SUBJECT NAME: PROJECT MANAGEMENT AND FINANCE CREDITS: 3

SUBJECT CODE: 1150MG101 HOURS: 3

UNIT – III: IDENTIFICATION AND FORMATION

Project environment – Identification of investment opportunities – Project screening – Project

selection – Project formulation – Stages in project formulation – Project report preparation

PROJECT ENVIRONMENT:

Project environment represents a connection, where the project is processed. It impacts

the project and is, therefore, conditioned. Such an interaction is provided by numerous factors as
operational, physical, ecological, social, cultural, economic, psychological, financial,
organizational etc. The environment not only formulates the project but also estimates it.
The project environment analysis is held at the beginning of the project. This method
identifies the lobbies and integrates the project stakeholders into project group. All impact
factors are analyzed in this analysis: project risks and chances, stakeholders and their interests,
measures for the control. The stakeholder type is thereby analyzed. It distinguishes between
active and passive type. The first group represents project team and project manager, principal
and customer. The second group contains authorities, works council, competitors, persons
affected by the project indirectly.
PROJECT ENVIRONMENTAL ANALYSIS:
A project is always part of a larger project environment, which makes managing projects
so challenging. A tool that helps project managers identify these threats, as well as opportunities,
is the PESTLE analysis.
A project does not exist in a vacuum but is always dependent on various internal and
external factors that can threaten its successful completion. Project managers need to take into
account factors such as the political, social and economic environment which can affect a
project’s outcome. Understanding the external forces that have an effect on the project means
that project managers can make more strategic decisions and steer the project into the right
direction.
 THE PESTLE ANALYSIS: PESTLE is an acronym for the various factors which surround a
project’s environment:
The analysis is also known as PESTEL or PEST, depending on how many environmental factors
are included. This method takes a big picture or birds view approach, which means that it looks
at the project in a wider context and takes into account how changes in the project’s environment
affect the project. This enables project teams to anticipate changes and include these changes
into their planning instead of being surprised by them.

THE ELEMENTS OF PESTLE:

Political factors you have to consider:

 Government stability/instability
 Corruption level
 Tax policies
 Freedom of press
 Government regulation and deregulation
 Special tariffs
 Political action committees
 Government involvement in trade unions and agreements
 Competition regulation
 Voter participation rates
 Amount of government protests
 Defense expenditures
 Level of government subsidies
 Bilateral relationships
 Import-export regulation/resctrictions
 Trade control
 Lobbying activities
 Size of government budgets

Example: If you’re working on an international project which spans across several countries, you
will have to keep in mind that different countries have different rules and regulations. Some
countries have stricter regulations than others, especially when it comes to health and safety
issues.

Economical factors you have to consider:

 Growth rate
 Interest rate
  Inflation rate
 Exchange rate
 Availability of credit
 Level of disposible income
 Propensity of people to spend
 Federal government budget deficits
 Gross domestic product trend
 Unemployment trend
 Stock market trends
 Price fluctuations
 Budget availability
 Import and export taxes
 Economic growth or recession
 Minimum wage

Example: If your supplier is located in another country and the exchange rate between the two
countries changes, it means that your costs might increase. If the exchange rate is in your favor,
you could save money on supplies.

Social factors you have to consider:

 Population size and growth rate

 Birth rates
 Death rates
 Number of mariages
 Number of divorces
 Immigration and emigration rates
 Life expectancy rates
 Age distribution
 Wealth distribution
 Social classes
 Per capita income
 Family size and structure
 Lifestyles
 Health consciousness
 Average disposable income
 Attitude towards government
 Attitude towards work
 Buying habits
 Ethical concerns
 Cultural norms and values
  Sex roles and distribution
 Religion and beliefs
 Racial equality
 Use of birth control
 Education level
 Minorities
 Crime levels
 Attitudes towards saving
 Attitude towards investing
 Attitudes towards retirement
 Attitudes towards leisure time
 Attitudes towards product quality
 Attitudes towards customer service
 Attitudes towards foreign people
Example: If you are planning on building an additional landing strip for an airport, you have to
take the local population, who will be affected by the construction, into account. Because in
order to build it, the people living there will have to relocate and people living close to the
airfield will have to expect increased noise from the arriving and departing airplanes. You have
to devise a strategy to address these concerns.

Technological factors you have to consider:

 Technology incentives
 Technological change
 Level of innovation
 Technological awareness
 Internet infrastructure
 Communication infrastructure
 Life cycle of technology
 New technologies that replace older technologies
 Technical constraints
 Automation
 Research and development

Example: A new technology or a technological shift could speed up your project’s progress,
which also means that you could decrease your project costs.

Legal factors you have to consider:

 Discrimination laws
 Antitrust laws
  Employment laws
 Consumer protection laws
 Copyright and patent laws
 Health and safety laws
 Education laws
 Consumer protection laws
 Data protection laws
 Regulatory frameworks

Example: Before you can start a construction project, you will have to get a building permit and
have to make sure that the construction plan is in accordance to regulations.

