CHAPTER ONE

INTRODUCTION TO PROJECT ANALYSIS AND MANAGEMENT

1.1 Introduction

Project analysis and management plays a key role in the economic development of the country.
Projects are the predominant means employed by business, industry, government and non-
governmental organizations to introduce major changes and undertake new activities to
accomplish objectives, regardless of whether the objective is very specific i.e., infrastructure
development, or increase profit by certain percent, or increase market share with a new product.
However, despite the pre-eminence of projects as means to achieve organizational ends there is a
gap in translating project plans in to actual investment and operation. No matter how
sophisticated or detail the project preparation work, it has no value unless it is transformed into
action or implemented. With this regard studies based on previous project implementation
experiences shown that there is continuing difficulties in many developing countries in
transforming plans or project studies into investment projects due to lack of adequate knowledge
and project management skills by most of the individuals engaged in project undertakings.

1.2 Project Definition

The word project has a wider meaning. Many people and organizations have defined what a
project is, or should be, but probably the most authoritative definition is that a project is a
unique set of coordinated activities, with definite starting and finishing points, undertaken by an
individual or organization to meet specific objectives within defined schedule, cost and
performance parameters. Turner defines project as: an endeavor in which human, financial and
material resources are organized in a novel way to undertake a unique scope of work, of given
specification, within constraints of cost and time so as to achieve beneficial change defined by
quantitative and qualitative objectives. A project is a complex of economic activities in which
we commit scarce resources in expectation of benefits that exceed these resources. A project is
an investment made on a package of interrelated time-bound activities; consequently, a project
becomes a time-bound task.

Project is a set of proposals for the investment of resources in to a clearly identified set of actions
and these actions are expected to produce future benefits of a fairly specific kind. It can be small,
as in the case of the construction of a house, awareness campaign or it can be large as in the case
of multi-lateral or integrated project involving a number of sectors or rural and urban
communities.

Project is also defined as a non-routine, non-repetitive, one-off undertaking, normally with

discrete time, financial and technical performance goal. Project may be defined as planning work
for various activities for a completion of a final work. Project is a plan for arranging,
coordinating, supervision, monitoring and complication of various activities related to a final
objective. A project is a unique venture with a beginning and an end, undertaken by people to
meet established goals within defined constraints of time, resources, and quality.
Examples of projects include construction of building, construction of road, establishment of
factories, launching of products, developing a new product, designing a software,
implementation of software, develop a new system or service, making significant improvements
to a system or service, improving internal processes or introduce new ones, building or
significantly enhancing infrastructure, researching new technology for a specific purpose, etc

Some examples of work that are not projects include daily production support activities (system
administration, system operations, break/fix activities, customer support, etc), other operational
activities that follow a defined process, very small system change requests, etc.

From the above definitions and examples, we can understand that projects:
have well defined objectives,
start and finish dates,
are designed and implemented to produce specific results,
require financial, material and human resources,
involve one or more individual or groups,
are unique (i.e., they will not be repeated precisely in the same way in the future), and
have definite location and target group (beneficiaries).

1.3 Project Characteristics

From the above definitions, we can have the following features (characteristics) of projects:
Projects have a purpose/objective: projects have clearly-defined aims and set out to
produce clearly-defined results. A project has a set of objectives or a mission. Once the
objectives are achieved, the project is treated as completed. For example the objective of
a project may be construction of a highway connecting two cities A and B. Once the
construction of the highway is completed the project comes to an end.
Projects are realistic: their aims must be achievable, and this means taking account both
of requirements and of the financial and human resources available.
Projects are limited in time and space: they have a beginning and an end, and are
implemented in a specific place and context. That means it can not continue forever.
Construction of a highway connecting two cities for instance is a project which is to be
completed within a given time limit.
Projects are complex: projects call on various planning and implementation skills, and
involve various partners and players.
Projects are collective: projects are the product of collective endeavor. They are run by
teams, involve various partners and cater for the needs of others. A project normally
consists of diverse areas. There will be personnel specialized in their respective areas. Any
project calls for the services of experts from a host of disciplines. Co-ordination among the
diverse areas calls for team work. Hence a project can be implemented only with
teamwork.
Projects are unique: all projects stem from new ideas. They provide a specific response
to a need (problem) in a specific context. The principal identifying characteristics of a
project is its novelty. No two projects ever exactly alike and even a repeated project will
 differ from its predecessor in one or more commercial, administrative, or physical
aspects.
Projects are an adventure: every project is different and ground-breaking; they always
involve some uncertainty and risk. It is a step into the unknown, fraught with risk and
uncertainty.
Projects can be assessed: projects are planned and broken down into measurable aims,
which must be open to evaluation.
Projects are made up of stages: projects have distinct, identifiable stages.
Commitment of Scarce Resources: A project consumes resources. The resources required
to for completing a project are man, material, money and time. The nature of resources is
that they are limited and scarce.
Change: A project is not rigid in its life span. Changes occur throughout the life span of
a project as a natural outcome of many environmental factors. The changes may vary
from minor changes which may have very little impact on the project to major changes
which may have a big impact or even may change the very nature of the project.

1.4 Classification of Projects

Projects may be classified in different way for different purposes. For example we can classify
projects from the point of view of ownership, sources of finance and forces behind as follows:
Ownership:
Private sector projects undertaken by business enterprises
Public sector projects undertaken by national/local government bodies
NGOs projects undertaken by nongovernmental not-for-profit entities
Projects undertaken by public sector such as federal/state governmental units and
NGOs are called development projects.
Sources of finance:
government treasury (equity) vs. external assistance/loan (debt)
Forces behind:
Demand/need driven - unsatisfied demand e.g. building schools and health centers.
Donor driven e.g. constructing donor backed health center.
Political driven e.g. constructing martyr (willing victim) building/monument.

It is convenient also to classify projects under the following four main headings.

Civil engineering, Construction, Petrochemical, Mining and Quarrying Projects: Projects in

this category are those which spring most readily to mind whenever industrial projects are
mentioned. There common future is that the fulfillment phase must be conducted on a site that is
exposed to the elements, and usually remote from the contractors head office. These projects
incur special risks and problems of organization. They often require massive capital investment
and they deserve (but do not always get) rigorous management of progress, finance and quality.

Manufacturing Projects: Manufacturing projects aim at the production of a piece of equipment

or machinery, ship, aircraft, land vehicle or some other item of specially designed hardware. The
finished product might be purpose-built for a single customer, or the project could be generated
and funded within a company for the design and development of a new product intended for
manufacture and sale in quantity. Manufacturing projects are usually conducted in a factory or
other home-based environment, where the company should be able to exercise-on-the-spot
management and provide an optimum environment.

Management Projects: This class of project proves the point that every company, whatever its
size, can expect to need project management expertise at least once in its lifetime. These are the
project that arise when companies relocate their headquarters, develop and introduce a new
computer system, prepare for a trade exhibition, produce a feasibility or other study report,
restructure the organization, mount a stage show or engage in any operation that involves the
management and coordination of activities to produce an end result that is not identifiable
principally as an item of hardware or construction.
Research projects: Projects for pure research can consume vast sums of money, last for many
years and result in a dramatically profitable discovery. They can on the other hand, result in a
complete waste of money and resources invested. Research projects carry the highest risk
because they are attempting to extend the boundaries of current knowledge. Unlike the other
types of projects, their end objectives are usually difficult or impossible to define. Research
projects might not, therefore, be amenable to the project management methods that can be
applied to industrial or management projects.

1.5 Project Analysis and Management

Project management is planning, scheduling, controlling and monitoring the complex non-
routine activities that must be completed to reach the predetermined objectives of the project. It
involves the coordination of a group activity, wherein the manager plans, organizes staffs,
directs, and controls to achieve an objective, with constraints on time, cost and performance of
the end product.
Projects analysis involves estimation and comparing the beneficial effects of an investment with
its costs. Though it originated many years ago, it has been extensively used in the last years.
The basic ideas of project analysis became clear only after their applications. In 1830s a
problem was formulated in the U.S. in relation to water resource investments. The costs of
investment could easily be estimated. But the benefits were not that much easy to compute
because there was no established price to value water. Thus, guidelines were established for
estimating the benefits and costs of water resource projects. The first use of project analysis was
made in the Soviet Union in 1930s. The emphasis was on expanding material production than
social service sectors.

The application of project analysis has been considerably increasing in developing countries.
India provides an example where project analysis has been extensively applied over a long
period in both commercial and non-commercial investments and in the assessment of private
investment proposals. In Jamaica, a committee primarily assesses the project proposals. Since
most of the projects in Sri Lanka are externally funded, assistance agencies carry out the analysis
work, which will be renewed by managerial planning staff.

Even socialist countries such as China and Mozambique have adapted project analysis as part of
a process of reform. The last two decades have witnessed serious applications of project analysis
in Africa and Asia. Internationalization (globalization) of products, privatization policies and
invitation of foreign investment has enhanced the applications of project analysis and
management techniques.

1.6 Project and Plans

Virtually every developing country has a systematically elaborated national plan to hasten
economic growth and further a range of social objectives. Planning in general is a conscious
effort to direct human energy for the purpose of securing a rationally desirable end. Planning is a
means to an end. It's a guide to achieving certain objectives in an optimum manner by means of
an orderly sequencing of activities. In other words, planning is a form of decision making in
using scare resources in selective and economical ways to achieve a pre-determined objectives or
goals.

Planning is necessary because:

- it helps to make necessary arrangements in advance of possible challenge
- it helps an organization to think ahead and anticipate future events
- it gives clear picture of future events to measure and control actual activities
- it helps to identify operational problems of past performance and future corrections

Projects provide an important means by which investment and other development expenditures
foreseen in plans can be clarified and realized. Sound development plans require good projects,
just as good projects require sound planning.
Plan requires projects: a sound plan requires a great deal of knowledge about existing and
potential project. Since a plan lay down growth rate target, for Gross Domestic Product
(GDP), investment, employment etc, a realistic assumption must be established with regard
to such growth. This pre-supposes knowledge of the rate at which good projects can be
planned. Thus, good and realistic plan cannot be formulated in the absence of a great deal of
project planning and without proper economic appraisal of projects.
Project requires plan: since projects commit scarce res, project selection is meaningful
only when it is placed within the broader development-planning framework. The best
economic appraisal of projects cannot be made without referring framework and plans and
policies. To choose the right project one must have an estimate of demand for the product.
But the estimation of demand could be more realistic if the plan is also realistic.

Development strategies are packages of ways and means by which available resources are put in
their best use in achieving specific objectives. Since projects commit scarce resources, project
selection is meaningful only when it is consistently placed within a broader development
framework. This framework is usually delineated in medium and long-term development plans
and policy statements issued by the government. It is within this framework that all affects a
project such as its requirements and benefits can be assessed properly. The more elaborate the
development plans and policy statements, the easier becomes the work of the project planner. As
a minimum, they should outline the desired socio-economic pattern of development and should
specify the major objectives. The analyst should constantly keep in mind the declared objectives
and should always verify that the selected project contributes to the maximum extent possible in
attaining them.

Components of a macro-plan (national): can also apply to private sector projects

Development goals/objectives: Are statements of intention or aspiration of a government to
improve the living conditions of its people. E.g. improving the material and cultural well
being of people, poverty reduction, etc

Development strategies: Are general methods of achieving specific objectives e.g. Ethiopias
development strategies e.g. Food security

Development programs: Are organized set of activities directed toward a common purpose or
goal and serve as frame of references for identifying and evaluating projects. E.g. Ethiopias
rural development program, sustainable development and poverty reduction program

Development projects: Are policy instruments through which national and sub-national
plans are translated in to action. They are the most practical aspects of the national plan (or
any other plan for that matter). They often referred to as the cutting edge of development

1.7. Project and Programs

The term project should be differentiated from the term program to avoid the confusion that
arises when they are used interchangeably. Policies are implemented through programs usually
overall lengthy time scale of five to ten years. Programs unlike projects are open ended means
they do not have a well defined finish date. A series of related projects make programs. While
projects are the building blocks of programs and are usually of shorter duration. A project is a
means by which national, regional local, etc plans are made operational. This means the plan has
to be elaborated into "package of action".

The package of action can be divided into two broad categories. These are:
Program: which is the first step in plan elaboration and
Project: the second step in plan elaboration.

Program, which is a bigger package of action, is composed of a number of projects aiming at

attaining one or more related objectives of plan. Project on the other hand achieves goals which
lead to the accomplishment of specific objectives within program.

The following are the basic difference between program and project.
A program is broader in scope than a project.
 A program is a domain out of which project can be found. For example, if we think of
extension program under this program we could identify different projects like irrigation,
crop production, Honey production etc.
A program has general objective while projects have a specific objectives. For example, if
the objective of the extension program is self food efficiency, the objective of the project
could be increasing crop production, milk production, honey production etc which are more
specification than being general.
Project has a specific project area while program don't have a specific program area.
Projects have specific beneficiary groups. For example, if one establishes a cattle raring
project at Somalia region, that doesn't mean that every Somalia will be willing to buy your
product rather there will be a specific client who will purchase your product like Yemen etc.
The difference and similarities between project and program can be summarized in the following
table:
Project Program
Is specific in objectives/purpose Has got general objectives
Has specific area/geographic unit May not have specific area
Has specific target groups May not have specific target groups
Differences Has clearly determined and May not have clear and detailed
allocated fund. financial allocation
Has specific life May not have specific time of ending.
Similarities Have purpose/objectives
Require input (financial, manpower, material, etc).
Generate output(goods and/or services)
Operate over space and time.

1.8 Projects and Capital Budgeting

1. Projects and Capital Expenditure
Almost all projects involve capital expenditure.
Capital expenditure requires capital budgeting decisions.
capital expenditure is characterized by:
Long-term effects
Effect on organizational operations extends far into the future.
Scope of current production activities governed largely by capital
expenditures in the past.
Current capital expenditure decisions provide the framework for future
activities.
Irreversibility
Wrong capital investment decision can not be reversed without incurring a
substantial loss.
Substantial outlay
Involve significant outlays of resources.
2. Capital Budgeting Decision
a long-term planning for making and financing investments on projects having a long-
term implication
 pose difficulties arising from:
cost and benefit measurement problems especially for;
development projects involving costs and benefits that cannot be objectively
quantified
projects involving some intangible consequences (e.g. improving employee
moral, quality of product)
projects having impact on other activities of an organization
uncertainty
great deal of uncertainty characterizes costs and benefits
temporal spread
costs and benefits are spread over a long period of time
example
cost reduction decision - e.g. facility replacement
expansion decision - e.g. construction of new facilities
facility selection decision - e.g. which facility to buy
make or buy decision
involves :
screening decision - whether a project meets standard of acceptance and
selection decision - selecting from among alternatives

1.9 Project Cycle

There are distinct stages that shall be passed in achieving goals of a project and that are repeated
in the right order whenever a project is to be undertaken. Project life cycle refers to the various
stages through which a project planning passes from its time of inception up to its completion. It
is the projects life cycle through which a project advances from infancy to maturity. The
stages/phases constitute a specific sequence that is cyclical in nature. Most, if not all, projects go
through a life cycle which varies with the size and complexity of the project. The main features
of this process are information gathering, analysis and decision making. Through the project
cycle, the primary preoccupation of the analyst is to consider alternatives, evaluate them and to
make decisions in which of them should be advanced to the next stage.

These stages of a project life cycle may differ according to the expression of different authors or
institutions. But the basic ones are the pre-investment phase, the investment phase and the
operational phases.

1.9.1 Project Cycle Models

Many Project Cycle models which differ in their perspective, emphasis and level of detail. Three
of these models are listed below and explained further in detail as follows:
A. The Baum Cycle
B. The New Project Cycle (World Bank 1994)
C. United Nation Industrial Development Organization (UNIDO) Project Life Cycle

A. The Baum Cycle (Adopted by the World Bank in 1970)

According to World Bank, project cycle involves five stages; namely, project identification,
project preparation, project appraisal, project implementation, and project evaluation. See the
following diagram:

Project identification

Project preparation

Project Appraisal

Project Implementation

Project evaluation

Lets highlight the major activities in each stage

1. Project Identification
This stage is also called pre-feasibility studies. In this stage, projects that can contribute towards
achieving the specified objectives are identified (listed). Project ideas may come from:
New experiments from previous project failures
New experiments from expansion
Replication of successful project tested elsewhere
New experiments from shortages or excess of resources
External threats
Opportunities
Internal strengths and/or weaknesses
Other sources
Project identification is also concerned with elimination of inferior alternatives (projects) from
the identified ones. The output of this stage is project that is prima-facie (at first sight or based
on first impression) promising and further work is justified. Chapter three will present pre-
feasibility study in more detail.
2. Project Preparation

Project preparation is the most important stage in project planning. Project preparation stage,
also called feasibility study, is concerned with the detailed study of all aspects of the projects.
Project feasibility study is the center of this course and will be explored in detail in chapter four
to seven.
3. Project Appraisal
Appraisal is the comprehensive and systematic assessment of all aspects of the proposed project.
The project is reviewed (appraised) to confirm that it accords with the broad objectives. It is to
ensure that the project represents a high priority use of the firms resources. What aspects of the
project should be appraised? The project is appraised from different perspectives: technical,
commercial (market), financial, economic and ecological.
4. Project Implementation
It is the stage at which the conclusions are reached & decisions made are put into action. What
activities should be done during project implementation? Some of the major activities in during
project implementation phase include:
Detailed designs and specifications are drawn;
Tender documents are prepared;
Bids are invited and evaluated,
Orders for imputes are placed;
Contracts are signed; workers are hired, trained and put to work;
Materials are moved to sites etc.
5. Project Evaluation
What is the major focus of project evaluation phase? Where it begins? Implementation phase is
followed by supervision and follow up. The execution of the project should be supervised closely
and progress should be reported regularly to ensure that the implementation is progressing
without deviating from the envisaged path and the objectives of the project have been reached.
Project evaluation is a monitoring (checking) activity in order to:
Find out how things are going
Encourage the project team
Check that promised resources are in fact working on project tasks
Rapidly learn about concerns and difficulties
Show concern for the success of the project
Take corrective action if things go wrong
B. New Project Cycle (World Bank 1994)
This cycle emphasizes on the issue of participation of different groups in the project. It is
particularly relevant where beneficiary participation is critical to the success of projects. It has
four distinct phases:
Listening- this is the stage of understanding the needs of the stakeholders of the
completed project.
Piloting- is a stage of trying the success or failure of the project in small scale operation
before scarce resources are spent and wasted.
Demonstrating-this is the stage of showing the stakeholders the successfulness of pilot
in an effort to convince them accept the whole project idea.
Mainstreaming- this is the stage of duplicating the pilot as large scale operation and
getting into the main project activity.
It can be shown by the following diagram:

Listening Piloting Demonstrating Mainstreaming

C. UNIDO (United Nation Industrial Development Organization) Project Cycle

According to UNIDO, project cycle involves three major phases. These are:
1. Pre-investment phase
2. Investment phase (Implementation phase)
3. Operation phase (operation and ex-post evaluation)
Each of the above stages (phases) will be explained in the section that follows:

1. Pre-investment phase
The pre-investment phase includes four major activities; namely, project identification, pre
selection, project preparation, and appraisal.

a). Project Identification / opportunity study/

Opportunity study is the main instrument used to quantity the parameters, information and data
required to develop a project idea in to a proposal. What aspects of the project should be
analyzed in opportunity study? In opportunity study, the firm is required to analysis the
following:
Availability of resources
Future demand for goods, increasing population and increasing purchasing power.
Import and export substitutions
Environmental impact
Success of similar projects elsewhere
Possible inter-linkage with other industries
Expansion through backward linkages (Backward integration) and forward linkages
(Forward integration)
Industrial policies of the government
General investment climate of the country
Export potentials
 Availability and cost of production

Generally, opportunity studies can be categorized in to Area studies, Industry studies, and
Resource based studies.

b). Pre-selection /pre-feasibility study/

This phase involves the analysis of the following factors:
Examination (investigation) of all possible project alternatives
Ensure that the detailed analysis of the project is justified.
In-depth investigation of critical areas of the project
Examine the attractiveness (viability) of the project
Investigate the stability of the environmental situation at the location site
The above analyses are based on guess-estimated data.

c). Preparation (feasibility study)

The projects justified by pre-feasibility study enter this phase for detailed analysis based on
investigated efforts than on guess-estimated. This stage provides all data, define, and critically
examine the commercial, technical, financial, economic, and environmental aspects for each
project. In feasibility study phase, window dressing approach should be avoided. What should be
the major components of feasibility study?
The components of feasibility study are:
1. Project Background and history
Name and address of the promoter
Project Background
Project objectives
Outline of the proposed basic project strategies
Project location
Economic and industrial policies supporting the project
2. Summary of market analysis and marketing concepts.
3. Raw materials and supplies
4. Location, site, and environment
5. Engineering and Technology
6. Organization and Management (
7. Implementation planning & budgeting
8. Financial Analysis and investment appraisal

d). Project Appraisal

After feasibility studies are completed, the projects should be presented to the appraising parties.
The appraisal of project is based on the objectives set earlier, the expected risk, costs, and gains.
The quality of feasibility studies makes easier the appraisal work. If the objective of the appraiser
is Return on investment, the project is appraised on this base.
Types of decisions to be taken during each pre-investment phases

Decision Type of study Decision goal

Identification Opportunity Identify opportunity
studies Determine critical areas for support studies
Determine area for pre-feasibility or feasibility study.
Pre-selection Support study Determine which of the possible choices is the most
viable
Pre-feasibility Determine provisional viability of the project
study Appraise whether the feasibility study should be
launched.
Support studies Investigate in detail selected criteria requiring in-
depth study
Final analysis Feasibility study Make the final choices of project characteristics
Determine the feasibility of the project and selected
criteria
Project Evaluation Make final investment decision
evaluation study
Project Appraisal report
Appraisal

2. Investment Phase

The investment phase, also called implementation phase, includes the following activities:
Establish legal, financial and organizational basis
Technology acquisition and transfer
Detailed engineering, design, contracting, tending & negotiations.
Acquisition of land, construction works, and installations
Pre- production marketing, securing of supplies, and setting up administration.
Recruitment, training, and placement of workers.
Plant commissioning and startup

3. Operating phase

Once activities listed under investment phase are completed, the project will go in to actual
operation. The operation involves producing the envisaged goods, and sale to the target market,
or renders the envisaged service to the target market. The project also requires evaluation, which
deals with the review of whether the project is being implemented as per expectation. The
necessary corrective actions should also be taken if deviation is identified.
 CHAPTER TWO
IDENTIFICATION AND FORMULATION OF PROJECTS

2.1 Generation of Project Ideas

Project idea is the statements of how a certain problem can be overcome or a particular policy
objective can be achieved

The search for promising project ideas is the first step towards establishing a successful venture.
Identification of investment opportunities requires imagination/thoughts, sensitivity to
environmental changes, and realistic assessment of what the investor can do. The task is partly
structured/planned and partly unstructured/unplanned, partly dependent on convergent thinking,
partly dependent on divergent thinking. However, there is no well-defined theory to guide the
task of identifying project opportunities.

