Financial Appraisal Part I Project Cost and Its Financing

7/30/2019 Financial Appraisal Part I Project Cost and Its Financing

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Prof. A. G. Mendhi

5. PROJECT MANAGEMENT

FINANCIAL APPRAISAL

PART I

PROJECT COST

ANDITS FINANCING


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INTRODUCTION

Basic questions raised (by Financial Institutions /stake holders) during any project appraisal exerciseare:

1. Can we sell the goods / services ?2. Can you produce the goods / render the services ?

3. Can we earn a decent (satisfactory) return on theinvestment made in the project?

ANSWER TO THE LAST QUESTION LIES INFINANCIAL APPRAISAL


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IN THIS SESSION:

Elements of project cost

Means of financing

Profitability Projections (Financial Institution

Guidelines)

Project financing Institutions, other means of financing

Projecting Cash Flows

Projecting Balance Sheet Break-even analysis


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ESTIMATING PROJECT COSTS

Two Methods of building project budget

or project cost:

1. Top Down approach: Quick and economicalmethod. Also called analogous method. Reliability

depends on the degree of similarity between the

projects, scalability of parameters and expertise of

the estimating team in given field.2. Bottom up approach: Time consuming and

costly but more accurate technique.


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ELEMENTS OF PROJECT COST

Land & site development

Buildings & civil works

Plant and machinery

Technical know-how & engg. Fees, expenses onforeign technicians & training of project personnelabroad

Miscellaneous fixed assets

Preliminary & Pre-operative expenses Margin money for working capital

Initial cash losses, if applicable


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LAND & SITE DEVELOPMENT

Cost of acquisition of land (basic cost, cost of

conveyance, stamp duty, etc.) (Extra land

acquired but not meant for the project is not

considered)

Premium paid on leasehold land & conveyance

charges paid. (Lease Rent?)

Cost of site development: Leveling, Approachroads, Internal Roads, Fencing, Gates, etc.

Cost of tube wells.


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COST OF BUILDINGS &

CIVIL WORKS

Factory building

Administrative building

Auxiliary buildings housing utilities equipment, warehousing/ storage house, etc.

Non-factory buildings: Residential buildings / staff quarters,canteen, guest house, watch & ward, time office, etc.

Places of prayer,

Silos, tanks, garages, etc.

Drainage, sewerage system, etc.

Any other civil work including special foundations, podiums,etc.

Architects fees


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PLANT AND MACHINERY

Cost of indigenous machinery (FOR value + sales tax,Octroi, other taxes and transportation cost to the site)

Cost of imported machinery (FOB value, shippingcharges, cost of insurance, clearing, loading &

unloading, import duty and local transportation costs) Cost of stores & spares

Foundation and installation charges

For financial appraisal, FIs normally insist on three latest

quotes and allow for a provision for inflation, foreigncurrency rate fluctuation, etc. if not separately provided in

provision for contingencies.


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TECHNICAL KNOW-HOW AND

ENGINEERING FEES

Fees of consultants, collaborators, etc. for:

Assistance on technical matters e.g. Project Report,

selection of process / technology, plant and machinery,

detailed project engineering, supervision duringinstallation and commissioning, etc.

Expenses on foreign technicians and on training of

Indian technicians abroad (all expenses).

Recurring payment of royalty does not form a part of the

project cost; it is treated as operating expense.


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MISCELLANEOUS FIXED ASSETS

Assets, which are not a direct part of themanufacturing process.

- Furniture and fixtures,

- Office equipment and machines,- Vehicles,

- D.G. sets, Transformers, Switchgear, boilers, pipingsystems, workshop and quality control / laboratoryequipment,

- Investment in effluent treatment plants,

- Payments for trade marks, licences, copyrights,deposits paid to Electricity Boards, etc.


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PRELIMINARY EXPENSES

Expenses incurred on identification of the project,

market survey, Techno-Economic Feasibility Report,

drafting of Memorandum and Articles of Association

for the company, Incorporating and registering of thecompany, Legal charges, etc..

Expenses incurred on capital issues by the company

such as underwriting commission, brokerage, fees to

registrars of issue, managers to the issue, printing,publishing, advertising, listing fees, stamp duty, etc.


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PRE-OPERATIVE EXPENSES

Expenses incurred on the following till the start of the commercialproduction:

Interest on borrowed funds during the implementation period,

commitment charges, etc.