Environmental factors you have to consider:

 Weather
 Climate
 Environmental policies
 Climate change
 Pressures from NGO’s
 Natural disasters
 Air and water pollution
 Recycling standards
 Attitudes towards green products
 Support for renewable energy
Example: A great example of taking environmental factors into account is the construction of
Macchu Picchu, which was built 7,000 feet above sea level on a mountain ridge in the Peruvian
Andes. The geographical location alone makes for an extremely difficult construction, but the
climate was just as challenging because of heavy rainfall as well as the danger of earthquakes.
Because the Incas knew of these environmental obstacles, they could adapt to them: They built
the buildings as terraces which perfectly adapt to the steep incline of the mountain and used
locally mined stones that fit together perfectly and are sturdy even without mortar.

ADVANTAGES AND DISADVANTAGES OF USING A PEST(EL) ANALYSIS

Advantages

 Simple framework
 Facilitates an understanding of the wider business environment
 Encourages the development of external and strategic thinking
 Can enable an organisation to anticipate future business threats and take action to avoid or
minimise their impact
 Can enable an organisation to spot business opportunities and exploit them fully
 By taking advantage of change, you are much more likely to be successful than if your
activities oppose it
 Avoids taking action that is doomed to failure from the outset, for reasons beyond your
control.
Disadvantages

 Some users over simplify the amount of data used for decisions – it is easy to use scant data
 To be effective this process needs to be undertaken on a regular basis
 The best reviews require different people being involved each having a different perspective
 Access to quality external data sources, this can be time consuming and costly
 The pace of change makes it increasingly difficult to anticipate developments that may affect
an organisation in the future
 The risk of capturing too much data is that it may make it difficult to see the wood for the trees
and lead to ‘paralysis by analysis’
 The data used in the analysis may be based on assumptions that subsequently prove to be
unfounded (good and bad).
• Political, economic, social, technological, legal, and environmental (PESTLE) structure
of the Indian Business Environment.
• Each of the PESTLE factors is explored in terms of four parameters: current strengths,
current challenges, future prospects, and future risks.
Political Analysis

Economic Analysis
Social Analysis

Technological Analysis

Legal Analysis
Environmental Analysis

IDENTIFICATION OF INVESTMENT OPPORTUNITIES:

Investment opportunities have to be identified or created; they do not occur automatically.
Investment proposals of various types may originate at different levels within a firm. Most
proposals of various types may originate at different levels within a firm. Most proposals, in the
nature of cost reduction or replacement or process or product improvements take place at
plant level. The contribution of top management in generating investment ideas is generally
confined to expansion or diversification projects. The proposals may originate systematically or
haphazardly in a firm. The proposal for adding new product may estimate from the marketing
department or from the plant manager who thinks be a better way of utilizing idle capacity.

Suggestions for replacing an old machine or improving the production techniques may arise
at the factory level. In view of the fact that enough investment proposals should be generated to
employ the firm’s funds fully well and efficiency, a systematic procedure for generating
proposals may be evolved by a firm.

In a number of companies, the investment ideas are generated at the plant level. The
contribution of the broad in idea generation is relatively insignificant. However, some companies
depend on the board for certain investment ideas, particularly those that are strategic in nature.
Other companies depend on research carters for investment ideas.

Companies use a variety of methods used are:

 Management sponsored studies for project identification

 Formal suggestion schemes
 Consulting advice
Most companies use a combination of methods. The offer of financial incentives for generating
investment idea is not a popular practice. Other efforts employed by companies in searching
investment ideas are:

 Review of researches done in the country or abroad,

 Conducting market surveys,
 Deputing executives to international trade fairs for identifying new products and
technology.

Once the investment proposals have been identified, they are be submitted for scrutiny. Many
companies specify the time for submitting the proposals for scrutiny.

CHARACTERISTIC OF INVESTMENT IDENTIFICAITON:

 Investment is capital expenditure in nature which will yield returns only in the long run.
 Investments made are irreversible and hence one must be careful in decision making and
take decision after expert opinion.
 Viability of the project and risk aspects should be analyzed thoroughly.
 Investment opportunities should consider the following elements/principles: Cost, timing,
risk, flexibility, uncertainty and control.
 Capital expenditure is basically classified as replacement, expansion, diversification,
R&D, amalgamation, merger and acquisition etc.,

GENERATION AND SCREENING OF A PROJECT IDEA – PROJECT

MANAGEMENT

Generation and Screening of a project idea Generation and Screening of a project idea begins
when someone with specialized knowledge or expertise or some other competence feels that
he can offer a product or service
♦ which can cater to a presently unmet need and demand

To serve a market where demand exceeds supply

♦ which can effectively compete with similar products or services due to its better quality/price
etc. An organization has to identify investment opportunities which are feasible and promising
before taking a full-fledged project analysis to know which projects merit further examination
and appraisal.