A very common route for project formation is someone with specialized technical knowledge or
marketing expertise or some other competence feels that he/she 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 certain favorable features like
better quality or lower prices. This idea is endorsed by his associates and financial institutions.

To stimulate the flow of project ideas, SWOT analysis is helpful. It analyzes strengths,
weaknesses, opportunities and threats; SWOT analysis represents a conscious, deliberate, and
systematic effort by an organization to identify opportunities that can be profitably exploited by
it. Periodic SWOT analysis facilitates generation of idea.

2.2 Methods of Project Identification

According to Ministry of Economic Development and Cooperation, there are five methods for
identifying projects. They are the following:
1. Analyze major development problems: Development of a country depends heavily on the
way of handling the problems related to development. The development possibilities of the
country together with the problems that confront with the development should be analyzed
thoroughly. The ideas for development and problems have to be listed down in their order of
priority.
2. Analyze National Objectives: The stated objectives of the government (country) have to be
analyzed to formulate projects. The objectives of the country can be achieved only by
formulating suitable projects. The national objectives are always emerged on the basis of the
social needs. In other words, a proper analysis of the social needs is inheritable for
identifying suitable projects.
3. Economic Analysis: The nature and type of trade in a country provides a number of
opportunities for establishing projects. Information on imports, exports etc. may be obtained
from trade reports such reports may also shed light to the possible accessibility to the trade
sector of other countries and the investment opportunities in other countries. This
 information may pave the way for the establishment of a number of projects inside and
outside a country.
4. Natural Resource Survey: A survey on the natural resources of a country may facilitate for
identifying a number of projects. A country may also have a lot of unidentified natural
resources. A part of the resources that have already been known to the people might not
have been properly exploited. Thus surveys on both identified resources and unidentified
resources are important sources of project opportunities. Especially, agricultural and
mineral projects depend heavily on natural resource surveys.
5. Socio-Spatial Approach to Project Identification: This approach for identifying projects
usually employs the following:

A) Participatory Approach: The participatory approach of formulating projects is on the belief

that the projects should be formulated with the participation of the people. This approach
emphasizes that the first step in the project planning cycle is to consult the population about the
development needs of their area. Then, a situational analysis of major development bottlenecks
will be done with the participation of the people. As a result, many key projects, which are very
essential for the people, could be identified. Since these projects are formulated with the
participation of the people, they will have more acceptability and commitment of the community.

B) Area-based functional Analysis: This approach is to identify package projects or

complementary projects for a particular area, village, district, or community. These projects
usually aim at addressing problem of social and spatial inequalities. They may be part of the
overall development plan of the region or the country.

2.3 Sources of Project Ideas

The following are some suggestions for trapping the sources of good project idea.

1. Analyze the performance of existing industries: A study of existing industries in terms of

their profitability and capacity utilization is helpful. The analysis of profitability and breakeven
level of various industries and an examination of capacity utilization of various industries
indicate promising investment opportunities.

2. Examine the inputs and outputs of various industries: An analysis of inputs may throw up
project ideas. If inputs required are purchased from distant sources or if some firms produce
their inputs internally that can be supplied at a lower cost investment opportunity is there.
Similarly, a study of output may reveal opportunities for adding value through further processing
of main products, by-products, as well as waste products. One persons trash may be another
persons treasure.

3. Review Imports and Exports: An analysis of import statistics from period of 5 to 7 years is
helpful in understanding the trend of imports and the potential for import substitution. Local
production of such goods may improve the balance of payment situation and create employment
opportunities.
4. Study Plan Outlays and Government Guidelines: The governments proposed outlays in
different sectors, its priority areas in the development process, and its attitude towards private
investment will lead to a number of investment opportunities. Various incentives offered by the
government will also be helpful for formulating projects.

5. Look at the suggestions of Financial Institutions and Developmental Agencies :

Financial institution and development agencies offer suggestions to potential entrepreneurs. The
suggestions of these agencies are helpful in identifying promising projects.

6. Investigate Local materials and resources: A search for local materials will lead to a
number of project opportunities. We may come across unexplored raw materials and
unexploited labor skills.

7. Analyze Economic and Social Trends: A study of economic and social trends is helpful in
projecting demand for various goods and services. Changing economic conditions and consumer
preferences provide new business opportunities. The demand for timesaving products like fast
food, ovens etc. have been increasing.

8. Study new technological development: New products or new processes and technologies
for existing products developed by researchers may offer investment opportunities.

9. Draw Clues from consumption abroad: Products or supply of services which are new to
the country but extensively used abroad may be good ideas for investment.

10. Explore the possibility of reviving sick units: There may be a number of units, which have
been characterized as sick. A significant proportion of sick units can be nursed back to health,
by sound management, infusion of further capital, and provision of inputs. Hence, there is a
fairly good scope for investment in this area.

11. Identify unfulfilled psychological needs: Though goods are available in the market, there
may be customers who are not satisfied with the available products. The available products may
not be suitable for satisfying the particular passions and desires of certain customers. A study on
such unsatisfied needs may open doors for investment.

12. Attend Trade Fairs: National and international trade fairs provide excellent opportunities to
get to know about new products and developments.

13. Stimulate creativity for generating new product ideas: New product ideas may be
generated by thinking along the following lines: Modification, Rearrangement, Magnification,
Combination and Substitution.

14. Chance factors: You may come across various investment opportunities accidentally,
particularly while you are on a journey.

15. Unusual events such as drought, flood, earthquake, hostilities etc.

2.4 More Points on Project Identification

For a preliminary analysis to ascertain the viability of the idea conceived and alternative
investment opportunities identified the following should be considered.
a) Related natural resources base with the potential for exploitation.
b) Relevant agricultural pattern that can motivate agriculture based activities.
c) Potential demand for products in reaction to population increase, national income
increase (hence personal income) or due to the novelty of the product.
d) Imports and possible import substitution.
e) Experience of other countries with similar development, resource and economic
background.
f) Possible interlink-age with domestic/foreign industries.
g) Possible product line extension through integration with other existing set-ups:
i. Horizontal integration combination of organizations producing essentially similar
products or existing at the same stage of production, marketing or distribution. The
most common approach is to buy out competitors.
ii. Vertical integration combination of different types of organizations along the
supply chain:
Backward: when an organization starts to produce materials or components
needed to produce a finish product it currently produces e.g. when a bakery starts
to process flour
Forward: when an organization engaged in supply of inputs (materials or
components) starts to produce finished goods/services based on the inputs it
supplies e.g. when a flour mill starts baking bread
h) Possible diversification:
i. Conglomerate diversification widening product range by adding products
unrelated to existing ones e.g. when a college is engaged in transportation/bottling
affairs.
ii. Concentric diversification widening product range by adding products related to
existing ones in terms of processing, input or other requirements e.g. when a college
diversifies to distance education or when a food processing plant enters into
processing drinking items
i) Expansion of current capacity to attain economies of scale
j) General investment climate
k) Industrial policies
l) Availability of production factors
m) Export possibilities
2.4.1 General Project Identification Studies

Descriptive providing highlights only and usually conducted by :

Federal, regional or local government units such as investment bureaus.
National or international chamber of commerce.
A national or international investment promotion agency.
A national or international financing agency.
It is free from detailed cost or other quantitative analysis and divided into area, sub-sector and
resource-based studies.
1. Area Study concerned with a given geographic area such as an administrative province,
region or locality
a) Basic features of the area size, physical features and maps.
b) Population occupational pattern, per capita income, socio-economic background.
c) Main exports from and imports to the area.
d) Basic production factors exploited or exploitable.
e) Existing industries utilizing local resources.
f) Infrastructure facilities (conducive for investment) communication and power.
g) List of possible industries that can be developed based on the available resources and
infrastructure facilities.
h) Revised list of industries identified above excluding those:
With too small local demand.
Involving too high transportation costs.
Facing too severe competition from adjoining areas.
Which can be more favorably located in other areas.
With unacceptable environmental impacts.
Requiring feeder industries not available nearby.
For which markets are distantly located.
Which do not merit priorities as per national plans, allocation, etc.
i). Estimate present demand for industries listed above.
j). Identify approximate capacity.
k). Estimate capital costs taking into account land, technology, equipment, civil engineering
works, project implementation, pre-investment capital expenditure and working capital
requirement.
l). Approximate estimation of major input requirements such as raw materials, components,
supplies, utilities and labor including sources (local vs. imported).
m). Estimate production costs.
n). Estimate annual sales revenue.
o). Organizational and management aspects typical for the industry.
p). An indicative time schedule for project implementation.
q). Total contemplated investments in project and peripheral activities.
r). Projected and recommended source of finance.
s). Estimated foreign exchange requirements and earnings.
t). Financial evaluation approximate payoff, RR, possible advantages and potentiality of
enlarged product-mix, diversification, etc.
u). Tentative analysis of overall economic benefits:
Those related to national economic objectives.
Balanced dispersal of economic activities.
Foreign exchange savings.
Generation of employment opportunities.
Economic diversification.
2. Sub-sectoral Study concerned with a certain industrial branch such as food processing,
leather or electronics:
i. Place and role of the sub-sector in industry.
 ii. Size, structure, growth rate of the sub-sector.
iii. Present size and rate of growth of demand of items that are not imported and of those
wholly or partially imported.
iv. Rough projection of demand for each item.
v. Identification of the items in short supply that have growth and/or export potential.
vi. A broad survey of the raw materials indigenously available.
vii. Identification of investment opportunities based on items ii, v and vi and other
important factors such as transport cost, available and potential infrastructure.
viii. Continue with items "k" to "u" of area study - once the investment opportunities are
identified, the structural requirements of both the area and sub-sect oral studies are the
same.
3). Resource-based Study dealing with utilization or exploitation of certain resources such as
forestry and minerals
i. Characteristics of the resource, prospective and proven reserves, past rate of growth and
potential for future growth.
ii. Role of the resources in the national economy, its utilization, demand in the country and
exports.
iii. Industries currently based on the resources, their structure and growth, capital employed
and labor engaged productivity and performance criteria, future plans and growth
prospects.
iv. major constraints and conditions in growth of industries based on the resources
v. Estimated growth in demand and prospects of export of items that could utilize the
resources.
vi. Identification of investment opportunities based on items iii, iv and v.
vii. Continue with items xi to xxi of area study - once the investment opportunities are
identified, the structural requirements of both the area and resource-based studies are the
same.
2.4.2 Specific Project Identification Studies

It is more common than a general opportunity studies and follow the general opportunity studies.
It can be defined as the transformation of a project idea into a broad investment proposition. In
developing countries, this is done by a governmental investment promotion agency or chamber
of commerce.

It may be undertaken by the prospective investor or an entrepreneurial group. As the objective is

to stimulate investor responses, the mere listing of products (based on general economic
indicators such as past imports, growing consumer demand or from one of the general
opportunity studies relating to areas, sectors or resources) that may have potential for domestic
manufacture is not sufficient, it, however, may serve as a starting point.

Should include certain basic information:

Be selective as to the products identified.
Incorporate data (e.g. demand and resource requirement) relating to each product so that
potential investors will be able to consider whether the possibilities are attractive enough
to proceed to the next stage of project preparation.
 Such data can be supplemented with information on basic governmental policies and
procedures that may be relevant to the production of the particular product.

2.5 Preliminary Screening

Using the above mentioned guidelines, it is possible to develop a long list of project ideas. But,
all these ideas may not be promising. Therefore, a preliminary screening is required to eliminate
ideas which prima facie are not promising. In order to do a preliminary screening the following
aspects have to be taken into account.

1. Compatibility with the promoter

In choosing from the project ideas, it has to be borne in mind that the ideas must be compatible
with the interest, personality, and resources of the entrepreneur. A real project opportunity has
three characteristics;
i. It fits the personality-ability and training-of the entrepreneur
ii. It is accessible to him and
iii. It offers him the prospect of rapid growth and high return on invested capital.
2. Consistency with Government Priorities

The project idea under consideration must be capable of meeting the national goals and be within
the framework of the regulation of the government. Some of these regulations are:
environmental regulations, foreign exchange restrictions, and the procedure for giving licenses.
The project must be within the environmental impacts regulations and should never be contrary
to such regulations. The foreign exchange requirement of the project must be within the foreign
exchange regulations of the country. It should also be checked whether the project is able to
obtain license from the government or it falls under business areas that are restricted by the
government.

3. Availability of Inputs

The resources and inputs required for the project must be reasonably assured. A number of
projects in some of the developing countries face with shortages of inputs like power, foreign
exchange, and important raw materials. Therefore, the project under consideration should make
sure that:
i. The capital requirements of the project are within the manageable limits.
ii. The technical knowhow can be obtained.
iii. Raw materials are available and
iv. The power supply and infrastructural facilities are adequate.

4. Adequacy of the Market

The size of the market offers the prospect of adequate sales volume. There should be a potential
for growth and a reasonable return on investment. Therefore, the overall situation of the market
should be paid attention in the secretion of a project idea. The total present domestic market,
export market, competitors and their market shares, sales and distribution system, and projected
increase in consumption are some of the factors that influence the marketing aspect of the
project. In other words, the project under consideration must make sure that adequate market
will be available for the product of the project.

5. Reasonableness of Cost

Availability of inputs at exorbitant rates will never help the project to be successful. Therefore,
the proposed project must see that it can get the necessary inputs at reasonable costs. The costs
of materials, labor costs, factory overheads, administrative and selling costs, and service costs
must be affordable and within the limits of the project cost structure. Thus, it is better to select a
project for which the inputs are available at reasonable cost and drop a project for which
materials and other inputs are available only at a high cost.

6. Acceptability of Risk Level

The desirability of a project is critically dependent on the risk characterizing it. A project that is
exposed to low risk is always advisable. In the assessment of risk, the factors to be considered
are;
(1) Technological changes
(2) Competition from substitutes
(3) Competition from imports and
(4) Governmental control over price and distribution

CHAPTER THREE
PROJECT PREPARATION (FEASIBILTY STUDIES)
3.1 Introduction

After ensuring that a project idea is suitable for implementation, a detailed feasibility study
giving additional information on financing, breakdown of cost of capital and cash flow is
prepared. Feasibility study is the final document in the formulation of a project proposal and it
can be prepared by either the entrepreneur or consultants or experts. Feasibility study (project
preparation) is a detailed analysis of prima facie promising/most viable project ideas. It provides
commercial, technical, environmental, financial, economic and social information needed for
investment decision making. Feasibility study must provide all data necessary for an investment
decision. The cost of feasibility study is can be debited to project cost and can be counted as part
of promoters contribution.
Feasibility study (project preparation phase) of a project may have the following major
components:
1. Market and demand analysis
2. Technical Analysis
3. Financial Analysis
4. Economic /social cost benefit analysis
5. Environmental Analysis
3.2 Market and Demand Analysis
3.2.1 Objectives of Market Analysis
Market and demand analysis is a key activity for determining the scope of an investment, the
possible production programme, the technology required, and the choice of location. What are
the objectives of market and demand analysis? The objectives of demand and marketing analysis
are:
To determine the effective demand for the envisaged (proposed) project
To determine the characteristics of the corresponding market in terms of unsatisfied
demand, competition, imports, exports etc.

Put differently, marketer and demand analyst is concerned with two broad issues;
1. What is the likely aggregate demand for the output? and
2. What share of the market will the proposed project enjoy?

The project analyst should be able to establish the relationship between the product and its
market. To do so, she/he may informally talk to the following parties:
- customers,
- competitors
- middlemen (wholesalers and retailers)
The purpose of contact with the above parties is to learn about the preferences and purchasing
power of customers, actions, and strategies of competitors, and practices of middlemen. The
main benefit of such informal contact is to avoid formal study of the market if adequate and
relevant information is obtained about project demand. If enough data was not generated at this
stage, formal market and demand analysis should be carried.

3.2.2 Marketing Research

A concise and systematic assessment of information on the market and market environment is
essential for the development of the project strategy. It is the task of marketing research to
obtain, analyze and interpret the information on the market. Marketing Research concentrate
mainly in the analysis of demand, competition, customer behavior, consumer needs etc.

In order to achieve the market and demand analysis objectives, information should be obtained
from various sources. These sources are generally classified into primary sources and secondary
sources.

Sources of Secondary Information (Desk Research)

Secondary information is information that is gathered in some other context and is already
available. The important sources of secondary information are:
 a) Census: The Central Statistical Authority (CSA) gathers and publishes data about
population, demographic characteristics, household size and composition and other
similar data
b) Economic survey
c) Annual reports on imports and exports
d) Industry specific sources
The reliability, accuracy and relevance of secondary information should be examined carefully in
terms of:
- Who gathered the information and the purpose (objective) for which it was gathered
- The time of information gathering and publication
- The relevance of information gathers for the period
- Target population
- The means of choosing the sample
- The representativeness of the sample
3.2.3 Primary Information/Market Survey (Field Survey)
Secondary sources may not provide a comprehensive data for market and demand analysis.
Information obtained through secondary sources should be supplemented with primary
information gathered through market survey.

The market survey may be a census, or a sample survey. In a census survey, the entire population
is covered. The term population refers to the totality of all units under consideration in a specific
study.
Example:
- All higher private educational institutions
- All firms producing textile
Census survey may involve high cost and insensible. When census survey is impractical (all
elements of the population are not covered), sample survey is more useful.

What kind of information should be gathered through market survey? The following types of
information may be collected through market survey:
- Total demand and rate of growth of demand
- Motives for buying
- Demand in different segments of the market
- Income and price elasticity of demand
- Purchasing plans and intentions
- Satisfaction with existing products
- Unsatisfied needs
- Attitudes towards various products
- Distribution and price practices and preferences
- Socio-economic characteristics of buyers
The steps in sample market survey include:
1. Define the target population
2. Selecting the sampling method and sample size
3. Develop the questionnaire
4. Recruit and train the field investigators
5. Obtain information as per the questionnaire from the sample of respondents
6. Summarized the information gathered
7. Analyze and interpret the information

3.2.4 Characterization of the Market

3.2.4.1 Breakdown of Demand/Market Segmentation
The total (aggregate) demand for the product may be broken down into demand for segments of
the market.

Market segmentation is defined as the dividing of the target market into subgroups of consumer
population with identifiable, distinct and homogeneous characteristics. (Philip Kotler, 1999). The
main reasons of market segmentation are:
- efficient use of marketing resources
- better understanding of customer needs
- better understanding of the competitive situation
- accurate measurement of goals and performance
- formulate marketing programs and strategies
- Design marketing mix (i.e., product, price, place, and promotion).
- Pay proper attention to particular area

Market is segmented on varies bases. Some of the most common bases are:
- Geographic segmentation divide the market into different geographic units such as
western, eastern, northern, southern, central etc.
- Demographic segmentation divide the market on the basis of age, sex, family size,
marital status, language, religion and so on
- Socio-economic segmentation divide the market on the basis of income levels,
consumption levels, caste level (exclusive social class), culture and the like
- Psychographics segmentation divide the market based on how consumers think, feel,
and behave
- Buyer behavior segmentation divide the market based on customers knowledge,
attitudes, rules, or responses to a product.

3.2.4.2Price
Price represents the value of a good or service for both the buyer and the seller. Price is the only
element in the marketing mix which generates revenues. Price may also be defined as the value
of product attributes expressed in monetary terms which a consumer pays or is expected to pay in
exchange and anticipation of the expected utility.

What factors affect the firms pricing decisions? Factors which affect the pricing decisions are
both internal and external. External factors that affect pricing decisions include:
- Demand for the product/service
- Competition
- Consumers quality perceptions
- Middlemen (distributors, detailers etc)
- Suppliers
- Government
- Economic conditions
- Ethical considerations
- Cost of materials and labor (or cost of inputs)

Internal factors that affect pricing decisions include:

- Organizational factors
- Marketing mix
- Product differentiation (different product attributes such as color, size, attractive package,
attractive uses, style etc).
- Cost of products
- Objective of the firm

What pricing strategy the firm may follow?

A firm that is planning to introduce new product may follow any one of the following pricing
strategy:
a) Market skimming pricing: It is the approach of setting a relatively high initial price for a
new product.

b) Market penetration pricing: It is the strategy of setting a relatively low initial price for new
product.

3.2.4.3 Distribution
What are the major components of the distribution system? Distribution system has two
components; namely, channels of distribution, and physical distribution. Channels of
distribution refer to intermediaries or the process through which the products are transferred
from the producers to the ultimate users. Channels include wholesalers, retailers, dealers, agents
and other parties involved in transferring the product or service to the consumers.

On the other hand, physical distribution is concerned with the flow of goods to the ultimate
consumers. Physical distribution includes transportation, warehousing, and inventory
management.
Therefore, the methods of distribution (channels and physical distribution) employed presently
and their rationale must be specified during market and demand analysis. Such a study may
explain certain patterns of consumption and highlights and difficulties that may be encountered
in marketing the proposed products.