Establishment expenses e.g. rent paid, traveling expenses, insurance

charges, mortgage expenses, etc.

Trial production or start up expenses.

Miscellaneous expenses

Pre-operative expenses can be apportioned to fixedassets on some acceptable basis. The firm may also treat them

as deferrred revenue expenditure and write them off over a

period of time.


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PROVISION FOR CONTINGENCIES

This is a provision for unforeseen expenses:

Inflation,

Exchange Rate risks, Delay in execution and hence

escalation of costs

Any other miscellaneous costs / liabilities that may

arise.

Normal provision is 5% of firm costs and 10%

for non-firm costs.


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MARGIN MONEY FOR WORKING

CAPITAL

Banks normally provide finance / credit facilities for

meeting requirements of working capital. A part of this

is to be brought in by the promoters basically from

long term sources of finance. This is a critical element of project cost particularly if

there are over-runs in the cost. FIs normally block an

amount equivalent of the margin money from the term

loans till the project is complete.


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INITIAL LOSSES

Most of the promoters do not show

these as a part of the project cost.

Prudence however calls for makingsuch a provision if there are any

initial losses since they could affect

the liquidity position of the company.


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PROJECT FINANCING

Types of Projects Manufacturing Projects

Infrastructure Projects

Scientific Research Projects

Innovative, experimental, developmental System development Projects

Systems / software development & implementation

Management Projects

Managing change within organization

All Projects could be: Greenfield Projects Expansion / Relocation Projects


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PROJECT FINANCING

Project financing is a special case of financing in whichlenders have to rely on repayment from the net cash flowgenerated by the project.

Project finance is usually provided against assets of and the

rights in a particular project rather than against theborrowers balance sheet, though Net worth of thepromoters is also important.

Financers are therefore concerned with the analysis of therisks associated with the project before they accept the

investment opportunity which it represents. The cost and terms of financing therefore reflect thefinanciers view about the risks involved in implementingthe project.


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NEED FOR PROJECT FINANCING

Project financing is required in a number ofsituations:

For companies in general, to enhance their investment limits.

To spread the risk among several parties to lessen adversefinancial impact if any, and to increase their capacity toundertake more projects.

For multinational corporations to protect their corporatebalance sheets from the impact of large projects

For governments to share the costs and risks of exploitingnatural resources

For governments to increase foreign capital investment in thecountry at no cost to the country.


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FINANCING STRATEGY

The project will fail, no matter what is its technical merit,unless enough finance is made available to complete it.

The design, implementation and management of projectfinancing demands the same level of commitment from the

promoters as the rest of the project management activities.

Financial planning should begin at the same time, or insome cases even earlier than the technical project planning.

While financing package is likely to reflect the complexity

of the project, finance has some inherent characteristics,which themselves add to the complexity of undertaking.


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SOURCES OF FINANCE

Identifying sources of finance

Identifying suitable sources of finance is the first stepin planning finance for a project.

Finance for projects falls into two major categories: Debt:Borrower has the obligation to repay. Debt also

usually carries obligation to pay interest and to adhere to aprearranged repayment schedule. The lender has priorityclaim if borrower goes into liquidation.

Equity:Funds subscribed by the shareholders from their own

resources. There is no guarantee that the dividend will bepaid and investors tend to loose their money if the projectfails to perform. Equity shareholders have the last claim ifthe project goes into liquidation.


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PROJECT FINANCING

Share Capital (Equity & Preference)- (dividend, claim, control,tax)

Term Loans (Secured Borrowings)major source of finance

Rupee or Foreign Currency Term Loan

Incentives (Capital subsidy or seed capital, tax deferment orexemption)

Debenture Capital (Debt instruments: convertible or non-convertible, more flexible than term loans)

Deferred Credit (usually offered by suppliers of plant andmachineryinterest and phased payment conditions varybankguarantees are required)

Other sources (unsecured loans by promoters, lease or hire-purchase programs, Public deposits, etc.)


