TOPIC- 1

PROJECT IDENTIFICATION And CLASSIFICATION

Meaning of Project

A project presupposes commitment to tasks to be performed with well defined objectives, schedules and
budget.

Definition (in Encyclopedia of Management):

A project is an organized unit dedicated to the attainment of a goal.

Thus, a project may be defined as a scientifically evolved work plan devised to achieve a specific objective
within a specified period of time. The objective may be to create, expand and/or develop certain facilities in
order to increase the production of goods and/or services in the community.

Project Classification

Projects have been classified in various ways by different authorities.

• Little and Mirrless divide the projects into:

 Quantifiable and Non-quantifiable projects: Quantifiable projects are those in which a
plausible quantitative assessment of benefits can be made. For e.g. Power generation projects.
Non-quantifiable projects are those where such an assessment isn’t possible. For e.g. Health,
education related projects.

 According to Indian Planning Commission, a project may fall in the following sectors:
 Sectoral Projects: Agricultural and Allied Sector, Irrigation and Power Sector, industry and
Mining Sector, Transport and Communication Sector, Social Service Sector and
Miscellaneous Sector.

 On the basis of Techno-Economic characteristics:

 Factors intensity-oriented classification: like labour intensive or capital intensive
 Causation oriented classification: like demand based or raw material based
 Magnitude oriented classification: like large-scale, medium-scale and small-scale projects

 All India and state FIs classify the projects according to their age and experience and the
purpose for which they are being taken up. They are:
 Profit-oriented projects: New projects, Expansion projects, Modernisation projects and
Diversification projects.
 Services oriented projects: Welfare projects, Service projects, R & D projects and Educational
projects.

Project Identification

Project Identification is concerned with the collection, compilation and analysis of economic data for the
eventual purpose of locating possible opportunities for investment and with the development of the
characteristics of such opportunities.
 This project identification comes to an end by laying down specific project objectives clearly and concisely
and without any ambiguity so that these convey one and the same meaning to all concerned.

Project Objectives

Project objectives are concerned with defining in a precise manner what the project is expected to achieve
and to provide a measure of performance for the project as a whole.

Project objectives are divided into two categories:

Retentive objectives: These are concerned with the retention and preservation of resources like money,
time, energy, equipment and skills.
Acquisitive objectives: These involve acquisition of resources or attaining states that the organisation or
its managers do not have.

Project Life Cycle

Project Life Cycle consists of three main stages:

 The Pre-investment Phase: This first stage is concerned with the objective formulation, demand
forecasting, selection of optimal strategy, evaluation of input characteristics, projections of the
financial profile, and if necessary cost benefit analysis and ultimately the pre-investment appraisal.
 The Construction Phase: In this phase, resources are invested in building the basic assets of the
project like land and buildings, plant and machinery, ancillary accommodation, communication
services, control systems and marketing organization.
 The Normalisation Phase: This phase starts after the trial run of the project framework developed
earlier. It involves routine procedures which are performed in a cyclic order.

Project Formulation

Project Formulation involves a step-by-step investigation and development of project idea. And it provides a
controlled mechanism for restricting expenditure on project development.

This project formulation is the systematic development of a project idea for the eventual objective of
arriving at an investment decision.

Elements of Project Formulation

Project Formulation is by itself an analytical management aid. It enables the entrepreneur to arrive at most
effective project decision.

Project formulation exercise normally includes such aspects as follows:

• Feasibility Analysis
• Techno-economic Analysis
• Project Design and Network Analysis
• Input Analysis
• Financial Analysis
• Social Cost-Benefit Analysis
• Project Appraisal
Feasibility Analysis
Feasibility Analysis is the process of evaluating the future of a project idea within the limitations of the
project implementing body and the constraints imposed on the project situation by the environment.

Project identified are normally analysed in order to establish their viability from different angles such as
technical, marketing, financial, etc.

Techno-Economic Analysis
Techno-Economic Analysis is primarily concerned with the identification of the project demand potential and
the selection of the optimal technology suitable for achieving the project objectives.

The Techno-Economic Appraisal report contains the recommendations of the project formulation regarding
the strategy which should form the basis for further development of the project idea.

Project Design and Network Analysis

Project Design is the heart of a project. It defines the individual activities comprising a project and the
interrelationship between these activities, which is depicted in the form of a network diagram.

Project Design and Network Analysis is primarily concerned with the development of the detailed work
plan of the project and its time profile.

Input Analysis
After a project idea has withstood the tests of previous analysis, it becomes necessary to determine the
resource requirements of the project.

Input Analysis is primarily concerned with the identification, quantification and evaluation of project
inputs.

Financial Analysis
Financial characteristics of an investment proposition have a significant impact on the acceptability of a
project. The purpose of financial analysis is to identify these characteristics and to determine the financial
feasibility of a project.

It involves estimates about project costs and revenues and the funds required for the project.

Social Cost-Benefit Analysis

Under this analysis, estimates of social costs and social benefits are made and presented for computation of
social profitability of the project. While the costs and benefits under the financial analysis are estimated
employing market prices based on financial objectives, this cost-benefit analysis considers them only at
certain imputed prices based on social or national objectives.

Generally, the purpose of this analysis would be to ascertain all social costs and secondary benefits with a
view to find out the impact of the project on the society.

Feasibility Report

The details gathered from feasibility studies and presented in various tables, reports and statements are
consolidated into one master report called Project Report or Feasibility Report.
 This report also contains some background information about the industry to which the project belongs,
and the enterprise submitting the report. The main purpose of this report is to provide information that is
required for the project appraisal.

General Contents of a Feasibility Report

• Introduction
• Summary and Recommendations
• Product, Capacity, Chemistry of the product, Specifications, Properties, Applications and Uses
• Market potential, Existing installed capacity and actual production for the last 5 years, New
capacities under consideration, Demand pattern
• Process and knowhow, Description of different processes available, selection of process, Prospective
collaborator
• Plant and Machinery, List of indigenous machinery, Broad specifications of machinery
• Location
• Investment Size
• Miscellaneous

TOPIC – 2
GENERATION & SCREENING OF PROJECT IDEAS

The search for promising project ideas is the first step towards establishing a successful venture. The key to
success lies in setting into the right business at the right time.

While this advice is simple, its accomplishment is difficult because good business opportunities tend to be
elusive. Identification of such opportunities requires imagination, sensitivity to environmental changes, and
realistic assessment of what the firm can do.

Steps of Discussion
 Generation of ideas
 Monitoring the environment
 Corporate appraisal
 Tools for identifying Investment Opportunities
 Scouting for project ideas
 Preliminary screening
 Project rating index
 Sources of positive net present value
 On being an entrepreneur

1. Generation of Ideas

Someone with specialised technical knowledge or marketing expertise or some other competence feels that
he can offer a product or service which can cater to a presently unmet need or serve a market where demand
exceeds supply or effectively compete with similar products or services because of a certain favourable
features like better quality or lower prices. His ideas are endorsed by his associates who encourage him .
Finally he receives support from investors.
Stimulating the flow of ideas
To Stimulate the flow of ideas, following are helpful:
 SWOT Analysis: It represents a conscious, deliberate, and systematic effort by an
organisation to identify opportunities that can be profitably exploited by it.
 Clear Articulation of Objectives: Operational objectives may be one or more like Cost
reduction, Productivity improvement etc.
 Fostering a Conducive Climate: To tap the creativity of people and to harness their
entrepreneurial urges, a conducive organisational climate has to be fostered.

2. Monitoring the environment

Basically a promising investment idea enables a firm to exploit opportunities in the environment by drawing
on its competitive strengths. Hence the firm must systematically monitor the environment and assess its
competitive abilities.

Key sectors of Environment are

 Economic Sector: state of the economy, overall rate of growth, BOP situation etc.
 Governmental Sector: Industrial Policy, Tax framework, Financing Norms etc.
 Technological Sector: Emergence of new technologies, Access to technical know-how,
foreign as well as indigenous etc.
 Socio-demographic Sector: Population trends, Income distribution, Employment of women
etc.
 Competition Sector: No. of firms in the industry & the market share of top few, Marketing
policies & practices, Entry barriers etc.
 Supplier Sector: Availability & cost of raw materials & sub-assemblies, Availability & cost
of energy & money etc.

3. Corporate Appraisal

A realistic appraisal of corporate strengths & weaknesses is essential for identifying opportunities which can
be profitably exploited.

Broad areas of Corporate Appraisal are:

 Marketing and Distribution: Market image, Market share, Distribution network, Customer
loyalty etc.
 Production and Operations: Condition and capacity of plant and machinery, Locational
advantage, Cost structure etc.
 Research and Development: Research capabilities of the firm, Labs and testing facilities,
Coordination between research and operations etc.
 Corporate Resources and Personnel: Corporate image, Competence and commitment of
employees, State of industrial relations etc.
 Finance and Accounting: Financial leverage and borrowing capacity, Cost of capital,
Relations with shareholders and creditors, Accounting and control system etc.

4. Tools for identifying Investment Opportunities

There are several useful tools or frameworks that are helpful in identifying promising investment
opportunities.
The more popular ones are:
 Porter model
 Life Cycle approach
 Experience Curve

Porter Model: Profit Potential of Industries

Michael Porter has argued that the profit potential of an industry depends on the combined strength of the
following five basic competitive forces:
 Threat of new entrants: New entrants add capacity, inflate costs, push prices down and reduce
profitability. So, if an industry faces the threat of new entrants, its profit potential would be
limited.
 Rivalry among existing firms: If the rivalry between the firms in an industry is strong,
competitive moves and countermoves dampen the average profitability of the industry.
 Pressure from Substitute Products: In a way, all firms in an industry face competition from
industries producing substitute products. Performing the same function as the original
product, substitute products may limit the profit potential of the industry by imposing a
ceiling on the prices that can be charged by the firms in the industry.
 Bargaining Power of Buyers: Buyers are a competitive force. They can bargain for price cut,
ask for superior quality and induce rivalry among competitors. If they are powerful, they can
depress the profitability of the supplier industry.
 Bargaining Power of Suppliers: Suppliers, like buyers, can exert a competitive force in an
industry as they can raise prices and lower the quality. Powerful suppliers can hurt the
profitability of the buyer industry.