3.2.4.4 Promotion
In marketing, the word promotion is used in many ways. In general sense, promotion is
defined as any identifiable activities (efforts) on the parts of the seller to persuade buyers to
accept the sellers information and store it in retrievable form. The promotional function of any
organization involves the transmission of message to present, past, and potential customers.

The means of promotion are:

a) Personal selling It involves face-to-face contact between sellers representative and the
buyer
b) Advertising. It is paid form of non-personal mass media communication by an identified
sponsor. The media may include print media, direct mail, TV, radio, billboard, Internet
etc.
c) Sales Promotion. It includes activities that seek to indirectly induce or indirectly serve as
incentives to motivate a desired response on the part of target customers, company sales
people and middlemen, and their sales force.
d) Publicity. It involves the news carried in the mass media about a firm and its products,
policies, personnel or actions, such as news releases, press conference etc.
e) Public relations. It is a planned effort by an organization to influence the attitudes and
opinions of a specific group.

The primary objectives of promotion are:

- to develop an awareness of, and an interest in, the organization and its products and
services
- to communicate the benefits of buying product or services
- To influence eventual purchase of the product or service
- To build the positive image of the organization
- To differentiate the product/service from its competitors
- To remind the people of the existence of the product/service and the organization

Therefore, during market and demand analysis, the project studying team should specify the
promotion methods employed presently and their rationale.

3.2.4.5 Supply and Competition

It is necessary to know the existing sources of supply. The existing sources may be domestic or
foreign. The following information should be gathered for domestic sources of supply.
- Location
 - Present production capacity
- Planned expansion
- Capacity utilization level
- Bottlenecks in production
- Cost structure
The study should also cover competition from substitutes and near-substitute products.

3.2.4.6 Government Policy

Government may have significant role in influencing the products demand and market. How
government affects the demand and market for the product? Governmental plans, policies and
legislations may have bearing on the market and demand of the product. Some of the areas of
influence are:
- production targets in national plans
- trade control on imports and exports
- import duties
- export and import incentives
- excise duties
- taxes
- industrial licensing
- credit controls
- financial regulations
- subsidies or penalties of any kind

3.2.5 Demand Forecasting Methods

After gathering information about various aspects of the market and demand from primary and
secondary sources, an attempt is made to estimate future demand. The market analyst has several
methods of forecasting the demand. Generally, these methods are classified in to qualitative and
quantitative methods.

Qualitative methods include:

1. Jury of executive opinion method
2. Delphi method
Quantitative methods include:
1. Trend projection method
2. Exponential smoothing method
3. Moving average method
4. End use (consumption coefficient) method
Each of these methods is explained below:
3.2.5.1 Qualitative Methods
1. Jury of Executive Opinion Method: This method involves soliciting the opinions of a group
of managers on expected future sales and then combining them into a sales estimate. It is the
most popular method used in practice. Some of the advantages of
Jury of Executive Opinion Method is:
- an expeditious method for developing a demand forecast
- Enables to consider a variety of factors to be included in the subjective estimates provided
by the experts. These factors include economic climate, competitive environment,
consumer preferences, technological developments and the like.
- Immense appeal to managers who tend to prefer their judgment to mechanistic forecasting
procedures.
The jury of executive opinion method is not without limitations. Some of its limitations are:
- It involves greater subjective
- Its reliability 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. Delphi method involves the following steps:
a) Send a questionnaire to a group of experts by mail asking them to express their views.
b) The responses received from the experts are summarized without disclosing the identity of
the experts. Then the summary is sent to the experts along with a questionnaire that helps
to probe further the reasons for the extreme views expressed in the first round.
c) The process may be continued for one or more rounds till a reasonable agreement emerges
in the view of the experts.

Delphi method has got the following advantages:

- It is intelligible to users
- It seems to be more accurate
- It seems to be less expensive than the tradition face-to-face group meetings
The limitations of Delphi method are:
- It is difficult to value the expert opinion
- It is not easy to measure the contribution of additional rounds and feedback to accuracy.

3.2.5.2 Quantitative Methods

1. Trend projection method (regression analysis) also called least square method; Demand
forecasting by trend projection method involves interrelated steps: These are:
i. Obtain demand data for some past periods, such as 10 years. This involves determine
the trend of consumption by analyzing past consumption statistics
ii. Establish liner relationship using the following formula:
Yt = a + bT
Where,
Yt = Demand for year t
a = Intercept of the relationship
b = Slope of the relationship
T= Time variable
The values of a and b can be determined using the following formula:
Sxy
b=
Sxx
n
n(n 1) n
Sxy n iDi Di
i 1 2 i 1

Where,
n = No of observation
i = the ith observation
Di = the ith outcome
n 2 (n 1)( 2n 1) n 2 (n 1) 2
Sxx
6 4
b(n 1)
a= D
2
Where, D = the arithmetic average of the demands during periods 1, 2, n.
To illustrate demand forecasting using simple regression analysis, consider the following data
concerning demand for product x during the last eight years.

Year 1 2 3 4 5 6 7 8
Actual demand 200 250 175 186 225 285 305 190
The linear equation for the above data is formulated as follows: assuming that the base line is the
first five years:

Yt = a + bT
n
n(n 1) n
Sxy n iDi Di
i 1 2 i 1

= 5[(200 x 1) + (250 x 2) + (175 x 3) + (186 x 4) + (225 x 5)

5(5 1)
2 [200 + 250 + 175 + 186 + 225]
5(6)
= 5[200 + 500 + 525 + 744 + 1125] - [1,036]= 5[3094] 15[1036]
2
= 15470 15,540 = -70
n 2 (n 1)( 2n 1) n 2 (n 1) 2 5 2 (5 1)( 2(5) 1) 5 2 (5 1) 2
Sxx =
6 4 6 4
 25(6)(11) 25(36)
= = 275 225= 50
6 4
After Sxy and Sxx are obtained, b can be computed as:
Sxy 70 7
b=
Sxx 50 5
Then a is computed as:
b(n 1)
a= D
2
200 250 175 186 225
D 207.20
5
7
5 1 42

a = 207.20 - 5 = 207.20 5 = 207.20 + 21 = 211.40
2 2 5


It follows that the regression equation based on five periods of data is:
7
Yt = 211.40 T
5

The above regression equation is used to forecast demand from period five to any period into the
future. For example, the demand forecast for period 7 (T = 7) is computed as follows:
7 7 49 1075 49 1008
Yt = 211.40 - T = 211.40 - (7) = 211.40 - = = = 201.6
5 5 5 5 5
Similarly demand for year 10 (T = 10) is forecasted as follows:
7
Yt = 211.40 - (10) = 211.40 14 = 197.4
5
Alternatively, the values of a and b can be computed as follows:
Yt = a + bT
n TY T Y Y b T
b= a=
n T 2 T
2
n
Using the above data, the computations of a and b are as follows:
Year (T) Actual demand (Y) TY T2
1 200 200 1
2 250 500 4
3 175 525 9
4 186 744 16
5 225 1125 25
= 15 = 1036 = 3094 = 55
 n TY T Y
b=
n T 2 T
2

5(3094) (15 x1036) 15470 15540 70 7

= = = =
5(55) (15) 2
275 225 50 5
7
1036 15
a=
Y b T = 5 = 1036 21 = 211.40
n 5 5
7
Yt = 211.40 - T
5
2. Exponential smoothing: Exponential smoothing is another very popular demand forecasting
method. Under exponential smoothing, the current forecast is the weighted average of the last
forecast and the current value of demand. That is:

New forecast: (current observation of demand) + (1-) (last forecast)

In symbols,
Ft = Dt-1 + (1 - ) Ft-1
Where 0 < 1 is the smoothing constant. (alpha) determines the relative weight placed on the
current observation of demand. 1 - is interpreted as the weight placed on past observations of
demand. D refers to the actual demand of current period (t-1). The above formula can be
rewritten as follows:
Ft = Ft-1 + (Dt-1 Ft-1)
Where
Ft-1 = previous forecast
= smoothing constant
Ft = New forecast
Dt-1 = the demand for the current period.
From the above description, it is possible to conclude that exponential smoothing method
requires only three items of data:
the last periods forecast,
the demand for the current period, and
the smoothing constant ().

To illustrate demand forecasting using exponential smoothing, assume that demand for product
X in April was forecasted to be 120 units (Ft-1 = 120). Actual April demand was 140 units (Dt-1 =
140). If smoothing constant is 0.4 ( = 0.40), the forecast for May would be:
FMay = Ft-1 + (Dt-1 Ft-1)
= 120 + 0.40 (140 120) = 120 + 8 = 128
Exponential smoothing applies a declining set of weights to all past data. If is large, more
weight is placed on the current observation of demand and less weight on past observations. On
the other hand, if is small, then more weight is placed on past data and the forecasts are more
stable. Thus, alpha () indicates the weight of importance given for past forecasting inaccuracies
in forecasting the next time period dictating how much correction will be made.

To further illustrate exponential smoothing, assume that Grace Company has the following
recorded demand for its product Y in the last 8 quarters: The smoothing constant is 10%.

Year 1 2 3 4 5 6 7 8
Actual demand (D) 200 250 175 186 225 285 305 190

Forecast (F): 200 (By assumption)

The demand forecast for periods 2 5 are shown below:
Ft = Ft-1 + (Dt-1 Ft-1)
F2 = 200 + 0.10 (200 200) = 200
F3 = 200 + 0.10 (250 200) 205
F4 = 205 + 0.10 (175 205) = 202
F5 = 202 + 0.10 (186 202) = 200.4

3. Moving Average Method: According to this method, the forecast for the next period is equal
to the average of the sales for several preceding periods.
S S t 1 ... S t b1
Ft 1 t
n
Where:
Ft+1 = Forecast for the next period
St = Sales for period t
n = period over which averaging is done

To illustrate, consider the following data for the past 10 years.

Year 1 2 3 4 5 6 7 8 9 10
Sales (Actual) 80 60 70 90 75 100 80 85 60 80
If the company uses a four-year moving average, sales forecast for year 5 is:
S1 S 2 S 3 S 4
4
80 60 70 90
F5 = = 75
4
If the company uses a nine-year moving average, sales forecast for the 10th year is:
S1 S 2 S 3 S 4 S 5 S 6 S 7 S8 S 9
9
 80 60 70 90 75 100 80 85 60
F10 = 77.78
9
If the company uses a five-year moving average, the sales forecast for year 11 is:
S 6 S 7 S8 S 9 S10
5
100 80 85 60 80
F11 = 81
5
To elaborate the above answer (F11 = 81), the sales figure of the last five years (year 6, 7, 8, 9
and 10) are taken to forecast sales of year 11.
If the company uses a five year moving average, what will be sales forecast for year 12 and year
13?
S S 8 S 9 S10 S11 80 85 60 80 81
F12 = 7 77.20
5 5
S S 9 S10 S11 S12 85 60 80 81 77.20
F13 = 8 76.74
5 5
4. End use method: End use method, also called consumption coefficient method, is more
suitable for estimating the demand for intermediate products. Intermediate products are
considered output of one company and then input of another company. For example, chips
are the output to the chip manufacturer but input to computer producing company. The use of
end use method in demand forecasting involves the following steps.

Step 1: Identify the possible uses of the product

Step 2: Define the consumption coefficient (usage rate) of the product for various uses.
Step 3: Project the output levels for the consuming industries
Step 4: Derive the demand for the product.

To illustrate the application of end use method, lets assume that four industries (electronics
industry, computer industry, Electricity Company, and Telecommunication Company) use chips
as input to their products. The chip manufacturer prefers to use End Use Method to forecasting
demand for chips in the upcoming year. The company collected consumption coefficient and
projected output of each industry and summarized the data below:
Industry Consumption Projected output for
Coefficient each industry

Electronics 5 10,000
Computer 4 30,000
Electricity 6 15,000
Telecommunication 7 20,000

Required: Determine the total forecasted demand for chips

To give a solution to the above question, it is advisable to understand the data properly. The
consumption coefficient indicates the rate of input (chips) per unit of output. For instance, the
consumption coefficient of 5 for electronics industry implies that the industry uses 5 chips to
produce one unit of its output. The 3rd column shows the planned production for each industry.
Accordingly, demand for chips in the coming year is computed as follows:

Industry Consumption Projected Projected demand

Coefficient output for chips
Electronics 5 10,000 50,000
Computer 4 30,000 120,000
Electricity 6 15,000 90,000
Telecommunication 7 20,000 140,000
Total forecasted chips

3.3 Technical Analysis

3.2.2 Introduction

Analysis of technical and engineering aspects is done continually when a project is being
examined and formulated. Other types of analysis are closely intertwined with technical analysis.
The broad purpose of technical analysis is (a) to ensure that the project is technically feasible in
the sense that all the inputs required to set up the project are available, and (b) to facilitate the
most optimal formulation of the project in terms of technology, size, location, and so on.

While technical analysis is essentially the preserve of the technical expert, the financial analyst
participating in the project appraisal exercise should be able to raise basic issues relating to
technical analysis using common sense and economic logic. To this effect, this section of
feasibility study covers these issues very broadly in terms of:
Manufacturing process/technology
Technical arrangements
Materials and inputs
Product mix
Plant capacity
Location and site
Machineries and equipments
Structures and civil works
Environmental aspects
Project charts and layouts
Project implementation schedule
Need for considering alternatives
3.2.3 Manufacturing Process/Technology

For manufacturing a product/service often two or more alternative technologies are available.
For example:
Steel can be made either by the Bessemer process or the open-hearth process.
Cement can be made either by the dry process or the wet process.
Soda can be made by the electrolysis method or the chemical method.
Soap can be manufactured by the semi-boiled process or the fully boiled process.

3.3.1.1 Choice of Technology

The choice of technology is influenced by a variety of considerations. Some of these are:

1. Plant Capacity. Often, there is a close relationship between plant capacity and production
technology. To meet a given capacity requirement perhaps only a certain production technology
may be viable.

2. Principal Inputs The choice of technology depends on the principal inputs available for the
project. In some cases, the raw materials available influence the technology chosen. For
example, the quality of limestones determines whether the wet or dry process should be used for
a cement plant.

3. Investment Outlay and Production Cost. The effect of alternative technologies on

investment outlay and production cost over a period of time should be carefully assessed.

4. Uses by Other Units. The technology adopted must be proven by successful use by other
units.

5. Product Mix. The technology chosen must be judged in terms of the total product mix
generated by it, including saleable byproducts.

6. Latest Developments. The technology adopted must be based on the latest developments in
order to ensure that the likelihood of technological obsolescence in the near future, at least, is
minimized.

7. Ease of Absorption. The ease with which a particular technology can be absorbed can
influence the choice of technology. Sometimes a high level technology may be beyond the
absorptive capacity of a developing country, which may lack trained personnel to handle that
technology.
3.3.1.2 . Appropriateness of Technology

Appropriate technology refers to those methods of production, which are suitable to local
economic, social, and cultural conditions. The advocates of appropriate technology urge that the
technology should be evaluated in terms of the following questions:
Whether the technology utilizes local raw materials?
Whether the technology utilizes local manpower?
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?
3.3.2 Technical Arrangements

Satisfactory arrangements must be made to obtain the technical know-how needed for the
proposed manufacturing process. When collaboration is sought, inter alia (among other things),
the following aspects of the agreement must be worked out in detail:
The nature of support to provided by the collaborators during the designing of the project,
selection and procurement of equipment, installation and erection of the plant, operation
and maintenance of the plant, and training of the project personnel.
Process and performance guarantees in terms of plant capacity, product quality, and
consumption of raw materials and utilities.
The price of technology in terms of one-time licensing fee and periodic royalty fee.
The continuing benefit of research and development work being done by the collaborator.
The period of collaboration agreement.
The assistance to be provided and the restrictions to be imposed by the collaborator with
respect to exports.
The level of equity participation and the manner of sharing management control,
especially if the technical collaboration is backed by financial collaboration.
Assignment of the agreement by either side in case of change of ownership.
Termination of the agreement or other remedies when either party fails to meet its
obligation.
Approach to be adopted in force majeure situations.

3.3.3 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 programmes.
There is an intimate relationship between the study of materials and utilities and other aspects of
project formulation, particularly those concerned with location, technology, and equipments.
Material inputs and utilities may be classified into four broad categories: (i) raw materials, (ii)
processed industrial materials and components, (iii) auxiliary materials and factory supplies, and
(iv) Utilities.

Raw Materials: Raw materials (processed and/or semi-processed) may be classified into four
types: (i) agricultural products, (ii) mineral products, (iii) livestock and forest products, and (iv)
Marine products.

1. Agricultural products. In studying agricultural products, the quality must first be examined.
Then, an assessment of the quantities available, currently and potentially, is required. The
questions that may be raised in this context are: What is the present marketable surplus? What is
the present area under cultivation? What is the likely increase in yield per acre?

2. Mineral Products. In assessing mineral raw materials, information is required on the quantum
of exploitable deposits and the properties of the raw materials. The study should provide details
of the location, size, and depth of the deposits and the viability of open cast or underground
mining. In addition, information should be generated on the composition of the ore, level of
impurities, need for beneficiation, and physical, chemical and other properties.

3. Livestock and Forest Products. Secondary sources of data on livestock and forest products
often do not provide a dependable basis for estimation. Hence, in general, a specific survey may
be required to obtain more reliable data on the quantum of livestock product and forest products.

4. Marine Products. Assessing the potential availability of marine products and the cost of
collection is somewhat difficult. Preliminary marine operations, essential for this purpose, have
to be provided for in the feasibility study.

Processed Industrial Materials and Components: Processed industrial materials and

components (base metals, semi-processed materials, manufactured parts, components, and sub-
assemblies) represent important inputs for a number of industries. In studying them the following
questions need to be answered: In the case of industrial materials, what are their properties?
What is the total requirement of the project? What quantity would be available from domestic
sources? What quantity can be procured from foreign sources? How dependable are the supplies?
What has been the past trend in prices?

Auxiliary Materials and Factory Supplies: In addition to the basic raw materials and
processed industrial materials and components, a manufacturing project requires various
auxiliary materials and factory supplies like chemicals, additives, packaging materials, paint,
varnishes, oils, grease, cleaning materials, etc. The requirements of such auxiliary materials and
supplies should be taken into account in the feasibility study.
Utilities: A broad assessment of utilities (power, water, steam, fuel, etc.) may be made at the
time of the input study though a detailed assessment can be made only after formulating the
project with respect to location, technology, and plant capacity. Since the successful operation of
a project critically depends on the adequate availability of utilities, the following questions
should be raised while conducting the inputs study. What quantities are required? What are the
sources of supply? What would be the potential availability? What are the likely shortages/
bottlenecks? What measures may be taken to augment supplies?
3.3.4 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. For
example, a garment manufacturer may have a wide range in terms of size and quality to cater to
different customers. It may be noted that variation in quality can enable company to expand its
market and enjoy higher profitability. For example, a toilet soap-manufacturing unit may, by
variation in raw material, packaging, and sales promotion, offer high profit margin soap to
consumers in the upper-income brackets.

3.3.5 Plant Capacity

Plant capacity (also referred to as production capacity) refers to the volume or number of units
that can be manufactured during a given period. Plant capacity may be defined in two ways:
feasible normal capacity (FNC) and nominal maximum capacity (NMC). The feasible normal
capacity refers to the capacity attainable under normal working conditions. This may be
established on the basis of the installed capacity, technical conditions of the plant, normal
stoppages, and downtime for maintenance and tool changes, holidays, and shift patterns. The
nominal maximum capacity is the capacity, which is technically attainable, and this often
corresponds to the installed capacity guaranteed by the supplier of the plant. Our discussion will
focus on the feasible normal capacity. Several factors have a bearing on the capacity decision.
These are:

Technological requirement
Input constraints
Investment cost
Market conditions
Resources of the firm
Governmental policy

Technological Requirement: For many industrial projects, particularly in process type

industries, there is a certain minimum economic size determined by the technological factor. For
example, a cement plant should have a capacity of at least 300 tons per day in order to use the
rotary kiln method; otherwise, it has to employ the vertical shaft method, which is suitable for
lower capacity.

Input Constraints: In a developing country, there may be constraints on the availability of

certain inputs. Power supply may be limited; basic raw materials may be scarce; foreign
exchange available for imports may be inadequate. Constraints of these kinds should be borne in
mind while choosing the plant capacity.

Market Conditions: The anticipated market for the product /service has an important bearing on
the plant capacity. If the market for the product is likely to be very strong, a plant of higher
capacity is preferable. If the market is likely to be uncertain, it might be advantageous to start
with a smaller capacity. If the market, starting from a small base, is expected to grow rapidly, the
initial capacity may be higher than the initial level of demand and further additions to capacity
may be effected with the growth of the market.

Resources of the Firm: The resources, managerial and financial, available to a firm define a
limit on its capacity decision. Obviously, a firm cannot choose a scale of operations beyond its
financial resources and managerial capability.

Government policy: The capacity level may be influenced by the policy of the government.
Traditionally, the policy of the government was to distribute the additional capacity to be created
in a certain industry among several firms, regardless of economies of scale. This policy has been
substantially modified in recent years and the concept of minimum economic capacity has been
adopted in several industries.

3.3.6 Location and Site

The choice of location and site follows an assessment of demand, size, and input requirement.
Though often used synonymously, the terms location and site should be distinguished.
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, availability of infrastructure, labor situation, governmental policies, and other
factors.

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. In
terms of a basic location model, the optimal location is one where the total cost (raw material,
transportation cost plus production cost plus distribution cost for the final product) is minimized.
This generally implies that:
 A resource- based project like a cement plant or a steel mill should be located close to the
source of the basic material (for example, limestone in the case of a cement plant and iron
ore in the case of a steel plant);
A project based on imported material may be located near a port; and
A project manufacturing a perishable product should be close to the centre of
consumption.

However, for many industrial products proximity to the source of raw material or the centre of
consumption may not be very important. Petro-chemical units or refineries, for example, may be
located close to the source of raw material, or close to the centre of consumption, or at some
intermediate point.

