CHAPTER FOUR

PROJECT PREPARATION
 Sub Topics
֍Markets and Demand Analysis
֍Raw Materials and Supplies Study
֍Location, Site and Environment Impact
Assessment (EIA)
֍Production Program and Plant Capacity
֍Technology Selection
֍Organizational and Human Resource Study
֍Financial Analysis
Markets and Demand Analysis
 4.1 Markets and Demand Analysis
♣The first step in project analysis is to estimate the potential size of the
market for the product proposed to be manufactured and get an idea about
the market share that is likely to be captured.
♣The key steps involved in market and demand analysis are organized into seven
sections as follows.
a) Situational analysis and specification of objectives
b) Collection of secondary information
c) Conducting market survey
d) Characterization of the market
e) Demand forecasting
f) Uncertainties in demand forecasting
g) Market planning
 a) Situational Analysis and Specification of
Objectives
♠In order to get a “feel” for the relationship
between the product and its market, the project
analyst may informally talk to customers,
competitors, middlemen, and others in the
industry to learn about the preferences and
purchasing power of customers, actions and
strategies of competitors, and practices of the
middlemen.
 Example
♥ To develop multi grain wheat flour.

♥ The objectives of market and demand analysis in this case may be to

answer the following questions

 Who are the buyers ?
 What is the total current demand for ordinary wheat flour?
 How is the demand distributed temporally (pattern of sales over the year) and
geographically?
 What is the break – up of demand for multigrain flour of different proportions?
 What price will the customers be willing to pay for the multigrain flour?
 How can potential customers be convinced about the superiority of the multigrain
flour?
 What price will ensure its acceptance?
 b) Collection of Secondary Information
• Secondary information provides the base and the starting
point for the market and demand analysis.
General sources of Secondary information:
-National level Report prepared by the Government
-Plan Report by the /government -Statistical abstract
• Economic Survey -Annual Reports by the
Ministry
• Bulletin of Banks -Publication of Advertising
agencies
• Other publications
 c) Conduct of Market Survey
♣Secondary information should be supported by primary
information through sample or census.
♣A sample survey is a study involving a subset of individuals
selected from a larger population by accepted statistical
method.
♣The market survey may be a census survey or sample survey.
♣ In a census survey the entire population is covered.
♣Census surveys are employed principally for intermediate
goods and investment goods when such goods are used by a
small number of firms.
Cont’d…
The information sought in a market survey may relate to one or more of the
following.
Total demand and rate of growth of demand
Demand in different segments of the market
Motives for buying
Purchasing plans and intentions
Satisfaction with existing products
Unsatisfied needs
Attitude toward various products
Distribute trade practices and preferences
Socio, economic characteristics of buyers
 d) Characterization of the market
Based on information gathered from secondary sources and
through the market survey, the market for the product/service
may be described in terms of the following;
Effective demand in the past and present
Break down of demand
Price
Methods of distribution and sales promotion
Consumers
Supply and competition
Government policy
 e) Demand forecasting
Methods of demand forecasting include:
I. Qualitative Methods
1) Jury of Executive Method: - This method is very
popular in practice, involves soliciting the opinions of a
group of managers on expected future sales and
combining them into a sales estimate.
2)Delphi Method: This method is used for eliciting the
opinions of a group of experts with the help of a mail
survey.
3) The sales-force-composition method
Is the pooling of the predictions and opinions of
experienced salespeople.
Their experience enables to forecast quite accurately
what various customers will do.
4)The customer evaluation/expectation
Involves a survey of customers as to their future
needs.
It is collecting data from costumers of the
organization.
 II. Quantitative forecasting techniques

♠They use mathematical analysis.

♠The most quantitative techniques are;
1. Time-series analysis (Trend Projection Method,
Exponential Smoothing Method and Moving Average Method).