Tasks involved in Generation and Screening of a project idea

Generation and Screening of a project idea involves the following tasks:-
1. Generation of ideas –

A panel is formed for the purpose of identifying investment opportunities. It involves the
following tasks which must be carried out in order to come up with a creative idea –
(a) SWOT analysis – Identifying opportunities that can be profitably exploited
(b) Determination of objectives – Setting up operational objectives like cost reduction,
productivity improvement, increase in capacity utilization, improvement in contribution margin
(c) Creating Good environment – A good organizational atmosphere motivates employees to be
more creative and encourages techniques like brainstorming, group discussion etc. which results
in development of creative and innovative ideas

2. Monitoring the Environment –

An Organization should systematically monitor the environment and assess its competitive
abilities in order to profitably exploit opportunities present in the environment. The key sectors
of the environment that are to be studied are :-
(a) Economic Sector –

i. State of economy
ii. Overall rate of Growth
iii. Growth of primary, secondary and tertiary sectors
iv. Inflation rate
v. Linkage with world economy
vi. BOP situation
vii. Trade Surplus/Deficit

(b) Government Sector –

i. Industrial policy
ii. Government programmes and projects
iii. Tax framework
iv. Subsidies, incentives, concessions
v. Import and export policies
vi. Financing norms

(c) Technological Sector –

i. State of technology
ii. Emergence of new technology
iii. Receptiveness of the industry
iv. Access to technical know how

(d) Socio-demographic sector –

i. Population trends
ii. Income distribution
iii. Educational profile
iv. Employment of women
v. Attitude towards consumption and investment

(e) Competition Sector –

i. No. of firms and their market share
ii. Degree of homogeneity and production differentiation
iii. Entry barriers
iv. Marketing policies and prices
v. Comparison with substitutes in terms of quality/price/appeal etc.
f Supplier Sector – Availability and cost of raw material, energy and money

(3) Corporate Appraisal –

It involves identification of corporate strengths and weaknesses. The important aspects that are to
be considered are:-
(a) Market and Distribution –
i. Market Image
ii. Market share
iii. Marketing and Distribution cost
iv. Product line
v. Distribution Network
vi. Customer loyalty

(b) Production and Operations –

i. Condition and capacity of plant and machinery
ii. Availability of raw materials and power
iii. Degree of vertical integration
iv. Location advantage
v. Cost structure – Fixed and Variable costs

(c) Research and Development –

i. Research capabilities of a firm
ii. Track record of new product developments
iii. Laboratories and testing facilities
iv. Coordination between research and other departments of the organization

(d) Corporate Resources and Personnel –

i. Corporate Image
ii. Clout with government and regulatory agencies
iii. Dynamism of top management
iv. Competence and commitment of employees
v. State of industrial relations

(e) Finance and Accounting –

i. Financial leverage and borrowing capacity
ii. Cost of capital
iii. Tax situation
iv. Relations with shareholders and creditors
v. Accounting and control system
vi. Cash flows and liquidity

Tools for identifying investment opportunities →

(a) Porter 5 forces Model → It helps in analyzing profit potential of an industry depending upon
strength of –

i. Threat of new entrants

ii. Rivalry amongst existing companies
iii. Pressure from substitute products
iv. Bargaining power of buyer
v. Bargaining power of seller

(b) Life cycle Approach → There are four stages a product goes through during his life cycle
each stage represents different investment and net profit value →
(a) Pioneering Stage – In this stage the technology and product is new, there is high competition
and very few entrants survive this stage.
(b) Rapid Growth Stage – This stage witnesses a significant expansion in sales and profit.
(c) Maturity Stage – It marks developed industries with mature product and steady growth rate.
(d) Decline Stage – Due to introduction of new products and changes in customer preference the
industry incurs a decline in market share and profits.

(c) Experience Curve → Experience curve analyzes how cost per unit changes with respect to
accumulated volume of production. Investment must be such that reduces costs.

(4) Looking for Project Ideas –

Various sources to look for good project ideas include:-

i. Trade fairs and exhibitions
ii. Studying Government plans and guidelines
iii. Suggestion of financial institutions and development agencies
iv. Investigating local materials and resources
v. Analyzing performance of existing industries
vi. Analyzing social and economic trends
vii. Analyzing new technological developments
viii. Studying the consumption pattern of people abroad
ix. Stimulating creativity to produce new ideas
x. Reducing exports and imports

(5) Preliminary Screening –

It refers to elimination of project ideas which are not promising. The factors to be considered
while screening for ideas are:-
♦ Compatibility with the promoter – The idea must be consistent with the interest, personality
and resources of entrepreneur.
♦ Consistency with Government priorities – The idea must be feasible with national goals and
government regulations.
♦ Availability of inputs – Availability of power, raw material, capital requirements, technology.
♦ Adequacy of Market – Growth in market, prospect of adequate sale, reasonable Return on
Investment.

♦ Reasonableness of cost – The project must be able to make reasonable profits with respect to
the costs involved.
♦ Acceptability of risk level – The desirability of the project also depends upon risks involved in
executing it. In order to access risk the following factors must be considered:-
-Project`s vulnerability to business cycles
-Change technology
-Competition from substitutes
-Government`s control over price and distribution
-Competition from imports

(6) Project Rating Index →

It is a tool used for evaluating large number of project ideas. It helps in streamlining the process
of preliminary screening. Hence a preliminary evaluation may be converted in project rating
index.
Steps to calculate project rating index→
I. Identifying the factors relevant for project rating
II. Assigning weights to these factors according to their relative importance (FW)

III. Rate the project proposal on various factors using suitable rating scale (FR) (5 point scale or
7 point scale)
IV. For each factor multiply the factor rating with factor weight to get factor scores
(FR X FW = FS)
V. All the factor scores are added to get the overall project rating index. Organization determines
a cut off value and the project below this cut off value are rejected.

