MERCHANT BANKING
PROJECT APPRAISAL
ABSTRACT
In the current scenario "Projects" is the new buzz word. A Project can be defined as an action plan, directed at achieving specific objectives within a stipulated period of time. A project can be long term or short term. Examples of projects are: Project to develop infrastructure facilities, preparation of a marketing plan or a research project. In this project work, we have tried to understand the various aspects related to Project. We have studied about what the term "Project" essentially means, different types of Projects, Project Life Cycle, Project Appraisal and Evaluation process.
OBJECTIVE OF STUDY
The main objective behind the preparation of this project is to study in detail the various aspects of a Project namely the Project Life Cycle, different types of Projects, Project Evaluation process and the analysis done while evaluating/appraising the project.
METHODOLOGY
In the preparation of this project report, we have extensively used the information collected from secondary sources. We relied heavily on the information available on web sources, newspapers articles available online and books.
PROJECTS: AN INTRODUCTION
"United Nations Industrial Development Organization (UNIDO) defines a project as a proposal for an investment to crate and or develop certain facilities in order to increase the production of goods/services in a community certain period of time."
A Project can be defined as an action plan, directed at achieving specific objectives within a stipulated period of time. A project can be long term or short term. Examples of projects are: Project to develop infrastructure facilities, preparation of a marketing plan or a research project.
CHARACTERISTICS OF A PROJECT
A Project has specific start and termination points.
A Project is spread over many functional departments like finance, marketing, engineering and Human Resources etc.
A Project has a pre determined cost structure
A Project has well defined and specific objectives.
Each and every Project is unique in itself.
TYPES OF PROJECTS
Different types of Projects are as follows:
Civil Engineering/Infrastructure/Mining Projects: These are one of the most common and popular types of projects. These projects require massive capital expenditure and are quite complex as far as execution is concerned. These projects are usually undertaken by a consortium of companies or a joint venture company established especially for this purpose.
Manufacturing Projects: Manufacturing projects are generally undertaken for the production of specific mechanical or electrical equipment which may be meant for a particular customer or which can be sold in all market sectors. Manufacturing projects are generally executed in a factory or a laboratory where it is easy to exercise on the spot management which is quite crucial for such projects.
Research and Development Projects: Research and Development projects are mostly internal projects which an organization initiates to further improve its products or services. These projects are extremely crucial for the sustenance of an organization in today's cut throat environment. For such projects funds are generally mobilized from the internal sources of the company.
Public welfare and Social Development Projects: The Projects conducted by not for profit organizations like local and national government departments, professional associations and charities, disaster relief agencies fall under this category. The projects are aimed at general good of the communities. Nowadays many corporate are also initiating projects for the welfare of the communities where they operate like ITC's e-chaupal and Hindustan Lever's Shakti Project.
PROJECT LIFE CYCLE
Project Life Cycle refers to the logical sequence of activities to achieve the Project's goal or objectives. In other words, Project Life Cycle refers to the various stages through which it passes until it achieves its objectives. Irrespective of its size or type each and every project has following stages in its life cycle:
INITIATION: This is the first stage in a Project's Life Cycle. At this stage the scope and the objectives of the project are decided. At this very stage only, the approach for the completion of the project is decided. The Project manager is appointed who in turn selects the members for the project team based on their skills and qualifications. The most common techniques used in the initiation stage are Project Charter, Business Plan, Project Framework (or Overview), Business Case Justification, and Milestones Reviews.
PLANNING: The second stage include preparation of a detailed plan for the execution of the project. It includes a detailed identification and assignment of each task to the desired person and fixation of responsibility. It also includes a risk analysis. The governance process is defined, stake holders identified and reporting frequency and channels agreed. The most common techniques used in the planning stage are Business Plan and Milestones Reviews.
EXECUTION AND CONTROLLING: This stage basically includes ensuring that project activities are properly executed and controlled. During the execution phase, the planned solution is implemented to solve the problem specified in the project's requirements. During controlling, it is analyzed that whether the activities are done as they have planned and within the budget allotted and time specified for them or not. If activities are not executed as planned then corrective actions are initiated.
