Project Formulation & Appraisal

Dr. P K Samanta
 Investment Options
• Replacement and Modernization
• Capacity Expansion
• Vertical integration (backward or forward integration)
• Concentric Diversification
– A company acquires or develops new products or services
(closely related to its core business or technology) to enter one
or more new markets.
• Conglomerate Diversification
– A firm enters (through acquisition or merger) an entirely
different market that has little or no synergy with its core
business or technology
 Sources of Project Finance
• Equity (Shareholders’ funds)
– Equity capital, retained earnings, preference capital
• Debt (loan funds)
– Term loans, debentures, short-term borrowings
 Debt and Equity Capital
Debt Capital Equity Capital
1. Investors are entitled to a 1. Investors have a claim on the
contractual set of cash flows (interest residual cash flows of the firm, after
and principal) it has satisfied all other claims and
liabilities.
2. Debt has a fixed maturity 2. Equity has an infinite life

3. Interest paid to debt investors 3. Dividend paid to equity investors

represents a tax-deductible expense. has to come out of profit after tax.

4. Debt investors play a passive role - 4. Equity investors enjoy the

often impose certain restrictions to prerogative to control the affairs of
protect their interests. the firm.
 Sources of Project Finance
• Preference Share Capital
– Cumulative and non-cumulative
– Redeemable and non-redeemable
– Convertible and non-convertible
• Internal Accruals
– Retained earnings
– Depreciation charges
• Term Loans
– Setting up of projects
– Expansion
– Modernization
– Renovation of projects etc.
• Debentures
– Short-term
– Medium-term
– Long-term
 Sources of Project Finance
• Venture Capital Financing
• Lease Financing
• Trade Credit
• Advances from Customers
• Govt. Subsidies
• Sales Tax Deferment/Exemption
 Project Life Cycle
• Defining stage
• Planning stage (what, when, where, whom and how)
• Executing stage
• Delivering stage
 Project Formulation
• Project formulation is defined as taking a first
look carefully and critically at a project idea by an
entrepreneur to build up an all-round beneficial
to project after carefully weighing its various
components.
 Project Formulation
• Feasibility Analysis
• Techno-Economic Analysis
• Project Design and Network Analysis
• Input Analysis
• Financial Analysis
• Social Cost Benefit Analysis
• Pre-Investment Analysis
 Project Appraisal Format
• Investment size
• Location
• Technology
• Equipment
• Marketing
• Power & water
• Working capital needs
• Labour component
• Economic viability
 Project Appraisal
• Economic Aspects
• Organizational Aspects
• Technical Aspects
• Financial Aspects
• Market/Commercial Aspects
 Economic Aspects
• Increased output
• Enhanced services
• Increased employment
• Larger government revenues
• Higher earnings
• Higher standard of living
• Increased national income
• Improved income distribution
 Financial Aspects
• Financial Soundness
• Efficient Operation
• Cost of Production
• Return on Investment
• Profitability
• Effective Control
• Budgeting
• Pricing
 Financial Aspects
• Time Value of Money
• Cost of Capital
– Opportunity cost of capital
– Cost of equity
– Cost of debt
– Weighted Average Cost of Capital
– Marginal and Average Cost of Capital
– Factors Affecting Cost of Capital
• Working Capital
 Technical Analysis
• Manufacturing process and choice of technology
• Technical knowhow
• Product mix
• Plant capacity
• Breakeven capacity
• Minimum economic size
• Plant location and site
 Market and Demand Analysis
• Target market identification
• Market survey
• Characterization of market
• Demand forecasting using primary and
secondary data
• Marketing plan
 Location and Site
• Raw materials supplies
• Proximity to markets
• Transportation facilities
• Power and fuel supply
• Water
• Manpower
• Labour laws and government policy
• Natural and climatic factors
• Taxes and fees
• Socio-economic and political factors
Generation of Project Ideas - Techniques
• Ideas from overseas
• Specialised market research techniques
• Ideas from company employees
• Ideas from company sales force
• Ideas from outside the company
• Product oriented techniques
• Creativity oriented techniques
• Consumer oriented techniques
• Competition oriented techniques
 Generation of Project Ideas
• Environmental Analysis
• PEST Analysis
• Political
• Economic
• Social
• Technological
• Porter’s Model
• Degree of rivalry
• Threat of entry
• Threat of substitutes
• Buyer power
• Supplier power
 Project Risk
• Operating risk
• Participant risk
• Completion risk
• Supply risk
• Market risk
• Infrastructure risk
• Environmental risk
• Political risk
• Force majeure risk
• Foreign exchange risk
• Engineering risk
• Syndication risk
• Interest/funding risk
• Legal risk
 Cash Flow from Operating Activities
• The principal revenues-producing activities of the
enterprise

