PROJECT
APPRAISAL
Table of Contents
PROJECT APPRAISAL OUTLINE............................................................................................... 5
Chapter One .................................................................................................................................... 6
Introduction ..................................................................................................................................... 6
1.1 Development Planning & Project Planning ........................................................................................ 6
1.1.1 Development Planning: ................................................................................................................ 6
1.1.2 Conceptual Definition of A project .............................................................................................. 9
1.1.3 The Role of Financial Institutions in the Financing & Evaluation of Projects .......................... 13
1.2
Project Cycle ............................................................................................................................... 13
1.2.1
Project Identification: .......................................................................................................... 14
1.2.2
Preparation: (including pre-feasibility and feasibility studies) ........................................... 15
1.2.3
Appraisal ............................................................................................................................. 15
1.2.4 Implementation .......................................................................................................................... 18
1.2.4
1.3
Evaluation ........................................................................................................................... 18
What is Project Finance?............................................................................................................. 19
1.3.1
Project Loan Vs Working Capital Finance ......................................................................... 19
1.3.2
Risk Exposure in Project Finance ....................................................................................... 20
Chapter Two.................................................................................................................................. 22
Market Analysis ............................................................................................................................ 22
2.1. General ............................................................................................................................................. 22
2.2. Demand Analysis: ............................................................................................................................ 23
2.3 Supply Analysis and Projection ........................................................................................................ 31
2.4
Demand and Supply Gap ............................................................................................................ 33
2.5 Price Analysis ................................................................................................................................... 33
2.5.1 Prices and Price trends ............................................................................................................... 33
2.5.2 Price build-up or cost plus Approach ......................................................................................... 34
2.6 Marketing .......................................................................................................................................... 34
2.6.1 Major Marketing Area for the Product or Service ..................................................................... 34
2.7 MARKETING STRATEGY: ............................................................................................................ 35
2.7.1 Market segmentation .................................................................................................................. 35
2.7.2 Market targeting ......................................................................................................................... 35
2.7.3 Positioning ................................................................................................................................. 35
2.7.4 Market Area Definition .............................................................................................................. 36
Chapter Three................................................................................................................................ 37
Technical Analysis ........................................................................................................................ 37
1
3.1 General .............................................................................................................................................. 37
3.2. MANUFACTURING PROCESS/TECHNLOGY ........................................................................... 38
3.1.1 Choice of Technology ................................................................................................................ 38
3.1.2 Appropriateness of Technology ................................................................................................. 39
3.3 TECHNICAL ARRANGEMENTS: ................................................................................................. 40
3.3.1 Technology and manufacturing process..................................................................................... 40
3.3.2 Size of the plant ......................................................................................................................... 41
3.4 MATERIALS AND UTILITIES: ..................................................................................................... 42
3.5
PRODUCT MIX: ........................................................................................................................ 46
3.6 PLANT CAPACITY ......................................................................................................................... 46
3.6.1 Technological Requirement: ...................................................................................................... 47
3.6.2 Input Constraints ........................................................................................................................ 47
3.6.3 Investment Cost ......................................................................................................................... 48
3.6.4 Market Conditions...................................................................................................................... 48
3.6.5 Resources of the Firm ................................................................................................................ 48
3.6.6 Government Policy .................................................................................................................... 48
3.7 Location and Site .............................................................................................................................. 48
3.7.1 Location ..................................................................................................................................... 48
3.8 MACHINERY AND EQUIPMENT:................................................................................................ 52
3.8.1 Constraints in Selecting Machineries and Equipment: .............................................................. 53
3.8.2 Procurement of Plant and Machinery......................................................................................... 54
3.9 STRUCTURES AND CIVIL WORKS ............................................................................................ 55
3.9.1 Site Preparation nd Development .............................................................................................. 56
3.9.2 Buildings and Structures ............................................................................................................ 56
3.9.3 Outdoor Works........................................................................................................................... 56
3.10 Land: ............................................................................................................................................... 57
3.11 PROJECT CHARTS AND LAYOUTS .......................................................................................... 57
3.11.1 General Functional Layout....................................................................................................... 57
3.12 SCHEDULE OF PROJECT IMPLEMENTATION ....................................................................... 59
3.12.1 Work Schedule ......................................................................................................................... 59
Chapter Four: ................................................................................................................................ 67
Socio-Economic and Environmental Study .................................................................................. 67
4.1 ECONOMIC ASPECTS ................................................................................................................... 67
4.2 Environmental Impact & Effluent disposal: ..................................................................................... 67
2
Chapter Five .................................................................................................................................. 70
Organizational, Managerial and Human Resource aspects........................................................... 70
5.1.
Training Requirement: ................................................................................................................ 71
Chapter Six.................................................................................................................................... 72
Financial Analysis ......................................................................................................................... 72
6.1 Financial Analysis and Appraisal ..................................................................................................... 72
6.1.1 Purpose of Financial Analysis in Project Planning: ................................................................... 73
6.2 Estimation of the cost of a project/fixed investment:........................................................................ 75
6.2.1 Capital costs: .............................................................................................................................. 75
6.4 Production Capacity: ......................................................................................................................... 82
6.5 Project Life: ...................................................................................................................................... 83
6.6 Depreciation: ..................................................................................................................................... 83
6.7 Project operating costs: ..................................................................................................................... 84
6.8
Costs of production: .................................................................................................................... 84
6.8.1
Materials ............................................................................................................................. 84
6.8.2
Utilities:............................................................................................................................... 85
6.8.3
Labor: .................................................................................................................................. 85
6.8.4
Factory Overheads .............................................................................................................. 86
6.8 Initial Working Capital Determination: ............................................................................................ 87
6.9
Accept or reject an investment proposal: .................................................................................... 88
6.10
Time value of money: ................................................................................................................. 89
6.11
The Discount Rate: ..................................................................................................................... 89
6.11.1
Indirect Effects: ................................................................................................................... 90
6.11.2
Indirect Costs: ..................................................................................................................... 90
6.11.3
Indirect Benefits .................................................................................................................. 91
6.11.4
Equity Source: ..................................................................................................................... 91
6.14 Financial projections: ...................................................................................................................... 92
6.15
Projected financial statements:.................................................................................................... 94
6.15.1
Cash Flow for Financial Planning or Flow Funds Statement: ............................................ 94
6.15.2
Projected profit and loss statement: .................................................................................... 96
6.15.3
Projected Balance Sheet: ..................................................................................................... 98
6.15.4
Net Present Value: ............................................................................................................ 100
6.15.5
Return on investment: ....................................................................................................... 102
6.15.6
Payback period: ................................................................................................................. 102
3
6.15.7
Average Rate of Return: ................................................................................................... 102
6.15.8
Internal Rate of Return...................................................................................................... 102
6.15.9
Break Even Analysis ......................................................................................................... 103
6.15.10
Debt Service Coverage.................................................................................................. 104
6.15.11
The Benefit/Cost (B/C) Ratio ....................................................................................... 105
6.15.12
Sensitivity Analysis: ..................................................................................................... 105
6.16
DISTINCTION BETWEEN FINANCIAL AND ECONOMICS ANALYSIS ........................ 106
6.16.1
Economic Appraisal/Analysis ........................................................................................... 107
4
PROJECT APPRAISAL OUTLINE
1.
Executive Summary & Recommendation
1.1. Brief summary of background of the project promoter, Market, Technical, and Financial study ( not more
than two pages)
1.2. Recommendation with terms and conditions
2. Background Information
2.1. Background information of the promoter and related parties
2.2. Request and purpose
2.3. Collateral
2.4. Licensing and legality
3. Market Study
3.1. Demand Analysis
3.2. Supply Analysis
3.3. Demand-Supply gap Analysis
3.4. Marketing Strategies
4. Technical Study
4.1. Location and Site
4.2. Construction and Civil works
4.3. Technology and Engineering
4.4. Raw Materials and Utilities
4.5. Production Process Program
4.6. Implementation Schedule
5. Socio-Economic and Environmental Study
5.1. Socio Economic benefits of the project
5.2. Environmental impact Assessment
6. Organization and Management
6.1. Organizational Structure
6.2. Human Resource Management
7. Financial Study
7.1. Basic Assumptions
7.2. Investment cost & Financing Structure
7.3. Financial Viability Indicators
Annexes
5
Chapter One
Introduction
A project is an activity on which scarce resources are expended in anticipation of creating more
benefits over an extended period of time. It is a commercial, economic or social plan or scheme
with a given objective to be achieved over a defined period of time after spending scarce
resources on it in expectation of higher or better results. Hence project planning and appraisal is
concerned with the technical comparison of the expenditure and revenue (financial concepts) or
costs and benefits (economic concepts) of an activity on which resources are spent to achieve
certain objectives.
Often projects form a clear and distinct portion of a larger, less precisely identified program. The
whole program might possibly be analyzed as a single project, but by and large it is better to
keep projects rather small, close to the minimum size that is economically, technically, and
administratively feasible and manageable.
In general, we can say that a project in the national development plan is that it is an activity for
which money will be spent in expectation of returns and which logically seems to lend itself to
planning, financing, and implementing as a unit. It is the smallest operational element prepared
and implemented as a separate entity in a national economic development plan or program. It is
a specific activity, with specific starting point and a specific ending point, intended to
accomplish specific objectives. Usually it is a unique activity noticeably different from
preceding, similar investments, and it is likely to be different from succeeding ones, not a routine
segment of an ongoing program.
1.1 Development Planning & Project Planning
1.1.1 Development Planning:
Development Planning is concerned with many decisions most of which are related to capital
expenditures (on projects) and their financing.
There are three distinct stages of development planning:

National Planning

Sectorial Planning and;

Project Planning
6
A) National Planning:
National planning refers to the drawing of a national plan indicating projections of the economy
on a macroeconomic basis. It requires the formulation of overall economic and social objectives
(called development strategy) identifying the constraints such as shortage of investment, foreign
exchange or skilled labor, and maintaining consistent inter-relations between the various sectors
and regions of the economy. Macroeconomic planning is concerned with the rate of economic
growth, establishing regional balances and priorities and with the formulation of investment
policies and programs, which will achieve the targets set.
The national economy is divided into sectors such as:





Agriculture
Manufacturing Industries
Service Industries
Infrastructure
Social Services
Within these sectors lie various sub-sectors, for example industry may be divided into the main
classification such as:

Food processing

Mining and quarrying

Iron and Steel

Engineering

Chemicals

Oil and Petrochemicals

Textiles, etc.
A national investment program would describe development objectives for each sector, largely
by way of an investment budget over a number of years (usually 5 years). Each sector would
then roughly allocate budgets to each sub-sector, which would then allocate budgets to individual
projects. This viewpoint of the relationship between national, Sectorial and project planning is
called “top-down” planning.
7
Another approach is “bottom-up” planning, which involves identifying a series of projects in
each sub-sector for investment and then basing Sectorial and sub-Sectorial allocation on the
bases of these projects. Countries have some ideas as to which may be its “strong” sectors and
sub-sectors, and on which investment programs to concentrate. These “strong” sectors are the
ones in which a country is both well endowed with resources and market possibilities for
productive projects, or where obvious bottlenecks or shortages need to be removed (e.g. in
service or infrastructure projects).
Thus, planning is a combination of setting over-all national objectives and development targets,
into which Sectorial, Sub-Sectorial and Project Planning is slotted. It is a matter of producing a
consistent combination of “top-down” and “bottom-up” planning.
B) Sectorial (or Sub-Sectorial) Planning:
In general, the analysis of individual sectors will provide indicative figures for investment,
employment, exports etc., but will usually not describe individual projects. The detailed structure
of the sector will also be lacking, as will the complex inter-relationships between sectors. Such
relationships are usually put forward in the form of input-output models, and form the basis for
Sectorial planning.
Before embarking on an individual project, it is frequently necessary to possess detailed
knowledge of the sector concerned (e.g. chemicals, textiles, referred to, here, as sub-sectors),
especially when the project is fairly large in relation to the sector. It is desirable to know for the
sector
a)
Its inputs and outputs
b)
Processes and technologies
c)
Capacities (where measurable)
d)
Structure, location and ownership
e)
Protection, incentives, taxes and constraints
f)
Import requirements and exports, markets & marketing arrangements
g)
Past record of growth
h)
Infrastructure requirements
8
Much of this data is descriptive (either verbal or statistical), but the inputs and outputs of the
sector and its relation to the rest of the economy, may involve complicated analysis, and may be
very important for project appraisal. In the case of the chemical and engineering sectors, for
example, the industry is its own main supplier and its own best customer.
Under these
circumstances, a new is likely to affect the pattern and size of demand faced by the rest of the
sector, and also the inputs available to the sector.
This is particularly important in the case of the engineering industry, which consists of a range of
processes rather than a series of capacities to manufacture individual products. Such Sectorial
planning should provide areas where new investments may be made, and as such, play an
essential part in project identification. In addition, it provides an important framework in which
to analyze new projects and to assess their ramifications.
C) Project Planning
Once a Sectorial (or sub-Sectorial) plan has been drawn up, the way is clear for project planning.
This consists of two stages.
a)
A pre-feasibility study
b)
A detailed feasibility study
A pre-feasibility study concentrates on the market identification and on the costing of a project to
satisfy the market, and a rough financial plan and economic analysis.
The detailed feasibility study will be undertaken when the investors are known the finance
available and financial structure has been discussed and will consist of a very detailed
description and analysis of the project.
1.1.2 Conceptual Definition of A project
In a very brief statement, a project is just a proposal to invest money in certain activities with the
expectation of returns in the future.
It may refer to investment in several areas of economic development including agriculture,
industry, education, transport etc.
9
The preparation and implementation of a project is an elaborate process. Capital expenditure
decisions often represent the most important decisions taken by a firm. Their importance stems
from three inter-related reasons:
1. Long-Term Effects; the consequences of capital expenditure decisions extend far into the
future. The scope of current manufacturing activities of a firm is governed largely by
capital expenditures in the past. Likewise, current capital expenditure decisions provide
the framework for future activities. Capital investment decisions have an enormous
bearing on the basic character of a firm.
2. Irreversibility; the market for used capital equipment in general is ill-organized. Further,
for some types of capital equipment, custom-made to meet specific requirements, the
market may virtually be non-existent. Once such equipment is acquired, reversal of
decision may mean scrapping the capital equipment. Thus, a wrong capital investment
decision often cannot be reversed without incurring a substantial loss.
3. Substantial Outlays; capital expenditures usually involve substantial outlays. An
integrated steel plant, for example, involves an outlay of several thousand million.
Capital costs tend to increase with advanced technology.
While capital expenditure decisions are extremely important, they also pose difficulties which
stem from three principal sources:
A. Measurement Problems; Identifying and measuring the costs and benefits of a capital
expenditure proposal tend to be difficult. This is more so when a capital expenditure has a
bearing on some other activities of the firm (like cutting into the sales of some existing
product) or has some intangible consequences (like improving the morale of workers).
B. Uncertain a capital expenditure decision involves costs and benefits that extend far into
the future. It is impossible to predict exactly what will happen in the future. Hence, there
is usually a great deal of uncertainty characterizing the costs and benefits of a capital
expenditure decision.
C. Temporal Spread the costs and benefits associated with a capital expenditure decision are
spread out over a long period of time, usually 10-20 years for industrial firms.
Capital investments may be classified in different ways. At the simplest level, capital
investments may be classified as physical, monetary, or intangible. Physical assets are tangible
10
investments like land, building, plant, machinery, vehicles, and computers. Monetary assets are
financial claims against some parties. Deposits, bonds, and equity shares are examples of
monetary assets. Intangible assets are not in the front of physical assets or financial claims. They
represent outlays on research and development, training, market development, franchises, and so
on that are expected to generate benefits over a period of time.
Capital investments may also be classified as strategic investments and tactical investments.
A strategic investment is one that has a significant impact on the direction of the firm.
Tata Motor's decision to invest in a passenger car project may be regarded as a strategic
investment. A tactical investment is meant to implement a current strategy as efficiently or as
profitably as possible. An investment by Tata Motors to replace an old machine to improve
productivity represents a tactical investment.
Capital budgeting is a complex process which may be divided into six broad phases: planning,
analysis, selection, financing, implementation, and review.
A) Planning
The planning phase of a firm's capital budgeting process is concerned with the articulation of its
broad investment strategy and the generation and preliminary screening of project proposals. The
investment strategy of the firm delineates the broad areas or types of investments the firm plans
to undertake. This provides the framework which shapes, guides, and circumscribes the
identification of individual project opportunities.
Once a project proposal is identified, it needs to be examined. To begin with, a preliminary
project analysis is done. 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.
B) Analysis
If 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.
The questions and issues raised in such a detailed analysis are described in the following section.
The focus of this phase of capital budgeting is on gathering, preparing, and summarizing relevant
11
information about various project proposals which are being considered for inclusion in the
capital budget. Based on the information developed in the analysis, the stream of costs and
benefits associated with the project can be defined.
C) Selection
Selection follows, and often overlaps, analysis. It addresses the question-Is the project
worthwhile? A wide range of appraisal criteria have been suggested to judge the worthiness of a
project. They are divided into two broad categories, viz., non-discounting criteria and
discounting criteria. The principal non-discounting criteria are the payback period and the
accounting rate of return. The key discounting criteria are the net present value, the internal rate
of return, and the benefit cost ratio.
D) Financing
Once a project is selected, suitable financing arrangements have to be made. The two broad
sources of finance for a project are equity and debt. Equity consists of paid-up capital, share
premium, and retained earnings. Debt (referred to as loan funds on balance sheets) consists of
term loans, debentures, and working capital advances etc.
Flexibility, risk, income, control, and taxes (referred to by the acronym FRIQT) are the
Key business considerations that influence the capital structure (debt-equity ratio) decision and
the choice of specific instruments of financing.
E) Implementation
The implementation phase for an industrial project, which involves setting up of manufacturing
facilities, concepts of several stages: (i) project and engineering designs, (ii) negotiations and
contracting, (iii) construction, (iv) training, and (v) plant commissioning.
Initially an entrepreneur, or a group of entrepreneurs conceive the idea of setting up, say an
industry, after an assessment which indicates that there is demand for the product to be
manufactured and that the profit margin would be attractive. After identifying the project one
has to do further preparatory work. This may include obtaining license, arranging foreign
partnership etc. and preparations of project report (proposal) by engaging a consultant, if
necessary. The stage is now set for approaching financial institutions for assistance, which they
provide only after appraisal.
12
1.1.3 The Role of Financial Institutions in the Financing & Evaluation of Projects
Financial institutions are considered as engines of growth. This is because they endowed to
accelerate the pace of economic growth by implementing projects in conformity with national
plans and priorities.
Because resources are scarce, in the face of high demand for all types of projects, there is a need
for judicious and rational allocation of resources. This implies selectivity in financing projects.
Systematic appraisal of projects, which is the main theme of this session of training, helps in
achieving this end.
1.2 Project Cycle
Preparation and implementation of projects involve stage or cycle. Mr. W.C. Baum of the World
Bank in a well-known article in “Finance and Development in 1970 coined the term '‘Project
Cycle'’. This article identified separate stage of project planning, namely:

Identification

Preparation

Appraisal

Implementation and

Evaluation
This should not, however, suggest that these are strict successive stages over time, which is
misleading. There is in fact, much feedback between the stages, and some stages have to be
undertaken simultaneously. It is preferable, therefore, to think of the project cycle in the form of
a computer program, which describes the process more accurately. A typical arrangement may
be as shown below:
13
Identification
Preparation
Evaluation
Interaction
Appraisal
Implementation
Even at the implementation stage, problems may arise which lead to the project being modified
or re designed.
Each of Baum’s main stages justifies separate brief discussion.
1.2.1 Project Identification:
Where do projects come from? There is no simple answer. Some may be ‘resource-based’, and
stem from the opportunity to make profitable use of available resources. Others may be ‘marketbased’, arising from an identified demand in home or overseas markets. Yet others may be
‘need-based where the purpose is to try to make available to all people in an area minimal
amount of certain basic material requirements and services. Most projects start as an elementary
idea. Eventually, some simple ideas are elaborated into a form to which the title ‘project’ can be
formally applied. The idea becomes a specific proposal of things to be financed, with individual
and group loyalties identified with it. At this stage, possible source of finance may also be
considered, and potential aid donors identified.
14
1.2.2 Preparation: (including pre-feasibility and feasibility studies)
The project is now being seriously considered as a definite investment action, and detailed
planning of the idea (and variations of it) can begin. Project preparation (sometimes called
project formulation) covers the establishment of technical, economical and financial feasibility.
Decisions have to be made on scope of the project, location and site, soil and hydrological
requirements, project size, farm or factory size, etc. Resource base (natural and otherwise)
investigations are undertaken, and alternative forms of project are explored. Complete technical
specifications of distinct proposals accompanied by full details of financial and economic costs
and benefits are the outcome of the project preparation stage. The project now exists as a set of
tangible proposals.
Project design and formulation is an area in which local or international consultants are usually
engaged, especially for big projects that cover large areas and have big budgets.
1.2.3 Appraisal
Project appraisal can be defined as a second look at a project report by a person or an institution
that is in no way involved in its preparation. It helps in taking an entirely independent view of
the project. Appraisal is a comprehensive and systematic review of all aspects of a project.
It would not be possible to have an out and dry formula with the help of which a project could be
judged straight away as acceptable or unacceptable. No doubt broadly the same set of factors is
taken into consideration in scrutiny of individual application by weight given to several factors
varies from case to case.
Appraisal highlights wide areas in the project with the ultimate objective of strengthening them
adequately so as to ensure final success of the project. The main objective of appraisal is to
improve and revamp the project with the co-operation of the promoters.
A person or a team of officers who take the prime responsibility in regard to the conclusions
emanating from the appraisal usually does appraisal of a project. However, for the promoters, it
is an appraisal by the financial institution or bank and it is natural to expect that such an appraisal
15
should be of a very high standard. The appraisal person or team should, therefore, ensure that
the prestige of the institution is not impaired by a faulty or lopsided appraisal done in a hurry or
negligence.
Since a project is an exercise in future based on certain assumptions, it is necessary to understand
the environment in which the project has to sustain itself. Appraisal is also a joint exercise by
promoters and financial institutions. It may be mentioned here that the approach of a
development banker is somewhat different than that adopted by a commercial banker. In the
commercial bank the officer should know that he is dealing with the public money and need
more attention in the appraisal process. The length of time in project financing is considerably
long. The relationship, in this aspect, between the borrower and the lender is of a durable nature.
Therefore, the investigation and scrutiny of an application or a proposal has to be detailed and
comprehensive with a view to ensure that the project is capable of coming to fruition according
to the professed intention of its promoter and will later thrive and grow. In this way, it can yield
adequate returns for the smooth servicing of the commitment undertaken by it.
Financial institutions generally insist on their loans to be adequately secured by a proper charge
on the assets.
However, the concept of a forced sale of the assets to recover the loans is
repugnant to the thinking and responsibilities of a financial institution. The real security is
represented by the surplus, which the project is estimated to yield and the appraisal has to ensure
doubly that such surplus shall be available not only to meet the loan commitments on time but
also to service the risk capital to a reasonable extent.
Project appraisal does not set down a categorical statement of the long-range prospects of a
project but only provides broad guidance to the financial institution to form its judgment
regarding the future profitability & prospects of a particular project and to work out terms and
conditions for the loans.
Appraisals should cover at least seven aspects of a project, each of which must have been given
special consideration during the project preparation phase.
1.
Technical - will what is proposed work in the way suggested?
16
2.
Financial - have the financial
requirements of the
project
been
properly
calculated, their sources identified, and reasonable plans made for their repayment
where this is necessary?
3.
Commercial - how will the necessary inputs for the project be supplied, and are the
arrangements for the disposal of the product satisfactory?
4.
Incentives - are things so arranged that all those whose
participation is required
(they can be many) will find it in their interest to take part
in the project, at least
to that extent envisaged in the plan?
5.
Economic - what is being proposed good from the viewpoint of the
national
development interest when all project effects (positive and negative) have been taken
into account and correctly valued?
6.
Managerial - does the capacity exist for those who will be responsible for
operating the project to do this satisfactorily, and are they given sufficient
power and scope to do what is required?
7.
Organizational – is the project organized internally and externally into
units, contact points, institutions, etc., so as to allow the
proposals
to
be carried out properly, and to allow for change as the project develops?
Frequently these questions are the subject of a specialized appraisal report. On the basis of this
report, final decisions are made about whether to go ahead with the project or not. In practice,
there can be quite a sequence of project selection decisions. Following appraisal, some projects
may be discarded.
If the project involves loan finance from banks, the lender will almost certainly wish to carry out
his own appraisal before completing negotiations with the borrower. Comments made at the
appraisal stage frequently give rise to alterations in the project plans. After negotiations, the
various covenants and agreements will be contained in a loan agreement that is signed by all
parties, after which the project proposal exists as an agreed line of action.
17
1.2.4 Implementation
In this stage, funds are actually disbursed to get the project set up and running. A major priority
during this stage is to ensure that the project is carried out in the way and within the period that
was planned. Problems frequently occur when the economic and financial environment at
implementation differs from the situation expected during appraisal.
Frequently original
proposals become modified, though usually only with difficulty, because of the need to get
agreement between the parties involved.
It is during implementation that many of the real problems of projects are first identified.
Because of this, the feedback effect on the discovery and design of new projects and in
deficiencies in the capabilities of the project actors can be starkly revealed. So as to allow
management to become aware of difficulties as they arise, recording monitoring and progress
reporting are important activities during the implementation stage.
1.2.4 Evaluation
Once a project has been carried out, it is often useful (but not always done) to look back over
what took place, to compare actual progress with the plans, and to judge whether the decisions
and actions taken were reasonable and useful. This we call evaluation. This kind of analysis can
help not only in the management of the project after the initial construction phase, but will also
help in the planning of future projects. Experience with one project can give rise to new ideas
for extension of the project, repetitions, the need for vertically associated projects, which supply
inputs to or process products from this project, and other ideas which become the seeds of new
project proposals. These new ideas then begin to pass through the project processes again.
The number of projects passing through stages generally declines as the cycle is pursued. Many
projects never pass the stage of being good ideas. Preparation of some projects is abandoned
before appraisal, while others are given up afterwards.
A few are abandoned during
implementation. But many are completed successfully! Nevertheless, the use of procedures for
the rejection of unsatisfactory proposals and less satisfactory alternatives are an essential feature
of any effective set of processes for handling projects from conception to completion. Crucial
18
for these procedures to be used is the existence from the outset of well-prepared alternative
project proposals, and of alternative forms for each project.
1.3 What is Project Finance?
Project finance (loan) is a medium- or a long-term loan intended for the financing of the
acquisition and/or leasing of fixed business assets (leased land, buildings, machinery,
equipment, public transport vehicles, trucks and trailers, etc.), the establishment of a new project
and the expansion of an existing business—all of which must be justified by a project feasibility
study and/or a business plan. The loans may embody working capital finance.
1.3.1 Project Loan Vs Working Capital Finance
The differences between project term loan and working capital credit are the following:
i.
The purpose of the project term loan is mainly for acquisition of capital assets but
it may include working capital finance,
ii.
The project term loan is an advance not repayable on demand but only installment
ranging over a period of years,
iii.
The repayment of the project term loan is not out of the sales proceeds of the
goods and commodities per se, whether given as security or not. The repayment
should come out of the future cash accruals from the activity of the unit,
iv.
In the case of project loans with security, the security is not the readily saleable
goods and commodities but the fixed assets of the units.
It may thus be observed that the scope and operation of project term loan are entirely
different from those of conventional working capital advances. The Bank’s commitment
is for long period and the risk involved is greater.
19
1.3.2 Risk Exposure in Project Finance
As observed from the structure of project finance, the following three major characteristics have
huge implications on their risk exposure.
First, they require large indivisible investments in a single-purpose asset. In most industrial
sectors where project finance is used, such as oil and gas and petrochemicals, over 50% of the
total value of projects consists of investments exceeding $1 billion.
Second, projects usually undergo two main phases (construction and operation) characterized by
quite different risks and cash flow patterns. Construction primarily involves technological and
environmental risks, whereas operation is exposed to market risk (fluctuations in the prices of
inputs or outputs) and political risk, among other factors. Most of the capital expenditures are
concentrated in the initial construction phase, with revenues instead starting to accrue only after
the project has begun operation.
Third, the success of large projects depends on the joint effort of several related parties (from the
construction company to the input supplier, from the host government to the off-taker) so that
coordination failures, conflicts of interest and free-riding of any project participant can have
significant costs.
A number of typical characteristics of project financing structures are designed to handle the
risks illustrated above. In project finance, several long-term contracts such as construction,
supply, off-take and concession agreements, along with a variety of joint-ownership structures,
are used to align incentives and deter opportunistic behavior by any party involved in the project.
The project company operates at the centre of an extensive network of contractual relationships,
which attempt to allocate a variety of project risks to those parties best suited to appraise and
control them: for example, construction risk is borne by the contractor and the risk of insufficient
demand for the project output by the off-taker.
20
•
Stages
i.
Development
•
Bid Risk
Promoter / Financial advisor
•
Resource Risk
Promoter
•
Cost Estimation
Financial advisor
Absorbed by
ii. Construction Stage
•
Construction Risk
Sponsor/ contractor/ supplier
•
Technology Risk
Contractor/ supplier
iii. Operation Stage
•
Market/ Off-take Risk
Sponsor
•
Operating Risk
Sponsor/ O& M Contractor
iv. Non Commercial Risk
•
Political Risk
Sponsor/ Govt./ Insurance
•
Environmental Risk
Contractor/ Govt.
Sponsor/Govt./Insurance
•
Force Majeure Risk
Sponsor/Govt./Insurance
v. Economic Environment
•
Interest rate and currency risk
•
Inflation Risk
Sponsor/ Government
Government
21
Chapter Two
Market Analysis
2.1. General
Market analysis enables to establish pricing, distribution and promotional strategies that will
enable to become profitable within a competitive environment.
Inadequate or inaccurate analysis of the demand/ growth pattern and degree of market
penetration usually results in either excess production capacity and poor capacity utilization, as is
often the case in developing countries, or plant capacity that is insufficient to meet market needs
and unable to take advantage of the economies of scale.
Economies of scale refer to the cost advantage that arises with increased
output of a product. Economies of scale arise because of the inverse
relationship between the quantity produced and per-unit fixed costs; i.e.
the greater the quantity of a good produced, the lower the per-unit fixed
cost because these costs are shared over a larger number of goods.
Economies of scale may also reduce variable costs per unit because of
operational efficiencies and synergies. Economies of scale can be
classified into two main types: Internal – arising from within the
company; and External – arising from extraneous factors such as industry
size.
A market can be viewed in a narrow terms as a set of consumers, existing and potential, or, in
broad terms, as the consumers plus such influences as the government policies in a particular
country or region.
Defining the market narrows the total market which is segmented by factors such as geographic
(where they live), demographic (who they are - age, sex, income), psychographic (why they buy
- life style factors) and synchrographic (when they buy).
22
2.2. Demand Analysis:
The first step in market analysis is to consider the current situation taking into account output of
the product to be manufactured and the existing demand for it with view to establish whether
there is unsatisfied demand. Market study should go beyond immediate prospects. Possible
future changes in the volume and pattern of supply and demand will have to be estimated in
order to assess the long term prospects of the unit. Ascertaining demand alone is not sufficient.
Knowledge of proper pricing, distribution and advertising policy are also essential to assess the
market.
More specifically analysis of demand requires the determination of:

The total demand for a product or service and

The share of the total market that can be secured by the firm through
appropriate marketing strategies.
The first step in project analysis is, in most cases, a detailed estimate of the size, structure and
demand characteristics of the product to be manufactured. In almost all cases certain amounts
of primary data have to be generated since secondary data in the requisite detail do not exist or
are not available. Also producers are reluctant to reveal information on operational aspects of
industry and consumers are reluctant to reveal information on family budgets, personal incomes,
buying habits, preferences and market responses. These reluctance plus frequent changes in
socio-economic living patterns often render the available historical data irrelevant for industrial
programming. Sometimes those difficulties are encountered especially when a new product,
either not domestically produced or imported in large quantities, is introduced. On the other
hand, the market and demand analysis in developing countries may be easier during the earlier
stages of development since the majority of industrial projects in such countries is geared, at the
beginning, to import substitution, and the amount of imports constitutes an indicative parameter.
Often the first entrepreneurs are former importers of such products who are fairly well
acquainted with existing market conditions.
The Contents of Demand Analysis required should be summarized as follows:
a.
The size and composition of present demand in a market whose geographical limits
should be defined;
23
b.
c.
Market segments identified by:
i.
End-use (e.g. consumers);
ii.
Consumer groups (e.g. different income levels of consumers);
iii.
Geographical division (e.g. regional, national and export markets)
The demand projections of the overall market and of the segments over a certain period,
preferably the first 10 years, of the operational life of the project:
d.
The market penetration ratio that the proposed project is expected to achieve over the
projected period in the context of developing domestic and international competition and
changing consumer responses;
e.
The broad pricing structure on the basis of which projections of growth and market
penetration are made.
f.
The nature/description of the product, its major uses, scope of the market, possible
competition for substitute products etc.,
g.
Customized products with short life times as required,
h.
Special features (regarding quality, price etc.) of the product which would result in
consumer preference for the product in relation to competitive products,
i.
Estimates of existing and future demand supply of the products proposed to be
manufactured.
j.
An assessment of likely competition in future and special feature of the project which
may enable it to meet the competition,
k.
Export possibilities and comparative data on manufacturing cost and price (domestic as
well as exports), export incentives available, if any,
l.
CIF and FOB prices and landed cost of the proposed product have to be stated,
m.
List of principal customer and particulars of any firm arrangements entered into with
them,
n.
Particulars of Government controls, restrictions, if any, on the sale price, distribution,
import, export, etc., in respect of the products proposed to be manufactured,
o.
Selling arrangements - Whether directly or through distributor/dealers have to be
clarified,
p.
Note on selling organization, copy of agreement with selling agents appointment of
relatives as selling agents to be avoided.
24
q.
Trend in prices during the last 5 years.
The above data collected by promoters/appraisal officer from various sources including
government agencies form the basis for market studies and surveys. The exact methodology that
needs to be adopted for a particular product depends on the type of the product.
Financial institutions, in their appraisal of projects, are primarily concerned with above because
the size of the overall market depends on a host of factors outside the promoters control and
hence their assistance to be committed to project.
The conditions of sales promotion, including, when necessary, the type of after-sales services
and the packaging standards contemplated as well as the sales organization to be established, are
normally also part of the demand and market study.
The factors governing export markets tend to be more complex than those governing domestic
markets, and the techniques of estimation and forecasting need to be considered separately.
Though a study should usually have as a starting point a product with definitive characteristics, it
may be necessary, in the course of such analysis, to modify the specifications of the product,
design, performance packaging etc. in order to suit the local, national or export market to be
served. Such modifications should not change the basic character of the product while the project
is being formulated.
Quantified statistical data on the demand situation of a product must be obtained from reliable
statistical sources. There are a few national as well as international institutions which release such
information and data for major traded commodities.
Among these institutions are Central Statistics Authority (CSA), National Bank of Ethiopia (NBE),
and Ethiopian Customs Authority, Investment Agency-Federal &/or regional. Publications of
the World Bank, Food and Agricultural Organization, etc are also major sources of data for market
analysis. Moreover, utilization of internet facilities and referring to available data in the bank as
25
regards to specific products or services is also advisable. Although it is quite apparent that the
aforementioned task is challenging and perhaps very difficult, it should not be by-passed to the
extent possible.
A) Size and Composition of Present Effective Demand
The initial objective of demand and market analysis for a feasibility study is the determination of
current effective demand.
The estimate of current effective demand is usually based on data from the year
preceding the one in which the study is made, or, if these data are insufficient, from the
year before that.
The base for estimation is the actual consumption figure during the relevant period. It may,
however, not be easy to obtain consumption figures for most products. A beginning has to be
made with “apparent consumption” of a product which, for a domestic market, is arrived at for a
given period by aggregating its production and deduction or adding the changes in the balance of
trade and in inventories.
Thus, apparent consumption (Co) is given by:
Co = P + (I-E) + (So – Sc)
Where P is the production during the period; I is the import; E is the exports; S0 is the level of
stocks at the commencement of the period: and Sc is the level of stocks at the close of the period.
Adjustments should be made for consumption of the product by the producers. Also, provision
should be made for abnormal factors, to the extent that these can be gauged at all, by inflating or
deflating the final figures. Where such factors cannot be identified it may be necessary to resort
to an average of the previous two or three years with appropriate adjustments. As with the
consumption of the current year (Co), the consumption of past year (C-n … C-1 may be
estimated. Any gaps in the series will have to be filled by interpolation.
Once current demand has been estimated for the entire market, it becomes necessary to segment
the market to make future projections and to determine the acceptable product-mix. Market
26
segments can be identified by the nature of the product (qualities and end-uses), by consumer
group or by geographical division of the market. The rationale for segmenting a market by
consumer characteristics is that demand varies from one segment to another as a result of several
conditions. Consumer habits in one case may change more rapidly than in another, and, for
instance, a high-income segment may show greater response in accepting a higher-priced
product. Or, some segments may grow faster than others may. Segmentation of the market may
facilitate the planning of marketing strategies for the project, as considerable gains are possible
by gearing promotional strategies to the characteristics of different market segments. One overriding consideration is that in most cases the appraisal and projection of market size can be made
only by analyzing separately each market segment.
Since end-use geographical and consumer group segmentation of markets differ from product to
product, it is not possible to design guidelines to their nature and structure, but it is necessary to
define such segments in a feasibility study for a particular product. In some cases, such as dairy
products, a large national market may be regionally divided; in other cases, such as the steal,
aluminum or paper industry, the market limits may extend beyond national frontiers. Even for
the same product or industry, the segments may differ for different countries, and where as
territorial segments may be critical for a product in one country, the end-use aspect would be
more important in another
B) Demand projection
Forecasting Demand/ Demand Forecasting Methods
27
The above classification being the widely used forecasting techniques in literatures, there are
three types of techniques that are most frequently used by financial institutions in preparing
demand forecasts:
i)
Trend/extrapolation Method
ii) Regression Method
iii) End – use/Consumption Coefficient Method
The first two methods are quite alike. Both are used to forecast demand statistically basing the
forecasts on past ends in certain variables.
In case of (i) the variable is consumption set against time. In case of (ii) it may be income,
prices etc. To elaborate more:
Regression Analysis is similar to trend analysis, except the independent variable is not
restricted to time. Instead of letting time represent our independent variable, we could
forecast sales based upon the price of the product. Since products often go on sale, we
could collect data over several months collecting the weekly price and number of items
sold for the week. For this model, we would find the regression equation in the same
manner in which we found the trend line except we would call the independent variable
x, instead of t.
1.
Trend (Extrapolation) Method:
 This involves the determination of a trend and the identification of its parameters.
 It is the most widely used alternative for forecasting technique
 Y = a + bt
◦
Y is the variable being forecast
◦
t is to be Estimated
◦
b is a constant growth rate
 NB. Moving average of two to three years should be taken in case of major annual
fluctuation.
Consumption –level method
2.
 considers the level of consumption, using standard and defined coefficients,