CLOSURE: This is the last stage in the project life cycle. At this stage the Project Manger is responsible for the successful completion of the project. The closure phase is characterized by a written formal project review report containing the following components: a formal acceptance of the final product by the client, Weighted Critical Measurements (matching the initial requirements specified by the client with the final delivered product), rewarding the team, a list of lessons learned, releasing project resources, and a formal project closure notification to higher management.
PROJECT APPRAISAL
Project Appraisal involves a careful checking of the basic data, assumptions and methodology used in project preparation, an in-depth review of the work plan, cost estimates and proposed financing, an assessment of the project's organizational and management aspects, and finally the viability of project.
PROJECT APPRAISAL: PROCESS
Initial Assessment
Define Problem and Long-List
Consult and Short-List
Develop Options
Compare and Select
VARIOUS ASPECTS OF PROJECT APPRAISAL
1. Management Appraisal Management appraisal is related to the technical and managerial competence, integrity, knowledge of the project, managerial competence of the promoters etc. The promoters should have the knowledge and ability to plan, implement and operate the entire project effectively. The past record of the promoters is to be appraised to clarify their ability in handling the projects.
2. Technical Feasibility Technical feasibility analysis is the systematic gathering and analysis of the data pertaining to the technical inputs required and formation of conclusion there from. The availability of the raw materials, power, sanitary and sewerage services, transportation facility, skilled man power, engineering facilities, maintenance, local people etc are coming under technical analysis. This feasibility analysis is very important since its significance lies in planning the exercises, documentation process, risk minimization process and to get approval.
3. Financial feasibility One of the very important factors that a project team should meticulously prepare is the financial viability of the entire project. This involves the preparation of cost estimates, means of financing, financial institutions, financial projections, break-even point, ratio analysis etc. The cost of project includes the land and sight development, building, plant and machinery, technical know-how fees, pre-operative expenses, contingency expenses etc. The means of finance includes the share capital, term loan, special capital assistance, investment subsidy, margin money loan etc. The financial projections include the profitability estimates, cash flow and projected balance sheet. The ratio analysis will be made on debt equity ration and current ratio.
4. Commercial Appraisal In the commercial appraisal many factors are coming. The scope of the project in market or the beneficiaries, customer friendly process and preferences, future demand of the supply, effectiveness of the selling arrangement, latest information availability an all areas, government control measures, etc. The appraisal involves the assessment of the current market scenario, which enables the project to get adequate demand. Estimation, distribution and advertisement scenario also to be here considered into.
5. Economic Appraisal How far the project contributes to the development of the sector, industrial development, social development, maximizing the growth of employment, etc. are kept in view while evaluating the economic feasibility of the project.
6. Environmental Analysis Environmental appraisal concerns with the impact of environment on the project. The factors include the water, air, land, sound, geographical location etc.
PROJECT EVALUATION PROCESS
According to International Labour Organization (ILO)"Project evaluation is a systematic and objective assessment of an ongoing or completed project. The aim is to determine the relevance and level of achievement of project objectives, development effectiveness, efficiency, impact and sustainability."
The following are the steps in the Project Evaluation process:
CONCEPT DEVELOPMENT: The first step in the project evaluation process is concept development. In concept development the need for the project is described. This step also includes establishment of desired outcomes and outputs, drawing of timetables or scheduling of activities and setting of strategies for the development and review of the project. During concept development, it is important to determine that the project proposal is consistent with any relevant laws or regulations and Government policy in general. There are two steps in Concept Development phase:
Defining the desired project outcomes and objectives
Defining proposed project outputs
Defining the proposed project outputs: It includes the various proposals or options regarding the range, mix and timing of outputs to be delivered, method of output production, financing of project etc.
STRATEGIC EVALUATION: Under the Output Based Management regime, agencies are required to report their performance in delivering a set of defined outputs, as measured by quality, quantity, cost and timeliness. The strategic evaluation phase of project evaluation requires project sponsors or agencies to report the impact of the project on the performance criteria of the relevant outputs. Where there is more than one option for project delivery, Strategic Evaluation will enable the agency to contrast the impact of each option on the performance of the agency. Strategic Evaluation comprises of the following steps:
Establish relevant outputs/outcomes: It is important to identify each of the agency's outputs that will be materially affected by the project and where necessary any influence the project will exert over the relationship between outputs and desired outcomes.