(7) Sources of the Net Present Value

In order to select a profitable and feasible project, a project manager must carry out a
fundamental analysis of the product and factor market to know about entry barriers which lead to
positive net present value. There are six entry barriers which result in a positive NPV project.
They are –
i. Economies of scale
ii. Product differentiation
iii. Cost advantage
iv. Marketing reach
v. Technological edge
vi. Government policy

(8)Entrepreneurial skills →
An individual must possess the following traits and qualities in order to be a successful
entrepreneur –
i. He must be willing to make sacrifices
ii. He must be a good Leader
iii. He must be able to make quick and rational decisions
iv. He must have confidence in the project
v. He must able to exploit market opportunities
vi. He must have strong ego in order to survive ups and downs of a business
PROJECT SCREENING:

Project Screening is an assessment of project applications to select those which are

not suitable for further consideration. Project screening includes completing a preliminary
examination of the project opportunity (project application) to obtain an idea of whether the
more time-consuming and costly effort for further business case development is reasonable.
Project screening embraces the preliminary indications for decision-making on pursuing the
project opportunities, so the next stage after screening is the project selection where the most
advisable projects are chosen.

Specialists, conducting this procedure, utilize special project screening criteria which
allow them to qualify applicant projects as suitable or not-suitable. One of the instruments used
during the project screening process is a special table (so called project screening matrix) that
lists applicant projects against the categories of screening criteria – every project is evaluated in
terms of suitability (a scoring number or qualitative wording should be given to every aspect
and by every project) and then they can be compared with each other to find out which applicant
projects are least interesting of all.

STEPS IN PROJECT IDENTIFICATION:

Project ideas are like other ideas which don’t take concrete shape immediately. There are
several stages of making propositions their considerations and scrutiny for their soundness. An
idea is first born, it is under incubation for sometimes and subsequently is begins to take some
definite shape. The project ideas to develop take almost the same course.

This project identification may be broadly divided into four stages, viz.,
A. Conceptual stage – where project ideas are generated
B. Screening stages – at which unviable ideas are eliminated.
C. Identification stage – at which viable projects are selected
D. Pre-feasibility state – at which pre-feasibility studies are taking up.

In Conceptual stage number of project ideas may be generated either by those officials or
non- officials and entrepreneurs individually or collectively who are conversant with the area. In
this context, one has to examine the potentialities of development and the problems, needs and
aspirations of the people of the concerned area.

Screening stage: In the second stage project ideas generated above are screened in a
preliminary exercise to weed out the bad or unviable ideas. All project ideas would not pass the
screening test. Some project ideas may be imaginary to warrant any serious consideration. The
third & fourth stages may be called as investment opportunity study.
 This study is necessarily preliminary and the broad one and has a limited objective of
providing planners with a choice of projects from which they can make a selection. Pre
feasibility study and these can be differentiated opportunity study and a detailed feasibility study
and these can be differentiated mainly on the basis of information required for respective stages.

SCREENING PROJECT IDEAS:

After gathering the project ideas from the various sources as aforesaid, it is essential to
eliminate ideas which are not promising. This process of eliminating the irrelevant and unviable
ideas is called screening of project ideas. It can be done with the help of testing the following
conditions of the propositions.
a.) Compatibility with the promoter
b.) Consistency with governmental priorities
c.) Availability of inputs
d.) Adequacy of market
e.) Reasonableness of cost
f.) Acceptability of risk level etc.
The project idea must be compatible with interest personality and resources of the entrepreneur.
It should be accessible to him and also it offers him the prospects of rapid growth and high return
on invested capital. The project idea must satisfy or go along with the governmental priorities,
National goals and governmental regulatory framework.

PROJECT SELECTION:

Types of Project Selection Models

Of the two basic types of selection models (numeric and non-numeric), non-numeric models are
older and simpler and have only a few subtypes to consider. We examine them first.
Non-Numeric Models
These include the following:
1. The Sacred Cow: In this case the project is suggested by a senior and powerful official in the
organisation. Often the project is initiated with a simple comment such as, “If you have a chance,
why don’t you look into . . .,” and there follows an undeveloped idea for a new product, for the
development of a new market, for the design and adoption of a global database and information
system, or for some other project requiring an investment of the firm’s resources. The immediate
result of this bland statement is the creation of a “project” to investigate whatever the boss has
suggested. The project is “sacred” in the sense that it will be maintained until successfully
concluded, or until the boss, personally, recognises the idea as a failure and terminates it.
2. The Operating Necessity: If a flood is threatening the plant, a project to build a protective
dike does not require much formal evaluation, which is an example of this scenario. XYZ Steel
Corporation has used this criterion (and the following criterion also) in evaluating potential
projects. If the project is required in order to keep the system operating, the primary question
becomes: Is the system worth saving at the estimated cost of the project?
If the answer is yes, project costs will be examined to make sure they are kept as low as is
consistent with project success, but the project will be funded.
3. The Competitive Necessity: Using this criterion, XYZ Steel undertook a major plant
rebuilding project in the late 1960s in its steel bar manufacturing facilities near Chicago. It had
become apparent to XYZ’s management that the company’s bar mill needed modernisation if the
firm was to maintain its competitive position in the Chicago market
area. Although the planning process for the project was quite sophisticated, the decision to
undertake the project was based on a desire to maintain the company’s competitive position in
that market. In a similar manner, many business schools are restructuring their undergraduate
and Masters in Business Administration (MBA) programs to stay competitive with the more
forward looking schools. In large part, this action is driven by declining numbers of tuition
paying students and the need to develop stronger programs to attract them.
Investment in an operating necessity project takes precedence over a competitive necessity
project, but both types of projects may bypass the more careful numeric analysis used for
projects deemed to be less urgent or less important to the survival of the firm.
4. The Product Line Extension: In this case, a project to develop and distribute new products
would be judged on the degree to which it fits the firm’s existing product line, fills a gap,
strengthens a weak link, or extends the line in a new, desirable direction. Sometimes careful
calculations of profitability are not required. Decision makers can act on their beliefs about what
will be the likely impact on the total system performance if the new product is added to the line.
5. Comparative Benefit Model: For this situation, assume that an organisation has many projects
to consider, perhaps several dozen. Senior management would like to select a subset of the
projects that would most benefit the firm, but the projects do not seem to be easily comparable.
For example, some projects concern potential new products, some concern changes in production
methods, others concern computerisation of certain records, and still others cover a variety of
subjects not easily categorised (e.g., a proposal to create a daycare center for employees with
small children).
The organisation has no formal method of selecting projects, but members of the selection
committee think that some projects will benefit the firm more than others, even if they have no
precise way to define or measure “benefit.” The concept of comparative benefits, if not a formal
model, is widely adopted for selection decisions on all sorts of projects. Most United Way
organisations use the concept to make decisions about which of several social programs to fund.
Senior management of the funding organisation then examines all projects with positive
recommendations and attempts to construct a portfolio that best fits the organisation’s aims and
its budget.
The organization you are working for has been handed a number of project contracts. Due to
resource constraints, the organization can’t handle all the projects at once, so they need to decide
which project(s) will maximize profitability.

Numeric Models
As noted earlier, a large majority of all firms using project evaluation and selection models use
profitability as the sole measure of acceptability. We will consider these models first, and then
discuss models that surpass the profit test for acceptance. These include the following:

1. Payback Period: The payback period for a project is the initial fixed investment in the project
divided by the estimated annual net cash inflows from the project. The ratio of these quantities is
the number of years required for the project to repay its initial fixed investment. For example,
assume a project costs $100,000 to implement and has annual net cash inflows of $25,000. Then
Payback period = $ 100,000 / $ 25,000 = 4 years
This method assumes that the cash inflows will persist at least long enough to pay back the
investment, and it ignores any cash inflows beyond the payback period. The method also serves
as an (inadequate) proxy for risk. The faster the investment is recovered, the less the risk to
which the firm is exposed.
2. Average Rate of Return: Often mistaken as the reciprocal of the payback period, the average
rate of return is the ratio of the average annual profit (either before or after taxes) to the initial or
average investment in the project. Because average annual profits are usually not equivalent to
net cash inflows, the average rate of return does not usually equal the reciprocal of the payback
period. Assume, in the example just given, that the average annual profits are $15,000.
Neither of these evaluation method is recommended for project selection, though payback period
is widely used and does have a legitimate value for cash budgeting decisions. The major
advantage of these models is their simplicity, but neither takes into account the time-value of
money. Unless interest rates are extremely low and the rate of inflation is nil, the failure to
reduce future cash flows or profits to their present value will result in serious evaluation errors.

3. Discounted Cash Flow: Also referred to as the Net Present Value (NPV) method, the
discounted cash flow method determines the net present value of all cash flows by discounting
them by the required rate of return (also known as the hurdle rate, cutoff rate, and similar terms)
as follows:
To include the impact of inflation (or deflation) where pt is the predicted rate of inflation during
period t, we have Early in the life of a project, net cash flow is likely to be negative, the major
outflow being the initial investment in the project, A0. If the project is successful, however, cash
flows will become positive. The project is acceptable if the sum of the net present values of all
estimated cash flows over the life of the project is positive. A simple example will suffice. Using
our $100,000 investment with a net cash inflow of $25,000 per year for a period of eight years, a
required rate of return of 15 percent, and an inflation rate of 3 percent per year, we have.
Because the present value of the inflows is greater than the present value of the outflow that is,
the net present value is positive—the project is deemed acceptable.

Example: PsychoCeramic Sciences, Inc. (PSI), a large producer of cracked pots and other
cracked items, is considering the installation of a new marketing software package that will, it is
hoped, allow more accurate sales information concerning the inventory, sales, and deliveries of
its pots as well as its vases designed to hold artificial flowers.