It can be usefully adopted for consumer products.
28
Example:
 The demand for cars can be estimated by:
◦
determining the ratio of cars per 1,000 inhabitants
◦
the coefficients of car ownership among identified income levels
 Per capita consumption levels for sugar, flour, etc
 Major determinants of consumption level is consumer income and price
 Product consumption level demonstrates high positive correlation with income levels of
consumers (change in per capita income)
 Income Elasticity of Demand
 Price Elasticity of Demand
 The ratio of relative variation in demand to relative variation in price
3. The basic steps involved in the End Use approach are as follows:

Identify the end - user industries/population;

Make an intensive study of the past and present situation and make a thorough assessment
of the future prospects of the various end – user industries/population;

Determine the expected levels
of production
for the various end –
user
industries/population.

Determine the consumption norms for each end - user industry/consumers in respect of the
product for which the forecasts are needed.

Estimate the requirements of the end - user industries/population for the forecast item as a
product of the consumption norms and the expected future production/consumption in the
end - user industries/population.

Sum the estimated needs for the forecast product from all the end user
industries/population.
Clearly, once the requisite data is available the exercise is comparatively simple. Hence the key
to effective market analysis depends on available data. For most products the data is available in
one form or another and in fact in many cases market forecasts are also available. In these cases
we use these forecasts as a starting point and cross check the data and the assumptions used in
the exercise to derive the result.
29
The use of end-user technique is relatively simple when the number of end-user
industries/population is small. In some cases where the number of end-users is phenomenally
large, we have to resort to the trend method of projection, supplemented by discussions with
knowledgeable persons in Government industry and trade to estimate future demand.
Finally, in cases where the number of end - users is very large and the product is new (so that
past consumption data does not exist) we must generate basic data. This requires a limited field
survey on a statistically valid sample, which is then blown up to provide regional or national
demand estimates depending upon the product and requirements. Normally, services of outside
consultants or research institutes are used for such surveys.
Steps in Market Analysis
1.
Product Description
◦
Detailed description of the nature of the product and its major uses;
2. Determine the target market of the project
3. Identification of customers, their needs and behaviours
◦
What is bought?
◦
Why is it bought? (What is the purchasing motive?)
◦
Who are the buyers? (exports may have to be thought)
◦
When is it bought? (seasonality)
◦
How much is bought (quantity and frequency)?
◦
Where is the purchase made?
4. Market segmentation based on:
◦
Geographic or linguistic criteria
◦
Socio-demographic criteria (age, sex, income, education, profession, size...)
◦
Psychological criteria (status etc.)
5. Estimate of the actual maximum possible demand of the total market.
◦
Use the apparent consumption level for the past and current period level of
demand.
◦
Apparent consumption level
◦
= Production + Import –Export – Stock
30
◦
Actual Data of 10 – 15 years shall be used to look in to movements on
consumption level
Estimated Actual Demand
YEAR
Local
Import
Production
Export
Apparent
Growth
Consumption
Rate
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
Average
2.3 Supply Analysis and Projection
A) Existing Supply:
Both the local sources of supply of product or services as well as imported supply of the same must be
assessed from available statistical data information. Domestic productions in terms of quantity, value,
capacity utilization of domestic firms and trend development have to be compiled and analyzed.
Imported supply of product must be assessed in terms of quantities as well as prices so as to make the
supply statistics complete and comprehensive.
B) Supply Projections:
31
Supply projections can also be conducted by considering the capacity utilization rates of the project and
the existing plants as well as new investments envisaged in the sub-sector in the future.
1. Identify major suppliers of the product or services
2. Gather information on past production level and attainable capacity of each supplier
3. Identify reasons for major deviation between actual level of production and attainable
capacity
4. Consider the attainable full capacity as potential supply from each supplier
5. In the absence of data on individual supplier or in case their number is large use CSA
data of local production
Local available production capacity /supply
Attainable
Capacity
Producer A
Producer B
Producer C
Total
 Include projects in pipeline (i.e. projects under implementation)
◦ Source: Investment Agency of federal or regional offices
 Consider attainable full capacity of projects in pipeline (90%)
Attainable Capacity
Project A
32
Project B
Project C
Total
2.4 Demand and Supply Gap
Once the demand and supply situation of a given product or services are assessed and quantified,
comparison to see whether there exists unsatisfied demand or over supply must be conducted.
The project can be proposed only and so long as there exist deficit or shortfall on the supply
situation of the product, either in the local or export markets, depending on the objective of the
project at hand. The quantified information must be compared as shown in the table below
Year
Demand
Supply
Unsatisfied
Excess
(1)
(2)
Demand (1-
Supply
2)
Existing
Planned
Total
2.5 Price Analysis
2.5.1 Prices and Price trends
Historical prices, at least for the past five years, of the items to be produced or services to be
rendered by the project being appraised should be collected. A simple trend or other forms of
analysis must there be applied to find out whether the overall price movement is upward,
downward or constant. If the price trend of the proud is downward, caution must be taken in
recommending the project for CBE financing.
33
2.5.2 Price build-up or cost plus Approach
It may be useful to work out the selling price of an industrial output. The price build up is
computed based on attainable capacity of the project. The details or price build is as shown
below
a. Volume of Output
b. Total Operating Cost
c. Production Cost per Unit
d. Sales Tax or Service Tax
e. Other Taxes
f. Interest and Other Charges
g. Profit Margin of 15% - 30% is recommendable
h. Selling Price Per Unit
But this “Selling price” must be compared with the ‘prevailing market price’ as well as the result
of the trend analysis so as to determine future price tag of the product or service.
2.6 Marketing
2.6.1 Major Marketing Area for the Product or Service
A commodity produced by an industrial project may not be marketed at the point/locality! of
production. In the majority of the cases the produce may be transported to long distances to reach
other region even within a country. These regions/zones and ‘woredas’ where the produce will
be potentially marketed must be identified when making the market assessment. This would, of
course, help for the products strategic market planning.
If commodity produced by an industrial project is to be exported, the importing country should
be identified and known so as to enable to prepare a sound market planning in the future, or find
alternative export market outlet.
Marketing Channels and Arrangements for the Product(s) or Services
An industrial project may not be directly involved in the marketing operation of their product or
services. When an Industrial project has different for marketing its produce or service, the officer
34
handling the project must carefully assess the different intermediaries involved starting from the
primary market to terminal or final disposal point.
2.7 MARKETING STRATEGY:
The marketing logic by which the company hopes to create customer value and achieve
profitable customer relationships is Marketing strategy. Guided by marketing strategy, the
company designs an integrated marketing mix made up of factors under its control—product,
price, place, and promotion (the four Ps). To find the best marketing strategy and mix, the
company engages in marketing analysis, planning, implementation, and control. Through these
activities, the company watches and adapts to the actors and forces in the marketing
environment.
There are too many different kinds of consumers with too many different kinds of needs. Most
companies are in a position to serve some segments better than others. Thus, each company must
divide up the total market, choose the best segments, and design strategies for profitably serving
chosen segments. This process involves market segmentation, market targeting, differentiation,
and positioning.
2.7.1 Market segmentation
Dividing a market into distinct groups of buyers who have different needs, characteristics, or
behaviors, and who might require separate products or marketing programs.
2.7.2 Market targeting
The process of evaluating each market segment’s attractiveness and selecting one or more
segments to enter
2.7.3 Positioning
Arranging for a product to occupy a clear, distinctive, and desirable place relative to competing
products in the minds of target consumers
Many large, well-established development companies conduct market analysis both before and
after site selection. Market analysis before site selection can help identify gaps in a given market
area that could present future development opportunities. Market analysis after site selection
35
focuses on refining the target market, finalizing the project concept and securing financing. For
most developers and sponsors, however, market analysis takes place before a site has been
selected, as the initial process of defining the target market and completing the market analysis
will ultimately drive the choice of a particular site.
2.7.4 Market Area Definition
The first step is to define the geographic market area that will form the basis of the investigation.
Defining the market area is important, because it carves out the survey area for testing the
project’s marketability and the focus of marketing efforts. Misjudging this territory will
undermine the usefulness of marketing activities. As well, it can result in competitive and
financial analysis that is unreasonably optimistic by, for example, omitting competing projects or
overestimating the rate of take-up in the local market.
The market for a housing project aimed at an older population will have a relatively narrow
geographic draw. The draw widens if the project is linked to a club, cultural group or other
distinct body representing a well-defined, less geographically limited community, or if amenities
such as recreational facilities associated with active adult housing have their own separate
appeal.
36
Chapter Three
Technical Analysis
3.1 General
On the technical side, we have to be sure that the alternatives have been adequately considered
and the correct technical solutions found. This means the right combination of seeds, pesticides,
and fertilizer for a particular crop-growing project, or the correct system of drainage for an
irrigation project, if it is a road project, that the width of the road, the shoulders, and the
thickness of the pavement are appropriate to the traffic, if a railroad construction project, that the
best alignment has been found, if a port project, that the design of the births and the depth of
dredging are correct for the kinds of vessels serving the port, if an education project that the
number and layout of classrooms and laboratories are suitable for the proposed input of students
and the curriculum envisaged. The list could be extends indefinitely. All features of the project
design, the cost estimates, and the construction schedule are re-examined and confirmed or
revised as necessary. In most cases this is the responsibility of engineers to do the technical study
of a project.
The analysis of technical and engineering aspects is done continually when a project is being
examined and formulated. Other types of analyses are closely intertwined with technical
analysis.
The broad Purpose of technical analysis is

to ensure that the project is technically feasible in the sense that all the inputs, required to
set up the project are available, and

To facilitate the most optimal formulation of the project in terms of technology, size,
location, and so on.
Technical analysis is essentially the preserve of the technical expert. The financial analyst
participating in the project appraisal exercise should be able to raise basic issues relating to
technical analysis using common sense and economic logic.
The issues to be covered in technical analysis are organized into eleven sections as follows:
37

Manufacturing process/technology

Technical arrangements

Materials and inputs

Product mix

Plant capacity

Location and site

Machineries and equipments

Structures and civil works

Project charts and layouts

Project implementation schedule
3.2. MANUFACTURING PROCESS/TECHNLOGY
For manufacturing a product/service often two or more alternative technologies are available.
For example:

Steel can be made either by the Bessemer process or the open hearth Process.

Cement can be made either by the dry process or the wet process.

Soap can be manufactured by the semi-boiled process or the fully boiled Process.
3.1.1 Choice of Technology
The choice of technology is influenced by a variety of considerations:

Plant capacity

Principal inputs

investment outlay and production cost

Use by other units

Product mix

Latest developments

Ease of absorption
38
A) Plant Capacity:, there is a close relationship between plant capacity and production
technology. To get a given capacity requirement perhaps only a certain production technology
may be viable.
B) Principal inputs: The choice of technology depends on the principal inputs available for the
project. In some cases, the raw materials available influence the technology chosen. For
example, the quality of limestone determines whether the wet or dry Process should be used for a
cement plant.
C) Investment Outlay and Production Cost: The effect of alternative technologies on
investment outlay and production cost over a period of time should be carefully assessed.
D) Use by Other Units: The technology adopted must be proven by successful use by other
units.
E) Product Mix: The technology chosen must be judged in terms of the total product-mix
generated by it, including saleable by-products.
F) Latest Developments: The technology adopted must be based on the latest developments in
order to ensure that the likelihood of technological obsolescence in the near future, at least, is
minimized.
G) Ease of Absorption: The ease with which a particular technology can be absorbed can
influence the choice of technology. Sometimes a high-level technology may be beyond the
absorptive capacity of a developing country which may lack trained personnel to handle that
technology.
3.1.2 Appropriateness of Technology
Appropriate technology refers to those methods of production which are suitable to local
economic, social, and cultural conditions. The advocates of appropriate technology urge that the
technology should be evaluated in terms of the following questions:
39

Whether the technology utilizes local raw materials?

Whether the technology utilizes local man power?

Whether the goods and services produced cater to the basic needs?

Whether the technology protects ecological balance?

Whether the technology is harmonious with social and cultural conditions?
3.3 TECHNICAL ARRANGEMENTS:
Satisfactory arrangements must be made to obtain the technical know-how needed for the
proposed manufacturing process. When collaboration is sought, inter alia, the following aspects
of the agreement must be worked out in detail:

The nature of support to be provided by the collaborators during the designing of the
project, selection and procurement of equipment, installation and erection of the plant,
operation and maintenance of the plant, and training of the project personnel.

Process and performance guarantees in terms of plant capacity, product quality, and
consumption of raw materials and utilities.

The price of technology in terms of one-time licensing fee and periodic royalty fee.

The continuing benefit of research and development work being done by the collaborator.

The period of the collaboration agreement.

The assistance to be provided and the restrictions to be imposed by the collaborator with
respect to exports.

The level of equity participation and the manner of sharing management control,
especially if the technical collaboration is backed by financial collaboration.

Assignment of the agreement by either side in case of change of ownership.

Termination of the agreement or other remedies when either party fails to meet its
obligation.

