Project Investment Appraisal Process

Steps Involved

• Generation and Screening of Project Ideas

• Market and Demand Analysis
• Technical Analysis
• Financial Analysis

Step 1: Generation and Screening of Project Ideas

Key to Success: Getting in to right business at the right time at

right place

Identification of such opportunities requires:

• Imagination
• Sensitivity to environmental changes
• Realistic assessment

Environment to be looked in to:

Economic sector: state of economy, growth rate, inflation, linkage

to world economy, balance of payment situation etc
Government policy: tax, subsidies, import/export policies,
industrial and environment policy etc.
Technology: emergence of new technology, availability of
knowhow
Socio-demographic: Population, income distribution, attitude etc
Competitors: Market share of players, product features, entry
barriers
Suppliers: Availability and cost of raw materials, energy, money
Development of Project Ideas

1. Analyse the performance of existing industries

Profitability and Breakeven levels
Capacity utilisation
2. Examination of Input and output of Industries
Materials/parts/components
Purchased/manufactured
Time lag and transportation cost of raw
materials/parts/components
Value addition possibilities of output/waste
3. Review of imports and exports
4. Investigate local materials/Resources/Skills
5. Study new technology development
6. Draw clues from consumption abroad
7. Analyse economic and social trends
8. Input from trade fairs
9. Suggestions from Government/Developmental agencies

Preliminary screening of projects

Factors based on which initial screening done

1. Compatibility of the promoter (interest, personality and

resources)
2. Consistency with government priorities
3. Availability of inputs (Money, technical knowhow, energy,
raw materials)
4. Adequacy of market (demand, supply, competition, export,
growth, sales and distribution)
5. Reasonableness of cost (man, material, administration,
overheads, service, tax)
6. Risk level (business cycle, technology change, competition
from substitutes and imports, government control)
7. Profitability
8. Any other factors.....
Construction of Rating Index

Factors Factor Rating Score

weight VG (5) G (4) A P VP
(3) (2) (1)
1 0.25 √ 1.00
2 0.10 √ 0.40
3 0.05 √ √ 0.25
4 0.40 √ 1.20
5 0.20 √ 1.00

Total 1.00 3.85

Max possible score:???

Minimum possible score:???
Predetermine the hurdle value (pass mark)

Steps involved in Preliminary Project Rating

1. Identify factors relevant for project rating

2. Assign weights to these factors
3. Rate the factors in view of the business proposal &
environment
4. Scale can be 5 point or 7 point scale
5. For each factor, multiply factor rating with factor
weight to get the score
6. Add all the scores to get overall project rating index
7. Compare the overall project rating index with hurdle
value as well as alternate proposals
Step 2 : Market and Demand Analysis

Objective

• To estimate the potential size of the market for proposed

product/service (aggregate demand)
• The market share that the proposed product likely to be
captured

In-depth study and assessment of following factors are required

• Consumption growth
• Income/Price elasticity of demand
• Composition of market
• Nature of competition
• Availability of substitutes
• Reach of distribution networks

Key steps in market and demand analysis

• Situation Analysis and Specification of Objectives

• Collection of Secondary Data
• Conduct of Market Survey
• Characterisation of Market
• Demand Forecasting
• Market Planning
Situational analysis

1. Carried out to get a feel of relationship between product and

market
2. To define the objective of market and demand analysis
clearly

Product-Market feel is obtained by informal discussions with:

• Customers – preference & purchasing power of customer
• Competitor-Action and strategies of competitors
• Middlemen-practices of middle man
Objectives are defined in the form of a set of questions.

Example for AC

• Who are the buyers?

• What is the total market demand?
• How demand is distributed over seasons?
• How demand is distributed over geographically?
• What is the break up demand of different sizes?
• What prices customers are willing to pay for improved
versions?
• How customers can be convinced for new product
• What price and warranty will ensure its acceptance
• What distribution channel is most suitable?
• What trade margins distributers expect?
• What are the prospects of immediate sale?

Secondary Data collection

• Information generated in another context and already

available
• Related to the product directly or indirectly
• Starting point for the study
• Give direction for collection of remaining data

Where available: Publications of Trade/Industry, Government

Reports, Statistical abstracts, Census/Population Survey,
Economic survey, Planning Commission Reports, Economic
journals etc.
Conduct of Market survey (Collection of Primary data)

Data collection related to Demand, Customers (income, motives,

product choice, habits...), socio economic characteristics,
Distribution & trade practices etc.