Life Cycle Approach

Many industrial economists believe that most products evolve through a life cycle which has four stages:
 Pioneering Stage: During this stage, the technology and/or the product is relatively new. Only
a few entrants may survive this stage.
 Rapid Growth Stage: Thanks to a relatively orderly growth during this period, firms which
survive the intense competition of the first stage, witness significant expansion in their sales
and profits.
 Maturity and Stabilisation Stage: During this stage, when the industry is more or less fully
developed, its growth rate is comparable to that of economy as a whole.
 Decline Stage: In this stage, which may continue indefinitely, the industry may grow slightly
during prosperous periods, stagnate during normal periods, and decline during recessionary
periods.

Experience Curve

Investments aimed at reducing costs are essential to the long-term survival and profitably of the firm. The
experience curve is a useful tool for planning investments.
The experience curve shows how the cost per unit behaves with respect to the accumulated volume of
production. The accumulated volume of production is the total no. of units produced cumulatively from the
very beginning – it should not be confused with the annual rate of production.
What factors contribute to decline in unit cost with respect to the accumulated volume of production? The
key factors are :

 Learning Effects: With more and more of production, labour skills improve and productivity
increases, leading to lower costs.
 Technological Improvements: Increased volume makes it possible to deploy improved
production techniques and processes that lower costs.
 Economies of Scale: As the capacity increases, the cost per unit decreases.

5. Scouting for Project Ideas

Good project ideas, the key to success are elusive. So a wide variety of sources should be tapped to identify
them.
Suggestions in this regard are:
 Analyse the performance of Existing Industries: A study of existing industries in terms of their
profitability and capacity utilisation can indicate promising, profitable and relatively risk-free
investment opportunities.
 Examine the Inputs and Outputs of Various Industries: Opportunities exist when materials,
purchased parts are supplied at a lower cost. Similarly, a study of output of the existing
industries may reveal opportunities for adding value through further processing.
 Review Imports and Exports: An analysis of import statistics is helpful in understanding the
trend of imports of various goods and the potential for import substitution. Likewise, an
examination of export statistics is useful in learning about the export possibilities of various
products.
 Study Plan Outlays and Governmental Guidelines: Governmental Outlays indicate the
potential demand for goods and services required by different sectors. A very valuable source
of information to estimate the scope for further investment is the Guidelines to Industries
published annually by the Department of Industrial Development.
 Looking at the Suggestions of FIs and Developmental Agencies.
 Investigate Local Materials and Resources.
 Analyse Economic and Social Trends.
 Study New Technological Developments.
 Draw Clues from Consumption Abroad.
 Explore the Possibility of Reviving Sick Units.
 Identify Unfulfilled Psychological Needs.
 Attend Trade Fairs
 Stimulate Creativity for Generating New Project Ideas

6. Preliminary Screening

Some kind of preliminary screening is required to eliminate ideas from a long list, which prima facie are not
promising.

For this, the following aspects may be looked into:

 Compatibility with the Promoter: The idea must be compatible with the interest, personality,
and resources of the entrepreneur.
  Consistency with Governmental Priorities: The project idea must be feasible given the
national goals and governmental regulatory framework.
 Availability of Inputs: The resources and inputs required for the project must be reasonably
assured.
 Adequacy of the market: The size of the present market must offer the prospect of adequate
sales volume.
 Reasonableness of Cost: The cost structure of the proposed project must enable it to realise an
acceptable profit with a price.
 Acceptability of Risk Level: The desirability of a project is critically dependent on the risk
characterising it.

7. Project Rating Index

When a firm evaluates a large no. of project ideas regularly, it may be helpful to streamline the process of
preliminary screening. For this purpose, a preliminary evaluation may be translated into a project rating
index. The steps involved in determining it are:

 Identify factors relevant for project rating.

 Assign weights to these factors.
 Rate the project proposal on various factors, using a suitable rating scale.
 For each factor, multiply the factor rating with the factor weight to get the factor score.
 Add all the factor scores to get the overall project rating index.

8. Sources of Positive Net Present Value

It is often taken for granted that there is an abundance of positive NPV projects which can be identified
rather easily. However, note that choosing positive NPV projects is akin to selecting under-valued securities
using fundamental analysis. Imperfections in real markets lead to entry barriers which create positive NPVs.
Six main entry barriers that result in positive NPV projects:
 Economies of Scale: In order to exploit the economies of scale, new entrants require a
substantial capital which serve as an entry barrier.
 Product Differentiation: A firm can create an entry barrier by successfully differentiating its
products from those of its rivals.
 Cost Advantage: If a firm can enjoy cost advantage vis-a-vis its competitors, it can be
reasonably assured of earning superior returns.
 Marketing Reach: A penetrating marketing reach is an important source of competitive
advantage.
 Technological edge: Technological superiority enables a firm enjoy good returns.
 Government Policy: Governmental policies that create entry barriers, include Restrictive
licensing, Import restrictions, Environmental controls.

9. On Being An Entrepreneur

Many persons have an entrepreneurial urge to set up their own project and be on their own.

The Questions Every Entrepreneur Must Answer:

 Are my goals well defined?
 Do I have the right strategy?
  Can I execute the strategy?

Qualities and traits of a Successful Entrepreneur :

 Willingness to make sacrifices
 Leadership
 Decisiveness
 Confidence in the project
 Making orientation
 Strong ego
 Open mindedness

TOPIC – 3
CAPITAL INVESTMENTS/EXPENDITURE: IMPORTANCE & DIFFICULTIES

An insurance company is planning to install a computer system for information processing, Govt. of India is
thinking of a plan to link the Ganges and Cauvery rivers, etc. all these situations involve a capital
expenditure decision. The basic characteristics of a capital expenditure are that it typically involves a current
outlay of funds in the expectation of a stream of benefits extending far into the future.

Thus, A Capital Expenditure, from the accounting point of view, is an expenditure which is shown as an asset
in the balance sheet. This asset, except in the case of a non-depreciable asset like land, is depreciated over its
life.

Capital Investments: Importance & Difficulties

 Importance: Capital expenditure decisions often represent the most important decisions taken by a
firm. Their importance stems from three inter-related reasons:
 Long-Term Effects: The consequences of capital expenditure decisions extend far into the
future. Capital expenditure decisions have an enormous bearing on the basic character of a
firm.
 Irreversibility: The market for used capital equipment in general is ill-organised. Once such
an equipment is acquired, reversal of decision may mean scrapping the capital equipment.
 Substantial Outlays: Capital expenditures usually involve substantial outlays.
 Difficulties: While Capital expenditure decisions are extremely important, they also pose difficulties
which stem from three principal sources:
 Measurement Problems: Identifying and measuring the costs and benefits of a capital
expenditure proposal tend to be difficult.
 Uncertainty: A capital expenditure decision involves costs and benefits that extend far into
the future. It is impossible to predict exactly what will happen in the future.
 Temporal spread: The costs and benefits associated with a capital expenditure decision are
often spread out over a long period of time, which creates some problems in estimating
discount rates and establishing equivalences.

Types of Capital Investments

Capital Investments may be classified in different ways:
First way:
 Physical assets are tangible investments like plant, building.
  Monetary assets are financial claims against some parties, like bonds, deposits, and shares.
 Intangible assets represent outlays on R&D, training, market development and so on that are expected
to generate benefits over a period of time.
Second way:
 A Strategic Investment is one that has a significant impact on the direction of the firm.
 A Tactical Investment is meant to implement a current strategy as efficiently or as profitably as
possible.
Third way:
 A Mandatory Investment is a capital expenditure required to comply with statutory requirements.
 A Replacement Investment is meant to replace worn out equipment with new equipment to reduce
operating costs, increase the yield, and improve quality.
 A Expansion Investment is meant to increase the capacity to cater to a growing demand.
 A Diversification Investment is aimed at producing new products .
 R&D Investments are meant to develop new products and processes which would sharpen the
technological edge of the firm.
 Miscellaneous Investments represent a catch-all category that includes items like interior decoration,
landscaped gardens.

Phases of Capital Budgeting

Capital Budgeting is a complex process which may be divided into 6 broad phases:
 Planning: It is concerned with the articulation of its broad investment strategy and the generation and
preliminary screening of project proposals.
 Analysis: If the preliminary screening suggests that the project is prima facie worth while, a detailed
analysis of the marketing, technical, financial, economic, and ecological aspects is undertaken.
 Selection: It addresses the question - Is the project worthwhile? A wide range of appraisal criteria like
discounting and non-discounting criteria is used to judge the worthwhile ness of a project.
 Financing: Once a project is selected, suitable financing arrangements have to be made. Two broad
sources of finance are equity and debt.
 Implementation: It involves setting up of manufacturing facilities which consists of project and
engineering designs, contracting, construction, training and plant commissioning. Networking
techniques are used for project planning and control.
 Review: Performance review is done periodically to compare actual performance with projected
performance.

Feasibility Study
Key Issues in Major Investment Decisions

While making a major investment decision, the following key issues are examined:
 Investment Story: The management must be convinced that the firm enjoys a comparative
advantage in investing in the project.
 Risks: The firm must carefully assess the risks associated with the project and its ability to
handle the same.
 Discounted Cash Flows: The DCF criteria like NPV and IRR are commonly employed to
judge the financial attractiveness of projects.
 Financing: There may be various ways of financing a major investment project. The
financing mix chosen should result in a low cost of capital and yet p0rovide enough
flexibility.
 Impact on Short-term EPS: The incentive compensation of managers is often linked to some
measure of earnings like profit after tax or EPS.
 Options: The important options embedded in a capital project are the option to delay, to
expand, to change the inputs or outputs of the project etc. As these options give managers
flexibility to amplify gains or to reduce losses, they are valuable.

Weaknesses in Capital Budgeting

The common weaknesses found in capital budgeting systems in practice are:
 Poor Alignment between Strategy and Capital Budgeting.
 Deficiencies in Analytical Techniques.
 No linkage between Compensation and Financial Measures.
 Reverse Financial Engineering.
 Weak Integration between Capital Budgeting and Expense Budgeting.
 Inadequate Post-audits.
 TOPIC – 4
Risk Analysis: Firm And Market Risk

While looking at a project in isolation may appear convenient and pragmatic, many consider it as a very
narrow approach to project evaluation.

