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Transcript of PM Module 2
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Project Management & Quality Assurance
Lecture 1
1) Synopsis: Market Analysis
2) Target: At the completion of the lecture you should be able to answer questions likea) What are the steps in project analysis?
b) How would you evaluate secondary information?
3) Introduction
We will proceed towards the exposition of the item mentioned in the
synopsis. We will emphasize the following:
Steps in Market Analysis
a) Situational analysis and specification of objectives
b) Collection of secondary information
c) Conduct of market survey
4) Revision
Please refer to pages 66-74 of the textbook Projects Planning, Analysis,
Financing, Implementation and Review (5th edition) Prasanna Chandra.
5.1) Introduction
Project analysis consists of a number of steps:
1) Market analysis
2) Technical analysis
3) Financial analysis
4) Economical analysis
5) Ecological analysis
Market analysis is done to find the size of the market for the product and the demand for
the project. Market analysis consists of steps like
a) Situational analysis and specification of objectives
b) Collection of secondary information
c) Conduct of market survey
d) Characterization of the market
e) Demand forecasting
f) Market planning
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5.2)Situational analysis and specification of objectives
In order to get a feel of the relationship between the product and the market, the
project analyst may informally talk to customers, competitors, middlemen and others in the
industry. Wherever possible, he may look at the experience of the company to study the
preferences and the purchasing power of the customers, actions and strategies of competitors.
After that a formal study of the market and demand has to be conducted. To carry out such a
study, it is necessary to spell out its objectives clearly and comprehensively. A helpful
approach to spell out objectives is to structure them in the form of questions. I.e. The
objectives of the market and demand analysis may be to answer questions like:
What is the demand of the item in the industry?
What price will the customers be willing to pay for the item?
What price and warranty will ensure its acceptance?
5.3) Collection of secondary information
Secondary information provides the base and starting point for the market and demand
analysis. The sources of secondary information are:-
1) Census of India A decennial publication of the Government of India. It provides
information on population, demographic characteristics, household size and composition, and
maps.
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Collection of
secondaryinformation
Situationalanalysis and
specification of
objectives
Characterization
of the market
Conduct of
marketsurvey
Demand
forecasting
Market
planning
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2) Nation Sample Survey Reports - Issued by the Cabinet Secretariat, Government of India.
It includes information like patterns of consumption, distribution of households,
distribution of industries and characteristics of economically active population.
3) Plan reports - Issued by the Planning Commission usually at the beginning, middle and
end of 5 year plans. It provides information on plan proposals, physical and financial targets,
actual outlays etc.
4) Statistical Abstract of the Indian Union - Publication of the Central statistical
organization. It provides information on demographic information, estimates of national
income and agricultural and industrial statistics
5) India year book - Publication of ministry of information and broad casting. It provides a
wide range of information on economic and other aspects.
6) Statistical Year Book - Publication of United Nations. It provides world statistics relating
to various aspects like population, demography, gross domestic publication, industrial
production, international trade etc.
7) Economic Survey An annual publication of the Ministry of Finance. It provides the latest
data on industrial production, wholesale prices, consumer prices, exports, agricultural
production, national income etc.
8) Guidelines to industries - Publication of Ministry of Industrial development.
9) Annual Survey of Industries - Publication of Central Statistical Organization. It contains
information on various aspects of industry : number of units and state wise distribution,
employment, quantity of products etc.
10) Annual bulletin of statistics of exports & imports - Publication of the Ministry of
commerce. It provides data on imports and exports for a very large number of items.
11) Stock Exchange Directory - Published by Bombay Stock Exchange. It provides a ten-
year picture of performance for all listed companies and other important companies.
12) Monthly studies of production of selected industries Monthly publication of Central
Statistical Organization. It provides all-India data on production, number of units installed,
capacity, state wise break up etc. for selected industries.
The secondary information gathered are then evaluated for its reliability, accuracy and
relevance for the purpose under consideration. The market analyst should seek to know the
following:
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Steps in Sample Survey are:-
1) Define target population
Population is divided into various segments based on income range.
2) Select the sampling scheme and sampling size
Sample is a portion of the population. There are several sampling schemes
like simple sampling, random sampling, cluster sampling, sequential sampling etc. Larger the
sample size, greater the reliability of the estimates.
3) Develop the questionnaire
Questionnaire is the best method for getting information. Developing the
questionnaire requires a thorough understanding of the product and its usage. The result of
the market survey depends on the quality of the survey.
