Planning This phase is concerned with the articulation

of 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 investment the firm plans to undertake. This provides the framework which shapes guides and circumscribes the identification of individual project opportunities.

To begin with, a preliminary project analysis is done. A prelude to the full blown feasibility study, this is meant to access:

Whether the project prima facie worthwhile to justify a feasibility study.

What aspects of the project are critical to its viability and hence warrant an in depth investigation.

AnalysisIf the preliminary screening suggests that

the project is prima facie worthwhile a detailed analysis of the marketing, technical, financial, economic and ecological aspect is undertaken.

The focus of this phase is on gathering, preparing and summarizing relevant information about various project proposals which are being considered for inclusion in capital budget.

Based on the information developed in this analysis, the stream of cost benefit associated with the project can be defined.

SelectionThis often overlap analysis.It addresses the question:

Is the project worthwhile?A wide range of criteria have been suggested to

judge the worthwhile ness of the project. They are divided into non-discounting criteria- payback period and the accounting rate of return. and discounting criteria-net present value, internal rate of return and benefit cost ratio.

Criteria Accept Reject

Pay back period (PBR)

PBR less than target period

PBR greater than target period

Accounting Rate of Return (ARR)

ARR greater than target rate

ARR less than target rate

Net present Value (NPV)

NPV greater than Zero NPV less than Zero

Internal Rate of Return (IRR)

IRR greater than cost of capital

IRR less than cost of capital

Benefit-Cost ratio (BCR)

BCR greater than 1 BCR less than 1

To apply the various appraisal criteria suitable cutoff values (hurdle rate, target rate and cost of capital) have to be specified. These are essentially function of the mix of financing and the level of project risk.

Despite a wide range of tools and techniques for risk analysis (sensitivity analysis, scenario analysis, Monte Carlo analysis, decision tree analysis etc.,) risk analysis remains the most intractable part of the project evaluation exercise.

FinancingOnce a project is selected, suitable financing arrangements

have to be made. The two broad sources of finance for a project are equity and debt. Equity(referred to as shareholders funds on balance sheets in India) consists of paid-up capital, share premium, and retained earnings. Debt(referred to as loan funds on balance sheets in India) consists of terms loans, debentures, and working capital advances.

Flexibility, risk, income, control, and taxes (referred to by the acronym FRICT) are the key business considerations that influence the capital structure (debt-equity ratio) decision and the choice of specific instruments of financing.

ImplentationThe Implementation phase for an industrial project, which

involves setting up of manufacturing facilities, consists of several stages

(1) project and engineering designs, (2)negotiations and contracting, (3)construction, (4) training and (5)plant commissioning. What is done in these stages is briefly described below:

Stage Concerned withProject and engineering designs Site probing and prospecting, preparation

of blueprints, and plant designs, plant engineering, selection of specific machineries and equipment.

Negotiations and contracting Negotiating and drawing up of legal contracts with respect to project financing acquisition of technology, construction of building and civil works, provision of utilities, supply of machinery and equipment, marketing arrangements, etc.

Construction Site preparation, construction of buildings and civil works, erection and installation of machinery and equipment.

Training Training of engineers, technicians , and workers.(This can proceed simultaneously along with the construction work)

Plant commissioning Start up of the plant. (This is a brief but technically crucial stage in the project development cycle.)

Translating an investment proposal into a concrete project is a complex , time –consuming, and risk-fraught task. Delays in implementation, which are common, can lead to substantial cost overruns. For expeditious implementation at a reasonable cost, the following are helpful:

1. Adequate Formulation of projects A major reason for the delay is inadequate formulation of projects. Put differently, if the necessary homework in terms of preliminary studies and comprehensive and detailed formulation of the project is not done, many surprises and shocks are likely to spring on the way. Hence , the need for adequate formulation of the project cannot be over-emphasised.

2. Use of the Principle of Responsibility Accounting Assigning specific responsibilities to project managers for completing the project with in the defined time-frame and cost limits is helpful in expeditious execution and cost control.

3. Use of Network Techniques For project planning and control two basic techniques are available - PERT (Programme Evaluation Review Technique) and CPM ( Critical Path Methods). These techniques have, of late, merged and are being referred to by a common terminology, that is network techniques. With the help of these techniques, monitoring becomes easier.

ReviewOnce the project is commissioned, the review phase has to

be set in motion. Performance review should be done periodically to compare actual performance with projected performance. A feedback device, it is useful in several ways:

(1) It throws light on how realistic were the assumptions underlying the project;

(2) It provides a documented log of experience that is highly valuable in future decision making;

(3) It suggest corrective action to be taken in the light of actual performance;

(4) It helps in uncovering judgmental biases; (5) It induces a desired caution among project sponsors.