The critics of the ‘project risk’ approach fall into two group.
1. The first group argues that risk of a project must be judged in the context of the total risk of the
firm. This means that the question to be asked is, what is the incremental contribution of a project
to the risk exposure of the firm as a whole? To answer this question, Portfolio Theory is employed.
2. The second group takes an even broader view of risk and argues that the risk of a project must be
judged in the context of the aggregate market portfolio of all assets. The analytical model primarily
employed by the votaries of this approach is the Capital Asset Pricing Model.

In theory, market risk is the most relevant measures of risk. Firm risk or corporate risk is also important for
the following reasons:
 Undiversified shareholders are concerned more about corporate risk .
 Empirical studies suggest that both market and corporate risk have a bearing on required rates of
return.
 Employees, customers, suppliers, creditors, and other stakeholders consider the stability of the firm as
important. Other things being equal, a high corporate risk tends to have a disrupting effect on the
operating side of the business.

Various Sections to be Discussed

 Portfolio related risk measures

 Mean-variance portfolio construction
 Portfolio theory and capital budgeting
 Capital asset pricing model
 Inputs required for capital asset pricing model
 Capital asset pricing model and capital budgeting

(a) Portfolio Related Risk Measures

Although there are various portfolio risk measures, the mean-variance portfolio model is the most widely
used. This model assumes that the risk of a portfolio is defined by the variance or standard deviation of the
probability distribution of portfolio returns.
The return of a security or investment is generally measured as a holding period return which is defined as:
(Cash inflow during the period + (Ending value – Beginning value))/ Beginning value
Variance, covariance, correlation, and beta are the key measures used in portfolio analysis. They are defined
as follows:
sA2 = S pi [RA, i – E (RA)]2
sB2 = S pi [RB, i – E (RB)]2
sA, B = S pi [RA, i – E (RA)] [RB, i – E (RB)]
rA, B = sA, B / sA. sB
bA,B = sA, B / sB2

where
sA2, sB2 = variance of returns on investments A and B
pi = probability of the state of nature i
RA, i, RB, i = holding period return on investments A and B if the state of nature i occurs
E (RA), E (RB) = expected return on investments A and B
sA, B = covariance of the returns on investments A and B
rA, B = coefficient of correlation of the returns on investments A and B
sA, sB = standard deviation of returns on investments A and B
bA,B = beta of returns on A with respect to B

(b) Mean-Variance Portfolio Construction

Harry Markowitz developed the principles of portfolio analysis.

The Two-Asset Portfolio:

The expected return and the standard deviation of return for a two-asset portfolio are:
E (Rp) = WA E (RA) + WB E (RB)
sp = (WA2 sA2 + WB2 sB2 + 2 WAWB sA, B)1/2

where WA and WB are the proportions of the total funds invested in assets in A and B

The n-Asset Portfolio:

The expected return and the standard deviation of return for a n-Asset portfolio are:
E (Rp) = S Wi E (Ri)
sp = (Sj Si Wi Wj rij si sj)1/2

where E (Rp) = expected return on the portfolio

E (Ri) = expected return on the asset i
Wi, Wj = weights associated with assets i and j
rij = coefficient of correlation between the returns on assets i and j
si, sj = standard deviations of the returns on assets i and j

Feasible Region and Efficient Frontier

The investments available can be combined into any number of portfolios. Each possible portfolio may be
described in terms of its expected rate of return and standard deviation of rate of return. The collection of all
possible portfolios represent the feasible region.
Given the feasible region, which portfolio should the investor choose? The investor should choose the
portfolio that maximises his utility function.

The boundary BC may be referred to as the efficient frontier. All other portfolios are inefficient.

We have merely defined what is meant by a set of efficient portfolios. How can this set be actually obtained
from the innumerable portfolio possibilities that he before the investor? The set of efficient portfolios may be
determined with the help of graphical analysis, or calculus analysis, or quadratic programming analysis.

The major advantage of graphical analysis is that it is easier to grasp. The disadvantage of graphical analysis
is that it can’t handle portfolios containing more than three securities.

The calculus method can handle portfolios containing any number of securities since mathematical analysis
can grapple with the n-dimensional space. However, the calculus method is not capable of handling
constraints in the form of inequalities.
Quadratic programming analysis is the most versatile of all the three approaches. It can handle any number
of securities and it can cope with inequalities as well. For practical purposes, the quadratic programming
approach is the most useful approach.

(c) Portfolio Theory and Capital Budgeting

In applying portfolio theory to capital budgeting we face some special problems:

 Indivisibility of assets: Unlike securities, which are almost infinitely divisible, capital investments
often come in large, indivisible units. They have to be accepted or rejected in total.
 Holding period: Mean-variance analysis can be used to determine the portfolio of capital investments
that has the highest NPV for each level of risk. Unfortunately, it is difficult to interpret such an
efficient frontier because asset lives tend to be different. To avoid ambiguity caused by unequal lives,
the return should be measured over a common holding period.
 Data requirements: Mean-variance portfolio analysis is highly data-intensive. For a portfolio of n
assets, the number of risk and return inputs required is 0.5 n2 + 1.5 n.

The basic ideas of portfolio analysis, however, may be applied in somewhat simpler ways:
 When a large project is being considered, it may be viewed as one asset and the existing firm as a
second asset. A portfolio consisting of the existing firm and the new asset may be compared to the
existing firm in terms of expected return and standard deviation.
 The mean-variance portfolio model may be used to allocate funds across major business divisions
which may be few in number, say 3 to 5 for most companies. Data requirement of such analysis is
quite manageable.
 When a small project is being considered, the beta between the project and the company’s existing
portfolio may be regarded as the risk measure for incremental decision making.

Developing the inputs for portfolio analysis:

Estimates of expected return, variance, and covariance are required to apply the mean-variance portfolio
model. For security portfolios, historical values can be used as proxies for future values. This is, however,
not feasible for proposed capital investments. What is the way out? One method is to identify various states
of nature. Based on this information, the required inputs for portfolio analysis, viz. Expected returns,
variances, and co variances, can be generated.

(d) Capital Asset Pricing Model

Portfolio theory is a normative theory which prescribes how rational utility-maximising investors should
behave. The Capital Asset Pricing Model, CAPM was developed to examine what would be the relationship
between risk and return in the capital market if investors behaved in conformity with the prescription of
portfolio theory. Thus, the CAPM may be viewed as an extension of portfolio theory.
CAPM is concerned with two sets of questions:
Set I:
 What is the appropriate measure of risk for an efficient portfolio?
 What is the relationship between risk and return for an efficient portfolio?
Set II:
 What is the appropriate measure of risk for an individual security or an inefficient portfolio?
 What is the relationship between risk and return for an individual security or an inefficient portfolio?

Assumptions of CAPM model

 Individuals are risk-averse.

 Individuals seek to maximise the expected utility of their portfolios over a single period planning
horizon.
 Individuals have homogeneous expectations.
 Individuals can borrow and lend freely at the riskless rate of interest.
 The market is perfect: there are no taxes, no transaction costs, securities are completely divisible, the
market is competitive.
 The quantity of risky securities in the market is given.

(e) Developing the inputs required for applying the CAPM

To apply the CAPM, you need estimates of the following factors that determine the SML version of the
CAPM line:
 Risk-free Rate: The risk-free rate is the return on a security that is free from default risk and is
uncorrelated with returns from anything else in the economy. Theoretically, the return on a zero-beta
portfolio is the best estimate of the risk-free rate. Constructing zero-beta portfolios, however, is costly
and complex. Hence they are often unavailable for estimating the risk-free rate. In practice, two
alternatives are commonly used: (a) rate on a short-term govt. security like 364-days T-bills, (b) rate
on a long-term govt. bond, which is a good choice because its duration is similar to that of a stock
market index.
 Market Risk Premium: It is the difference between the expected market return and the risk-free rate.
It can be estimated on the basis of historical data or forward looking data. Historical Risk Premium is
the difference between the average return on stocks and the average risk-free rate earned in the past.
Forward Looking Risk Premium is the difference between the Expected market rate of return and
Risk Free Rate and Expected market rate of return is the sum of Dividend Yield and Constant growth
rate.
 Beta: The beta of an investment i is the slope of the following regression relationship:

Rit = ai + bi RMt + eit

where Rit = return on investment i in period t
RMt = return on the market portfolio on period t
ai = intercept of the linear regression relationship between and
bi = slope of the linear regression relationship between and
eit = error term
To measure the systematic risk of a project, we have to calculate the slope of the regression. The
estimate of the regression model is:
bi = riM si sM / sM2
Where bi = estimate of the slope in the regression model
riM = coefficient of correlation between the return on investment i and the return on investment M
si = standard deviation of the return on investment i
sM = standard deviation of the return on market portfolio

Estimation Issues: Estimating the historical beta may appear straightforward. However, there are several
issues in practice relating to the length of the estimation period, the return interval, the choice of the
market index, and the statistical precision of the estimates.

Adjusting Historical Beta: The beta calculated above reflects a measure of historical alignment of the price
of a stock with that of a market. However, two reasons are given for not regarding it as a measurement of
past relationship as an estimate of future risk:
 The historical alignment may have been significant influenced by chance factors.
 A company’s beta may change over time.