Approach to be adopted in force majeure situations.
3.3.1 Technology and manufacturing process
40
It is to be ensured that the manufacturing process to be adopted is modern and at the same time
appropriate to the level of economic development of the country. A study is made of the
suitability of the technology being adopted to ensure that benefit of advances and developments
in technology are available to project.
If a product can be manufactured by using alternative raw materials with alternative process, a
comparative study would be necessary to choose the more suitable process. However, if a new
process is more economical, it should be preferred but its workability at least on a pilot plant
basis should be that in the case of a new process, the process suppliers join in equity participation
to have their more involved association with the project.
A process from a foreign country should not be adopted with out the consideration to local
conditions. Instead of going in for a highly sophisticated process, a developing country may
prefer to opt for a manufacturing process, which is labour intensive because labour is not only
abundant but also comparatively cheap.
The manufacturing process and section-wise capacities proposed are also examined in detail with
a view to inter ail determining the balancing of different sections of the plans and insure fuller
utilization of the in-built capacity.
In the process is obtained through an agreement with a foreign collaborator, the terms and
conditions of the agreement should be studied carefully. It should be insured that the agreement
clearly defines the nature of support to be provided by the collaborators in planning and
designing the project, selection and procurement of equipment, installation and operation of the
plan, training of personnel etc. The agreement should also define the royalty payable to the
collaborators, production parameters and guarantees.
3.3.2 Size of the plant
Generally a large size unit economical but if setting up of a large size unit needs large capital
investment or the demand for the end product is limited or adequate raw material is not available,
41
a small size unit should be preferred. The concept of economic size of plant changes with the
change in technology, price structure, availability of raw material, demand for the end product
etc. Provision should be made to increase the capacity in phased manner.
3.4 MATERIALS AND UTILITIES:
An important aspect of technical analysis is concerned with defining the materials and utilities
required, specifying their properties in some detail, and setting up their supply program. There is
an intimate relationship between the study of materials and utilities and other aspects of project
formulation, particularly those concerned with location, technology, and equipments.
Material inputs and utilities may be classified into four broad categories:
(i) Raw materials,
(ii) processed industrial materials and components,
(iii) Auxiliary materials and factory supplies, and
(iv) Utilities.
3.4.1 Raw Materials:
The availability of raw materials and components required for a project is an essential factor to
ensure its success. The appraisal should show that the essential raw materials required for the
project would be readily available on a sustained basis. In this connection it is necessary to be
clear about the existing Government policies in regard to the regulation of supplies and price of
both indigenous and imported raw materials. Arrangements should be made or proposed for
steady procurement of raw materials and if any difficulties are envisaged in the matter of
procurement of the requisite materials should be indicated.
In the case of industries like cement or glass, which have to depend on mines or quarries for
regular supply of the required ores/minerals, estimates, should be based on proven reserves of
minerals.
In general, concerning raw materials look into the following:
 Raw material (quantity, source, availability and cost)
42
 Input supply agreement, if any
 Transportation facilities for raw materials and finished products
 Available facilities for handling and storing
Raw materials (processed and/or semi-processed) may be classified into four types:
I.
II.
agricultural products,
mineral products,
III.
livestock and forest products, and
IV.
marine products.
A) Agricultural Products
In studying agricultural products, the quality must first be examined. Then, an assessment of the
quantities available, currently and potentially, is required. The questions that may be raised in
this context are:
 What is the present marketable surplus?
 What is the present area under cultivation?
 What is the likely increase in yield per acre?
B) Mineral Products
In assessing mineral raw materials, information is required on the quantum of exploitable
deposits and the properties of the raw materials. The study should provide details of the location,
size, and depth of the deposits and the viability of open cast or underground mining. In addition,
information should be generated on the composition of the ore, level of impurities, need for
beneficiation, and physical, chemical and other properties.
C. Livestock and Forest Products:
Secondary sources of data on livestock and forest products often do not provide a dependable
basis for estimation. Hence, in general, a specific survey may be required to obtain more reliable
data on the quantum of livestock produce and forest products.
43
D) Marine Products:
Assessing the potential availability of marine products and the cost of collection is somewhat
difficult. Preliminary marine operations, essential for this purpose, have to be provided for in the
feasibility study.
E) Processed Industrial Materials and Components:
Processed industrial materials and components (base metals, semi-processed. materials,
manufactured parts, components, and sub-assemblies) represent important inputs for a number of
industries. In studying them the following questions need to be answered: In the case of
industrial materials, what are their properties? What is the total requirement of the project? What
quantity would be available from domestic sources? What quantity can be procured from foreign
sources? How dependable are the supplies? What has been the past trend in prices? What is the
likely future behavior of prices?
F) Auxiliary Materials and Factory Supplies:
In addition to the basic raw materials and processed industrial materials and components, a
manufacturing project requires various auxiliary materials and factory supplies like chemicals,
additives, packaging materials, paint, varnishes, oils, grease, cleaning materials, etc. The
requirements of such auxiliary materials and supplies should be taken into account in the
feasibility study.
3.4.2 Utilities:
A broad assessment of utilities (power, water, steam, fuel, etc.) may be made at the time of the
input study though a detailed assessment can be made only after formulating the project with
respect to location, technology, and plant capacity. Since the successful operation of a project
critically depends on the adequate availability of utilities, the following questions should be
raised while conducting the inputs study. What quantities are required?
44
What are the sources of supply?
What would be the potential availability?
What are the likely shortages/bottlenecks?
What measures may be taken to augment supplies?
A) Power Supply
The appraisal should show what the present requirements of power supply for the project are and
the arrangements made for its delivery. Moreover it should indicate power installation
arrangement and the entailed costs. Power requirement in peak KW demand and annual KWH
consumption should be mentioned. Further it should show the requirements for expansion and
how these are to be met. In the case of projects, such as aluminum and heavy chemical
industries, steady and economic supply of electric power is an essential prerequisite. Where the
process of manufacture is of a continuous type as in the case of a glass industry, it is necessary
that adequate standby arrangements are made at the project site so that production is not
interrupted on account of any sudden or unforeseen break-down in the normal source of power
supply.
B) Water Supply
All industries require large quantities of water for the manufacturing process although some like
paper mills require more. Others also have to make adequate arrangements for water supply both
for factory and non-factory purposes, including the requirements of the staff colony and labor
quarters.
The technical appraisal of the project should, therefore, include examination of the arrangements
made or proposed to be obtained by boring tube - well, a report on the adequacy of such supplies
is desirable. In the case of certain processes, the quality of water is also relevant and if it is
found unsuitable, provision has to be made for the installation of a filtration or water treatment
plant.
C) Labor Supply
45
An appraisal of a project must also include a study of the availability of skilled, semi -skilled and
unskilled labor required for a project. Where the requirements of skilled personnel is of a
specialized type, an enquiry into the arrangements for training including the phasing of such
program vis-à-vis the program of construction and production is desirable.
3.5 PRODUCT MIX:
The choice of product mix is guided by market requirements. In the production of most of the
items, variations in size and quality are aimed at satisfying a broad range of customers. For
example, a garment manufacturer may have a wide range in terms of size and quality to cater to
different customers.
As to product mix, the analysis may have to cover the following properties:
a. Physical properties: dimensions, form, specific gravity, viscosity, porosity, state (gas,
liquid, solid) and melting and boiling points.
b. Mechanical properties: formability, machinability, tensile strength, shearing strength,
elasticity,
c. fatigue resistance, hardness, and anneal.
d. Chemical properties: form (suspension, emulsion), composition, purity, inflammability,
and oxidizing and reducing potentials.
e. Electrical: and magnetic properties, magnetization, conductance, and resistance.
While planning the production facilities of the firm, some flexibility with respect to the product
mix must be sought. Such flexibility enables the firm to alter its product mix in response to
changing market conditions and enhances the power of the firm to survive and grow under
different situations. The degree of flexibility chosen may be based on a careful analysis of the
additional investment requirement for different degrees of flexibility.
3.6 PLANT CAPACITY
Plant capacity (also referred to as production capacity) refers to the volume or number of units
that can be manufactured during a given period. Plant capacity may be defined in two ways:
46

feasible normal capacity (FNC) and

Nominal maximum capacity (NMC).
The feasible normal capacity refers to the capacity attainable under normal working conditions.
This may be established on the basis of the installed capacity, technical conditions of the
plant, normal stoppages, downtime for maintenance and tool changes, holidays, and shift
patterns.
The nominal maximum capacity is the capacity which is technically attainable and this often
corresponds to the installed capacity guaranteed by the supplier of the plant. Our discussion will
focus on the feasible normal capacity. Several factors have a bearing on the capacity decision.
These are:

Technological requirement

Input constraints

Investment cost

Market conditions

Resources of the firm

Governmental policy
3.6.1 Technological Requirement:
For many industrial projects, particularly in process type industries, there is a certain minimum
economic size determined by the technological factor. For example, a cement plant should have a
capacity of at least 300 tonnes per day in order to use the rotary kiln method; otherwise, it has to
employ the vertical shaft method which is suitable for lower capacity.
3.6.2 Input Constraints
In a developing country like Ethiopia, there may be constraints on the availability of certain
inputs. Power supply may be limited; basic raw materials may be scarce; foreign exchange
available for imports may be inadequate. Constraints of these kinds should be borne in mind
while choosing the plant capacity.
47
3.6.3 Investment Cost
When serious input constraints do not exist, the relationship between capacity and investment
cost is an important consideration. Typically, the investment cost per unit of capacity decreases
as the plant capacity increases.
3.6.4 Market Conditions
The anticipated market for the product/service has an important bearing on the plant capacity. If
the market for the product is likely to be very strong, a plant of higher capacity is preferable. If
the market is likely to be uncertain, it might be advantageous to start with a smaller capacity. If
the market, starting from a small base, is expected to grow rapidly, the initial capacity may be
higher than the initial level of demand-further additions to capacity may be effected with the
growth of the market.
3.6.5 Resources of the Firm
The resources, managerial and financial, available to a firm define a limit on its capacity
decision. Obviously, a firm cannot choose a scale of operations beyond its financial resources
and managerial capability.
3.6.6 Government Policy
The capacity level may be influenced by the policy of the government.
3.7 Location and Site
The choice of location and site follows an assessment of demand, size, and input requirement.
Though often used synonymously, the terms 'location' and 'site' should be distinguished.
3.7.1 Location
Location refers to a fairly broad area like a city, an industrial zone, or a coastal area; site refers to
a specific piece of land where the project would be set up. The choice of location is influenced
by a variety of considerations:
48

proximity to raw materials and markets,

availability of infrastructure,

labor situation,

governmental policies, and

other factors.
A) Proximity to Raw materials and Markets
An important consideration for location is the proximity to the sources of raw materials and
nearness to the market for the final products. In terms of a basic location model, the optimal
location is one where the total cost (raw material transportation cost plus production cost plus
distribution cost for the final product) is minimized. This generally implies that:
(i) a resource-based project like a cement plant or a steel mill should be located close to the
source of the basic material (for example, limestone in the case of a cement plant and
iron ore in the case of a steel plant);
(ii) A project based on imported material may be located near a port; and
(iii) A project manufacturing a perishable product should be close to the centre of
consumption.
However, for many industrial products proximity to the source of raw material or the centre of
consumption may not be very important. Petro-chemical units or refineries, for example, may be
located close to the source of raw material, or close to the centre of consumption, or at some
intermediate point.
B) Availability of Infrastructure:
Availability of power, transportation, water, and communications should be carefully assessed
before a location decision is made. Adequate supply of power is a very important condition for
location-insufficient power can be a major constraint, particularly in the case of an electricityintensive project like an aluminum plant.
49
In evaluating power supply the following should be looked into:

the quantum of power available,

the stability of the power supply,

the structure of the power tariff., and

the investment required by the project for a tie-up in the network of the power supplying
agency.
For transporting the inputs of the project and distributing the outputs of the project, adequate
transport connections-whether by rail, road, sea, inland water, or air-are required. The
availability, reliability, and cost of transportation for various alternative locations should be
assessed.
Given the plant capacity and the type of technology, the water requirement for the project can be
assessed. Once the required quantity is estimated, the amount to be drawn from the public utility
system and the amount to be provided by the project from surface or sub-surface sources may be
determined. For doing this the following factors may be examined: relative costs, relative
dependability’s, and relative qualities.
In addition to power, transport, and water, the project should have adequate communication
facilities like telephone and internet.
C) Labor Situation
In labor-intensive projects, the labor situation in a particular location becomes important.
The key factors to be considered in evaluating the labor situation are:

Availability of labor, skilled, semi-skilled and unskilled

Prevailing labor rates

Labor productivity

State of industrial relations judged in terms of the frequency and severity of strikes and
lockouts

Degree of unionization
50
D) Governmental Policies
Government policies have a bearing on location. In the case of public sector projects, location is
directly decided by the government. It may be based on a wider policy for regional dispersion of
industries.
In the case of private sector projects, location is influenced by certain governmental restrictions
and inducements. The government may prohibit the setting up of industrial projects in certain
areas which suffer from urban congestion. More positively, the government offers inducements
for establishing industries in backward areas. These inducements consist of subsidies,
concessional finance, sales tax loans, power subsidy, income tax benefits, lower promoter
contribution, and so on.
E) Other Factors
Several other factors have to be assessed as well before arriving at a location decision. These are:

Climatic conditions

General living conditions

Proximity to ancillary units

Ease in coping with pollution
Climatic Conditions: The climatic conditions like temperature, humidity, wind, sunshine,
rainfall, snowfall, dust, flooding, and earthquakes have an important influence on location
decision. They have a bearing on the cost as they determine the extent of air-conditioning, dehumidification, refrigeration, special drainage, and so on required for the project.
General Living Conditions: The general living conditions like the cost of living, housing
situation, safety, and facilities for education, health care, transportation and recreation need to be
assessed carefully.
51
Proximity to Ancillary Units: Most firms depend on ancillary units for components and parts.If
the ancillary units are located nearby coordination becomes easy, transportation costs are lower,
and inventory requirements become considerably less.
Ease in Coping with Environmental Pollution: A project may cause environmental pollution in
various ways: it may throw gaseous emissions; it may produce liquid and solid discharges; it
may cause noise, heat, and vibrations. The location study should analyze the cost of mitigating
environmental pollution to tolerable levels at alternative locations.
3.7.2 Site Selection:
Once the broad location is chosen, attention needs to be focused on the selection of a specific
site. Two to three alternative sites must be considered and evaluated with respect to cost of land
and cost of site preparation and development.
The cost of land tends to differ from one site to another in the same broad location. Sites close to
a city cost more whereas sites away from the city cost less. Sites in an industrial area developed
by a governmental agency may be available at a concessional rate.
The cost of site preparation and development depends on the physical features of the site, the
need to demolish and relocate existing structures, and the work involved in obtaining utility
connections to the site. The last element, viz., the work involved in obtaining utility connections
and the cost associated with it should be carefully looked into. It may be noted in this context
that the cost of the following may vary significantly from site to site: Power transmission lines
from the main grid, railway siding from the nearest railroad, feeder road connecting with the
main road, transport of water, and disposal of effluents.
3.8 MACHINERY AND EQUIPMENT:
The requirement of machineries and equipment is dependent on production technology and plant
capacity. It is also influenced by the type of project. For a process-oriented industry, like a
petrochemical unit, machineries and equipments required should be such that the various stages
are matched well. The choice of machineries and equipments for a manufacturing industry is
52
somewhat wider as various machines can perform the same function with varying degrees of
accuracy. For example, the configuration of machines required for the manufacture of
refrigerators could take various forms.
To determine the kinds of machinery and equipment required for a manufacturing industry, the
following procedure may be followed:
(i) Estimate the likely levels of production over time.
(ii) Define the various machining and other operations.
(iii) Calculate the machine hours required for each type of operation.
(iv) Select machineries and equipment required for each function.
The equipment required for the project may be classified into the following types:
(i) plant (process) equipment,
(ii) mechanical equipment,
(iii)electrical equipment,
(iv) instruments,
(v) controls,
(vi) internal transportation system, and
(vii)
others'
In addition to the machineries and equipment, a list should be prepared for spare parts and tools
required. This may be divided into:
(i)
spare parts and tools to be purchased with the original equipment, and
(ii)
spare parts and tools required for operational wear and tear.
3.8.1 Constraints in Selecting Machineries and Equipment:
In selecting the machineries and equipment certain constraints should be borne in mind:

there may be a limited availability of power to set up an electricity-intensive plant
like, for example, a large electric furnace;
53

there may be difficulty in transporting heavy equipment to a remote location;

workers may not be able to operate, at least in the initial periods, certain sophisticated
equipments such as numerically controlled machines;

The import policy of the government may preclude the import of certain machineries
and equipment.
3.8.2 Procurement of Plant and Machinery
For procuring the plant and machinery, orders for different items of the plant and machinery may
be placed with different suppliers or a turnkey contract may be given for the entire plant and
machinery to a single supplier. The factors to be considered in selecting the supplier (s) of the
plant and machinery are the desired quality of machinery, the level of technological
sophistication, the relative reputation of the various suppliers, the expected delivery schedules,
the preferred payment terms, and the required performance guarantees
If in house technical expertise is inadequate, external consultant (s) may be employed to select
the plant and machinery and supervise the installation of the same. The guarantees provided by
machinery suppliers are of three types: mechanical guarantees, input guarantees, and output
guarantees'
In the case of an existing undertaking, it is necessary to show details of the plant and equipment
already installed for the project in the study. In respect of plant and machinery to be acquired for
the project, it is necessary to ascertain the details of the equipment to be obtained from
indigenous sources and the machinery that is proposed to be imported.
The points looked into are:

Type of machinery and equipment to be installed, and technology proposed (includes
machinery and equipment specification).

Auxiliary capital equipment (spare parts, stand by, transport or vehicles, material
handling)
54
 Suitability and adequacy of plant and machinery for the manufacturing process
proposed to be adopted.
 basis of selection,
 reasonableness of cost;
 reputation
 ability of the machinery suppliers to effect deliveries in time,
 arrangements/agreements with machinery suppliers with special reference to guarantee
for workmanship
 Performance and provision for supply of spare parts.

Production process.

Proven reliability of plant processes and equipment (assurance that factory will
produce the quantity and quality of products specified on a continuity and dependable
basis).


Theoretical and planned capacity (shifts implied) must be specified and quantified.

Estimated output as percentage of plant capacity for first few years.

Justification for capacity fixing.
Plan for execution (installation schedule, availability of skilled/unskilled labour for
erection training scheme, if any must be described.

Proposed use of consultants in the design, execution and operation of the project.
Special care should be taken in projects involving the acquisition of reconditioned machinery.
The justification for reconditioned machinery, viz, lower initial capital outlay and suitability of
the technology to the stage of development in the country should be carefully weighed against
the possibility of the cost of machinery being highly inflated and the operational efficiency of the
plant. Generally, the acquisition of reconditioned machinery should be discouraged.
3.9 STRUCTURES AND CIVIL WORKS
Structures and civil works may be divided into three categories:
(i) site preparation and development,
(ii) buildings and structures, and
55
(iii) outdoor works.
3.9.1 Site Preparation nd Development
This covers the following:
(i) grading and leveling of the site;
(ii) demolition and removal of existing structures;
(iii) relocation of existing pipelines, cables, roads, power lines, etc.;
(iv) reclamation of swamps and draining and removal of standing water;
(v) connections for the following utilities from the site to the public network: electric power
(high tension and low tension), water for drinking and other purposes,
communications (telephone, telex, internet, etc.), roads, railway sidings; and (vi)
other site preparation and development work.
3.9.2 Buildings and Structures
Buildings and structures may be divided into:
(i) factory or process buildings;
(ii) ancillary buildings required for stores, warehouses, laboratories, utility supply centre,
maintenance services, and others;
(iii) administrative buildings;
(iv) staff welfare buildings, cafeteria, and medical service buildings; and
(v) Residential buildings.
3.9.3 Outdoor Works
Outdoor works cover
(i) supply and distribution of utilities (water, electric power, communication, steam, and
gas);
(ii) handling and treatment of emission, wastages, and effluents;
(iii)transportation and traffic signals;
(iv) outdoor lighting;
56
(v) landscaping; and
(vi) Enclosure and supervision (boundary wall, fencing, barriers, gates, doors, security posts,
etc.)
3.10 Land:
Land requirement can be assessed from the plant layout and buildings to be constructed. Land
should be sufficient not only for the proposed project but also for future expansion. If the
proposed plant and machinery were very heavy, the load bearing capacity of the land would have
to be ascertained. A copy of agreement for purchase of land is obtained. In other words give
emphasis to:
Project Building & Civil Works

Total site area --------m2

Built-up area --------m2
Plant layout (including storage for raw materials, finished products, administration
buildings, workshops, and provision for possible expansion)

Get approved plan, bill of quantity and title deed

Get the bill of quantities submitted appraised/reviewed by the Bank’s engineers

Remarks on appropriateness of plant-layout
3.11 PROJECT CHARTS AND LAYOUTS
Once data is available on the principal dimensions of the project-market size, plant capacity,
production technology, machineries and equipment, buildings and civil works, conditions
obtaining at the plant site, and supply of inputs to the project-project charts and layouts may be
prepared. These define the scope of the project and provide the basis for detailed project
engineering and estimation of the investment and production costs.
The important charts and layout drawings are briefly described as follows:
3.11.1 General Functional Layout.
57
This shows the general relationship between equipment, buildings, and civil works. In preparing
this layout, the primary consideration is to facilitate smooth and economical movement of raw
materials, work-in-process, and finished goods. This means that:
(a) The layout should seek to allow traffic flow in one direction to the extent possible, with a
minimum of crossing.
(b) Go downs, workshops, and other services must be functionally situated with respect to
the main factory building.
1. Material Flow Diagram. This shows the flow of materials, utilities, intermediate products,
final products, by-products, and emissions. Along with the material flow diagram, a quantity
flow diagram showing the quantities of flow may be prepared.
2. Production Line Diagrams. These show how the production would progress along with the
key information for the main equipment.
3. Transport Layout. This shows the distances and means of transport outside the production
line.
4. Utility Consumption Layout. This shows the principal consumption points of utilities (power,
water, gas, compressed air, etc.) and their required quantities and qualities. These layouts
provide the basis for developing specifications for utility supply installations.
5. Communication Layout. This shows how the various parts of the project will be connected
with telephone, internet, intercom, etc.
6. Organizational Layout. This shows the organizational set-up of the project along with
information on personnel required for various departments and their inter-relationship.
7. Plant Layout. The plant layout is concerned with the physical layout of the factory. In certain
industries, particularly process industries, the plant layout is dictated by the production
58
process adopted. In manufacturing industries, however, there is much greater flexibility in
defining the plant layout. The important considerations in preparing the plant layout are:

Consistency with production technology

Smooth flow of goods from one stage to another

Proper utilization of space

Scope of expansion

Minimization of production cost

Safety of personnel
3.12 SCHEDULE OF PROJECT IMPLEMENTATION
As part of the technical analysis, a project implementation schedule is also usually prepared. For
preparing the project implementation schedule the following information is required:

List of all possible activities from project planning to commencement of production.

