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Technical, Economic, Financial, Legal and Social Appraisal of the industrial projects, Problems arising due to rate of discount, wagerates, treatment of taxes, social cost benefits, treatment of risk and uncertainty, sensitivity analysis and probability approach single as well as multiple projects
Project Appraisal
Project appraisal is the process of detailed examination of several aspects of a Given project before its recommendation. Various aspects of project appraisal are as mentioned below:1. Technical appraisal: Selection of process / technology Scale of operation Technical know how Collaboration agreement Product mix Selection and procurement of plant and machinery Plant lay out Location of a project Project scheduling and implementation
Project Appraisal
Collaboration agreements:- If the project promoters have entered into agreement with foreign collaborators, the term and conditions of the agreement may be studied appropriately. Following points deserve special consideration:1. The competence and reputation of the collaborators need to be ascertained through possible sources. 2. The technology proposed to be imported should suit to local conditions. 3. It should have necessary approval of the government of India. 4. There should not be any restrictive clause regarding import of machinery /equipment. There should not be any clause for the payment of any kind of commission. There should not be any restriction on import of goods/services. Promoters should be free for targeting any market. 5. It is better to have buy back agreement with the technical collaborator, this to ensure that the collaborator will be serious about the transfer of correct know how and would ensure quality of the output. 6. And few other points.
Project Appraisal
Project scheduling:- scheduling is nothing but the arrangement of activities of the project in the order of time in which they are to be performed. The schedule which broadly indicates the logical sequence of events would be as mentioned:1. Land acquisition 2. Site development 3. Preparing building plans, estimates, designs, getting necessary approvals and entrusting the construction works to the contractors. 4. Construction of building, machinery foundation and other related civil works and completion of the same. 5. Placing order for machinery. 6. Receipt of machinery at site. 7. Erection of machinery. 8. Commissioning of plant and taking trial runs. 9. Commencement of regular commercial production.
Basic amenities
Government policies
Proximity to subcontractors
Factors of location
Primary factors 1. Availability of raw materials 2. Nearness of market for the finished product 3. Availability of fuel and power 4. Transport facilities 5. Availability of labor 6. Availability of water (for paper & chemical inds) and other resources required
Secondary factors 1. Soil and climate 2. Industrial atmosphere 3. Financial and other aids 4. Availability of facilities like housing, schools, hospitals and recreation clubs 5. Momentum of an early start 6. Special advantage of the place(subsidies, tax holidays) 7. Personal factors. 8. Historical factors 9. Political stability
Location analysis
Cost analysis (comparative cost analysis):- In this method all the costs involved in establishing and operating the plant are listed and total cost is calculated. Based on the total cost the location decisions are being made.
Factors (Cost of) Land Building Water Power Labor Freight (In coming + out going) Fuel Raw mat & other supplies Taxes Total cost Community facilities, community attitude Housing facilities Cost of living Community size Location 1 (cost in Rs.) 100000 1200000 5000 15000 140000 280000 40000 140000 4000 1924000 Good, all right Very good High Small Location 2 (cost in Rs.) 90000 1300000 6000 17000 120000 260000 35000 130000 2000 1960000 Excellent, Encouraging Good Normal Medium
Considering cost alone location 1 is better, but considering cost plus facilities, location 2 can be recommended
The lay out should be such that future expansion can be done without much alteration. It should facilitate effective supervision of work. It should ensure smooth flow of men and materials during the process. Lay-out should create a favorable environment for the process and the workers ensuring maximum efficiency, health, safety and hence maximum profitability.
Types of Layouts
Project Appraisal
2. Commercial appraisal:Commercial appraisal of the project is done studying the commercial successfulness of the product/service offered by the project from the following angles:1. Demand for the product 2. Supply position for the product 3. Distribution channel 4. Pricing of the product 5. Government policies
Project Appraisal
Demand forecasting techniques:- Broadly speaking there are two approaches to business forecasting. One approach is to obtain information about the intentions of consumers through collecting views and opinions of experts in the field or by conducting interviews with the consumers. This approach is called survey method . The other approach is to use historical data i.e extrapolating the statistical data. This approach is called statistical approach. While survey method is suitable for short term planning, the statistical approach is suitable for long term forecasting. Estimating future demand for the existing products can be done by either of the methods but demand forecasting for the new products can only be done by survey methods, since historical data is not available in this case for extrapolation.