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SOURCES OF FINANCE

The main sources of debt finance are:

Commercial banks

Multilateral lending institutions

Suppliers of equipment & services for the project

Suppliers of raw materials to the project

Buyers of output from the project The main sources of equity finance are:

Internal: Corporate cash flow generated by existing businessoperations

Public: Corporate or individual investors, or funds raised throughstock markets

Joint venture partners Government subscriptions & aids

Multilateral investment institutions

*Venture capitalists


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RAISING CAPITAL IN

INTERNATIONAL MARKETS:

Global Depository Receipts: Indirect equityinvestment - Shares issued by a firm are held by aDepository (International Bank), which receivesdividends, reports, etc. and issues claims.

1. Each receipt is a claim on specific number of shares.

2. GDRs are denominated in a convertible currency

3. GDRs may be listed on major stock exchanges

4. Issuer firm pays dividends in home currency.5. Issuer firm can thus avoid listing procedures,

disclosures, etc.


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UNCONVENTIONAL SOURCES OF

PROJECT FINANCING:

Leasing & Hire Purchase: Use of project assets through

off-balance sheet financing.

Forfaiting: Sale of financial instruments due to mature in

future.

Counter-Trade: Seller accepts goods or services in lieu of

cash payments.

Switch Trading: Making use, via a third party, of un-cleared

credit surpluses arising from bilateral trade agreements.

Offset: Exporter of technically advanced project incorporatesan agreed value of materials, equipment & services supplied

by the buyer.


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UNCONVENTIONAL SOURCES OF

PROJECT FINANCING:

Franchise Financing: Engineering, Procurement &Construction (EPC) contractors become equity holding jointventure partners for the project they design & build.

Debt/Equity Swapping: Multinational technology ownerbuys host country debt at a discount. The debt is redeemed inlocal currency at favorable rate of exchange for setting up alocal company. The local company uses transferredtechnology to earn foreign exchange, replace imports &generate local employment.

Build Own - Operate Transfer (BOOT): Government

grants concession to a project company (SPV) to build afacility and operate it on commercial basis. Facility istransferred to the government at the end of the concession.This type of finance arrangement is usually used forinfrastructure projects.


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EQUITY V/S DEBT

Shareholders have a residual

claim over the income and

assets of the firm.

Dividend paid to equity

holders is not a tax

deductible payment.

Equity ordinarily has

indefinite life.

Equity investors have aprerogative to control the

affairs of the company.

Creditors have a fixed claim

equivalent to principal and

interest outstanding.

Interest paid to creditors is a

tax deductible payment.

Debt has a fixed maturity.

Creditors play a passive role

in the affairs of the company

though they may imposecertain restrictions to protect

their interest.


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LEADING FINANCIAL INSTITUTIONS

/ BANKS IN INDIA

Industrial Finance Corporation (IFC),

Industrial Bank of India (IDBI),

Industrial Credit and Investment Corporation of India(ICICI),

Infrastructure Development Finance Corporation Ltd,(IDFC)

State Industrial & Investment Corporations (SICOM,PICUP, RIICO, IPICOL, etc.)

State Finance Corporations (SFCs like MSFC, GSFC,etc.)

Banks like SBI, BoB, others


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LEADING FINANCIAL INSTITUTIONS

/ BANKS IN INDIA (Contd.)

Export Credit Guarantee Corporation of India (ECGC).

Export-Import (EXIM) Bank of India

General Insurance Corporation of India (GIC)

Life Insurance Corporation of India (LIC)

National Bank for Agriculture And Rural Development

(NABARD)

National Housing Bank (NHBC) Small Industries Development Bank of India (SIDBI)

Unit Trust of India (UTI)


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TERM LOANS

Primary sources for term loans are Financial

Institutions.

Term Loans are normally payable in less than ten

years. Usually there is a moratorium of two years andrepayment is made in five to seven years.

Repayment of principal is in terms of equated semi-

annual or quarterly installments.

Term loans are used to finance purchase of fixed assets

and margin money only.


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TERMS AND CONDITIONS OF TERM

LOANS

Currency: Rupee as also Foreign currency loans arepossible

Processing fee charged: usually one percent of loan

amount sanctioned Security:

First equitable mortgage of immovable properties/ fixed assets

Hypothecation of all movable properties subjectto prior charges in favor of commercial banks forworking capital loans


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LOANS

Interest Payment & Principal repayment:

Payable irrespective of the financial

position of the borrower. Penalty imposed by FIs in case of

default on interest and 2% p.a. for

liquidated charges in case of default onprincipal repayment.