The sequence in which various activities have to be performed.

The time required for performing the various activities.

The resources normally required for performing the various activities.

The implications of putting more resources or less resources than are normally required.
For small projects with few activities, a bar chart showing when a particular activity would begin
and when it would end is a fairly simple tool for drawing up the implementation schedule. For
most real life projects which have numerous activities and are fairly large, PERT/CPM analysis
is required. PERT is an acronym for Program Evaluation Review Technique and CPM is an
acronym for Critical Path Method. These are network planning techniques that can handle
innumerable activities, complex interdependency relationships, resource constraints, probabilistic
estimates, and cost-time trade-offs. Lending institutions often insist on the use of network
techniques by the project sponsors.
3.12.1 Work Schedule
59
The work schedule, as its name suggests, reflects the plan of work concerning installation as well
as initial operations. The purpose of the work schedule is:

To anticipate problems likely to arise during the installation phase and suggest possible
means for coping with them.

To establish the phasing of investments taking into account the availability of finances.

To develop a plan of operations covering the initial period (the running-in period).
Often, it is found that the required inputs like raw material and power are not available in
adequate quantity when the plant is ready for commissioning, or the plant is not ready when the
raw material arrives.
In the first case the plant remains idle and in the second the material may tend to deteriorate
and/or pose problems of storage. To avoid losses arising from idle capacity and deterioration of
stocks of material, the work schedule should be drawn up with care and realism so that
commissioning of the plant is reasonably synchronized with the availability of the basic inputs.
This is a very important aspect in appraising a Project. Once a project is found out to be
profitable, viable in all aspects, and therefore bankable, it means it is ready for implementation.
Project implementation is not an easy task. Before lying down, the implementation plan of a
Project, all the major activities and components must be carefully identified, clearly defined and
quantified, allied activities must be grouped and re-grouped. The duration, which each activity
will take for completion, must be estimated and quantified. Finally, the resources required for
implementing the project must be identified, estimated and quantified (physical, financial, human
etc.).
For complete Projects, the technique of “Critical path analysis” and “Net work analysis” are
imperative in planning project implementations.
For simple these techniques may not be
required. Depending on the type and complexity of the project, the implementation period may
take from one to five years. (E.g. coffee plantation, irrigation projects, Hydro power station,
60
Cement factory, etc.). Under longer circumstances a project is said to be implemented phase by
phase (phasing of a project) or a “development phase”, when the development phase of a project
is completed, the operational or production phase will commence.
If the physical implementation plan of a project is carefully designed, loan fund disbursements as
well as the time for loan collection could be easily geared to each activity. The principal loan
repayments should be scheduled only after the production and marketing phases (i.e. Grace
period, gestation period, marketing period etc. must be considered]. A schedule of
implementation to be drawn up may be as shown in the following table.
SCHEDULE OF IMPLEMENTATION
Sr.
No.
Description
1
Acquisition of land
2
Development of land
3
Civil works
Commencement
Completion
(Month & Date)
(Month & Date)
 Factory building
 Machinery foundation
 Auxiliary building
4

Administrative building

Miscellaneous .buildings
Plant and machinery
Imported
- placement of order
- Delivery at site
Indigenous - placement of order
- Delivery at site
5
Arrangements for power
6
Arrangements for water
7
Erection of machinery and equipment
8
Commissioning
9
Procurement of raw material & chemicals
10
Training of personnel
11
Trial runs
61
12
Commercial production
62
SUMMARY
1.
Location:
 Visit the project site to get general impression
 Specify the project location
 Region, Zone, Woreda, locality, boundaries, & telephone
 Look into the following:
Proximity to market
Proximity to raw materials
Availability of labor
Availability of transport & communication
Proximity to effluent disposal
Proximity to CBE
Availability of other infrastructure
2.
Land:
 Purchase contract & ownership certificate
 Lease contract & lease certificate
 Assess soils character – carrying capacity
 Mention the total land holding and its purposes (uses)
 Accommodation of expansion
 Collect copies of purchase or lease contract and certificate
3.
Building:
 Collect copies of construction plan & bill of quantities
 Examine the participation of construction professional/s
 Collect copy of the applicant contract with the contractor/s
 Assess the total layout:
total built-up area
check whether all the necessary constructions such as production/service
houses, stores, offices & workshops are properly identified and included
 Check whether the building is fit for the intended purpose
63
 Check the inclusion of lifts, water and electric installations
 Assess the flexibility of the building
 Estimate the percentage of work executed
 Check the existence of construction guarantee
 Assess the capacity of the building to satisfy the collateral need of the Bank:
-Value stability
-Marketability
-Transferability
-Loan to building ratio
4.
Technology & Manufacturing Process:

Assess the method of acquiring the technology: (International bid or
purposive)

Obtain sales contract or Performa invoice

Collect catalogue, manual or specifications of technology

Exploit internet information (e-mail or websites)

Assess different guarantees:
 -bid bond
 Performance bond
 Warranty

Degree of the machinery & equipment to satisfy the collateral need of the Bank:Value stability

-Marketability

-Transferability


-Loan to building ratio
Examine size of the plant in terms of demand, capacity utilization and flexibility
(economy of scale)

See the details of machinery and equipment:
-Type, made & reputation
-Suitability & adequacy for the intended quality product
-Reasonableness of costs
64
-Ability of suppliers to effect deliveries timely
-Guarantee for workmanship
-Spare parts availability
-Production process
-Theoretical and planned capacity utilization
-Plan for execution (design, installation, training,
commissioning & operation)
-Take care, reconditioned or secondhand machinery

Suitability advantage

Price advantage, but

Generally should be discouraged
5. Raw materials:
 Identify the sources
 Availability of component required & sustainability
 Price
 Establish stock size
 Handling & storing
6. Utilities
 Power:
-Availability of electric power including for possible expansion
-Stand by generator
 Water:
-All projects require water
-Report on adequacy, source and quality of water
-Consider reservoir
-Examine the need of boring tube-wall and water pump
 Fuel, oil & lubricant :
-Identify the need & availability of fuel, oil & lubricant
-Price
7. Labor:
 Availability of skilled, semi-skilled & unskilled labor
65
 Enquiry the arrangement of training
 Describe the benefits & remuneration that labor deserve
8. Furniture, fixture, office equipment and vehicles:
 Identify or verify the required office equipment & vehicles
 Collect Performa invoices at least from two suppliers
 Examine the suppliers and prices
9. Implementation schedule:
 Identify major activities and components
 Group allied activities
 Estimate the time requirement of each group activities
 Establish the sequence of work to be accomplished with bounded time frame
 Prepare loan disbursement & loan collection schedule
66
Chapter Four:
Socio-Economic and Environmental Study
4.1 ECONOMIC ASPECTS
Investment projects should also be justified within the wider context of the national economic
and social environment. Net benefits generated from the national and socio-economic point of
view should be determined.
Economic analysis is important to an investor due to the following:
1. Financial feasibility can be affected by the economic environment and its
future
development
2. Economic benefits generated by a project may be used as an argument in favor of reformed
public policy measures.
In the absence of “perfect” markets, the market mechanism cannot ensure the optional allocation
of resources from the national point of view.
Economic evaluation may be characterized as follows:

The national development impact of a project is assessed and evaluated.

Project inputs and outputs are valued at shadow prices that reflect their true value to the
national economy.

Direct effects on the economy (including imports, exports, employment, foreign exchange,
supply and demand, ecological conditions etc.), as well as indirect effects (including reduced
under utilization of capacities) are included in the analysis where significant time preferences
are accounted for.
4.2 Environmental Impact & Effluent disposal:
67
Projects may have direct/indirect as well as positive/negative impact on the environment. Such
impacts should be identified and discussed including the corrective measures that should be
taken to minimize the negative impacts in particular.
Negative environmental impacts have far-reaching cost implications. Improper application of
irrigation water, for instance, will cause soil salinity. To reclaim the soil back to its fertility (i.e.
remove salinity), millions of Birr have to be spent. Forest clearing for crop production might
result in soil degradation (erosion) or even desertification and the social cost that result is not
measurable even in monetary terms.
In many industrial projects it is necessary to examine that arrangement for effluent disposal
should be in conformity with the state regulations.
It may be verified whether adequate
arrangements have been made in this regard and permission of local authorities obtained for
disposal thereof.
The impact of a project and its alternatives (in terms of size, technology etc.) on the surrounding
area, including its population has to be assessed.
The environmental impact assessment should incorporate assessment of environmental conflicts
that might lead to compensation claims, substantial costs for purification and equipment. The
potential conflicts with existing and future neighboring industries, population in the vicinity of
the project need to be studied in so far as they may affect the investment decision.
A project may cause environmental pollution in various ways: it may throw gaseous emissions; it
may produce liquid and solid discharges; it may cause noise, heat, and vibrations. Projects that
produce physical goods like cement, steel, paper, and chemicals by converting natural resource
endowments into saleable products are likely to cause more environmental damage. Hence the
environmental aspects of these projects have to be properly examined.
The key issues that need to be considered in this respect are:

What are the types of effluents and emissions generated?

What needs to be done for proper disposal of effluents and treatment of emissions?
68

Will the project be able to secure all environmental clearances and comply with all
statutory requirements?
69
Chapter Five
Organizational, Managerial and Human Resource aspects
A financially viable and technically feasible project needs competent entrepreneurs to make it
successful commercial or industrial activity. Over and above all other positive features of any
project, strong and committed promoters and project managers provide a comfort to project
lenders which can even justify certain possibly weak aspect of the project. Arguably, there does
not exist any project which is perfect and risk free, viewed from the perspectives of the lenders.
Strong and committed project management are necessary particularly to meet any eventuality of
distress or adverse circumstances when lenders and promoters
sit together to forge a way
forward out of the problematic situation.
For smooth implementation and operation of the industrial project, availability of experienced
and qualified human power is very important. Thus, at the time of project appraisal, availability
of sufficient human power should be duly scrutinized. On the basis of the qualitative and
quantitative human resource requirement of the project, the availability of the required human
power, the cost estimates for the wages, salaries, and other personnel related expenses and
training are prepared for financial analysis of the project. The cost of unskilled labor must be
shown separately for economic evaluation.
The operational functions and activities of an enterprise are structured and assigned to
organizational units, represented by managerial staff, supervisors and workforce, with the
objective of co-ordinating and controlling the performance of the enterprise and the achievement
of its business targets. The organizational structure of an enterprise indicates the delegation of
responsibilities to the various functional units of the company. The organizational structure may
be designed based on different functions or products or production lines, or on geographical
areas or markets.
The organization is designed in such as way that it attends the following issues:

General management

Accounting and financial control

Marketing organization
70

Organization of supplies

Organization of storage

Organization of production

Organization of quality assurance

Organization of maintenance

Organization of personnel
Human resource planning is also an important aspect of this chapter.
It focuses on the
determination of categories of functions, socio-economic and cultural requirements and also
planning in terms of assessing the availability of human resources and recruitment planning.
Moreover training requirements need also be planned.
In general, due attention should be given concerning the availability of management and non
management staffs. The following factors should be given due consideration when the
availability and employment of human resources are analyzed. The general availability of
relevant human resource categories in the project region and country, the supply and demand
situation in the project region (human resource), recruitment policy and methods, training policy
and program shall be assessed.
5.1.
Training Requirement:
Lack of experienced and skilled personnel can constitute a significant bottleneck for project
implementation and operation in developing countries. The extensive training program should be
designed and carried out as part of implementation of investment projects.
Therefore, training plan may be organized during the pre-production stage at the plant site, at the
plant of joint venture partners or suppliers of technologies and equipment, in similar factories in
the country or abroad or at the special training institute. Training can be provided at the factory
be managerial and technical personnel, by specially recruited experts or by expatriate personnel.
The timing of training program is of critical importance, since persons should be sufficiently
trained to be able to take-up their position as and when required. Thus, personnel at various
levels should have undergo any training necessary before production starts, during the preproduction and construction stage.
71
Chapter Six
Financial Analysis
6.1 Financial Analysis and Appraisal
Financial appraisal refers to the process of evaluation of viability of the proposed project by
assessing the value of the net benefits and net cash flow. The financial appraisal aims at
analyzing the volume of cash flows-outflows and inflows and its time value. More specifically,
financial appraisal involves evaluating the cash flow models developed by the project sponsors
from lenders perspective and taking a view on the integrity of the said model.
The purpose of financial analysis of the financing company is to assess the financial viability of
the project proposed to be financed. In this regard, the unit of analysis is the project not the entire
economy. The financial analysis includes determining the key variables such as determining the
revenue of the project, project costs, calculate annual project net benefits; determining the
appropriate discount rate, calculate the financial net present value, calculate the cash flow from
the project, calculate the financial rate of return and conduct risk and sensitivity analysis.
Financial 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 expectation of those who provide the capital.
In this regard, any project proposal should be accompanied by project feasibility study. A
feasibility study is a tool that helps the project promoter to take a decision on the investment
proposal. To facilitate this decision, both investment and production costs have to be arranged
clearly, keeping in mind that the profitability of a project will ultimately depend on the size and
structure of investment and production costs and their timing. Therefore, the project feasibility
study shall clearly point out among other things existence of demand for the product, the
technical feasibility as well as the financial viability of the proposed project.
Viability for a project refers to the assessment of whether the project has the capacity to meet the
defined objectives, and in addition to generate significant financial and economic returns to the
stockholders and to the economy in general.
Financial and economic viability is not the
overriding criteria for approval of all projects. There may be projects which appear to have very
high potential for economic gains but which are very risky in terms of the technical, social and
72
institutional factors; or have negative impacts on the environment. There may be other projects
where social and environmental factors are very strong but all the economic gains cannot be
easily estimated or valued.
Project viability depends on a number of factors in addition to economic and financial ones, and
decision to go ahead with a project or not will depend on multiple criteria. But when investment
funds and resources are limited, project sponsors tend to try to ensure that funds are used to
enhance economic development by generating additional resources for the economy. More
significantly, the appraisal of project viability must seek to identify cases where investments of
scarce resources are likely to lead to actual net losses, and avoid or change there projects. In
designing a project, planners must have established the social, institutional, environmental and
technical base for viability. These must also be the bases for financial and economics viability.
The selection or rejection of a proposed project should be made on a number of different criteria,
of which economic and financial viability will be necessary but not always a sufficient
conditions.
6.1.1 Purpose of Financial Analysis in Project Planning:
The purpose of financial analysis in project is to answer the following questions.
Adequate financial resource to planning horizon:
Does the financial plan demonstrate that there are adequate financial resources from internal and
external sources to cover all project phases i.e. planning, implementation and operation?
Adequate return to the investor:
Does the project study demonstrate with sufficient degree of confidence that returns to investors
will be adequate to meet their criteria?
Financial structure acceptability:
Does the financial structure satisfy the criteria of investors, lenders and guarantors? Are the
provisions of equity and debt financing structure satisfactory in terms of liquidity and financial
risks such as inflation and potential fluctuation in interest rates and exchange rates?
Financial risks and risk sharing acceptability:
Are the elements of risk and probabilities of undesirable outcomes acceptable to participants?
Are all risks considered and within acceptable limits?
73
Financial analysis is simply means to the analytical work required to identify the critical
variables which are useful for likely to determine the success or failure of an investment. We
can define investment as a long term commitment of scarce resources made with the objective of
producing and obtaining future benefits. The investor transfers the liquid financial resources (his
own or borrowed money) into production assets.
The commitment by the investor needs the transformation of liquid financial resources (own or
borrowed) into productive assets for financing an investment project. Project financing includes
the design for proper financial structure, considering adequacy of the financial plan, and the
optimization of project financing from the different factors or beneficiaries point of view. It is
therefore, the scope and objective of financial analysis are to determine, analyze and interpret all
the financial consequences of an investment that might be relevant to and significant for the
investment and financing decisions.
Financial analysis should accompany various alternatives and the design of the project strategies
that basically determine the marketing strategies, project scope, resources, location, production
capacities and technology, thus providing a yardstick for the evaluation of the financial and
economic success or failure of a project. It would also indicate and highlight any other critical
impact which affect the project would have to be considered during the appraising of a project.
Financial analysis is, therefore, essentially undertaken for the following purposes:
Provide an adequate financing plan for the proposed investment;

To determine the profitability of a project from the point of view of the financial agency
(Bankers), the owners or the project beneficiaries;

To assist in planning the operation and control of the project by providing management
information to both internal and external users;

To illustrate the financial structure of a project entity, and its existing and potential
financial viability including the financial efficiency and effectiveness of its operations;

To advice on method of improving the financial viability of a project entity including the
appropriateness of tariffs, prices and cost recovery generally.
Hence, the purpose of financial analysis is therefore not just to document the expected impact of
the project liquidity, credit worthiness, financially efficiency, earnings, etc., of the various agents
74
involved; it should also be part of the process of project design itself. As much as possible, the
results of financial analysis should feedback to the selection of design options by demonstrating
the incentives (or disincentives) which will exist to encourage agents to participate in the project.
In general, the project financial analysis has four main parts:

Estimation of total project costs - the aim here is to insure that the projects financial
requirements are accurately estimated; estimates of total costs broken down into local
and foreign currency costs for land, construction, equipment, installation, working
capital and pre-operating expenses are to be provided.

