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Project Appraisal

Class 1

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What is a project?

A set of well defined activities , clear cutbeginning and end

Having a desired objective/ outcome. Consumption of large amounts of money Limitations on resources Not undertaken frequently

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The Process

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What is a project?

Definition:

Channelising predetermined amounts ofmoney to generate something that willassist the organization in designing andexecuting its strategies.

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What is project appraisal?

- A process of analyzing the technicalfeasibility and economic viability of projectproposal with a view to financing theircosts.

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Importance of project appraisal

It is a capital investment decision

It has long term effects Decision once taken is irreversible Expenditures are high

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Difficulties in respect of projectappraisal

Measurement of costs and potentialbenefits are difficult

High degree of uncertainty Long term spread time value of money

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Types of projects

Mandatory investment (to comply with statutoryrequirement)

Replacement investment New projects Expansion projects Diversification projects

Research and Development projects Public good /social welfare projects Infrastructure projects

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Project FinancingIn India barring infrastructure projects , projectfinancing is identical to corporate financing

Balance sheet based financing

Project financing is based on the creditworthiness of the sponsor (company or the bodyproposing the business idea to launch theproject )

Such loans are secured by not only the pool ofassets created out of the project but also theexisting assets of the sponsor.

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Project Financing

However in Western Economies the term Project Financing connotes financing that as apriority does not depend on the soundness or

creditworthiness of the sponsors.

Instead, it is a function of the projects ability torepay the debt contracted and remuneratecapital invested at a rate commensurate withdegree of risk associated with the project.

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Modern Definitionof Project Finance

Structured financing of a specificeconomic entity, the SPV created bysponsors using equity or mezzanine debtand for which lenders consider cash flowsas the primary source of loan repaymentwhereas assets represent only collateral .

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Distinctive features The debtor is a project company Lenders have only limited recourse or no recourse to the

sponsors Sponsors involvement in the deal is limited in terms of

time, amount and quality. Project risks are equitably allocated between all partieswith the objective of assigning risks to those parties whoare best able to control and manage them.

Cash flows generated by the SPV must be sufficient to

cover payments for operating costs and to service debt. Only residual funds after servicing debt are payable tothe sponsors.

Collateral is given by the sponsors to lenders for receiptsand assets tied up in managing the project.

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Why - Project Financing1. Avoidance of contamination risk

Where the size of the proposed project is very large compared tosize of the existing operations

Where the project means of financing involves higher leverage (D/Eratio)

In such a scenario with t radi t ional Corporate Financing the failureof the project (inability to yield ROI higher than WACC of theproject) can pull down even the existing operations of the sponsorand jeopardize returns to existing shareholders.

Failure of the new project leads to failure of existing operations andfailure of the business

In such cases project financing option is preferable

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Why - Project FinancingConflict of interest between sponsors and lenders and

wealth expropriation

However project financing will not provide the co-insurance benefit to the creditors.

This would happen in a case where the project fails butthe existing operations continue to perform.

The absence of contamination effect saves the existingcreditors and shareholders but the new creditors lose asthey do not partake the benefits of existing operations.

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Categories of project sponsors

Industrial sponsors

Public sponsors with social welfare goals Contractor/sponsors who develop , build

and run the plant

Pure financial investor.

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Risk Management aspects

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Project Life Cycle

Project life cycle and its impact onfeasibility

Conception and selection phase Planning and scheduling phase Implementation, monitoring and control

phase Evaluation and termination phase

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Project Life Cycle

Uncertainty regarding cost and time estimates inrespect of later stages

Estimates need to be adjusted and revised

periodically depending on the lessons leant inthe earlier cycles.

Typically the focus of project managers is initiallyon performance, and then shifts to costs andfinally meeting the deadline. But focus should beon performance from the beginning.

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THINK LIKE A PROJECTMANAGER

A clergyman, a doctor and a project manager were playing golf together oneday and were waiting for a particularly slow group ahead. The projectmanager exclaimed, "What's with these people? We've been waiting overhalf and hour! It's a complete disgrace." The doctor agreed, "They'rehopeless, I've never seen such a rabble on a golf course." The clergymanspotted the approaching greenkeeper and asked him what was going on,"What's happening with that group ahead of us? They're surely too slow anduseless to be playing, aren't they?" The greenkeeper replied, "Oh, yes,that's a group of blind fire-fighters. They lost their sight saving ourclubhouse from a fire last year, so we always let them play for free anytime."The three golfers fell silent for a moment. The clergyman said, "Oh dear,that's so sad. I shall say some special prayers for them tonight." The doctoradded, rather meekly, "That's a good thought. I'll get in touch with an

ophthalmic surgeon friend of mine to see if there's anything that can bedone for them." After pondering the situation for a few seconds, the projectmanager turned to the greenkeeper and asked, "Why can't they play atnight?"