• Census survey (entire user group-which is small)

• Sample survey (for bigger user groups)

Steps:

1. Target population determination

2. Sampling scheme/Size
3. Development of questionnaire
4. Training of field investigators
5. Data collection
6. Analysis of data

Characteristics of Market

Based on the information gathered from secondary data and

market survey, the market for the product/service is described in
following terms

• Effective demand in past and present

Apparent Consumption = Production + Import –Export
–Changes in Stock Level
In competitive market effective demand and apparent
consumption are equal. In non competitive market
such balance may not exist due to exchange
restrictions, control on production & distribution and
other market imperfections.

• Breakdown of demand (nature of demand may vary from

one segment to other)
• Nature of the product (passenger cars, sports car, luxury
cars etc)
• Consumer groups (Industrial and domestic etc..)
• Geographical divisions
• Price (Manufacturing price, Cost+ Insurance+ freight,
Landed price of imported goods, average wholesale price,
average retail price)

• Method of distribution and sales promotion

• Consumers (age, Sex, Income, Profession, Social
background, Preference, attitude, habits etc.)
• Supply and Competition (Domestic or foreign, their location,
present production capacity, planned expansion, capacity
utilisation, bottleneck in production)
• Government policy (government plans, policies, legislations,
tax structures, licensing, import/export restrictions,
penalties etc
Demand forecasting

Demand forecasting is the activity of estimating the quantity of

a product or service that consumers will purchase. Demand
forecasting involves techniques including both informal methods,
such as educated guesses, and quantitative methods, such as the
use of historical sales data or current data from test markets.

Demand forecasting may be used in making pricing decisions, in

assessing future capacity requirements, or in making decisions
on whether to enter a new market.

Qualitative methods

Jury judgment method

• Seeking opinion from Managers on expected future sales

and combining them to a sales estimate.
• It take consideration of many factors depends on the
expertise of managers
• Expeditious method
• Could be biased/subjective and non reliable

The Delphi method

• It is a systematic, interactive forecasting method which

relies on a panel of experts.
• The experts answer questionnaires in two or more rounds.
• After each round, a facilitator provides an anonymous
summary of the experts’ forecasts from the previous round
as well as the reasons they provided for their judgments.
• Experts are encouraged to revise their earlier answers in
light of the replies of other members of their panel.
• Process is continued till a reasonable consensus is
developed
Quantitative methods

Trend Projection method

• Trend/relation is developed from past data

• Calculate future demand from trend equation

Linear trend

Y Y= a + bt

b=slope, y/x

t
Exponential trend

Y Y= a e bt

b=slope, y/x

Exponential trend can be transformed to Logarithmic trend

Log Y = Log a + bt

Log Y Log Y = Log a + bt

b=slope, y/x

Log a

t
Polynomial trend

Y = a0 +a1 t1 +a2 t2 +..........an tn

Y Y = a0 +a1 t1 +a2 t2 +..........an tn

Second order Polynomial

Y = a0 +a1 t1 +a2 t2
A0

Estimation of trend

Demand

a0

Year
Visual Curve fitting

b = Change in Demand between two co ordinate/ Change in time

co-ordinate between the two points

Midpoint method

Arrange demand data in to two parts

Part 1 Part 2
Year Demand Year Demand
0 10 7 20
1 13 8 22
2 14 9 23
3 (Mid 17 10 22
point)
4 18 11 24
5 18 12 24
6 19 13 25
T2

b=

Demand corresponding to 2nd midpoint (22) - Demand corresponding to 1st

midpoint (17)

Time corresponding to 2nd midpoint (10)- Time corresponding to 1st

midpoint (3)

Least square Method

Income Elasticity Method

EI= (Q2-Q1/I2-I1) *( I1+I2/Q2+Q1)

EI=Income Elasticity
Q1= Quantity Demand of Base year
Q2 =Quantity Demand of following year
I1= Income level of Base year
I2= Income level of following year

Projected Demand in n years

= Present Demand x (1+ (% change in income level in n year x EI)

