project mgt

1. Project Analysis
9/9/2022 1
UNIT - VII
PROJECT FINANCING
Project finance or Project Financial analysis seeks to ascertain
(establish) whether the proposed project will be financially
viable (feasible) in the sense of being able to meet the burden
of servicing debt and whether the proposed project will satisfy
the return expectations of those who provide the capital.
A feasibility study is a tool that helps the project promoter to
take a decision on the investment proposal. To facilitate this
decision, both investment and production costs have to be
arranged clearly, keeping in mind that the profitability of a
project will ultimately depend on the size and structure of
investment and production costs and their timing.
The basic components of investment and production costs of a
project of defined capacity are determined in the form of:
 Land and site development
 Building and civil works
 Technology and equipment
 Material inputs
 Labour inputs
 Project implementation costs
The study should then assemble these components so as to
obtain an estimate of the
a) Total investment cost,
b) Total production costs and
c) The financial and economic viability of the project.
Once the size of the investment is known, an assessment of
project financing should be made. Assembling the
components of investment and production costs, particular
attention should be paid to the timing of expenditure and
costs, as it influences the cash flow of the project and its
internal rate of return.
Investment and production costs should be planned on an
annual basis in line with the requirements of cash flow
analysis. There is no exact formula for computing the
investment and production costs, thus various ways to
estimate these figures can be considered. However,
calculations of;
a. Fixed cost,
b. Pre – production capital costs,
c. Working capital, and
d. Production costs,
Should have scope for correction for contingencies
(unforeseen event) and price escalation (increase)
11.1 Total Investment costs
11.1.1 Initial Investment Costs
Initial investment costs are defined as sum of fixed assets
(fixed investment costs plus pre – production expenditures)
and net working capital, with fixed assets constituting the
resources required for construction and equipping an

2. Project Analysis
9/9/2022 2
investment project, and net working capital corresponding to
resources needed to operate the project totally or partially.
At the pre – investment stage, two mistakes are frequently
made. Most commonly:
I. Working capital is included either not at all or in
insufficient amount, thus causing liquidity
problems for project.
II. Total investment costs are sometimes confused
with total assets, which correspond to fixed assets
plus pre – production expenditures plus current
assets.
The amount of total investment costs is, in fact, smaller than
total assets, since it is composed of fixed assets and net
working capital, the latter being the difference between
current assets and current liabilities.
11.1.2 Investment Required during Plant Operation
The economic lifetime is different for the various investments
(buildings, plant machinery and equipment, transport
equipment et.), and, in order to keep a plant in operation,
each item must, therefore, be replaced at the appropriate
time, and the replacement cost must be included in the
feasibility study. A convenient starting point for establishing
the period of the analysis is the technical life of the major
investment item.
In some projects, the technical life (physical life) of the major
investment item may be quite long, and the economic life of
the item is expected to be shorter because of the
technological obsolescence (rapidly changing technology will
make a major investment obsolete over a period), changing
tastes, international competitiveness of the extent of a natural
resource or mineral deposit.
A distinction may be made between the physical life and
economic (or optional) life of an asset. The physical life of an
asset represents the number of years it can be used to
produce a certain output by regular maintenance and repair,
which of course, tends to cost more and more as the years roll
by. The economic life of an asset refers to the number of years
the asset should be used to produce a certain output.
Therefore:
 Economic life – is the period during which a fixed asset is
capable of yielding service to the owner.
The economic life of an asset is conceptually defined as the
period after which the asset should be replaced to minimize
the sum of operating and maintenance costs and capital costs
expressed on an annual basis.
 Physical life – is a period often longer during which a fixed
asset can continue to function not withstanding its
acquired obsolescence, inefficient operation, high cost of
maintenance or obsolete product.