(f) CAPM and Capital Budgeting

We can apply the CAPM to figure out a project’s required rate of return.
 Equity Beta and Asset Beta: To explore the relationship between equity beta and asset beta, we will
initially ignore taxes. Let us take an example of Zenith Limited, which has:
Equity : 50 Debt : 50 Assets : 100
If you buy all the securities of Zenith, you will own all its assets. So, the beta of your portfolio (bp) of
Zenith’s securities is equal to the beta of the Zenith’s assets (bA).
bp = bA
Now, the beta of your portfolio is simply the weighted arithmetic average of the betas of its components,
viz. Equity (E) and debt (D).
bp = bE E/(E+D) + bD D/(E+D)
Hence, bA = bE E/(E+D) + bD D/(E+D)
Or, bE = bA + (bA – bD)D/E.
If bD = 0, means debt is considered to be risk-free, then
bE = bA + (bA)D/E = bA (1 + D/E)
in a world of taxes, bE = bA (1 + D/E(1-T))
Or, bA = bE / (1 + D/E(1-T))

 Procedure for calculating a Project’s Required Rate of Return:

 Step 1: Find a sample of firms engaged in the same line of business.
 Step 2: Obtain equity betas for the sample firms.
 Step 3: Derive asset betas after adjusting equity betas for financial leverage.
 Step 4: Find the average of the asset betas.
 Step 5: Figure out the equity beta for the proposed project.
 Step 6: Estimate the cost of equity for the proposed project.
 Step 7: Calculate the project’s required rate of return, which is the weighted average of cost of
capital.
 TOPIC – 5
Financial Analysis

There are three basic questions to be answered in a project appraisal exercise: Can we produce the goods or
services? Can we sell the goods or services? Can we earn a satisfactory return on the investment made in the
project?
For answering these questions we have to do a technical appraisal, a market and demand appraisal and a
financial appraisal. In this chapter, we will discuss about the financial appraisal.

Cost of Project

Conceptually, the cost of project represents the total of all items of outlay associated with a project which are
supported by long-term funds. It is the sum of the outlays on the following:
 Land and Site development: It includes Basic cost of land including conveyance and other allied
charges; Premium payable on leasehold and conveyance charges; Cost of levelling and development;
Cost of laying approach roads and internal roads; Cost of compound wall and gates; Cost of tube
wells. This cost varies considerably from one location to another.
 Buildings and Civil Works: It covers Buildings for the main plant and equipment; Buildings for
auxiliary services like steam supply, workshops, labs, water supply etc.; God owns, warehouses, and
open yard facilities; Non-factory buildings like canteen, guest houses, time office, excise house, etc.;
Quarters for essential staff; Silos, tanks, wells, chests, basins, and other structures; Garages; Sewers,
drainage, etc.; and other Civil engineering works. This cost depends on the kinds of structures
required which, in turn, are dictated largely by the requirements of the manufacturing process.
 Plant and Machinery: This cost consists of Cost of imported machinery; Cost of indigenous
machinery; Cost of stores and spares; Foundation and installation charges. It is based on the latest
available quotation adjusted for possible escalation.
 Technical Know-how and Engineering Fees: Often it is necessary to engage technical consultants
in various technical matters like preparation of the project report, choice of technology, selection of
the plant and machinery, detailed engineering and so on. This cost is a part of the project cost, the
royalty payable annually, is an operating expense.
 Miscellaneous Fixed Assets: They include items like furniture, office machinery and equipment,
tools, vehicles, railway siding, diesel generating sets and so on.
 Initial Cash Losses: Most of the projects incur cash losses in the initial years. Hence prudence calls
for making a provision, overt or covert, for the estimated initial cash losses.
 Expenses on Foreign Technicians and Training of Indian Technicians Abroad
  Preliminary and Capital Issue Expenses: Expenses incurred for identifying the project, conducting
the market survey, drafting the memorandum and articles etc. are referred to as preliminary expenses.
Expenses borne in connection with the raising of capital from the public are referred to as capital
issue expenses.
 Pre-operative Expenses: Expenses like establishments expenses; rent, rates, and taxes; travelling
expenses; interest and commitment charges on borrowings, insurance charges etc. are directly related
to the project implementation schedule.
 Margin Money for Working Capital: The principal support for WC is provided by commercial
banks and trade creditors. However, a certain part of the WC requirement has to come from long-term
sources, referred to as the ‘margin money for WC’. This money is sometimes utilised for meeting
over-runs in capital cost, which leads to a WC problem. To mitigate this problem, FIs stipulate that a
portion of the loan amount, equal to margin money, be blocked initially so that it can be released
when the project is completed.
 Provision for Contingencies
Means of Finance

To meet the cost of the project various means of finance are available which are Share Capital; Term Loans;
Debenture Capital; Deferred Credit; Incentive Sources; Miscellaneous Sources.
Planning the means of Finance: We have discussed the various means of finance that can be used for a
project. How should you go about determining the specific means of finance for a given project? The
guidelines and considerations that should be borne in mind for this purpose are as follows:
 Norms of Regulatory Bodies and FIs: The proposed means of finance must either be
approved by a regulatory agency or conform to certain norms laid down by the govt.
 Key Business Considerations: The key business considerations which are relevant for the
project financing decision are: cost, risk , control, and flexibility.

Estimates of Sales and Production

Typically, the starting point for profitability projections is the forecast of sales revenues. In estimating
sales revenues, the following considerations should be borne in mind:
 It is not advisable to assume a high capacity utilisation level in the first year of operation. It is
sensible to assume that capacity utilisation would be somewhat low in the first year and rise
thereafter gradually to reach the maximum level in the third or fourth year of operation.
 It is not necessary to make adjustments for stocks of finished goods. For practical purposes, it may be
assumed that production would be equal to sales.
 Selling price considered should be the price realisable by the company net of excise duty.
 It is generally assumed that changes in selling price will be matched by proportionate changes in cost
of production.

Cost of Production

Given the estimated production, the cost of production may be worked out. Major components of cost of
production are:
 Materials cost: This cost comprises of the cost of raw materials, chemicals, components, and
consumable stores required for production.
 Utilities cost: It consists the cost of power, water, and fuel. The cost of power would include only the
cost of bought out power.
  Labour cost: It is the cost of all the manpower employed in the factory. It is a function of the number
of employees and the rate of remuneration.
 Factory Overhead cost: The expenses on repairs and maintenance, rent and taxes, insurance on
factory assets, and so on are collectively referred to as factory overheads. In addition, a contingency
margin may be provided on the items of factory overheads.

Working Capital Requirement and its Financing

In estimating the WC requirement and planning for its financing, the following considerations should be
borne in mind:
 WC requirement consists of raw material and components; stocks of goods-in-process; stocks of
finished goods; debtors; operating expenses, and consumable stores.
 The principal sources of WC finance are WC advances provided by commercial banks; trade credit;
accruals and provisions; and long-term sources of financing.
 There are limits to obtaining WC advances from commercial banks.
 Tandon Committee has suggested three methods for determining the maximum permissible amount
of bank finance for WC.
 Margin requirement varies with the type of current asset.

Profitability Projections

Given the estimates of sales revenues and cost of production, the next step is to prepare the profitability
projections or estimates of working results. The estimates of working results may be prepared along the
following lines:
A. Cost of Production
B. Total administrative expenses
C. Total sales expenses
D. Royalty and know-how payable
E. Total cost of production (A + B + C + D)
F. Expected sales
G. Gross profit before interest
H. Total financial expenses
I. Depreciation
J. Operating profit (G – H - I)
K. Other income
L. Preliminary expenses written off
M. Profit/Loss before taxation(J + K - L)
N. Provision for taxation
O. Profit after tax (M - N)
Less Dividend on
- Preference capital
- Equity capital
P. Retained profit
Q. Net cash accrual (P + I + L)

Projected 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. The format of preparing the cash flow statement may be on a half-yearly basis for
the construction period and on annual basis for the operating period (for 10 years) for managerial purposes, it
may be helpful to prepare it on a quarterly basis for the construction period and on a half yearly basis for the
first 2 to 3 operating years for managerial purposes. This would facilitate better financial planning, project
evaluation, and fund control.

Projected Balance Sheet

The Balance Sheet, showing the balances in various asset and liability accounts, reflects the financial
condition of the firm at a given point of time.

The liabilities side of the balance sheet shows the sources of finance employed by the business. Its
components are Share capital; Reserves and Surplus; Secured Loans; Unsecured Loans; and Current
liabilities and provisions.

The assets side of the balance sheet shows how funds have been used in the business. Its components are
Fixed assets; Investments; Current assets, loans and advances; Miscellaneous expenditure and losses
TOPIC – 6

Project risk financial analysis

Risk is inherent in almost every business decision and the risk analysis is one of the most complex and
slippery aspects of capital budgeting. Many different techniques have been suggested and no single
technique can be deemed as best in all situations. The variety of techniques suggested to handle risk in
capital budgeting fall into two broad categories: (i) Techniques that consider the stand-alone risk of a project.
(ii) Techniques that consider the risk of a project in the context of the firm or in the context of the market.
This chapter discusses different techniques that consider the stand-alone risk of a project, examines ways
of managing risk, explores various approaches to project selection under risk, and describes risk analysis in
practice.

Techniques of Risk Analysis

Sources, Measures and Perspectives on Risk

  Sources of Risk: There are several sources of risk in a project. The important ones are project-
specific risk, competitive risk, industry-specific risk, market risk, and international risk.
 Project-specific risk: The earnings and cash flows of the project may be lower than expected
because of estimation error or due to some other factors specific to the project like the quality
of management.
 Competitive risk: The earnings and cash flows of the project may be affected by unanticipated
actions of the competitors.
 Industry-specific risk: Unexpected technological developments and regulatory changes, that
are specific to the industry to which the project belongs, will have an impact on the earnings
and cash flows of the project as well.
 Market risk: Unanticipated changes in macroeconomic factors like the GDP growth rate,
interest rate, and inflation have an impact on all projects, albeit in varying degrees.
 International risk: In the case of a foreign project, the earnings and cash flows may be
different than expected due to the exchange rate risk or political risk.
 Measures of Risk: Risk refers to variability. It is a complex and multi-faceted phenomenon. The
various measures of risk are:
 Range: The range of a distribution is the difference between the highest value and the lowest value.
 Standard Deviation: The SD of a distribution is: s = [ S pi (Xi – X)2 ] ½
where s is the standard deviation, pi is the probability associated with the ith value, and X is the expected
value.
 Coefficient of Variation: It adjusts SD for scale. It is defined as:

 Margin Money for Working Capital: The principal support for WC is provided by commercial banks
and trade creditors. However, a certain part of the WC requirement has to come from long-term
sources, referred to as the ‘margin money for WC’. This money is sometimes utilised for meeting
over-runs in capital cost, which leads to a WC problem. To mitigate this problem, Fis stipulate that a
portion of the loan amount, equal to margin money, be blocked initially so that it can be released
when the project is completed.
 Provision for Contingencies

(Incomplete)
 TOPIC – 7
Market And Demand 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 and get an idea about the market share that is likely to be captured. Put
differently, market and demand analysis is concerned with two broad issues: What is the likely aggregate
demand for the product? What share of the market will the proposed project enjoy?
Given the importance of market and demand analysis, it should be carried out in an orderly and systematic
manner.

