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UNIT - III
FINANCING
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What you will know:
Estimating your financial requirements:– Pre operative expenses– Fixed & Working capital
Sources of fund, Promoter’s Capital Debt equity ratio, Margin money Venture capital Pvt. and Public Ltd. Co. Shares & related issues Marketing expenses Office expenses Cash flow statement Break even point Profit planning Project preparation
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Pre-operative Expenses
Definition: Pre-operating expenses are those expenses which are needed in order to plan and to prepare for the business operation.
Expenses incurred after company formation but before commencement of business
This includes preliminary expenditure to be incurred by the unit – For project formulation– Legal opinion charges– Clearances from various govt. departments / bodies– Loan acquisition costs – Interest during construction– Salaries– Travel expenditure – Trial run expenditure
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Contd…
Market survey Testing Travel expenses to source
- Suppliers of raw materials - Machinery - Negotiate with potential market outlets, etc.
Worker training costs, before production commences
- On-the-job training to the workers by trained/ experienced professionals/ trainers
- Stipend during on-the-job training
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Fixed Capital
Fixed capital is that portion of the total capital that is invested in fixed assets that is not used up in the production of a product and that stay in the business almost permanently, or at the very least, for more than one accounting period.
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Working Capital
Working capital measures how much in liquid assets a company has available to build its business.
The number can be positive or negative, depending on how much debt the company is carrying.
In general, companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth.
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Source of funds
In considering the sources keep in mind the following:
Cost of borrowing Time factors
– Period for which funds are needed– Time taken to obtain money– Purposes for which funds are needed– Norms of financial institutions– Repayment capacity
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Contd…
sources
internal external
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Contd…
Internal sources: Personal savings and investments Loans from PF, LIC etc. Loan from friends and relatives Mortgage of assets like land, building,
shares , bonds, debentures etc. Profits earned or transferred from existing
business or investment or trade.
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Contd…
External sources Financial institutions ( TIIC, SIDBI,IFCI etc.) Banks
For term loan– To acquire fixed assets for setting up the
enterprise
For short term loan– 1 day to 1 year
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Contd…
For plant leasing– Leasing plant and equipment
For hire purchase– hire now and own later
Working capital loan– For day to day needs of the unit– Renewable every year– Given against hypothecation and /or
mortgage of assets
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Overview of external financial sources
Type Description Source Comments
Overdrafts- Short term-As working capital
BanksNot to be used for long term
Mortgage loans
Purchase of land, bldg., plant, equipment
Finance Companies, Insurance Companies
Secured on land and buildings.
Leasing finance
Lease of plant and equipment
Banks, leasing companies
Lessee uses equipment without capital outlay
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Contd…
Working capitalFund assistance to fund working capital requirements
BanksFinancial limits sanctioned, renewable annually
Hire purchase Financing purchase of plant and equipment
Finance Cos., NSIC, state small industries corporation
Ownership vested with lender, Flat interest, borrower deposit required
Bridging finance Interim finance for land , Bldg., loans sanctioned
Banks, finance Cos.,State finance corp.
For short term periods only
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Contd…
Commercial bills
Bridging finance and seasonal fluctuations
Banks, Pvt. Discounting agencies
For cos. with solid credit rating
loans Secured by assets or income stream
Banks, pvt. Lenders, finance cos.
Flat interest rate
Equity and venture capital
Source for med or long term capital
Banks, state level financial institutions and pvt VCs
Low interest,Eligibility criterion of product or experience
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Stages of business development funding
1. Early stage financing Seed capital Relatively small amounts to prove concepts and finance feasibility studies Start-up Product development and initial marketing,
but with no commercial sales yet; funding actually to get company operations started
2. Expansion or Development financing2nd stage Working capital for initial growth phase
3rd stage major expansion for company with rapid sales growth
4th stage Bridge financing to prepare company for public offering
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Contd…
3. Acquisition and Leveraged buyout financing Traditional acquisition Assuming ownership and control
of another company Leveraged buyout management of a company acquiring
company control by buying out the present owners
Going private some of the owners / managers of a company buying all the outstanding
stock, making the company privately held again
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Promoter’s Capital
Promoter’s capital is the capital invested by the promoters in the business.