Availability of Infrastructure: Availability of power, transportation, water, and

communications should be carefully assessed before a location decision is made.

Adequate supply of power is a very important condition for location-insufficient power can be a
major constraint, particularly in the case of an electricity-intensive project like an aluminum
plant. In evaluating power supply the following should be looked into: the quantum of power
available, the stability of the power supply, the structure of the power tariff, and the investment
required by the project for a tie-up in the net work of the power supplying agency.

For transporting the inputs of the project and distributing the outputs of the project, adequate
transport connections-whether by rail, road, sea inland water, or air-are required. The
availability, reliability, and cost of transportation for various alternative locations should be
assessed.

Given the plant capacity and the type of technology, the water requirement for the project can be
assessed. Once the required quantity is estimated, the amount to be drawn from the public utility
system and the amount to be provided by the project from surface or sub-surface sources may be
determined. For doing this the following factors may be examined: relative costs, relative
dependability, and relative qualities.

In addition to power, transport, and water, the project should have adequate communication
facilities like telephone and Internet.

Labor Situation: In labor-intensive projects, the labor situation in a particular location becomes
important. The key factors to be considered in evaluating the labor situation are:
Availability of labor, skilled semi-skilled and unskilled
Prevailing labor rates
Labor productivity
 State of industrial relations judged in terms of the frequency and severity of strikes and
lockouts
Degree of unionization

Government Policies: Government policies have bearing on location. In the case of public
sector projects, location is directly decided by the government. It may be based on a wider policy
for regional dispersion of industries.

In the case of private sector projects, location is influenced by certain governmental restrictions
and inducements. The government may prohibit the setting up of industrial projects in certain
areas, which suffer from urban congestion. More positively, the government offers inducements
for establishing industries in backward areas. These inducements consist of subsidies,
concessional finance, tax, loans, power subsidy, income tax benefits, lower promoter
contribution, and so on.

Other Factors: Several other factors have to be assessed as well before arriving at a location
decision
These are:
Climatic conditions
General living conditions
Proximity to ancillary units
Ease in coping with pollution

Climate Conditions: The climatic conditions like temperature, humidity, wind, sunshine,
rainfall, snowfall, dust, flooding, and earthquakes have an important influence on location
decision. They have a bearing on the cost as they determine the extent of air-conditioning, de-
humidification, and refrigeration, special drainage, and so on required for the project.

General Living Conditions: The general living conditions like the cost of living, housing
situation, safety, and facilities for education, health care, transportation and recreation need to be
assessed carefully.
Proximity to Ancillary Units: Most firms depend on ancillary units for components and parts. If
the ancillary units are located nearby, coordination becomes easy, transportation costs are lower,
and inventory requirements become considerably less.
Ease in Coping with Environmental Pollution: 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 location study should analyze the cost of mitigating
environmental pollution to tolerable levels at alternative locations.
 Site Selection: Once the broad location is chosen, attention needs to be focused on the selection
of a specific site. Two or three alternative sites must be considered and evaluated with respect to
cost of land and cost of site preparation and development.
The cost of land tends to differ from one site to another in the same broad location. Sites close to
a city cost more whereas sites away from the city cost less. Sites in an industrial area developed
by a governmental agency may be available at a concessional rate.

The cost of site preparation and development depends on the physical features of the site, the
need to demolish and relocate existing structures, and the work involved in obtaining utility
connections to the site. The last element, viz., the work involved in obtaining utility connections
and the cost associated with it should be carefully looked into. It may be noted in this context
that the cost of the following may vary significantly from site to site: power transmission lines
from the main grid, railway siding from the nearest rail road, feeder road connecting with the
main road, transport of water, and disposal of effluents.

3.3.7 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 equipment required should be such that the various stages
are matched well. The choice of machineries and equipment for a manufacturing industry is
somewhat wider as various machines can perform the same function with varying degrees of
accuracy. For example, the configuration of machines required for the manufacture of
refrigerators could take various forms. To determine the kinds of machinery and equipment
required for a manufacturing industry, the following procedure may be followed: (i) Estimate the
likely levels of production over time. (ii) Define the various machining and other operations. (iii)
Calculate the machine hours required for each type of operation. (iv) Select machineries and
equipment required for each function.

The equipment required for the project may be classified into the following types:
(i) Plant (process) equipment,
(ii) Mechanical equipment,
(iii) Electrical equipment,
(iv) Instruments,
(v) Controls,
(vi) Internal transportation system and others.
In addition to the machineries and equipment, a list should be prepared of spare parts and tools
required. This may be divided into: (i) spare parts and tools to be purchased with the original
equipment, and (ii) spare parts and tools required for operational wear and tear.
3.3.7.1 Constraints in Selecting Machineries and Equipment

In selecting the machineries and equipment, certain constraints should be borne in mind. Some of
these are:
(i) There may be a limited availability of power to set up an electricity-intensive plant like,
for example, a large electric furnace;
(ii) There may be difficulty in transporting heavy equipment to a remote location;
(iii) Workers may not be able to operate, at least in the initial periods, certain sophisticated
equipment such as numerically controlled machines;
(iv) The import policy of the government may preclude the import of certain machineries
and equipment.

3.3.7.2 Procurement of Plant and Machinery

For procuring the plant and machinery, orders for different items of the plant and machinery may
be placed with different suppliers of a turnkey contract may be given for the entire plant and
machinery to a single supplier. The factors to be considered in selecting the supplier(s) of the
plant and machinery are the desired quality of machinery, the level of technological
sophistication, the relative reputation of the various suppliers, the expected delivery schedules,
the preferred payment terms and the required performance guarantees. Performance guarantees
provided by machinery suppliers may take three forms; namely, mechanical guarantee, input
guarantee, and output guarantee. If in-house technical expertise is inadequate, external
consultant (s) may be employed to select the plant and machinery and supervise the installation
of the same

3.3.8 Structure and Civil Works

Structure and civil works may be divided into three categories: (i) site preparation and
development, (ii) buildings and structures, and (iii) outdoor works.
3.3.8.1 Site Preparation and Development

This covers the following: i) grading and leveling of the site; (ii) demolition and removal of
existing structures; (iii) relocation of existing pipelines, cables, roads, power lines, etc.; (iv)
reclamation of swamps and draining and removal of standing water; (v) connections for the
following utilities from the site to the public network: electric power (high tension and low
tension), water for drinking and other purposes, communications (telephone, telex, internet, etc.),
roads, railway sidings; and (vi) other site preparation and development work.

3.3.8.2 Buildings and Structures

Buildings and structures may be divided into: (i) factory or process buildings; (ii) ancillary
buildings required for stores, warehouses, laboratories, utility supply centers, maintenance
services, and others; (iii) administrative buildings; (iv) staff welfare buildings, cafeteria, and
medical service buildings; and (v) residential buildings.

3.3.8.3 Outdoor Works

Outdoor works cover (i) supply and distribution utilities (water, electric power, communication,
steam, and gas); (ii) handling and treatment of emission, wastages, and effluents; (iii)
transportation and traffic signals; (iv) outdoor lighting; v) landscaping; and (vi) enclosure and
supervision (boundary wall, fencing, barriers, gates, doors, security posts, etc.)

3.3.9 Project Charts and Layouts

Once data is available on the principal dimensions of the project (market size, plant capacity,
production technology, machineries and equipment, buildings and civil works, conditions
obtaining at the plant site, and supply of inputs to the project) project charts and layouts may be
prepared. These define the scope of the project and provide the basis for detailed project
engineering and estimation of the investment and production costs.

The important charts and layout drawings are briefly described as follows:
1. General functional Layout: this shows the general relationship between equipment,
buildings, and civil works. In preparing this layout, the primary consideration is to facilitate
smooth and economical movement of raw materials, work-in-process, and finished goods.
This means that:
a) The layout should seek to allow traffic flow in one direction to the extent possible, with a
minimum of crossing.
b) Godowns, workshops, and other services must be functionally situated with respect to the
main factory building.

2. Material flow diagram: This shows the flow of materials, utilities, intermediate products,
final products, by-products, and emissions. Along with the material flow diagram, a quantity
flow diagram showing the quantities of flow may be prepared.

3. Production Line diagrams. These show how the production would progress along with the
key information for the main equipment.

4. Transport Layout. This shows the distances and means of transport outside the production
line.

5. Utility Consumption Layout. This shows the principal consumption points of utilities
(power, water, gas, compressed air, etc.) and their required quantities. These layouts provide
the basis for developing specifications for utility supply installations.
6. Communication Layout. This shows how the various parts of the project will be connected
with telephone, intercom, etc.

7. Organizational Layout. This shows the organizational set-up of the project along with the
information on personnel required for various departments and their interactions

8. Plant Layout. The plant layout is concerned with the physical layout of the factory. In
certain industries, particularly process industries, the plant layout is dictated by the
production process adopted. In manufacturing industries, however, there is much greater
flexibility in defining the plant layout. The important considerations in preparing the plant
layout are:
Consistency with production technology
Smooth flow of goods from one stage to another
Proper utilization of space
Scope of expansion
Safety of personnel

3.4 Financial Analysis

3.4.1 Introduction

Financial analysis and final project appraisal involves the assessment, analysis and evaluation of
the required project inputs, the outputs to be produced and the future bet benefits, expressed in
financial terms. The objective is to measure the financial viability of the project under prevailing
market conditions. Question - Can the project survive financially if it is left to the forces of the
market?

The objective and significance of financial analysis differs when it is applied to privately
financed projects and public financed projects. Financial analysis may not have direct application
in the case of some of public financed projects such infrastructural project (so it requires
modification).

In case of such public financial projects financial analysis may aim at

o Measuring the extent of subsidies required -
o Identifying least cost alternatives for the project (ex. Different designs) - a project with least
life time costs is desired.
o Establishing cost-recovery schemes cost recovery scheme is a very popular issue
nowadays. Some of the cost should be recovered from the community and use the money
recovered for expansion purpose for the project widely in the society. The idea is users
should contribute to the cost otherwise expansion of the project will not be possible. It is
became important issue for donors and government.
3.4.2 Inputs to Financial Analysis

The following need to be considered before appraisal is taken up:

The amount and timing of initial investment outlays
The amount and timing of subsequent investment outlays
The economic life of the project
Salvage value at the end of the project
The amount and timing of cash inflows
1. Initial Investment Outlays: This covers the total cash required to implement the proposal. It
includes expenditure on design, survey, consultancy fees and the working capital costs, such as
costs of maintaining stocks, contingency reserves to cover the cost of supporting additional
debtors. Benefit of credit from suppliers will have the effect of reducing the quantum of
additional working capital required.
2. Subsequent Investment Outlays: The cost of maintenance, replacement and updating
exercises are to be treated as outflows during the period in which they are expected to be
incurred.

3. Economic Life of a Project: The economic life of a project is to be distinguished from the
life of an individual asset. A building may have a life of sixty years, plant may have a life of
fifteen years and some equipment may have a life of five years only. The economic life of the
project is determined by the duration of the `earnings flow' generated by the project.
The economic life may end:
When the cost of replacement or renovation becomes uneconomical in relation to the
likely benefits;
When the viability of the project is adversely affected due to obsolescence,
When rising maintenance costs exceed the estimated disposal value; and
When the development of new technology necessitates new investment.
4. Salvage Value: Some equipment may have some value for the enterprise at the end of the
life of the project or there may be an anticipated sale value of the equipment. Such amount is
to be treated as an inflow at the end of the life of the project.
5. Operating Cash Flows: Three main areas are to be considered here:
a).Sales revenue: It is a function of sales volume and unit selling price. Any miscalculation of
sales revenue may have a crucial impact on appraisal of an investment proposal. In assessing any
investment opportunity, the additional or incremental revenues generated by it need to be
considered.
b). Production costs: A distinction between fixed and variable costs will be very meaningful to
anticipate the likely behavior of costs. Only incremental costs have to be considered.
c). Other direct costs: These costs will cover selling and promotion costs and additional rent,
etc. The net inflow/outflow of cash can be worked out by allocating the aforesaid items period-
wise. It may appear to you that in order to make an appraisal regarding the financial viability of
an investment proposal, or to make a choice between two proposals, it will be enough to find out
the net cash flow, that is the difference between total outflow (amount to be invested) and the
inflow (net of Sales Revenue + Salvage Value).
3.4.3 Methods of Projects Financial Appraisal
After the costs and benefits for a project are defined in the form of cash flows, the profitability of
the project has to be determined. There are several criteria that have been suggested by
economist, accountant, and other to judge the worthwhileness of capital project. The important
investment evaluation methods discussed in the following subsequent paragraphs are classified
into two broad categories are:
Non-Discounting Methods
1. Urgency (Priority)
2. Pay Back Period (PBP)
3. Accounting Rate of Return (ARR)
Discounting Methods
4. Net Present Value (NPV)
5. Benefit Cost Ratio (BCR)
6. Internal Rate of Return (IRR)

3.4.3.1 Non-Discounting Methods

1. Urgency (Priority): According to this criterion projects that are deemed to be more urgent
get priority over projects that are regarded as less urgent. However, it is difficult to determine
the relative urgency of projects because of the lack of an objective basis. The use of urgency
criterion may imply that the persuasiveness of those who propose/ prepare projects would
become a very important factor in investment decisions. Resource allocation may deteriorate
into a political battle

2. Pay Back Period (PBP): The payback period is the number of years needed to recover the
initial investment of the project. It is the number of years required for investments
cumulative cash flows to equal its net investment.

Decision rule: An investment is acceptable if it calculated payback period is less than some pre-
specified number of years (maximum desired payback period).
Example 1: a) Uniform (annuity) cash flow
Investment $20,000
Cash flows per year $4,000

Pay Back Period = Investment

 Uniform Cash Flows
$12,000
= = 3 years
$4,000
When cash flow of an investment is an annuity form, payback period is computed by dividing
the net investment by the annuity as shown in above example.

b) Non-Uniform Cash Flows: Suppose the annual cash flows are not equal for the same initial
investment of $20,000. The cash inflows from the project for the first five consecutive years are
$8, 000, $9, 000, $15, 000, $20,000 and $ 25,000 respectively. What is the payback period? To
determine the payback period of the above project, we have to use the cumulative cash flow
method as follows.

Year Cash Flow Cumulative Cash Flow Investment to be recovered

0 - - 20,000
1 8,000 8,000 12,000
2 9,000 17,000 3,000
3 15,000 - -
rd
3 year = $3,000/$15,000 = 0.2 years
PBP = 2 years +0.2 years= 2.2 years
Payback period (PBP) can be determined by using the following formula:
PBP= E+ B
C
Where, PBP stands for payback period
E stands for number of years immediately preceding the year of final recovery
B stands for the balance amount still to the recovered
C stands for cash flow during the year of final recovery
Example 2: Consider two projects A and B each with initial outlay and expected cash flow as set
out below.
Year Description Project A Project B
0 Initial Investment 15,000 12,000
1 Cash flow 6,000 3,000
2 Cash flow 6,000 5,000
3 Cash flow 3,000 2,000
4 Cash flow 500 1,000
5 Cash flow 500 1,000
Required:
a) What is the payback period for each period?
b) Which of the two projects would you choose? Why?
Advantage of payback period method:
- It is simple, both in concept and application. It does not use involved concepts and tedious
calculations and has few hidden assumptions.
- Adjust for uncertainty of later cash flows
- Biased toward liquidity
Disadvantage of payback period:
- It fails to give any considerations to each proceeds earned after the payback date.
- It is a measure of the project's capital recovery, not profitability.
- It fails to take into account the time value of money.
- It is unusable to distinguish between projects with the same payback period.
- It may lead to excessive investment in short term projects.
Modified Pay Back Period (Discounted Pay Back Period): As we can see from the
disadvantages of PBP method, it ignores the time value of money. To overcome this limitation,
the discounted payback period has been suggested. In this method cash flows are first converted
in to their present value and then calculate the discounted payback period. The discounted
payback period is the length of time it takes for the discounted cash flows to equal the amount of
initial investment.
Decision rule: Accept, if a project discounted payback is less than some prespecified numbers of
years.
Example: Initial investment of a project $25,000
Annual Cash Flow for 5 years 10,000
Required: assume that the discount rate is 10%.
a) Compute the modified (discounted) PBP.
b) If the expected PBP is 4 years, should the project be accepted or rejected?
c) If the expected PBP is 2 years, should the project be accepted or rejected?
Solution
Years Cash Flow PV of $1 PV of Cash Cumulative Investment to
@10% Flow Cash Flow be Recovered
0 (25,000) - - - 25,000
1 10,000 0.909 9,090 9,090 15,910
2 10,000 0.826 8,260 17,350 7,650
3 10,000 0.751 7,510 24,860 140
4 10,000 0.863 6,830 - -
5 10,000 0.621 6,210 - -
th
4 year = 140/6830=0.2 years
a) Discounted (Modified) PBP= 3+0.2 =3.2 years.
b) The project has to be accepted.
c) The project has to be rejected.
3. Accounting (Average) Rate of Return (ARR)
The accounting rate of return (ARR), also referred to as the average rate of return on investment,
is a measure of profitability which relates income to investment, both measured in accounting
terms. Since income and investment can be measured in various ways, there can be a very large
number of measures for accounting rate of return.
The measures that are employed commonly in practice are:
1) ARR = Average Income after Tax (AIAT)
Initial Investment
2) ARR = Average Income after Tax (AIAT)
Average Investment
Example 1: ARR with 50% tax rate.
Year Investment Depreciation EBIT Interest EBT Tax EAT
1 100,000 10,000 40,000 5000 35,000 17,500 17,500
2 80,000 10,000 50,000 15,000 35,000 17,500 17,500
3 60,000 22,000 60,000 10,000 50,000 25,000 25,000
4 40,000 25,000 50,000 10,000 40,000 20,000 20,000
5 40,000 28,000 70,000 10,000 60,000 30,000 30,000
6 40,000 25,000 90,000 10,000 80,000 40,000 40,000
Total 360,000 120,000 360,000 60,000 300,000 150,000 150,000
Average 60,000 20,000 60,000 10,000 50,000 25,000 25,000
a) AIAT=150,000/6 =25,000
b). Initial Investment =100,000
c). Average Investment=360,000/6 =60,000
1. ARR = Average Income after Tax (AIAT) =25,000/100,000=25%
Initial Investment
2. ARR = Average Income after Tax (AIAT) =25,000/60,000=41%
Average Investment
Decision rule: The higher the ARR the better the project would be. Projects which have an ARR
equal or greater than a prespecified cut-off rate of return are accepted.
Advantages of Accounting Rate of Return (ARR)
It is simple to calculate
It considers benefits over the entire life of a project as well as the profitability of
employed resources.
It is based on accounting information which is readily available and familiar to
businessmen.
Disadvantages of Accounting Rate of Return (ARR)
It does not take account of the timing of the profits from an investment
 It implicitly assumes stable cash receipts over time.
It is based on accounting profits and not cash flows. Accounting profits are subject to a
number of different accounting treatments.
It is a relative measure rather than an absolute measure and hence takes no account of the
size of the investment.
It takes no account of the length of the project.
It ignores time value of money.
3.4.3.2 Discounting Methods
This concept is based on the premise of the `time value of money'. The flow income is spread
over a few years. The real value of a rupee in your hand today is much more than that of a rupee
which you will earn after a year. Why is it so? It is the value of time. The future income,
therefore, has to be discounted in order to be associated with the current outflow of funds in the
investment. Two methods of appraisal of investment project are based on this concept. These are
Net Present Value method and Internal Rate of Return method.
1. Net Present Value (NPV) Method: The net present value of the project is the sum of the
present value of all the cash flows-positive as well as negative-that are expected to occur over the
life of the project. This means that, NPV= PV of Inflows-PV of Outflows.
The formula of NPV is given by:
n
Ct
NPV of a Project = - Initial Investment
t 1 (1 r )
t

Where Ct = cash flow at the end of year t

n= life of the project
r= discount rate
t= time or year
Decision rule: The net present value represents the net benefit over and above the compensation
for time and risk. Hence the decision rule associated with the net present value criteria is:
If the net present value (NPV) is positive or greater than 0; accept the project
If the net present value (NPV) is negative or less than 0; reject the project.
If we are going to select one project from two or more projects with a NPV>0, mutually
exclusive, we should select the project which has greater NPV.
Example 1: Consider a project which has the following cash flows.
Year Cash Flows
0 65,000
1 (2,000)
2 (4,000)
3 25,000
4 40,000
5 42,000
If the cost of cash is 10%, what is the NPV?
Solution
Year Cash Flow PV of Birr 1 @10% Total PV
0 (65,000) 1.000 (65,000)
1 (2,000) 0.909 (1,818)
2 (4,000) 0.826 (3,304)
3 25,000 0.751 18,775
4 40,000 0.683 29,320
5 42,000 0.621 26,082
Total PV of cash inflows 74,177
Total PV of cash out flows (70,122)
NPV Birr 4,055

Example 2: Project Y has a net investment of $10,000 and a cash inflow of $4,000 for each
three years. Compute and interpret the NPV if the required rate of return (cost of capital) is 12%.
Advantage of NPV method
- The cash flows from the beginning to the end of the project are considered
- It gives a measure of the discounted absolute surplus from an investment
- It is particularly used for comparison and selection from among mutually exclusive projects
that are of the same size
- It discounts cash flows by the cost of capital which gives explicit recognition to the returns
required by investors
- Since it is expressed in birr/dollar the decision maker can easily understand it than percentage
and ratio.