Key Steps Involved in Market and Demand Analysis

 Situational analysis and specification of objectives

 Collection of secondary information
 Conduct of market survey
 Characterisation of the market
 Demand forecasting
 Uncertainties in demand forecasting
 Market planning

Situational analysis and specification of objectives

In order to get a feel of the relationship between the product and its market, the project analyst may
informally talk to customers, competitors, middleman, and others in the industry.
If such a situational analysis generates enough data to measure the market and get a reliable handle over
projected demand and revenues, a formal study need to be carried out, particularly when cost and time
considerations so suggest.
A helpful approach to spell out objectives is to structure them in the form of questions, but always bear in
mind how information generated will be relevant in forecasting the overall market demand and in assessing
the share of the market that the project will capture.

Collection of secondary information

Secondary information is information that has been gathered in some other context and is already available.
Primary information, on the other hand, represents information that is collected for the first time to meet the
specific purpose on hand. Secondary information provides the base and the starting point for the market and
demand analysis.
General sources of Secondary information are:
 Census of India: Provides information on population, demographic characteristics etc.
 National Sample Survey Reports: Issued by GOI, present information on various economic
and social aspects like patterns of consumption, distribution of industries etc.
 Plan Reports: Issued by Planning Commission, provides information on physical and financial
targets, actual outlays, etc.
 Statistical Abstract of the Indian Union: Provides information on national income, agricultural
and industrial statistics.
 India Year Book
 Statistical Year Book
 Economic Survey
 Guidelines to Industries
 Annual Survey of Industries
 Annual Bulletin of Statistics of Exports and Imports
 Techno-Economic Surveys
 Industry Potential Surveys
 The Stock Exchange Directory
 Monthly Bulletin of RBI
 Publications of Advertising Agencies etc.

Evaluation of Secondary Information: While secondary information is available economically and readily, its
reliability, accuracy, and relevance for the purpose under consideration must be carefully examined.

Conduct of Market Survey

Secondary information needs to be supplemented with primary information gathered through a market
survey.

The market survey may be a census survey or a sample survey.

In a census survey, the entire population is covered. These surveys are employed principally for intermediate
goods and investment goods when such goods are used ay a small no. of firms. In other cases a census
survey is prohibitively costly and may also be infeasible.

In a sample survey, a sample of population is contacted or observed and relevant information is gathered.

Steps in a Sample Survey:

 Define the Target Population
 Select the Sampling Scheme and Sample Size
 Develop the Questionnaire
 Recruit and Train the Field Investigators
 Obtain Information as per the Questionnaire from the Respondents
 Scrutinise the Information Gathered
  Analyse and Interpret the Information

A market researcher in India has to face the following problems:

 Heterogeneity of the Country: Since it is impossible to cover all the states in an all India
survey, the country has be divided into broad territories going beyond the state boundaries.
 Multiplicity of Languages
 Design of Questionnaire

Characterisation of the Market

Based on the 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:
Apparent Consumption: Production + Imports – Exports – Changes in stock level
In a competitive market, effective demand and apparent consumption are equal.
 Breakdown of Demand: To get a deeper insight into the nature of demand, total market
demand may be broken down into demand for different segments of the market. Market
segments may be defined by (i) nature of product (ii) consumer group (iii) geographical
division
 Price
 Methods of Distribution and Sales Promotion
 Consumers
 Supply and Competition
 Governmental policy

Demand Forecasting

After gathering information about various aspects of the market and demand from primary and secondary
sources, an attempt may be made to estimate future demand.

Methods of Demand Forecasting:

 Qualitative Methods: These methods rely essentially on the judgement of experts to translate
qualitative information into quantitative estimates. Important of two are:
 Jury of executive method: It involves soliciting the opinions of a group of managers
on expected future sales and combining them into a sales estimate.
 Delphi method: It involves the following steps:
1. A group of experts is sent a questionnaire by mail and asked to express their
views.
2. The response received from the experts are summarised without disclosing the
identity of experts, and sent back to the experts, along with a questionnaire
meant to probe further the reasons for the extreme views expressed in the first
round.
3. The process may be continued for one or more rounds till a reasonable result
comes.
 Time Series Projection Methods: These methods generates forecasts on the basis of an analysis of
the historical time series. Important of three are:
 Trend projection method: The trend projection method involves (a) determining the
trend of consumption by analysing past consumption statistics and (b) projecting
 future consumption by extrapolating the trend, by mostly using this linear relationship
Yt = a + bT, where to find the ‘a’, intercept and ‘b’, slope we use linear square method
and ‘T’ denotes Time variable while ‘Y’ denotes the Demand.
 Exponential smoothing method: In this method, forecasts are modified in the light of
observed errors. In general Ft+1 = Ft + aet where Ft+1 = forecast for year t + 1, a =
smoothing parameter, et = error in the forecast for year t = St – Ft, St = actual value
for year t.
 Moving average method: As per this method of sales forecasting, the forecast for the
next period is equal to the average of the sales for several preceding periods.
 Casual Methods: More analytical than preceding methods, these seek to develop forecasts on the
basis of cause-effect relationship specified in an explicit quantitative manner. Important of five are:
 Chain ratio method: The potential sales of a product may be estimated by applying a
series of factors to a measure of aggregate demand. It uses a simple approach to
demand estimation but its reliability is critically dependent on the ratios and rates of
usage used in the process of determining the sales potential.
 Consumption level method: This method is useful for a product which is directly
consumed, it estimates consumption level on the basis of elasticity coefficients the
important ones being the income elasticity of demand and the price elasticity of
demand.
 End use method: Useful for estimating the demand for intermediate products. It
involves the following steps:
1. Identify the possible uses of the product
2. Define the consumption coefficient of the product for various uses.
3. Project the output levels for the consuming industries
4. Derive the demand for the product.
5. Leading Indicator method: Leading indicators are variables which changes
ahead of other variables, the lagging variables. Hence, observed changes in
leading indicators may be used to predict the changes in lagging variables. It
involves main two steps: (i) identify the appropriate leading indicators (ii)
establish the relationship between the leading indicators and the variable to be
forecast.
6. Econometric method: An Econometric model is a mathematical representation
of economic relationships derived from economic theory. Its primary objective
is to forecast future behaviour of economic variables incorporated in the
model. It involves four basic steps:
 Specification: means expression of an economic relationship in a
mathematical form
 Estimation: determination of parameter values and other statistics
 Verification: accepting or rejecting the specification as a reasonable
approximation to the truth on the basis of results of estimation
 Prediction: projection of the value of explained variable

Uncertainties in Demand Forecasting

Demand forecasts are subject to error and uncertainty which arise from three principal sources:
 Data about past and present market: The analysis of past and present markets, which serves as
the springboard for the projection exercise, may be vitiated by the following inadequacies of
data:
 Lack of standardisation
  Few observations
 Influence of abnormal factors like war
 Methods of Forecasting: Methods used for demand forecasting are characterised by the
following limitations:
 Inability to Handle Unquantifiable Factors
 Unrealistic Assumptions
 Excessive Data Requirement
 Environmental Changes: The environment in which a business functions is characterised by
numerous uncertainties. The important sources of uncertainty are:
 Technological Change
 Shift in Governmental Policy
 Developments on the International Scene
 Discovery of New Sources of Raw Material
 Vagaries of Monsoon

Coping with Uncertainties

Adequate efforts may be made to cope with uncertainties:

• Conduct analysis with data based on uniform and standard definitions
• In identifying trends, coefficients, and relationships, ignore the abnormal observations
• Critically evaluate the assumptions of methods and choose a method which is appropriate to the
situation
• Adjust the projections derived from quantitative analysis in the light of unquantifiable, but
significant, influences.
• Monitor the environment imaginatively to identify important changes
• Consider likely alternative scenarios and their impact on market and competition

Market Planning

A marketing plan usually has the following components:

 Current marketing situation: It paints a pen-picture of the present. It examines the following
situations:
 Market Situation: It deals with size, the growth, the consumer aspirations, and buying
behaviour in the market under consideration.
 Competitive Situation: It deals with the major competitors, their objectives, strategies,
strengths, etc.
 Distribution Situation: It compares the distribution capabilities of the competitors.
 Macro-environment: It describes the effect of social, political, technological, and other
external variables on the market.
 Opportunity and Issue Analysis
 Objective: Objectives have to be clear-cut, specific, and achievable.
 Marketing Strategy: It covers the target segment, positioning, product lines, price,
distribution, sales force, sales promotion, and advertising.
 Action Programme: It operationalise the strategy.
 TOPIC – 8
Multiple Projects and Constraints

When investment projects are considered individually, any of the discounted cash flow criteria – NPV,
IRR, or benefit cost ratio –may be applied for obtaining a correct “accept or reject” signal. In an existing
organisation, however, capital investment projects often can’t be considered individually or in isolation. This
is because the pre-conditions for viewing projects individually – project independence, lack of capital
rationing, and project divisibility – are rarely, if ever, fulfilled. Under the constraints obtaining in the real
world, the so-called rational criteria per se may not necessarily signal the correct decision.

In this section, the nature of constraints which render “selection of projects in isolation” meaningless,
discusses the problems with the method of raking, and shows how the techniques of mathematical
programming may be employed to select the capital budget in the face of constraints

Various Sections to be Discussed

 Constraints
 Method of Raking
 Mathematical Programming approach
 Linear Programming model
 Integer Linear Programming model
 Goal Programming model

Constraints

The various constraints are:

  Project Dependence: Projects A and B are economically independent if the acceptance or rejection
of one does not affect the acceptance or rejection of other. For example, an investment in a power
press and an investment in a computer installation are economically independent. On the other hand,
Projects A and B are economically dependent if the acceptance or rejection of one affects the
acceptance or rejection of other. Likewise, Mutually Exclusive projects are substitutes for each other.
Another economic Dependency exists when projects, even though not mutually exclusive, negatively
influence each other’s cash flows if they are accepted together.
A third kind of economic dependency, which may be referred to as positive economic dependency, occurs
when there is complementarity between projects. Complementarity may be of two types: Asymmetric
Complementarity in which, the favourable effect extends only in one direction and Symmetric
Complementarity in which, the favourable effect extends in both the directions.