Identify impact of Project on Quality
Identify the impact of Project on Timeliness: Some projects seek to enhance the level of service provided by an agency. It is important that the cost of the project should be assessed against benefits such as improved timeliness of the agency's outputs and it may involve reduced waiting times and will often also be reflected in a positive impact on quantity.
Identify the impact of Project on Quantity: Many projects contemplated by agencies aim to expand the quantity of output. Strategic evaluation allows for the demonstration of how different project options will affect the quantity of services delivered by the agency and hence promotes expansion in an efficient manner. Quantity is also an essential component for calculating unit costs of an agency. It is possible for a project to actually reduce the unit costs of the agency even if it comes at the cost of a significant initial outlay.
Identify the impact of Project on Cost: The identification of unit costs allows agencies to measure the efficiency with which services or products are delivered. Unit costs are defined as total cost divided by total quantity.
Summarize Results: Finally, it is necessary to summarize the impact of each project option under consideration on the relevant performance measures for each affected agency output. Hence measuring the impact of a project on unit costs demonstrates how the project influences an agency's or sponsor's efficiency.
FINANCIAL EVALUATION: The financial evaluation of a project focuses on the revenues and expenditures created by the project from the perspective of the agency responsible for the project's implementation. Financial evaluation is conducted from an internal perspective. That is, it seeks to establish the net cash impact of the project on the financial position of the agency undertaking it. This approach enables agencies to clearly understand the financial and budget implications of their proposals.
Financial evaluation is conducted using discounted cash flow (DCF) analysis. Based strictly on project cash flows, DCF analysis recognizes several important features:
An amount of money, even when adjusted for inflation, is worth more now than it is in the future. This is termed the 'time preference of money'.
Resources employed by a project could be utilized elsewhere. This is termed the project's 'opportunity cost'.
Project cash flows are frequently risky; i.e. not certain.
Investors require greater returns to invest in projects with more risk.
The 'time preference of money', its 'opportunity cost' and the risk associated with a project can be accounted for by discounting future cash flows by an appropriate discount rate.
The project's net present value (NPV) is calculated by subtracting the initial investment from the sum of discounted revenues and costs. A project is financially viable when the NPV is positive; i.e. when the present value of the cash in-flows from the project exceeds the present value of the cash out-flows.
Generally Weighted Average Cost of Capital is used as a discount rate for discounting project revenues.
The financial evaluation can be conducted in the following six steps:
Setting key parameters and defining relationships: All assumptions and key parameters need to be clearly stated at the outset of the evaluation.
Identification of cash flows: The evaluation must identify all cash flows that accrue to, or are incurred by, the agency as a direct result of the project. This involves determination of capital costs, residual values, annual operating costs and revenues. Other issues include treatment of inflation, avoiding double counting and determining the appropriate period of the evaluation.
There are five basic principles that apply to the successful identification of project cash flows: incremental analysis, opportunity costs, incidental effects, sunk costs and capital costs.
Incremental Analysis: In most cases incremental revenues and costs are highly uncertain, so it is appropriate to weight these against the appropriate probability and then discount with the discount rate. The discount rate incorporates a risk premium for the project so that risky projects will have their future revenues discounted reflecting the uncertainty that they will eventuate. It follows that by discounting costs in the same way as revenues, the assumption is made that both are equally uncertain. Discounting does not resolve the problem of trying to calculate the most likely outcome of the project both in terms of costs and revenues, however. This can be handled by calculating weighted-average revenue and cost cash flows in accord with the method outlined below:
Imagine a project with revenues that are highly uncertain and that are best represented by three possible scenarios.
no revenue (10% probability);
revenue of Rs10 crores (80% probability); and
revenue of Rs 50 crores (10% probability).
