Basics of Project Management: Project Appraisal

                                          2.PROJECT APPRAISAL

2.1.  Technical Analysis/Technical Appraisal

It is distinct from commercial, financial and managerial feasibility and it may vary from project to project. The common aspects to be analyzed are:

1. Objectives

• A project proposal must fall within the domain of the stated mission of the organization.

1. Location and site

• Identify as many as possible locations initially and choose the one which meets most of the requirements.
• In some of the projects like resource-oriented projects involve geological analysis also (Ex: Mining and Mineral projects)
• The location decision should be made after giving due consideration to benefits offered by Govt, and local bodies such as tax concessions, capital loans, subsidies, etc. For this purpose location cost index can be used for different cities.

Location Cost Index (LCI)

LCI for location A is

Where CA = cost of selling of plant at location ‘A’

CB = cost of the setting of a plant at location ‘B’

If LCI < 100, then project location should be preferred.

1. Plant size

Plant size should be optimum. The size of the plant may have an impact on break-even, loss and profit-

1. Technology

Same services/products can be obtained by using different technologies, for example solar energy or Hydel or thermal energy, manual or mechanised services, etc.

• A technology is considered appropriate of it assessed satisfactorily under specific situation of a project.

The important aspects to be considered in selection of technology are:

• Specifications of the task
• Life or gestation period
• Ease or availability
• Adoptability or simplicity
• Cost involved
• Safety
• Operation and maintenance
• Environmental and Social aspects

1. Design, Layout and Machinery

• The design should be such that it is viable operating entity which not only works but works harmoniously under minimum cost and sustainable environment.
• The selection of machinery and plant layout should meet industrial and safety standards.

1. Construction process

This should be considered in feasibility study in terms of five aspects.

(a) Methodology to be followed i.e. whether it is capital intensive or otherwise.

(b) It is to be done in house or out-sourced.

(c) Procurement method (purchase of material/machinery)

(d) Sequence and scheduling of time to form bar chart/PERT network etc.

(e) Assessment of financial implications.

1. Operation inputs

These are related to operation phase but need to be identified during feasibility stage to examine technical feasibility

The main inputs to be examined are:

• Raw material
• Processed material
• Components and sub assemblies
• Spare parts
• Water, gas and fuel supply

1. Infra structural facilities

• Make assessment of roads, railways and other transport mechanisms.

1. Man power

• Availability
• Skills

1. Environmental Impact Assessment (EIA)

• Examine the impact of project on local environment.

2.2.  Market and Demand Analysis

Market and Demand Analysis are required to meet planning and decision making. Following are specifications needed for planning:

 (i) For short term planning decisions (Less than one year), the data required is specific items and that demand.

(ii) For Medium term planning (One to three years), the data required is aggregate demand of technology and site selection.

(iii) For long term planning (Four years or more), broad data and technology is required.

2.2.1. Demand Forecasting

Time of demand forecasts varies from 1 to 5 years and demand forecasting can be made at the following levels.

1. Firm level: It is micro-level forecasting based on specific industry.
2. Industry level. It is based on industry as a whole for the region. Those forecasts may be taken by group of companies or trade associations.
3. National level: It includes parameters like national income, index of industrial/agricultural production It is required for governmental decisions.
4. International level: It is required for multinational companies.

2.2.2. Criteria for a Good Forecasting

A good forecasting should have following attributes:

(i) Accuracy     

(ii) Plausibility (reasonable and consistent)

(iii) Economical

(iv) Less time taken

(v) User friendly and availability       

(vi) Durability

(vii) Flexibility

2.2.3. Steps Used in Demand Forecast

1. Determine the use of forecast
2. Select the item to be forecast
3. Determine the time horizon of the forecast
4. Select forecasting method
5. Gather data
6. Make forecast
7. Validate and implement results

2.2.4. Methods of Demand Forecasting

To facilitate proper and reliable appraisal of investment proposal, we require a reasonably accurate forecast of demand. Following methods are used for compiling and computing demand forecasts.

