PROJECT PLANNING AND CAPITAL - kopykitab.com€¦PROJECT PLANNING AND CAPITAL BUDGETING An Overview...

PROJECT PLANNING AND CAPITALPROJECT PLANNING AND CAPITALBUDGETINGBUDGETING

An Overview1.1 Project Planning1.2 Project Report

• Meaning• Objective• Advantages• Contents• Techniques of project planning and scheduling

1.3Capital Budgeting• Meaning• Need for Capital Budgeting• Types of investment proposals• Techniques of Evaluation

Pay back period Pay back reciprocalAverage or Accounting rate of return Net present valueDesirability factor/Profitability index Internal rate of return Comparison of Techniques

• Impact of inflation⇒ Relevance of inflation⇒ Inflation and financial analysis⇒ Project appraisal under inflationary conditions⇒ Impact of inflation on Capital Budgeting⇒ Impact of inflation on investors⇒ Impact of inflation on inventory management

• Estimation of future cash flows⇒ Steps in developing relevant information for cash flow analysis⇒ Elements of risk and uncertainties⇒ Models of Risk analysis

� Hillier’s Model� Hertz Model

⇒ Methods of accounting for risk• Social Cost Benefit Analysis

⇒ Meaning⇒ Need⇒ Indicators of social desirability of the product⇒ Steps

TEAM OF PROFESSORS AT KALPESH CLASSES

PROF. KALPESH SANGHAVI (C.A.)

PROF. L.MURALIDHARAN (C.A.)

PROF. SOWMYNARAYANAN (C.A.)

PROF. RAJAGOPALAN (C.A.)

PROF. JAISON (C.A.)

NOW LIVING WORKING TOGETHER.

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1.1 PROJECT PLANNING:

Define Project Planning

It refers to the plan of an undertaking to:a. build up productive capacities,b. diversify its business, orc. extend its existing capacities

1.2 PROJECT REPORT

What do you mean by Project Report? Give the objectives?

1.2.1 Meaning:

It is a pre-investment and comprehensive study of investment proposals of an organization. It encompasses a thorough investigation relating to economic, technical, financial, social,managerial and commercial aspects.

A. project report deals with: a. Location of the projectb. The size and capacity levelc. The technological aspects, e.g., production process, availability of raw materials,

requirements of labour and machines.d. Government laws and regulations, etc.,

1.2.2 Objectives of Project Report:

a. To compare different investment opportunitiesb. To obtain financial assistance from a financial institutions and banks.

Enumerate the Advantage of a Project Report

1.2.3 Advantages of a Project Report:

a. It lays down objectives in various spheres of business.b. It evaluates the objectives in right perspective.c. It identifies constraints on resources, viz., manpower, equipment, financial and technological

etc.,d. It paves the way for management to seek financial assistance from financial institutions and

bank.e. Financial intermediaries like merchant bankers and underwriters also require project report

to evaluate project viability to revise funds from capital market.f. Successful implementation of a project depends upon the line of action as suggested in the

project report.

List out the contents of a Project Report

1.2.4 Contents of a Project Report

1. Information about industry and its status in the economy, present production and demand pattern, government policies, export potential, licensed and installed capacity.

2. Broad market trend of the product and by-products within and outside the states / country for 5 years.

3. Specifications and quality of raw materials required and their sources of availability.4. Production process.5. Availability of technical know-how within and outside country.6. Location of plant, its advantages and justification.7. Requirement of water, sources of water availability, etc.8. Total power requirements for the factory.9. Requirement for steam raising or processing, source and price.10. Implementing programme in the form of CPM / PERT and flow charts indicating critical path

and schedules.11. Cost of project-. It consists of cost incurred on land, building, plant and machinery,

equipment, off-site facilities, utilities and auxiliary facilities, preliminary expenses,contingencies, cost of spare, repairs and maintenance during trial run, pre-commissioningand commissioning expenses, working capital margin, etc.