Project Appraisal
Survey methods:Jury of experts opinion method:- In this method, experts in the particular field are requested to give their view on the likely demand for the product in future. Delphi Technique:This is a group decision by experts in which the individual experts act separately. Their views are pooled together and an attempt is made to arrive at consensus. Consumers survey method:- this is the most direct method. Sales forecast = tot population size/sample size X no. of respondents who said yes X % of
those who said yes who will actually purchase X ave. qty. that will be purchased by a buyer
Project Appraisal
Statistical methods:1. Trend analysis 2. Regression techniques Trend analysis:- following are some of the methods used in trend analysis to estimate the future demand based on historical data. The process of extending the past trend to the future is called extrapolation. 1. Curve fitting 2. Moving average method 3. Weighted moving average method 4. Exponential smoothing method The basic assumption of trend analysis is that in future all the factors that were responsible for the past movements will be present and will exert influence in the same way as they had been in the past. The relationship is often expressed in the form of a mathematical formula or model.
Project Appraisal
7 B
X
5 4 2 1 Y2 Y3
Fitment error at point 1 = (Y1 Y1) Fitment error at point 2 = (Y2 Y2) Fitment error at point 3 = (Y3 Y3) etc
Y2 Y1 Y1
Y3
X1
X2 X3
Project Appraisal
The best fitting line will be one for which the absolute value of fitment error is minimum. Hence our aim is to find a line that passes closest to the all points. Since some of the points are above the line and others are below the line, so the difference between the line and points above the line would be +ve and the difference between the line and the points below the line would be ve. Thus, the differences would cancel out one another and hence the total sum of differences as a measure of best fit would be incorrect. So we take square of the differences to solve this problem. Sice we are looking for a line that is closest to all the points, for such a line, sum of squares of differences would be minimum. Hence this method of arriving at the line of best fit, is called the method of least squares. If Y = a + bX is the relation for the best fitting line, using the principles of least squares, the value of the parameters a and b can be calculated, using the equations:y = n . a + b . x and x y = a . x + b . x^2
Project Appraisal
Fit a straight line trend to the following data, using the method of least squares. From the straight line trend, estimate the demand in the year 1995.
Year (X) Demand for household water heaters (Y) (numbers in 1000s) 1979 600 1980 825 1981 970 1982 1210 1983 1440 1984 1790 1985 2070
Project Appraisal
Year (X) 1979 Demand (Y) 600 X -- 3 X^2 9 XY --1800
1980 1981
1982 1983 1984 1985
825 970
1210 1440 1790 2070 = 8905
--2 --1
0 1 2 3 =0
4 1
0 1 4 9 = 28
--1650 --970
0 1440 3580 6210 = 6810
Here no. of observations = 7, so n = 7 Now we will use two equations to find values for a and b and we will calculate demand for the year 1995
Value of a = 1272.14 Value of b = 243.21 Y = 1272.14 + 243.21 X, substitute X = (x-1982) and you will get demand in 1995 = 4433070 units
Project Appraisal
Moving average method:- According to moving average method of forecasting, the forecast for the next year is arrived at by taking the average of the actual data for a few immediately preceding years. If the data of preceding three years are considered for arriving at the forecast for the fourth year, it is called a three year moving average. For example,
Actual sales year 1994 1995 1996 1997 2219 2302 2007 (2219+2302+2007) / 3 = 2176 sales Forecast
Determining the period of moving average is an important factor in calculating the trend values in the moving average method. This method is used when past data do not exhibit a steady increase or decrease in trend over time, but show fluctuations.
Project Appraisal
Weighted moving average method:- in the moving average method of forecasting , only the simple average of a few previous years data are taken as the forecast for the next year. It is likely that the more recent data might give a better indication of the trend than a past data. If this is so, in the calculation of moving average, weight of moving average will vary according to their period, the more recent data will get more weight and vice versa.
Actual sales year 1987 1988 1989 1990 1991 1992 1993 sales 2999 1999 2182 2219 2302 2007 0.6 0.7 0.8 0.9 (0.6X2182 + 0.7X2219 + 0.8X2302 + 0.9X2007) / 4 = 1627.6 weight Forecast
The forecast for the next time period is given by the following relationship. F(t+1) = . At +(1 ) . Ft, Where, F(t+1) = forecast for the time period (t+1) = smoothing factor (which lies between 0 and 1, including 0 and 1) At = Actual value for the time period t Ft = forecast for the time period t
Solution
Old forecast = F1 = 320 units Actual observation = D1 = 350 units for = 0.5, F0 = F1 + (D1 F1) = 320 + 0.5(350 320) = 320 + 15 = 335.