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LOANS

Restrictive clauses:

Nomination on Board of Directors. Management setup to be finalized in consultation with the FIs.

Insist on making arrangements for additional funds ifrequired through unsecured loans / deposits frompromoters.

Refrain from taking additional projects / financialcommitments not related to the project without prior

approval from FIs. Obtain various licences / permissions / clearances etc.from relevant Govt. Authorities.


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TERM LOAN PROCEDURES

Submission of loan application:

Promoters background

Particulars of the industrial concern (Annual reports andbalance sheets)

Particulars of the project (Project Report: Capacity,process, technical arrangements, manpower, utilities,implementation schedule, project cost, financing pattern,marketing arrangements, etc.)

Profitability and cash flow statements, Economic considerations, social cost benefit analysis,EIA study if necessary

Government consents / permissions.


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TERM LOAN PROCEDURES (contd.)

Initial processing of loan application (Flash Report).

Appraisal of the proposed project.

Issue of the letter of sanction.

Acceptance of terms and conditions by the applicant

unit.

Execution of loan agreement.

Creation of security. Disbursement of loans.

Monitoring.


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FINANCIAL APPRAISAL BY

FINANCIAL INSTITUTIONS:

Justification of estimate of cost of capital

Justification for estimate of working capital

Adequacy of Rate of Return:

IRR: should be 3 to 5 % more than WACC and not less than 15%

DSCR: 1.5 to 2.0 or more

ROI: should be ideally 15% or more

Justification of Debt:Equity Ratio

Should be 1.5:1

Debt should be adequately covered by investment in immovablefixed assets

Stock Exchange regulations are to be met in case of listing. Promoters should contribute a certain minimum percentage of the

project cost

Means and capacity of the promoters to contribute to a reasonableshare of the project cost


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FINANCIAL ESTIMATES AND

PROJECTIONS

Estimates of production and sales

Assume progressive increase in effective capacityutilization (50%, 60%, 75% and 90% in 1st, 2nd, 3rd and fourthyear of operationconstant thereafter).

Assume production equal to sales or make a provision forstocks.

Assume realistic x-factory selling price. Each product to betreated separately.

Selling price is net of excise and if selling commission is

included, it should also be shown as item of expense (partof selling expenses)

Changes in selling price should be considered only withcorresponding changes in costs of production.


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ESTIMAATES OF

COST OF PRODUCTION

Cost of raw materials

Cost of consumables

Cost of utilities

Cost of labor

Cost of Factory overhead


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ESTIMATED REQUIREMENTS OF

RAW MATERIALS & CONSUMABLES

(At 70% Capacity Utilisation, for Year I)

S

r.

N

o.

Raw

Material

Requirement per

1000 litres of

Biodiesel

Unit

Approx.

CIF

Price

Per unit

(Rs.)

Annual

Requirement

Quantity

Cost

(Rs.

Lakh)

1. JatrophaSeeds 3.42 Tonne 5.00 7,187 359.33

2. Methanol 150 Litre 22.00 3,15,000 69.30

3.Caustic

Potash3.8 Kg 42.00 7,980 3.35

4.Liquid

Catalyst 6.00 Litre 10.00 12,600 1.26

5.Solid

Catalyst6.00 Kg 20.00 12,600 2.52

6. TOTAL 435.76


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ESTIMATED REQUIREMENTS OF

UTILITIES

Norms of consumption given by consultants or

technical collaborators. Else, go by the standards

established in existing units. Make a higher

provision. Power: Connected load X loading factor X No. Of

hours in a day X No. of working days in a year X

prevailing tariff+ provision for other requirements.

Fuel: Annual consumption X Price

Water: Annual consumption X Price


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LABOR

All manpower employed in the factory to be

considered

Salaries and wages assumed on the basis of prevailing

rates in the industry. Remuneration to include basic salaries, allowances

(DA, HRA, LTA, Medical, etc.), statutory provisions

like PF, gratuity, insurance, bonus, etc.

Normally (basic + fixed percentage) provided. Annual

rise of 5% is usually assumed for annual increments.


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FACTORY OVERHEADS

These would normally include

Cost of repairs and maintenance (Generally 2 to

3% on plant & machinery and 1.5% on

Buildings/civil construction and MFA). Costswould increase with the age of machinery.