4) Recruit and train field investigators
Field investigators should be recruited and training should be given to them.
They need to have knowledge of the product and its technical background.
5) Collect information from questionnaire
Customers can be interviewed personally, telephonically. Personal interviews
ensure a high rate of response, but they are expensive. Mail surveys are economical but have
less response. Telephonic interviews are common in western countries only.
6) Scrutinize the information gathered Information gathered should be thoroughly
scrutinized to eliminate data which is internally consistent and which is of dubious validity.
7) Analyze and interpret the information - Results of the data based on the sample survey
will have to be extrapolated to the target population. For this we take the ratio of the size of
target population to the size of the sample.
Market survey can fail due to the following reasons:-
1) Inadequacies in the questions
2) Failure of the respondents to comprehend the questions
3) Inept handling of the interviews by the investigators
4) Deliberate distortions in the answers given by the respondents
5) Non-representativeness of the sample
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6. Summary
Today we have seen the steps in project analysis. We discussed the
stages of market analysis. We studied in detail the situational analysis and specification
of objectives, collection of secondary information etc.
7. Exercise Questions
1. List the important industry-specific sources of secondary information in India.
2. Discuss the key steps in a sample survey.
Lecture 2
1) Synopsis: Market Analysis (continued)
2) Target: At the completion of the lecture you should be able to answer questions like
a) What are the different methods for demand forecasting?
b) What steps are involved in Delphi method?
3) Introduction
We will proceed towards the exposition of the item mentioned in thesynopsis. We will emphasize the following:
Steps in Market Analysis
a) Characterization of the market
b) Demand forecasting
c) Market planning
4) Revision
Please refer to pages 75-97 of the textbook Projects Planning, Analysis,
Financing, Implementation and Review (5th edition) Prasanna Chandra.
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5.1) Characterization of the market Based on the information gathered from secondary
sources and through the market survey, the market for the product/service may be described
in terms of the following:
Effective Demand in the Past and Present Breakdown of demand
Price
Methods of distribution and sales promotion
Consumers
Supply and competition
Government policy
Effective Demand in the past and present To gauge the effective demand in the past and
present, apparent consumption has to be calculated. Apparent consumption is defined as:
Production + Imports Exports Changes in stock level
The apparent consumption has to be adjusted for consumption of the product by the
producers and the effect of abnormal factors.
Breakdown of Demand To get a deeper insight into the nature of demand, the aggregate
market demand may be broken down into demand for different segments of the market.
Market segments may be defined by i) nature of product ii) consumer group iii) geographical
division.
Price Price statistics must be gathered along with statistics pertaining to physical quantities.
It may be helpful to distinguish the following types of prices: i) manufacturers price quoted
as FOB (free on board) price or CIF (cost, insurance and freight) price, ii) landed price for
imported goods, iii) average wholesale price and iv) average retail price.
Methods of Distribution and Sales Promotion The method of distribution may vary with
nature of product. Capital goods, industrial raw materials or intermediates, and consumer
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Advantages
It is an expeditious method for developing a demand forecast.
It permits a variety of factors like economic climate, consumer preferences etc.
Disadvantages
The biases underlying subjective estimates cannot be unearthed easily.
The reliability of this technique is questionable.
1.b) Delphi method The steps involved in this method are :
1. A group of experts is sent a questionnaire by mail and asked to express their
views.
2. The responses received from the experts are summarized without disclosing the
identity of the experts and sent back to the experts along with a questionnaire to
probe further the reasons for the extreme views expressed in the first round.
3. The process may be continued for one or more rounds till a reasonable agreement
emerges in the view of the experts.
Advantages
It is intelligible to users.
It is more accurate and less expensive.
2. Time series projection method These methods generate forecasts on the basis of an
analysis of the historical time series. The important time series projection methods are:
2.a) Trend projection method It involves determining the trend of consumption by
analyzing the past consumption statistics and projecting future consumption by extrapolating
the trend.