The expected, or weighted-average, revenue is calculated as Rs.0 for scenario 1 plus Rs. 8 crores for scenario 2 (Rs10 crores x 0.80) and Rs 5 crores for scenario 3 (Rs 50crores x 0.10) giving a total weighted revenue projection of Rs. 13 crores. The figure of Rs.13 crores should be used as the revenue estimate and then discounted with the appropriate discount rate.
Opportunity Costs: The cost of a resource is relevant even if it is already owned by the agency. Although it does not need to purchase these resources, their value still needs to be taken into account because if they are applied to a particular project then they cannot be used for other purposes. In other words, the resources have an 'opportunity cost'. More formally, the opportunity cost is the return on the next best alternative foregone as a result of the project. This is often the sale of the resources at their market value.
Financial Opportunity cost of capital is the expected return foregone by investing in a project rather than in comparable financial securities.
Incidental Effects: It is important to include all incidental effects of the project on other agency activities. This may include additional corporate overheads (to the extent that the project creates extra expenditure), increased flow-on demand for other services provided by the agency, or even, in some cases, a decline in demand for activities in competition with the new project.
Sunk Costs: Sunk costs are non-recoverable costs spent before the project evaluation report. Sunk costs should thus be excluded from the assessment of future project costs and benefits. All prior expenditure on the project must still be specified, however. This prevents the arbitrary allocation of incremental costs associated with the project as sunk so as to artificially bolster returns or understate the true project cost.
While the decision to proceed with a proposal will ignore sunk costs, they are relevant when determining the overall project benefits.
Capital Costs: Capital costs include all up-front development expenditures required to achieve the forecast benefits. This should not be confused with the taxation or accounting definitions of capital costs, which also include later capital expenditures required to refurbish or replace equipment during the lifespan of the benefits proposed. The types of expenditure typically contained in the capital cost of a project can include the following:
construction costs;
furniture and fittings;
equipment purchases;
legal and consulting fees;
contingencies; and
Working capital.
Capital costs should be treated in the same way as other costs in the discounted cash flows; that is, they should be incorporated and discounted in accord with the year of their expenditure. This means that immediate capital costs will not be subjected to any discounting while deferred capital costs will be discounted by the appropriate discount rate.
Another tool for financial evaluation of a Project is Cost-Benefit Analysis. Following are the steps in a Cost-Benefit Analysis:
Defining Objectives and Project Scope: It involves answering of the following questions:
How will it meet objectives?
Will it involve new capital works/equipment acquisition?
Will there be a need to replace existing facilities/assets?
Will there be a need to upgrade or enhance existing facilities?
What are the constraints?
Who is likely to be effected and how might impacts manifest?
Identify Project Options: Options are prepared to fulfill project objectives. The range of feasible options will vary with the nature of the problem. Tasks set at the strategic level may generate a wide range of options. It will be necessary to determine the feasible options.
When describing the options, the analyst should include:
A schedule for the project/proposal phase comprising a planning and development schedule
The expected operational date of the option plus an operational schedule (eg, airspace organization and structure, route structure, etc) and a replacement schedule (for individual system components)
Type of equipment required if there are different levels of service to be considered
Economic life of the key assets involved
A transition schedule (if appropriate)
Identification of who will be investing in the project (as well as to whom the 'case' needs to be justified to).
Identify Costs and Benefits: All relevant costs and benefits must be included in the evaluation. Quantitative costs (e.g. Capital costs, project management costs and decommissioning costs etc.) and benefits (e.g. cost savings, residual value and disposal of assets) are to be included in the discounted cash flow analysis, whilst qualitative costs and benefits must be described as appropriate.
Discount Future Costs
Calculate the Decision Criteria: The decision criteria can either be NPV or Internal Rate of Return.
Sensitivity Analysis: Sensitivity analysis should be undertaken to test the robustness of results under different scenarios, using different assumptions for various variables. It is a necessary part of any investment appraisal as it can:
Test the impact of using different discount rates (the agreed rate should be used with sensitivity analysis two or three per cent points 'above' and 'below' the agreed rate)
Assess the possible impact of uncertainty
Illustrate what would happen if the assumptions made about some variables proved to be wrong and show how changes in the values of various factors affect the overall costs or benefit of a given project
Indicate the critical elements on which the positive outcome of the project depends.
