PROJECT MANAGEMENT

CHAPTER – III

By
Dr. A. G. VIJAYA KRISHNA
Associate Professor
Department of Management
College Of Business and Economics(CBE)
Oda Bultum University
 PROJECT PREPARATION
Markets and Demand Analysis
• The first step in project analysis is to estimate the potential
size of the market for the product proposed to be
manufactured and get an idea about the market share that
is likely to be captured.
• The key steps involved in market and demand analysis are
organized into seven sections as follows.
– Situational analysis and specification of objectives
– Collection of secondary information
– Conducting market survey
– Characterization of the market
– Demand forecasting
– Uncertainties in demand forecasting
– Market planning.
Situational Analysis and Specification of Objectives:
• Situational analysis generates enough data to measure the market
and get a reliable hand over projected demand and revenues.
• To carryout such a study, it is necessary to spell out its objectives
clearly and comprehensively. Often this means that the
inscriptive and informal goals that guide situational analysis
need to be expanded and articulated with greater clarity.

Collection of Secondary Information:

• Information may be obtained from secondary and /or primary
sources. 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:
• The important sources of secondary information
that is useful for market and demand analysis are
as follows:
– National level Report prepared by the Government
– Planning Report by the government
– Statistical abstract
– Economic Survey
– Annual Reports by the Ministry
– Bulletin of Banks
– Publication of Advertising agencies
– Other publications
Conduct of Market Survey:
• Secondary information, though useful often, doest
not provide a comprehensive basis for market and
demand analysis.
• It needs to be supplemented with primary
information gathered through a market survey,
specific to the project being appraised.
• The Market survey may be a census survey and
sample survey.
• In a census survey the entire population is covered.
Census surveys are employed principally for
intermediate goods and investment goods when such
a goods are used by a small number of firms.
 The information sought in a market survey
may relate to one or more of the following.
– Total demand and rate of growth of demand
– Demand in different segments of the market
– Income and price elasticity’s of demand
– Motives for buying
– Purchasing plans and intentions
– Satisfaction with existing products
– Unsatisfied needs
– Attitude toward various products
– Distribute trade practices and preferences
– Socio, economic characteristics of buyers.
Steps in a sample survey:
• Typically, a sample survey consists of the following
steps.
– Select the sampling scheme and sample size.
– Develop the questionnaire
– Recruit and train the field investigators
– Obtain information as per questionnaire from the sample
respondents
– Scrutinize the information gathered
– Analyze and interpret the information.
Characterization of the market:
• Based on information gathered from secondary
sources and though the market survey, the market
for the product/ service may be described in terms of
the following;
– ►Effective demand in the past and present
– ►Break down of demand
– ►Price
– ►Methods of distribution and sales promotion
– ►Consumers
– ►Supply and competition
– ►Government policy
Demand forecasting:
After gathering information about various aspects of the market and demand from
primary and secondary sources, attempt may be made to estimate future demand. A
wide range of forecasting method is available to the market analyst.

Methods of Demand Forecasting

Causal Method
Qualitative Methods Time Series Projection
Methods

Jury of Executive Delphi

Method Method Exponential Trend Projection Moving Average
Smoothing Method Method Method