In this method, a linear relationship is used
Yt = a + bT where
Yt = demandfor year t
T = time variable
a = intercept of the relationship
b = slope of the relationship
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To estimate the parameters a and b of the linear relationship, the least squares method is
used. According to the least squares method, linear relationship is chosen in such a manner
that the sum of squared deviations of the observations from the line is minimized
Sum of squared deviations = (Y-a-bT)2
Tominimize this with respect to a & b, partial derivative of this sum with respect to a & b are
set equal to zero
i.e., / a (y-a-bT)2 = -2 (y-a-bT) = 0 ----------------- (1)
/ b (y-a-bT)2 = -2T (y-a-bT) = 0 ---------------- (2)
considering (1) (y-a-bT) = 0
Y = (a+bT)--------------------------------------(3)
considering (2) TY- aT- bT2=0
TY= (aT-bT2)------------------------------------(4)
Solving (3) & (4) we get the value of a & b
Dividing (3) by n we get
Y/n = a/n- bT/n
y = na/n+bT , a = y-bT
b = ( TY-nT y )/( T2-nT
2)
where T=timeY=demand
N=no of observations
T=mean of T
y =mean of Y
a=intercept
b=slope.
We can use other relationships like1) Exponential relationship
Yt=aebt
2) Polynomial relationship Yt = a0+a1t.antn
2.b) Exponential smoothing method -
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Ft+1=Ft+ et where Ft = forecast for year t
Ft+1 = forecast for year t+1
= smoothing parameter lies between 0 & 1
et = error in the forecast for year t.(St-ft) where St is the actual
value for year t.
2.c) Moving average method - According to this method, forecast for the next period is equal
to the average of the sales for several preceding periods.
Ft+1=(St+St-1+St-n-1)/n
where F t+1 = forecast for the next period.
S t = sales for the current period.
n = period over which averaging is done.
Weighted moving average method - It is likely that the sales for the recent years give a clear
picture of the trend than that in the past .So a weight is assigned to the sales in all the years.
3.) Causal Methods This method develop forecasts on the basis of cause-effect
relationships specified in an explicit, quantitative manner.
3.1 Chain ratio method The chain ratio method uses a simple analytical approach to
demand estimation. Given below is an example of chain ratio method to estimate the
potential sales of stainless steel blades in India.
Adult male population in the country=150 million.
Proportion of adult male population using shaving blades=60%
Adult male population using shaving blades=150*60/100=90 million
No of times in a year a person who uses shaving blades=100
Total shavings done per year = 9000 million.
Proportion of shavings done with stainless steel blades = 40%
Average no of shavings per stainless steel blade = 6No of stainless steel blades used per year = 600 million
Proportion of the stainless steel blade market the firm could capture = 20%
Potential Sales = 600*20/100 =120 million
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3.2 Consumption level method This method estimates consumption level, on the basis of
elasticity coefficients.
Income elasticity of demand:- Reflects the responsiveness of demand to variations in income.
It is measured as
E1=Q2-Q1/I2-I1 * I1+I2/Q2+Q1
where E1=income elasticity of demand
Q1=quantity demanded in the base year.
Q2=quantity demanded in the following year
I1=Income level in the base year
I2=Income level in the following year.
3.3 Price elasticity of demand - This measures the responsiveness of demand to variations in
price. It is defined as
Ep= Q2-Q1/P2-P1 * P1+P2/Q2+Q1 where
Ep=price elasticity of demand.
Q1=quantity demanded in the base year.
Q2=quantity demanded in the following year.
P1=price per unit in the base year.
P2=price per unit in the following year.
3.4 End Use Method It is also known as consumption coefficient method. It involves the
following steps:
1. Identify the possible uses of the product.
2. Define the consumption coefficient of the product for various uses.
3. Project the output levels for the consuming industries.
4. Derive the demand for the product.The key inputs required for the application of the end use method are: i) projected output
levels of consuming industries ii) consumption coefficients.
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3.5 Leading Indicator Method Leading indicators are variables which change ahead of
other variables, the lagging variables. Hence observed changes in leading indicators may
be used to predict the changes in lagging variables. Steps involved in this method are:
i) Identify the leading indicators.ii) Establish the relationship between the leading indicator(s) and the variable to
forecast.
3.6 Econometric Method Steps involved are:
1. Specification This refers to the expression of an economic relationship
in a mathematical form.
2. Estimation This involves the determination of the parameter values and
other statistics by a suitable method such as the least squares method.3. Verification This step is concerned with accepting or rejecting the
specification as a reasonable approximation to the truth on the basis of the results
of estimation.
4. Prediction This involves projection of the value of the explained
variable(s).
Advantages
1. Sharpens the understanding of complex cause-effect relationships.
2. Provides a basis for testing assumptions and for judging how sensitive the results
are to changes in assumptions.