12. Details of capital structure.13. Cost of production Break-even point of production cost should be given; effect or variation of

cost of raw materials, utilities, selling price, etc. should be indicated.14. Projected profitability for 5 years after commission.15. Cash flow statement and payback period.16. Technical feasibility and financial viability17. Organisation and management-description of corporate management, promoters

experience, organizational chart key personnel, power and responsibility structure.

Write a note on CPM/PERT as a technique of Project Planning

BRIEF TIME TABLE FOR NOVEMBER 2005 C.A. FINAL EXAMINATION. SUBJECT : DIRECT TAX

EXAMINATION BRANCH COMMENCING ADMISSION STATUS

NOV 2005 (A.Y. 2005-2006) ANDHERI 19-07-2005 In Progress

NOV 2005 (A.Y. 2005-2006) CHARNI ROAD 24-05-2005 In Progress

NOV 2005 (A.Y. 2005-2006) GHATKOPAR 17-07-2005 In Progress

Course Coverage for all the branches is the same.

1.2.5 TECHNIQUES OF PROJECT PLANNING AND SCHEDULING (CPM/PERT)

Following steps should be taken for using CPM and PERT for planning and Scheduling-

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a. Each project should be divided into a number of several independent jobs or activities. Thesejobs or activities must be separately listed.

b. The order of preference for different jobs should be determined.c. There will be certain jobs which have to be completed before others can be started while

some jobs may be done simultaneously. The jobs, therefore, are to be programmed and synchronized in a manner that no bottlenecks are created.

d. A graph or a picture may be drawn portraying each of the jobs and showing the predecessor and successor relationships amongst them. Such a chart shows which job has to come first and which has to come later. It also shows the time required for completion of various jobs.

Determination of critical path – The minimum time required to complete a project is shown by critical path. Critical path is the longest path in the project diagram. This helps in determining the date on which the project is completed. In order to make sure that the project is completed in time, attention has to be given to this path since any increase in time or activity / job will delay the completion of the project.







What is meant by capital Budgeting?

1.3 CAPITAL BUDGETING:

Capital Investment involves a cash outflow in the immediate future in anticipation of returns at future date. The investment of funds requires a number of decisions to be taken in which funds are invested and benefits are expected over a long period. A capital investment decisioninvolves a largely irreversible commitment of resources that is generally subject to significant degree of risk. The finance manager therefore is required to do a proper planning of project to know in advance technical and financial feasibility of the project.

1.3.1 Meaning of Capital Budgeting:

• Capital budgeting refers to the long term planning of expenditure whose returns stretch over future period

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• It is the process of deciding whether or not to commit the resources to a project whose benefits would be spread over several time periods.

• It considers proposed capital outlay and its financing. Thus, it includes both raising of long term funds as well as their utilization.

Elaborate on the nature of Capital Budgeting

1.3.2 Nature of Capital Budgeting:

• Involves Huge Cash Outlays• Intended to receive benefits over a longer period.• Irreversible decisions are involved.• Capital assets once acquired cannot be disposed off except at a substantial loss.• Wrong decisions may lead to liquidation• If there are no increased earnings from the purc hase of the additional capital assets, the

ability of the company to discharge its financial obligations may be affected adversely.• Expansion of capital facilities by means of the issue of shares may dilute holdings in the

company and if not carefully planned and controlled, it can result in the loss of control by the management.

• In this context the forecasting and budgeting of capital expenditure becomes a vital part of policy making and management function. It influences long-term prospects and future earning capacity of the firm.

What are the types of Investment Proposal?

1.3.3 Types of Investment Proposal:

A firm may have several proposals for its consideration. It may adopt one of them, some of them or all of them depending upon whether they are independent, contingent or dependent or mutually exclusive.

1. Independent proposals:These are the proposals, which do not compete with one another. In case of such proposals the firm may straight away accept or reject on the basis of a minimum return on investment required.