Chain Ratio Consumption End use Leading indicator Econometric

Method level Method Method Method Method
Qualitative Methods:
1.Jury of Executive Method:
• This method is very popular in practice, involves soliciting the
opinions of a group of managers on expected future sales and
combining them into a sales estimate.
• It is an expeditious method for developing a demand forecast
• It permits a variety of factors like economic climate,
competitive environment, consumer preferences,
technological developments, and so on, to be included in the
subjective estimates provided by the experts.
• It has immense appeal to managers who tend to prefer this
judgment to mechanistic procures.
• But the main drawback of this method is biased underlying
subjective estimates.
• The reliability of this technique is questionable.
2.Delphi Method:
• This method is used for eliciting the opinions of a
group of experts with the help of a mail survey. The
steps involved in this method are.
– A group of experts is sent a questionnaire by mail and
asked their views
– The responses received form the experts are summarized.
– The process may be continued for one or more rounds till
reasonable agreement Emerges in the view of the experts.
II Time Series Projection Methods:
1.Trend projection Method:
Trend projection method involves the following steps
• Determining the trend of consumption by analyzing past consumption statistics.
• Projecting future consumption by extrapolating the trend.
• When the trend projection method is used the most commonly employed
relationship is the linear relationship.
Y = a + bx
Where; Y = Trend value
a = intercept of the relationship
a = y - bx
b = slope of the relationship
xy – nx.y
b = -----------------
x - nx
y = Average all ys ( y/n)
x = Average of all xs ( x/n)
x = x Value at each data point (years )
y = y value at each data point (sales)
2. Exponential smoothing Method In exponential
smoothing, forecast are modifies in the light of
observed errors
Ft = 1+ Aet
A = Smoothing parameter (which lies between 0 and 1)
Et = Error in the forecast for year
St= Data
Ft= Forecast
3.Moving Average Method:
• Moving average method of sales forecasting, the
forecast for the next period is equal to the average of
the sales for several preceding periods.
III Causal Method:
1.Chain ratio Method:
• The potential sales of a product may be estimated by
applying a series of factors to a measure of aggregate
demand.
• The chain ratio method uses a simple analytical
approach to demand estimation.
• However, its reliability is critically dependent on the
ratios and rates of usage used in the process of
determining the sales potential.
• While some of the ratios and rates of usage may be
based on objective proportions, others will have to be
subjectively defined.
2.Consumption Level Method:
• This method estimates consumption level on the basis of
elasticity coefficients, the important ones being the income
elasticity of demand and the price elasticity of demand.
Income Elasticity of Demand:
• The income elasticity of demand reflects the responsiveness of
demand to variations in income. It is measured as follows.
E1 = Q2 – Q1 I1 + I2
---------- X ---------
I2 – I1 Q2 +Q1
E1 =Income elasticity of demand
Q1 = Quality demanded in the base year
Q2 = Income level in the base year
I1 = Income level in the base year
I2 = Income level in the following year
Price Elasticity of Demand:
• The price elasticity o demand measures the
responsiveness of demand to variations in price.
Ep = Q2 - Q1 P1 + P2
------------ X ----------
P2 - P1 Q2+ Q1
Ep = Price elasticity of demand
Q1 = Quantity demanded in the base year
Q2 = Quantity demanded in the following year
P1 = Price per unit in the base year
P2 = Price per unit in the following year
3. End Use Method:
• Suitable for estimating the demand for intermediate
products, the end use method, also referred as the
consumption coefficient method involves the
following steps.
– Identify the possible use of the product.
– Product for various uses
– Project the output levels for the consuming industries
– Desire the demand for the product.
4. Leading indicator Method:
• Leading indicators are variables, which change ahead of other
variables, the lagging variables. Hence, observed changes in
leading indicator may be used to predict the changes in lagging
variables.
• For example, the change in the level of urbanization (a leading
indicator) may be used to predict the change in the demand for
air conditioners (a lagging variable) two basic steps are involved
in using the leading indicator method.
– First, identify the appropriate lading indicator(s)
– Second, establish the relationship between the leading indicator (s) and
variables to the forecast.
• The principal merit if this method is that, it does not require a
forecast of an explanatory variable.
• Its limitations are that it may be difficult to find appropriate
leading indicator(s) and the lead-lag relationship may be staple
over time.
5. Econometric Method:
• An Econometric method is a mathematical representation of economic
relationship(s) derived from economic theory. The primary objective of
Econometric behavior of the economic variables incorporated in the model.
• The construction and use of an econometric model involves four broad steps.
Specification:
• This refers to the expression of an economic relationship in a mathematical
form.
Þ Estimation:
• This involves the determination of the parameter values and other statistics
by a suitable method such as the least squire method.
Þ Verification:
• This step is concerned with accepting or rejecting the specification as a
reasonable approximation to the truth on the basis of the results of
estimation.
 Prediction:
• This involves projection of the value of the explained variable(s).
Advantages:
• The Process of econometric analysis sharpens the
understanding of complex cause effect relationships.