5.3) Uncertainties in demand forecasting Demand forecasts are subject to error and
uncertainty which arise from three principal sources:
Data about past and present market
Methods of forecasting
Environmental change
5.4) Market Planning A market planning usually has the following components:
1) Current marketing situation
2) Opportunity and issue analysis
3) Objectives
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4) Marketing strategy
5) Action programme
1. Current marketing situation This part of the marketing plan deals with the different
dimensions of the current situation. It examines the market situation, competitive
situation, distribution situation and the macro-environment.
a. Market situation This deals with size, the growth, the consumer aspirations and
buying behavior in the market under consideration.
b. Competitive situation This dwells on the major competitors, their objectives,
strategies, strengths etc.
c. Distribution situation This compares the distribution capabilities of the competitors.
d. Macro environment This describes the effect of social, political, economic,
technological and other external variables on the market.
2. Opportunity and issue analysis In this section a SWOT (Strength, Weakness,
Opportunity, Threat analysis) is conducted and the core issues before the product are
identified.
3. Objectives Objectives have to be clear-cut, specific and achievable.
4. Marketing Strategy The marketing strategy covers the following: target positioning,
product line, price, distribution, sales force, sales promotion and advertising.
5. Action programme Action programmes operationalize the strategy.
6. Summary
With this we got an idea about the different methods for demand forecasting. We
discussed the pros and cons of each method. Thus we got a clear picture of market
analysis.
7. Exercise Questions
1. What are the different kinds of relationship commonly used in the trend projection
method?
2. What are the steps involved in the end use method?
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Lecture 3
1) Synopsis: Technical Analysis
2) Target: At the completion of the lecture you should be able to answer questions like
a) What aspects are considered in technical analysis?
b) What factors have a bearing on the choice of technology?
3) Introduction
We will proceed towards the exposition of the item mentioned in the
synopsis. We will emphasize the following:
a) Manufacturing process/technology
b) Technical arrangements
c) Material and inputs
d) Product mix
e) Plant capacity
f) Location and site
g) Machineries and equipments
h) Structures and civil works
i) Environmental aspects
j) Project charts and layouts4) Revision
Please refer to pages 98-113 of the textbook Projects Planning, Analysis,
Financing, Implementation and Review (5th edition) Prasanna Chandra.
5.1)Technical analysis - The purpose of technical analysis is to ensure that the project
is technically feasible. It deals with the following aspects: Manufacturing
process/technology, Technical arrangements, Material and inputs, Product mix, Plant
capacity, Location and site, Machineries and equipments, Structures and civil works,Environmental aspects, Project charts and layouts, Project implementation schedule,
Need for considering alternatives.
a) Manufacturing process/technology
There can be 2 or more alternative technologies for manufacturing a product.
E.g.:- Steel can be manufactured by Bessemer process or open hearth process. Cement
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can be made either by the dry process or wet process. Soap can be manufactured by the
semi boiled process or the fully boiled process.
The appropriate technology can be chosen by considering factors like
1) Plant capacity - Plant should have the capacity to accept the new technology.
2) Principal inputs - Inputs for the process must be available.
3) Production cost - Cost of the technology should be feasible.
4) Use by other units The technology adopted must be proven successful by other units.
5) Product mix The technology chosen must be judged in terms of the total product mix
and saleable by-products generated by it.
6) Latest development - The technology adopted must be based on latest development.
7) Ease of absorption - Sometimes a high level technology may be beyond the absorptive
capacity of a developing country. Country may lack trained personnel to handle that
technology.
b)Technical arrangements - Satisfactory arrangements must be made to obtain the
technical know-how needed for the proposed manufacturing process.
The following aspects have to be worked out
a) Nature of support to be provided by the collaborators during the phases of project
development.
b) Process and performance guarantees in terms of plant capacity, product quality etc.
c) Price of technology in terms of one-time licensing fee and periodic royalty fee.
d) Period of collaboration agreement.
e) Restrictions to be imposed by the collaborator with respect to exports.
f) Termination of the agreement when either party fails to meet its obligation.
c) Material inputs and utilities This can be classified into four broad categories:
i) Raw materials
ii) Processed industrial materials and components
iii) Auxiliary materials and factory supplies
iv) Utilities
Raw materials It may be classified into four types: i) Agricultural Products ii) Mineral
Products iii) Livestock and Forest Products iv) Marine Products.
d) Product mix - There can be wide range of items manufactured by a particular
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company. Some products can be manufactured in varying size, smell etc. This helps to
increase the market .