Disadvantage of NPV method

- The NPV method can be employed in selection from mutually exclusive projects only when
the projects are of the same size. If the levels of investment are different, deciding the
acceptability of the project only on the basis of NPV is misleading.
- The discount rate needs to be obtained externally to the method of calculation. that is
determined exogenously
- The opportunity cost of capital is assumed to remain constant throughout the life of the
project. But usually the cost of capital changes over the lifespan of project.
- It does not show the exact profitability rate of the project

2. Benefit Cost Ratio (BCR) or Profitability Index (PI): BCR gives the return for each
dollar invested. There are two ways of defining the BCR.
- The first definition related the PV of benefits (PVB) to the initial investment.
- The second measure relates NPV to initial investment.
The benefit cost ratio is obtained by dividing the present worth of the benefit stream by the
present worth of the cost stream.
 PVB
Benefit Cost Ratio: BCR= or Present Value of Cash Inflows
I
Present Value of Cash Outflows
PVB I
Net Benefit Cost Ratio: BCR= or BCR-1
I
Where PVB = Present Value of Benefit
I = Initial investment
Decision rule:
When BCR or NBCR Decision rule
>1 >0 Accept
=1 =0 Indifferent i.e., benefit=cost
<1 <0 Reject
Example 1: The project which has a cost of capital of 12%, initial investment and cash flows are
given below
Year 0 1 2 3 4
Cash Flows $ 1,000,000 25,000 40,000 40,000 50,000

The benefit cost ratio measures for this project are:

25,00 40,000 40,000 50,000

PVB (1.12) (1.12) 2 (1.12) 3 (1.12) 4
Benefit cost ratio: BCR = = = 1.145
I 1,000,000
Net Benefit Cost Ratio = BCR - 1 = 1.145 - 1 = 0.145
The project should be accepted, since the BCR is greater than 1.
Example 2: The following are the cash flows of a project.
Year 0 1 2 3 4
Cash Flows $ 25,000 8,000 7,000 20,000 15,000

The discount rate is 7%. Calculate the BCR and NBCR.

Solution
Year Cash Flow PV of $1 @7% Total PV
1 8,000 0.935 7,480
2 7,000 0.873 6,111
3 20,000 0.816 16,320
4 15,000 0.763 11,445
Total PV of Benefit (PVB) 41,356

Benefit Cost Ratio (BCR) = PVB = 41,356 = 1.65

I 25,000
NPV= $41,356 ( NPV of IF )-$25,000 (NPV of OF)=$16,356
 NBCR=NPV = $16,356 = 0.65
I 25,000
BCR (1.65) means $1 investment will becomes $1.65 including the investment and profit.
NBCR (0.65) means $1 investment will bring $ 0.65 profit.
Therefore, the project should be accepted, since its BCR and NBCR are greater than 1 and 0
respectively.
Advantage of Cost Benefit Ratio method:
- Closely related to NPV, generally leading to identical decisions.
- Easy to understand and communicate
- May be useful when available investment funds are limited.
Disadvantage of Cost Benefit Ratio method:
- May lead to incorrect decision in comparison of exclusive investment.

3. Internal Rate of Return (IRR): The IRR is the discount rate that makes the NPV of the
incremental net benefit stream equal to zero. The IRR may also be defined as the discount rate
that equates the present value of benefits with the present value of costs. Thus, it is the discount
rate at which it is worth while doing the project. This is the maximum interest rate that a project
could pay for the resources used if the project is to recover its investment and operating cost till
breakeven.

IRR is the rate where PV of Inflows=PV of Outflows or NPV

NB: an IRR of a series of value such as a cash flow can exist only when at least one value is
negative .If all the values are positive no discount rate can make the NPV equal to zero. No
matter how high the discount rate the NPV of a series would have to be positive if it includes no
negative number. Thus, we need to treat the initial investment as negative.

How do we compute IRR? The arithmetical rule for computing the IRR relies on using two
discount rates. In the NPV calculation we assume that the discount rate (cost of capital) is known
and determine the NPV. In the IRR calculation, we set the NPV equal to zero and determine the
discount rate that satisfies this condition.

Example 1: Consider the following:

Year 0 1 2 3 4 5
Cash Flows $ 60,000 10,000 20,000 15,000 15,000 20,000

Required: Find the IRR (use the Trial and Error Method).
Solution: Trial and Error Method
a) Guess any discount rate and compute the NPV
b) If the NPV is negative (<0) try with a lower discount rate.
 c) If the NPV is positive (>0) try with a higher discount rate

a). Guess 10% and then compute the NPV using 10% discount rate as follow:
Year Cash Flow PV of $1 @10% Total PV
1 10,000 0.909 9,090
2 20,000 0.826 16,520
3 15,000 0.751 11,265
4 15,000 0.683 10,245
5 20,000 0.621 12,420
Total PV of CIF - 59,540
Total PV of COF - 60,000
NPV - (460)

b). Since the NPV is negative (460), we should try the lower discount rate.
Year Cash Flow PV of $1 @9% Total PV
1 10,000 0.917 9,170
2 20,000 0.842 16,840
3 15,000 0.772 11,580
4 15,000 0.708 10,620
5 20,000 0.650 13,000
Total PV of CIF - 61,210
Total PV of COF - (60,000)
NPV - 1,210

c). Use interpolation method

9% 10%
$61,210--------------------------------------------$59,540
The total distance between 9% and 10%: =$61,210-59,540 =1,670
Percentage of distance between 9% and 10%= 1210/1670=0.72
Therefore, IRR= Lower discount rate+ % of distance b/n lower and higher distance rate
= 9% +0.7 =9.72%
Example 2: To compute the IRR of a project, consider a project that has cash flows of the
following amount of Dollar.
Year 0 1 2 3 4
Cash flow (100,000) 30,000 30,000 40,000 45,000
The IRR is the value of r that satisfies the following equation:
30,000 30,000 40,000 45,000
(1 r )1 (1 r ) 2 (1 r ) 3 (1 r ) 4
100,000= + + +
The calculation r involves a process of trial and error. We try different values of r till we find that
the right-hand side of the above equation is equal to 100,000. Let us, to begin with, try r=15 %.
This makes the right-hand side equal to:
30,000 30,000 40,000 45,000
(1.15)
+ (1.15) 2 + (1.15) 3 + (1.15) 4 = 100,802

This value is slightly higher than our target value, 100,000. So we should increase the value of r
from 15% to 16%. (In general, a higher r lowers and a smaller r increases the right-hand side
value). The right hand side becomes the following value at 16% interest rate;
30,000 30,000 40,000 45,000
(1.16 )
+ (1.16) 2 + (1.16) 3 + (1.16) 4 = 98,641.

Since this value is now less than $100,000, we conclude that the value of r lies between 15
percent and 16 percent. If a more refined estimate of r is needed, use the following procedure:
1. Determine the net present value of the two closest rates of return. In our example the NPV at
15% is $802 and NPV at 16% is 1,359
2. Find the sum of the absolute values of the net present values obtained in step 1, that is, in our
example, 802 + 1,359 = $2,161.
3. Calculate the ratio of the net present value of the smaller discount rate, identified in step 1, to
the sum obtained in step 2. That is, 802 2,161 = 0.37
4. Add the number obtained in step 3 to the smaller discount rate. That is, 15%+ 0.37= 15.37 %.

We can use the following formula to determine the IRR of a project also.
IRR= LDR + (NPVLDR) X (HDR-LDR)
(NPVLDR-NPVHDR)
Where, LDR= Lower Discount Rate
HDR=Higher Discount Rate
NPVLDR=Net Present Value of Lower Discount Rate
NPVHDR= Net Present Value of Higher Discount Rate
Example 3: Consider the following project with the initial investment of $60,000 and 4 years of
life to calculate the IRR. It has the following the estimated cash flows.
Year Estimated Cash Flow
1 15,000
2 20,000
3 30,000
4 20,000

Advantages of Internal Rate of Return (IRR)

It is clearly understood and it is closer to business man's rate of return measure.
It is determined internally as part of the calculation method, i.e., it conveys direct
message about the yield on the project.
 It is a useful measure to calculate where there is uncertainty about the correct discount
rate.
Disadvantages of Internal Rate of Return (IRR)
It omits a consideration of the size or scale of an investment because it is a ratio.
It requires specification of an opportunity cost of capital to make a decision.
It might be tedious to calculate.

ADDITIONAL EXERCISES
1. Rank the following projects in order of their desirability according to Pay Back Period
(PBP), Net Present Value (NPV) and Profitability Index (PI). Assume the discount rate is
10%.
Project Initial Outlay Annual Cash Flow Life in Years
A 10,000 2,500 5
B 8,000 2,600 7
C 4,000 1,000 15
D 10,000 2,400 20
E 5,000 1,125 15
F 6,000 2,400 6
G 2,000 1,000 2

2. A company has an investment opportunity costing $40,000 with the following expected net
cash flows after tax and before depreciation.
Year 1 2 3 4 5 6 7 8 9 10
Net Cash Flows 7000 7000 7000 7000 7000 8000 10000 15000 10000 4000

Required: Using 10% as a cost of capital determine the following:

a) Payback period (PBP)
b) NPV at 10% discount factor.
c) Profitability Index at 10% discount factor.
d) Internal Rate of Return.
3. Sulabh international is evaluating a project whose expected cash flows are as follows:
Year 0 1 2 3 4 5
Net Cash Flows 1000,000 100,000 200,000 300,000 600,000 300,000
Required:
a) What is the NPV of a project, if the discount rate is 14% for the entire period?
b) What is the NPV of the project if the discount rate is 12% for year 1 and rises every year
by 1%?
4. What is the IRR of an investment which involves a current outlay of $300,000 and results in
an annual cash inflow of $60,000 for 7years?
5. Farewell Company has an investment opportunity costing $30,000 with the following
expected net cash flow (i.e. after taxes and before depreciation):

Year 1 2 3 4 5 6 7 8 9 10
Net Cash Flows 4000 4000 4000 4000 4000 7000 9000 12000 9000 2000

Required: Using 10% as the cost of capital (rate of discount), determine the following:
a) Payback period
b) Net present value at 10 % discounting factor
c) Profitability index at 10% discounting factor.
d) Internal rate of return with the help of 10 % discounting factor and 15 % discounting
factor.
6. The management of Maratha Udyog has two alternative projects under consideration. Project
`A' requires a capital outlay of $ 300,000 but project `B' needs $ 420,000: Both are estimated
to provide a cash flow for six years: A $ 80,000 per year and B $110,000 per year. The cost
of capital is 12%. Show which of the two projects is preferable from the viewpoint of (i) Net
Present Value and (ii) Internal Rate of Return.

3.4.4 Risk/Threat Analysis

Risk is inherent in almost every business decision. More so in capital budgeting decisions as
they involve costs and benefits extending over a long period of time during which many things
can change in unanticipated ways.

3.4.4.1 Sources of 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 an 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 the
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 projects as well.
- Market risk: unanticipated changes in macroeconomic factors like the GDP growth rate,
interest rate, and inflation have an impact on all projects, although in varying degrees.
- International risk: in case of a foreign project, the earnings and cash flows may be different
than expected due to the change rate risk or political risk.
3.4.4.2 Measures of Risk
Risk refers to variability. It is ca complex and multi-faceted phenomenon. A variety of measures
have been used to capture different facets of risk. The more important ones are range, standard
deviation, coefficient of variation, and semi-variance. To illustrate the calculation of these
measures, consider a capital investment whose net present value has the following distribution.

NPV Probability
200 0.3
600 0.5
900 0.2
The expected NPV works out to: E (NPV) = pi NPVi
= 0.3x200+0.5x600+0.2x900=$540
Now let us see the various measures of risk as follows:

Range: is the difference between the highest value and the lowest value i.e., $900-$200=$700
Standard Deviation: = [ pi (Xi- X ) 2]1/2
Where, = standard deviation
Pi=probability associated with the ith value
Xi=ith value
X =expected value
The standard deviation of the NPV distribution presented above is:
= [0.3(200-540)2 +0.5(600-540)2 +0.2(900-540)2
= [62,500)1/2 =250
The square of standard deviation is called variance i.e., Variance=2
The variance of the above distribution is 62,500.

Coefficient of Variation (CV) = Standard Deviation

Expected Value
The coefficient of variation for the investment in our illustration is:
CV=250 =0.46
540
Semi-Variance (SV) =pidi2
= 0.3(200-540)2 =34,680

3.5 Social Cost Benefit (Economic) Analysis

Economic analysis is one step forward in the project planning effort. Because as compared to
financial analysis, which should assess the impact of a project on the income of its owners,
economic analysis is a form of more general tool of cost benefit analysis. The use of the word
"economic" implies the analysis is undertaken is from the point of view of the nation or the
economy as a whole. It can be seen as a cost benefit analysis from the social and national
perspective. It ascertains the overall country impact of a project. In other words, it is the measure
of the costs and benefits of a project to the society. The exercise of project appraisal is not
accomplished till the proposed project is also viewed from the economic viewpoint. Therefore,
this unit focuses on economic analysis and items included in it.

3.5.1 Distinction between Financial and Economic Analysis

The reason for conducting both financial and economic analysis is to view the project from
various angles and to obtain different perspectives. Decision makers need both profiles in order
to evaluate the project and to design the necessary fiscal and monetary measures to meet its
financial requirements. Even though the tools of analysis are the same, financial analysis is
concerned with private profitability and is based on financial flows which relate to:
- market prices for products and inputs
- the terms of credit and borrowing in general
- tax and subsidy policy
- Financial depreciation and other financial conventions.

The financial analysis focuses on money profits accruing to the project entity. Various financial
indicators are used to evaluate the entity's ability to meet its financial obligation and to finance
future investment.
Economic analysis, on the other hand, is concerned with public "profitability" which is based on
economic resource flows. It measures the project's effect on the efficiency of the whole
economy. In economic analysis shadow prices (set of prices that is believed better reflect the
opportunity cost) are used.

Economic resource flows relates to:

a) Social opportunity costs (shadow prices) which adjust market prices to take into account
differences based on tax and subsidies, external costs and benefits, monopolistic pricing,
price control and rationing, quantitative trade restrictions, over-valued (or undervalued)
exchange rate and labor opportunity costs.
b) Divergence between real rate of interest and nominal (financial) rate of interest, and
difference between private and social/public rate of discount.

Economic analysis consists mainly of adjustments to information used in financial analysis and
of a few additional ones. The methodology and the criteria used to evaluate a project using
financial and economic information are the same. However, the main difference lies in the value
that the NPV and IRR take. This difference occurs because of the difference of:
- the items considered as inputs and outputs of the project
- the prices used in the valuation of the project inputs and outputs
 - the treatment of taxes, subsidies and other transfer payments.
The following table and the discussion that follows best explain the difference between
economic and financial analysis.
Factors Financial Analysis Economic Analysis
Pricing of inputs Domestic market price Shadow prices
Treatment of transfer payments, tax, All included Excluded
subsidy, etc
Externalities Excluded Included
Discount rates Takes into account the current The economic
lending rate discount rate
3.5.1 Rationale for SCBA

External costs and Benefits (Externalities): Some real costs and benefits attributed to the
project do not appear among its inputs and outputs when it is analyzed from the company's
viewpoint and they do not enter in the calculation of NPV and IRR. The reason is they are
considered as "external" to the organization. But they are internal from economy's angle and
included in the calculation of IRR and NPV. Because, somebody pays for such externals and
somebody receives the benefits of such externals even if it is not the enterprise. Therefore, to the
extent they can be measured and evaluated they are included in the economic analysis. Examples
of externalities include access to roads, energy lines, sewerage services, flood control dams etc.
Externalities in short are costs or benefits to the economy as a whole that are attributed to the
project but not taken into account in estimating quantities and values for the project inputs and
outputs.

Prices of Inputs: As it is shown in the table above, another difference between financial analysis
and economic analysis is that even inputs and outputs are "internal" to both the single firm and
the economy, they are valued differently. In financial analysis the need is to value input over
output at actual market prices while in economic analysis shadow prices are employed.
Consequently, using different prices will give different economic and financial NPV and IRR,
even if the inputs and outputs are identical in physical terms.
Domestic/market price is a price we can get in the market. It is set by cost plus certain
percentage of margin. Whereas, shadow price is estimated price. They are not observed prices.
One cannot find them in the market. They are estimated by the macro planners and are taken as
given by the project analysts in all types of projects.

Transfer Payments: The third reason why financial and economic NPV and IRR might differ
emanates from the treatment of taxes, subsidies and other transfer payment. Transfer payments
are payments that are made between different persons or organizations but are not related to any
particular resource cost. These payments affect the distribution of income but do not affect the
volume of resources available to the country is economy.
Taxes and custom duties from which the enterprise is not exempted are taken as costs in financial
analysis. But they are excluded from economic analysis because they do not reflect the
commitment of real resources. Similarly, subsidies paid to the enterprise from the government
are viewed as transfer payments and are omitted in economic analysis, but they are treated like
any other revenue of the enterprise in the financial analysis that is, IRR and NPV calculations.
Discount Rate: In financial analysis the discount rate used is simply the rate the sponsors expect
they will have to pay for borrowed funds or the rate they wish to receive on capital invested.
However, in economic analysis accounting or shadow prices are used, which are believed to be
more competitive, to receive signals that will guide the allocation of resources and the structure
of domestic production.
The existence of the above mentioned factors demands economic analysis so that the value of
inputs and outputs of a project can reflect its real value. Markets like commodity market, labor
market, foreign exchange and capital markets are highly distorted in developing countries.
Therefore, adjustment of price to reflect the real cost of resources should be made using shadow
prices, which is a set of prices that better reflect the opportunity costs of goods and services in
their best use. The objective of economic analysis is utilization or best use of the scarce
resources of a nation.
Economic analysis, to achieve its intended purposes, should follow the following steps. These
are:
Step 1: Identify and eliminate transfer payments. As it is explained above, transfer payments
like duties, taxes etc should be eliminated.
Step 2: Identify linkages and externalities
Step 3: Identify the effect on the use or creation of traded goods
Step 4: Identify the effect of the project on the employment of labor.
A frequent cause of confusion is that project analysis can be applied in different ways, from
different perspectives. This may give the impression that there are conflicting measures of
project worth. The following table attempts to clarify the techniques used to analyze projects,
their objectives and indicators that can be calculated at each analysis level.
Levels of Project Analysis
Perspective What is measured? Indicator
Financial Owners or lenders Change in private FNPV, FIRR
analysis income for owners or
lenders
Economic National economy Change in national ENPV, EIRR
analysis income
Distributional All groups affected Distribution of Proportion of ENPV going to
analysis by the project. change in national target group or cost of income
eg., government, income change for target group
lenders, workers,
owners, etc
Note: FNPV, FIRR stands for financial NPV and IRR respectively
ENPV, EIRR stands for economic NPV and IRR respectively.
More recently, there has been a renewal of interest in the distributional impact of projects
associated with attempts to determine the fiscal impact of projects (effect on government
income). Although it is not always straightforward in principle it should always be possible to
show how the income of different groups is affected by project. The easiest way to do this is to
show how projects economic net present value ENPV (discounted value of the change in national
income), is allocated between different groups. Normally, the ENPV may compose of positive
income steams for some groups and negative ones for others. In other words, in reality there are
losers and gainers of the income of the project. Identifying these groups is known as
distributional analysis.

3.5.2 Shadow Prices

Shadow prices are a set of prices that are believed to better reflect the opportunity cost of
resources in their best use. They are employed instead of domestic market prices in guiding the
allocation of resources since the later is distorted and using them would lead to resource
misallocation.

Shadow prices for economic analysis are based on the opportunity costs. If costs can be broken
down into basic resource categories on an opportunity cost basis, all that remains to be done is to
value the basic categories according to their opportunity cost.

Opportunity Cost: Before we proceed to the discussion of shadow price and its calculation, let
us first outline the opportunity costs of resources because opportunity cost is the most important
concept underlying economic analysis. It is defined as the next best alternative foregone in
undertaking a course of action. Whenever, there is an opportunity cost, there is an argument for
using shadow prices. Opportunity cost can best be explained by reference to examples commonly
used in the economic analysis of projects: land, labor and capital.

a) Opportunity Cost of Land

In economic analysis land is not usually treated as a capital value. The opportunity cost of land is
defined by its next best alternative use. Urban land can be used for houses, offices, shops and
factories. Rural land is normally used for crops, pasture, forestry or sometimes conservation.

The opportunity cost of rural land is likely to be very important in the assessment of any
agricultural or agro industrial project. When agricultural land is being used, the opportunity cost
is the value of the alternative crop produced less the other costs involved in producing the crop.
For urban land the opportunity cost is usually defined by rental values.
b) Opportunity Cost of Labor

Opportunity cost of labor is the value of the worker's output in the next best alternative. It
usually varies significantly between occupational groups and often between regions. In
determining the opportunity cost of labor it is important to identify the potential source of labor
(urban or rural). Project appraisal also distinguishes between skilled and unskilled labor. The
most common assumption is that skilled labor is in scarce supply and has an opportunity cost
equal or greater than its market price, while unskilled labor is in excess supply and has an
opportunity cost below its market price.

The first assumption implies that skilled workers are able to obtain the same salary whether they
work on the project in question or on another project. This assumption is reasonable for most
countries including Ethiopia. For our country, on the other hand, the labor category assumed to
be in excess supply is formal sectoral rural and urban unskilled labor. The largest potential
source of unskilled labor is the agricultural sector.

Skilled labor was assumed to be relatively scarce and so the opportunity cost of skilled
manpower was assumed to be the same as the market price. The opportunity cost is assumed to
consist of outputs of the various sectors in proportion to the estimated employment of skilled
labor in each sector.

c) Opportunity Cost of Capital

In principle the opportunity cost of capital (investment funds) for an individual, a company or an
economy is the rate of return available on the next best alternative project. For an individual or
company the bank interest rate may give a reasonable guide. Because the alternative to investing
in a project is to lend to a bank that pays a periodic interest. However, it is not easy to directly
estimate the opportunity cost of capital for an economy at large because economic analysis using
shadow prices is not applied consistently to all projects.

3.5.3 Approaches of Social Cost Benefit Analysis

Towards the end of the sixties and in the early seventies, two principal approaches for SCBA
emerged, the UNIDO approach and the Little Mirrlees Approach.