Levels of Decision Making In addition to looking at the various phases of capital

budgeting, researches have also examined different levels of decision making. Gordon, Miller , and Mintzberg, for example, defined three levels of decision making: operating , administrative , and strategic. The key characteristics of decisions at these levels are described below:

Operating decisions

Administrative decisions

Strategic decisions

Where the decision is taken

Lower level Management

Middle level Management

Top level Management

How structured is the decision

Routine Semi-structured

Unstructured

What is the level of resource commitment

Minor resource Moderate resource

Major resource

What is the time horizon

Short-term Medium-term Long-term

The 3 levels of decision making can be readily applied to capital budgeting decision. Examples are given below:

Operating capital budgeting decision :Minor office equipment

Administrative capital budgeting decision :Balancing equipment Strategic capital budgeting decision : Diversification

project

While the methods and techniques covered in this are applicable to all levels of capital budgeting decisions, our discussion will mainly be oriented towards administrative and Strategic capital budgeting decision.

Facets of Project Analysis

The important facets of project analysis are: 1. Market analysis 2.Technical analysis 3.Financial analysis 4.Economic analysis 5.Ecological analysis

Market analysis Market analysis is concerned primarily with 2 questions:

1. what would be the aggregate demand of the proposed product/service in the future?

2. what would be the market share of the project under appraisal?

To answer the above questions, the market analyst requires a wide Varity of information & appropriate forecasting methods. The kind of information required are :

o Consumption trends in the past and present consumption level.o past and present supply position o Production possibilities and constraints

o Imports and Exportso Structure of competitiono Cost of structureo Elasticity of demando Consumer behavior, intentions, motivations, attitudes,

preferences, and requirements.o Distribution channel and marketing polices in use.o Administrative , technical and legal constraints

Technical AnalysisAnalysis of the technical and engineering aspects of a project

needs to be done continually when a project is formulated. Technical analysis seeks to determine whether the prerequisites for the successful commissioning of the project have been considered & reasonably good choices have been made with respect to location, size, process, etc. The important questions raised in technical analysis are:

1.Whether the preliminary tests & studies have been done or provided for?

2. Whether the availability of raw materials, power, & other inputs has been established?

3.Whether the selected scale of operation is optimal.4. Whether the production of process chosen is suitable.?5. Whether the equipment & machines chosen are appropriate?

6. Whether the auxiliary equipments & supplementary engineering works have been provided for?

7.Whether provision has been made for the treatment of effluents?

8. Whether the proposed layout of the site , buildings, & plant is sound?

9.Whether work schedules have been realistically drawn up?

10. Whether the technology proposed to be employed is appropriate from the social point of view?

Financial AnalysisFinancial analysis seeks to ascertain whether

the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt & whether the proposed project will satisfy the return expectations of those who provide the capital.The aspects which have to be looked into while conducting financial analysis are:

1. Investment outlay & cost of project.2. Means of financing3. Cost of capital

4. Projected profitability5.Break-even point6. Cash flows of the project7. Investment worthwhileness judged in

terms of various criteria of merit8 Projected financial position9. Level of risk

Economic AnalysisEconomic analysis also referred to as social cost

benefit analysis , is concerned with judging a project from the larger social point of view. In such an evaluation the focus is on the social costs & benefits of a project which often be different from its monetary costs & benefits. The questions sought to be answered in social cost of benefit analysis are:

1. What are the direct economic benefits & costs of the project measured in terms of shadow process and not in terms of market prices.

2. What would be the impact of the project on the distribution of income in the society?

3. What would be the impact of the project on the level of saving & investment in the society?

4. What would be the contribution of the project towards the fulfillment of certain merit wants like self-suffiency, employment & social order?

Ecological AnalysisIn recent years , environmental concerns have

assumed a great deal of significance – and rightly so. Ecological analysis should be done particularly for major projects which have significant ecological implications & environment-polluting industries.

The key questions raised in ecological analysis are:1. What is the likely damage caused by the projects

to the environment.2. What is the cost of restoration measures required

to ensure that the damage to the environment is contained within acceptable limits?

Key issues in the Project Analysis:

Market Analysis Potential Market Market share Technical Analysis Technical Viability Sensible choices

Financial Analysis Risk ReturnEconomic Analysis Benefits & costs in shadow

prices Other ImpactsEcological Analysis Environmental Damage Restoration Measures

Feasibility study:Generation of

ideas

Initial screening

Is the idea prima facie promising?

Plan feasibility analysis

Conduct financial analysis

Conduct economic and ecological

analysisIs the project worthwhile?