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PROF. JAISON (C.A.)


2. Contingent or dependent proposals:These are the proposals, whose acceptance depends on the acceptance of one or more other proposal. When a contingent investment proposal is made, it should also contain the proposal on which it is dependent in order to have better perspective of the situation.

3. Mutually Exclusive Proposals:These are proposals which compete with each other in such a way that the acceptance of one precludes the acceptance of other(s). Thus in case of two or more mutually exclusive proposals, only one of the proposal can be accepted.

What factors affect Capital Investment Decisions?

1.3.4 FACTORS AFFECTING CAPITAL INVESTMENT DECISIONS:

1) Amount of investment2) Operating cash inflows3) Choice of horizons

Risk and Uncertainty involved in appraisal:

Evaluation of capital expenditure proposal involves projects of the future. Future is always uncertain. Nobody can say with certainty about the quantum and frequency of the future cash flows. There are too many unknown and uncertain factors which influence cash flows and therefore, it is important to recognise that each cash inflow or outflow is only a probable figure.It is necessary to consider risk and uncertainty while carrying out the capital budgeting exercise.Risk and return have a direct relationship. Higher the return from the project, higher would be the risk normally and vice versa. It is, therefore, necessary that the capital budgeting exercise

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should attempt to optimise both, the return and risk factors. The Hiller’s or Hertz’s models of risk analysis may be used. (For any inquiry or admission to kalpesh classes dial 2382 0676)

1.3.5 Techniques of Capital Budgeting:

Briefly explain about Payback period as a Capital Budgeting technique. Give its Merits & Demerits.

1. PAYBACK PERIOD:

Meaning: Payback period refers to the period in which the project will generate the necessarycash to recoup the initial investment (i.e., Capital Recovery Period) Give its Merits & Demerits

Formula: Payback period = lowinfCashAnnual

investmentInitial

Annual cash flows = Estimated cash inflow resulting from the proposed investment (i. e. net income on account of investment before depreciation but after taxation)In case of uneven cash inflows, by calculating cumulative cash inflows, the pay-back period can be calculated.

Accept or reject criterion: A project whose actual pay-back period is more than what has been predetermined by the management will be straightaway rejected. The fixation of maximum acceptable pay-back period is generally done by taking into account the reciprocal of the cost of capital (i.e. maximum acceptable pay-back period = 100 divided by desired rate of return)

The payback period can also be used in case of mutually exclusive projects. The projects are then arranged in ascending order according to the length of their pay back periods.

It may be said that pay-back period is a measure of liquidity of investments rather than their profitability. It should more appropriately be treated as a constraint to be satisfied rather than as a profitability measure to be maximized.

Sometimes payback period is calculated after discounting the cash flows by a predetermined rate. The payback period so calculated is called “Discounted Payback Period”.

Merits:1. The method is very useful in evaluating those projects which involve high uncertainty2. The use of pay-back method is preferred on the ground that returns beyond 3 or 4 years are

so uncertain as to disregard them altogether in a planning decision.3. A firm which is short of cash, must necessarily place a premium on quick return of its funds.4. The method is easy to understand and simple to operate5. The method reduces the possibility of losses through obsolescence.

Demerits:

1. The method ignores the returns beyond pay-back period, so that a project of long gestation period with merit is likely to be rejected. Thus the method ignores the ‘Bigger the Better Principle’.

2. The method fails to take into account the period of time over which an investment is likely to yield savings.

PAYBACK RECIPROCAL:

Meaning: It is a reciprocal of payback period. It is calculated as follows:

Formula:InvestmentInitial

InflowCashAnnual

Payback period method does not indicate any cut off period for the purpose of investment decision. The reciprocal of payback is a close approximation of the internal rate of return, if the life of the project is at least twice the payback period and project generates equal amount of the annual cash inflows.