• The econometric model provides a basis for testing
assumptions and for judging how sensitive the results
are to changes in assumptions.
Limitations:
• It is expensive and data demanding.
• To forecast the behavior of the dependent variable,
one needs the projected values of the independent
variable(s). The difficulty in obtaining these may be
the main limiting factor in employing the
econometric method for forecasting purposes.
Raw materials and supplies study:
• Different materials and other inputs required for the operating of the project
should be identified and their availability, supply and method of estimating
operating costs should be analyzed.
Raw materials classification:
Agricultural products:
• If the basic raw material is agricultural products, its quality, present and
potential quantities should be identified.
• In food processing industry, only the marketable surpluses of agricultural
products should be viewed as basic raw materials, after meeting the
consumption and sowing requirements.
• If the project requires large quantities the production of agricultural products
should be increased by extending area of cultivation (sugar cane) or adding one
more crop to estimate availability, the data on the past crop to be collected and
also to study their distribution by market segment.
• Storage and transportation costs to be considered. Future cultivation studies
should be based under varied conditions and the quality and suitability to be
tested.
Livestock and Forest Product:
• Specific surveys are conducted for viability of an
industrial project to have a more dependable and precise
database about livestock and forest products.
Marine Product:
• To assess the potentials of availability, yield and cost of
collection, other considerations are, ecological factors,
national policies, fishing quotas by quantity related
licenses and the danger of over fishing.
Mineral Products:
• Information about metallic, non-metallic and clays and
their exploitable deposits, proven reserves, viability open
cast or underground mining, location, size, depth, quality
of deposits, impurities etc. should be gathered.
Processed industrial materials and components:
• To defined requirement of base metals, semi
processed material parts and components and
specifications to be detailed. Their availability and
price may be unstable in international market.
• Substitutes and FOREX constraints should be
enquired into.
• Careful analysis should be conducted regarding
source of chemicals and petrochemicals, both on the
domestic and foreign markets, their costs and
backward linkages.
Factory Supplies:
• These include auxiliary materials like chemicals, additives,
packing materials, paints, vanishes, maintenance materials,
oils, grease, cleaning materials, wear and tear parts and tools
etc, an estimate of utilities consumption is essential for
identifying the existing sources of supply and shortages.
• The utilities include:
• Electricity: An analysis of energy situation, sources, cost,
power demand, load aspect, stand by arrangements,
consumption level and rejection of thermal power plants for
environmental reasons are certain points to consider in the
study.
• Fuels: while using large combustion materials, environmental
protection and technologies to be integrated in the planning.
Usage of coal is resulting in worldwide carbon dioxide
pollution and increased global temperatures.
• Water: The requirement of the water estimated
considering recycling arrangements, for various
purposes.
• Packing Materials Packing materials most important for
the commodity, For export markets, special protective
packing may be required and in competitive markets
attractive packing may be helpful.
• Recycled waste: pollution controlling is assuming
increasing importance and is becoming controversial
issue in developing countries. Dumping of wastes is no
longer possible. Proper technology usage and
sophisticated recycling methods should be suggested.
• Spare Parts: To avoid break downs essential spare parts
and tools should be identified and keep it in stock. They
may comprise large number of small items.
Specification of requirements:
• All requirements of material and supplies should be
identified and specified in the study considering all socio,
economic, commercial, financial and technical factors.
• Project characteristics and envisaged technology determines
the requirement of materials and supplies.
• Flow sheets for materials and other inputs indicating
quantitative flows should be prepared.
• The quality of various inputs and their quantities are
estimated based on the user demands and market
expectations about the products of the project.
• To identify the characteristics of materials and inputs, the
analysis should cover physical properties, mechanical
properties, chemical properties and electrical and magnetic
properties.
Availability and supply:
• The source of materials availability, their users and price
of inputs are to be analyzed.
• The interdependencies between project, material and
input requirements and supply of these items should be
considered.
• The machinery, equipment, production process, capacity
etc. may have to be revised if inputs with the specified
characteristics and quantities are not available.
• Data regarding locations of availability, area of supply,
whether concentrated or dispersed, transportability,
transport costs and alternate usage of such materials
need to be collected. If the material has to be imported,
the implications of such imports should be assessed.
Costs of raw materials and supplies:
• The costs of materials and other supplies have to be
analyzed in detail to determine project economies.
• In case of domestic materials, current prices have to be
viewed in the context of past trends and future
projections of the elasticity of supply.
• Cost estimates are to be divided into foreign and local