Little Mirrless and UNIDO approach -A comparison

The UNIDO approach: The UNIDO guidelines provide a comprehensive framework for
appraisal of projects and examine their desirability and merit by using different yardsticks in a
step-wise manner. The desirability is examined from various angles, such as the impact on
(a) Financial profitability of utilization of domestic resources,
(b) savings and consumption pattern,
 (c) income distribution, and
(d) Production of merit and demerit goods.
These different aspects are examined in five stages, each stage leading towards a social benefit-
cost of the project.
1. Measures financial profitability from detailed integrated standard analytical tables
enumerating various costs and benefits at the market price and examines profit viability from
investors point of view.
2. Adjusts the financial costs and benefits to various distortions introduced by market
imperfections by valuing costs and benefits or net benefits in terms of economic efficiency or
shadow prices. For shadow prices, it categorizes project inputs and outputs into traded,
tradable and on-traded. For traded and tradable, the guidelines use the border prices
(f.o.b/c.i.f)as the relevant shadow prices, whereas non-traded inputs and outputs are broken
down into their components and each tradable subcomponent is valued at border prices, and
so on. The residual non-traded components of commodities are valued at domestic
willingness to pay criterion and the labour is valued at shadow wage rate.
3. This stage designed to examine the impact of projects on savings and consumption which are
of vital consideration in the choice of alternative investments in labour-intensive and capital-
intensive projects. If saving is assigned great importance, as should be the case in capital-
scarce countries, this stage recommends the rate for adjustment for savings by which the
social value of a rupee/dollar investment exceeds its consumption value.
4. This important for those countries that regard income redistribution in favor of weaker
sections and backward regions as desirable objectives. The guidelines suggest weighting net
benefits to various income groups or regions that reflect the judgment of politicians or the
planners.
5. Finally, in stage five, the UNIDO analysis suggests a methodology for necessary adjustment
of the deviations in economic and social values and difference between the efficiency and
social value of project output, say, between good and bad or merit and demerit goods. It has
been claimed that the analysis of merit and demerit goods is not designed for purists in
economics who think that economics should be devoid of political or subjective judgments
(UNIDO 1978).

Little Mirrlees Approach: The seminal work of Little and Mirrlees on benefit-cost analysis
systematically develops a theoretical basis for the analysis and its underlying assumptions and
lays down step-wise procedure for undertaking benefit-cost studies of public projects. The
mathematical formulation is identical to the UNIDO method except for differences in assigning
value to discount rates and accounting for imperfections and other market failures and social
considerations.

Like UNIDO guidelines, the Little-Mirrlees method also suggests valuation of project investment
at opportunity cost (shadow prices) of resources to correct distortions due to market
imperfections. Both methods make use of border prices to correct distortions but with a major
difference.

While Little and Mirrlees express the numeraire in terms of border prices in foreign currencies,
the guidelines recommend that foreign exchange values be calculated in terms of domestic
currency.

Little and Mirrlees have also suggested an elaborate methodology for calculating shadow prices
of non-tradable. Use of detailed input-output tables is suggested with a view to tracing down the
chain of all non-traded and traded inputs that go into their production. However, in the case of
non-availability of detailed input/output tables, a conversion factor based on the ratio of domestic
costs of representative items to world prices of these items could be used for approximation of
shadow prices of non-traded resources. Little and Mirrlees believe that in all less developed
countries, one of the major criteria for the choice of a project should be its ability to generate
savings and, hence, the Little-Mirrlees method suggests the use of accounting rate of interests
to calculate present worth of future annuities of savings and consumption. Guidelines, on the
other hand, do not make any adjustment for consumption and saving impact of project
investment. Unlike the five stages of UNIDO, the Little and Mirrlees procedure is relatively
more practical, although, unlike guidelines, it does not provide sufficient insights by examining
project investment from different angles.

3.6. Environmental Impact Assessment

The feasibility study should include a thorough and realistic analysis of the environmental
impact of investment projects. The environmental impact assessment is designed to develop an
understanding of the environmental consequences of a newly planned or existing project or any
project related activities.

Environmental impact assessment should classify the environmental impact factors. Common
system classifies environmental impacts according to the affected environment (atmosphere,
land, water, communities, etc) and the nature or types of impact (physical, chemical, and
economic).

Physical and chemical impacts, including noise emissions and impacts on energy resources,
encompass the effects on physical and chemical characteristics of the whole ecological system
consisting of the atmosphere, water, and land.

3.7 Implementation Planning

The project implementation phase embraces the period from the decision to invest to the start of
commercial production. Implementation planning aims at determining the technical and
financial implications of the various stages of project implementation, with a view to securing
sufficient finance. A series of simultaneous and interrelated activities taking place during the
implementation phase have to be identified together with their financial impact on the project.
When preparing the implementation plan for the feasibility study, it should be borne in mind
that, at a later stage, this plan will be the basis for monitoring and controlling the actual project
implementation. The implementation schedule must present the costs of project implementation
as well as the schedule for the complete cash outflows (for all initial investments), in order to
allow the determination of the corresponding inflows of funds.

Implementation planning includes the following major tasks:

a) Determination of the type of work tasks that is necessary to implement the project.
b) Determination of the logical sequence of events in the work tasks.
c) Preparation of a time-phased implementation schedule, allowing for adequate time to
complete each individual task.
d) Determination of the resources needed to complete the individual task along with its cost.
e) Preparation of an implementation budget and cash flow that will ensure the availability of
adequate funds.
f) Documentation of all implementation data, allowing the implementation plan and budget as
well as the forecasts made in the feasibility study, to be updated.

3.6.1 Stages of Project Implementation

Project implementation has the following stages:

1. Appointment of the implementation team: The main objective in the appointment of a
project team is to ensure that the execution of all work complies with the implementation plan
and budget.
2. Company formation and legal requirements: The formation of a new company would be
necessary if the investors are starting a new project. In case if the investment is to take place
within an existing enterprise, many of the legal requirements for forming a new company will
not be required.
3. Government approvals: Government approval may be necessary for importing machinery
and materials. Adequate time should be provided to obtain the necessary approvals.
4. Financial planning: After the decision to invest has been taken and once the total investment
costs and their scheduling are known, detailed arrangements for financing need to be initiated.
5. Project management and organization: It is usually advisable to appoint a key person who
would build up a company-internal management team. During the stage of organizational build-
up the recruitment of human resources is initiated. The training plan that has been prepared
earlier in the feasibility study is an important planning tool for the implementation team.
Recruitment is too often left to a very late stage, and training programme is initiated only when
the plant is ready to commence production.
6. Technology acquisition and transfer: Negotiations with technology suppliers may take
considerable time in certain cases. Legal problems such as patent rights, exploitation limitations,
restrictions on the trade names etc., have to be solved. The feasibility study should contain a
projection of the time schedule and the costs related to the technology.
7. Detailed engineering and contracting: The final plant layout as prepared in the feasibility
study will be the beginning of detailed engineering. The time required for civil works site
preparation etc., and the cost of these works have to be estimated in the feasibility study.
Reasonable time must also be allowed for rendering, evaluation of renders, contract negotiations,
and award of contracts.
8. Acquisition of land: Acquisition of land may take time-consuming negotiations.
Accessibility to the plant site, climate conditions, facilities for utilities etc., should be considered
in selecting the land. The acquisition of land may require approval by the authorities of
environmental protection.
9. Construction and installation: Any delays during the actual construction phase will have an
impact on the costs and income projections made in the feasibility study. The sequence of civil
works and construction activities needs to be carefully defined. For scheduling the construction
and installation work, it is important to understand that such work can begin only after designing
the layout, acquiring the land, and getting approval from the authorities.
10. Supply of materials and services: It is necessary to finalize arrangements for the delivery
of basic production materials during the implementation phase. Both the domestic and foreign
suppliers have to be studied to ensure that they are capable of delivering the specified quality and
quantity materials in accordance with the supply schedule.
11. Pre-production marketing: The preparation of the sales market must start early enough to
ensure that the output can be sold as scheduled. Market preparation ranges from advertising and
training of salesmen and dealers to the organization of distribution newt work.
12. Plant commissioning: One of the most critical stages during the implementation period is
the commissioning of the plant. This stage normally comprises the following activities:
a) Pre-operational checks
b) Trail runs
c) Performance test
d) Acceptance and take-over

3.6.2 Implementation Scheduling

The implementation schedules are normally prepared in three steps. In the first step, the planner
determines the logical sequence of events in implementation without paying much attention to
the exact duration of each task. In the second step the planner will analyze how specific tasks
are to be undertaken. Some tasks will be further divided into subtasks. Finally, the analyst
established the implementation schedule showing the correct positioning and duration of all
activities, and tasks. The description of each task should include:
1. The resources needed for the task
2. The time required to complete the task
 3. The responsibility for the task
4. Information inputs required for the task
5. Results to be produced
6. Interrelationship with other activities, etc.

Suppliers of plant and equipment will be able to provide information concerning installation and
commissioning. Shipping companies can provide valuable information on transports times and
the customs clearance procedures.

3.6.3 Projecting the Implementation Budget

The objective of implementation budgeting is to determine the cost of resources required to
implement a project. The feasibility study should determine the cost of resources in accordance
with the timing of the various states of project implementation. The estimated implementation
costs are capitalized pre-production costs forming part of the total initial investment costs.

The cost estimates are based on the implementation activities and tasks determined for the
project. For various cost items standard costs can be found in publicly available reference
material. For example, associations of architects and engineers in many countries have
established rules for calculating fees for engineering services. Other cost items may require local
surveys.
CHAPTER FOUR
FINANCIAL ESTIMATES AND PROJECTIONS

4.1. Total Investment Cost of Project

Cost of project is costs incurred for which the goods (service) are believed to serve the project
for a long period of time.
Conceptually, cost of project represents the total of all items of outlays associated with a project
which are supported by long term funds. Its the sum of the outlays on the following:
1. Land and site development
2. Building and civil work
3. Plant and machinery
4. Technical know-how and engineering fees
5. Expenses on foreign technicians and training of technicians abroad
6. Miscellaneous fixed asset
7. Preliminary and capital issue expenses
8. Pre-operative expenses
9. Provision for contingencies
10. Margin money for working capital
11. Initial cash losses
1. Land and site development: The cost of land and site development is the sum of the following
- Basic cost of land including transportation and other allied charges
- Premium payable on leasehold and transportation charges
 - Cost of leveling and development
- Cost of laying approach roads and internal roads
- Cost of gates
- Cost of tube wells
The cost of land varies considerably from one location to another. While it is very high in urban
and even semi-urban location, it is relatively low in rural locations. The expenditure on site
development, too, varies widely depending on the location and topography of the land

2. Building and civil work: The cost of building and civil works depends on the kinds of
structures required which, in turn, are dictated largely by the requirements of the manufacturing
process. Once the kinds of structures required are specified, cost estimates are based on the base
area and the rates for various types of structures. These rates, of course, vary with location to
some extent.

Building and civil works cover the following:

Building for the main plant and equipment
Building for auxiliary services like steam supply, workshops, laboratory, water supply,
etc
Godowns, warehouses, and open yard facilities
Non-factory buildings like canteen/cafeteria/dinning, guest houses, time office, exercise
house ,etc
Quarters for essential staff
Garages
Sewers and drainage, etc
Other civil engineering works.

3. Plant and Machinery: The cost of the plant and the machinery, typically the most significant
component of the project cost, consists of the following:
Cost of imported machinery which is the sum of:
i) FOB (free on board) value
ii) Shipping, freight, and insurance cost
iii) Import duty, and
iv) Cleaning, loading, unloading, and transportation charges
Cost of indigenous machinery which consist of:
i) Acquisition cost,
ii) Sales tax, and other taxes, if any,
iii) Railway freight and transport charges to the site.
Cost of store and spares
Foundation and installation charges

4. Technical know-how and engineering fees: Often it is necessary to engage technical

consultants or collaborators from Ethiopia and abroad for advice and help in various technical
matters like:
 preparation of the project report
choice of technology
selection of the plant and machinery
detailed engineering ,and so on

While the amount payable for obtaining the technical know-how and engineering service for
setting up the project is a component of the project cost, the royalty payable annually, this is
typically a percentage of sales, the operating expense taken into account in the preparation of the
projected profitability statement.

5. Expense on Foreign Technicians and Training of Ethiopians Abroad: Services of foreign

technician may be required in Ethiopia for setting up the project and supervising the trail runs.
Expenses on their travel, boarding, and lodging along with their salaries and allowance must be
shown here. Likewise, expenses on Ethiopian technicians who require training abroad must also
be included here.

6. Miscellaneous Fixed Assets: Fixed assets and machinery which are not part of the direct
manufacturing process may be referred to as miscellaneous fixed assets. They include items like
furniture, office machinery and equipment ,tools ,vehicles, railway siding, diesel generating sets,
transformer, boilers, piping system, laboratory equipment, work shop equipment, and so on.
Expenses incurred for the procurement or use of patent, licenses, trademarks, copyright, etc. and
deposits made with the electricity board may also be included here.

7. Preliminary and Capital Issue Expenses: expenses incurred for identifying the project,
conducting the market survey, preparing the feasibility report, drafting the memorandum and
articles of association and incorporating the company 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. The major components of capital issue expenses are underwriting commissions,
brokerage fees to managers and registrars, printing and postage expenses, advertising and
publicity expenses, listing fees, and stamp duty.

8. Pre-Operative Expenses: expenses of the following types incurred till the commencement of
commercial production are referred to as pre-operative expenses:
Establishment expenses
rent, rates and taxes
traveling expenses
interest and commitment charges on borrowings
insurance charges
mortgage expenses
interest on deferred payments
start up expenses, and
Miscellaneous expenses.
Pre-operative expenses are directly related to the project implementation schedule. So, delays in
project implementation, which are fairly common, tend to push up these expenses. Appreciative
of these financial institutions allow for some delay (20 to 20%) in the project implementation
schedule and accordingly permit a cushion in the estimate for pre-operative expenses.

Pre-operative expenses incurred up to the point of time the plant and machinery are set up are
treated as revenue expenditure. The firm may however, treat them as referred revenue
expenditure and write them off over a period of time.

9. Provision of Contingencies: a provision for contingencies is made to provide for certain

unforeseen expenses and price increase over and above the normal inflation rate which is already
incorporated in the cost estimates.

To estimate the provision for contingencies the following procedures may be followed:
Divide the project cost items in to two categories, such as "cost items and "non firm" cost
items (firm cost items are those which have already been acquired or for which definite
arrangements have been made).
Set the provision for contingencies at 5 to 10% of the estimated cost of non-firm cost
items.
Alternatively, make provisions of 10% for all items (including the margin money for working
capital) if the implementation period is one year or less. For every additional one year, make an
additional provision of 5%.

10. Margin money for working capital: The principal support fro working capital is provided by
commercial banks and trade creditors. However, a certain part of the working capital
requirement has to come from long term sources of finance referred to as the margin of money
for working capital this is an important element of the project cost.

The margin of money for working capital is sometimes utilized for meeting over-runs in capital
cost. This leads to a working capital problem (and sometimes a crisis) when the projects is
commissioned. To mitigate this problem, financial institutions stipulate that a portion of the loan
amount, equal to the margin money for working capital, be blocked initially so that can be
released when the project is completed.

11. Initial Cash Losses: Most of the project incurs cash losses in the initial years. Yet, promoters
typically do not disclose the initial cash losses because they want the project to appear attractive
to the financial institutions and the investing public. Failure to make a provision for such cash
losses in the project cost generally affects the liquidity position and impairs the operations.
Hence prudence calls for making a provision, overt or covert, for the estimated initial cash
losses.
4.2 Means/Source of Finance

To meet the cost of the project, the following means of finance are available:
1. Equity/share capital
2. Term loans
3. Debenture capital
4. Deferred credit
5. Incentive source
6. Miscellaneous source

1. Share Capital: there are two types of share capital - Equity capital and Preference
capital. Equity capital represents the contribution made by the owners of business, the
equity shareholders, who enjoy the reward and bear the risks of ownership. Equity capital
being a risk capital carries fixed rate of dividend. Preference capital represents the
contribution made by preference shareholders and the dividend paid on it is generally
fixed.
2. Term loan: provided by financial institutions and commercial banks ,term loans
represents secured/safe/protected borrowing which are very important source (and often
the major source) for financing new projects as well as the expansion ,modernization ,and
renovation schemes of existing firms.
3. Debenture capital: debenture capital similar to promissory notes, debentures are
instruments for raising debt capital. There are two broad types of debentures
Convertible debenture: are debentures which are convertible, wholly or partly, into
equity share. The conversion price and period are announced in advance.
Non convertible debenture: are straight debt instrument. Typically they carry a
fixed rate of interest and have a maturity period of 5 to 9 years.

4. Deferred credit: many a time the suppliers of the plant and machinery offer a deferred credit
facility under which payment for the purchase of the plant and machinery can be made over a
period of time.

5. Incentive source: the government and its agencies may provide financial support as an
incentive to certain types of promoters or for setting up industrial units in certain locations. For
example the government of Ethiopia provides many incentive packages to investors in selected
industries such as flower farming. Construction, hospitals and education sectors. These
incentives include tax holiday for a certain period of life of a project, duty free import of
machineries and equipment, and lease free delivery of lands.

6. Miscellaneous sources: a small portion of the project finance may come from miscellaneous
sources like unsecured loans, public deposits, leasing and high purchase finance. Unsecured
loans are typically provided by the promoters to bridge the gap between the promoters'
contribution (as required by the financial institutions) and equity capital the promoters can
subscribe to. Public deposits represent unsecured borrowing different from the conventional term
loans and debenture capital.

4.3 Planning the Means/Source of Finance

This section assess how should you go about determining the specific means of finance for a
given project? The guidelines and the consideration that should be borne in mind for this purpose
are as follows:

i) Norms of regulatory bodies and financial institution

ii) Key business consideration

Norms of regulatory bodies and financial institutions: In some countries, the proposed means of
finance for a project must either be approved by a regulatory agency or conform to certain norms
laid by the government or financial institutions in this regard. The primary purpose of such
regulation is to convey carefulness to project financing decisions and provide a measure of
protection to investors. In addition, the norms of financial institution, which often provide
substantial assistance to projects significantly shape and circumscribe project financing decision.
In Ethiopia, the regulatory body of all financial institutions is National Bank of Ethiopian which
outlines loan policies to be followed by banks. And Development Bank of Ethiopia is especially
established to grant loan to development projects. It has also its own norms under the umbrella of
national policies.

Key business consideration: The key business considerations which are relevant for the project
financing decision are:

Cost-cost of debt is lower than the cost of equity funds. Why? The primary reason is
that the interest payable on debt capital is a tax deductible expense whereas the
dividend payable on equity capital is not.
Risk-the two main sources of risk for a firm (or project) are business and financial
risk. Business risk refers to the variability of earnings before interest and taxes and
arises mainly from fluctuations in demand and variabli8ty of process and costs.
Financial risk represents the risk arising from financial leverage. It must be
emphasized that while debt capital is cheap it is also risky because of the fixed
financial burden associated with it.
Control-from the point of view of the promoter of the project, the issue of control is
important. They would ordinarily prefer a scheme of financing which enables them to
maximize their control as well as potential, over the affairs of the firm, given their
commitment of funds to the project.
Flexibility- this refers to the ability of a firm (or project) to raise further capital from
any source it wishes to tap to meet the future financing needs. This provides
maneuverability to the firm.
4.4 Estimates of Sales and Cost of Production

So far you have learned about what cost of project is and its component, the means of financing
it and planning of the means of finances. In this section, we are going to make note the different
aspects that are to be born while estimating the level of sales and sales revenue, cost of
production of a project over its estimated life.

1. Sales: Typically, the starting point for profitability projections is the forecast of sales revenue.
In estimating sales revenue the following consideration should be born in mind:
It is not advisable to assume a high capacity utilization level in the first year of operation.
Even if the technology is simple and the company may not have technical problems in
achieving a high rate of capacity utilization in the first year itself, there are likely to be
other constraints like raw materials shortage, limited market problem, etc, it is sensible to
assume that capacity utilization would be somewhat low in the first year and rise there
after gradually to reach the maximum level in the third or fourth year of operation.
It is not necessary to make adjustments for stock of finished goods. For practical
purposes it may be assumed that production would be equal to sales.
the selling price considered should be the price realizable by the company net of excise
duty it shall ,however, include dealers commission as shown as an item of expense (as
part of the sales expense).

2. Cost of production: Give the estimated production, the cost of production may be worked
out. The major components of cost of production are:
Material cost- the most important element of cost, the material cost comprises the cost of
raw materials, chemicals, components, and consumable stores required and the prices
payable for them.
Utilities cost- utilities cost consist of power, water, and fuel.
Labor cost- labor cost is the cost of all manpower employed in the factory.
Factory overhead cost- the expenses on repairs and maintenance, rent, taxes, insurance on
factory assets, and so on are collectively referred to as factory overheads.
4.5 Profitability, Cash Flows and Balance Sheet Projections

Given the estimates of sales revenue and cost of production as discussed above, the next step is
to prepare the profitability projections or estimates of working results (as the are referred to by
term-lending financial institutions in Ethiopia). Once the income statement is projected the next
step will be the preparation of cash flow statement and cash flow statement over the same period
as the income statement.
1. The Estimates of Working Results/Profitability Projection: The estimates of working
result may be prepared along the following lines:
A. Cost of production xx
B. Total administrative expense xx
C. Total sales expense xx
D. Royalty and know how payable xx
E. Total cost of production(A+B+C+D) (xxx)
F. Expected sales xxx
G. Gross profit before interest(E-F)-PBI xx
H. Total financial expense (xx)
I. Depreciation (xx)
J. Operating profit(G-H-I) xxx
K. Other income xx
L. Preliminary expense written off (xx)
M. Profit or loss before taxation(J+K-L)-PBT xxx
N. Provision of taxation (xx)
O. Profit after tax(M-N)-PAT xxx
Less: dividend on
- preference capital (xx)
- equity capital (xx)
P. Retained profit xxx
Q. Net cash accrual(P+I+L) xxx

Cost of production represents the cost of materials, labour, utilities, and factory overheads as
calculated earlier.