The Information Systems (IS) department has submitted a project proposal that estimates the
investment requirements as follows: an initial investment of $125,000 to be paid upfront to the
Pottery Software.

Corporation, an additional investment of $100,000 to modify and install the software; and
another $90,000 to integrate the new software into the overall information system. Delivery and
installation is estimated to take one year; integrating the entire system should require an
additional year.
Thereafter, the IS department predicts that scheduled software updates will require further
expenditures of about $15,000 every second year, beginning in the fourth year. They will not,
however, update the software in the last year of its expected useful life.
The project schedule calls for benefits to begin in the third year, and to be upto a particular speed
by the end of that year. Projected additional profits resulting from better and more timely sales
information are estimated to be $50,000 in the first year of operation and are expected to peak at
$120,000 in the second year of operation.

Project life is expected to be 10 years from project inception, at which time the proposed system
will be obsolete for this division and will have to be replaced. It is estimated, however, that the
software can be sold to a smaller division of Psycho Ceramic Sciences, Inc. (PSI) and will thus,
have a salvage value of $35,000. The Company has a 12 percent
hurdle rate for capital investments and expects the rate of inflation to be about 3 percent over the
life of the project. Assuming that the initial expenditure occurs at the beginning of the year and
that all other receipts and expenditures occur as lump sums at the end of the year, we can prepare
the Net Present Value analysis for the project.

The Net Present Value of the project is positive and, thus, the project can be accepted. (The
project would have been rejected if the hurdle rate were 14 percent.) Just for the intellectual
exercise, note that the total inflow for the project is $759,000, or $75,900 per year on average for
the 10 year project. The required investment is $315,000 (ignoring the biennial overhaul
charges). Assuming 10 year, straight line depreciation, or $31,500 per year, the payback period
would be: A project with this payback period would probably be considered quite desirable.

4. Internal Rate of Return (IRR): If we have a set of expected cash inflows and cash outflows,
the internal rate of return is the discount rate that equates the present values of the two sets
of flows. If At is an expected cash outflow in the period t and Rt is the expected inflow for
the period t, the internal rate of return is the value of k that satisfies the following equation
(note that the A 0 will be positive in this formulation of the problem). The value of k is
found by trial and error.

5. Profitability Index: Also known as the benefit–cost ratio, the profitability index is the net
present value of all future expected cash flows divided by the initial cash investment.
(Some firms do not discount the cash flows in making this calculation.) If this ratio is
greater than 1.0, the project may be accepted.

This is where project selection methods come into play. There are two categories of
project selection methods:

 Benefit Measurement Methods

 Constrained Optimization Methods

Although time-consuming, employing these methods is essential for an effective business plan.
There are a variety of documented methods for selecting a project, but the basic thumb rule is:
for small projects that aren’t very complex, the Benefit Measurement Model is useful, whereas if
it’s a large, complex project, the Constrained Optimization Method is a better fit. Let’s take a
look at both these methods in further detail.

Benefit Measurement Methods

Benefit Measurement is a project selection technique based on the present value of estimated
cash outflow and inflow. Cost benefits are calculated and then compared to other projects to
make a decision.
The techniques that are used in Benefit Measurement are as follows:

Benefit/Cost Ratio

Cost/Benefit Ratio, as the name suggests, is the ratio between the Present Value of Inflow or the
cost invested in a project to the Present Value of Outflow, which is the value of return from the
project. Projects that have a higher Benefit Cost Ratio or lower Cost Benefit Ratio are generally
chosen over others.

Economic Model
EVA, or Economic Value Added, is the performance metric that calculates the worth-creation of
the organization while defining the return on capital. It is also defined as the net profit after the
deduction of taxes and capital expenditure.

If there are several projects assigned to a project manager, the project that has the highest
Economic Value Added is picked. The EVA is always expressed in numerical terms and not as a
percentage.

Scoring Model

The scoring model is an objective technique: the project selection committee lists relevant
criteria, weighs them according to their importance and their priorities, then adds the weighted
values. Once the scoring of these projects is completed, the project with the highest score is
chosen.

Payback Period

Payback Period is the ratio of the total cash to the average per period cash. It is the time
necessary to recover the cost invested in the project. The Payback Period is a basic project
selection method. As the name suggests, the payback period takes into consideration the payback
period of an investment. It is the time frame that is required for the return on an investment to
repay the original cost that was invested. The calculation for payback is fairly simple:

Cost of the project/ average annual cash inflow

When the Payback period is used as the Project Selection Method, the project that has the
shortest Payback period is preferred since the organization can regain the original investment
faster. There are, however, a few limitations to this method:

It does not consider the time value of money.

Benefits accrued after the payback period are not considered; it focuses more on the liquidity
while profitability is neglected.

Risks involved in individual projects are neglected.

Net Present Value

Net Present Value is the difference between the project’s current value of cash inflow and the
current value of cash outflow. The NPV must always be positive. When picking a project, one
with a higher NPV is preferred. The advantage of considering the NPV over the Payback Period
is that it takes into consideration the future value of money. However, there are limitations of the
NPV, too:
There isn’t any generally accepted method of deriving the discount value used for the present
value calculation.