currency components are specified exchange rates.
• Some costs may vary with capacity utilization and
production levels and others may be fixed.
• The amounts resulting from environmental protection
and pollution control measures should be included in
indirect costs element in addition to over head costs at
the level of service, administration and sales centers.
Location, Site and Environmental Impact assessment:
Location:
• Traditional approach to industrial location focused, on
the proximity of raw materials and marketing’s, mainly
with a view to minimizing transport costs. The modern
view requires consideration of commercial, technical
and financial factors, but also of the social and
environment impact a project might have.
• A project can potentially located in a number of
alternatives regions, and the choice of location should
be made for a fairy wide geographical area within
which several alternatives sites may have to be
considered.
• Project promoters may sometimes suggest a location to an
early stage. But it has to fulfill the requirements identified as
essential or critical for a feasible and visible implementation
and operation of a project. The location impacts and
requirements to be identified may be classified as follows.
• Natural environment, geophysical conditions and project
requirements.
• Ecological impact of the project, environment impact
assessment.
• Socio-economic policies, incentives and extractions and
government plans and policies.
• Infrastructure services, conditions and requirements such as
the existing industrial infrastructure, the economic and
social infrastructure, the institutional framework,
urbanization and literacy.
• The strategic orientation of the choice of suitable locations
requires an assessment of inter alias, market and marketing
aspects, the availability of critical project inputs such as raw
materials and factory supplies, technical project requirements, the
type of industry, technological and process characteristics,
products or outputs, size of the plant, organizational requirements
and management structure.
• The identification of key requirements helps to reduce the number
of potential locations and sites at an early stage.
• In a feasible study, a good starting point for the final selection of a
suitable location is the location of raw material and factory
supplies, or if project is market oriented, the location of the
principal consumption centers.
• However their environmental (ecological and socio economic)
factors, including the climate and social welfare facilities such as
education, medical services and recreation facilities, will probably
also influence the selection of a feasible location and site.
• Projects based on specific raw material are located at source. Water,
oil, coal, minerals, timber, agricultural products etc, will have to be
exploited where quantities, qualities and other condition are
adequate.
• The simplest locations model is to calculate the transport,
production and distribution costs at alternative locations determined
principally by the availability of raw material and principal markets.
• Projects based largely on imported material may need to be located
at ports or near terminals.
• Perishable products or agro- processing industries are market
oriented and it is advantageous to locate such production near the
principal consumption centers.
• Petroleum products and pharmaceuticals can be located at source or
near consumption centers or even at some intermediate point.
• A wide range of consumer goods and other industries can be located
at various distances form materials and marketing without unduly
distorting project economics.
• As far as financial feasibility of alternative locations in concerned,
the following data – as well as related financial risks, should be
assessed.
– Production costs (including environmental protection costs)
– Marketing Costs
– Investment costs
– Revenues
– Taxes, subsidies, grant and allowance.
– Net cash flows.
• A location where the project can be expected to face problems in the
future, if certain conditions change, as should be avoided, if better
alternatives exist.
• Most industrial projects have been located at palaces where owners
and key decision makers grew up, were educated and trained, were
resident at the time of the project establishment and where they had
friends or business connections.
• Local partners tend to prefer areas where they have either previous
experience of local conditions or resident representative.
• 4.3.2 Site Selection:
• Once the location is decided upon, a specific project site alternative should
be defined in the feasibility study. This will require evaluation of the
characteristics of each site.
• The structure of site analysis is basically the same as for location analysis
and the key requirements identified for the project may give guidance also
for the site selection. For sites selected within the selected area, the
following requirements and conditions are to be assessed.
• Ecological conditions on site (soil, site hazards, climate etc.)
• Environment impact (restrictions, standards, guidelines)
• Social- economic conditions (restrictions, incentives, requirements)’
• Local infrastructure at site location (exciting industrial infrastructure,
economic a social infrastructure, availability of critical project inputs such
as labor and factory supplies.
• Strategies aspects (corporate strategies regarding possible future
extension, supply and marketing policies)
• Cost of land
• Site preparation and development requirements and costs.
• The importance of theses characteristics varies depending on:
– The nature of projects
– The type of civil construction contemplated.
– The weight of the heavier equipment items
– The type of the efficient and number of workers.
– Environmental condition may discourage the selection of sites
to an existing polluting industry.