• Qualitative Methods

1. Collective Opinion Survey Method (Sales force composite method)

It is based on market survey i.e., opinion based on people of marketing and sales.

This method forms the basics of market analysis and demand forecasting. Although it is simple direct, first hand and most acceptable, but it suffers from following weaknesses.

(a) Estimates are based on personal judgement hence may be biased.

(b) It is difficult at national level.

(c) There may be error or lack of accuracy.

(d) There may be lack of experience

Note: This method may be used for long term forecast and for new products or new variants of existing products.

1. Survey of Customer intention method/Consumer Survey method

It is based on “what customer intends or prefers to buy". It can be done by personal contact or printed questionnaire or mail.

This method is preferred when bulk mass is from institutions and industrial buyers and only few of them have to be contacted, because the demand is similar type.

1. Delphi Method

It is group process, based on panel of experts which may include ordinary employees or industry expert; it aims at achieving a 'consensus' of the members.

It is based on:

• Analysing economic conditions
• Carrying out sample surveys
• Conducting opinion polls

Based on above, demand forecast is done as follows:

Step-1: Coordinator sends out a set of questions in writing to all the experts co-opted on the panel who are requested to write back a brief prediction.

Step-2: Written predictions of experts are collected, edited and summarized together by the Coordinator.

Step-3: Based on the summary, Coordinator designs a new set of questions and gives them to the same experts who answer back again in writing.

Step-4: Coordinator repeats the process of collating, editing and summarizing the responses. 

Step-5: Steps 3 and 4 are repeated by the Coordinator to experts with diverse backgrounds until consensus is reached.

1. Nominal Group Technique/Jury of Executive Opinion

It is an improvement over Delphi method. A panel of 7 to 10 experts is formed to interact and discuss all the suggestions in descending order as per following procedure.

(i) Experts sit around a table in full view of one another and are asked to speak to each other.

(ii) Facilitator hands over copies of questionnaire needing a forecast and each expert is expected to write down a list of ideas about the questions.

(iii) After everyone has written down their ideas, facilitator asks each expert to share one idea from his own list with the group. The idea shared is written on the 'flip chart' which everyone can see.

(iv) Experts give ideas in rotation until all of them are written on the 'flip chart'. No discussion takes place in this phase and usually 15 to 25 ideas emerge from this format.

(v) In the next phase, experts discuss ideas presented by them. Facilitator ensures that all ideas have been adequately discussed. During discussions similar ideas are combined and paraphrased appropriately. This reduces the number of ideas.

(vi) After completing group discussions, experts are asked to give in writing ranks to ideas according to their perception of priority.

(b) Quantitative Methods

There are two models in quantitative forecasting:

(a) Time series model

(b) Casual model

Time series is a evenly spaced numerical data approach which is obtained by observing response at regular interval. Past collected data are used for future forecast.

Where as in casual model, mathematical technique known as regression analysis is used that relates dependent variables (ex. Demand) to independent variables (ex. Price and advertisement) through linear equations.

1. Simple Average Method/ Naïve approach

Simple average of all past data is figured out for every month of the last 12 months.

Simple average 

1. Moving Average Method

It is better than simple average method because the obsolete and old data is discarded where as the trend for most recent period is used.

Moving average 

1. Weighted Moving Average Method

It is further improved in which weighted moving average allows to varying weightage for demand in old periods.

Weighted Moving average = W₁ . D₁ + W₂ . D₂ + …….. W_n . D_n 

Where W₁, W₂ … W_n are the weightage of the different periods in fraction such that

W₁ + W₂ + …. + W_n = 1

D₁, D₂ …… D_n are the demand of various periods.