Proposed financial plan - the purpose is to insure that all investment expenses of the
project are covered through an adequate financing plan that indicates expected sources
and terms (e.g. debt and equity financing)

Operating costs –direct and indirect costs should be properly forecasted

Expected profitability and returns - here there are two purposes i.e. it insure that
adequate funds are available during the operation phase to pay for needed inputs and
to repay debt, and to insure sufficient profit (under reasonable assumptions about the
future) to pay share holders.
A careful examination of the above aspects is essential to assess the financial soundness of a
project. Lets us look at each of these one by one.
6.2 Estimation of the cost of a project/fixed investment:
6.2.1 Capital costs:
Capital costs should be identified carefully. These include all advance expenditures on research,
legal work, land acquisition, building & site work; machinery and equipment; motor vehicles,
spare parts; duties and taxes; consulting services; intangibles like patent and copyrights;
preliminary staff training and interest during construction. For agricultural project the capital
costs include additional items such as farm tools, tractors and various types of machineries. In
general, it various from project to project.
Outlays in foreign exchange should be shown after converting them into local currency at the
official exchange rate.
A) Land
75
The cost of land including and other local authority charges is generally based on actual price
paid by the project and/or ruling in the particular area. In cases where land is acquired in other
ways, a detailed investigation is carried out to see that the transaction is appropriate.
B) Building and site development
The project is required to furnish details of civil construction for factory and administrative
buildings, indicating, inter alias, type of construction area and rate per square meter of
construction. Due provision should be made for go downs, railways siding etc. These estimates
are checked by the financial institutions on the basis of their experience of other cases. The
agreement, if any, entered with the building contractors should be scrutinized. Site development
expenses include provision of leveling land, laying road etc. In this regard, any engineer remarks
against the project building should be scrutinized.
C) Plant and machinery:
It is to be verified whether the project has obtained competitive quotations for the plant. The
estimates are scrutinized to ensure those intangible expenses such as erection charges, expenses
on foreign technicians, import duty insurance and freight charges for transport of equipment to
the plant site have been included. The cost of indigenous and imported machinery has to be
verified as far as possible from actual quotations.
Contracts entered with the machinery
suppliers should be examined. In general, the source documents presented in connection with
plant and machinery acquisition and the specification for same should be thoroughly checked.
The plant and machineries to be financed at our end shall only be brand new.
D) Technical Know-how and engineering fees:Provision made for technical Know-how and engineering fees, expenses on foreign technicians
and training of local technicians abroad, payment of consultancy fees etc. should be examined to
see whether the same are reasonable or not. Agreement entered into with suppliers of know how and consultants should be scrutinized in this regard. Source document that genuinely testify
the payment or agreement for payment of such costs shall be submitted.
E) Miscellaneous fixed assets:
These include furniture office equipment, tools, vehicles, equipment for distribution of power,
steam, water, laboratory equipment, fire fighting equipment, plant for effluent disposal etc. It is
to be seen whether adequate provision has been made for the same. The source documents for
76
the purchase of the said fixed assets and the relevant importance of acquiring such assets shall be
verified.
It is also to be noted that all such assets to be acquired are brand new. If the stated assets are to
be acquired from abroad related costs such as port clearance, transportation and others shall be
incorporated as part of the fixed assets to be acquired.
F) Preliminary and pre- operating expenses:A) Preliminary and Capital issue Expenses:
Expenses incurred for identifying the project, conducting the market survey, preparing the
feasibility report, drafting the memorandum and articles of association and incorporating the
company are referred to as preliminary expenses. Expenses borne in connection with the raising
of capital from the public are referred to as capital issue expenses. The major components of
capital issue expenses are: underwriting commission, brokerage, fees to managers and registrars,
pitting and postage expenses, advertising and publicity expenses, listing-fees, and stamp duty.
B) Pre-operative Expenses:
Expenses of the following types incurred till the commencement of commercial production are
referred to as pre-operative expenses: (i) establishment expenses, (ii) rent,- rates, and taxes, (iii)
travelling expenses, (iv) interest and commitment charges on borrowings, (v) insurance charges,
(vi) mortgage expenses, (vii) interest on deferred payments, (viiif startup expenses, and (ix)
miscellaneous expenses. Pre-operative expenses are directly related to the project
implementation schedule. So, delays in project implementation, which are fairly common, tend
to push up these expenses. Appreciative of this, financial institutions allow for some delay (20 to
25 percent) in the project implementation schedule and accordingly permit a cushion in the
estimate for pre-operative expenses.
Pre-operative expenses incurred up to the point of time the plant and machinery are set-up may
be capitalized by apportioning them to fixed assets on some acceptable basis. Preoperative
expenses incurred from the point of time the plant and machinery are set up are treated as
revenue expenditure. The firm may, however, treat them as deferred terrettn" expenditure and
write them off over a period of time.
It has to be ascertained whether the project has made adequate provision for expenses for rising
of share capital and term loans, including charges for creation of legal mortgage for loans. The
pre-operating expenses are determined on the basis of schedule of construction; besides the day 77
to -day expenses, adequate provision is made for interest on the loans payable and deferred
payment installment falling due during the period of construction.
G) Working capital:
Working capital requirements of the project should be carefully worked out as any paucity of
working capital fund in the initial stages when the unit will have no internal accruals might
throttle the project. It is usual to provide for 2-3 months’ stock of indigenous materials and up to
6 months stock of imported materials. Wages, salaries, cost of power, steam, fuel, packing and
sales expenses are taken at one month. The provision for good in process is generally taken at
around 15 days but this would obviously vary depending on the nature of the industry. Provision
is also made for receivable at the rate of about 2 months’ sales. It is usual to deduct from the
working capital so arrived at the amount of purchase available is added to the project cost of
margin required for working capital. The working capital requirements of the project cost as
margin required for working capital. The working capital requirements of the project are worked
out on the basis of its requirement during the first year. It is presumed that increase in working
capital requirement is subsequent years would be met out of internal accruals.
The capital cost of a project may be as shown under:
‘000
Description
Local Costs (Birr)
Foreign Costs (Birr)
Total Costs (Birr)
Land
Building & Site Dev’t
Plant & Machinery:

Imported

Indigenous

Know how

Training
Miscellaneous Fixed Assets
Preliminary & pre-operating
Base Costs
Provision for contingency (10%)
Working Capital
Total Investment Costs
6.3 Financing Plan:
After identifying the projects investment costs the next step is to show how it is to be finance.
The usual sources of finance for a project are as follows:
78

Equity Capital

Term loans

Deferred payment

Unsecured loans from promoters

Internal accruals

Government
Project financing is the long term financing of investments based upon the cash flow of the
project rather than the balance sheets of its sponsors. Usually, a project financing structure
involves a number of equity investors, known as ‘sponsors’ as well as a bank or ‘syndicate’ of
banks or other lending institutions that provide loans to the operation. They are most commonly
non-recourse loans, which are secured by the project assets and paid entirely from project cash
flow, rather than from the general assets or creditworthiness of the project sponsors, the
financing is typically secured by all of the project assets, including the revenue producing
contract. Project lenders are given a lien on all of these assets and are able to assume control of a
project if the project company has faced difficulties complying with the loan terms.
Accordingly, capital contribution commitments by the owners of the project are necessary to
ensure that the project is financially sound or to assure the lenders of the owners’ commitment.
In this regard, Risk identification and allocation is a key component of project finance. A project
may be subject to a number of technical, environmental, economic and political risks,
particularly in developing countries and emerging markets. Hence, the risk of financing of such
projects must be distributed among multiple parties while simultaneously ensuring profits or
returns to each party involved.
A careful balance has to be struck between debt and equity. A ratio of 1:1 is considered ideal but
it is usually relaxed to 2:1 in most cases. Further relaxation considered ideal but it is usually
relaxed to 2:1 in most cases. Further relaxation in debt-equity is made in the case of high cost
projects.
All long-term loans and deferred credit are treated as debt while equity includes reserves and in
the case of existing companies with losses, it is arrived at after deducting carry forward losses.
Another important aspect is to ensure reasonable promoter’s contribution in the project. The
current norm is 40% of project cost with somewhat lower promoter contribution in case of
projects promoted by technician entrepreneur. Suitable undertakings are obtained from the main
79
promoters for non-disposal of their share holdings. Normally the promoter’s contribution should
be brought in by way of equity capital. However, a portion of it may be raised by means of
unsecured loan deposits from relatives and friends in case of need.
If unsecured loans from promoters/directors form an integral part of the means of finance, it is
desirable to stipulate a condition that the same shall not be withdrawn during the currency of the
loan and shall not carry interest higher than that payable on institutional loans.
It is important that no gap is left in financing pattern. Otherwise it will result in delay in
implementation of the project. It is also important that funds should be available to the project
during the implementation as and when needed. Thus, the capacity of the promoters in this
regard shall be evaluated so as to avoid delay in implementation of the project.
A condition is stipulated that the promoters shall arrange for funds to meet any over-run in the
cost of the project.
Security and Margin:
The approach of financial institutions should not be security-oriented. The emphasis should be
on the viability of the project rather than the security cover available for the financial assistance.
However, financial agencies generally stipulate, by way of security, a first legal charge on the
fixed assets of the company ranking pair pass with the charge, if any, in favor of other term
financing institutions.
While the margin available in each case is worked out, no special
significance is attached to the margin concept. Personal guarantees of promoters/directors as
security for loan/deferred payments should not be stipulated except in case of closely held
companies or partnership or proprietorship.
Contingency consideration:
Contingency provisions provide for the possibility that the base cost estimate may not have
accurately estimated the quantity or quality of goods and services needed or that the prices of
those goods and services may change subsequent to the date of the cost estimate. Physical
contingencies allow for physical events such as adverse weather during construction, providing a
safety factor to cover unforeseen or forgotten minor costs etc. Price contingence allow for
general inflation.
Contingencies address the possibility that unanticipated costs may need to be incurred or that
quantities required and/or prices may change between the specific date of the base cost estimate
and the actual expenditures for those items when implementing the project. Contingency
80
allowances should reflect the costs of probable physical and price changes arising from special
risks that can reasonably be expected to increase the base cost estimate. However, contingencies
cannot provide assurance against the effects of all possible adverse events or conditions. Usually
In a project appraisal, a certain percentage of total project cost should be assumed as
contingency.
Contingencies are an integral part of the expected total cost of a project as well as the financing
plan and are normally necessary for all project items involving significant expenditures. Separate
estimates should be made of physical contingencies and of price contingencies. Contingency
allowances should be identified in the project cost tables and shown as individual line items in
the project cost table separately from base cost estimates. For projects with several major
components, it is generally desirable to present contingency estimates separately for each
component as well as for the project as a whole. The text accompanying the cost tables should
discuss the physical factors, price changes and risk factors expected to affect the project costs
from the date of the base cost estimates to the completion of the project.
Physical contingencies:
Allowances for physical contingencies reflect expected increases in the base cost estimates of a
project due to changes in quantities, methods and/or the period of implementation. Physical
contingencies should be calculated on both foreign and local cost items, and expressed as
percentages of the foreign and local base costs in the Project Cost Table.
The principal factors from which uncertainties arise in civil works and for which provisions for
physical contingencies should be made are (i) the type of terrain where the project is to be
constructed, particularly, (a) geologically difficult areas where slips and slides that are difficult
to predict are frequent, (b) areas of thick marine clay deposits where the flooding potential is
high and (c) areas subject to frequent earthquakes, (ii) the climatic conditions in the project area
e.g. the likelihood of unusual rain that may cause flooding or strong windy conditions, (iii)
difficult access to the site of the work because of long and poorly maintained roads or railroads
which may be subject to destruction due to flooding, landslides, etc., (iv) the amount of field
work which has been completed, particularly the degree of thoroughness of borings and subsurface exploration as well as the location and testing of construction material sources (gravel,
81
rock quarries, etc.). Some projects covering a large area or involving very long and deep
excavations, such as tunnels, are so expensive or even impossible to explore thoroughly in
advance that it may be prudent to assume some risks of encountering poor conditions, (v) the
consultant's knowledge of local conditions of materials and labour costs, (vi) the degree of
precision with which the quantity estimates have been prepared (vii) the possibility of design
changes during construction and the addition of unforeseen items and (vii) the quality of contract
supervision.
Some of the main factors that cause uncertainties with regard to material and equipment
components are (i) the degree of precision with which quantity estimates of needed material and
equipment, including necessary spare parts, have been prepared; (ii) the extent to which detailed
specifications for material and equipment have been set; and (iii) the extent to which equipment
is to be purchased off-the-shelf or on special order.
Price Contingencies:
Price contingency allowances reflect forecast increases in project base costs and physical
contingencies due to changes in unit costs/prices for the various project components/elements
subsequent to the date of the base cost estimates. Price contingencies should be expressed as
percentages of the base costs plus physical contingencies calculated separately for the local and
foreign expenditures of the project.
6.4 Production Capacity:
Capacity utilization refers to the relationship between the actual output that is actually produced
with the installed equipment and the potential output which could be produced with it if capacity
was fully utilized. Implicitly, the capacity utilization rate is also an indicator of how efficiently
the factors of production are being utilized. In this regard, various factors could affect the
production capacity of the plant. Some of the factors that could affect the production capacity of
a business firm are market, availability of sufficient raw materials, utilities, technology, trained
manpower and etc.
Therefore, at the time of financial projection taking into consideration of the stated facts, the
production capacity of the firm usually starts at a lower level and assumed to gradually increase
through time. It is inevitable that the capacity utilization assumed at the time of project appraisal
82
directly affects the revenue as well as the operating costs and thereby influences the viability of
the project.
6.5 Project Life:
At the time of project appraisal, the life of the project to be considered is the economic life of the
major fixed. For example, for manufacturing industry the project life is usually 10 years since the
major assets are production machineries. On the other hand, for hotel projects, the project life is
20 years as the major asset is building. In this regard, economic life of a certain fixed asset is the
time period at which the fixed asset is able to give service efficiently.
6.6 Depreciation:
It is apparent that depreciation is a practice of allocating in a systematic and rational manner the
cost of a capital asset over the period of its useful life. Accordingly, depreciation takes into
account the decrease in the service potential of capital assets invested in a business venture,
resulting from such causes as physical wear and tear during the operation period, as in the case of
machinery; deterioration primarily by action of the elements, as in the case of an aging building
or the erosion of farmlands; or obsolescence that is caused by technological changes and the
introduction of new and better machinery and methods of production.
At the establishment of a certain project, there is a need to invest a huge amount of funds on
different fixed assets as well as working capital requirements. The fixed assets to be acquired
will be in use or operation throughout the project life. Thus, so as to match the benefits from the
fixed assets with the cost, depreciation on fixed assets has to be considered.
Format for Depreciation and amortization determination:
Cost Item
Total cost
Rate Applied
Year 1-5
Year 6-10
Leased land
0.00
Based on the lease life
0.00
0.00
Building & civil work
0.00
5%
0.00
0.00
Production plant & machinery
0.00
10%
0.00
0.00
Furniture & Equipment
0.00
10%
0.00
0.00
Motor Vehicles
0.00
20%
0.00
Other fixed assets
0.00
Pre-operating Costs
0.00
Total Depr. & Amortization
0.00
0.00
20%
0.00
-
0.00
0.00
83
6.7 Project operating costs:
Operating costs of a project mainly comprises of direct material costs of production, direct labor
costs, factory overhead costs of production as well as the various administrative and selling
expenses. In this case it is worth mentioning that the types of project costs vary from project to
project.
Operating costs incurred only once the project is underway and are normally divided into Fixed
and Variable cost components. The later covering such items as materials, power, and labor
inputs required for manufacture which will vary directly with the volume of production while
fixed costs (FC) will include maintenance, administration and managerial charges etc. which will
be relatively fixed with respect to the volume of production but may vary with scale of operation.
Total operating costs will then be the sum of the fixed and variable costs and will increase over
the operating years until full utilization of the investment assets is reached. Thus, in project
appraisal the variable and fixed costs shall be clearly segregated and reasonably estimated.
6.8
Costs of production:
Given the estimated production, the cost of production may be worked out. The major
components of cost of production are:
o Material cost
o Utilities cost
o Labor cost
o Factory overhead cost
6.8.1 Materials
The most important element of cost, the material cost comprises the cost of raw materials,
chemicals, comPonents, and consumable stores required for production. It is a function of the
quantities in which these materials are required and the prices payable for them.
While estimating the material cost, the following points should be borne in mind:
1. The requirements of various material inputs per unit of output may be established on the basis
of one or more of the following: (a) theoretical consumption norms, (b) experience of the
industry, (c) performance guarantees, and (d) specification of machinery suppliers.
2. The total requirement of various material inputs can be obtained by multiplying the
requirements per unit of output with the expected output during the year.
3. The prices of material inputs are defined in CIF (cost, insurance, and freight) terms.
84
4. The present costs of various material inputs is considered. In other words, the factor of
inflation is ignored. It may be recalled that the factor of inflation is ignored in estimating the
sales revenues too.
5. If seasonal fluctuations in prices are regular, the same must be considered in estimating the
cost of material inputs.
6.8.2 Utilities:
Utilities consist of power, water, and fuel. The requirements of power, water, and fuel may be
determined on the basis of the norms specified by the collaborators, consultants, etc. or the
consumption standards in the industry, whichever is higher. The cost of power shown here would
include only the cost of bought out power and it may be estimated on the basis of power tariff
structure of the concerned electricity boards.
The cost of captive Power would naturally be reflected in the cost of fuel, etc. The cost payable
to local authorities and charges payable to some other firms for water and./or steam supply may
be shown separately. Where the entire water requirement is met out of one's own wells, water
charges need not be shown separately. The cost of fuel (furnace oil, coal, firewood, bagasse, etc.)
often an important item, is somewhat more difficult to estimate.
6.8.3 Labor:
Labor cost is the cost of all the manpower employed in the factory. Labor cost naturally is a
function of the number of employees and the rate of remuneration. The requirement of workers
depends on the number of operators/helpers required for operating various machines and
manning various services. The number of supervisory personnel and administrative staff may be
calculated on the basis of the general norms prevailing in the industry. In estimating
remuneration rates, the prevailing rates in the industry/area should be taken into account. The
remuneration should include, besides basic pay, dearness allowance, house rent allowance,
conveyance allowance, medical reimbursement, leave travel concession, provident fund
contribution, gratuity contribution, and bonus payments. In addition, account should be taken of
vacations, overtime work, night work, work on holidays, etc. Sometimes labour cost is estimated
by adding a certain percentage, on a global basis, to the basic pay. It is, however, advisable to
make a detailed analysis, at least in the beginning. Labour cost estimates may be raised at the
85
rate of 5 per cent per annum to allow for annual increment, etc. Labour cost may be calculated
for the year in which the maximum capacity utilization is first achieved. For the earlier years,
when the capacity utilization tends to 6e low, somewhat lower labour costs, but not
proportionately lower in relation to capacity, may be assumed.
6.8.4 Factory Overheads
The expenses on repairs and maintenance, rent, taxes, insurance on factory assets, and so on are
collectively referred to as factory overheads. Repairs and maintenance expense depends on the
state of the machinery-this expense tends to be lower in the initial years and higher in the later
years. Rent, taxes, insurance, etc. may be calculated at the existing rates. A provision should be
made for meeting miscellaneous factory expenses. In addition, a contingency margin may be
provided on the items of factory overheads.
The following table illustrates the building up of total operating costs with FCs remaining
constant from the beginning of operations, whilst other costs increase according to the output
produced. The output produced is expressed as a proportion of capacity output, or by a capacity
utilization factor.
Project Operating Costs and Benefits
(‘000 Birr)
Items
Project Years
0
1
2
3
4
5
6
7
8
9
10
11
12
13
0
0
0.5
0.75
1
1
1
1
1
1
1
1
1
1
Fixed Costs
20
20
20
20
20
20
20
20
20
20
20
20
Variable costs:
20
30
40
40
40
40
40
40
40
40
40
40
Materials
10
15
20
20
20
20
20
20
20
20
20
20
Power
14
21
28
28
28
28
28
28
28
28
28
28
Capacity Utilization
14
Labor
Total Operating Costs
0
0
64
86
108
108
108
108
108
108
108
108
108
108
Benefits
0
0
100
150
200
200
200
200
200
200
200
200
200
200
0
Here it is worth mentioning that any project usually starts at lower capacity utilization. In this
regard, it is clear that capacity utilization of a project is influenced by the product market,
86
availability of sufficient raw materials, power, and technology and so on. Due to change in
production capacity, operating costs will also change.
6.8 Initial Working Capital Determination:
Working capital is a fund required to keep the business organization running on a day to day
basis. It represents a net investment in short term assets. Net working capital is the difference
between current assets minus current liabilities. Working capital is required for new project to
finance the purchase of raw materials, direct labor, FOH and to cover related expenses such as
wages, salaries, utilities and etc.
There are three basic components of physical working capital that are initial stock of materials,
work in progress and final stock of outputs. The physical stocks have to be build-up with
operations & will have a residual value at the end of the project life.
The value of the total working capital required in any year depends upon the operating Costs of
the project. Initial materials can be estimated as a proportion of the annual requirement of
materials, say one month’s worth of materials. To facilitate production, these stocks must be
committed in the previous year.
Similarly, stocks of final outputs can be estimated in terms of the total annual production, say
one month worth of output. The value of final stocks is then 1/12 of the total production in that
year. However, before the output is actually sold or used its value is given by the sum of
resources embodied in it, or the total operating cost to produce a unit of output.
When we come to working in progress, it refers to the additional resources committed as items
pass through the production process from raw materials to final outputs. The value of resources
tied up as work in progress is calculated firs from the difference between total operating costs
(TOC) and materials costs (MAT). Each item on average is half day through the production
process and so half this difference is taken from the value of TOC to represent resources passing
through the production process. However, resources are not tied up for the whole year by for the
time it takes for materials to be turned into outputs, or the production period (PP). This quantity,
say 20 days, can be compared with the annual production year (PY) in days (say 250 days). On
average, working capital resources tied up are given by the proportion of the production period to
the production year.
87
In summary, using the definitions about, working capital as work in progress can be calculated
from the following:Work in progress = (TOC - (TOC - MAT)/2 x PP/PY
Work in progress is general the smallest component of working capital as a whole.
When these three components of working capital have been estimated, they can be summed to
give the total working capital requirements in any year. The working capital resources that need
to be allowed for in a project statement are the incremental amount as the stocks are built up or
vary from year to year, as given in the table below. At the end of the project the total working
capital outstanding can be recovered as a residual value in the last operating year, when material
and output stocks will not have to be renewed.
Project Working Capital Costs
(‘000 Birr)
Project
Item
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Years
Materials - 1 month
0.0
1.7
2.5
3.3
3.3
0.0
Working progress-20 days
0.0
0.0
3.4
4.6
5.9
5.9
Output at cost - 1 month
0.0
0.0
5.3
7.2
9.0
9.0
Total working capital
0.0
1.7
11.2
15.1
18.3
54.9
1.7
9.5
3.9
3.1
Incremental working capital
6.9
0
0
0
0
0
0
0
0
-183
Accept or reject an investment proposal:
The criterion for accepting or rejecting an investment decision is simple if the alternatives are
mutually exclusive: accept an investment if it has a positive net present value or reject that
investment if it has a negative net present value. This simple criterion is possible because when
the benefit stream or the annual net cash flows for a particular investment are discounted with the
cost of capital, the resulting figure represents the maximum amount that could afford to pay for
the investment and expect to just “break even,” including opportunity costs on the money
invested. Therefore, a net present value of zero indicates that the particular investment is
generating a return exactly equivalent to the cost of capital or the cost of debt and equity funds
that have been used to finance the investment.
88
A positive net present value indicates that the particular investment is generating a benefit stream
larger than the cost of the funds used to finance the investment; hence, the investment is a
profitable one. In essence, the additional return adjusted by the time value of money is larger
than the additional cost of the investment. In contrast, a negative net present value indicates that
the increased income received from the investment will be less than the cost of funds required to
support that investment. Thus, the investment is undesirable, and you should commit the funds to
some alternative investment that will generate a return at least equivalent to their cost. In some
cases, the decision may not be one of accepting or rejecting a particular investment but of
choosing among a number of alternative investments. In this situation, you can rank the
investment alternatives in order of preference based on their net present values, with the
alternative having the highest net present value ranked first and the one with the lowest net
present value ranked last. You would then implement all those alternatives with a positive net
present value if the funds were available to do so. If the funds to acquire the alternative
investments were limited, you would choose that combination of projects that generates the
largest total net present value with the limited funds.
6.10
Time value of money:
The basic concept of net present value in investment decision is that a dollar in hand today is
worth more than a dollar to be received sometime in the future. A dollar is worth more today
than tomorrow because today’s dollar can be invested and can generate earnings. In addition, the
uncertainty of receiving a dollar in the future and inflation make a future dollar less valuable than
if it is received today. The procedure for accounting for the delay in receiving funds or the
income given up is to discount, or penalize, future cash flows. The longer you must wait to
receive them, the more heavily you must discount them. This discounting procedure converts the
cash flows that occur over a period of future years into a single current value so that alternative
investments can be compared on the basis of that single value. As the investment project is with
the view of generating income in the future time series, this conversion of flows over time into a
single figure via the discounting procedure takes into account the opportunity cost of having
money tied up in the investment.
6.11
The Discount Rate:
89
In financial analysis the discount rate used is simply the rate the sponsors expect they will have
to pay for borrowed funds or the rate they wish to receive on capital invested. For the economy
as a whole, however, the cost of committing investment funds to a new project is the rate of
return, which could have been obtained an alternative investment. This is not always easy to
determine. To open with this problem the concept of the marginal project is employed. This is
the least attractive project in the government prospective investment plan and is, therefore, the
first to be omitted if a new project accepted. The accounting rate of interest, or shadow rate of
interest, that is the test discount rate, is given by the internal rate of return at world prices, on the
marginal government project. To justify inclusion in the plan for investment a project must earn
at least the equivalent of the least attractive alternative. This discussion above assumes that the
government investment budget is given. Sometimes there may be not alternative but to simply
use the rate at which the government can obtain funds. In some instances a rate of return is
simply fixed by government and if too many projects come forward at that rate then the rate is
raised, conversely if there are too few, it is lowered. In other words a process of trial and error is
used.
6.11.1 Indirect Effects:
Indirect effects are costs and benefits which arise because of the project but which accrue not to
the project but to other sector or enterprises in the economy. We shall give first some examples
of indirect costs and then go on to give some of indirect benefits.
6.11.2 Indirect Costs:
Pollution of water, and or land, affecting fishing, drinking water supplies, tourism, other
industries, and/or the living condition of the people.
Loss of income or profits from new investments e.g., handicraft shoe production may be
destroyed by a new shoe factory, or the new beer factory or new milk reconstituting plant may
decide to produce soft drinks thus adversely affecting the profits of the traditional soft drink
manufacturers.
A new project may raise the price of its product (and hence the cost of industries that use the
product) if the investment has to be protected. For example the new fertilizer - blending factory
could raise the price of fertilizer.
90
6.11.3 Indirect Benefits
The establishment of the project may benefit others. A dam built to improve water supplies and
electricity generation may turn out to be useful for tourism and fishing. A road built for factory
may benefit other users. The training provided by one industry may prove of greater benefit in
setting up other industries.
Project may create extra profits in the industries, which supply it. For example a supplying
factory may prove of greater benefit in setting up other industries.