 Capital Rationing: It exists when funds available for investment are inadequate to undertake all
projects which are otherwise acceptable. It may be recalled that a project is acceptable, if the NPV is
greater than zero or the IRR is greater than the cost of capital or the benefit-cost ratio is greater than
one.
Capital Rationing may arise because of an internal limitation or an external constraint.
Internal capital rationing is caused by a decision taken by the management to set a limit to its capital
expenditure outlays. External capital rationing arises out of the inability of the firm to raise sufficient amount
of funds at a given cost of capital.
 Product Indivisibility: Capital projects are considered indivisible, i.e. A capital project has to be
accepted or rejected in total – a project can’t be accepted partially. Given the indivisibility of capital
projects and the existence of capital rationing, the need arises for comparing projects.

Method of Ranking

Because of economic dependency, capital rationing, or project indivisibility, a need arises or comparing
projects in order to accept some and reject others. Two approaches are available for determining which
projects to accept and which projects to reject, which are: (i) the method of ranking and (ii) the method of
mathematical programming.

The method of ranking consists of two steps:

 Rank all the projects in a decreasing order according to their individual NPV’s, IRR’s, or
BCR’s.
 Accept projects in that order until the capital budget is exhausted.

Conflict in Ranking: In a given set of projects, preference ranking tends to differ from one criterion ton
another. For example, NPV and IRR criteria may yield different preference rankings. When preference
rankings differ, the set of projects selected as per one criteria tends to differ from the set of projects selected
as per some other criteria.
Ranking conflicts are traceable to differences in scale and patterns of cash flows.

Product Indivisibility: A project in choosing the capital budget on the basis of individual ranking arises
because of indivisibility of capital expenditure projects.

Feasible Combinations approach: Following procedure may be used for selecting the set of investments
under capital rationing:
 Define all combinations of projects which are feasible, given the capital budget restriction and
project interdependencies.
  Choose the feasible combination that has the highest NPV.

Mathematical Programming Approach

The feasible combinations procedure described above becomes increasingly cumbersome as the number of
projects increases and as the number of years in the planning horizon increases. To cope with a problem of
this kind, it is helpful to use mathematical programming models. The advantage of mathematical
programming models is that they help in determining the optimal solution without explicitly evaluating all
feasible combinations.

A mathematical programming model is formulated in terms of two broad categories of equations: (i) the
objective function, and (ii) the constraint equations. The objective function represents the goal, the decision-
maker seeks to achieve. Constraint equations represent restrictions – arising out of limitations of resources,
environmental restrictions, and managerial policies – which have to be observed. The mathematical model
seeks to optimise the objective function subject to various constraints.

The objective function and constraint equations are defined in terms of parameters and decision variables.
Parameters represent the characteristics of the decision environment which are given. Decision variables
represent what is amenable to control by the decision-makers.

Types of Mathematical Programming Models

Linear Programming Model
This most popular model, is based on following assumptions:
• The objective function and the constraint equations are linear.
• All the coefficients in the objective function and the constraint equations are defined with
certainty.
• The objective function is Unidimensional.
• The decision variables are considered to be continuous.
• Resources are homogeneous.
Linear Programming Model of a Capital Rationing Problem:
The formulation of a LPP for a capital rationing problem is:
Maximise S NPVj Xj
Subject to S CFjt Xj <= Kt (t = 0,1,...., m)
0 <= Xj <= 1
Where NPVj = net present value of project j
Xj = amount of project j accepted
CFjt = cash outflow required for project j in period t
Kt = capital budget available in period t.

The following features of the model may be noted:

 All the input parameters - NPVj, CFjt, Kt – are assumed to be known with certainty.
 The Xj decision variables are assumed to be continuous but limited by a lower restriction (0) and an
upper restriction (1).
 The NPV calculated is based on a cost of capital figure which is known with certainty.

Non-Financial Constraints: Besides funds there may be other constraints pertaining to labour, material and
demand. These constraints can be readily incorporated in the linear programming model. An example of a
material constraint is: S mj Xj <= M
where mj = material required for project j
 Xj = proportion of project j accepted
M = total availability of material.

Integer Linear Programming Model

It permits only 0 or 1 value for the decision variables. It is capable of handling virtually any kind of project
interdependency.

Integer Linear Programming Model for Capital Rationing Problem:

The formulation of a IPP for a capital rationing problem is:
Maximise S Xj NPVj
Subject to S CFjt Xj <= Kt (t = 0,1,...., m)
Xj = (0, 1)

It may be noted that only difference between IPP and LPP is that IPP model ensures that a project is either
completely accepted (Xj = 1) or completely rejected (Xj = 0).

Incorporating Project Interdependencies in the Model

By constraining the decision variables to 0 or 1, IPP model can handle any kind of project interdependency.
Following kinds of project interdependencies are incorporated in IPP:
 Mutual Exclusiveness: It is reflected in IPP by the following constraint: SjeJ Xj <= 1
where J = the set of mutually exclusive projects under
consideration
j e J = an expression which means that project j belongs to set J
Constraint means that the upper limit on the number of projects that can be selected from the set J is 1. this,
of course, means that the firm may not select any project from the set J. If it is necessary to choose one
project, but only one project, constraint would be:
SjeJ Xj = 1

 Contingency: A contingency relationship between two or more projects implies that the acceptance
of one project is contingent on the acceptance of some other projects. For example, if project B can’t
be accepted without accepting project A, we say that project B is contingent on project A.
It is shown by: XB <= XA
So, project B can be accepted only when project A is accepted; project a, however, can be accepted
independently.
 Complementariness: If undertaking a project influences favourably the cash flows of another
project, the two projects are complementary projects. Consider two projects R and S. Either of them
can be accepted individually. To reflect a complementary relationship, composite project RS
representing the combination of R and S is set up; the cash inflow of RS would be 10% higher than
the sum of the cash inflows of R and S.

Evaluation of IPP
The principal Strengths of IPP model are:
 It overcomes the problem of partial projects.
 It is capable of handling virtually any kind of project interdependency.
The major Shortcomings of IPP model are:
 It’s solution takes considerably more time than the solution of LPP. The solution time for IPP tends to
grow exponentially as the no. of projects increases and may be highly variable also.
  Minor variations in the problem may lead to significant increase in solution times.
 No single solution algorithm works best for all types of IPP.
 Meaningful shadow prices are not available for IPP formulation, because it permits only discrete
variation, not continuous variation of the decision variables.

Goal Programming Model

Generally, we assume that the principal goal of financial management is to maximise the wealth of
shareholders, which can be realised by selecting the set of capital projects that maximise NPV.

However, in the real world, capital market imperfections exist. Further, empirical observation show that
managers pursue a multiple goal structure which includes following:
 Growth in sales and market share.
 Growth and stability of reported earnings.
 Growth and stability of dividends.
Therefore, a realistic representation of real life situations should reflect the multiple goals pursued by the
management.

The goal programming approach, provides a methodology for solving an optimisation problem that involves
multiple goals. This approach, originally proposed by Charnes and Cooper in 1961, has been extended by
Ijiri, Ignizio, and others.
To use the goal programming model, the decision maker must:
 State an absolute priority order among his goals.
 Provide a target value for each of his goals.

The goal programming methodology seeks to solve the programming problem by minimising the absolute
deviations from the specific goals in order of the priority structure established. Goals at priority level one are
sought to be optimised first. Only when this is done will the goals at priority level two be considered; so on
and so forth. At a given priority level, the relative importance of two or more goals is reflected in the weights
assigned to them.

Goal Programming Format

The goal programming model is formulated in terms of three principal components:
 Objective Function: A formal representation of the objective function calls for specifying the
following:
 The priority levels of goals.
 The relative weights attached to each goal where there are two or more goals at the same
priority level.
 The relevant deviational variables which should be minimised with respect to each goal.
 Economic Constraints: The economic constraints represent resource limitations or restrictions
emanating from the decision environment. Which can’t be violated. So, they are also called “Hard
Constraints”.
 Goal Constraints: The goal constraints represent target levels of various goals that are pursued by the
decision maker.

TOPIC – 9
 Social And Cost Benefit Analysis

Social Cost Benefit analysis, SCBA, called economic analysis is a methodology developed for evaluating
investment projects from the point of view of the society (or economy) as a whole.

Used primarily for evaluating public investments, SCBA has received a lot of emphasis in the decades of
1960s and 1970s in view of the growing importance of public investments in many countries, particularly in
developing countries, where governments have played a significant role in the economic development.

SCBA is also relevant, to a certain extent, to private investments as these have now to be approved by
various governmental and quasi-governmental agencies which bring to bear large national considerations in
their decisions.

In the context of planned economics, SCBA aids in evaluating individual projects within the planning
framework which spells out national economic objectives and broad allocation of resources to various
sectors.

SCBA is concerned with tactical decision making within the framework of broad strategic choices defined
by planning at the macro level. The perspectives and parameters provided by the macro level plans serve as
the basis of SCBA which is a tool for analyzing and appraising individual projects.

Various aspects of SCBA

 Rationale for SCBA
 UNIDO approach
 Net benefits in terms of economic prices
 Savings impact and its value
 Income distribution impact
 Adjustment for merit and demerit goods
 Little-Mirrlees approach
 Shadow prices
 SCBA by financial institutions
 Public sector investment decisions in India

Rationale for SCBA

In SCBA the focus is on the social costs and benefits of the project. These often tend to differ from the
monetary costs and benefits of the project.