2. Casual modeling (Chain Ratio, Consumption level

Method , End use Method, Leading indicator Method,
Econometric Method).
 1) Time series method
a. Trend projection Method
Determining the trend of consumption by analyzing past
consumption statistics.
When the trend projection method is used, the most commonly
employed relationship is the linear relationship.
Y= a + bt
Where; Y = Trend value
a = intercept of the relationship
a = y - bt
b = slope of the relationship
 2) Exponential smoothing Method:- In
exponential smoothing, forecasts are modified in the
light of observed errors.
Ft = Ft-1 + α(At-1 - Ft-1)
Where
Ft = Forecast value for the coming time period
Ft-1 = Forecast value in 1 past time period
At-1 = Actual occurrence in the 1 past time period
α = Alpha smoothing constant
Example
3) Moving Average Method:- the forecast for the next period
is equal to the average of the sales for several preceding
periods.
III. Causal Methods
1) Chain ratio Method: - this method uses a simple analytical
approach for demand estimation.
However, its reliability is critically dependent on the ratios
and rates of usage used in the process of determining the sales
potential.
2) Consumption Level Method: - estimates consumption level on
the basis of elasticity coefficients. The two types are:
a) Income Elasticity of Demand:- reflects the responsiveness of
demand to variations in income.

E1= Q2 – Q1 I1 + I2
---------- X ---------
I2 – I1 Q2 +Q1
E1 =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
b) Price Elasticity of Demand:- measures the responsiveness of
demand to variations in price.
Ep = Q2 - Q1 P1 + P2
------------ X ----------
P2 - P1 Q2+ Q1
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
3. End Use Method:-Suitable for estimating the
demand for intermediate products.
 The end use method, also referred as the consumption
coefficient method involves the following steps.
Identify the possible use of the product.
Product for various uses
Project the output levels for the consuming
industries
Desire the demand for the product.
Example
4. Leading indicator Method:- Leading
indicators are variables, which change ahead of
other variables, the lagging variables.
Hence, observed changes in leading indicator
may be used to predict the changes in lagging
variables.
For example, the change in the level of
urbanization (a leading indicator) may be used to
predict the change in the demand for air
conditioners (a lagging variable) .
5. Econometric Method:- is a mathematical representation of
economic relationship(s) derived from economic theory.
 The construction and use of an econometric model involves four
broad steps.
a) Specification: refers to the expression of an economic relationship
in a mathematical form.
b) Estimation: involves the determination of the parameter values
and other statistics by a suitable method such as the least squire
method.
c) Verification: is concerned with accepting or rejecting the specification as a
reasonable approximation to the truth on the basis of the results of estimation.
d) Prediction: involves projection of the value of the explained
variable(s).
 Reading Assignment
f) Uncertainties in demand forecasting
g) Market planning
 4.2 Raw materials and supplies study
• 4.2.1 Raw materials classification:
 Agricultural products
 Livestock and Forest Product:
 Marine Product
 Mineral Products
Processed industrial materials and components
 Factory Supplies
 4.3. Location, Site and Environmental Impact
assessment
4.3.1 Location
 Traditional approach to industrial location focused, on the
proximity of raw materials and marketing’s, mainly with a
view to minimizing transport costs.
 The modern view requires consideration of commercial,
technical and financial factors, but also of the social and
environment impact a project might have.
 The best choice of location would be one where the costs of
production sold (production and marketing costs) are
minimum.
 Best location for different project
A wide range of consumer goods located at various distances form
and other industries materials and marketing without
unduly distorting project
economics.