Moving average method

The forecast for next period is average of the sales for n previous
periods
F t+1=St+St-1+.........+St-n+1
F t+1=Forecast for next period
St=Sales for current period
N=period for which averaging is done

t Demand Forecast N=4

(Ft)
1 28
2 29
3 28.5
4 31
5 32.4 29.1 (28+29+28.5+31)/4
6 32.7 30.7 (29+28.5+31+
32.4)/4
7 33.5 31.6 28.5+31+
32.4+32.7)/4
8 31.8 32.9
9 31.9 33.1

N can be 4, 5, 6 depends on the estimator

Step 3: Technical Analysis

Technical Analysis

Technical analysis of a project idea includes decision on

suitability of the various processes, installing equipment,
specifying material and prototype testing. The investor has to be
careful in finalizing the technical aspects of the project as the
decision is irreversible and the investments involved may be high.
He has to select the technology required in consultation with
technical experts and consultants.

• Raw material/project inputs and supplies

• Technology/Process facility
• Location and site
• Organisation and Manpower
• Preproduction activities
• Environmental impact

Scope of Technical Analysis

• What and when to be produced/served?

• What quality of the product/services?
• What is the most appropriate technology?
• What is the cost of Technology?
• What facilities are needed?
• Environmentally and socially acceptable?
• Where should be the plant located?
• Required Materials and other inputs available
• Is the labour and other resources available
Raw material/project inputs and supplies

• Raw materials
• Processed industrial materials (base metals, semi-processed
materials, manufactured parts, components)
• Auxiliary Materials chemicals/additives/packing, fuel etc
• Utilities

Technology Selection – Major internal factors

• Product design and quality

• Production scale, plant and capacity
• Product mix & By-products
• Raw material properties and price
• Consumption of scarce resources
• Labour/capital costs
• Reliability considerations (less maintenance, breakdown etc)
• Cost of technology
• Use by other units/competitors
• Capacity to absorb technology
• Spareparts supply (cost/availability)
• Environmental impact

Technology Selection – Major external factors

• Environmental impact and mitigation

• Sustainability under local environmental conditions
• Infrastructure (water/electricity…..)
• Economic benefit/cost (labour intensive, forex saving etc…)
Technology Selection through SOWT Analysis

Favorable to Harmful to business

business objectives objectives
Internal factors Strength Weakness
External factors Opportunities Threats

Technology Strength Weakness Opportunities Threats

Tech-1 1.
2.
3.
Tech-2 1.
2.

Guidelines for Technology Selection

• Review the process flow chart

• Favor less maintenance and operational complexity
• Consider long term service and spare parts availability
• Identify qualification requirement of technical personals
• Environmental impact in terms of cost to be considered

Location and site

Project Locaion preferences depends on

• Production/Service factors (Raw material, man power)

• Site requirements
• Infrastructure (Road, water, Electricity)
• Markets & suppliers
• Cost and risk factors
• Environmental considerations
• Tax issues/Government Policies
• Access
Multi Criteria Location Analysis

Factors Factor Ranking

weight Location Location Location 3
1 2
1 0.25
2 0.10
3 0.05
4 0.40
5 0.20
Total xxxx
score
Ranking: Most Suitable to Least Suitable (5 to 1)
Score= Weight x Ranking
Organization and Manpower

Organization

o Organizational structure
o Clear chain of command
o Functional demarcation
o Project charts and layouts
o General plant layouts
o Material flow diagram
o Production line diagrams
o Transport layouts
o Utility consumption layouts (power, water, gas,
compressed air etc-principal consumption points, their
quantity and qualities)

Manpower

o Classification
o Salaries and wages
o Benefits and surcharge
o Training
o Recruitment

Manpower requirement of a typical project

• L1 Board of Administration
• L2 Advisor (1)
• L3 General Mamager (2)
• L4 Managers/Supervisory Staff (10/205)
o Planning (3)
o Administration (17)
o Sales (80)
o R&D (15)
o Production (100)
Environmental impact

Environmental impact: The effect of the proposed

business/human activities on environment (short term and long
term)

Environmental Impact Assessment (EIA) objectives

i. Predict environmental impact of projects

ii. Find ways and means to reduce adverse impacts
iii. Shape project to suit local environment
iv. Present the predictions and options to the decision-makers
v. Mitigation strategies and cost

Among the question to be asked include:

• What is the likely damage caused by the project to the

environment?
• What is the cost of restoration measures required to ensure
that the damage in the environment is contained within
acceptable limits?
Step 4 Financial Analysis

Evaluation Methods

• Net Present Value (NPV)

• Internal Rate of Return (IRR)
• Payback Period
• Profitability Index (PI)
• Equivalent Annual Annuity (EAA)

Steps in Financial Analysis

• Estimate cash flows (inflows & outflows).