Insurance (o.5% on all factory assets)

Rents, taxes to be guided by prevailing rates. Provision for miscellaneous factory expenses

ESTIMATES OF WORKING CAPITAL


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ESTIMATES OF WORKING CAPITAL

& ITS FINANCING

Working capital is required mainly for maintaining adequate stocksof raw materials (both indigenous and imported), Work in progress,finished goods and provision for accounts receivables (i.e. creditgiven to customers) and cash on hand required for meeting day today expenses.

Usually Tandon Committee norms are followed by Banks.Accordingly at least 25% of the requirements of working capital areto be financed by the promoters and to be brought in as long termfinance. Banks normally insist that Cash-on-hand be financedentirely by the promoters.

Promoters can follow the format given in the application formprepared by all India Financial Institutes.


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WORKING CAPITAL (CONTD.)

ITEM NO. OFMONTHS

FINANCIAL YEAR OF OPERATIONI II

(A) Current

AssetsRaw Material &

Packaging

Work in progress1.50

0.1Finished goods 1.50Outstanding

Debtors / Accounts

receivable 1.00

Sub-total (A)


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(B) Minimum cash

on handNO. OFMONTHS

YEAR I YEAR II

Salaries and wages 1.00

Utilities 1.00

Others (Rent, Tax,

packing and selling

expenses, Repairs

& maintenance,

Insurance, etc.)

1.00

Sub-total (B)

(to be funded 100%

by promoters)



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(C) Current

Liabilities

N0. of

months

YEAR I YEAR II

Trade credit on raw

materials0.5

Trade credit onconsumables 0.5

Other credits 1.0

Sub-total (C)

NET W. Capital

N=(A+B-C)

M= Margin @ 25% of

(A-C) + B

Working capital loan

availed= N-M


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ESTIMATES OF WORKING RESULTS

/ PROFITABILITY STATEMENTS

A= Cost of production

B=Total Administrative expenses (2 to 3% of sales)

C= Total Selling expenses (5 to 10% of sales)

D= Royalty payable (2 to 5% of sales)

E=Total cost of production

(A+B+C+D)

F= Sales revenue

G= Gross profit before interest= F-E


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ESTIMATES OF WORKING RESULTS /

PROFITABILITY STATEMENTS (contd.)

H= Total financial expenses (Interest payable

on both long and short term loans)

I=Depreciation

J= Operating profit (G-H-I)

K= Other income

L= Preliminary expenses written off

M= Profit or (Loss) before taxation (J+K-L)


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N= Provision for tax

O= Profit after Tax (PAT=M-N)

P= retained profit= (O- Dividend declared on

Equity & preference shares)

Q= Net cash accrual = (P+I+L)


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DEPRECIATION

Straight Line

Depr.Rate (%)

Non Factory Building 1.63% Factory Building 3.34%

*Plant and

Machinery 10.34%

Miscellaneous

Fixed Assets 6.33%

WDV Method

(Taxation purpose)

Non Factory Building 5.0% Factory Building 10.0%

*Plant and

Machinery 25.0%

Miscellaneous

Fixed Assets 10.0%

*Three shifts per day basis


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DEPRECIATION CALCULATIONS

Provision for contingency and pre-operative expensesestimated in project cost are added proportionately tothe cost of fixed assets to arrive at the depreciablevalue of fixed assets.

Preliminary expenses in excess of 2.5 % of the projectcost (excluding margin money) should also be added tothe cost of the fixed assets to arrive at the depreciable

value of fixed assets.

St.Line

Valu FINANCIAL YEAR OF OPERATION


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ITEM LineDepr.Rate

(%)e

at

Cost I II III IV V VIVI

I VIII IX X

Land - 14 - - - - - - - - - -

Building 1.63 78 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2

Plant and Machinery 10.34 124 13 13 13 13 13 13 13 13 13 7

Miscellaneous Fixed

Assets6.33 14 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8 0.8

TOTAL BOOK

WDVFINANCIAL YEAR OF OPERATION


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ITEM Depr.Rate

(%)Value

at Cost I II III IV V

Land - 14 - - - - -

Building 10.00 78.26 7.83 7.04 6.34 5.70 5.13

Plant and Machinery 25.00 124.21 31.05 23.29 17.47 13.10 9.83

Miscellaneous Fixed

Assets15.00 13.94 2.09 1.78 1.51 1.28 1.09

TOTAL TAX

DEPRECIATION 40.97 32.11 25.32 20.09 16.05


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INTEREST CALCULATIONS

Interest on Long Term loans is taken as the present rate

of interest charged by the Financial Institutions. The

interest burden will decrease with the repayment of the

loan by the borrower. For simplicity, Interest is calculated on the average of

the balances at the beginning and at the end of the year.