3. Project Analysis
9/9/2022 3
Fixed Assets: Fixed assets comprise fixed investments and pre
– production capital costs.
Fixed Investments: Fixed investments should include:
a) Land purchase and site preparation
b) Buildings and site preparation
c) Plant machinery and equipment including auxiliary
equipment
d) Certain incorporated fixed assets such as industrial
property rights
Total fixed investment can be projected for each year of the
construction period until full production is reached. The
estimate includes supply, packing and transport duties and
installation charges.
Provision should also be made for physical contingency
allowances providing a safety factor to cover unforeseen or
forgotten minor cost.
 Contingency allowance: is an amount included in a
project account to allow for adverse conditions that will
add to baseline costs.
 Physical contingencies: allow for physical events such as
adverse weather during construction, etc. (They are
included in both Financial and Economic analysis)
 Price contingencies: allow for general inflation. In project
analysis they are omitted both from financial and
economic analysis when the analysis is done in constant
prices.
 Constant price is a value, most often a price, from which
the overall effect of general price inflation has been
removed.
A “constant price” is a price that has been deflated to Real
terms by an appropriate “price index” (a series that records
changes in a group of prices relative to a given of base period).
Pre – production Capital Expenditure: Pre – preparation
capital expenditures include the following.
a) Preliminary capital – issue expenditure
These are expenditures incurred during the registration and
formation of the company, including legal fee for preparation
of the memorandum and articles of association and similar
documents, and for capital issues. The capital – issue
expenditures included advertising, public announcements,
underwriting commissions, brokerage, expenses for
processing of share applications and allotment.
b) Expenditures for Preparatory Studies:
There are three types of expenditures for preparatory studies.
- Expenditures for pre – investment studies
(opportunity, pre – feasibility, feasibility and
support or functional studies)
- Consultant fees for preparing studies, engineering
and supervision of erection and construction
- Other expenses for planning the project

4. Project Analysis
9/9/2022 4
c) Other pre – production Expenditures are:
- Salaries, fringe benefit and social security contribution of
personnel (for project implementation team)
- Travel expenses
- Preparatory installation (workers camps, temporary
houses and stores)
- Pre – production marketing costs, promotional activities
- Training costs (fees, travel, living expenses)
- Interest and insurance during construction
Trial runs, start – up and commissioning expenditure are
expenditures that include fees payable for supervision of start
– up operations, wages and salaries, fringe benefits and social
security etc.
In allocating pre – production expenditures, one of the
following two practices is generally followed
I. All pre – production expenditures may be capitalized
and amortized over a period of time that is usually
shorter than the period over which equipment is
depreciated.
II. A part of the pre – production expenditures may be
initially allocated, where attributable, to the respective
fixed assets and the sum of both amortized. Pre –
production expenditures that are not attributable are
capitalized as a total and also amortized over a certain
number of years.
11.2 Net Working Capital:
Net working capital indicates the financial means required to
operate the project according to its production program. Net
working capital is defined as current assets minus current
liabilities.
Production costs are divided into four major categories:
a) Factory costs
b) Administrative overhead costs
c) Depreciation costs
d) Cost of financing
The sum of factory and administrative overhead cost is
defined as operating costs.
Factory costs: include the costs of
- Materials, predominantly variable costs such as raw
materials, factory supplies and spare pars.
- Labour (production personnel) (fixed or variable costs)
- Factory overheads (in general, fixed costs)
Administrative Overheads: Administrative overhead costs
include
- Salaries, wages
- Social costs etc. (on salaries)
- Materials and services
- Rents, leasing costs
- Insurance
Depreciation Costs: Depreciation costs are charges made in
the annual net income statement (profit-loss account) for the
productive use of fixed assets.

5. Project Analysis
9/9/2022 5
While depreciation costs have to be considered in accounting
for the computation of the balance sheet and net income
projections, they present investment expenditure (cash
outflow during the investment phase) instead of production
expenditure (cash outflow during production).
Depreciation charges must therefore be added back if net
cash flows are calculated from the net profit after corporate
tax, as obtained from the net income statements.
Depreciation cost do have an impact on net cash flows,
because the higher the depreciation charges, the lower the
taxable income and the lower the cash outflow corresponding
to the tax payable on income.
Financial Costs: Financial costs (interests) are sometimes
considered as part of the administrative overhead. For the
purposes of financial analysis and investment appraisal,
however, it is necessary to determine financial costs
separately. With a declining amount of external finance there
is a decreasing financial costs.
11.4 Project Financing:
The allocation of financial resources to a project constitutes an
obvious and basic prerequisite for investment decisions, for
project formulation and pre-investment analysis, and for
determining the cost of capital (without which the decision to
accept or reject a project on the basis of the NPV and IRR
cannot be made).
A feasibility study would serve little purpose if it were not
backed by reasonable assurance that resources are available
for a project if the conclusions of the study proved positive
satisfactory.
The capital outlay of a project can be appropriately
determined only after plant capacity and location have been
decided, together with estimates of the costs of a developed
site, buildings and civil works, technology and equipment.
Determining the financial requirements of a project at the
operational stage in terms of working capital is equally
necessary. The determination of working capital can be only
done once estimates are made of production cost, on one
hand, and sales and income, on the other. These estimates
should cover a period of time and be reflected in a cash flow
analysis.
Unless both estimates are available and unless the available
resources are sufficient to meet the fund requirements, both
in terms of initial capital investment and working capital needs
over a period of time, it would not be prudent to proceed to
the financing decision and project implementation.
11.4.1 Sources of Finance
a) Equity