e) Plant capacity - Theplant capacity depends on factors like
1) Technological requirement
2) Input constraints
3) Investment cost
4) Market conditions
5) Resources of the firm
6) Governmental policy
f) Location and site - Thechoice of location and site follows an assessment of demand,
size and input requirement. Location refers to the broad area like city and site refers to
the specific piece of land.
g) Machineries and equipment - To select machinery the steps to be followed are
1) Estimate the likely level of production
2) Define the machining operations
3) Calculate the machine hours
4) Select machineries and equipment
The equipments can be classified in to
a) Plant equipment
b) Mechanical equipment
c) Electrical equipment
d) Instruments
e) Controls
f) Internal transportation system
h) Structures and civil works Thiscan be classified into
a) Site preparation and development
b) Buildings and structures
c) Outdoor works
i) Environmental aspects
Project has to consider
a) Types of effluents and emissions generated
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b) Proper disposal of effluents and emissions.
c) Statutory requirements
j) Project charts and layouts
1) General functional layout
2) Material flow diagram
3) Production line diagram
4) Transport layout
5)Utility consumption layout etc
6. Summary
With this we got an idea about the different aspects considered in technical analysis. We
have seen that 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 etc.
7. Exercise Questions
1. How would you evaluate the appropriateness of a technology?
2. What factors have a bearing on the plant capacity?
Lecture 4
1) Synopsis: Financial Analysis
2) Target: At the completion of the lecture you should be able to answer questions like
a) What are the components of cost of project?
b) What are the different techniques used for financial analysis?
3) Introduction
We will proceed towards the exposition of the item mentioned in the
synopsis. We will emphasize the following:
a) Introduction to Financial Analysis
b) Cost of Project
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c) Means of finance
d) Financial Evaluation Techniques
4) Revision
Please refer to pages 116-140 of the textbook Projects Planning, Analysis,
Financing, Implementation and Review (5th edition) Prasanna Chandra.
5.1)Introduction to Financial Analysis - To judge a project from financial angle, we
need information about the following: (i) cost of project (ii) means of financing (iii)
estimates of sales and production (iv) Cost of Production (v) working capital requirement
and its financing (vi) Estimates of Working results (vii) break-even point (viii) projected
cash flow statements and (ix) projected balance sheets.
Cost of Project Cost of Project represents the total of all items of outlay associated
with a project which are supported by long-term funds. It is the sum of the outlays on the
following:
Land and site development
Buildings 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 finance To meet the cost of project the following means of finance are
available:
1. Share capital There are two types of share capital equity capital and
preference capital. Equity capital represents the contribution made by the owners
of the business, the equity shareholders. Equity capital does not carry fixed rate of
dividend. Preference capital represents the contribution made by preference
shareholders and the dividend paid on it is generally fixed.
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2. Term Loans Term loans represent secured borrowings which are a very
important source for financing new projects as well as for the expansion,
modernization and renovation schemes of existing firms. There are two broad
types of term loans available in India: rupee term loans, given for financing land,
building, civil works etc. and foreign currency term loans, provided for meeting
the foreign currency expenditures towards the import of equipment and technical
know-how.
3. Debenture Capital Debentures are instruments for raising debt capital. There are
two broad types of debentures: non-convertible debentures and convertible
debentures. Non-convertible debentures carry a fixed rate of interest and have a
maturity period of 5 to 9 years. Convertible debentures are convertible, wholly or
partly, into equity shares.
4. Deferred Credit Many a time the suppliers of the plant and machinery offer a
deferred credit facility under which payment for the purchase of plant and
machinery can be made over a period of time.
5. Incentive Sources The government and its agencies may provide financial
support as an incentive to certain types of promoters or for setting up industrial
units in certain locations. These incentives may take the form of seed capital
assistance or capital subsidy or tax deferment or exemption for a certain period.
6. Miscellaneous Sources A small portion of the project finance may come from
miscellaneous sources like unsecured loans, public deposits and leasing and hire
purchase finance.
7. Lease Financing - Lease is a contract where by the lessor (the owner of an asset)
gives to the lessee (user of the asset) the right to use the asset for an agreed period
of time. In return the lessee has to pay the lease rentals.
5.2) Financial Evaluation Techniques
Financial evaluation techniques are broadly classified into two types: Non-discounted
cash flow techniques and discounted cash flow techniques. Non-discounted cash flow
techniques are further divided into Payback period (PB) method and Accounting rate of
return (ARR) method. Discounted cash flow techniques are divided into Net Present
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Value (NPV) method, Profitability Index (PI) method, Internal Rate of Return (IRR)
method and Benefit Cost Ratio (BCR) method.