Total administrative expenses consists of administrative salaries, remuneration to directors,

professional fees, light, postage, telegrams, and telephones, and office supplies (stationery,
printing, etc), sales promotion and advertising expenses and other miscellaneous expenses.

The selling expenses depend mainly on the nature of industry and the kind of competitive
conditions that prevail. Typically, selling expenses vary between 5 and 10% of sales. The
experience of similar firms in the industry may be used as a basic guideline.

Royalty and Know-how payable annually may be shown here. The royalty rate is usually 2-55 of
sales. Further, royalty is payable often for a limited number of years, say 5 to 10%.
Total cost of production is simply the sum of cost of production, total administrative expenses,
selling expenses and royalty and know-how payable. The figures of expected sales are drawn
from the estimates of sales and Gross Profit Before Interest is the difference between expected
sales and total cost of production.

Total financial expenses consist of interest on term loans, and commission of bank guarantees.
The principal financial expenses, of course, are interest on term loans and interest on bank
borrowings. In estimating the interest on terms loans, two points should be borne in mind:
Interest on term loans is based on the present rate of interest charged by the term lending
financial institutions and commercial banks.
Interest amount would decrease according to the requirement schedule of the term loan.

The interest on bank borrowings may be estimated as follows:

determine the total requirement of the working capital
find out the quantum of bank borrowing that would be available against the total working
capital requirement, and
Calculate the interest charges on the basis of the prevailing interest rates.

Other income represents income arising from transactions not part of the normal operations of
the firm such as from sale of machinery, disposal of scrap, etc.
Illustration-1: The balance sheet of Bahir Dar enterprise at the end of year n is as follows:
Bahir Dar Enterprise
Balance Sheet
December 31, 2009
Asset Liabilities and Capital
Cash Br. 20,000 Reserves and surplus Br.20, 000
Receivable 80,000 Secured loans 80,000
Inventories 80,000 Unsecured loans 50,000
Fixed asset 180,000 Current liabilities 90,000
Investments - Provisions 20,000
----- Share capital 100,000
Total 360,000 Total 360,000

The projected income statement and the distribution of the earnings for the year n+1 are given
below:
Sales 400,000
Cost of goods sold (300,000)
Depreciation (20,000)
Earnings before interest and tax (EBIT) 80,000
Interest expense (20,000)
Profit before tax 60,000
Tax (30,000)
Earnings after tax (EAT) 30,000
Dividend (10,000)
Retained earnings 20,000

Additional information
During the year n+1 the firm plans to rise a secured term loans of 20,000, pay a previous
term loan to the extent of 5,000 and increase unsecured loans by 10,000.
Current liabilities and provisions are expected to remain unchanged.
Further, the firm plans to acquire fixed asset worth 30,000 and increase its inventories by
10,000.
Receivables are expected to increase by 15,000.
Other assets, except cash, would remain unchanged.
The firm plans to pay 10,000 by way of equity dividend.
Given the above information the projected cash flow statement and balance sheet are shown
below:

1. Source and Uses of Funds Statements (Projected Cash Flow Statement)

Sources

Profit before tax with interest added back (EBIT) 80,000

Depreciation 20,000
Increase in secured loan 15,000
Increase in unsecured loan 10,000
Total sources 125,000

Uses
Expenditure 30,000
Increase in working capital 25,000
Interest 20,000
Taxation 30,000
Dividend-equity 10,000
Total uses (115,000)
Cash surplus/deficit (125,000-115,000) 10,000

Ending Cash Balance

Beginning cash balance 20,000
Net surplus or deficit (125,000-115,000) 10,000
Ending cash balance 30,000

Points to be kept in mind:

Decrease in any asset is source of fund
Increase in any asset is use of fund( except cash)
Increase in any liability is source of fund
Decrease in any liability is use of fund
Retained earnings are not shown in cash flow statement.
 2. Projected Balance Sheet

The balance sheet, showing a balance in various asset and liability account, reflects the financial
condition of the firm at a given point of time. The liability side of a balance sheet shows the
source of finance employed by the business.

For preparing the projected balance sheet at the end of year n+1 we need information about the
following.

- the balance sheet at the end of year n

- the projected income statement and the distribution of earning for the year n+1
- The source of external financing proposed to be tapped in the year n+1.
- The proposed repayment of debt capital (long-term, intermediate term, and short term)
during the year n+1.
- The outlay and disposal of fixed asset during the year n+1.
- Change in the level of current asset during the year n+1.
- The change in other asset and certain outlay like preoperative and preliminary expense
during the year n+1.
- The cash balance at the end of year n+1
The projected balance sheet of the illustration for the year n+1 is as follows:
Assets Changes Ending Balance.
Current assets
Cash 20,000 +10,000 30,000
Receivable 80,000 +15,000 95,000
Inventories 80,000 +10,000 90,000
Fixed asset 180,000 +10,000 190,000
Total 360,000 45,000 405,000
Liabilities and Capital
Share capital 100,000 - 100,000
Reserves and surplus 20,000 +20,000 40,000
Secured loans 80,000 +15,000 95, 000
Unsecured loans 50,000 +10,000 60,000
Current liabilities 90,000 - 90,000
Provisions 20,000 --- 20,000
Total 360,000 45,000 405,000

Illustration-2: Prepare projected cash flow statement and balance sheet from the following
information:
1. Balance Sheet at the end of year n.
Assets Liabilities and Shareholders Equity (SHE)
Cash 25,000 Current liabilities 50,000
Receivables 40,000 Long-term liabs. 90,000
Inventories 35,000 Total liabilities 140,000
Total CA 100,000 SHE
 Fixed Assets 150,000 Common equity 80,000
RE 30,000
------- Total equity 110,000
Total Assets 250,000 Total L &SHE 250,000
2. Projected income statement for the year is as follows:
Sales 120,000
Cost of Goods Sold (80,000)
Depreciation (6,000)
EBIT 34,000
Interest expense (4,000)
EBT 30,000
Tax (10,000)
EAT 20,000
Dividend (5,000)
Retained Earnings 15,000
3. Additional Information
During the year n+1 the firm plans to raise a long term liability of 50,000 and to repay a
previous long term liability of 5,000.
The firm plan to acquire fixed asset worth 25,000 and increase its inventories by 20,000.
Receivables are expected to increase by 10,000.
Other assets, except cash, would remain unchanged.

CHAPTER FIVE: PROJECT FINANCING

5.1 Capital Structure

5.1.1 What is capital structure?

Capital structure, according to Gitman, is the mix of long-term debt and equity maintained by the
firm. Gitman further explains that capital structure is one of the most complex areas of financial
decision making because of its interrelationship with other decision variables. Poor capital
structure decisions can result in a higher amount of cost of capital, thereby lowering the NPVs of
newly coming investment options and making more of them unacceptable. Effective capital
structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable
projects-and thereby increasing the value of the firm.
Financing is the way in which the firms assets are contributed by internal (spontaneous sources
of capital: accounts payable and accruals) and external fund providers (owners and creditors). In
general the total capital of a firm can be broadly broken-down into two components:
Debt and
Equity capital.
The cost of debt is lower than the cost of other forms of financing. This is because lenders
demand/require lower returns from their investment as they take the least risk of any long-term
contributors of capital:
 They have a higher priority of claim against any earnings and assets available to
payment.
They can exert far greater legal pressure against the company to make payment than can
owners of preferred or common stock.
The interest payable to creditors is tax deductible.

The above three reasons lower the cost of debt substantially.

Unlike debt capital, which must be repaid at some future date, equity capital is expected to
remain in the firm for an indefinite period of time. The two basic sources of equity capital are
preferred stock and common equity which includes common stock and retained earnings.
Common stock is typically the most expensive form of equity followed by retained earnings and
then preferred stock.
Because of equitys secondary position relative to debt, suppliers of equity capital take greater
risk than suppliers of debt capital and therefore must be compensated with higher expected
returns. Our concern in this part of the chapter is the relationship between debt and equity capital
or the effect of use of different mixes of debt and equity capital on the firms value.
The other term that is going to be used in this chapter frequently is the financial structure of
firms. The term financial structure refers to the mix of all items that appear on the right-hand
side of a balance sheet. In other hand, it refers to the mix of short-term debt (current liabilities),
non-current liabilities (long-term debt), preferred capital, and equity capital. Though the two
terms; capital structure and financial structure, have the above theoretical differences, in this
chapter we will use both terms interchangeably to refer to the mix of debt and equity to finance
total assets.

5.1.2 Determinants of Capital Structure

Capital structure has to be determined at the time a company is promoted. The initial capital
structure should be designed very carefully. The management of the company should set a target
capital structure and the subsequent financing decisions should be made with a view to achieve
the target capital structure. Once a company has been formed and it has been in existence for
some years, the financial manager then has to deal with the existing capital structure. The
company may need funds to finance its activities continuously. Every time the funds have to be
procured, the financial manager weighs the pros and cons of various sources of finance and
selects most advantageous sources keeping in view the target capital structure: Thus the capital
structure decision is a continuous one and has to be taken whenever a firm needs additional
finance.
Generally, the factors to be considered whenever a capital structure decision is taken are:
1. Leverage or Trading on equity
2. Cost of capital
 3. Cash flow
4. Control
5. Flexibility
6. Size of the company
7. Marketability
8. Floatation costs.

1. Leverage or Trading on Equity: The use of sources of finance with a fixed cost, such as debt
and preference share capital, to finance the assets of the company is known as financial leverage
or trading on equity. If the assets financed by debt yield a return greater than the cost of the
debt, the earnings per share will increase without an increase in the owners' investment.
Similarly, the earnings per share will also increase if preference share capital is used to acquire
assets. But the leverage impact is felt more in case of debt because:

(i) the cost of debt is usually lower than the cost of preference share capital, and
(ii) The interest paid on debt is a deductible charge from profits for calculating the taxable
income while dividend on preference shares is not.
Because of its effect on the earnings per share, financial leverage is one of the important
considerations in planning the capital structure of a company. The companies with high level of
the Earnings before Interest and Taxes (EBIT) can make profitable use of the high degree of
leverage to increase return on the shareholders' equity. One common method of examining the
impact of leverage is to analyze the relationship between Earnings per Share (BPS) at various
possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one
important tool in the hands of the financial manager to get an insight into the firm's capital
structure management. He can consider the possible fluctuations in EBIT and examine their
impact on EPS under different financing plans.
2. Cost of Capital: Measuring the costs of various sources of funds is a complex subject and
needs a separate treatment. Needless to say that it is desirable to minimize the cost of capital.
Hence, cheaper sources should be preferred, other things remaining the same.

3. Cash Flow: One of the features of a sound capital structure is conservation. Conservation
does not mean employing no debt or a small amount of debt. Conservatism is related to the
assessment of the liability for fixed, charges, created by the use of debt or preference capital in
the capital structure in the context of the firm's ability to generate cash to meet these fixed
charges. The fixed charges of a company include payment of interest, preference dividend and
principal. The amount of fixed charges will be high if the company employs a large amount of
debt or preference capital. Whenever a company thinks of raising additional debt, it should
analyze its expected future cash flows to meet the fixed charges
4. Control: In designing the capital structure, sometimes the existing management is governed
by its desire to continue control over the company. The existing management team may not only
what to be elected to the Board of Directors but may also desire to manage the company without
any outside interference.

The ordinary shareholders have the legal right to elect the directors of the company. A
shareholder or a group of shareholders could purchase all or most of the new shares and thus
control the company. Since holders of debt do not have voting right, it is often suggested that a
company should use debt to avoid the loss of control. However, when a company uses large
amounts of debt, lot of restrictions are imposed on it by the debt-holders to protect their interests.
These restrictions curtail the freedom of the management to run the business. An excessive
amount of debt may also cause bankruptcy, which means a complete loss of control.

5. Flexibility: Flexibility means the firm's ability to adapt its capital structure to the needs of the
changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing
its capitalization or sources of funds. Whenever needed the company should be able to raise
funds without undue delay and cost to finance the profitable investments. The financial plan of
the company should be flexible enough to change the composition of the capital structure. It
should keep itself in a position to substitute one form of financing for another to economize on
the use of funds.

6. Size of the Company: The size of a company greatly influences the availability of funds from
different sources. A small company may often find it difficult to raise long-term loans. If
somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on
inconvenient terms. Small companies, therefore, have to depend on owned capital and retained
earnings for their long-term funds. A large company has a greater degree of flexibility in
designing its capital structure. It can obtain loans at easy terms and can also issue ordinary
shares, preference shares and debentures to the public. A company should make the best use of
its size in planning the capital structure.

7. Marketability: Marketability here means the ability of the company to sell or market
particular type of security in a particular period of time which in turn depends upon -the
readiness of the investors to buy that security. Marketability may not influence the initial capital
structure very much but it is an important consideration in deciding the appropriate timing of
security issues. At one time, the market favors debenture issues and at another time, it may
readily accept ordinary share issues. Due to the changing market sentiments, the company has to
decide whether to raise funds through common shares or debt.

If the share market is depressed, the company should not issue ordinary shares but issue debt and
wait to issue ordinary shares till the share market revives. During boom period in the share
market, it may not be possible for the company to issue debentures successfully. Therefore, it
should keep its debt capacity unutilized and issue ordinary4shares to raise finances.
8. Floatation Costs: Floatation costs are incurred when the funds are raised. Generally, the cost
of floating a debt is less than the cost of floating an equity issue. This may encourage a company
to use debt rather than issue ordinary shares. If the owner's capital is increased by retaining the
earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor
influencing the capital structure of a company except in the case of small companies.
5.2 Sources of Project Financing
There are different sources of project finances available to a company to raise capital. These are:
A. Common/Ordinary Shares
B. Preference shares
C. Debenture/Bond
D. Term Loans
A. Common/Ordinary Shares: represent the ownership position in a company. The holders of
ordinary shares, called shareholders, are legal owners of the company. Ordinary shares are the
sources of permanent capital since they do not have a maturity date. For the capital distributed by
shareholders by purchasing ordinary shares, they are entitled for dividend. Since the rate of
dividend that the shareholders receive annually is not fixed, an ordinary share is known as a
variable income security.

Features of Common/Ordinary Shares

Claim on income: ordinary shareholders have a residual ownership claim. They have a
claim to the residual income, which is, earning available for ordinary shareholders, after
paying expenses, interest charges, taxes and preference dividends, if any.
Claim on assets: ordinary shareholders have a residual claim on the companys assets in
the case of liquidation. Liquidation is a winding-up of companys activities, usually by
selling assets, paying liabilities and distributing any remaining cash to shareholders. Incase
of liquidation, out of the realized value of assets, first claims of debt holders and the
preference shareholders are satisfied.
Right to control: ordinary shareholders are able to control the management of the company
through their voting rights and right to maintain proportionate ownership.
Voting rights: ordinary shareholders are required to vote on a number of important matters
like:
- election of board of directors
- change in the memorandum of associations
- Changes in companys objectives etc.
Pre-emptive right: they are entitled to purchase new shares in the same proportionate as
their current ownership.
Limited liability: the shareholders of a company have limited liability. This means that
creditors usually may not go beyond the assets of the company to satisfy their claims.
Advantages of Common Shares

The main advantages of the equity shares are listed below:

Potential for profit: the potential for profit is greater in equity share than in any other
investment security. Current dividend yield may be low but potential capital gain is great.
 Limited liability: in corporate form of business organization, its owners have limited
liability. The shareholders are not liable for any failure on the part of the corporation to
meet its obligation except their investment.
Hedging against inflation: the equity share is good hedge against inflation though it does
not fully compensate for the declining purchasing power as it is subject to the money rate
risk. But, when interest rates are high, shares tend to be less attractive, and price tend to
be depresses.
Free transferability: the owner of share has the right to transfer his/her interest to
someone else.
Share in the growth: the major advantage of investment in equity share is its ability to
increase in value by sharing in the growth of company profits over the long run.
Tax advantage: equity shares of officer tax advantages to investors. The larger yield on
equity shares results from an increase in principal or capital gains, which are taxed at
lower rate than other income in most of the countries.
Pros and Cons of Common Shares

Equity capital is the most important long term source of financing. It offers the following
advantage:
Permanent capital: since ordinary shares are not redeemable, the company has no
liability for cash outflow associated with its redemption.
Borrowing base: lenders generally lend in proportion to the companys equity capital. By
issuing ordinary shares, the company increases is financial capabilities because it can
borrow additional funds. Thus, the amount of equity capital increases the borrowing limit
of a company.
Dividend payment discretion: a company is not legally obliged to pay dividend. In times
of financial difficulties, it can reduce or suspend payment of dividend. Thus, it can avoid
cash outflow associated with ordinary shares.
Common stock has the following limitations:
1. Cost: equity capital have a higher cost at least for two reasons:
a. dividends are not tax deductible as an interest payment
b. flotation costs on ordinary shares are higher than those on debt
2. Risk: equity shares are riskier from investors point as there is uncertainty regarding
dividend and capital gains. Therefore, the equity holders require relatively higher rate of
return.
3. Earning dilution: the issue of new ordinary share dilute the existing shareholders
earning per share if the profit is not increase in capital proportion with the increase in
number of ordinary shares.
 4. Ownership dilution: the issuance of new ordinary shares may dilute the ownership and
control of the existing shareholders. That means the issuance of ordinary shares can
change the ownership.
B. Preference Shares

A preference share is often considered to be a hybrid security since it has many features of both
ordinary shares and debentures. It is similar with ordinary shares in:
The non payment of dividend does not force the company to insolvency.
Dividends are not deductible for tax purpose.
In some cases, it has no fixed maturity date.
It is similar with denture in:
Dividends are fixed
Preference shareholders have claims on income and assets prior to ordinary shareholders.
They do not share in the residual earnings
They do not have voting rights.

Features of Preference Shares

1. Claims on income and assets: preference shares are a senior security as compared to
ordinary shares. It has prior clam on the companys income in the event of distribution
dividend and prior claim on assets incase of liquidation.
2. Fixed dividend: the amount of preference dividend is fixed. That is, it will be equal to
the dividend rate multiplied by the par value.
3. Cumulative dividend: preference shares are requiring that all past unpaid preference
dividend be paid before any ordinary dividends are paid. This feature is a protective
device for preference shareholders.
Pros and Cons of Preference Shares

Preference shares have been providing the following advantages:

1. Risk less leverage advantage: preference share provides financial leverage advantage
since preference dividend is a fixed obligation. This advantage occurs without a series
risk default. The non payment of preference dividend does not force the company into
insolvency.
2. Dividend postponability: since preference shares can postpone payment of dividend, it
provides some financial flexibility to the company.
3. Fixed dividend: the preference divided payments are restricted to the sated amount.
Shareholders do not participate in excess profit as do the ordinary shareholders.
4. Limited voting rights: preference shareholders do not gave the voting rights except in
case of dividend arrears exist.
Preference shares have the following disadvantages:
1. Commitment to pay dividend: preference dividend can not be omitted, they have to be
paid because of their cumulative nature.
2. Non-deductible of dividend: preference dividend is not tax deductible. Thus it is costlier
than debenture.

C. Debenture/Bond
Debenture is a long term promissory note for raising loan capital. The firm promises to pay
interest and principal as stipulated. The purchaser of debenture are called debenture holder.
Debenture holders are the creditors of the firm.
Features of Debenture
Debenture has the following features:
a) Interest rate: the interest rate on the debenture is fixed and known. It is called the
contractual rate of interest. It indicates the percentage of the par value of the debenture
that will be paid out annually in the form of interest.
b) Maturity: debentures are issued for a specific period of time. The maturity of a
debenture indicates the length of time until the company redeems or returns the par value
to debenture holder and terminates the debenture.
c) Redemption: most debentures are generally redeemed or returned on maturity.
Pros and Cons of Debenture

Debenture has the following advantages:

1. Less costly: debentures are less cost to the firm than equity because;
a. Investors consider it as less risky investment as a result they require lower rate of
return.
b. Interest payments are tax deductible.
2. No ownership dilution: since debenture holders do not have voting right, debentures issue
does not cause dilution of ownership.
3. Fixed payment of interest: debenture holders do not participate in extraordinary earnings of
the company. Thus, the payments are limited to interest.
4. Reduced real obligation: during inflation the obligation of paying interest and principal
which are fixed decline in real terms.

Debenture has the following disadvantages:

Obligatory payment: debenture results in a legal obligation of paying interest and
principal. If not paid, it can force the company into liquidation.
Financial risk: it increases the firms financial leverage.

Types of Debenture
There are different types of debenture such as:
Non-Convertible Debenture: they are pure debentures without a feature of conversion
in to equity. They are repayable on maturity to debenture holders. Therefore, the
investor is entitled for interest and repayment of principal.
Fully Convertible Debenture: they are converted into shares as per the terms of the
issue with regard to price and time of conversion.
Partly Convertible Debenture: it has a convertible and non-convertible part.

D. Term Loans

Term loans are also sources of long term debt. They represent long-term debt with a maturity of
more than one year. They are obtained from banks and other financial institutions. The purpose
of term loan is mostly finance the companys capital expenditure.

CHAPTER SIX: PROJECT MANAGEMENT

Chapter Objectives: After completing this chapter, you should be able to:-
Define project management
Know the primary tasks of project manager
Understand the forms of project organization
Understand contract administration
Explain the procurement and materials management issues of project management.
Discuss

6.1 Definitions

Project management is the discipline of planning, organizing, securing and managing resources
to bring about the successful completion of specific project goals and objectives.
Project management deals with planning, scheduling, controlling and monitoring the activities
that must be completed to reach the predetermined objectives of the project.

Project management is a carefully planned and organized effort to accomplish a specific (and
usually) one-time objective, for example, construct a building or implement a major new
computer system. Project management includes developing a project plan, which includes
defining and confirming the project goals and objectives, identifying tasks and how goals will be
achieved, quantifying the resources needed, and determining budgets and timelines for
completion. It also includes managing the implementation of the project plan, along with
operating regular 'controls' to ensure that there is accurate and objective information on
'performance' relative to the plan, and the mechanisms to implement recovery actions where
necessary.
The primary challenge of project management is to achieve all of the project goals and objectives
while honoring the preconceived project constraints. Typical constraints are scope, time, and
budget. The secondaryand more ambitiouschallenge is to optimize the allocation and
integration of inputs necessary to meet pre-defined objectives.