The NPV does not provide any picture of profit or loss that the organization can make by
embarking on a certain project.

For more details on the NPV and how to use the NPV as a tool to filter projects out, here’s an
insightful article on calculating the opportunity costs for projects.

Discounted Cash Flow

It’s well-known that the future value of money will not be the same as it is today. For example,
$20,000 won’t have the same worth ten years from now. Therefore, during calculations of cost
investment and ROI, be sure to consider the concept of discounted cash flow.

Internal Rate Of Return

The Internal Rate of Return is the interest rate at which the Net Present Value is zero—attained
when the present value of outflow is equal to the present value of inflow. Internal Rate of Return
is defined as the “annualized effective compounded return rate” or the “discount rate that makes
the net present value of all cash flows (both positive and negative) from a particular investment
equal to zero.” The IRR is used to select the project with the best profitability; when picking a
project, the one with the higher IRR is chosen.

When using the IRR as the project selection criteria, organizations should remember not to use
this exclusively to judge the worth of a project; a project with a lower IRR might have a higher
NPV and, assuming there is no capital constraint, the project with the higher NPV should be
chosen as this increases the shareholders’ profits.

Opportunity Cost

Opportunity Cost is the cost that is given up when selecting another project. During project
selection, the project that has the lower opportunity cost is chosen.

Constrained Optimization Methods

Constrained Optimization Methods, also known as the Mathematical Model of Project Selection,
are used for larger projects that require complex and comprehensive mathematical calculations.
The techniques that are used in Constrained Optimization Methods are as follows:

The Techniques in constrained optimization method:

 Linear Programming  Non linear Programming Integer programming

Dynamic Programming Multiple objective Programming
 Non-Financial Considerations
LINEAR PROGRAMMING: In this method, you look towards reducing the project cost by
efficiently reducing the duration of the project. You look for running an activity in its
normal time or the crash time. The crash time of the activity enables you to reduce the
activity time or the project as a whole.

INTEGER PROGRAMMING: In this method, you look towards a decision that works on
integer values and not on fractional values. For example, producing a number of cars can
never be fractional.

DYNAMIC PROGRAMMING: In this method, you break a complex problem into a sequence
of simpler problems. This method provides a general framework of analyzing many
problem types. In this framework, you use various optimization techniques to solve a
specific aspect of the problem. This method requires your creativity before you can decide
if the problem needs to use dynamic programming for its solution.

MULTIPLE OBJECTIVE PROGRAMMING: In this method, you make decision for multiple
problems with mathematical optimization. In case, in a multi objective programming, a
single solution cannot optimize each of the problems, then the problems are said to be in
conflict and there is a probability of multiple optimal solutions. A solution is called as non-
dominated if values of none of the problem can be optimized without degrading values of
another problem.

 Non-Financial Considerations

There are non-financial gains that an organization must consider; these factors are related
to the overall organization goals. The organizational strategy is a major factor in project
selection methods that will affect the organization’s choice in the choice of project.
Customer service relationships are chief among these organizational goals. An important
necessity in today’s business world is to build effective, cordial customer relationships.

Other organizational factors may include political issues, change of management,

speculative purposes, shareholders’ requests, etc.

PROJECT FORMULATION:

Project Formulation is a concise, exact statement of a project to set the boundaries or

limits of work to be performed by the project. It is a formal document that gives a distinctive
identity of the project and precise meaning of project work to prevent conflict, confusion, or
overlap.

Project formulation can be also defined as one of the stages in the lifecycle of a project. The
formulation stage is also called Initiation, Conceptualization, Definition, Pre-Project. This stage
aims to:
  Carefully identify and weight various components of project work
 Analyze project feasibility and cost-effectiveness
 Examine and approve project inputs and outputs
 Identify stakeholders and their involvement and contribution
 Define benefits and expectations
 Estimate resources needed
 Perform a preliminary analysis of risks
 Make an outline of project schedule

When all these steps are done, the stage results in developing a formulation document that
defines and approves a proposed project. This document is to be submitted to the sponsor for
review and signature. Once it is signed, the project is to be provided with necessary funds.

STAGES OF PROJECT FORMULATION:

1. Feasibility analysis
2. Techno-Economic Analysis
3. Project Design and network analysis
4. Input analysis
5. Financial analysis
6. Cost-benefit analysis
7. Pre-investment analysis

Feasibility Analysis

 First stage in project formulation

 Examination to see whether to go in for a detailed investment proposal or not
 Screening for internal and external constraints

Techno-Economic Analysis

Screens the idea to

 Estimate of potential of the demand of goods/services choice of optimal technology.
 This analysis gives the project a platform for preparation of detailed project design

Project Design and Network Analysis

 It is the heart of the project entity

 It defines the sequences of events of the project
 Time is allocated for each activity
 It is presented in a form of a network drawing
 It helps to identify project inputs, finance needed and cost benefit profile of the project
Input Analysis

 It’s assesses the input requirement during the construction and operation of the project
 It defines the inputs required for each activity
 Inputs include materials, human resources
 It evaluates the feasibility of the project from the point of view the availability of
necessary resources
 This aids in assessing the project cost

Financial Analysis:
 It involves estimating the project costs, operating cost and fund requirements
 It helps in comparing various project proposals on a common scale
 Analytical tools used are discounted cash flow, cost-volume-profit relationship and ratio
analysis
 Investment decision involve commitment of resources in future, with a long horizon
 It needs caution and foresight in developing financial forecasts

Cost Benefit analysis

 The overall worth of a project is considered

 The project design forms the basis of evaluation
 It considers costs that all entities have to bear and the benefit connected to it.