For short term loans / credit facilities, the rate of

interest would be equal to the rate of interest chargedby commercial banks. No repayment is assumed.

TYPE OFFINANCIAL YEAR OF OPERATION


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Table 7.6: LOAN REPAYMENT AND INTEREST SCHEDULE (Figures in Rs. Lakh)

TYPE OF

LOANI II III IV V VI VII VIII

Short-termloan13% InterestLoan at the end of

the year 65.91 79.12 93.53 109.19 114.60 120.28 126.24 132.49 1Interest 8.57 10.29 12.16 14.19 14.90 15.64 16.41 17.22Long-term

loan@ 13%

Loan at the

beginning 142.90 142.90 142.90 122.49 108.20 93.91 79.62 65.33Repayment - - 20.41 14.29 14.29 14.29 14.29 14.29Loan at the end of

the year 142.90 142.90 122.49 108.20 93.91 79.62 65.33 51.04Interest 18.58 18.58 17.25 14.99 13.14 11.28 9.42 7.56


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PART IIMARCH 5, 2006




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ESTIMATING CASH FLOWS

It is important to estimate the cash flows for aproject to make a proper investment evaluation.

All care and precautions need to be taken to

ensure that the implementation of the projectdoes not get hampered as a result of lack ofadequate cash or finance in time.

Correct estimate of cash flows is thus a keyelement in the process of successful financialplanning.


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ELEMENTS OF CASH FLOWS

There are three phases in the life of any project:

1. Setting up or investment phase.

2. Operational phase

3. Terminal phase / Winding up phase

Accordingly the cash flows would also be categorized

in three classes.

1. Initial investment,2. Operational cash flows and

3. Terminal cash inflow


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LIFE OF A PROJECT

How is the life of a project determined and whatshould be the normal period / horizon for estimatingcash flows?

Life of a project is usually minimum of the following:

1. Physical life of the plant (wear and tear, depreciation,ask the supplier).

2. Technological life of the plant (chips manufacturing -Manual to automatic operations)

3. Product life of the plant (computers / chips)

4. Investment Planning Horizon of the Firm


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BASIC PRINCIPLES OF CASH FLOW

ESTIMATION

1. Separation principle

2. Incremental principle

3. Post tax principle and

4. Consistency principle


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SEPARATION PRINCIPLE

Two sides viz. investment side and financing side should be

treated separately.Cost of capital is used as a hurdle rate againstwhich rate of return on investment side is compared.

TIME

CASH FLOW TIME

CASH FLOW

0 +100 0 -100

1 - 115 1 +120

COST OF CAPITAL 15% RATE OF RETURN 20%

PROJECT

FINANCING SIDE INVESTMENT SIDE


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SEPARATION PRINCIPLE

Operationally this means that in cash flows on

investment side, interest on debt is ignored

while computing profits & Taxes.

Hence, Profit before interest and tax (1-tax rate) =

(profit before tax +interest) * (1-tax rate)

= (profit before tax) (1-tax rate) +interest (1-tax

rate)= Profit after tax + interest (1-tax rate)


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INCREMENTAL PRINCIPLE

Cash flows of a firm should be measured in incremental terms.

= -

To ascertain the cash flows following principles should be followed:

1. Consider all incidental effects (positive and negative effects such as productcannibalization).

2. Ignore sunk costs,

3. Include opportunity costs (Is there any alternative use of existing resource with thefirm if the project is not undertaken?),

4. Check allocation of overhead costs and

5. Estimate Working capital systematically.

Project cash flowsFor the year t

Cash flows for firmwith the project for t

Cash flows for firmWithout project for t


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POST TAX PRINCIPLE

Cash flows are measured on a after tax basis.

1. What tax rate should be used for project cash

flows? Average tax rate or the marginal tax

rate that would be applicable to projects

income?

2. Treatment of losses

3. Effect of non-cash charges (depreciation)


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CONSISTENCY PRINCIPLE

Cash flows and discount rates applied to them

must be consistent with respect to investor

group and inflation.