The principal sources of discrepancy are:

 Market imperfections: Market prices, which form the basis for computing the monetary costs
and benefits, reflect social values under condition of perfect competition, which are rarely, if
ever, realised by the developing countries. When imperfections like rationing, prescription of
minimum wages rate exist, market prices do not reflect social values.
 Externalities: A project may have beneficial external effects. Such benefits are considered in
SCBA, though they are ignored in assessing the monetary benefits. Likewise, a project may
have a harmful external effect like environmental pollution. In SCBA, the cost of such
harmful effects is relevant.
  Taxes and Subsidies: From the private point of view, taxes are definite monetary costs and
subsidies are definite monetary gains. From the social point of view, however, taxes and
subsidies are generally regarded as transfer payments and hence considered irrelevant.
 Concern for Savings: From the social point of view, the division of benefits between
consumption & savings is relevant, particularly in capital-scarce countries, which is irrelevant
from private point of view.
 Concern for Redistribution: A private firm does not bother how its benefits are distributed
across various groups in the society. The society however, is concerned about this distribution.
 Merit Wants: Goals and preferences not expressed in the market price, but believed by policy
makers to be in the largest interest, may be referred to as Merit Wants. While these are
irrelevant from private point of view, they are important from the society point of view.

UNIDO APPROACH
The UNIDO approach was first articulated in the “Guidelines fro Project Evaluation” which provides a
comprehensive framework for SCBA in developing countries. The length of work created a demand for an
operational guide for project evaluation in practice. To fulfil this need, UNIDO came out with another
publication, “Guide to Practical Project Appraisal” in 1978.

The UNIDO method of project appraisal involves five stages:

 Calculation of the financial profitability of the project measured at market prices.
 Obtaining the net benefit of the project measured in terms of economic prices.
 Adjustment for the impact of the project on savings and investment.
 Adjustment for the impact of the project on income distribution.
 Adjustment for the impact of the project on merit goods and demerit goods whose social
values differ from their economic values.

Net Benefit in terms of Economic (Efficiency) Prices/Shadow Prices

Market prices represent shadow prices only under conditions of perfect markets which rarely exist in
developing countries. Hence, there is a need for developing shadow prices and measuring net economic
benefit in terms of these prices.

Shadow Pricing: Basic issues

• Choice of Numeraire: It is the unit of account in which the value of inputs or outputs is expressed.
• Concept of Tradability: A key issue in shadow pricing is whether a good is tradable or not. For a good
that is tradable, the international price is a measure of its opportunity cost to the country.
• Sources of Shadow Prices: Three imp. sources are:
• Increase or decrease the total consumption in the economy.
• Increase or decrease the production in the economy.
• Increase imports or decrease imports.
• Increase exports or decrease exports.
• Taxes: These should be ignored for fully traded goods.
• Consumer Willingness to Pay: If the impact of the project is on consumption in the economy, the
basis of shadow pricing is consumer willingness to pay.

Shadow Pricing of Specific Resources

 • Tradable Inputs and Outputs: A good is fully traded when an increase in its consumption results in a
corresponding increase in import or decrease in export or when an increase in its production results in
a corresponding increase in export or decrease in import. For fully traded goods, the shadow price is
the border price, translated in domestic currency at the market exchange rate.
• Non-tradable Inputs and Outputs: A good is non-tradable when (i) its import price is greater than its
domestic cost of production and (ii) its export price is less than its domestic cost of production. The
value of a non-traded good should be measured in terms of what domestic consumers are willing to
pay, if the output of the project adds to its domestic supplies and in terms of marginal cost of
production if the output of the project causes reduction of production by other units.
• Externalities: An externality, also referred to as an external effect, is a special class of good which is
not traded in the market place. It may be beneficial or harmful. The valuation of external effects is
rather difficult because they are often intangible in nature and there is no market price which can be
used as a starting point. Thus, some economists have suggested that these effects should be ignored.
So, even if these effects can’t be measured in monetary terms, some qualitative evaluation must be
attempted.
• Labour Inputs : The principles of shadow pricing for goods may be applied to labour as well, though
labour is considered to be a service. When a project hires labour, it could have three possible impacts
on the rest f the economy:
• It may take labour away from other employments – in this case the shadow price of labour is
equal to what other users of labour are willing to pay for this labour.
• It may induce the production of new workers – in this case the shadow price of labour is equal
to marginal product of such labour.
• It may involve import of workers – in this case the shadow price of labour is equal to wage
they command which is the social cost associated with their import.
• Capital Inputs: When a capital investment is made in a project two things happen (i) financial
resources are converted into physical assets and (ii) financial resources are withdrawn from the
national pool of savings and alternative projects are foregone, also called opportunity cost. Hence,
physical assets can be valued like tradable or non-tradable goods and its opportunity cost is measured
by the consumption rate of interest.
• Foreign Exchange: The valuation of inputs and outputs that was measured in border rupees has to be
adjusted upward to reflect the shadow price of foreign exchange.

Measurement of the Impact on Distribution

For measuring the value of a project in terms of its contribution to income distribution and savings, we must
first measure the income gained or lost by individual groups within the society.

Groups: For income distribution analysis, the society may be divided into various groups like Project, Other
private business, Government, Workers, Consumers, External sector. The UNIDO approach seeks to identify
income gains and losses by these.

Measure of Gain or Loss: The gain or loss to an individual group within the society as a result of the project
is equal to the difference between the shadow price and the market price of each input or output in the case
of physical resources or the difference between the price paid and the value received in the case of financial
transactions.

Savings Impact and its Value

Most of the developing countries face scarcity of capital. Hence, the governments of these countries are
concerned about the impact of a project on savings and its value thereof.
Impact on Savings: The savings impact of a project = S DYiMPSi
where DYi = change in income of group i as a result of the project
MPSi = marginal propensity to save of group i

Value on Savings: The value of a rupee of savings is the present value of the additional consumption stream
produced when that rupee of savings is invested at the margin.

Income Distribution Impact

Many governments regard redistribution of income in favour of economically weaker sections. Due to
practical difficulties in pursuing the objective of redistribution entirely through the tax, subsidy, and transfer
measures of the government, investment projects are also considered as the investments for income
redistribution and their contribution toward this goal is considered in their evaluation. This calls for suitably
weighing the net gain or loss by each group, measured earlier, to reflect the relative value of income for
different groups and summing them.

Adjustment for Merit and Demerit Goods

A Merit good is one for which the social value exceeds the economic value. For e.g., a country may place a
higher social value than economic value on production of oil because it reduces dependence on foreign
supplies.
A Demerit good is one for which the social value is less than its economic value.

The procedure for adjusting for the difference between social value and economic value is:
• Estimate the economic value.
• Calculate the adjustment factor as the difference between the ratio of social value to economic value
and unity.
• Multiply the economic value by the adjustment factor to obtain the adjustment.
• Add the adjustment to the NPV of the project.

Little-Mirrlees Approach

I.M.D. Little and J.A. Mirrlees have developed an approach to SCBA.

The similarity between the UNIDO approach and Little-Mirrlees approach is:
• Calculating accounting (shadow) prices particularly for foreign exchange savings and unskilled
labour.
• Considering the factor of equity.
• Use of DCF analysis.
The difference between the UNIDO approach and Little-Mirrlees approach is:
• UNIDO measures costs and benefits in terms of domestic rupees whereas L-M measures costs and
benefits in terms of border prices.
• UNIDO measures costs and benefits in terms of consumption whereas L-M measures costs and
benefits in terms of uncommitted social income.
• The stage-by-stage analysis recommended by UNIDO focuses on efficiency, savings and
redistribution considerations in different stages. L-M, however, tends to view these considerations
together.

Shadow Prices
  Shadow Price of Traded Goods: The shadow price of a traded good is its border price.

 Accounting Price of Non-Traded Goods: The accounting price for non-traded goods is defined in
terms of marginal social cost and marginal social benefit. The Marginal social cost of a good is the
value in terms of accounting prices of the resources required to produce an extra unit of the good. The
Marginal social benefit of a good is the value of an extra unit of the good from the social point of
view. Thus, accounting price of the non-traded input will be 2/3 Marginal social cost + 1/3 Marginal
social benefit.

 Use of Conversion Factors: Ideally, the accounting price of a non-traded good is defined in terms of
marginal social cost and marginal social benefit. In practice, their calculation is a difficult task. So, L-
M suggest that the monetary cost of a non-traded item be broken down into tradable, labour, and
residual components. The tradable and residual components may be converted into social cost by
applying suitable social conversion factors; the labour component’s social cost be can be obtained by
using social wage rate.
 Shadow Wage Rate: L-M suggest following formula for this:
SWR = c’ – 1/s (c - m)
Where SWR = Shadow Wage Rate
c’ = additional resources devoted to consumption
1/s = value of a unit of committed resource
c = consumption of the wage earner
m = marginal product of the wage earner.
 Accounting Rate of Return (Interest): It is the rate used for discounting social profits.

SCBA by Financial Institutions

The all-India term-lending financial institutions-IDBI, IFCI and ICICI – appraise project proposals primarily
from the financial point of view. However, they also scrutinise projects from the larger social point of view.
ICICI was perhaps the first FI to introduce a system of economic analysis. IFCI adopted a system of
economic appraisal in 1979. finally, IDBI also this introduced. These three institutions follow a similar
approach like L-M approach. While appraising the industrial projects, IDBI consider three aspects:
 Economic Rate of Return: It is also called “Partial L-M” method because while international prices
are used for valuation of tradable inputs and outputs, L-M method is not followed in its entirety.
Significant elements of IDBI’s method are:
 International prices are regarded as the relevant economic prices.
 For tradable items, where international prices are directly available, CIF prices are used for
inputs and FOB price for output.
 For tradable items, where international prices are not directly available, and for non-tradable
items, social conversion factors are used to convert actual rupee cost into social cost.

 Effective Rate of Protection, ERP: Tariffs, import restrictions, and subsidies are used to encourage
domestic industries and protect them against international competition. The extent to which a project
is sheltered is measured by ERP. It is calculated as follows:
ERP = (Value added at domestic prices – Value added at world prices) / Value added at world prices
 Domestic Resource Cost: It reflects the domestic cost incurred per unit of foreign exchange saved or
earned.
Public Sector Investment Decisions in India

The public sector has been assigned a pre-eminent role in the Indian economy. The public sector today
commands a predominant position in many basic industries: coal, crude oil etc.

It is even surprising that even though substantial investments were made in the public sector since
independence, the mechanisms of appraisal and selection were rather primitive till the middle 1960s.