Pre-investment Analysis

 The results obtained in previous stages are consolidated to arrive at clear conclusions.
 Helps the project-sponsoring body, the project implementing body and the external
consulting agencies to accept/reject the proposal

PROJECT REPORT PREPARATION:

If a company seeking financial assistance for implementation of its business idea is required
to prepare a Project Report covering certain important aspects of the project as detailed below:

 Promoters background/experience
 Product with capacity to be built up and processes involved
 Project location
 Cost of the Project and Means of financing thereof
 Availability of utilities
 Technical arrangements
  Market Prospects and Selling arrangements
 Environmental aspects
 Profitability projections and Cash flows for the entire repayment period of financial
assistance

Spreadsheets formats attached with this document will help you prepare a Detailed Project
Report for your Bank. You may omit the manufacturing related information in case you are
applying for a non-manufacturing project.

Since the appraisal of the Project involves evaluation of the Project in the following areas, your
company/you would be required to submit certain documents/information in the matter.

Management Evaluation

 Memorandum and Articles of Association : Object, authorised and paid-up share

capital,promoter's contribution, borrowing powers, list of directors on the Board, terms of
appointment of directors
 Your company as the Promoter : Corporate plan of the Company, projects
promoted/implemented/under implementation, Bankers' report on dealings and
repayment of past loan assistance, details of group companies, operations, balance sheet
and profit & loss account of the promoter company
 New Promoters : Educational background, any industrial experience, family background,
sources of income, details of personal properties, banker's reference, income tax/ wealth
tax returns
 Management and Organisation set up : Broad composition of the Board, details of full
time directors and their responsibilities, details of Chief executive and functional
executives including qualification, experience, organisation set-up for existing company
and during project implementation for new company.

Technical Feasibility

 Technology and manufacturing process : Proven/new technology, basis of selection of

technology, competing technologies, performance data of plants based on the technology,
details of licensor of technology, process flow chart and description
 Location of the Project : Locational advantage, availability of raw material and other
utilities, infrastructure facilities, availability of labour, environmental aspects
 Plant and Machinery : List of machinery & equipment, details of suppliers, competitive
quotations, technical & commercial evaluation of major equipment
 Raw material, Utilities and Manpower : Details of raw materials and suppliers,
electricity and water supply, basis of manpower estimates, details of manpower eg.
managerial, supervisory, skilled/unskilled, training needs
  Contracts : Agreement with contractors detailing on know-how, engineering,
procurement, construction, financial soundness and experience of contractors
 Project monitoring and implementation : Mode of implementation, details of monitoring
team, detailed schedule of implementation.

Environmental Aspects: Air, Water and Soil Pollution, list of pollutants / Hazardous
substances, their safety, handling and disposal arrangements, compliance with national and
International Standards, Clearances and No objection certificates required and obtained etc.

Commercial Viability

 Existing and potential market demand and supply for the proposed product in respect of
volume and pattern
 Share of the proposed product of the company in the total market through marketing
strategy
 Selling price of the product and export potential, if any.
 Buy-back arrangements, if any.

Financial Appraisal

 Cost of the Project : This includes the cost of land & site development, building, plant &
machinery, technical know-how & engineering fees, miscellaneous fixed assets,
preliminary & preoperative expenses, contingencies, margin money for working capital.
Your company is expected to submit realistic estimates and reasonableness of the cost of
the project will be examined with reference to various factors such as implementation
period, inflation, various agreements, quotations etc.
 Means of Financing : Means of financing shall have to conform to proper mix of share
capital and debt. This includes share capital, unsecured loans from Promoters/associates,
internal accruals, term loans, Government subsidy/grant. Reasonableness of Promoters'
contribution in the form of equity and interest-free unsecured loans, if any, is ascertained
in view of commitment to the Project.
 Profitability Projections : Past records of financial performance of Your company will
be examined. Your company needs to submit profitability estimates, cash flow and
projected balance sheet for the project and for the Company as a whole. Based on the
projections, various financial ratios such as Debt -Equity ratio, Current ratio, Fixed asset
coverage ratio, Gross profit, Operating profit, Net profit ratios, Internal rate of
return(over the economic life of the project), Debt Service Coverage ratio, Earning per
share, Dividend payable etc. would be worked out to ascertain financial soundness of
your Project.

Economic Viability
 Your company will have to take real value of input as against the value accounted in
financial analysis for the purpose of economic evaluation of the project.
 Your company should carry out social cost benefit analysis as a measure of the costs and
benefits of the project to Society and the Economy.
 Economic analysis is therefore aimed at inherent strength of the Project to withstand
international competition on its own.