Prepare funding proposal

Conduct technical analysis

Conduct market analysis

Objectives of capital budgetingFinance theory rests on the premise that

managers should manage the firm’s resources with the objective of enhancing the firm’s market value.

Common Weakness capital budgeting1. Poor alignment between strategy and

capital budgeting.

2. Deficiencies in analytical techniques. a. the base case is poorly identified. b. risk is treated inadequately c. options are not properly evaluated. d. there is lack of uniformity in assumptions e. side effects are ignored.

3. no linkage between compensation and financial measures.

4.Reverse financing engineering.

5. week integration between capital budgeting and Expense budgeting.

6. inadequate post audits.

Generation of ideas1. stimulating the flow of ideas: SWOT analysis Clear articulation of objectives like cost

reduction, productivity improvement, increase in capacity utilization, improvement in contribution margin, expansion in promising field.

Fostering a conducive climate.2. Monitoring the environment: a. economic sector like state of econ0omy,

overall rate of growth, growth rate of primary secondary and tertiary sectors, cyclic fluctuations, linkage with world economy, trade surplus/deficit balance of payment situation.

b.Governmental sectors: like industrial policy, government program and projects, tax framework, subsidies, incentives and concessions, import and export policies, financing norms, lending conditions of financial institutions and commercial banks.

c. Technological sector like emergence of new technologies, access to technical know-how, foreign as well as indigenous, receptiveness on the part of industry.

D. Socio demographic sector: population trends, age shift in population, income distribution, educational profile, employment of women and attitude towards consumption and investment.

e. competition sector: number of firms in the industry and the market share of the top few, degree of homogeneity and differentiation among products, entry barrier, comparison with substitutes in terms of quality, price, appeal and functional performance and marketing policies and practices.

f. supplier sector: availability and cost of raw material and sub assemblies, availability and cost of energy and availability of cost of money.

Scouting for project ideasGood ideas are key to the success of a project.

However they are elusive. So a wide variety of sources should be tapped to identify them.

Analyze the performance of the existing industry.Examine the input and outputs of various

industries.Review imports and exports.Study plan outlay and governmental guidelines.Look at the suggestions of financial institutions

and development agencies.Investigate local materials and resources.

Analyze economic and social trends.Study new technological developments.Explore the possibilities of reviewing sick

units.Identify unfulfilled psychological needs.Attend trade fairs.Hope that chance factor will favor you.

Primiliminary screening

Compatibility with the promoterConsistency with governmental priorities.Availability of inputs.Adequacy of market.Reasonableness cost.Acceptability of risk level.

Technical analysis Manufacturing process/technology: choice of technology

and appropriateness of technology. Technical arrangements Materials and inputs. Product mix Plant capacity. Location and site. Machineries and equipments. Structure and civil works. Environmental aspects. Project charts and layout. Project implementation schedule. Need for considering alternatives.

Cost of Capital It is the total of all items of outlay associated with

a project which are supported by long-term funds. It is the sum of the following:

Land and site development.Building and civil works.Plant and machinery.Technical know-how and engineering fees.Expenses on foreign technicians and training of

Indian technicians abroad.Miscellaneous fixed assets.Preliminary and capital issue expenses.Pre-operative expenses.Margin money for working capital. Initial cash losses.

Means of FinanceShare Capital: Equity capital-contribution of owners of

business and equity shareholders who enjoy the rewards and bear the risk of ownership. This no fixed rate of dividend.

Preference capital- contribution made by preference shareholders and the dividend paid is generally fixed.

Term Loans: These are provided by the financial institutions

and commercial banks, these are important source and sometimes major source of financing a new project. These loans are provided for new projects as well as for expansion, modernization and renovation schemes.

There are two types of terms loans in India 1. rupee terms loan given for land, building, plant and machinery and 2. foreign currency term loan given for foreign currency expenditure towards import of equipments and technical; Know-how.

Debenture Capital:These are investments for raising debt capital.

There are two types of debentures. 1. non convertible debentures-they carry fixed rate of interest and have maturity period of 5 to 9 years. 2. convertible debentures- these are wholly are partly covetable into equity shares. The conversion period and price are announced in advance.

Deferred credit:Many suppliers of the plant and machinery offer

a deferred credit facility under which payment for the purchase of the plant and machinery can be made over a period of time.

Incentive sources: the government and its agencies may provide

financial support as an incentive to certain type of promoters for setting up industrial units in certain locations like capital subsidy or tax exemption for a certain period.

Miscellaneous sources:A small portion of the project finance can come

from miscellaneous sources like unsecured loans, public deposits and leasing and hire purchase finance.