6. Project Analysis
9/9/2022 6
A generally applied financing pattern for an industrial project
is to cover the initial capital investment by equity and long-
term loans to varying extents, and to meet working capital
requirements by additional short and medium term loans
from national banking sources.
The minimum net working capital requirements should be
financed from long-term capital. In situation where
institutional capital is scarce and available only at high cost,
equity capital covers the initial capital investment and net
working capital.
b) Supplier Credits
Imported machinery and spares can often be financed on
deferred credit term. Machinery suppliers in developed
countries are willing to sell machinery on deferred – payment
terms with payments spread over 6 to 10 years.
c) Leasing:
Instead of borrowing financial means it is sometimes possible
to lease plant equipment or even complete production units
that is productive assets are borrowed. Leasing (borrowing of
productive assets) requires usually a Down payment and the
payment of an annual rent, the leasing fee. These are,
however, contained in balance sheet of the lessor and not in
the lessee – which is off – balance sheet financing.
The problem is basically to decide which alternative should be
preferred, leasing or purchasing of capital assets. To evaluate
the two alternatives, the discounted cash flow should be
applied.
The initial down payment, the current leasing fees and
additional payments under the leasing agreements are part of
the cash outflow (replacing the investment costs).
Since the duration of leasing contracts is in general much
shorter than the technical and economic life of an asset, it is
necessary to include the residual value (cash inflow) of the
leased asset when comparing with loan financing.
The inflow for the lessee would usually not be the book value,
but either the book value or the market value (minus the
lessors cost of setting the used items) which ever is lower.
If the investor has a choice between loan and leasing
financing, he would compare the discounted cash flow for
both flow arrays to determine which alternative would bring
the higher yield (IRR, NPV).
Cost of Capital: Lending means a long medium or short-term
commitment reducing the liquidity of the lender and would
also imply uncertainty concerning the full return of the funds
lent. To obtain finance, an investor must, therefore, pay a
charge, the cost of capital or finance for the funds lent. This
charge comprises an interest rate, usually expressed as a

7. Project Analysis
9/9/2022 7
percentage per annum, as well as certain fixed charges
(Commitment fee, charge on capital not drawn, commissions
et.). Interest is usually computed for the outstanding balance
of the corresponding liabilities of a firm, for example, interest
payable on current account.
11.5 Basic Accounting Statements
Although the cash flow analysis has been adopted as the
principal instrument of investment appraisal, it is to have an
understanding of basic accounting principles and statements.
The accounting statements are also important for the analysis
of the structure of project financing and for the computation
of the capital costs of a company. There are basically two
categories of accounting statements:
a. The net income statement or profit and loss
account, which is linked to the balance sheet, and
b. The cash flow table for financial planning.
11.5.1 Net Income Statement
The net income statement is used to compute the net income
/net earnings/ or deficit of the project arising each year.
The projections are required for the entire duration of the
planning period chosen for the project. The net income
statement differs from the cash flow statement in as much as
it shows costs and incomes (and not expenditures and
revenues) by period.
For the purpose of a feasibility study the net income
statement should show at least how the net earnings are
divided between different classes of equity shareholders, the
different suppliers of loan capital and the tax authorities.
11.5.2 Balance Sheet
A balance sheet is a statement showing the accumulated
assets the wealth-of a company and how this wealth is
financed.
The sources of finance are treated as the aggregated liabilities
of the company, the sources being the investors (equity
shareholders) and the group of creditors, banks and
debenture holders. By definition both sides of a balance sheet,
representing assets and liabilities are equal.
11.6.1 Net Present Value (NPV)
The net present value of a project is defined as the value
obtained by discounting, at a constant interest rate and
separately for each year, the differences of all annual cash
outflows and inflows accruing throughout the life of a project.
11.7.2 Simple or Annual Rate of Return
The simple rate of return method relies on the operational
accounts. It is defined as the ratio of the profit in a normal
year of full production to the original investment outlay (fixed
assets, pre – production capital expenditures and net working
capital).