A special case of this is when the project increased the incomes of local shopkeepers and
suppliers, through what are called ‘multiplier effects.’

A new project may be more efficient than its predecessor and lower the price of what it
produces thereby lowering the costs of production of other producers of increasing the real
income of consumers.

Theoretically, the most satisfaction way of dealing with them is to define the project
sufficiently widely so that it includes all the spin off projects and effects. If this is taken to its
logical conclusion the project may well become the entire medium term plan. Very often
they are dealt with by simply noting them somewhere in the appraisal document.
6.11.4 Equity Source:
It is apparent that funds are required to establish a project which, up on completion, generates
revenue and repay debts to the financers. In this regard, the project cost is normally obtained
through a combination of debt and equity. What is important is that once the project
implementation begins, the project should not be starved of funds either through equity or debt.
Any disruptions of the flow of funds may bring forth project delay. Thus, detail financial
analysis should be conducted so as to assess the financial strength of the project promoter/s.
Adequate levels of equity guarantee that promoter takes interest in the project and runs the
project efficiently. Thus, at the time of project appraisal due emphasis should be given on the
availability of sufficient resources with the promoter for infusing equity in the project. Source of
equity also require detail and careful scrutiny by the financers. In this regard, what is critically
important is to assess the liquidity position of the resources available with the promoters. In
general, it has to be assured that the source for equity by any means shall not be external source
or debt finance.
91
In addition, when a lenders are not comfortable in respect of the promoters’ ability to infuse in
the project in time, they may insist that a certain percentage of a total equity or the whole part
may be demanded depending on the case to brought upfront (first) before the disbursement of the
loan.
6.14 Financial projections:
The profitability of a project should be estimated for the purpose of determining the ability of the
project to:
*
*
service its loan
pay reasonable return on equity capital
For this estimate of cost of production, profitability, cash flow and projections of balance sheets
for a period of about 5-10 years are required. Theses are interrelated and are prepared on the
basis of the estimated cost of the project, sources of finance envisaged and various assumptions
regarding capacity utilization, availability of inputs and their price trend, selling price of end
product, etc.
The important assumptions looked into are capacity build-up, raw material cost estimates of
wages and salaries, cost of utilities, estimates of administrative expenses, selling prices assumed
and provision made for depreciation and statutory taxes. Verification of profitability is the core
of proper appraisal of a project. The entrepreneur may be naturally tempted to present a bright
picture. It is the task of appraising officer to verify the figures furnished by the entrepreneur.
Mere checking of arithmetical calculations, though are important, are not sufficient. The basis of
the various figures should be ascertained and verified to ensure that the profit is realistic.
In the case of new unit, any sharp build up capacity within a year or two will be unwarranted
more or so if the product is new.
The quantum of raw materials and utilities to be put up into order to obtain particular
quality/quantum of end product is the key to cost of manufacture and this aspect should be
carefully checked with reference to the performance guarantees furnished by the
collaborators/machinery suppliers. The product-mix is decided based on contribution of each
product and plant capacity as well as market.
Wages and salaries should be raise by not less than 5% annually.
92
Repairs and maintenance will have to be provided keeping in view the type of industry and the
number of shifts to be worked. Repairs and maintenance may be lower in the first one/two years
it should be gradually stepped up in the later years.
There may be tendency on the part of entrepreneurs to provide somewhat higher amounts for
administrative expenses but entrepreneurs should be advised to keep such expenses to the bare
minimum during initial years.
Depreciation on various fixed assets should be provided as per income tax rules.
Financial expenses such as interest on term loans and on bank borrowings are provided at
contracted rates.
The sale price should be fixed keeping in view the present domestic price of the product
envisaged and where possible also export/international price.
The profitability projections are closely linked to the schedule of implementation. The appraising
team should carefully assess the implementation schedule and be well certain about it.
Wherever feasible, the profit projections are compared with the actual performance of
comparable units in the industry. In some cases sensitivity studies are conducted to see that the
unit would be able to service its debts and give a reasonable return even under less optimistic
conditions.
On the basis of the profitability projections, cash flow and projected balance sheets are prepared
for a period of 5-20 years depending on the nature of the project. Cash flow statements help in
studying availability and use of funds both during implementation and operation.
amortization program of term loan is scuttled on the basis of the cash flow.
The
It may be
emphasized that while fixing a repayment schedule, the intention should not be to mop up all
surpluses available with the unit rather adequate amount should be left with the unit to enable it
to pay reasonable dividend and have some cash to take care of contingencies.
During the earlier years when the profits are likely to be low, the loan installments may be for
smaller amounts, which should be increased, in later years when profits increase. Therefore, a
reasonable repayment schedule should establish based on the cash flow.
93
6.15
Projected financial statements:
Some of the major projected financial statements of project proposals are illustrated here under.
6.15.1 Cash Flow for Financial Planning or Flow Funds Statement:
Cash insufficiency can negatively affect the activities of a project. Even, it can lead to an
extinction of the project. Therefore, the project planner has to develop some techniques of
forecasting cash receipts and payments; such a technique is called cash flow statement for
financial planning or flow of funds statement. The cash flow statement is the basis for showing:
the cash flows associated with those resources flows; the cash flows associated with funding the
investment.
The Cash Flow is the main tool of financial planning and is sometimes referring to as the Source
and Application of Funds Statement. Its main function is to analyze the liquidity position of the
project - identifying potential periods of cash shortage - and planning appropriate responses
designed to remove such shortages. Therefore, during project appraisal process, the time at
which the project cash inflow is not sufficient to entertain the outflow of funds should be
identified and the loan repayment period shall be set to be in conformity with the cash flow of
the project.
Financial cash flows will be devised for the funding of the initial investment through credit and
other funds. Credit is not shown in the resource flow as it is purely a financial transfer, no
physical resources are involved.
An example of a typical cash flow is given below:
Typical Cash Flow for Financial Planning
Item
1
2
3
4
5
Inflow
Equity (a)
Loans (b)
Sales (c)
Total Inflow (a+b+c=d)
Out flow
Capital Costs (e)
Variable Operating Costs (f)
Fixed Operating Costs (g)
Working Capital (Physical and Financial) (h)
94
Loan Repayments (i)
Taxation (j)
Dividends (k)
Total Outflow (e+f+g+h+i+j+k = l)
Net Annual Cash Flow (d-1 = m)
Cumulative Cash flow (m1 + m2 + m3 etc.)
The bottom line, the cumulative cash flow, or the balance carried forward, must always be
positive, a negative amount signals that the project has run out of money. The cash flow
records cash inflows and outflows when they actually occur, it is not based on the accruals
concept and it does not give an indication of profitability. It simply tells you the amount of
cash available at any one point in time and whether it is sufficient to be able to meet
commitments as they fall due. It is possible for a project to be profitable yet find itself short of
cash when it is needed to meet commitments such as interest and loan repayments. This may
be because sales revenue has not been collected.
If a project has a negative cash flow but is acceptable in terms of its IRR and NPV and
profitable in terms of the Net Profit figure then there are a number of options the analyst can
pursue to improve the liquidity position:
 Increase owners equity
 increase credit purchases
 Increase long term borrowing
 increase grace period on loan
 Increase short term borrowing
 increase loan repayment period
 Reduce credit sales/discounts
 reduce working capital
 rent/lease assets rather than purchase
 Improve stock management
Typical format for cash flow for discounting:
(for ten year project)
Year
Item
0
Sales Revenue
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
Working capital Recovery
0.00
Salvage Value
0.00
Total Cash Inflow
Fixed Investment
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
95
Operating Cost less Dep. & Int.
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
Replacement cost
Working Capital Increment
Profit Tax
Total Cash Outflow
Net Cash Surplus/Deficit
0.00
NPV
0.00
IRR
%
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0..00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.0
0.0
0.00
Here all the cash inflows and outflows are discounted to the present value and NPV and IRR are
determined. The inflows comprises of annual sales revenue and salvage value of fixed assets at
the end of the project life. Usually, a certain percentage of the cost of fixed assets such as
building, plant and machinery are considered as salvage value at the end of the project life.
Besides, working capital recovery is also part of the inflow of funds at the end of the project life.
In this instance, in the project appraisal, the total value of it is considered to be recovered at the
end of the project life.
On the other hand, the cash outflows comprises of operating costs, incremental working capital,
and profit taxes. Besides, if there is a need for replacement of fixed assets within the project life
it has to be considered as part of outflow when it is acquired.
6.15.2 Projected profit and loss statement:
The main purpose of project establishment is to generate return and thereby increase owners’
capital. Accordingly, the primary purpose of preparing the Income Statement is to calculate the
profit or loss of an enterprise or project. It is the business measure of performance and profit.
Enterprises are required by law to prepare an Income Statement at the end of each year to report
to shareholders on performance and to calculate the tax liability to the government of the
enterprise. Commercial enterprises also use the Income Statements. In project planning the
Income Statement is used both as a tool to analyze the past performance of an existing project
and also to project the future performance of the project. The projected profit and loss statements
is generally prepared based on the data or information obtained from the various sources such as
pro-forma invoices for fixed assets, bill of quantity or independent estimation for building and
civil works and the various assumptions considered during the appraisal process concerning
revenue and operating costs.
96
The format of the Income Statement varies according to who is preparing it and for what
purpose, and on the type of activity, be it a manufacturing, retail or service project. An example
of a typical Income statement is given below:
Typical Example of an Income Statement for five years project
Item
1
2
3
4
5
Total Sales(a)
Less Total Variable Cost of Sales (b)
Gross or Trading Profit (a-b+c)
Less Overhead or Fixed Costs (d)
Less Depreciation (e)
Less Loan Interest (f)
Net Profit (c-d-e-f=g)
Less Taxation (h)
Net Profit After Tax (g-h=i)
Less Dividends(i)
Retained Profit (i-j=k)
The first part of the statement is known as the trading Account, which calculates Gross Profit or
Trading Profit (c). This is calculated by deducting Direct Production Costs (cost of sales) from
Sales Revenue. Net Profit (g) is calculated in the Profit and Loss account by deducting Fixed or
Overhead Costs (including Depreciation) form Gross Profit. The Net Profit after tax and interest
(i) is found by deducting tax and interest charges from Net Profit. The last part of the Income
Statement is the Appropriation Account which shows how much of the Net Profit is appropriated
between the different types of shareholder and how much is transferred to building up project
97
reserves i.e. retained profit. The Appropriation account is not commonly used in project analysis
since the project analyst is concerned with the benefits generated by a particular project and not
with what the project owners do with the benefits. If these benefits are invested it would be the
subject of a difference project appraisal.
The fundamental principle of the Income Statement is the accrual concept, which matches sales
made in an accounting period, with the actual cost of making those sales. Accordingly Sales
Revenue is made up of all sales, including those for which payment has not been received in the
accounting period. Similarly Cost of Sales will account for materials that have been received
and used but not paid for.
6.15.3 Projected Balance Sheet:
The Balance Sheet is a statement of the assets and liabilities of the enterprise at a point of time.
It has been likened to a still camera shot, which freezes the action at a moment. The Income
Statement by contrast measures the flow of activity over a period. It is at this point that
economists and accountants often disagree. The Balance Sheet is considered by commercial
bankers to be one of the most important statements when deciding whether or not to invest in an
existing project.
Information presented on the balance sheet is drawn from wide range of current balance to
present a picture of the enterprise on one day in the year. The information, therefore, represents
the account balances recorded and does not indicate exact economic values. It is usual to expect
the accountant to aim at a system which is both uniform and consistent with the way other
accounts are kept and it is assumed that:-
i.
the enterprise is a separate entity,
ii.
the enterprise is a going concern,
iii.
all the data is expressed in a single stable currency.
Having a separate identity both financial and legal requirements prevents the accounts from
being mixed up with other interests, whether of associated companies or of the personal interests
of shareholders. Being a going concern affects the value of the assets and the attitude of
98
creditors and lenders. It is convenient that the records are maintained in a single unit of value,
although it is clear that money values can and do change.
The Balance Sheet shows the way in which a company is financed, whether by sponsors, lenders
or creditors and how these funds have been employed. The sources of funds, even where they
represent the capital invested by shareholders are regarded as the liabilities of the Company and
the use to which funds have been put are the assets. Any increases in assets due to profitable
operation are added to the shareholders funds and any losses are deducted, so that with these
funds giving the residual value of any changes in assets, the assets are always the same as the
liabilities. As the other sources of funds together with the “ownership” or shareholders funds are
equal to the assets of the Company, the ownership or net worth of the Company is the total asset
value less “liabilities” - (sources of funds other than shareholders reserves).
The Balance Sheet is the key to understanding the financial position of a project or enterprise. It
is a statement comparing the assets and liabilities and gives the “net worth” of an enterprise at a
specific point in item. It is usually prepared annually for project analysis, but it is not unusual to
see half year or monthly balance sheets prepared in the private sector unlike the Income
Statement, which measure of what the business is worth at a particular point in time. This is
done by comparing assets (what the project owns), & liabilities (what the project owes).
Balance Sheets are presented in a number of different formats. An example of typical vertical
format is given below;
Typical Balance Sheet Format
Item
1
2
3
4
5
99
Fixed Assets
Building (a)
Machinery and Equipment (b)
Other Assets (c)
Total Fixed Assets (a+b+c=d)
Less Accumulated Depreciation (e)
Net Book Value of Assets (d-e=f)
Current Assets
Stock (g)
Debtors (h)
Cash and Bank balance (i)
Total Current Assets (g+h+i) = j
Current Liabilities
Short Term Loan (k)
Creditors (l)
Tax Payable (m)
Total Current Liabilities (k+l+m=n)
Net Working Capital (j-n=o)
Employment of Funds (f+o=p)
Funds Employed
Owners Equity (q)
Retained Earnings (r)
Term Loan (s)
Total Funds Employed (q+r+s=t)
6.15.4 Net Present Value:
Net present value method is the most classical method of evaluating the investment proposal. It
is one of the discounted cash flow techniques, recognizing the time value of money. Net present
value (NPV) is defined as the total present ( discounted) value of a time series of cash flows.
NPV aggregates cash flows that occur during different periods of time during the life of a project
100
in to a common measuring unit i.e. present value.
In other words, under this method, the future
costs and revenues are discounted by the required rate of return in order to compare the present
value of the future benefits with the present value of investments. It is a standard method for
using the time value of money to appraise long-term projects. NPV is an indicator of how much
value an investment or project adds to the capital invested. In principal a project is accepted if
the NPV is non-negative i.e if the present value of the future benefits exceeds the present value
of investment, the financier could accept the project; otherwise it may out rightly reject it.
In general, using the concepts of time value of money, one can determine the net present value
(NPV) for a particular investment as the sum of the annual cash flows discounted for any delay
in receiving them, minus the investment outlay.
NPV = NCF0 + (NCF1 * a1 ) + (NCF2 * a 2 ) + … + (NCFn * an ) (4)
Where
NPV = net present value of a project;
NCF = net cash flow of a project in years 0,1,2,…n;
a = discount factor in years 1,2,…,n, corresponding to the selected rate of discount.
The discount factors are to be found in the present value table in the annex.
The same expression could be presented in a more aggregated way in the following formula:
n
NPV =  (Cl – co)t at
t 0
Where
n = a sum total for the whole lifetime of the project
t = 0 from year 0 to year n;
Clt = cash inflow in the year t;
COt = cash outflow in the year t;
a
t
= discount factor in the year t corresponding to the selected rate of discount.
101
6.15.5 Return on investment:
The very first information that a project appraiser seeks in project report is the return on the
investment. The appraiser may compare this with the cost of capital. He may think of further
appraisal of the project only if the return on investment is more than the cost of capital. Some of
the methods used to evaluate the return on cost of capital are described here under.
6.15.6 Payback period:
The pay back period, also called pay – off period is defined as the period required to recover the
original investment outlay through the accumulated net cash flows earned by the project. In other
words, the payback method is a technique by which the project financers find out the number of
years required to recover the original cash outlays invested in a project. It may be calculated as
follows.
Payback period = cash outlay
Annual net cash inflow
One of the limitations of this method is that it does not consider the flow of funds after the
payback period. However, it is an unusual technique for a financer who lends funds to the
borrower.
6.15.7 Average Rate of Return:
Average rate of return is a method used to determine the average annual profit during the lifetime
of the project. It is normally expressed in percentage. It can be calculated in the following
manner.
ARR = cash outlay
Average net cash inflow
6.15.8 Internal Rate of Return
The internal rate of return (IRR) is the annualized effective compounded return rate that can be
earned on the invested capital, i.e., the yield on the investment. Put another way, the internal rate
102
of return for an investment is the discount rate that makes the net present value of the
investment's income stream total to zero. It is an indicator of the efficiency or quality of an
investment. A project is a good investment proposition if its IRR is greater than the rate of return
that could be earned by alternate investments or putting the money in a bank account.
In the internal rate of return method the discount rate is unknown, unlike the net present value
method in the application of which the discount rate is given outside the project. By definition,
the internal rate of return is the rate of discount that reduces the net present value of a project to
zero.
n
0=

