflows: project cash inflows are expected to appear from the following
sources:
 Sales of the products or services

 Sales of by products
 recovery of net working capital
 other miscellaneous sources
Cash outflows- the project will have the following major categories of cash
outflows:
Initial investment costs: These are defined as the sum of fixed assets (fixed
investment costs plus pre-production expenditures) and net working capital.

Expenditures for fixed assets constitute the resources required for construction and
equipping an investment project.
 Investment costs = fixed capital + Net working capital

 Fixed capital = fixed investment + pre-production capital costs,
Hence, investment costs = fixed investment + pre-production capital costs + Net

working capital
Production costs: Production costs include the following three main categories
of costs:
 Material costs (direct)

 Labor costs (direct)
 Factory overhead costs- represent indirect materials and parts, indirect labor
and other overhead costs such as depreciation of facilities and equipments
etc.
Two approaches of determining the projected cash flows of a project:
 A cash flow forecast based on the income statement, in which the statement
is adjusted for non-cash items. The resulting figure refers to funds provided
by operations. Considering cash flows not recognized in the income
statement leads to the final funds position of the project.
 A cash receipts and disbursement statement, or the cash budget, reflecting
the initial cash balance, the receipt for the period, the expected
disbursements and the ending cash balance.
Supporting schedules for financial analysis are the following:
 Investment cost schedule

 production cost schedule
 Working capital schedule
 Loan repayment schedule
INVESTMENT PROJECT APPRAISAL METHODS:
Once the above analysis is made, the next tasks are going directly to the project
appraisal techniques. Investment project appraisal methods are classified into two
basic categories. These are non discounted cash flow methods and discounted cash
flow methods.
A. NON-DISCOUNTED CASH FLOW METHODS:

I. PAYBACK PERIOD METHOD: The payback period is the number of
years required to return the original investment from the net cash flows (net
operating income after taxes plus depreciation). When deciding between two
or more competing projects the usual decision is to accept the one with the
shortest payback.
The decision rules are:
 If payback < acceptable time limit, accept project

 If payback > acceptable time limit, reject project
Merits of payback as an investment appraisal technique:
 Simplicity
 Rapidly changing technology- If new plant is likely to be scrapped in a
shorter period because of obsolescence, a quick payback is essential.
 Improving investment conditions-when investment conditions are expected
to improve in the near future, attention is directed to those projects which
will release funds soonest, to take advantage of the improved climate.

 Payback favors projects with a quick return.
Demerits of payback as an investment appraisal technique:
 Project return may be ignored

 Timing is ignored
 Lack of objectivity
 Project profitability is ignored
Example: Assume that a firm is considering two projects: Project A and Project B, each requires an
investment of Br 100 millions. The cost of capital is 10%. Below is the summary of expected net cash
flows in millions.
Year Project A Project B

1 50 10
2 40 20
3 30 30
4 10 40
5 1 50
6 1 60
Required: Calculate the payback period and comment upon the two projects.
II. ACCOUNTING RATE OF RETURN (ARR): It uses data from the income
statement. This is computed by using the following formula:
Accounting rate of return= Average net profit
Average Annual Investment

Example: Assume the company invested in the construction of Business Machine
whose investment cost is $607,500. Useful life is 4 years. Estimated disposal value
is zero, and expected cash inflow from operations is $ 200,000.
Required: Accounting Rate of Return
Advantages of using ARR method:
 It is simple to calculate using accounting data

 Earnings of each year are included in calculating the profitability of the
project.
Disadvantages of using ARR method:
 It is inconsistent with wealth maximization as the objective of the firm

 Since it uses the accounting data it includes the amount of accruals in
calculating the earnings “net profit”
 It is based on the familiar accrual accounting
 It ignores the time value of money
B. DISCOUNTED CASH FLOW METHODS:

I. NET PRESENT VALUE METHOD (NPV): It is the method of
evaluating projects that recognizes that the Birr received immediately is
preferable to a Birr received at some future date. It discounts the cash
flows to take into account the time value of money.
NPV = Present value of cash inflows – Present value of cash outflows
If the NPV is positive, the project will be accepted; if negative, it
should be rejected.
Problems with NPV are it is difficult to explain to non-finance people
and solution is in Birr amounts, not in percentage rates of return.
II. INTERNAL RATE OF RETURN METHOD (IRR): The IRR is the
estimated rate of return for a proposed project, given its incremental cash
flows.
OR The IRR is the discount rate that makes the present value of a
project’s cash flows equals its initial investment.
OR The IRR is the discount rate that makes the NPV equal to zero.
Note: The hurdle rate is considered the firm’s required rate of
return on investment projects of average risk. If the project’s IRR
the hurdle rate, it should be accepted, otherwise it should be rejected.
Advantages of using IRR include the following:
 Considers all cash flows