– Heavy machinery
– Foundation works
– Transport, and
– Technical installations, any require specific ground conditions.
– Site hazards such as strong winds, fumes, and flue gasses from
neighboring industries or risks of floods etc should be
analyzed.
• The site are required should be specified on the basis of
buildings, technical installations and facilities included
in the project.
• Topography, attitude and climate may be important for a
project as well as access to water, electric power, roads
and railways transport.
• Recruitment of managerial staff and labor may be a
critical factor for the viability of the project.
• Skilled labor and management staff is often in scarce
supply; recruitment of labor with poor skills and
experience may jeopardize the whole project.
• It may be necessary to develop a social infrastructure
next to envisaged site – housing, schools, medical and
social centers to attract the required staff and labor force.
• 4.3.2 Environmental Impact Assessment is designed to
develop an understanding of the environmental
consequences of newly planned or existing projects and of
any project related activities.
• EIA is part of project planning process. Environmental
benefits or costs are usually externalities or side effects that
affect the society in whole or in part.
• Environmental conflict might also lead compensation
claims, substantial costs for equipment and purification and
risk of closing the plant.
• Environmental impacts are assessed components 1)
planning phase (social and economic, new political and
social alignments, economic consequences for associated
resources) 2) Construction phase – one time effects 3)
operational phase – recurring effects.
Production Program and Plant Capacity:
• The production program, range and volume of products to be
produced depend on the market requirements, proposed
marketing strategy and the availability of resources.
• A production program should define the levels of output to be
achieved during specified periods related to the sales forecast.
• Within the overall plant capacity, there can be various levels of
production activates during different stages.
• Full production level may not be possible during initial
production operations owing to various technological,
Production and commercial difficulties in addition to marketing
bottlenecks.
• Normally a production and sales target of 40 – 50 per cent of
the capacity for the first year is considered reasonable. Picking
up gradually, towards third or fourth year full production level
can be achieved.
• Depending on the nature of industry, production has to be
tailored for development of skills and production integration.
• A suitable production pattern should be determined in relation to
projected sales and growing demand.
• The nature of technology choice and know how constitutes a key
factor in determining the production program and plant capacity
that are functions of various interrelated socio, economic,
ecological and financial factors.
• Generally two capacity terms used in relation to level of
operation.
• A feasible normal capacity, achievable under normal working
conditions considering normal stoppages, down time, holiday’s
maintenance, shift pattern and management system applied.
• A nominal maximum capacity, is the technically feasible
capacity that corresponds to the installed capacity as guaranteed
by the supplier of the plant.
Technology selection:
• Appropriate technology choice is directly related to the
conditions of application in particular situations.
• Competitive production capability in the intended markets is one
of the most crucial factors for tech-choice and the related plant
capacity can be a major determination of such capability.
• Consideration of environmental aspects in modern project
engineering and technology assessment, is not limited to the
minimization of pollution, but should also include preservation
of natural resources, and saving non-renewable resources.
• Major disasters in the past; have highlighted the need for careful
evaluation and assessment of hazardous technologies and the use
of toxic materials at different stages of production.
• The measure required mitigating the use of hazardous
technologies and those having an adverse impact on the
environment, must be identified and assessed as part of the
technology choice.
• The primary goals of technology assessment are to be
determined and evaluate the impact of different technologies on
the society and national economy (cost –benefit analysis
employment and income effects, satisfaction of human needs etc)
• To allow the careful assessment of the suitability of the
technological alternatives requires and available for the project
under study, the following logical sequence of steps should be
follows:
– Technology description
– Technology forecast
– Social description
– Social forecast
– Impact identification
– Impact analysis
– Impact evaluation
– Policy analysis and
– Communication of results
Organization and human Resource:
Organization and management:
• A division of the company into organizational units, in line with the
marketing, supply, production and administrative functions is
necessary for efficient management of operations and designing a
proper organizational structure in accordance with the corporate
strategies and policies.
• The recommended organization will depend on the social
environment as well as techno-economics necessities. The
organizational set up depends to large extent on the of industrial,
enterprise, strategies, policies and values of those in power in the
organization
• Organization is the means by which operational functions and
activities of the enterprise are structured and assigned activities to
various individuals represented by managerial staff, supervisors and
work force, with the objective of coordinating and controlling the
performance of the enterprise and the achievement of its business