Identify Preferred Option: On the basis of ranking by NPV/IRR/BCR identify the most suitable option.
Determination of the discount rate: The next step in a financial evaluation is to determine the appropriate discount rate. The discount rate is one of the key factors in determining the financial feasibility of a project. The NPV, BCR and IRR financial evaluation measurement criteria all require the use of a risk-adjusted discount rate to determine the project return. the weighted-average cost of capital (WACC) model - to ascertain a market based risk premium or discount rate for a given project.
Calculation of financial evaluation measures: The Guidelines require up to three financial evaluation measures to be reported where appropriate: NPV, internal rate of return (IRR) and discounted payback period (DPP). The benefit-cost ratio (BCR) is also useful to compare project viability where projects are of a different size.
Sensitivity analysis The risk of key parameters not turning out as forecasted is assessed by examining the sensitivity of the project's returns to movements in key assumptions and the discount rate. This also helps to highlight the relatively more important risk factors that need to be managed closely. Sensitivity analysis enables project analysts to examine how sensitive project outcomes are to specific assumptions underpinning the evaluation. It is an explicit recognition of the uncertainty regarding project outcomes. Sensitivity analysis therefore seeks to achieve the following:
The identification of variables that have a material impact on the project. Identified, key project variables can be managed and risks minimised;
Identification of where more information is needed in order to improve assumptions;
Identification of the consequences of misestimating variables; and
Exposure of inappropriate or confused forecasts.
Reporting budgetary implications The final step is to establish the project's likely impact on the financial position of the agency through an examination of the capital and recurrent implications of the project. In larger projects, it is also appropriate to outline the balance sheet impact of the project.
ECONOMIC EVALUATION: While the financial evaluation seeks to quantify a project's expected impact on the agency's finances, the economic evaluation focuses on quantifiable costs and benefits that are expected to flow on to the wider community. The project impacts identified in this analysis must be tangible and occur as a direct result of the project.
SOCIAL IMPACT ANALYSIS: Many Government agency projects undertaken affect public goods and do not generate revenues or have clearly quantifiable benefits. Examples include most activities in health, education, law and order, and welfare. Social-impact analysis provides an opportunity to fully address the unquantifiable impacts of the project on the community. Social impacts can be assessed on a range of categories which includes:
Environment: Environmental impacts were first considered seriously about three decades ago. Since then, community awareness has evolved to the extent that such concerns are often foremost in people's thinking when social impacts are discussed. While a proportion of environmental impacts may be assigned a shadow price and incorporated into the economic analysis, a monetary value is rarely able to reflect the full effect of an environmental impact. 'The environment' is given a relatively narrow definition, as it is restricted to the natural environment in which we live. Unquantifiable effects on land, flora, fauna, the air or water would all be included here.
Heritage: Heritage impacts are those that affect the existence or integrity of a historical site which people value and want to preserve for future generations.
State development goals: State development goals are intended to encapsulate the focal points for the growth and progress of the State. Impacts that contribute to or detract from the achievement of State goals include effects on tourist numbers, State reputation, community morale, technological progress and development of regional areas. Effects that hinder or facilitate the progress of the State in these areas are often of interest to decision makers.
Quality of life: Quality of life impacts are those that alter the population's enjoyment of life. Both practical and aesthetic items fall under this category. Travel time differences, availability of recreational facilities, increased consumer choice and the beautification of a streetscape can all affect our quality of life. Preservation of human dignity is also integral to the well-being of society.
Health and safety: Health and safety issues are wide in scope and include hygiene levels, pest control, disease control, safety in the workplace and natural disaster protection. Impacts that affect the ability of people to maintain the required standards would be subsumed in this category.
Intangible economic effects: Some economic impacts may have an additional intangible dimension. For example, changes in trade relations or domestic expenditure levels may also have a bearing on business confidence. Business confidence cannot be directly translated into monetary changes, but it is a good indicator of the well-being of the economy. A positive or negative impact on business confidence, for instance, would be a definite inclusion in the analysis.