What do you understand by ARR? Explain Discuss the Merits & Demerits

2. ACCOUNTING OR AVERAGE RATE OF RETURN (ARR):According to this method, the capital investment proposals are judged on the basis of their relative profitability. For this purpose, capital employed and expected income are determined according to commonly accepted accounting principles and practices over the entire economic life of the project and then the average yield is calculated. Such a rate is termed as Accounting rate of return. It may be calculated, according to either of the following formulae –

i.investmentOriginal

earningsnetannualAveragex 100

ii.InvestmentAverage

earningsnetaverageAnnualx 100

The term “Average annual net earnings” is the average of the earnings (after depreciation and tax) over the whole of the economic life. One may calculate “Average annual net earnings “before tax. Such rate is known as pre – tax accounting rate of return.

BRIEF TIME TABLE FOR NOVEMBER 2005 C.A. FINAL EXAMINATION.SUBJECT : DIRECT TAX






The amount of “Average Investment” is calculated as follows –

2valueScrapinvestmentOriginal −

+ Additional Net Working Capital + Scrap Value

Accept / Reject Criterion – Any project expected to give a return below minimum desired rate of return will be straightaway rejected. In case of several projects, where a choice has to be made, the different projects may be ranked in the descending order on the basis of their rate of return.

Merits:1. The method is superior to pay-back period as it takes into account savings over the entire

economic life, even though estimates of distant future may be subject to wide margins or errors.

2. The projects differing widely in character can be compared properly.3. The method embodies the concept of ‘Net earnings’ after allowing for depreciation as it is of

vital importance in the appraisal of a proposal.

Demerits:1. The method suffers from the fundamental weakness as that of pay-back method i.e. it

ignores the fact that receipts occur at different time intervals i.e. it ignores time value of money.If earnings from different investments accrue at the same time, this method can be safely used.

2. The method has different variants, each of which emerge different rate of return for oneproposal. This situation arises due to diverse concept of investments as well as earnings.

3. Some analysts are of the opinion that as the, method takes into account earnings after depreciation, it is gross error because it is only the cash flows, occurring subsequent to the sinking fund investments, that are relevant for the decision making purpose.

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Write a brief note on DCF method used in Capital Budgeting Decision.

3. DISCOUNTED CASH FLOW (DCF) METHOD:An investment is an essential outlay of funds in anticipation of future returns. The presence of time as a factor in investment is fundamental rather than incidental for the purpose of evaluation of investments. Time is always a crucial for the investor, so that a sum received today is worth more than the sum to be received tomorrow. Thus in evaluating investment projects, it is important to consider the timings of return on investments.

Assumptions of Discounting Factor Table:1. Opportunity for investment is available at any time for any amount.2. Interest will accrue at the same rate.3. Interest will be received at the end of the year.4. Interest will be reinvested at the same opportunity rate5. Price level remains the same.

DCF methods for evaluating capital expenditure proposals are of two types –i. Present Value Method (PV) / Net Present Value Method (NPV)ii. Internal Rate of Return Method (IRR)







I. PRESENT VALUE METHOD / NET PRESENT VALUE METHOD / PROFITABILITY INDEX:

a. Present Value Method :

Explain:a. Present Value Method (PVM)b. Net Present Value Method (NPVM)c. Profitability Index

This method is also know as discounted cost-benefit ratio method. It takes into account the entire income whenever received and to this extent it complies with “The Bigger the Better” Principle. Moreover, introduction of compound interest into the calculations gives more weight to the early receipts than the late ones. Thus this method gives effect to both the principles.

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Under the present value method, present value of cash inflows is calculated at the rate of return acceptable to the management, which is compared with the original investment to determine prospective profitability. This method is not suitable in case of projects having different size of Investment. (To know more about us visit KalpeshClasses.com)

Accept / Reject Criterion:An investment proposal should be accepted, other things remaining the same, if the present value of its cash inflows, discounted at a specified rate of return, equals or exceeds the amount of the investment required. The discounting rate or factor is also referred to as the required earning rate.