Payback period Method Payback period is defined as the length of time required to
recover the original investment on the project through cash flows earned. The cash inflow
includes operating profit, less income tax payable plus depreciation.
Find the payback period of the project with the following details
Investment -14,00,000
Years to implement-2
Expected profit from third year onwards
Year 3 4 5 6 7
Profit 1,50,000 1,75,000 2,00,000 2,25,000 2,00,000
Tax 50,000 60,000 68,000 75,000 68,000
Depreciation 3, 30,000 2, 21,000 1, 48,000 99,000 67,000
Solution:
Year Profit tax + depreciation Cumulative cash flow
3
45
6
7
430000
336000280000
249000
199000
4,30,000
7,66,00010,46,000
12,95,000
14,94,000
Cumulative profit(4 years after implementation) = Rs 12, 95, 000
Cumulative profit
(5 years after implementation) = Rs 14, 94, 000
Difference =1, 99, 000
Pay back period = 4 + 12*(14, 00,000-12, 95,000)
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1, 99,000
= 4 years + 6.33 months
NPV method
Net present value of cash flow = (Present value of all future cash in flows over the life of
the project) (Present value of cash out flow). The present value of future cash
inflows is arrived at by discountingthe future cash inflows at an interest rate equalto the cost of capital.
E.g. compare projects A and B using the given data. Use NPV method of evaluation.
Project-A
Investment on the project :Rs 10,00,000/-
Life of the project :5 years
Period of implementation :1year
Cost of capital :15%
Project-B
Investment on the project :Rs 10,00,000/-
Life of the project :5 years
Period of implementation :1year
Cost of capital :13%
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Year 1 2 3 4 5
Cash inflow 2,00,000 3,00,000 4,00,000 3,00,000 1,00,000
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Solution:
Project A
Present value of future cash inflows is given by
=CF1 + CF2 + CF3 + CF4 + CF5
(1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)5
=2,00,000 + 3,00,000 + 4,00,000 + 3,00,000 + 1,00,000
(1+.15)1 (1+.15)2 (1+.15)3 (1+.15)4 (1+.15)5
=1,73,913+2,26,843+2,63,002,1,71527+49,717
=8,85,002
NPV=8,85002-10,00,000
= -1,14,998
The net present value is negative, so the project should not be taken up.
Project B
Present value of future cash inflows is given by
=CF1 + CF2 + CF3 + CF4 + CF5
(1+r)1 (1+r)2 (1+r)3 (1+r)4 (1+r)5
=3,00,000 + 4,00,000 + 4,00,000 + 3,00,000 + 2,00,000(1+.13)1 (1+.13)2 (1+.13)3 (1+.13)4 (1+.13)5
=2,65487+313259+277219+183993+108548
=1148506
NPV=1148506-10,00,000
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Year 1 2 3 4 5
Cash inflow 3,00,000 4,00,000 4,00,000 3,00,000 2,00,000
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=1,48,506/-
since net present value is positive, project can be taken up.
Profitability Index method
If there are two projects that require the same amount of investment, the project with a
higher net present value can be chosen. If the two projects have different investment
outlays, comparing the net present value of the projects will not give a correct picture
since net present value only indicates the excess of present values of cash inflows over
cash outflow in absolute terms.
E.g. Compare 2 projects using the Profitability Index using the following data
Project A Project BPresent value of investment 5,00,000 11,00,000
Present value of cash inflows 6,00,000 12,50,000
Net present value 1,00,000 1,50,000
If NPV is compared, project B is better.
But since investment is different we take P.I for comparison
Profitability Index (PI) = (Present value of cash inflows) (Present value of cash
outflows)
P.I for project A = 6,00,000 5,00,000
= 1.200
P.I for project B = 12,50,000 11,00,000
=1.136
Since PI of project A is more than project B, project A is better than project B.
6. Summary
With this we got an idea about the different means of financing a project. We alsodiscussed the different techniques used in financial analysis.
7. Exercise Questions
1. Describe briefly the various means of financing a project.
2. Explain NPV method of financial analysis.
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Lecture 5
1) Synopsis: Risk Analysis
2) Target: At the completion of the lecture you should be able to answer questions like
a) What are the different methods for risk analysis?
b) What are the sources of risk?