333.0859375 66.9140625
33.4570313 366.5429688
Project Appraisal
3. Economic Appraisal:- It measures the effect of the project on the whole economy. Developing and under developed countries face scarcity of capital, foreign exchange and many other resources. Government in such countries wants to make sure that scarce resources are being used in the possible best manner in the overall interest of the economy. So, among the project Alternatives, policy makers make a choice based on the economic return.
4. Financial appraisal:- Financial appraisal of project consists of two major areas. 1. arriving at the cost of the project and 2. arriving at the appropriate means of financing the project. By means of financing we mean the combination of debt and equity. The proper debt equity combination depends upon the revenue earning capacity of the project. We have already discussed about these two points in the earlier unit. For details please refer to slides of unit 2.
Project Appraisal
5. Management appraisal:- Management is the most important factor that Can either make a project a success or a failure. A good project at the hands of poor management may fail while a not so-good project at the hands of an effective management may succeed. Hence banks and financial institutions, that lend money for financing projects lay more emphasis on the management appraisal.
6. Legal and Social appraisal:- Till now, we examined the financial yields from the projects. While financial yields of a project are very important for an industrial project, there are other legal and socio-economic considerations such as projects conformity with the rules and regulation of the concerned economy or projects overall impact on the economic and social health of a country, its impact on forex reserve of a country, development of backward areas, defense requirement, self reliance etc. these factors may carry more weight with certain projects. While legal considerations are important for all projects, social profitability analysis is most used for evaluating public sector projects where the principal objective may not be to maximize financial yields from the capital investments.
Project Appraisal
It may be relevant for certain Private projects also, since the fund providing institutions would like to see that the national interests / considerations are taken care of in the private investment proposals. Besides, implementation of the project may result in self sufficiency in certain crucial areas. These benefits may be more important to the society than mere financial returns.
Problem arising due to:Rate of Discount:This will lead to inappropriate financial evaluations. Its adverse effect will be even more in long term project evaluations. This will lead to inappropriate calculations of various cash flows and so, may result into difficulty in successful completion of the projects.
Wage rate:Inappropriate cost of production, so lead to inappropriate profitability estimates Exchange rate:In case of imported capital/raw material /repayment of loan, inappropriate profitability estimates / company may face financial problems in serving its obligations
Treatment of Taxes
Year ------------------ Building at 10% on WDV (starting value: Rs. 11.82 Lakhs) Plant & Machinery, Electricals, Transport, & erection @ 25% on WDV (starting value Rs. 47.27 Lakhs) Miscellaneous asset at 10% on WDV (starting value: Rs. 1.18 Lakhs)
i 1.18
11.82 0.12
Ii 1.06
8.86 0.11
Iii 0.96
6.65 0.10
Iv 0.86
4.99 0.09
V 0.78
3.74 0.08
Vi 0.70
2.80 0.07
Vii 0.63
2.10 0.06
viii 0.57
1.58 0.06
Total
13.12
10.03
7.71
5.94
3.65
3.57
2.79
2.21
CALCULATION OF TAX
Profit before tax (after providing for depreciation as per companies act)
9.53
16.83
24.97
22.49
18.91
15.06
9.80
3.74
3.97
13.50
3.97
20.80
3.97
28.94
3.97
26.46
3.97
22.88
3.97
19.03
3.97
13.77
3.97
7.71
TOTAL
Less: Depreciation for tax purpose TAXABLE INCOME
Income tax @ 35% with a surcharge of 10% (net 38.50%)
13.12
0.38
10.03
10.77
7.71
21.23
5.94
20.52
3.65
19.23
3.57
15.46
2.79
10.98
2.21
5.50
0.15
4.15
8.17
7.90
7.40
5.95
4.23
2.12
UNIDO approaches
Famous economists S.Marglin, Amartya Sen and Partha Dasgupta prepared a manual based on UNIDOs (United Nations Industrial Development Organization (UNIDO)) experience in costbenefit analysis of projects. UNIDO method involves five stages: 1. Calculation of financial profitability measured at market prices to analyze the financial profitability of a project 2. Obtaining the net benefit of the project measured in terms of economic (efficiency) prices (using shadow prices for resources corrected market prices of various inputs and outputs, i.e calculating real prices/costs of inputs and outputs after considering subsidy and other factors) 3. Adjustment for the impact of the project on savings and investment required in the case of developing countries where there is shortage of capital as well as the required amount of savings and investment. It is important for project that generates benefits to groups who save very little out of additional income. 4. Adjustment for the impact of the project on income distribution Any project has to be analyzed whether it will make poor people poorer or rich people richer. 5. Adjustment for the impact of the project on merit goods and demerit goods If the project produces a good whose social and economic values are different, adjustment of this impact
savings
All India term lending financial institutions like ICICI, IFCI, and IDBI, apart from appraising the projects from financial point of view, give also consideration to social aspects. These institutions follow a partial L-M approach in the sense that some of the recommendations of L-M approach are followed and some are modified. International prices are used for the valuation of tradable inputs and outputs as recommended by L-M approach while for non tradable inputs and outputs, the valuation is done by using social conversion factors instead of by the methods suggested by the L-M approach.
