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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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TERMS AND CONDITIONS OF TERM
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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TERMS AND CONDITIONS OF TERM
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)
WORKING CAPITAL (CONTD.)
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WORKING CAPITAL (CONTD.)
(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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ESTIMATES OF WORKING RESULTS /
PROFITABILITY STATEMENTS (contd.)
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
ESTIMATES OF WORKING RESULTS /
PROFITABILITY STATEMENTS (contd.)
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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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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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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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VARIABLE COSTS
Raw Materials
Consumables
Utilities
Wages
Variable Selling Expenses / commissions /
royalty linked to sales
Interest on short term loans
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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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DETERMINING BREAK-EVEN POINT
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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DETERMINING BREAK-EVEN POINT
Mathematical Formula:
F
Qb = ----------
(sv)
Total fixed costs
= ---------------------------------------------selling pricevariable cost per unit
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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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BREAK EVEN CHART
Value
Output
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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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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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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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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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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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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)