2.2.5. Some Other Methods

1. Adoptive Exponential Smoothing
2. Exponential Smoothing with trend and seasonal data
3. Double exponential smoothing
4. Projection by curve fitting Economic models Leading
5. Regression Analysis
6. Indicator Method
7. End Use Method
8. Leading Indicator Method
9. Chain-Ratio Method

2.3. Financial Analysis/Financial Feasibility

Financial appraisal of project consists of two major areas viz., arriving at the cost of the project and arriving at the appropriate means of financing the project. By means of financing, we mean the combination of equity and debt. The proper equity-debt combination for a project depends upon the revenue earning capacity of the project. Though equity does not attract any interest and does not involve any repayment obligation, the debt obtained for financing the project is to be repaid along with interest. Hence, the revenue earning capacity of the project should be sufficient enough to meet the repayment of debt with interest. Moreover, the project should also generate additional revenue to meet the cost of equity capital. Though equity is contributed by the project promoters, it is not without any cost. An entrepreneur invests his capital in a project with a hope of getting returns on his capital invested apart from meeting debt obligations.

2.3.1. Financial Appraisal Involves:

• Estimation of project cost
• Estimation of project operating cost
• Estimation of project funds

2.3.2. Methods of Financial Analysis/Criteria Used for Selection of Investment Opportunities 

1. Average Rate of Return on Investment (ARR or ROI) or Accounting Rate of Return

This is an accounting method. There is no agreement on the definition and a number of alternative methods of calculating it are available. The most common ratio is:

• Average Annual Profit after taxes is calculated by adding up the after-tax profits for each year of project life and dividing it by the no. of years of estimated useful life (for annuities, after-tax profit is equal to one year’s profit).
• Average Investment over the project life is computed by dividing the net investment by two (straight line depreciation is assumed) and adding the salvage value that would be received at the end of the project life (since it remains invested throughout) and full amount of working capital required.

Average investment over project life

NOTE:

1. Working capital = Current Assets - Current Liabilities

It represents operating liquidity available to a business.

if current assets are less than current liabilities then working capital is deficit.

Payback Period (PB)

• It is a traditional method and widely used for project evaluation.
• It is a measure in terms of time which will take to recover the cost of investment.
• If Cash in Flow After Tax (CFAT) per annum is uniform / even / constant, then
• If cash inflow non even or variable year to year then

Where, A = Last period with negative cumulative cash outflow (Net invested cash flow)

B = Absolute value of cumulative cash outflow (i.e., Net invested cash flow) at the end of period A

C = Cash in flow during the next period after A 

NOTE: Accept the project only if its Payback period is less than the targeted Payback period. 

• If there are two projects then accept the project with least payback period. 

1. Discounted Cash Flow Techniques

Traditional methods of project evaluation do not take into account the total benefits from the entire life cycle of a project and they do not consider the time value of money. The techniques described below, discount life cash flows by the cost of capital—a discounting factor for adjusting time value of money. This analysis uses the future free cash flow projections and discounts them to arrive at present value estimates which is used to assess the potential of investment.

Discounted cash flow is calculated as

CF = Future cash flow, 

r  = Discounted rate (WACC), 1, 2, …..n is period

If DCF > Net present value (NPV)/Current cost, then project should be preferred.

(i) Net Present Value (NPV)

• The money received today is worth more than the sum received in the future i.e., it. has time value. This occurs for three reasons.

(a) Potential for earning interest (cost of finance)

(b) Impact of inflation

(c) Effect of risk

• Net Present Value (NPV) computes the net present value of the cash inflows (CFAT) in each of (he future year by discounting them suitably and then subtracting the cash outflow in each year.

2.4.  Economic Analysis (Economic Feasibility)

Economic analysis is done from the viewpoint of society or economy as a whole. The evaluation is done from a wider angle not merely in financial terms. Economic analysis of projects should cover whether

• It fits into national priorities
• it contributes to the development of that sector of economy
• benefits justify the consumption of scarce resources of the nation
• The project has to be evaluated for its economic viability

2.5.  Social Cost Benefit Analysis (SCBA)

This concept has evolved over years since 1844 when Jules Dupuit, A French engineer, referred to it in his paper on the measurement of "Utilities of Public Works’. In 1936, Flood Control Act of USA provided that a project should be deemed feasible only if sum-total of benefits to whom-so-ever they may accrue exceed the estimated costs, highlighting the social nature of investment decision. In UK, this was applied first time in 1917 for evaluating Motorway project, and nationalized industries were directed to use SCBA. India is a pioneer in the third world countries and has applied SCBA in appraising projects especially in the public sectors.