What is risk
Risk is defined in Websters as a hazard; a peril; exposure to loss or injury. Thus, risk refers to the chance that some unfavourable event will occur. If you engage in sky diving, you are taking a chance with your life sky diving is risky. If you bet on the horses, you are risking your money. If you invest in speculative stocks, you are taking a risk in the hope of making an appreciable return. The most common risks associated with a project are:- Project completion risk, resource risk, price risk, technology risk, political risk, interest rate risk, exchange rate risk, An assets risk can be analysed in two ways: 1.On a stand-alone basis 2.On a portfolio basis
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We will discuss about various risks and specially project risk in details and we will also understand different techniques of risk analysis in the coming slides.
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Force majeure
Sensitivity Analysis
A technique of risk analysis which can be used to study the responsiveness of a criterion of merit like NPV or IRR to variations in underlying factors like selling price, quantity sold, etc. If a small change in one factor leads to a major change in the profitability of the proposed investment then the project is considered more sensitive to that factor. The sensitivity of a project can be studied as under:1. What happens to the NPV if the demand for the product drops down 2. What happens to the NPV if the economic life of the project reduces 3. What happens to the DSCR if the selling price of the project falls down etc. It provides the management the much needed information as to which are the critical factors that are prone to affect the profitability of the project.
Success prob = 1
Chance point
Decision point
Success prob = .8
No investment
Gross Expected income: 8.0 L E.M.V : :6.4 L
Chance point
Success prob = .4
46
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There will be 100 tag numbers representing a cumulative probability of 1 (0-99, both inclusive). After assigning tag numbers, the next step is to choose a set of 2 digits nos (random 2 digit numbers because the tag numbers are between 0 and 99). The number of random numbers to be chosen depends upon the accuracy required. More the Numbers more the accuracy. Lets choose say 30 numbers from the table.
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3
4 5 6 7 8 9 10 11 12 13 14 15
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01 60 05 69 79 09 66 77 69 45 18 93
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18
19 20 21 22 23 24 25 26 27 28 29 30
22
62 70 28 31 07 68 22 46 30 23 76 33
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Game Theory
In real life situation, business firms compete with one another. Game theory deals with situations in which two intelligent opponents have conflicting interest. To achieve their goals two firms will form strategies. The strategy that one firm will depend upon the strategy formed by the other firm. The approach to such competitive problems was formed by Von Neuman, who named it game theory. Following are the properties of a competitive game:-
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This is one of the most effective and conceptually sound tools of appraising projects in a case of uncertainty.
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Scenario Analysis
Managers are often interested in establishing the worst case and the best case scenario. That is, what NPV will result if all the assumptions made turn out to be too optimistic and too pessimistic.
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When we undertake a Sensitivity Analysis of a project, or when we look at alternative scenarios (as per scenario analysis) we are asking how serious it would be if sales and cost turns out to be worst than forecasted. Managers sometime rephrase the question and ask how bad sales may get before the project begins to loose money. This exercise is known as break even analysis.
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(NPV)=
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Simulation Analysis
The basic principle in Simulation is that since risk arises out of the events which cannot be fixed into a pattern, i.e. random events, a model can be developed in which all factors excepting the random factors are fixed, and the impact of the random factors on he output can be studied by generating the random events artificially. Using Simulation the manager or decision maker should: Define the problem Identify the fixed and variable factors Identify the various courses of action available to him Construct a mathematical model incorporating all the variables Decide on the best possible course of action
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Break even Analysis As a finance man he or she might be interested in knowing how much should be manufactured and sold at a minimum to ensure that the project does not loss money. To know the answer of this basic question one should undergone this particular model
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Risk Adjusted Discount The risk adjusted discount rate is commonly employed in practice. Rate Method Firms use different discount rates for different types of investment projects. In that case a risk adjusted discount rate is the only solution. Certainty Method Equivalent When the risk free rate is applied for discounting purposes and the expected cash flow of the project are converted into their certainty equivalent, then it will be useful.
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