or It’s the stake that the promoters have in the
business. The sources of finance, which can be included in
the promoter's contribution, are:– Cash profit of the company (in case the project
is being set up in a existing profit making company)
– Sale of asset of the company (can be land, investments etc etc)
– Equity brought in by the promoter
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Contd…
– Equity brought in by A venture Capital fund (please read further for core promoters contribution)
– Unsecured loans brought in by the promoter– Fully convertible, unsecured debentures
subscribed by the promoters of the company
The sum of total of the above should be at least 25 % of the project cost.
We had mentioned above that the promoter's contribution could also include funds brought in by Venture Capital funds. This amount has a limitation as the minimum amount of promoter's contribution should be at least 15% of the project cost.
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Debt Equity Ratio
A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.
= Total liabilities Share holder’s equity
Where share holder’s equity = Total assets - total liabilities
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In other words…
Debt/equity ratio is a measure of the proportion of equity versus debt that is used to finance various portions of a company's operations.
It is used as a standard for judging a company's financial standing.
A debt/equity ratio is calculated by taking the total liabilities and dividing it by shareholders' equity.
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Contd…
Investors will use the debt/equity ratio primarily to determine what amount of risk there may be in either buying equity in the company through stock, or purchasing bonds issued by the company.
If a debt/equity ratio reveals a higher amount of debt compared to equity, investors may consider the company a greater risk.
It is the capacity for debt repayment and it indicates proportion of firm's total capital contributed by trade creditors and lenders.
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Margin Money
Its the money a person need to invest through his pocket out of total money of any loan
The aim of margin money is to minimize the risk of default by either counter-party.
The payment of margin ensures that the risk is limited outstanding position.
Margin money is like a security deposit or insurance against a possible future loss
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Venture Capital
Venture capital is viewed broadly as a professionally managed pool of equity capital and frequently the equity pool is formed from resources of wealthy limited partners.
The limited partners, who supplied the funding, are frequently institutional investors such as insurance companies, endowment funds, bank trust departments, pension funds, and wealthy individual families.
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Types of Venture Capital funds
Types of Venture Capital firms
Pvt. VC firms Small business investment cos.
Industry sponsored:
BanksFin. Inst.
Non Financial Inst.
State Govt. sponsored
University sponsored
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Venture Capital Process
Entrepreneur needs to understand the Venture Capital– Philosophy– Objective – Process
Objective:– To generate long term capital appreciation through debt
and equity investments– More risk is involved in early stages of a company
hence high ROI is expected compared to later stages of development
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Risk and return criteria
Highest risk
Highest return expected
Lowest risk
Lowest return expected
Early stage
Development
financing
Acquisitions and leveraged buyouts
50% ROI
40% ROI
30% ROI
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Contd…
The VC may or may not seek control of the company
The VC would prefer to have the firm and entrepreneur at most risk
A VC would want at least one seat on the board A VC would do anything to support the
management team so that the firm prospers The VC is expected to provide guidance and the
management is expected to run the firm The VC will support the management with
investment, financial skills, planning and expertise in required fields.
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Contd…
The VC expects the firm to satisfy 3 general criteria before committing to the venture
1. A strong management team- Experience- Background- Commitment- Expertise- Capabilities- Flexibility etc.
2. Product and/or market opportunity must be unique, having a differential advantage in a growing market - It is better when protected by a patent or trade secret
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Contd…
3. The business opportunity must have significant capital appreciation
A VC typically expects 40 to 60 % ROI
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Venture Capital process
4 stages1. Preliminary screening2. Agreement on principal terms3. Due diligence4. Final approval
A good business plan is a must for contacting a VCThe executive summary plays a major role as it is
used in initial screening in preliminary evaluation
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Contd…
Stage 1 VC checks if a similar deal has already
been done previously Does proposal fit in their long term policy
in developing portfolio balance Evaluation of economy of the industry Appropriate knowledge and investing
ability in that industry Reasonable ROI
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Stage 2 and stage 3
Agreement on principal terms Basic understanding of principal terms
Stage 3– Due-Diligence– • What is It?– • Key Issues– –Background: WHY?– –Products & Services– –Market & Competition– –Technology & Manufacturing– –Marketing & Sales Strategy– –Organization & Management– –Finance– –Legal Aspects– • How to Perform Due Diligence
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Stage 4
This is the last stage where the final approval is done.