Investor group: cash flow to be estimated from

the point of view of all investors (equity

holders as also the lending agencies)


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CASH FLOW FOR ALL INVESTORS

PBIT (1-tax rate)

+Depreciation

- Capital Expenditure- Change in working capital

CASH FLOW FOR EQUITY


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Prof. A. G. Mendhi

CASH FLOW FOR EQUITY

SHAREHOLDERS

Profit after tax (PAT)

+Depreciation

- preference dividend

- Capital Expenditure

- Change in working capital- repayment of debt

+ proceeds from debt issues

- Redemption of preference capital

+ proceeds from preference issue

You can discount the cash flows at WACC for all investors while for the

equity holders, you can discount using cost of equity


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Prof. A. G. Mendhi

PROJECTED CASH FLOW STATEMENTS

(B) Uses / disposition of Funds:1. Capital Expenditure for the project.

2. Other normal capital expenditure.

3. Increase in working capital

4. Decrease in secured long term loans.5. Decrease in other medium / long term loans.

6. Decrease in unsecured loans or deposits.

7. Decrease in short term loans for working capital

8. Increase in investments in other companies.

9. Interest on both long and short term loans.10. Taxes paid

11. Dividends paid during the year.

12. Other expenditure


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PROJECTED CASH FLOW STATEMENTS

C. Opening Balance of cash in hand and

at bank.

D. Net Surplus / Deficit (A-B)E. Closing Balance of cash in hand and

at bank

(C + AB)


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PROJECTED BALANCE SHEET

LIABILITIES

1. Share Capital

Equity

Preference

2. Reserves & Surplus

3. Secured Loans

4. Unsecured Loans5. Current Liabilities &

Provisions

ASSETS

1. Fixed Assets

2. Investments

3. Current Assets, Loans& Advances given

4. Miscellaneous

Expenditures & Losses


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BREAK-EVEN ANALYSIS

Also called Cost, Volume, Profit (CVP) Analysis.

Studies relationship between costs, revenues and

profits.

Break-even indicates the level of sales at which thecosts and revenues are in equilibrium i.e. there is no-

loss and no-profit situation. This equilibrium point is

called break-even point.

In other words, break even point is that level / point ofsales at which the total revenue is equal to total costs.


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BREAK-EVEN ANALYSIS

Pre-requisite of break-even point calculation

or using CVP analysis is that total costs can

be divided into fixed costs and variable costs.

Variable costs are those that change in direct

proportion to change in volume of production.

Fixed costs remain fixed / constant

irrespective of the volume of operation.


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FIXED COSTS

Salaries

Fixed Selling Expenses

Depreciation

Administrative overheads

Repairs and maintenance

Insurance

Interest on long term loans Amortization of expenses


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Prof. A. G. Mendhi

VARIABLE COSTS

Raw Materials

Consumables

Utilities

Wages

Variable Selling Expenses / commissions /

royalty linked to sales

Interest on short term loans


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Prof. A. G. Mendhi

DETERMINING BREAK-EVEN POINT

Two methods are usually adopted:

1. Mathematical Formula

2. Graphic approach

Mathematically, Break Even Point (BEP) can be calculated in

terms of units, sales or percentage capacity utilization.

Each unit sold will cover its part of the variable cost andleave remainder (called contribution) to cover a part of thefixed costs.

Break even will occur when sufficient units are sold so thattotal contribution is just equal to total fixed costs.

Contribution per unit is the difference between selling priceper unit and variable cost per unit.


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Prof. A. G. Mendhi


1. Mathematical Formula:

sv = c (selling price - variable cost = contribution)perunit

c . Q = C (Q = Total sales in units,

C= Total contribution)

S = s.Q (S= Total Sales in value terms)

CF = Profit (Total contribution less total fixed costs)

For break even, C - F = 0 F

c.Qb = F Hence, Qb = ----------(sv). Qb = F (sv)


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Prof. A. G. Mendhi


Mathematical Formula:

F

Qb = ----------

(sv)

Total fixed costs

= ---------------------------------------------selling pricevariable cost per unit


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Prof. A. G. Mendhi

2. Mathematical Formula in Rupee terms:F.s F

Qb.s = ---------- = ------------(s v) 1 v/s

Total fixed costsRb = ---------------------------------

1- variable cost ratio

Total fixed costsRb = ---------------------------------

Contribution ratio

Contribution Ratio is also called P/V ratio


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Prof. A. G. Mendhi

BREAK EVEN CHART

Value

Output


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Prof. A. G. Mendhi

LIMITATIONS OF BEP This is only a supply side (i.e.: costs only) analysis.