Imported material Located at ports or near terminals

Perishable products or agro-
processing industries
Petroleum products and
pharmaceuticals
Near the principal consumption
centers
Located at source or near
consumption centers or even at
some intermediate point
 4.3.2 Site Selection
For sites selected within the selected area, the following requirements and
conditions are to be assessed.
♥Ecological conditions on site (soil, site hazards, climate
etc.)
♥Environment impact (restrictions, standards, guidelines)
♥Social- economic conditions (restrictions, incentives,
requirements)’
♥Local infrastructure at site location.
♥Strategies aspects
♥Cost of land
♥Site preparation and development requirements and costs.
 4.3.2 Environmental impact assessment
It is designed to develop an understanding of the environmental
consequences of newly planned or existing projects and of any
project related activities.
Environmental benefits or costs are usually externalities or side
effects that affect the society in whole or in part.
Environmental effects are measured both qualitatively and
quantitatively.
Environmental conflict might also lead to compensation claims,
substantial costs for equipment and purification and risk of closing
the plant.
 4.4 Production program and plant capacity
The production program, range and volume of products to be
produced depend on the market requirements, proposed
marketing strategy and the availability of resources.
Full production level may not be possible during initial
production operations owing to various technological,
production and commercial difficulties in addition to
marketing bottlenecks.
Normally a production and sales target of 40 – 50 per cent of
the capacity for the first year is considered reasonable.
 4.5 Technology selection
 Appropriate technology choice is directly related to the
conditions of application in particular situations.
 Major disasters in the past have highlighted the need for
careful evaluation and assessment of hazardous technologies
and the use of toxic materials at different stages of
production.
 4.6 Organization and human Resource
4.6.1 Organization and management
 A division of the company into organizational units, in line with the
marketing, supply, production and administrative functions is
necessary for efficient management of operations and designing a
proper organizational structure in accordance with the corporate
strategies and policies.
 The recommended organization will depend on the social
environment as well as techno-economics necessities.
 The organizational set up depends to large extent on the of industrial,
enterprise, strategies, policies and values of those in power in the
organization
 4.6.2 Organizational Structure
• The organizational structure of an enterprise indicates the
delegation of responsibilities to the various functional units
and is normally shown in a diagram usually the organization
structure is designing primarily in line with the different
functions such as finance, marketing, production and
purchasing. However there is no unique organizational
pattern.
• It is also possible to base organizational structures on product
to production lines or on geographical areas or markets, the
later are typical for marketing organizations.
 4.6.3 Human Resources
• The successful implementation and operation of industrial projects
need different categories of human resources e.g. Management,
supervisory staff and workers – sufficient skills and experience.
• Human resources have to be defined by categories such as
Management and Supervisory, Personnel, skilled and Unskilled
workers, and by function such as general management, production
management, administration (accounting, finance, purchasing etc)
production control, machine operations and transport.
• The numbers, skills and experience required 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.
 4.7. Financial and Economic Analysis
Since reliable cost estimates are fundamental to the
appraisal of an investment project, it is necessary to
check carefully all cost items that could have a
significant impact on financial feasibility.
Cost estimates cover the costs of initial investment
cost, production, marketing and distribution, plant and
equipment replacement, working capital requirements
and decommissioning at the end of the project life.
 4.7.1 Initial Investment Cost
• Initial Investment costs are defined as the total of
fixed assets (fixed investment costs) plus pre-
production expenditures) and net working capital.
Fixed assets constitute the resources required for
constructing and equipping an investment project.
 Net working capital corresponds to the resources
needed to operate the project totally or partially.
 4.7.1 A) Pre-production Expenditures
i) Preliminary Capital – issue expenditures:
ii) Expenditure for preparatory studies
iii) Other Pre-Production Expenditures
iv) Trail runs, start up and commissioning
expenditures
 4.7.1. B) Fixed Assets
• Fixed investment should include the following main costs items,
which may be broken down further if required:
i) Land Purchase, site preparation and improvements
ii) Building and civil works
iii) Plant machinery and equipment including auxiliary equipments
iv) Certain other assets such as industrial property rights and lump sum
payments for knowhow and patents. The estimates include supply,
packing and transport, duties and installation charges.
4.7.1. C) Net Working Capital
• Net working capital is defined as the sum of inventories, marketable
securities, prepaid items, accounts receivables and cash minus current
liabilities (accounts payable).
 4.7.2 Production cost
• It is essential to make realistic forecasts of production or
manufacturing costs for a project proposal in order to
determine the future viability of the project.
• Production cost must be determined for the different levels of
capacity utilization.
Cont’d…
•The production costs are classified in to:
i) Factory costs
ii) Administrative overhead costs
iii) Depreciation costs and costs of financing
The sum of factory and administrative
overhead costs is defined as operating costs.
 4.7.3 Marketing Costs
• Marketing costs comprise the costs for all marketing activities
and may be divided into direct marketing cost and indirect
marketing costs.
• Direct marketing costs are packaging and storage, sales costs
(sales persons’ commission, discounts, royalties, product
advertisements), transport and distribution costs.
• Indirect marketing costs are costs relating to marketing
department. They are salaries of personnel, materials and
communication market research, public relation and
promotional activities.
 4.7.4 Cash Flow Statement
• The Cash flow statement shows the movement of cash into and out of
the firm and its net impact on the cash balance within the firm.
4.7.5 Financial Evaluation
• Ranking projects and measuring their profitability have replaced
evaluation based on inadequate planning and subjective judgment.
• Quantitative methods were developed to use in evaluating proposed
projects.
• The investment criteria, classified into two broad categories.
Discounting criteria and Non-discounting criteria are shown in the
following exhibit.
 4.7.5 A . Net Present Value
• The Net Present Value has certain properties that make
it a very attractive decision criterion.
• The NPV method is a discounted cash flow method.
• In this method all net cash inflows are discounted to
present value using the required rate of return and is
then compared with the initial outlay.
• If the discounted cash flow exceeds the initial outlay it
means the project investigated is attractive since it is
expected to earn more than the required rate of return.
• Mathematically, the method can be expressed as follows:

Decision Criteria:
If NPV is greater than Zero = Accept the Project
If NPV is less than Zero = Reject the project
 4.7.5. B. Benefit Cost Ratio
There are two ways of determining the relationship between benefit and costs.
PVB
BCR = _______
I
BCR = Benefit Cost Ratio
PVB = Present Value of Benefit
I = Initial Investment

PVB – I
NBCR = ________ Or BCR - 1
I
NBCR = Net Benefit Cost Ratio
Cont’d…
 4.7.5. C Internal Rate of Return
IRR for an investment is defined as the discount
rate (or interest rate) that will make the present (or
discounted) value of each flow operations equal to
the initial outlay for an investment.
It is the discount rate that equates the present
value of initial cost of the investment with the
present value of the expected net cash flows.
Definition:
• IRR = discount rate that makes the
NPV = 0

Decision Rules:
• If IRR > cost of capital, accept the project
• If IRR < cost of capital, reject the project
• If IRR = cost of capital, be indifferent.

8-50
 Use of interpolation formula
•IRR= ri + NPVri X (rh-ri)
NPVri- (NPVrh)
First compute the NPV with a given cost

51
Example

Calculate the IRR and NPV where the project cost is

10%
Project Year0 Year1 Year2 Year3 Year4 Year5 IRR(%) NPV

A (135) 10 40 70 80 50 20% 45.4

B (100) 40 40 50 40 - 25% 34.3

52
 4.7.5 D. Pay Back Period Method
• Sometimes called the Pay off or pay out method.
• the length of time required to recover the initial investment
• using project cash flows, PBP answers 'How long will it take to
pay back its cost?'

• Among alternative projects, the one with the shortest payback

period is more desirable .
Decision Rules:
• • If payback < acceptable time limit, accept project
• If payback >acceptable time limit, reject project
Cont’d…

Uniform Cash inflow:

Initial Investment
PBP = _____________________
Annual net cash flow
Non Uniform Cash flows:

Decision Criteria:
If the PBP is less than some accepted PBP = Accept the project
Or otherwise = Reject the project
 For a project with equal annual receipts

Years 0 1 2 3 4 5

Project A 1,000,000 250,000 250,000 250,000 250,000 250,000

For a project with equal annual receipts:

Payback period= Initial investment/Annual cash flow

PBP= 1,000,000/250,000= 4 years.

56
 0 1 2 3 4
Years
Project B - 10,000 5,000 2,500 4,000 1,000
Cumulative - 10,000 -5,000 -2,500 1,500 2,500
incremental flow

• Payback period lies between year 2 and year 3.

• At the end of year 2, the remaining amount to be collected= 2,500.
• This means (2500/4000)=0.625 or 62.5 % of the time is required to gain a financial return equal to
the original investments.

= 2.625 years or 2 years and (.625 * 12 months)= 2 years

and 8 months
57
 Example: Computing Payback for the Project
Capital Budgeting Project

Year CF Cum. CFs

0 $ (165,000) $ (165,000)
1 $ 63,120 $ (101,880)
2 $ 70,800 $ (31,080)
3 $ 91,080 $ 60,000

Payback = year 2 +
+ (31080/91080)

Payback = 2.34 years

• Do we accept or reject the project?

8-58
 4.7.5. E Accounting rate of Return
• The accounting rate of return referred to as the average
rate of return an investment
• It is a measure of profitability, which relates income to
investment.
• Since income and investment can be measured in
various ways, there are number of methods to measure
ARR.
• The measures that are employed commonly in practice
are as follows.
Cont’d…
Decision criteria:
Projects, which have an ARR, equal to or greater than a pre specified cut off rate
of return – Which is usually between 15% and 30% - are accepted otherwise
rejected.
Advantages:
It is simple to calculate
It is based accounting information, which is readily available, and familiar to
businessmen.
It considers benefits over the entire life of the project.
Since it is based accounting measures, which can be readily obtained from the
financial accounting system of the firm, it facilitates post auditing of capital
expenditures.
Cont’d…
While income data for the entire life of the project is normally
required for calculating the ARR, one can make do even if the
complete income data is not available.
Limitations:
• It is based upon accounting profit, not cash flow
• It does not take into account, the time value of money.

Using the given formulas, search for

examples and practice.