 Considers time value of money
 Comparable with hurdle rate
Disadvantages of using IRR include the following:
 It does not show Birr improvement in value of firm if a project is accepted

 IRR can be affected by the scale (size) of the project, i.e., initial investment.
 There will be possibility if existence of multiple IRRs.
III. PROFITABILITY INDEX: It is sometimes called Benefit Cost Ratio or

Present value index. It is calculated by taking the present value of cash
inflows divided by the present value of cash outflows.
The decision criteria are to accept project with a profitability Index
(PI) greater than one. Using this criterion, projects will be ranked
from the one with highest PI down to one with the lowest, and then

project would be selected in the order of ranking up to the point
where the budget is exhausted.
Example: Assume that Mina PLC, a financial analyst, is doing a consulting work
for evaluating the two projects given below. The projects costs Br. 500 million
each and the required rate of return for each of the projects is 12%, the projects’
expected net cash flows are as follows:
Year Project I Project II

0 (500) (500)
1 325 175
2 150 175
3 150 175
4 50 175
Required:
1. Calculate each of the project’s payback, net present value( NPV) and
Internal rate of return (IRR)
2. Which project or projects should be accepted if they are independent?

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CHAPTER 4

PROJECT PREPARATION (FORMULATION)

Feasibility Study: Dimensions and Reporting

A feasible business venture is one where the business will:

 generate adequate cash-flow and profits,

During this process the number of business alternatives under consideration is

Project Analysis and Management By Mesfin Abiye. Page 1

REASONS TO DO A FEASIBILITY STUDY

Conducting a feasibility study is a good business practice. Examination of

A feasibility study will:

 Narrow business alternatives and give focus to the project

Project Analysis and Management By Mesfin Abiye. Page 2

The feasibility study is a critical step in the business assessment process. If

REASONS GIVEN NOT TO DO A FEASIBILITY STUDY

 We know that it is feasible as an existing business is already doing it

Project Analysis and Management By Mesfin Abiye. Page 3

SUPPORT (FUNCTIONAL) STUDIES)

Support or functional studies cover specific aspects of an investment project,

Examples of such studies are as follows:

Project Analysis and Management By Mesfin Abiye. Page 4

PROJECT APPRAISAL (APPRAISAL REPORT)

The findings of a feasibility study will be summarized in what is called the

 The degree of reliability of the data on the business environment.

1. Summary of the project background and history:

Project Analysis and Management By Mesfin Abiye. Page 6

Project Analysis and Management By Mesfin Abiye. Page 7

Project Analysis and Management By Mesfin Abiye. Page 8

4.1 MARKET AND DEMAND ANALYSIS:

Objective of the study:

 To systematically assess the market and the market environment to

IMPLICATIONS FOR PROJECT ANALYSIS:

 Likely aggregate demand for the product, and

Project Analysis and Management By Mesfin Abiye. Page 10

The key steps in such analysis/research could broadly be stated as follows:

 Situational analysis and specification of objectives

Market and Marketing Concepts:

1. A market is an institution set up by society as an important means to

Project Analysis and Management By Mesfin Abiye. Page 11

Project Analysis and Management By Mesfin Abiye. Page 12

Projection of Sales Revenue

The projection of sales revenue is essentially an extension of marketing research,

1. Factors to be considered in Forecasting sales:

Project Analysis and Management By Mesfin Abiye. Page 13

In addition to sales revenue, the associated marketing costs should be estimated

 Variable-advertisement, promotion, salesperson salaries etc.

Project Analysis and Management By Mesfin Abiye. Page 14

Supply Potential Estimates

Project’s marketing Strategy

Expected Competitors’ Strategies (if any)

TECHNIQUES OF DEMAND FORECASTING:

Project Analysis and Management By Mesfin Abiye. Page 15

Delphi method appeals to many organizations for the following reasons:

Project Analysis and Management By Mesfin Abiye. Page 16

Y= demand for the year (dependent variable)

Project Analysis and Management By Mesfin Abiye. Page 17

Yea Demand/ Yea Demand/Sales Yea Demand/sales

a) State the sales forecast equation/demand function.

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1995 0 2000 5 200 10

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Y = ∑y/n =269,000/14 = 19,214.29

b= ∑xy – nxy = 1,998,000-14(6.5)(19,214.29) = 1,096.7

∑x2 – nx2 819-14(6.5)2

a= y-bx = 19,214.29 – 1,096.7(6.5) = 12,085.74