PM Module 2

8/7/2019 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

Prepared by Lakshmi K.S, DIT.


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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.


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





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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.


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


a) What aspects are considered in technical analysis?

b) What factors have a bearing on the choice of technology?

3) Introduction



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



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.


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


a) What are the components of cost of project?

b) What are the different techniques used for financial analysis?

3) Introduction



a) Introduction to Financial Analysis

b) Cost of Project



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c) Means of finance

d) Financial Evaluation Techniques

4) Revision



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%


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


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.


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


a) What are the different methods for risk analysis?

b) What are the sources of risk?

3) Introduction



a) Sensitivity analysis

b) Breakeven analysis

c) Decision tree analysis

d) Simulation analysis

4) Revision



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


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


Decision

point

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.


1. Discuss the steps involved in sensitivity analysis.

2. Discuss the procedure for simulation analysis.

Lecture 6

1) Synopsis: Social Cost Benefit Analysis


a) What are the objectives of SCBA?

b) What are the two approaches of SCBA?

3) Introduction



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a) Objectives of SCBA

b) UNIDO approach

c) Little-Mirrless approach

4) Revision



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.


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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1. What do you mean by shadow wage rate?

2. Discuss the UNIDO approach for SCBA.

PM Module 2

Documents

Transcript of PM Module 2