A comprehensive, internal investment memorandum is prepared
This information is used to prepare the formal legal documents.
The deal is finalized.
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Private Limited Company
Two to fifty persons can join together to form a Pvt. Ltd. Company.
A minimum of Two members are elected to form the board of directors
This board is given the responsibility to run the day to day business of the company.
Shares are not freely transferable. No invitation to public for subscription.
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Features
Life span– The life span of a company is not dependent
upon the death or resignation of its member.– It can be dissolved when its members are no
longer interested in continuing the business Liabilities
– The liabilities are limited to the total shares contributed to the company’s capital.
– Personal assets are not affected regardless of what happens to the company
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Contd…
– It can acquire assets under its own name
– A company can also take legal action and face legal action under its own name
– It has specific authority to transfer ownership of members’ shares with the approval of the company’s Board of Directors
– A company is not allowed to offer or sell any share or debenture to the general public
– A company is not allowed to offer the general public to deposit money within a stipulated time frame; and
– A company must use the word “Private Limited” at the end of its name
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Advantages
Funds are easy to acquire through the exchange of share ownership or loan from a financial institution.
All shareholders are legally protected by law
Shareholders are not burdened with the management of the business
The liabilities of the company’s members are limited to the capital that they contribute to the company. (personal assets are not affected)
The life span of the business is not dependent upon the age or resignation of its members
It has greater potential for expansion
Legally, the company is one business entity by itself
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Disadvantages
A Private Limited Company is subject to more rules and regulations
The company’s shares cannot be transacted through the share market
The company must pay corporate tax
The qualified Auditors must audit the company’s yearly financial statement
The financial affairs of the company must be made transparent to the general public.
The cost of setting up a company is high.
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Public Ltd. Company
Public limited company Closely held public limited company Publicly held public limited company
Closely held public limited company– Not a listed company.– No invitation to public for subscription.
Publicly held public limited company– A listed company.– Held by large number of shareholders.
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Features
Owners are shareholders Independent legal identity Limited liability Lasting continuity Possible separation of ownership &
management
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Advantages/ Disadvantages
Advantages Limited Liability Widest source of capital Lasting continuity Higher efficiency in management Shares easily transferable
Disadvantages• Longer time in making decision• More costly to maintain morale• Lower incentive• More complicated to set up
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Difference between Pvt. and Public Company
DESCRIPTIONS PRIVATE COMPANY PUBLIC COMPANY
Incorporation Time
22 to 3 weeks 2 to 3 weeks
Minimum Paid up Capital
INR 1,00,000/- INR 5,00,000/-
Maximum No. of shareholders
50 (Fifty)
No limit
Minimum No. of Shareholders
2 (Two) 7 (Seven)
Transferability of Shares
Restricted Freely. If company is listed then through stock exchange(s)
Minimum No. of Directors
2 3
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Contd…
DESCRIPTIONS PRIVATE COMPANY PUBLIC COMPANYWhether a Foreigner can be Director
Yes Yes
Whole Time Director (WTD) / Managing Director (WTMD): Appointment
Appointment not compulsory and No restriction on
appointment
Appointment :Not compulsory, If
paid up capital < Rs. 5 Cr.Compulsory. If
paid up capital => Rs.5 Crs
WTD / WTMD: Remuneration
No restriction As per schedule XIII, otherwise permission of
Central Government. Foreigner as WTM D / WTD
No restriction With the approval of Central Government
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Contd …
DESCRIPTIONS PRIVATE COMPANY PUBLIC COMPANYLoan to Director etc. Yes
With the previous approval of Central Government
Contracts with Director etc.