targets.
• A design of the organization, usually includes the
following steps
– Goals and objective for the business are stated
– Then functions are identified
– Functions are grouped or related
– Organizations structure or frame work designed
– All key jobs are analyzed, designed and described
– A recruiting and training program prepared.
• The two reasons for preparing an organization;
– To achieve optimal coordination and control or all project
inputs (it becomes possible to implement project strategies
economically)
– To structure the investment and production costs and to
determine the costs linked with corresponding organizational
units.
• The organization design should then consider some
of the fundamental aspects of optimal organization
viz.
– Span of control (no. of employees reporting to a
supervisor)
– Number of organization levels
– Subdivision of activities by function, process, equipment,
location, product or class of customer and
– Distribution of responsibility and authority.
• Then all information applicable to the organization
will be presented/provided in an “organizational”
manual, which may include.
• An overall description and identification of the
strategic objective and policies of the company.
• A description of the various functional units,
selections or division specifying the main task to be
performed by the individual unit.
• Job description for at least all key personnel and
• Administration procedures according to which
business transactions are to be carried out, both
internally and externally and covering all functions
and at all levels of the company.
Organizational Structure:
• The organizational structure of an enterprise
indicates the delegation of responsibilities top the
various functional units and is normally shown in a
diagram.
• Usually the organization structure is designing
primarily in line with the different functions such as
finance, marketing, production and purchasing.
However there is no unique organizational pattern.
• It is also possible to base organizational structures
on product to production lines (for instance, profit
or cost centers) or on geographical areas or markets,
the later are typical for marketing organizations.
Human Resources:
• The successful implementation and operation of
industrial projects need different categories of human
resources.
• Human resource have to be defined by categories such
as Management and Supervisory, Personnel, skilled and
Unskilled workers, and by function such as general
management, production management, administration
(accounting, finance, purchasing etc) production
control, machine operations and transport.
• The numbers, skills and experience required on the type
of industry, the technology used, plant size, the cultural
and socio-economic environment of the project location
as well as the proposed organization of the enterprise.
• Bad management or the inadequate skills and
experience of personnel in key positions can easier
jeopardize a promise and careful planned project.
• The definition of human resource by categorized and
functions is necessary of the preparation of a detailed
manning table including the total cost of
management, staff and labor, and for a comparison of
the needed personnel with resources available in the
project region.
• Human resource requirements not only depend on
techno-economic and financial or commercial factors,
but also are determine to a certain extent, by social
and socio-economic conditions in the country and
location of the project.,
• The prevailing legislation regarding national
holidays, shift work, working hours, and annual sick
and training leave, will have an impact on the
effective number of working hours and days per year
and therefore, effect the human resource
requirements, given the production targets and other
conditions.
• In many developing countries, minimum standard
of occupational safety have not been established or
are not enforced strictly enough.
• ILO has published a number of documents on the
subject of occupational safety, health and working
conditions in developing countries and in different
employment situations.
• The following factors should be given due
consideration when the availability and
employment of human resource are analyzed.
– The general availability of relevant human resource
categories in the country and the project region.
– The supply and demand situation in the project region
– Recruitment policy and methods
– Training policy and program
– Difficulties in the recruitment of key personnel (such
as Managers, Supervisors and skilled labor) can be
dealt with, in different ways.
– Recruitment is combined with intensive training of
key personnel in order to meet quality requirements.
– Foreign expertise is recruited.
• 4.7. Financial And Economic Analysis:
• Since reliable cost estimates are fundamental to the
appraisal of an investment project. It is necessary to check
carefully all cost items that could have a significant impact
on financial feasibility. Cost estimates cover the costs of
initial investment cost, production, Marketing and
distribution, plant and equipment replacement, working
capital requirements and decommissioning at the end of the
project life.
• 4.7.1 Initial Investment Cost: Initial Investment cost are
defined as the total of fixed assets (fixed investment costs
plus pre-production expenditures) net working capital, with
fixed assets constituting the resources required for
constructing and equipping an investment project, and net
working capital corresponding to the resources needed to
operate the project totally or partially.
• 4.7.1 a Pre-production Expenditures:
• In every industrial project certain expenditures are
incurred prior to commercial production. They are
• Preliminary Capital – issue expenditures:
• These are expenditures incurred during the registration
and formation of the company, including legal fees for