(CI – CO)t a t
t 0
-Where all the symbols have the same meaning as in the case of net present value.
When applying the internal rate of return, one starts with an assumption that NPV =0 and tries to
find out the discount rate that will make the present value of the cash inflows of a project equal
to the present value of the cash outflows.
6.15.9 Break Even Analysis
The purpose of break even analysis is to determine the equilibrium point at which sales revenues
equal the costs of products sold. When sales (and the corresponding production) are below this
point the firm is making a loss and at the point where revenues equal costs the firm is breaking
even. Break even analysis serves to compare the planned capacity utilization with the production
volume below which a firm would make losses.
The break-even point is one where the firm does not make either profit or loss when it
manufactures/sells a particular number of units. It is a point of just recovering the amount that it
has spent initially in the manufacturing of the product. This analysis is very vital for the financer
as the repayment of the loans is generally scheduled to begin after the break-even point.
Before calculating the break-even value the following conditions and assumptions should be
satisfied.

Production and marketing costs are a function of the production of sales volume.
103

The volume of production equals the volume of sales

Fixed operating costs are the same for every volume of production

Variable costs vary in proportion to the volume of production and consequently total
production costs also change in proportion to the volume of production.

The sales prices for a product or product mix are the same for all levels of output
(sales) over time. The sales value is, therefore, a linear function of the sales prices and
the quantity sold.

The level of unit sales prices and variable and fixed operating costs remain constant
that is the price elasticity of demand for inputs and outputs is zero

The break even values are computed for one product in case of a variety of products
the product mix, i.e., the ratio between the quantities produced should remain
constant.
Since the above assumptions will not always hold in practice the break-even point should
also be subject to sensitive analysis assigning different fixed and variable costs as well as
sales prices.
BE =
Fixed Cost
Sales – Variable Cost
6.15.10
Debt Service Coverage
The debt service coverage ratio serves as a guide to determining the period of repayment of a
loan. This is calculated by dividing cash accruals in a year by amount of annual obligations
towards term debt. The cash accruals for this purpose should comprise net profit after tax with
interest, depreciation and other non cash expenses added back to it.
Debt Service =
Coverage ratio
Cash Accruals.
Maturing annual obligations
104
The ratio is variable in that it serves as a measure of the repayment capacity of the
project/business and is, therefore, appropriately included in the cash flow statement.
6.15.11
The Benefit/Cost (B/C) Ratio
The third measure is calculated by dividing discounted benefits (or revenue) by discounted costs
(or expenditure)-including capital costs. A ratio at least one is required for acceptability. A B/C
ratio of 1.00 indicates that the NPV is zero at a particular discount rate- which is also the IRR for
the project.
The calculation of the B/C ratio requires the appraisers of an investment to maintain the year-byyear separation of costs and benefits i.e. not to show just a net cash flow, as may be sufficient for
the calculation of NPV of IRR. With a systematic approach to project preparation and the design
of Cash Flow statements, however, it is clearly possible to calculate the B/C ratio in addition to
other measures if necessary.
It is important to remember that it is a ratio as such, like the IRR (but not NPV) it can be
regarded as an efficiency measure, and this may make comparative analysis easier. However, a
danger lies in ensuring that the ratio always represents the same thing.
It is best used as measure relating gross discounted benefits, and gross discounted costs. Another
ratio may use a benefit figure which is net of “capital” cost or “associated”(usually means
recurrent) costs. The “netting out” procedure leads to inconsistent results and should therefore
be avoided.
6.15.12
Sensitivity Analysis:
Financial cost-benefit analysis is based on forecasts of quantifiable variables such as demand,
revenue and costs. The values of these variables are estimated based on the most probable
forecasts, which cover a long period of time. The values of these variables for the most probable
outcome scenario may be influenced by many factors and the actual values may differ
considerably from the forecast values depending on future events. It is therefore necessary to
consider the sensitivity of project viability to potential changes in key variables.
The viability of projects is evaluated based on a comparison of its FIRR to the WACC
Alternatively, the project is considered to be viable when the NPV is positive, using the WACC
105
as the discount rate. The WACC is usually considered to be constant because loan funds and
government capital contributions are fixed and made at the beginning of the cash flow stream.
However some funding may result from variable rate instruments in which case it would be
appropriate to test project viability for its sensitivity to changes in interest rates. In the example
below WACC is assumed to be constant. Sensitivity analyses, will therefore focus on analyzing
the effects of changes in key variables on the project’s FIRR or NPV, the two most widely used
measures of project viability.
Sensitivity analysis tests the impact of changes in project variables on the base-case (most
probable outcome scenario). Typically, only adverse changes are considered in sensitivity
analysis. The purpose of sensitivity analysis is: (i) to identify the key variables that influence the
project cost and benefit streams; (ii) investigate the consequences of possible adverse changes in
these key variables; (iii) assess whether project decisions are likely to be affected by such
changes; and (iv) identify actions that could mitigate possible adverse effects on the project.
Sensitivity analysis needs to be carried out in a systematic manner. To meet the above purposes,
the following four steps are suggested.
Step 1: identify key variables to which the project viability may be sensitive.
Step 2: calculate the effect of possible changes in these variables on the base-case FIRR
or NPV, and calculate a sensitivity indicator and/or switching value.
Step 3: Consider possible combinations of variables that may change simultaneously in
an adverse direction.
Step 4: Analyze the direction and scale of likely changes for the key variables identified,
involving identification of the sources of change.
Usually sensitivity analysis is considered for a decrease in revenue, an increase in operating
costs and increase in investment costs by a certain percentage.
6.16
DISTINCTION BETWEEN FINANCIAL AND ECONOMICS ANALYSIS
The differences in the definitions of economic and financial viability are reflected in the
differences of financial and economic analysis. While some of the actual tools of analysis are
106
the same financial analysis is concerned with private profitability and is based on financial flows
which relate to:

market prices for products and inputs

the terms of credit and borrowing in general

tax and subsidy policy

financial depreciation and other financial conventions
The financial analysis focuses on money profits accruing to the project entity. Various financial
indicators are used to evaluate the entity’s ability to meet its financial obligation and to finance
future investment.
Economic viability, on the other hand, is concerned with public “profitability” which is based on
economic resource flows. Economic analysis measures the project’s effect on the efficiency of
the whole economy. Rather than financial prices shadow prices are used that reflect opportunity
cost. Economic resource flows relates to:
 Social opportunity costs (shadow prices) which adjust market prices to take into account
differences based on:

tax and subsides

external costs and benefits

monopolistic pricing

price control and rationing

quantitative trade restrictions

over-value (or under-valued) exchange rate

labour opportunity costs
6.16.1 Economic Appraisal/Analysis
The profitability analysis and financial projections shown above represent benefits that are likely
to accrue to private promoters and various other agencies involved in promoting a project
including financial institutions, government etc. These, however, may not be the true benefits to
the society of the economy as a whole.
107
Economic analysis is made to ascertain the overall country impact of a project. It is a measure of
the costs and benefits of a project to the society. The exercise of project appraisal is not
accomplished till the proposed project is also viewed from the economy viewpoint.
This
measure involves two basic adjustments:
o It treats import duties, sales taxes, profit taxes etc. as internal transfers and excludes them
from the financial cash flow.
o It substitutes shadow (economic) prices for market prices because market prices do not
reflect their true or scarcity prices.
Thus adjustments have to be made. A full appreciation of the main adjustments required for
economic analysis can be obtained if we compare economic and financial analysis:
*
In financial analysis the formulation of the cash flow i.e. the sum of capital cost and
operational cost which is then subtracted from our revenue to arrive at a net cash flow is all
done at market prices. To this net cash flow we apply a rate of discount to get NPV and IRR.
The IRR we derive using the cash flow is called the financial Rate of Return (FIR)
*
In economic analysis we deal with the same parameters but valued at economic prices. The
cash flow obtained in this way gives us the Economic Internal Rate of Return (EIRR) which
is what we get when we use similar parameters in economic prices.
The essential difference between financial and economic analysis is that economic analysis is
concerned with the cost and benefits to the economy or society as a whole. Financial analysis
on the other hand, deals with the returns to individuals who sponsor the project be they sole
traders, partnership, companies, banks or even public corporations.
As mentioned earlier the items included in a cash flow for financial analysis are often the same
as those for an economic analysis. Differences between the two derive from two sources.
Firstly, there are some items that are included in cash flow compiled for financial analysis.
Secondly, the valuation put on the items for financial analysis is not always the same as that for
108
economic analysis. Additionally, economic analysis draws attention to indirect effect that are
irrelevant in financial analysis. Inflation too is not treated in the same way in economic analysis
as it is in financial analysis. The discount rate used in economic analysis may also differ from
that used in financial analysis. Let us look at these differences closely.
6.16.1.1 Items Include in Financial but not Economic Analysis
The major items usually included in the financial cash flow but not in the economic cash flow
are taxes and subsidies. It is not difficult to understand the reason for this. To the sponsor of a
project taxes are very much a cost just as a subsidy is very much a benefit. But to the society as
a whole which is concerned with the utilization of all the limited resources available to it, taxes
and subsidies do not represent any additional use of resources, they are merely transfer payments
within the economy. So the first step in converting a cash flow prepared for financial analysis
into one to be used for economic analysis is to get rid-of the taxes and subsidies. It is important
to remember that many subsidies are indirect, that is, the entrepreneur may not receive his
subsidy directly but simply pay a subsidized price for his inputs. Similarly many taxes are
indirect and are included in the cost of particular inputs.
Differences in Valuation:
In Financial analysis, the market price of an item in the cash flow is a sufficient indication of its
value. The only cost that matters in economic terms is opportunity cost, that is, the benefits
foregone by not using the particular resources in the next best alternative use. Now, if we were
operating in a perfectly competitive economy, then the market price and the opportunity cost
would be one and the same thing. But as we all know by now perfectly competitive economies
are those we read about in textbooks but rarely encounter in real life. We have to be content with
second best approximation life. We have to be content with second best approximations of the
opportunity costs. These we call ‘Shadow price’’ or ‘’accounting price ‘’ to distinguish them
from the market prices we use in financial analysis.
The main factors that give rise to these shadow prices are foreign exchange, labor, land, and
devices for protecting the domestic market such as quotas and tariffs. We shall look at each of
these in turn.
109
Most developing countries particularly in those that do not produce oil have balance of payments
problems. Not only is the rate of foreign exchange, but its availability, are rigidly controlled by
the Government. More often than not this official rate does not reflect the scarcity value of
foreign funds. The local currency is overvalued in relation to foreign currencies. One has to
note how widespread black markets in foreign currencies are; to appreciate the prevalence of this
practice. As economic analysis, as distinct from financial analysis, is concerned with the real cost
of resources it is widely felt efforts ought to be made to arrive at the most realistic cost of foreign
exchange possible.
Where the domestic market is protected by tariffs and quotas the price paid for inputs for the
project of the price at which the output is sold may be higher or lower than at which they can be
bought or sold on the world market. In economic analysis the world market prices ought to be
used as this hives a better indication of the value of resources involved to the economy.
In economic analysis wages rates ought to reflect the opportunity cost of labor that is the rate
worker would receive in the best alternative to him. In many developing countries the rate of
unemployment being high, the alternative available may be no job at all and therefore
opportunity cost of unskilled labor is considered by some to be zero. For several reasons,
including minimum wage legislation, subsistence farming and availability of remittances, this is
never actually the case. The wage rates for economic purposes, therefore, lies somewhere
between zero and the market wages that is used in financial analysis. Exactly what it is depends
upon the particular country. For skilled labor which is assumed to be scarce in most developing
countries market prices are regarded as adequately reflecting opportunity costs.
In many projects, the cost of land is a very insignificant portion of total project cost and too
much attention need not be devoted to it. However, in agricultural and ago-industrial projects
land cost can be major significance. In financial analysis, we would simply insert the purchase
price, or the cost of leasing the land. if these are not available we use an estimate thereof. For
economic analysis we have to find the opportunity cost. These will often be net benefits derived
from the land in its previous use. If the land was not being used previously then the opportunity
costs and therefore economic cost is zero, even though for the financial analysis whatever the
user pays for it will have to be entered as the cost.
110
111