It tells you nothing about what sales are actually likely to be for theproduct at various prices.

It assumes that total costs can be separated into two components viz.fixed and variable costs

It assumes that fixed costs (F) are constant It assumes average variable costs are constant per unit of output, at

least in the range of sales (both prices and likely quantities) ofinterest.

The selling price per unit remains the same i.e. it does not changewith volume or other factors.

The firm manufactures only one product or in case of multipleproducts, the product mix remains the same.

Production and sales are synchronized i.e. inventories remain thesame!!

DEBT SERVICE COVERAGE RATIO


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Prof. A. G. Mendhi

DEBT SERVICE COVERAGE RATIO

(DSCR)

It shows to FIs the capacity of the company to

pay back the principal as well as the interest on

the term loans given by them.

PAT + DEPR. + Intr. On LT Debt + Amortized Exp.

DSCR = -------------------------------------------------------------------

Repayment of LT Debt + Interest on LT Debt

Total cash accrual over ten year period

= ----------------------------------------------------------

Total Debt service burden over ten years


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Prof. A. G. Mendhi

SENSITIVITY ANALYSIS

FIs normally carry out sensitivity analysis onprojected working results to assess the impact ofadverse changes in following parameters of the

project:

1. Increase in raw material prices,

2. Decrease in selling prices,

3. Increase in operating costs

Impact on IRR, BEP & DSCR of 5% to 10% variationin above parameters is usually assessed to know howwell the project can sustain these changes.

CONCEPT OF AVERAGE COST OF


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Prof. A. G. Mendhi

CONCEPT OF AVERAGE COST OF

CAPITAL

A firms cost of capital is the weighted average cost ofvarious sources of finance used by it viz. Equity,Preference shares, Long Term Debt and short termdebt.

Many firms do not take into account the short termdebt while calculating WACC.

WACC is used as the hurdle rate in capital budgeting /project financing (why?)

WACC = Pi X riWhere,Pi is the proportion of the ith source of financeand ri is the cost of this source of finance.


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Prof. A. G. Mendhi

QUESTIONS

1. What is Long Term Funds principle for evaluation of

project cash flows? Why is it necessary to exclude

Financing costs when the long-term funds principle is

accepted? (2002)

2. What are the relative merits of building a project

budget from bottom-up and from the top-down

methods?

How does the assignment of costs to individual projectactivities help in effective cost & schedule control?

(2003)


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Prof. A. G. Mendhi

QUESTIONS

3. Following information is available about a proposed expansion project: Initial project outlay is Rs.50.0 crores consisting of Rs.40.0 crores fixed

assets & Rs.10.0 crores current assets. The financing pattern: Equity Rs.15.0 crores, Term loans Rs.30.0 crores,

Working Capital advances Rs.4.0 crores & Trade Credits Rs.1.0 crores. Term loan repayable in ten equal six monthly instalments, the first

instalment due 18 months after starting of production. Interest on termloan will be @ 12.0% p.a. applicable on opening balance at thebeginning of the year.

The levels of working capital and trade credit remain unchanged till end.The interest on working capital advance will be @ 15.0% p.a.

Sales revenues are Rs.65.0 crores p.a. while operating costs excludingdepreciation & interest are Rs.45.0 crores. Depreciation on fixed assetsis charged @ 25.0% p.a. on Written down value (W.D.V.) basis.

Project life being 7 years, the salvage value will be Rs.5.34 crores forfixed assets. Current assets recovery will be at cost. Average corporate Income Tax rate is 40.0%Work out the project cash flows during its life from long term fundspoint of view. (2002)


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QUESTIONS

4. What are the various ways of financing a project

along with the relative merits or demerits of each of

them? Your answer should include all traditional as

well as non-traditional means of financing. The

sources should cover both domestic as well as

foreign sources of financing.

5. What is the criterion used for determining Life of

the project for determining time span of cash flowprojections? (2003)

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Financial Appraisal Part I Project Cost and Its Financing

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