preparation of the memorandums and articles of
association and similar documents for capital issues.
Capital issues expenditure included basically the
preparation and issue for a prospectus, advertising, public
announcements, underwriting commission, brokerage,
expenses for processing of share applications and
allotments of shares, preliminary expenditures also
included legal fees for loan applications and land purchase
agreements.
• ii) Expenditure for preparatory studies:
• These includes expenditures for pre investment studies like opportunity
and feasibility (Project design and reports) and other expenses for
planning the project)
• iii) Other Pre-Production Expenditures:
• The following are the Pre-production expenditures:
• Salaries, fringe benefits and social security contributions of personnel
engaged during the pre production period.
• Travel expenses
• Preparatory installations, such as works camps, temporary offices and
stores
• Pre production marketing costs, promotion activities, creation of sales
network etc.
• Training costs, including fees, travel living expense, salaries and stipends
of the trainees and fees payable to external institutions.
• Know-how and patent fees
• Interest on loans accrued or parable during constructions.
• Insurance cost during construction.
 iv). Trail runs, start up and commissioning expenditures:
• This item includes fees payable for supervision of start up
operations wages, salaries, fringe benefits and social security
contributions of personal employed, consumption of production
materials and auxiliary supplies, utilities and other incidental start
up costs.
4.7.1.b Fixed Assets:
• Fixed investment should include the following main costs items,
which may be broken down further if required:
•  Land Purchase, site preparation and improvements
•  Building and civil works
•  Plant machinery and equipment including a auxiliary
equipment
•  Certain other assets such as industrial property rights and lump
sum payments for know how and patents. The estimates include
supply, packing and transport, duties and installation charges.
• 4.7.1 c Net Working Capital:
• Net working capital is defined current assets (the sum of inventories,
Marketable securities, prepaid items, accounts receivables and cash minus
current liabilities (accounts payable)
• Production cost:
• It is essential to make realistic forecasts of production or manufacturing costs
for a project proposal in order to determine the future viability of the project.
The analysis of cost structures and identification of critical cost items as well as
critical comparisons with similar projects are proper means of improving the
reality and accuracy of cost of projections and predictions of the financial
feasibility of the investment. Production cost should be calculated as total
annual costs a preparedly also as cost per unit produced. Production cost must
be determined for the different levels of capacity utilization. The production
costs are classified in to four major categories.
• They are
•  Factory costs  Administrative overhead costs Depreciation cost and
costs of financing The sum of factory and administrative overhead costs is
defined as operating costs.
 Marketing Costs:
• Marketing Costs comprise the costs for all marketing activities and
may be divided into direct marketing Cost and indirect marketing
costs.
• Direct marketing costs are packaging and storage,, sales costs
(sales persons’ commission, discounts, royalties, product
advertisements), transport and distribution costs. Indirect
marketing costs are costs relating to marketing department. They
are salaries of personnel, materials and communication market
research, public relation and promotional activities.
• 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.
 Financial Evaluation:
• Ranking projects and measuring their profitability
have replaced evaluation based on inadequate
planning and subjective judgment. Quantitative
methods were developed to use in evaluating
proposed projects.
• The investment criteria, classified into two broad
categories, Discounting criteria and Non-discounting
criteria are shown in the following exhibit.
4.7.5 A . Net Present Value:
• The Net Present Value has certain properties that make it a very attractive
decision criterion. The NPV method is a discounted cash flow method. In
this method all net cash inflow a5e discounted to present value using the
required rate of return and is then compared with the initial outlay. If the
discounted cash flow exceeds the initial outlay it means the project
investigated is attractive since it is expected to earn more than the required
rate of return. Mathematically, the method can be expressed as follows:
CF1 CF2 CF3 ……CFn
NPV = ----- + ----- + ----- ------
(1+K) ¹ (1 + K) ² (1+K) ³--- (1+K) n
CF = Cash inflow per period (Year)
K = Discount Rate
ICO = Initial Cash outlay
Decision Criteria:
• NPV is greater than Zero = Accept the Project
• NPV is less than Zero = Reject the project
• Advantages:
• ►Time value of money is considered
• ►Direct measure of the benefit
• ►It is an objective method of selecting and
evaluation of project
• Limitations:
• ►The NPV expressed in absolute terms rather than
relative terms and hence does not factor in the scale
of investment
• ►The NPV rile does not consider the life of the
project
• Modified NPV:
• The standard NPV method is based on the assumption that the
intermediate cash flows are reinvested at a rate of return equal to the cost
of capital. When this assumption is not valid, the investment rates
applicable to the intermediate cash flows need to be defined for
calculating the modified NPV, the steps involved in this process are as
follows
• Step: 1 Terminal value of the Project Cash inflows
• TV = CF1 (1+K) ³ + CF2 (1+K) ² + CF3 (1+K) ¹ +CF4
• Step:2 Determine the Modified NPV
TV
NPV = -------- - ICO
(1+K) n