8. Project Analysis
9/9/2022 8
11.8 Financial and Efficiency Ratios
The figures appearing in the balance sheet, the net income
statement and the cash flow tables convey a considerable
amount of information in terms of their absolute value. In
financial analysis it is usual to refer to several well – known
ratios that facilitate the analysis and specially the comparison
of projects and alternatives.
1. Financial Ratios
1.1 Long – term debt – equity ratio:
The long – term debt – equity ratio is an indicator of the
financial project risk for both the equity and the loan capital.
Debt service represents a legally binding commitment of a
firm, the financial risk is higher for the firm as well as the bank
or financing institution, the higher the debt in relation to
equity capital.
1.2 Current ratio or current assets to current liabilities ratio
The current ratio is a liquidity measure computed by dividing
current assets by current liabilities.
Current Ratio = Current Assets
Current Liabilities
In case the inventory could not be sold for cash, to guard
against this possibility, the quick ratio is frequently used in
addition to the current ratio. The quick ratio is computed by
dividing cash plus marketable securities and discounted
receivable by current liabilities.
Quick Ratio = Cash + Receivables + Marketable Securities
Current Liabilities
1.1 Net present value ratio
When the present value of the accumulated net benefits of a
project (i.e. the annual output of the project net of annual
operating expenditures and income taxes, discounted and
accumulated over the planning horizon) is related to the
present value of the total capital invested the NPVR.
1.2 Relation between personnel employed and
investment.
The relation between total initial investment and the number
of workers and staff employed is used when comparing
alternative technologies.
2..4 Turnover of inventories
The rate of turnover of products in stock is a measure of the
marketing capabilities of management. In general, the faster
the turnover, the better for the finance of the company.
11.9 Financial Evaluation Under Conditions of Uncertainty
(Risk Analysis)
Forecast of demand, production and sales may not be exact
because of uncertainty about the future. Similarly,

9. Project Analysis
9/9/2022 9
assumptions concerning the estimates of production and
investment costs, prices or the lifetime of the project may not
always be correct.
When dealing with an investment under conditions of
uncertainty, three variables should particularly be examined:
 Sales revenue
 Production cost and
 Investment cost
A host of individual items enter into these variables, all of
which are composed of a price and a quantity. The most
common reasons for uncertainty are inflation, changes in
technology, false estimation of the rated capacity and the
length of the construction and running – in – period.
Uncertainty analysis includes: Sensitivity analysis and break –
even analysis among others.
11.9.1 Sensitivity Analysis
Sensitivity analysis, sometimes called “what if” analysis
answers question like;
a. What will happen to NPV (or other criteria) if sales
are reduced?
b. What will happen to NPV if the economic life of
the project is reduced?
Sensitivity analysis as a popular method for assessing risk has
certain merits;
a. It forces management to identify the underlying
variables and their interrelationships
b. It shows how robust or vulnerable a project is to
changes in the underlying variables
c. It indicates the need for further work. If the NPV
or IRR is highly sensitive to changes in some
variables, it is desirable to gather further
information about that variable.
d. It is intuitively a very appealing as it articulates the
concerns that project evaluators normally have.
11.9.2 Break – even analysis
In sensitivity analysis we ask what will happen to the project if
sales decline or costs increase or something else happens. A
financial manager will also be interested in knowing how
much should be produced and sold at a minimum to ensure
that the project does not ‘lose money’. Such an exercise is
called break-even analysis and the minimum quantity at which
loss is avoided is called the break-even point. The break-even
point may be defined in accounting terms or financial terms.
Break – even analysis serves to compare the planned capacity
utilization with the production volume below which a firm
would make losses.

10. Project Analysis
9/9/2022 10
The break – even point can also be defined in terms of
physical units produced, or the level of capacity utilization at
which sales revenues and production costs are equal. The
sales revenues at the break – even point represent the break –
even sales value, and the unit price of a product in this
situation is the break – even sales price.
Before calculating the break – even values, the following
condition and assumptions should be satisfied.
 Production and marketing costs are a function of
the production or sales volume (e.g. in the
utilization of equipment)
 The volume of production equals the volume of
sales
 Fixed operating costs are the same for every
volume of production
 Variable costs vary in proportion to the volume of
production, and consequently total production
costs also change in proportion to the volume of
production
 The sales prices for a product or product mix are
the same for all levels of output (sales overtime).
The sales value is therefore a linear function of the
sales prices and the quantity sold.
 The level of unit sales prices and variable and fixed
operation costs remain constant, that is the price
elasticity of demand for inputs and outputs are
zero.
 The bread – even values are computed for one
product; in case of a variety of products, the
product mix, that is the ratio between the
quantities produced, should remain constant.
Since the above assumption will not always hold in practice,
the break – even point (capacity utilization) should also be
subject to sensitivity analysis, assigning different fixed and
variable costs as well as sales prices.