3) Introduction
We will proceed towards the exposition of the item mentioned in the
synopsis. We will emphasize the following:
a) Sensitivity analysis
b) Breakeven analysis
c) Decision tree analysis
d) Simulation analysis
4) Revision
Please refer to pages 284-329 of the textbook Projects Planning, Analysis,
Financing, Implementation and Review (5th edition) Prasanna Chandra.
5.1) Introduction to Risk analysis
5.2) Sensitivity analysis
If a small change in one factor leads to a major change in the profitability of the proposed
investment, the project is said to be more sensitive to that factor .The technique used to
measure this is known as sensitivity analysis.
E.g.:- What happens to NPV if the demand of the project drops down.
What happens to the NPV if the economic life of the project reduces?
5.3) Breakeven analysis
Break even point refers to the level of operation at which the project neither earns profit
nor incur loss. It indicates the minimum capacity utilization the firm should aim inorder
to have a no-gain no-loss situation.
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BEP = fixed cost (Selling price/unit -Variable cost/unit)
Fixed cost - Costs that are fixed in nature are fixed cost. They remain constant
irrespective of the changes in the volume of output.
E.g.:-Rent payable for land
Rent payable for factory
Insurance premium
Interest payable on long term borrowing
Administrative expenses
Annual maintenance chargesDepreciation
Property tax
Variable cost - Cost that vary directly with the level of output.
Eg:-1) Consumable stores
2) Power, fuel, water charges
3) Advertisement expenses.
E.g.:- Estimates for the third year of production of ABC private Ltd with production
capacity of 400000 units/annum of umbrellas are given below.
Cost of raw materials -1,62,00,000.
Cost of consumables -40,00,000.
Salary for permanent staff 60,00,000.Wages for casual workers 8,00,000.
Repair and maintenance charges -6,00,000.
Interest payment -42,00,000.
Selling expenses -10,00,000.
Rent, Insurance etc. -4,00,000.
Power, fuel, water etc -20,00,000.Depreciation -32,00,000
Work outa) Sales realization.
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b) Contribution
c) variable cost/unit.
d) Break-even point in terms of volume of production.
Solution
Fixed cost
60,00,000.+8,00,000+6,00,000+42,00,000+10,00,000+4,00,000+32,00,000=20200000
Variable cost
1,62,00,000+20,00,000=18200000
Sales realization = total cost +fixed cost = 38400000
Selling price/unit=38400000/400000= Rs 96/-
Variable price/unit=18200000/400000=Rs 45.5/-
Contribution=Selling price/unit-variable cost/unit = 96-45.5= Rs 50.5/-
BEP in terms of volume = fixed cost/(contribution) = 20200000/50.5 = 400000 units .
5.4) Decision tree analysis
It isa graphical technique used to analyze the pros and cons of alternative decisions and
choosing the best possible course of action .A decision tree is made of nodes and
branches. Nodes are of two types
1) Decision nodes (decision point) represented by
2) Chance node (chance point)
Different alternatives available for the given situation emerge from the decision point. At
each chance point this different possible outcomes of one decisions are marked.
Alternative 1 chance point
Alternative 2 chance point
E.g.:-A chief executive of a company wants to introduce a new product
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Decision
Point
1
2
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There are two alternatives for him.
1) Importing the product from abroad-net benefit is 500,000
2) Setting up a new plant for the manufacture net benefit is 6,00,000
Draw the decision tree.
Net benefit=5,00,000
import
manufacture Net benefit=6,00,000
5.5) Simulation analysis
Monte Carlo simulation - Steps
1) From the given probability of events, establish cumulative probability
2) Assign tag numbers to the events
3) Obtain random numbers from random number table
4) Correlate random numbers with the tag numbers
E.g.:-
Demand per
day
25 33 42 51
Probability 0.15 0.25 0.45 0.15
Solution
Demand probability Cumulative
probability
Tag no
25 0.15 0.15 0-14
33 0.25 0.40 15-39
42 0.45 0.85 40-84
51 0.15 1.00 85-99
Let the random numbers and the simulated demand/day be
Trial no Random no Simulated
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Decision
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1
2
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demand/day
1 40 42
2 92 51
3 47 42
4 01 25
5 60 426 05 25
7 69 42
8 79 42
9 09 25
10 66 42
11 77 42
12 69 42
13 45 42
14 18 33
15 93 51
6. Summary
Today we have seen the need for risk analysis. We discussed about the sources of risk.