Yes
With the consent of Board, If paid up capital of the company is (One) 1 Cr. or more, approval of Central Govt. is necessary
Loan, Investment & Guarantee by the company
No restriction Some restrictions
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Shares and related issues
A share is: ‘the interest of a shareholder in the company measured by a sum of money, for the purposes of a liability in the first place, and of interest in the second, but also consisting of a series of mutual covenants entered into by all shareholders inter se.’
– Signifies ownership in the company– A company might have thousands of
Shareholders
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Characteristics of a share
Right to dividends declared on shares. Generally a right to vote at general meetings. Right to receive assets. Obligation to subscribe capital of a given
amount. Rights of membership under the CA 1985 &
Memorandum & Articles of Association, e. g. right to vote attached to ordinary shares.
Transferable nature subject to restrictions in the articles.
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Types of shares
All shares will have the same rights if there are no differences expressed.
Special rights can be attached to different shares at the company’s option:– Dividends– Return of capital– Voting rights– Right to appoint a director
Any share which has different rights from others is grouped with the other shares carrying identical rights to form a class.
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shares
Ordinary – carry normal rights. Preference – have the right to preferred
dividends, therefore guaranteed payment of a certain amount.
Redeemable – company has a right to redeem/ buy back the shares.
Deferred/ founders’ shares. Non- voting – generally issued to first
time employee
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Preference Shares – priority dividend entitlement
Right is merely to receive a dividend at the specified rate before any other dividend may be paid or declared.
Right to receive preference dividend is deemed to be cumulative unless the contrary is stated.
Holders of preference shares have no entitlement to participate in any additional dividend over and above their specified rate.
In the event of liquidation, a company which has arrears of unpaid cumulative preference dividends will not entitle preference shareholders to the arrears unless: (1) a dividend has been declared though not yet paid when
liquidation commences. (2) the articles expressly provide that in a liquidation arrears are
to be paid in priority to return of capital to members
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Preference Shares – return of capital
Unless otherwise stated preference shares carry the same rights as ordinary shares.
The result of preference shares priority right to return of capital is that: (1) the amount paid up on the preference shares is to
be repaid in liquidation or reduction of capital before ordinary shareholders.
(2) Preference shareholders are not entitled to share in surplus assets when the ordinary share capital has been repaid.
Preference shareholders will be paid off first when the share capital is reduced.
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Points of interest
Which company issued shares for the first time in the world???– The Dutch East India Company in 1602
How many Companies are listed on BSE?– More than 4000
How many Companies are listed on NSE?– Around 1200
What is the amount of trading in BSE?– Rs. 22510 Crores in May 2009
What is the amount of trading in BSE?– Rs. 3328.235 Crores in July 2009
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Stock Exchange
Place where the shares are traded– BSE – NSE
BSE – Bombay Stock Exchange– Oldest Stock Exchange in Asia– Sensex – Sensitive Index
Index of 30 Actively traded Companies NSE – National Stock Exchange
– Incorporated in 1992– Nifty
Index of 50 Actively traded Companies
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Why do people / institutions invest and trade in the stock market?
Increase capital Generate an income stream Minimize risk of others doing better Need to be in the market Fear of value being eroded by inflation Diversify risk Social e.g. investment clubs Pay less tax Enjoyment Test judgment against others
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Marketing expenses
Marketing expenses predominantly include wages and salaries, marketing and advertising costs, costs relating to trade shows and conventions, as well as other merchandising costs (such as catalogs, brochures, etc.).
Marketing is a necessary expense in running practically any business and the IRS acknowledges as much. You may run advertisements on or in the Internet, radio, television, magazines, newspapers and other media to sell your products or services. You should be deducting all of the associated costs on your tax returns.
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Contd…
Ordinary Marketing Expenses
Marketing costs must be "ordinary and necessary" business expenses.
Put in layman's terms, your marketing must be reasonably related to the promotion of your business and the expense amount must be a reasonable amount.
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Contd…
Common marketing expenses include the costs associated with the following items:
A. Yellow Page Advertisements,
B. Business Cards,
C. Advertisements in print media such as newspapers,
D. Telemarketing,
E. Business Cards,
F. Web site costs including creation and maintenance,
G. Costs for Advertisements on the Internet,
H. Billboards, and
I. Graphic design costs.
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Contd…
Goodwill Marketing For Your Business
Marketing that is intended to portray your business positively is best for the organization. Such marketing creates a long-term potential for business and, thus, falls within the ordinary and normal requirements of the tax code.