• Cash receipts from the sale of goods and rendering of

services
• Cash receipts from royalties, fees, commissions, and
other revenue
• Cash payment to suppliers for goods and services
 Cash Flow from Investing Activities
• The acquisition and disposal of long-term assets and
other investments not included in cash equivalents

• Cash payments to acquire fixed assets (including

intangibles)
• Cash receipts from disposal of fixed assets (including
intangibles)
• Cash payments to acquire shares, warrants, or debt
instruments of other enterprises
• Cash advances and loans made to third parties
• Cash payments for future contracts, forward contracts, and
option contracts
 Cash Flows from Financing Activities
• Activities that result in changes in the size and
composition of the owners’ capital and borrowings
of the enterprise.

• Cash proceeds from issuing shares or other similar

instruments
• Cash proceeds from issuing debentures, loans, bonds
and other short-term and long-term borrowings
• Cash repayments of amounts borrowed
• Payment of dividend
 Capital Budgeting/Expenditure Decisions
• Financial Decisions of the firm
– Financing decisions
– Dividend decisions
– Investment decisions
• Long-term investments
– Capital Budgeting decisions
• Short-term investments
 Capital Budgeting/Expenditure Decisions
• Most important strategic decisions affecting
firm’s long-term value.
• It deals with acquisition or generation of assets.
• Expansion of existing capacity and purchase of
new assets.
• It deals with corporate restructuring initiatives.
 Capital Budgeting/Expenditure Decisions
Importance:
• Large investments
• Long-term commitment of funds
• Irreversible nature
• Long-term effect on profitability
• Difficulties of investment decisions
• National importance
 Capital Budgeting Process
• Identification investment proposals
• Screening the proposals
• Evaluation of various proposals
• Fixing priorities
• Final approval and preparation of capital
expenditure budget
• Implementing proposal
• Performance review
 Capital Budgeting
Methods
• Pay-back period method
• Average rate of return method
• Net present value method
• Internal rate of return method
 Project Cash Flow
• Elements of Cash Flow Stream
– Initial investment
– Operating cash inflows
– Terminal cash inflow
• Time Horizon for Cash Flow Analysis
– Physical Life of the Plant
– Technological Life of the Plant
– Product Market Life of the Plant
– Investment Planning Horizon of the Firm
 Project Finance: Participants
• Government
• Project sponsors or owners
• Project company
• Contractor
• Operator
• Supplier
• Customer
• Commercial Banks
• Capital Markets
• Multilateral agencies
• Export credit agency
• Insurers, Legal advisors, Financial advisors
 Project Financing Risks
• Country (civil unrest, guerrilla sabotage of projects, work stoppages)
• Political
• Industry
• Project (adequacy and track-record of the concerned tech & exp)
• Customer (demand for the product declines or widely fluctuates)
• Supplier (quality, quantity and availability of supply for the project)
• Sponsor (experience, mgt ability, ability to contribute equity)
• Contractor (schedule delays and budget overruns)
• Operating risk (maintaining the quality of asset)
• Product (product liability, design problems)
• Competitor
• Funding
• Currency
• Interest rate
• Risk allocation
 Typical Risks in Project Financing
Financial Risk Non-financial Risk

Construction delay Dynamic

Currency Inherent

Interest rate Contingent

Equity Regulatory

Corporate bond Reputation

Liquidity Organizational

Counterparty Interpretational

Maintenance

Reinvestment

Country
The Participants in Project Finance