Law and order: Law and order is a growing concern for many in the community. Project impacts that result in an improvement or decline in the maintenance of law and order may have a significant bearing on a project's appeal. Crime rates, the speed at which investigations are finalized and perceptions of justice being done are examples of relevant factors that fall within this category.
The incidence (or distribution) of benefits and costs: The mere incidence of the quantifiable (i.e. tangible) impacts of a project may have dramatic social consequences. A proposal that involves the closure of a rural town's core business has widespread ramifications for the residents. There are effects on community morale, the town population, other town businesses and relationships within the town due to the stress and uncertainty caused by the situation. The mere incidence of the financial and economic impacts of the closure causes a ripple of social effects that affect the whole community. Rather than list each individual impact, it is simpler to combine them under the 'Incidence' heading.
SOCIAL COST -BENEFIT ANALYSIS (SCBA): A TOOL FOR SOCIAL IMPACT ANALYSIS
Various social costs include mainly the following items:
Goods and Material Acquired
Labor and Services Used:
Work-related injuries and illness
Occupational disease
Social losses resulting from employment of children, women and young persons.
(iii) Fixed Assets Purchased
(iv) Environmental Damage
(v) Public Service and Facilities Used
(vi) Discrimination
(vii) Payments from Other Elements of Society
viii) Other Costs:
Depletion of animal resources
Depletion of energy sources
Costs of technological change
Costs of unemployment and idle resources
Monopoly costs
Social costs of distribution
Soil erosion and deforestation
Social cost of transportation
Disruption of family life
Reduction In the life expectancy in hazardous industries
Wastage of natural resources
Economic disparity
Adverse effect on social order
Urbanization
Undesirable practices.
A project has many social benefits. These Benefits may be listed as follows:
Products and Services Provided
Payments to the Other Elements of Society
Creation of Employment Opportunities
Additional Direct Employee Benefits
Improvements in Environment
Staff, Equipment and Facility Donated
Other benefits
Providing employment opportunities in those areas where unemployment or under employment is prevalent.
Creation of employment opportunities to weaker sections of the society e.g., schedule castes, scheduled tribes etc. on a preferential basis.
Postponing opportunities for the preservation of precious natural resources.
(vii) Other Benefits: (contd)
Programmes e.g. free day care Centres, special assistance to minority organizations etc.
Establishment of projects in those areas which are comparatively less profitable but are significant in the interest of the nation.
Providing good township and better social life to the employees.
Earning foreign exchange for the national welfare.
Marketing efforts to enhance health of the workers.
Rise in standards of living.
Exploitation of natural resources.
Equality.
Decrease in poverty
End of class system
Population control
Activities related to community welfare.
Social welfare works.
Social Cost Benefit Analysis provides a scientific and quantitative base for the appraisal of projects with a view to determine whether the total benefits of a project justify the total social costs.
RATIONALE BEHIND SOCIAL COST-BENEFIT ANALYSIS (SCBA)
SCBA brings out a comparison between the social benefits and social costs in order to reveal the net return on investment as a difference quantified. In such cases, social costs are investment cost that would have available without the project and the benefits can be defined as contribution made to the objectives of the economic policy of the government. SCBA is a part of feasibility report detailing and justifying assumptions made about the inputs and outputs and their appropriate market price. There could have same factors in an investment decision by the government in particular instance, which gives rise to a social cost or a social benefit but this may not have a market.
STEPS IN SOCIAL COST-BENEFIT ANALYSIS
There are five broad steps to be gone through in the process of social cost benefit analysis of a project.
The project must be defined in clear terms. The time-frame of the project must be specified.
The 2nd step in the application of the technique is to list out all costs and benefits of the project.
Similarly there are both explicit and implicit benefits to be listed.
The fourth step in computing the SCBA of a project is to discount the future benefits back to the present in order to determine the true return on cost.
Last step in SCBA is to make decision in respect of inclusion or exclusion of a project in the development programmes. Given the resources constraint, one way out is to list the project In descending order and implementing them one by one , beginning with the first till the investment resources are exhausted.