• The main objective of an individual, a firm or a company in investing on a project is to earn the maximum possible returns for the investment. Accordingly, the project promoters are solely interested in wealth maximization. Hence the project promoters tend to evaluate only the commercial profitability of a project. But there are some projects that may not offer attractive returns as far as commercial profitability is concerned, but still such projects are undertaken since they have social implications. Such projects are public projects like road, railway, bridge and other transport projects, irrigation projects, power projects etc., for which socio-economic considerations play a significant part rather than mere commercial profitability. Such projects are analysed for their net socio-economic benefits and the profitability analysis of such projects is known as national profitability analysis, which is nothing but the socio-economic cost-benefit analysis done at the national level.
• Every project imposes certain costs to the nation and produces certain benefits to the nation. The costs may be of two types viz. direct costs and indirect costs. So also, the benefit derived from any project will also be of two types, viz. direct benefits and indirect benefits.

(a) The social cost-benefit analysis lakes into account the real cost of inputs i.e., the cost of inputs had they not been subsidised. Accordingly, the required adjustments to direct costs of inputs are made for social cost-benefit analysis.

(b) Whereas in the direct cost and direct benefits are considered for commercial profitability analysis, socio economic cost-benefit analysis takes into account the indirect costs and indirect benefits to the nation. While a nation bears the indirect cost, the people of the nation enjoy the indirect benefits.

2.5.1. Objectives of Social Cost Benefit Analysis (SCBA)

SCBA aims to appraise the total impact that a project will have on an economy. Accordingly, SCBA focuses on the following objectives that a project is expected to fulfill.

• Contribution of the project lo the GDP (Gross Domestic Product) of the economy.
• Contribution of the project to improve the benefits to the poorer sections of the society arid to reduce the regional imbalances in growth and development.
• Justification of the use of scarce resources of the economy by the project.
• Contribution of the project in protecting /improving the environmental conditions.

2.5.2. Methods or Approaches to Social Cost Benefit Analysis (SCBA)

There are two approaches:

(a) UNIDO Method (United Nation Industrial Development Organisation)

UNIDO gave SCBA tor projects in developing countries in 1960s & followed it by a detailed guideline in 197B, which suggests live stages as below:

• Calculation of financial profitability of the project measured at market prices
• Calculations of not benefits of projects in terms of economic prices or shadow prices.
• Adjustment for the impact of project on savings and investments.
• Adjustment for the impact of project on income distribution.
• Adjustment for the impact on the merit goods and demerit goods for which social values differ from monetary values.

2.5.3. What Is Shadow Price?

If the price does not reflect the actual value of a good or commodity or no market value for a good exit, then shadow pricing can be used. The shadow price is a proxy value of a good, often defined by what an individual should pay to buy one unit of a good. It may be greater, equal, or less than the market price.

Ex. If there is unemployment then the shadow wage of labor is less than the market wage.

2.5.4. Little—Mirrless Method (L-M Method)

• L- M’s approach measures costs and benefits in terms of international price (also represented ns border price) as against the UNIDO method that measures costs and benefits in terms of domestic prices, The argument in favor of using international price as shadow price is that it helps offset the fluctuations in domestic price and justifies the project from the economy's point of view. It also helps to improve production efficiency and trade efficiency.

L-M Standard Wage Rate (SWR): L-M approach suggests the following relationship.

SWR = C- (1/s). [c-m]

Where SWR = Standard Wage Rate

C = Additional resources devoted to consumption

1/s = Social value of a unit of consumption so committed

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