Introduction to Project FinanceByProf. Anirban Dutta

Learning ObjectivesAppreciate the importance and difficulties associated with capital investmentsDescribe the broad phases of capital budgetingDiscuss the important facets of project analysisExplain the three goals of a projectUnderstand the management of risk

Capital Investments: Importance and Difficulties

ImportanceCapital expenditure decisions often represent the most important decisions taken by a firm. Their importance stems from three inter-related reasons:Long-Term EffectsIrreversibilitySubstantial Outlays

DifficultiesWhile capital expenditure decisions are extremely important, they also pose difficulties which stem from three principal sources:Measurement ProblemsUncertaintyTemporal Spread

Types of Capital Investments

Strategic vs. Tactical InvestmentA strategic investment is one that has a significant impact on the direction of the firmITCs decision to invest in a agro-food project may be regarded as a strategic investmentA tactical investment is meant to implement a current strategy as efficiently or as profitably as possibleAn investment made by ITC to replace an old machine to improve productivity represents a tactical investment

Expansion vs. Diversification InvestmentAn expansion investment is meant to increase the capacity to cater to a growing demandA diversification investment is aimed at producing new products or services or entering into new geographical areas

Phases of Capital Budgeting

Capital Budgeting ProcessCapital budgeting is a complex process which may be divided into six broad phases:PlanningAnalysisSelectionFinancingImplementationReview

Capital Budgeting ProcessThe solid arrows reflect the main sequence: planning precedes analysis; analysis precedes selection; and so on.

The dashed arrows indicate that the phases of capital budgeting are not related in a simple, sequential manner. Instead, there are several feedback loops reflecting the iterative nature of the process.

PlanningThe planning phase of a firms capital budgeting process is concerned with the articulation of its broad investment strategy and the generation and preliminary screening of project proposals.A prelude to the full blown feasibility study, this exercise is meant to assess:(i) whether the project is prima facie worthwhile to justify a feasibility study and(ii) what aspects of the project are critical to its viability and hence warrant an in-depth investigation

AnalysisIf the preliminary screening suggests that the project is prima facie worthwhile, a detailed analysis of the marketing, technical, financial, economic, and ecological aspects is undertaken.Based on the information developed in this analysis, the stream of costs and benefits associated with the project can be defined.

SelectionSelection follows, and often overlaps, analysis.A wide range of appraisal criteria have been suggested to judge the worthwhileness of a project.They are divided into two broad categories:Non-discounted criteriaDiscounted criteriaTo apply the various appraisal criteria, suitable cut-off values (hurdle rate, target rate, and cost of capital) have to be specified.

FinancingOnce a project is selected, suitable financing arrangements have to be made. The two broad sources of finance for a project are equity and debt.Flexibility, risk, income, control, and taxes (referred to by the acronym FRICT) are the key business considerations that influence the capital structure (debt-equity ratio) decision and the choice of specific instruments of financing.

Implementation

StageConcerned withProject and engineering designsSite probing and prospecting, preparation of blueprints, and plant designs, plant engineering, selection of specific machineries and equipmentsNegotiations and contractingNegotiating and drawing up of legal contracts with respect to project financing, acquisition of technology, construction of building and civil works, provision of utilities, supply of machinery and equipments, marketing arrangements, etc.ConstructionSite preparation, construction of buildings and civil works, erection and installation of machinery and equipmentTrainingTraining of engineers, technicians, and workers. (This can proceed simultaneously with the construction work.)Plant commissioningStart up of the plant. (This is a brief but technically crucial stage in the project development cycle.)

ReviewOnce the project is commissioned, the review phase has to be set in motion.Performance review should be done periodically to compare actual performance with projected performance.

Levels of Decision Making

Different LevelsOperating capital budgeting decision:Minor office equipmentAdministrative capital budgeting decision:Balancing equipmentStrategic capital budgeting decision:Diversification project

Operating decisionsAdministrative decisionsStrategic decisionsWhere is the decision takenLower level managementMiddle level managementTop level managementHow structured is the decisionsRoutineSemi-structuredUnstructuredWhat is the level of resource commitmentMinor resource commitmentModerate resource commitmentMajor resource commitmentWhat is the time horizonShort-termMedium-termLong-term

Facets of Project Analysis

Market AnalysisMarket Analysis is concerned primarily with two questions:What would be the aggregate demand for the proposed product / service in the future?What would be the market share of the project under appraisal?

Market AnalysisThe kinds of information required are:Consumption trends in the past and the present consumption levelPast and present supply positionProduction possibilities and constraintsImports and exportsStructure of competitionCost structureElasticity of demand

Market AnalysisConsumer behaviour, intentions, motivations, attitudes, preferences, and requirementsDistribution channels and marketing policies in useAdministrative, technical, and legal constraints

Technical AnalysisAnalysis of the technical and engineering aspects of a project needs to be done continually when a project is formulated.Technical analysis seeks to determine whether the prerequisites for the successful commissioning of the project have been considered and reasonably good choices have been made with respect to location, size, process, etc.

Financial AnalysisFinancial analysis seeks to ascertain whether the proposed project will be financially viable 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.

Financial AnalysisThe aspects which have to be looked into while conducting financial analysis are:Investment outlay and cost of projectMeans of financingProjected profitabilityBreak-even pointCash flows of the project

Financial AnalysisInvestment worthwhileness judged in terms of various criteria of meritProjected financial positionLevel of risk

Economic AnalysisEconomic analysis, also referred to as social cost benefit analysis, is concerned with judging a project from the larger social point of view.The questions sought to be answered in social cost benefit analysis are:What are the direct economic benefits and costs of the project measured in terms of shadow (efficiency) prices and not in terms of market prices?

Economic AnalysisWhat would be the impact of the project on the distribution of income in the society?What would be the impact of the project on the level of savings and investment in the society?What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficiency, employment, and social order?

Ecological AnalysisIn recent years, environmental concerns have assumed a great deal of significance.The key questions raised in ecological analysis are:What is the likely damage caused by the project to the environment?What is the cost of restoration measures required to ensure that the damage to the environment is contained within acceptable limits?

Three Goals of a Project

What is Managed? The Three Goals of a ProjectThe performance of a project is measured by three criteria.Is the project on time or early?Is the project on are under budget?Does the project meet the agreed-upon specifications to the satisfaction of the customer?

What is Managed? The Three Goals of a ProjectProjects have three interrelated objectives: toMeet the budget,Finish on schedule, andMeet specifications that satisfy the client.Because we live in an uncertain world, as work on the project proceeds, unexpected problems are bound to arise.

Confronting UncertaintyThe Management of Risk

Project RisksThe real world or business is fraught with risks.Effective project management requires an ability to deal with uncertainty.The actions of a project manager (PM) can reduce the uncertainty but, can never eliminate it.

Project RisksIn todays turbulent business environment, effective decision making is predicated on an ability to manage the ambiguity that arises while we operate in a world characterized by uncertain information.

THANK YOUEnd of Session