Since projects are the investment of resources on a package of interrelated time-bound activities,
project management should focus on coordinating the activities. The manager has to organize,
staff, direct and control in the midst of constraints on time, cost, and performance. Efficient
managerial techniques are required for project planning and controlling. Project planning is the
process of preparing for the commitment of resources in the most economical manner.
Controlling is the process of making events conform to schedules by coordinating the action of
all parts of the project.

A Project Manager is a systems analyst with a diverse set of skills management, leadership,
technical, conflict management, and customer relationship who is responsible for initiating,
planning, executing, and closing down a project. The project managers environment is one of
continual change and problem solving. The project managers understanding of the project
management process is critical.

6.2 Forms of Project Organization

There are a large number of factors that influence the organizational structure. Some of them are
delegation of powers, authority, leadership styles, skills, targets, etc. Generally, project
organization may be done in one of the following forms:
1. Line and Staff Organization: Under this form of organization, a person commonly referred
to as the project coordinator, is appointed to coordinate the activities of various departments. He
acts in a staff position to facilitate the coordination of line management in functional
departments. He doesnt have any authority and direct responsibility of line management. He
serves as a local pint for receiving project-related information and serves the project by rendering
services. Sharing information and providing assistance.
Since he doesnt enjoy formal organizational authority, he may become indifferent towards his
duties and may not be able to control the various departments. Thus, it is a weak form of
organization.
2. Divisional organization: In this form of organization, a separate division is set up to
implement the project. The division is headed by the project manager who enjoys full line
authority over the personnel of the division. As a result, he has total control over the division.
He is in a better position to integrate the efforts and strengthen the commitment of project related
personnel to the objectives of the project. It can also improve the time and cost targets.
However, a company that runs two or more projects has to produce many specialists of the same
type because of the necessity to allocate them in total to each project. Such a duplication of
experts will result in wastage of time, energy and money.
3. Matrix organization: The matrix form is more suitable for achieving the twin objectives of
efficient use of resources and effective realization of project objectives. Under this form, the
authority is shared between the project manager and the functional managers. As a result, the
personnel working in the project have a responsibility to their functional superior as well as to
the project manager. The project manager integrates the contributions of personnel in various
functional departments towards the realization of project objectives. However, a major
drawback of this form of organization is the dual subordination.

6.3 Network Techniques

During the implementation stage, you focus on completing a number of activities for
commencing the operations of the project. Most of these activities are interrelated.
In order to execute the implementation process, these activities have to carry out in a proper
order. For proper planning and scheduling and controlling the activities of a project, given their
relationships, network techniques have been found quite useful.
Performing the activities in a certain sequence, which is technologically ordered, is referred to as
employing network techniques. In order to employ network techniques, the project should be
broken down into a well-defined set of jobs or activities. Within a defined sequence, the
activities may be started and stopped in an independent manner.
Development of Project Network: Basic to PERT and CPM is the network diagram. The
network diagram also referred to as the project graph which shows the activities and events of
the project and their logical relationships.
A network is an arrow diagram, which is a graphic presentation of the project plan. The network
diagram is constructed in terms of activities and events. It depicts the logical sequence of the
various elements of work, in relation to each other that must be accomplished before a project
can be completed.

An event is an occurrence at a point in time marking the commencement or completion of one or

more activities. It doesnt consume any resources. The symbol for an event is a circle. The
events are numbered logically and are inscribed inside the circle.
An activity represents a clearly defined project work, job or task and requires time and resources
for carrying out. An arrow represents an activity. The tail of the arrow is its start and the head is
its completion.
For example, a simple network diagram for a dinner party:

Preparing dinner
2
2 Receiving
1 guests
Inviting guests 3 4
Taking dinner
In order to construct a network diagram, the activities of the project have to be enumerated.
Then, the sequence of the activities has to be decided. The preceding, succeeding and
simultaneous activities for each activity should be defined.
Rules for Network Construction: the following are some rules of network construction:
o Each activity must have a preceding and a succeeding event.
o Each event must have a distinct number.
o There should be no loops in the project network
o Not more than one activity can have the same preceding and succeeding activity.
Time estimation: The network plan has to produce a timetable of work, with each job allocated
a starting point and a finishing date. The time estimate for completing each activity should be
established. Generally three time values are assigned for each activity.
1. Optimistic Time (to): is the time required to complete a piece of work if no hurdles or
complications arise.
2. Most likely time (tm): is the time in which the activity is most likely to be completed. It
makes allowance for some delays.
3. The pessimistic time (tp): is the time required if unusual complications and unforeseen
difficulties arise.
6.3 Contract Management
A contract is an agreement enforceable by law and is made between two or more parties.
Contracting is the process of establishing a relation between the owner and the contractors to
execute the project work, especially construction. Since it has many legal and commercial facets
its handling calls for specialized knowledge and practical experience.

Contracting Approach
1. Entrust the total responsibility for engineering, procurement and construction to a
consortium of contractors who may divide the total responsibility among themselves
2. Divide the project into engineering, construction, supplies etc, and entrust the
responsibilities to suitable suppliers and contractors.
 3. Accomplish a portion of the work yourself with your own departmental organization and
contract out the balance to one or more agencies.

Contracting Procedure: There may be directives from the government with regard to the
contracting procedures. The world Bank, Asian Development Bank, UNDP, etc, have their own
detailed procedures.

The usual steps in contracting are:

1. Work Packaging: Work packages are made for the purpose of contracting with
concentration in particular schedule areas. As far as possible one package must be
independent of other packages and each package must be well defined. The size of each
package must be either too large or too small.
2. Preparation of Tender Documents: The preparation of tender documents requires serious
attention because it aims at furnishing the prospective contractors with the details of the
contract. Documents given to contractors should contain sufficient information. They shall
include the following:
A. Instruction to tenders: Instructions may cover contractors qualifications, guidelines for
the preparation of the tender, the number of copies to be submitted, currency, bid bond
requirement, tender evaluation criteria, dates of submission and opening etc.
B. Model form of lender: The prescribed form of tender shall be included in the tender
documents.
C. Drawings and specifications: Specifications should be complete and clear, and set out
the way in which all work should be done. With respect to goods, they should specify
physical and chemical properties. Regarding work they should specify standards,
methods, quality and quantity. Specifications should cover also site conditions, soil
conditions etc.
D. General Conditions of Contract (GCC): GCC is a document made applicable to all
contractors. It must cover contract documents, drawings, terms of payments,
performance security, and procedure for settlement of claims and disputes, rights and
obligations of parties and other conditions which are generally applicable to contractors.
3. Determination of Contractors Qualifications: One of the modern contracting approaches
is to invite submissions for prequalification before issuing a tender. The criteria for
qualification of contractors for every work package should be determined in advance. The
contract will be given only to a party possessing those qualifications. This technique is
employed with a view of avoiding incapable contractors. However, prequalification is not
compulsory. The minimum qualifying requirements should include a contractors
qualification, experience, employees, equipment, and financial stability. Different
organizations determine the qualifications of the contractors in different ways. If
prequalification is included in the contracting procedure, the following steps must be taken:
1. Advertisement of prequalification notice inviting submission of applications.
2. Evaluation of applications.
3. Enlistment of the qualified contractors and intimation to them.
4. Tender Invitation: If contractors are short-listed through prequalification procedures, send
them enquiry letters to know their interest in participating in the tender. An open tender may be
advertised in the absence of such a list. The invitation to tender should be properly worded and
should not give room for any dispute or disadvantage.
5. Tender Submission: Tender is usually submitted in sealed envelopes. Tenders will submit
the required number of copies of tender documents together with the other necessary documents
on or before the last date for submission. The invitation to tender should clearly say the
requirements and last date for submitting a tender.
6. Tender opening: Unless a justifiable confidentiality is to be maintained, like in a national
defense project, tenders should be opened in the presence of tenders authorized representatives.
The time, place and date of opening the tenders must be informed in advance.
7. Evaluation and recommendation: The project manager and the interested department heads
have to participate in the evaluation of tenders. One of the very important tasks in the evaluation
process is to add the costs of the elements that the tenders have not included with their prices.
Costs of excluded components shall be added at the maximum market price. The other areas of
observation in the evaluation process are the quantity, quality and other technical specifications.
8. Award of contract: Usually, contract is awarded to the tender who offers the lowest price.
In certain cases, the tenders may be called by the project managers for negotiations for brining
down the price. But negotiations are not encouraged by many international organizations,
especially the World Bank.
9. Signing of Agreement with detailed contract conditions: Once the tender is awarded to a
contractor, a contract agreement is signed. It is document by which the contractor agrees with
the owner to execute the defined work and the owner agrees to pay the agreed contract price in
the manner stipulated in the contract.
6.4. Procurement and Materials Management
Proper planning and control of procurement and efficient post-procurement materials
management are essential for an efficient project management.

Procurement: Procurement is a multidimensional activity with a number of significant features.

Delay in the supply of critical equipment and materials may lead to project overruns. The
ultimate objective of project procurement is to ensure that all required materials are made
available at the right time. The most important activities in procurement process of projects are
Material Scheduling, Procurement Planning, and Procurement Budgeting.
1. Material Scheduling: The first step in materials scheduling is listing. This is done on the
basis of the need for materials and equipment. A schedule for purchasing the materials will be
prepared after listing the materials taking the lead time into account.
Unless procurement of materials is scheduled in accordance with the work schedule, the project
may face overruns. It is usual to break down the total procurement into (1) goods, (2) works, and
(3) services, the first for all manufacture and supplies, the second for construction, and the third
services like those of consultants.
2. Procurement Planning: Procurement planning includes the following:
a) Indenting: Indent is the purchase requisition raised by the project manager.
 b) Making-buying decisions: The project manager may seek the possibility of making some
items on the indent inside the project, if possible.
c) Initiation of procurement action: The principal methods of bidding for supplies and
purchasing are:
(1) Open bid against advertisement,
(2) Prequalification of bidders, and
(3) Search out and invite to quote.

d) Logistic Planning: It includes planning of loading, transport, port, clearance, unloading,

storage, and site transportation.
3. Procurement Budget: Procurement budget has to be prepared on the basis of the final project
estimate. In short, a well-planned procurement system aims at right quantity, right quality, right
price, and right time.
Materials Management: The functions of material management, with respect to project
management particularly with construction management are the following:
1. Checking the materials on arrival: Checking the materials on arrival has two purposes: (1)
to see if they have suffered any damage or loss in transit, and (2) to satisfy technically that the
supply tallies exactly with the order specifications.
2. Recording the receipts: Besides the book entries of the stores, the project manager has to
record the receipt of every item in his documents.
3. Storage on site, Handling, and Retrieval
Distribution logistics in project consisting of storage, handling retrieval, issue and movement to
job site are major activities often giving rise to problems which all project managers face.
4. Risk Management: Security of the materials during the storage and transportation, safe
handling to avoid damage and sufficient lighting, fencing etc. are necessary for reducing the risk
of materials. Moreover, proper insurance coverage must be given to reduce the extent of risk.

5. Wastage and damage during usage: Wastage during the usage and handling beyond a
permissible level and damage by accident or negligence can cause for financial loss and
emergency replacement buying. People should be educated to avoid wastage and prevent
damage.
6. Make it at the site: The project team should try to make at the site workshop, the
replacement of damaged items, if possible so that the time could be saved. Components can also
be partly bought and partly made and then assembled.
7. Rectifications, repairs and replacements: Care should be taken to ensure that no time is lost
in the inspection of the defects. Saving project time by immediate decision to do necessary
rectification at your cost may be more economical than waiting for a credit acceptance by a
supplier.
8. Inventory control: An efficient inventory control system focuses on timely procurement of
materials and avoids high expenditure on inventory holding. ABC analysis is also employed in
inventory control. ABC analysis is a technique of sorting out the materials on the basis of the
value of total usage of individual materials and taking better care of the more expensive ones.
The items are listed in the order of value and special care is given in the order of value. Care and
control over the stock must include proper accounting, insurance, periodic checking maintaining,
suitable stock levels, and maintaining proper material records.

6.5 Project Control

Once the project is launched, control becomes the dominant concern of the project manager.
Project control involves a regular comparison of performance against targets, a search for the
causes of deviation, and a commitment to check adverse variances. It serves two major
functions: (1) It ensures regular monitoring of performance, and (2) It motivates project
personnel to strive for achieving project objectives.
Cost Control Tools
Reliable and accurate data and information are the keys for controlling. The master budget is the
most important tool for the cost control. The master budget has to be broken down into various
components of cost such as material, equipment, labour, office expenditure, technology
acquisition, sundry costs etc. These schedules of cost serve as the basic for controlling cost.

In addition to the schedules of costs, output information is used in cost control. At different
operating levels, important data are collected and converted into management information.
Progress reports, cash flow statements, and reports on cost trends, cost status, and bottlenecks or
constraints etc. are the important pieces of information required for controlling costs. A number
of ratios, such as ratios of total project cost and individual activity costs, are also used for cost
control.

The control function includes:

o Check on activities
o Measure the qualitative output
o Compare the results with the budgeted figures
o Based on the present performance, predict the future costs
o Ascertain and analysis the past and the predicted variances
o Investigate and trace the causes of variances to their roots
o Offset the adverse variances and correct the root causes of the variances to prevent their
recurrence.
6.6 Performance Analysis: Modern Approach to Control
Effective control over a project requires systematic performance analysis. This calls for
answering the following questions:
Is the project as a whole on scheduling, a head of schedule or behind schedule?
Has the cost of the project been as per budget estimates or different?
What is the trend of performance? What would be the final cost for completion of the
project?

Performance analysis may be done for individual components of the project. In performance
analysis, we consider the value of work that has been done. This enables us to know
systematically whether the expenditure incurred was commensurate with progress.
Control of Contingency and Changes: Contingency control and changes control are often used
interchangeably. Unless an effective control is exercised on contingencies and changes, the
budget and schedule will be thrown out of control. Project cost control to be effective, should
have two streams of accounting, one for the estimated definitive budgeted cost and the other for
the potential contingencies or changes. Approved and accrued contingency amounts shall get
added on to the cost.

Contingency controlling or change controlling is done through a system of continual trending,

and predicting changes, and brining down the level of contingency. The system should identify
changes form the original scope, estimate their impact on the cost budget, evaluate their benefits
with reference of to cost, and provide the management with sufficient information on these
variables for making decisions on giving effect to the changes. There are optional changes like
modifications and additional facilities being incorporated, and inescapable changes like statutory,
regulatory, and inflationary changes. If approved, the changes shall be implemented as if they
were parts of the original scope, with an additional contingency budget or add on budget. Price
escalations may also be combined with contingency.

The project manager must try to reduce the impact of contingencies and changes through
trending and predicting. They are simple forecasting exercised through which the future
performance of work and cost are predicted.

Corrective and Preventive Actions: Variances identified or predicted shall form the basis for
management actions of correction and prevention. In project implementation, there are
controllable and uncontrollable factors of variance either existing at the present time or likely to
occur in the future. The manager should always be alert and be in contact with the external and
internal environment to be able to predict the potential deviations and take preventive measures
in times.

As for the past variances and the existing situation, urgent corrective actions must be taken on
controllable factors. A revision of budget is necessary for uncontrollable factors. Controllable
variance factors include wrong resource assessment, poor productivity, etc. Among
uncontrollable factors we usually find errors in design, unenvisaged events, statutory changes,
wrong selection of equipment, etc.

Management action in variance control shall be aimed at reducing further adverse variance, and
simultaneously accelerating the pace of activities to put the project back on schedule.
Preplanning, rescheduling, closer monitoring, change in project team to induct more number of
committed people, faster decision making, deletion of some work packages, etc. are among
corrective measures.
6.7 Project Monitoring and Evaluation

Monitoring is about systematically collecting information that will help you answer questions
about your project. You can use this information to report on your project and to help you
evaluate. This type of evaluation is performed while a project is being implemented, with the aim
of improving the project design and functioning while in action. It is an internal project activity
designed to provide constant feedback on the progress of a project, the problems it is facing, and
the efficiency with which it is being implemented.

Evaluation is about using monitoring and other information you collect to make judgments about
your project. It is also about using the information to make changes and improvements. An
evaluation studies the outcome of a project (changes in income, housing quality, benefits
distribution, cost-effectiveness, etc.) with the aim of informing the design of future projects.
Evaluation studies can assess the extent to which the project produced the intended impacts
(increases in income, better housing quality, etc.) and the distribution of the benefits between
different groups, and can evaluate the cost-effectiveness of the project as compared with other
options

Monitoring and evaluation need not be expensive or complicated, nor do they require specialists
or grand calculations. The complexity and extent of the studies can be adapted to fit the program
needs. The job of the project manager in this process is to point out those areas in need of
monitoring or evaluation. If this is left to the researchers, the studies may tend to be too
academic and not as useful to project management.

Evaluation and monitoring systems can be an effective way to:

Provide constant feedback on the extent to which the projects are achieving their goals.
Identify potential problems at an early stage and propose possible solutions.
Monitor the accessibility of the project to all sectors of the target population.
Monitor the efficiency with which the different components of the project are being
implemented and suggest improvements.
Evaluate the extent to which the project is able to achieve its general objectives.
Provide guidelines for the planning of future projects (Bamberger 4).
Influence sector assistance strategy. Relevant analysis from project and policy
evaluation can highlight the outcomes of previous interventions, and the strengths and
weaknesses of their implementation.
Improve project design. Use of project design tools such as the logframe (logical
framework) results in systematic selection of indicators for monitoring project
performance. The process of selecting indicators for monitoring is a test of the
soundness of project objectives and can lead to improvements in project design.
Incorporate views of stakeholders. Awareness is growing that participation by project
beneficiaries in design and implementation brings greater ownership of project
objectives and encourages the sustainability of project benefits. Ownership brings
accountability. Objectives should be set and indicators selected in consultation with
stakeholders, so that objectives and targets are jointly owned. The emergence of
recorded benefits early on helps reinforce ownership, and early warning of emerging
problems allows action to be taken before costs rise.
Show need for mid-course corrections. A reliable flow of information during
implementation enables managers to keep track of progress and adjust operations to take
account of experience (OED).

6.7.1 Components Monitoring and Evaluation Design

Good monitoring and evaluation design during project preparation is a much broader exercise
than just the development of indicators. Good design has five components:

Clear statements of measurable objectives for the project and its components, for which
indicators can be defined.
A structured set of indicators, covering outputs of goods and services generated by the
project and their impact on beneficiaries.
Provisions for collecting data and managing project records so that the data required for
indicators are compatible with existing statistics, and are available at reasonable cost.
Institutional arrangements for gathering, analyzing, and reporting project data, and for
investing in capacity building, to sustain the M&E service.
Proposals for the ways in which M&E findings will be fed back into decision making.

6.7.2 Indicators of Project Monitoring and Evaluation

Input indicators are quantified and time-bound statements of resources to be provided.

Information on these indicators comes largely from accounting and management records. Input
indicators are often left out of discussions of project monitoring, though they are part of the
management information system. A good accounting system is needed to keep track of
expenditures and provide cost data for performance analysis of outputs. Input indicators are used
mainly by managers closest to the tasks of implementation, and are consulted frequently, as often
as daily or weekly.

Examples: vehicle operating costs for the crop extension service; levels of financial contributions
from the government or cofinanciers; appointment of staff; provision of buildings; status of
enabling legislation.

Process indicators measure what happens during implementation. Often, they are tabulated as a
set of contracted completions or milestone events taken from an activity plan.

Examples: Date by which building site clearance must be completed; latest date for delivery of
fertilizer to farm stores; number of health outlets reporting family planning activity; number of
women receiving contraceptive counseling; status of procurement of school textbooks.

Output indicators show the immediate physical and financial outputs of the project: physical
quantities, organizational strengthening, initial flows of services. They include performance
measures based on cost or operational ratios.

Examples: Kilometers of all-weather highway completed by the end of September; percentage of

farmers attending a crop demonstration site before fertilizer top-dressing; number of teachers
trained in textbook use; cost per kilometer of road construction; crop yield per hectare; ratio of
textbooks to pupils; time taken to process a credit application; number of demonstrations
managed per extension worker; steps in the process of establishing water users' associations.

Impact refers to medium or long-term developmental change. (Some writers also refer to a
further class of outcome indicators, more specific to project activities than impact indicators,
which may be sectoral statistics, and deal more with the direct effect of project outputs on
beneficiaries.) Measures of change often involve complex statistics about economic or social
welfare and depend on data that are gathered from beneficiaries. Early indications of impact may
be obtained by surveying beneficiaries' perceptions about project services. This type of leading
indicator has the twin benefits of consultation with stakeholders and advance warning of
problems that might arise.

Examples of impact: (health) incidence of low birth weight, percentage of women who are
moderately or severely anemic; (education) continuation rates from primary to secondary
education by sex, proportion of girls completing secondary education; (forestry) percent decrease
in area harvested, percent increase in household income through sales of wood and non-wood
products. Examples of beneficiary perceptions: proportion of farmers who have tried a new
variety of seed and intend to use it again; percentage of women satisfied with the maternity
health care they receive.

6.8 Project Review

The expenditure authorization for a project generally specifies how much can be spent by whom
and when. To ensure that the actual expenditure does not deviate significantly from the
authorized expenditure, periodical control is exercised during project implementation.

An audit of a project after it has been commissioned is referred to as post audit or post
completion audit. Most firms do a post audit for almost every project above some threshold
limit. Such an audit compares actual performance with planned performance when the operations
of the project stabilize. Post audit will have the following advantages:

Post audit provide a documented log of experience that may be valuable in improving
future decision making.
It enables the project in identifying individuals with superior abilities in planning and
forecasting.
It helps in discovering systematic biases in judgment.
It induces healthy caution among project sponsors.
It serves as useful training ground for promising executives who need broader
perspective.