• Assess risk of cash flows.
• Determine appropriate discount rate for project.
• Evaluate cash flows. (Find NPV or IRR etc.)
• Make Accept/Reject Decision

Cost considerations of a new project

• Pre-investment cost (sunk cost)

• Capital Investment
• Preproduction expenditure
• Operating expenditure/Working capital
• Contingency
• Opportunity cost
• Externalities (effect of cash flows in other parts of the firm
due to new project)

Pre-investment cost (sunk cost) - Cost of Feasibility studies,

Project proposal, Planning, Designing, , approvals etc. A sunk
cost is an outlay that already has been committed or that already
has occurred and hence it cannot be recovered regardless of
whether the project is accepted or rejected.
Capital investments

• Land
• Site preparation and development
• Plant and office building & Infrastructure
• Plant machinery and equipments
• Transportation and Installation costs
• Vehicles and material handling equipments

Preproduction expenditure

• Company registration charges and Legal documentation

• Interest during construction phase
• Preproduction marketing
• Trail runs
• Training
• Insurance charges/taxes

Operating expenditure/Working capital

• Raw Material Cost

• Packaging
• Maintenance and Spare Parts
• Water, Fuel and electricity
• Handling, Freight and Distribution
• Marketing costs
• Labour (Wages)
• Factory overheads
• Depreciation and financial charges

Opportunity cost

It is the benefit earned by the firm from the assets they already
own provided they are not used for the project in question. The
possible benefits (inflows) of alternate use must be charged as the
opportunity cost against the project. ex: Land that has to be
used by the project that could be sold and generate cash inflows.
Types of Risks Associated with Projects

Market risk - No enough information on the market of the

product/services the project is intended to offer. This will cause
reduction of the project return.

Human resource
Some of the projects requires highly specialized people who might
not be available locally or who are not available easily. More
applicable to the technical related projects.

Financial resources
In most cases, projects can be financed by the use of various
sources as discussed in Module 2. However, the financing
sources of the project can not be raised easily or the sources can
be very expensive than expected.

Technology risk - Issue of technology should be analyzed fully in

terms of its availability and sustainability.

Management risk
Sometimes the management for the project can be a risk of itself.
Management requires special skills to be developed and
maintained. The successful management of the project will lead
to the desired results and the vice versa is also true.

Timing
Timing of the project is very important to its success. Poor timing
may also result to the copying of the project idea by the
competitors in the market.

Intellectual property right issues

The consideration of the intellectual property rights is very
important in projects. This is because some of the resources for
the project may be subject to the intellectual property rights and
thus making the company incurring extra costs for this purpose.

Regulation risks
Changes in regulations can also be regarded as risk component
in the implementation and survival of projects. Another set of
regulation risk is tax changes on the pricing of the
products/services.

Discount Rate: Average Cost of Capital + Profit expected + Risk

Premium

Average Cost of Capital

Following are the Financial arrangement of a Capital Budgeting

Project of a particular Business organization. Find out the
Average Cost of Capital

Financing % Cost of Capital

Options Contribution
1 –Private Equity 25% 9%
2- Public Equity 20% 11.5 %
3- Loan Bank 1 20% 13.5%
4-Loan Bank 2 20% 15%
5-Loan from 15% 6%
Govt.

Financing % Cost of Average Cost of

Options Contribut Capital Capital
ion
1 –Private 25% 9% 0.25X9
Equity +0.2x11.5+0.2x13.
2- Public 20% 11.5 % 5+0.2x15+0.15x6
Equity =11.15%
3- Loan Bank 20% 13.5%
1
4-Loan Bank 2 20% 15%
5-Loan from 15% 6%
Govt.

Discount Rate= 11.5% + 5% Profit-Assumed + 3% (Risk

premium- Low business risk assumed)=19.9%