Examples of such marketing include:
A. Sponsoring local youth sports teams,
B. Distributing samples of your business product, and
C. Costs associated with prizes offered by your business in a contest.
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Office expenses
The amount of expense incurred for the general and safe operation of an office.
Office space Phones , Faxes used Internet connections Wireless connections Stationery ( pen/pencil /erasers/ papers/ business cards etc.) Repairs Taxes Insurances Rent Utilities (power, gas, cleaning, maintenance of office etc.)
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Cash flow statement
The cash flow statement (CFS), a mandatory part of a company's financial reports since 1987,
It records the amounts of cash and cash
equivalents entering and leaving a company.
The CFS allows investors to understand how a company's operations are running, where its money is coming from, and how it is being spent.
It does not include the amount of future incoming and outgoing cash that has been recorded on credit.
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Contd…
Cash flow is determined by looking at three components by which cash enters and leaves a company:
1. Core operations, 2. Investing and 3. Financing,
Operations
Measuring the cash inflows and outflows caused by core business operations
The operations component of cash flow reflects how much cash is generated from a company's products or services.
Generally, changes made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations.
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Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses and credit transactions (appearing on the balance sheet and income statement) resulting from transactions that occur from one period to the next.
Changes in accounts receivable on the balance sheet from one accounting period to the next must also be reflected in cash flow.
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If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts.
An increase in inventory, on the other hand, signals that a company has spent more money to purchase more raw materials
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Additional points
If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales.
A decrease in inventory would be added to net sales.
If inventory was purchased on credit, an increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other would be added to net sales.
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The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.
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Investing
Changes in equipment, assets or investments relate to cash from investing.
Usually cash changes from investing are a "cash out" item, because cash is used to buy new equipment, buildings or short-term assets such as marketable securities.
However, when a company divests of an asset, the transaction is considered "cash in" for calculating cash from investing.
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Financing
Changes in debt, loans or dividends are accounted for in cash from financing.
Changes in cash from financing are "cash in" when capital is raised, and they're "cash out" when dividends are paid.
Thus, if a company issues a bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the company is reducing its cash.
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From this CFS, we can see that the cash flow for FY 2003 was $1,522,000.
The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors.
It means that core operations are generating business and that there is enough money to buy new inventory.
The purchasing of new equipment shows that the company has cash to invest in inventory for growth.
Finally, the amount of cash available to the company should ease investors' minds regarding the notes payable, as cash is plentiful to cover that future loan expense.
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A negative cash flow should not automatically raise a red flag without some further analysis. Sometimes, a negative cash flow could a result of a company's decision to expand its business at a certain point in time, which would be a good thing for the future.
This is why analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether or not a company may be on the brink of bankruptcy or success.
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Conclusion
A company can use a cash flow statement to predict future cash flow, which helps with matters in budgeting.
For investors, the cash flow reflects a company's financial health: basically, the more cash available for business operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow results from a company's growth strategy in the form of expanding its operations.
By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of what some people consider the most important aspect of a company: how much cash it generates and, particularly, how much of that cash stems from core operations.
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Break even analysis – concept &
Implications
It answers the question “ How much should we produce so that after covering all the costs, you can still make some profits?”
Break Even point- key components:
Fixed cost: The cost which does not vary or change with variations in other factors in the production level.
Certain items of cost such as Interest on long term loan Rents for factory, shed or office Depreciation on building and machinery
These are costs incurred whether you run your company or not.
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Contd..
Example: Borrowed amount : Rs. 100,000 Interest rate 12.50% P.A.= Rs. 12,500 P.A. Building rent : Rs. 12,000 P.A. Machine cost : Rs.80,000. Depreciation@ 10% P.A.= Rs. 8,000 P.A.