Initiatives to Improve the Quality of Investment Decisions

To improve the quality of project planning and strengthen the public investment decision making process in
India, the following steps were taken:
 In 1965, GOI set up a separate Bureau of Public Enterprises, BPE with the objective of
“integrating and strengthening the arrangement for economic coordination and evaluation of
technical, economic, and financial aspects of projects and the working of public enterprises in
India”. The BPE is an autonomous organisation under the Ministry of Finance and is required
to supervise and regulate all aspects of public sector projects.
 In 1965, the Planning Commission prepared and circulated a Manual of Feasibility Studies for
public sector projects. This manual outlines in detail the procedure required to be adopted for
project evaluation.
 In 1972, GOI set up a special division in the Planning Commission called the Project
Appraisal Division, PAD to appraise the central sector projects.
 In 1972, set up a high-powered Public Investment Board, PIB with a view to evolve a
scientific procedure for taking investment decisions

Key Steps in the Public Investment Decision Making Process in India

Very broadly the steps are:
 The Planning Commission formulates the five-year plan indicating the broad strategy of
planning, the role of each sector, the physical targets to be achieved by each sector, and the
financial outlays to be made available for the development of each sector.
 The administrative ministries develop sectoral plans. It is in these plans that the projects of the
public sector enterprises are identified. The identification of a project provides the green
signal for the preparation of its feasibility report.
 The concerned public sector enterprises prepares the feasibility report and forwards it to its
administrative ministry.
 The administrative ministry carries out a preliminary scrutiny of the feasibility report and
sends copies of the same to the various appraising agencies.
 The PAD of the Planning Commission carries out a detailed appraisal.
 The Investment Planning Committee of the Planning Commission discusses the appraisal note
of the PAD and recommends to the PIB the view of the Planning Commission on whether the
project should be accepted, rejected, deferred, reformulated, or redesigned.
 The PIB considers the (a) appraisal note of the PAD along with the view of the Planning
Commission, (b) the comments of the BPE, (c) the comments of the plan division of the
ministry of finance, and (d) the note of the administrative ministry. If the PIB clears the
project, it sends it to the cabinet for its approval.
 The cabinet generally accepts the recommendation of the PIB and approves its
implementation.
 TOPIC – 10
Technical Analysis

Analysis of technical and engineering aspects is done continually when a project is being examined and
formulated.
The broad purpose of technical analysis is:
 To ensure that the project is technically feasible in the series that all the inputs required to set up the
project are available.
 To facilitate the most optimal formulation of the project in terms of technology, size, location and so
on.

Various Sections to be Discussed

 Manufacturing process / technology
 Technical arrangements
 Materials and inputs
 Product mix
 Plant capacity
 Location and site
 Machineries and equipments
 Structures and Civil works
 Environmental aspects
 Projects charts and layouts
 Project implementation schedule
 Need for considering alternatives

Manufacturing Process / Technology

For manufacturing a product/service often two or more alternative technologies are available.

 Choice of Technology: It is influenced by a variety of considerations which are Plant Capacity,

Principal Inputs, Investment Outlay and Production Cost, Use by Other Units, Product Mix, Latest
Developments, Ease of Absorption.
 Appropriate of Technology: It refers to those methods of production which are suitable to local,
econo0mic, social and cultural conditions. The advocates of appropriate technology urge that the
technology should be evaluated in terms of following questions:
 Whether the technology utilises local raw materials?
 Whether the technology utilises local man power?
 Whether the goods and services produced cater to the basic needs?
 Whether the technology protects ecological balance?
 Whether the technology is harmonious with social and cultural conditions?

Technical Arrangements
Satisfactory arrangements must be made to obtain the technical know-how needed for the proposed
manufacturing process. When collaboration is sought, following aspects of the agreements must be worked
out in detail:
 The nature of support to be provided by the collaborators
  Process and performance guarantees
 Price of technology
 Period of collaboration agreement
 Assistance to be provided and the restrictions to be imposed by collaborator
 Level of equity participation
 Termination of the agreement

Material Inputs and Utilities

An important aspect of technical analysis is concerned with defining the materials and utilities required,
specifying their properties in some detail, and setting up their supply programme.
Material inputs and utilities may be classified into four broad categories:
 Raw Materials: These may be Agricultural Products (for which quality is the most important factor
for consideration), Mineral Products, Livestock and Forest Products, and Marine Products.
 Processed Industrial Materials and Components: These may be base metals, semi-processed
materials, manufactured parts, components and sub-assemblies which represent important inputs for a
number of industries.
 Auxiliary Materials and Factory supplies: These are like chemicals, additives, packaging materials,
paint, varnishes, oils , grease, clearing materials etc.
 Utilities: A broad assessment of utilities like power, water, steam, fuel etc. May be made at the time
of the input study.

Product Mix
The choice of product mix is guided by market requirements. In the production of most of the items,
variations in size and quality are aimed at satisfying a broad range of customers. It may be noted that
variation in quality can enable a company to expand its market and enjoy higher profitability.

While planning the production facilities of the firm, some flexibility with respect to the product mix must
be sought.

Plant Capacity
It refers to the volume or number of units that can be manufactured during a given period. Plant Capacity/
Production Capacity may be defined in two ways:
 Feasible Normal Capacity, FNC: The capacity attainable under normal working conditions.
 Nominal Maximum Capacity, NMC: The capacity which is technically attainable and this
often corresponds to the installed capacity guaranteed by the suppler of the plant.
Our discussion will focus on FNC. Several factors have a bearing on the capacity decision which are:
 Technological Requirement: Sometimes certain minimum economic size is determined by the
technological factor.
 Input Constraints
 Investment Cost
 Market Conditions
 Managerial and Financial resources of the firm
 Governmental Policy

Location and Site

The choice of location and site follows an assessment of demand, size, and input requirement. Location
refers to a fairly broad area like a city, an industrial zone, or a coastal area; Site refers to a specific piece of
land where the project would be set up.
The choice of Location is influenced by a variety of considerations:
 Proximity to Raw Materials and Markets: An important consideration for location is the proximity to
the sources of raw materials and nearness to the market for the final products. Optimal location is one
where the total cost (raw material transportation cost plus production cost plus distribution cost for
the final product) is minimised.
 Availability of Infrastructure: Availability of power, transportation, water, and telecommunications
should be carefully assessed before a location decision is made.

 Labour Situation: Availability of Labour, skilled, semi-skilled and unskilled; prevailing labour rates;
labour productivity; degree of unionisation etc. should be considered.
 Governmental Policies: These have a bearing on location. In the case of public sector projects,
location is directly decided by the government.
 Other Factors: Several other factors like Climate Conditions; General Living Conditions like cost of
living, facilities for education, health care, transportation; Proximity to ancillary Units; Ease in
Coping with Pollution have a bearing on Location of a project.

Site Selection
Once the broad location is chosen, attention needs to be focussed on the selection of a specific site. Two to
three alternative sites must be considered and evaluated with respect to cost of land and cost of site
preparation and development.

Machineries and Equipment

The requirement of machineries and equipment is dependent on production technology and plant capacity. It
is also influenced by the type of project. For a Process – oriented industry, like a petrochemical unit,
machineries and equipments required should be such that the various stages are matched well.
The equipment required for the project may be classified into plant equipment, mechanical equipment,
electrical equipment, instruments, controls, internal transportation system and others.
In selecting the machineries and equipment certain constraints like limited availability of power, difficulty
in transporting heavy equipment, workers inability to operate, the import policy of government etc. should be
borne in mind.
For Procuring the plant and machinery, orders for different items of the plant and machinery may be placed
with different suppliers or a turnkey contract may be given for the entire plant and machinery to a single
supplier.

Structures and Civil Works

Structures and civil works may be divided into three categories:

 Site Preparation and Development: It covers the (i) grading and levelling of site ; (ii) removal of
existing structures; (iii) relocation of existing pipelines, cables, roads, power lines etc.; (iv) removal
of standing water; (v) connections for utilities.
 Buildings and Structures: It covers the (i) factory or process buildings; (ii) ancillary buildings
required for stores, warehouses, labs, utility supply centres, maintenance services and others; (iii)
administrative buildings; (iv) staff welfare buildings, cafeteria and medical service buildings; and (v)
residential buildings.
 Outdoor Works: It covers the (i) supply and distribution of utilities; (ii) handling and treatment of
emission, wastages; (iii) outdoor lighting; (iv)supervision.

Environmental Aspects
A project may cause Environmental pollution in various ways: it may throw gaseous emissions; it may
produce liquid and solid discharges; it may cause noise, heat and vibrations. The key issues that need to be
considered in this respect are:

 What are the types of effluents and emissions generated?

 What needs to be done for project disposal of effluents and treatment of emissions?
 Will the project be able to secure all environmental clearances and comply with all statutory
requirements?

Project Charts and Layouts

Once data is available on the principal dimensions of the project – market size, plant capacity etc., - project
charts and layouts may be prepared. These define the scope of the project and provides the basis for detailed
engineering and estimation of the investment and production costs.
The important charts and layouts drawings are:
 General Functional Layout: It shows the general relationship between equipments, buildings, and
civil works.
 Material Flow Diagram: It shows the flow of materials, utilities, intermediate products, final
products, etc.
 Production Line Diagrams
 Transport Layout
 Utility Consumption Layout
 Communication Layout
 Organisational Layout
 Plant Layout

Schedule of Project Implementation

As part of the technical analysis, a project implementation schedule is also usually prepared.
For preparing this schedule the following information is required:
 List of all possible activities
 The sequence in which various activities have to be performed
 The time required for performing the various activities
 The resources normally required
 The implications of putting more resources or less resources than the normally required.
PERT and CPM, network planning techniques can be very useful for preparing this schedule.
Work Schedule: It reflects the plan of work concerning installation as well as initial operations. Main
purpose of work schedule is to anticipate problems likely to arise during installation and to account the
availability of finances.

Need For Considering Alternatives

There are alternative ways of transforming an idea into a concrete project. These alternatives may differ in
one or more of following aspects:
 Nature of Project: The project may envisage the manufacture of all the parts and components in a
vertically integrated unit or it may consist of an assembly type unit.
  Production Process
 Product Quality
 Scale of Operations and Time Phasing

While evaluating various alternatives, the inter-linkages among key facets of the project must be borne in
mind.