We have seen the different methods used for risk analysis.
7. Exercise Questions
1. Discuss the steps involved in sensitivity analysis.
2. Discuss the procedure for simulation analysis.
Lecture 6
1) Synopsis: Social Cost Benefit Analysis
2) Target: At the completion of the lecture you should be able to answer questions like
a) What are the objectives of SCBA?
b) What are the two approaches of SCBA?
3) Introduction
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We will proceed towards the exposition of the item mentioned in the
synopsis. We will emphasize the following:
a) Objectives of SCBA
b) UNIDO approach
c) Little-Mirrless approach
4) Revision
Please refer to pages 403-425 of the textbook Projects Planning, Analysis,
Financing, Implementation and Review (5th edition) Prasanna Chandra.
5.1) Introduction to Social Cost benefit analysis
The main objective of company is to earn maximum profit from the investment. So
project promoters are solely interested in wealth maximization. There are some projects
which are undertaken due to their social implications. Such projects are public projects
like road, railway, bridge, irrigation projects etc. Analysis of such projects is known as
socio economic cost benefit analysis. (SCBA)
5.2) Objectives of SCBA
Contribution of the project to the GDP of the economy
Contribution of the project to improve the benefits of the poorer sections of the
society.
Justification of the use of scarce resources of the company.
There are 2 approaches to SCBA
1) UNIDO approach
2) Little-Mirrless approach
5.3) UNIDO approach
Stages1) Arriving at the financial profitability of the project based on the market prices
2) Using shadow prices for the resources to arrive at the net benefit of the project at
economic process
3) Adjustment of the net benefit for the projects impact on savings and investment
4) Adjustment of the net benefit for the projects impact on income distribution
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5) Adjustment of the net benefit for the goods produced whose social values differ from
their economic values
Shadow prices - For SCBA market prices of both inputs and outputs of a project are
required to be corrected if they do not represent the real prices of inputs/outputs.
E.g.:-The newly setup small scale industries are given subsidy on electricity charges
by State Electricity Board (SEB). SEB produces electricity at the rate of 2.50/unit
The company may be charged as follows:
Year rate/unit
1 1.50
2 1.75
3 2.00Here the price of electricity to be taken for SCBA is 2.5/unit which is the actual price
(shadow price).
Numeraire - The unit of account used in UNIDO. It is the domestic rupee.
Tradeability of goods/services - A tradeable good is that one which can be traded
without restrictions. Shadow price for traded goods is border price or international price.
A non tradeable good is that which cant be traded due to the trade policies of the
country. A non tradeable good can become tradeable only if the domestic cost of it
becomes cheaper as compared to international price. A good is non tradeable if its import
price (CIF price) is greater than domestic cost of production and its export price (FOB) is
less than domestic cost of production.
Externalities - Certain effects of the project do not impose a cost or do not confer a
benefit within the domain of the project. But if these effects have a bearing on the
achievement of countries objectives, they need to be considered for economic
analysis. They are known as externalities. For calculating the NPV consumption rate
of interest, (CRI) is used as the discount rate in UNIDO. CRI = [parameter of utility
function*growth rate of per capita consumption] + rate of pure time preference.
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Shadow wage rate - When labor is used in one project, its use in the best alternative
project is ruled out. The formula suggested by UNIDO to arrive at the shadow wage
rate (SWR) is Shadow Wage Rate = Labors forgone marginal product at accounting
prices + Net social cost of increased consumption + Social cost of reduced leisure.
5.4) Little mirrless approach
Numeraire Measured in terms of convertible foreign exchange.
L-M shadow price - Measures costs and benefits in terms of international price (border
price)
L-M Standard Wage Rate (SWR)
SWR = C-1/s[c-m]
C = Additional resources devoted to consumption
1/s = Social value of unit of consumption
c = consumption of wage earner
m = marginal productivity of wage earner
UNIDO versus L-M
6. Summary
Today we have seen what is SCBA. We discussed the objectives of SCBA. We have seen
in detail the two approaches of SCBA i.e. UNIDO approach and L-M approach.
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UNIDO L-M
Measures cost and benefit in terms ofconsumption
Measures costs and benefit in termsof uncommitted social income
Measures shadow price in terms ofdomestic price
Measures shadow price in terms ofborder price
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7. Exercise Questions
1. What do you mean by shadow wage rate?
2. Discuss the UNIDO approach for SCBA.