Fixed cost = 12,500 + 12,000 + 8000 = 32,500 /-
Note: whatever be your production this value will not change
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Contd…
Variable expenses: Cost that is variable with the production level. It is directly related to the quantity of output
Example: Raw material cost per ton= Rs. 1000 Labour cost per ton = Rs. 750 Electricity requirement per ton = Rs. 500 Consumables per ton = Rs. 250
Total cost per ton = 1000 + 750 + 500 + 250 = Rs. 2500 /- Total cost for 5 tons = 2500 x 5 = 12,500/- Total cost for 10 tons = 2500 x 10 = 25,000 /-
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Calculation of BEP
Gross profit = Total sales revenue- Total costs Difference between variable cost per unit and
selling price per unit = contribution (contribution is directly proportional to sales)
Fixed costs will remain the same throughout hence we need to sell enough to make at least to meet fixed costs.
In other words sell enough to have contribution = fixed cost.
The production level at which you make no profit or no loss is called BEP
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Mathematically
Let X= No. of units produced Total cost for output of X= VC + FC for X units Contribution = Sales revenue – VC Profit = sales revenue for X units – Total cost i.e Profit = Contribution – FC
CAPACITY UTILIZATION INDICATOR BEP is usually expressed in terms of capacity
utilization BEP = {FC / (Sales Rev.- Var. Cost)} x 100 % = {FC/ contribution} x 100 %
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Sales revenue indicator
Can be calculated using two figures viz Fixed cost (FC) and Profit- volume ratio (PVR)
Where the PVR = Contribution / Sales = (Sales – VC) / Sales = ( SR- VC) / SR
Break Even Sales Revenue = FC / PVR
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Applications of Break even Analysis
Helps in taking investment decisions Provides necessary data to optimize
profits Helps you in make or buy decisions Helps as a convenient tool for product
pricing Profitability at various production levels
are made simpler
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Profit planning
Profit planning is a part of an overall planning process in which finance plays a major role.
Profit planning represents an overall plan of operations, covers a definite period of time, and formulates the planning decisions of management
It consists of operating budget - revenues and expenses financial budget - budgets, the balance sheet and
supporting schedules appropriation budget - expenditure on advertising
and research.
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Long-term profit planning implies a sacrifice of today’s profit for tomorrow’s.
Profit is an essential cost of business activity and must be planned and managed just like other costs.
Successful business performance requires
balancing costs and revenues
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contd..
The Need for Profit Planning
"Profit is a condition of survival. It is the cost of the future, the cost of staying in business". Peter Drucker
The effective manager must make trade-offs among these variables to keep this equation in balance and this requires effective profit planning.
A business must earn sufficient profit to maintain access to the capital markets for the investment it needs to grow and prosper.
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Contd…
This profit can be difficult to determine but it cannot be less than the business' cost of capital where Cost of capital is the cost the business must pay for its debt and equity financing.
These minimum profit requirements enable the business sustain its current operations and maintain its wealth producing potential.
Profits come from the surplus generated from business operations or operating profit (also known as net income before interest and taxes).
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Contd…
Profitability should be calculated as an average of the profits over good and bad years.
For this reason profit planning needs an historical perspective.
5 to 7 years of data provides a good profit planning horizon because this captures the up and down market cycle for many industries.
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What is a project?
Project is often used to describe something outside normal day-to-day work.
project is a proposal for implementation of a certain intention together with the way it is supposed to be implemented
It is a unique undertaking: each one will differ from every other in some respect
Has specific objectives (or goals) to achieve Requires resources Has budget
Project Preparation
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Project has schedules; Project requires the effort of people; and
measures of quality will apply.
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Start to write: project title sources of financing required amount project beneficiaries partners project intention project objective project applicant
process
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Project Activities
Levels of objective What are project activities? Activities features Project Components
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Activities are:
tasks executed as part of a project to produce the project results
objectives that – by the “means-to-ends” – produce the Results
Activities features: what when how long who dependency/independency sources
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Project Components ‘deliverables’ - things that must be
delivered if the project is to be successful
each of these will contain many tasks at the beginning of a project everyone
involved needs to work together to identify its components.
once of the first decisions that has to be made concerns the order in which the components will be worked.
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End of unit - III