PV > C accept the proposalPV = C accept the proposalPV < C reject the proposal

Where,PV = Present value of Cash in flowC = Present value of cash out flow

b. Net Present Value Method :

The net present value is the difference between present value of benefits and present value of costs. If the net present value is positive, the conclusion is favourable to the decision to go ahead with the project but if it is negative, the project is rejected. The analyst who uses this method feels that it gives desired indication with the least confusion.

Accept/Reject Criterion:NPV > Zero accept the proposalNPV = Zero accept the proposalNPV < Zero reject the proposal

Where,NPV = Net Present Value

c. Profitability Index / Desirability Factor :

If the present value method is used, the present value of the earnings of one project cannot be compared directly with the present value of earnings of another, unless the investments are of the same size. In order to compare proposals of different size, the flows to investment must be related. This is done by dividing the present value of earnings by the amount of investment, to give a ratio i. e. called the profitability index / ratio or desirability factor.

Profitability Index = OutflowCashDiscounted

flowinCashDiscounted

Or

Profitability Ratio = OutflowCashDiscountedInflowCashDiscounted

x 100

Higher the index number, the better the project. This is also called benefit cost ratio.

Accept / Reject Criterion –PI > 1 accept the proposalPI = 1 accept the proposalPI < 1 reject the proposal

Where,PI = Profitability Index

What do you understand by IRR?

II. TIME ADJUSTED RATE OF RETURN OR INTERNAL RATE OF RETURN (IRR):

In the net present value method, the required earnings rate is selected in advance. There is an alternative method which finds the earnings rate at which the present value of the earnings equals the amount of the investment. This rate is called the time – adjusted rate of return, DCF rate of return, internal rate of return, yield rate, marginal efficiency of capital etc.,IRR is the rate which brings the sum of the future cash flows to the same level as the original investment. Thus IRR is the rate of return at which the sum of discounted cash inflows equals the sum of discounted cash outflows.

Accept / Reject Criterion:IRR > Cut-off-rate accept the proposalIRR = Cut-off-rate accept the proposalIRR < Cut-off-rate reject the proposal

Where,IRR = Interest Rate of Return

Under this method it is presumed that cash inflows can be reinvested at internal rate of return.

Discuss the Merits & Demerits of DCF Technique

Merits of DCF Technique:1. Conceptually DCF techniques are superior to other methods. It is more objective because its

conclusion is not directly influenced by decisions regarding depreciation methods,capitalization v/s expense decisions etc.,

2. Erratic flow of revenues and expenses over the project’s life are directly considered under this method while they are averaged out under other methods.

3. DCF method automatically gives more weight to the units of money which are nearer, than to those which are distant, while, under other methods, distinct units of money areunrealistically treated with the same weight as present units.

4. The method enables a ready comparison to be made between projects having different lives and different timings of cash inflows because discounting process allows comparison to be made at the same point of time.

5. It is strictly comparable to cost of capital ratios so that decisions can be made quickly and safely by comparing rate of return and value of money to the firm.






PROF. JAISON (C.A.)


Demerits of DCF Technique:1. It is pointed that other methods of ranking investment proposals are easier to understand

and simple to apply than DCF methods. The supporters of this method argue that the difficulty is over estimated and reluctance in using this method is more on account of unfamiliarity than its complexity.

2. The method does not correspond to accounting concepts for recording costs and revenue with a consequence that special analyst is necessary for the study of a capital investment.

3. Though the method is an advanced one over the other methods, it is not a dependable ranking method in as much as it does not reflect the firm’s cost of capital. As a matter of fact the profitability of a capital proposal can be judged only when net income on account of operations is considered.

4. The method is based on the presumption that the cash inflow can be invested at the discounting rate in the new projects. However this assumption does not always hold good especially when IRR is much higher than normal opportunity rate say Bank Rate. This also depends upon available investment opportunities.

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Strategic Financial Management

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