NPV = Modified Net Present Value

TV = Terminal Value
K = Discount Rate
ICO = Initial Cash Outlay
NPV – Time Varying Discount Rate:
• The basic assumption in NPV, the discount rate remains
constant over time. This need not always be the case.
The NPV can calculate using time varying discount
rates. The general formula of NPV is as follows:
CF1 CF2 CF3 ………CFn
NPV = ----- + ----- + ----- ------ -
ICO
(1+K) ¹ (1 + K) ² (1+K) ³ (1+K) n

CF = Cash inflow per period (Year)

K = Discount Rate
ICO = Initial Cash outlay
• 4.7.5.B. Benefit Cost Ratio:
• There are two ways of determining the relationship
between benefit and costs.
PVB
BCR = ------
I
BCR = Benefit Cost Ratio
PVB = Present Value of Benefit
I = Initial Investment
PVB – I
NBCR = ----------- Or BCR - 1
I
NBCR = Net Benefit Cost Ratio
• Decision Criteria:
• The following decision rules are associated with
them;
• When BCR NBCR Rule
>1 >1 Accept the
project
=1 =1 Indifferent
<1 <1 Reject the
Project
• 4.7.5. C Internal Rate of Return:
• Also known as the time adjusted rate of return or
yield method computes the yield that is the expected
to be earned on an investment. The IRR for an
investment is defined as the discount rate (or interest
rate) that will make the present (or discounted) value
of each flow operations equal to the initial outlay for
an investment.
• In simple, the IRR for an investment proposal is the
discount rate that equates the present value of initial
cost of the investment with the present value of the
expected net cash flows.
• How to calculate IRR:
• Step: 1 Calculate the present value of cash flow form
the investment project using arbitrary investment rate
• Step: 2 compare the present value with initial
investment
• Step: 3 Present values are higher than the cost figure,
when try for the higher investment rate.
• Step: 4 repeat the three procedures until the exact
rate of investment that relates PV of cash flow and
outflow.
• Step: 5 Get for the exact rate through interpretation,
after finding, the lower rate and higher rate, relates
PV of cash inflow.
 CF1 CF2 CF3…… CFn
IRR = ----- + ----- + ----- + ------ - ICO
(1+IRR)¹ (1 + IRR)² (+IRR)³ (1+IRR) n
CF = Cash Flow
IRR = Internal Rate of Return
ICO = Initial Cash Outlay
Decision Criteria:
• The IRR us greater than the required rate of the project is hurdle
rate, when we accept the project, or otherwise reject the project.
• Advantages:
• Recognize the time value of money
• Recognizes income over the whole life of the project
• The percentage return allows a sound basis for ranking projects.
• Limitations: 1. Implies that earnings are reinvested at the IRR
 • D. Pay Back Period Method:
• Some times called the Pay off or pay out method. It
determines the length of time required by the project
to recover the initial investment. It is simple and
widely used evaluation method. The Pay back Period
of a fixed asset tells us the number of years required
to recover the initial investment of the asset.
• Methods of Calculation PBP
• On the basis of Uniform Cash inflow
• On the basis of Non-uniform Cash inflow
Uniform Cash inflow:
Net initial Investment
PBP = --------------------------
Uniform increase in Annual cash flows
Non Uniform Cash flows:
B
PBP = E + ------
C
E = Year immediately before Pay Back Period
B= Difference between cumulative savings of earnings of earlier
period and pay Back Period amount
C= Difference between cumulative savings of earlier period and
subsequent period.
Decision Criteria:
The PBP is less than some accepter PBP = Accept the project
Or other wise = Reject the project
• Advantages:
• ►Simple to compute
• ►Easy to understand
• ► Superior to rate of return
• Limitations:
• Time value of money is ignored
• It ignores income earned after pay back period
Pay Back Profitability:
• After computing the PBP, the project may give cash
inflows for some more years, ie, called Payback
Profitability.
• PBP Profitability = Earnings per annum (Working life –
Pay Back period)
Discounted Pay Back Period:
• A major shortcoming of the conventional pay back period
is that it does not take into account the time value of
money. To overcome these limitations, the discounted
PBP has been suggested. In this modified method, cash
flows are converted into the present values (by applying
suitable discounting factor) and then added to ascertain
the period of time required to recover the initial outlay on
the project.
4.7.5. E Accounting rate of Return:
• The Accounting rate of return refereed to as the average rate of return an investment is a measure of
profitability, which relates income to investment, both measures in according terms. Since income and
investment can be measured in various ways. These can be a very large number of measures for ARR
• The measures that are employed commonly in practice are;
Average income after tax
1. ARR = ---------------------------------
Initial Investment
Average income after tax
2 ARR = ---------------------------------
Average investment

Average income after tax but before interest

3. ARR = ---------------------------------------------------
Initial Investment

Average income after tax before interest

4 ARR = ------------------------------------------------
Average Investment

Total income after tax but before depreciation - Initial investment

5. ARR = ---------------------------------------------------------------------------------
(Initial Investment /2) X Years
Decision criteria:
• Projects, which have an ARR equal to or greater than a pre specified cut off rate of return – Which is usually
between 15% and 30% - are accepted other wise rejected.
• Advantages:
• It is simple to calculate
• It is based accounting information, which is readily
available, and familiar to businessman.
• It considers benefits over the entire life of the project.
• Since it is based accounting measures, which can be
readily obtained from the financial accounting system of
the firm, it facilitates post auditing of capital expenditures.
• While income data for the entire life of the project is
normally required for calculating the ARR, one can make
do even if the complete income data is not available.
• Limitations:
• It is based upon accounting profit, not cash flow
• It does not take into account, the time value of money.