Project Management Pai 2019

PROJECT
MANAGEMENT
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PRADEEP PAI
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1e
Project Management
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1e
Project Management
Pradeep Pai
Associate Professor
Narsee Monjee Institute of Management Studies School
of Business Management
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Copyright © 2019 Pearson India Education Services Pvt. Ltd
Published by Pearson India Education Services Pvt Ltd,

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Dedication
I dedicate this book to the memory of my father Late Kulyadi Prabhakar Pai
and my mother Late Prabha Prabhakar Pai.
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Contents
Preface xi
Acknowledgements xii
Foreword xiii
About the Author xi v
Chapter 1 Introduction to Project Management 1
Chapter 2 Project Network Analysis–I 31
Chapter 3 Project Network Analysis–II 143
Chapter 4A Demand Forecasting for Commercial Appraisal

of Projects 183
Chapter 4B Decision Tree Analysis 215
Chapter 5 Project Selection and Screening 235
Chapter 6 Project Financial Appraisal 269
Chapter 7 Detailed Project Report 319
Chapter 8 International Project Appraisal 391
Chapter 9 Project Finance and Cash Flows 401
Chapter 10 Project Risk Analysis and Management 419
Chapter 11 Real Options: Options to Enhance Project

Value 439
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x | Contents
Chapter 12 Organization Structure for better Project

Management 473
Chapter 13 Earned Value Analysis 491
Chapter 14 Future Trends in Project Management 517
Glossary 533
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Preface
Projects and Project Management techniques have been around for ages. Entrepreneurship,
which is an essential element for successful businesses, also follows the concepts of project
management very closely. Further, decision making, a key requisite for managers also
imbibes the properties of project management. It is therefore imperative that all managers
and business leaders be groomed in the skills of project management. The subject of project
management is thus an important part of the academic curriculum for all management
programs.
The subject of project management has many dimensions like the optimising aspects,
conceptual aspects, practical aspects, operational aspects, project case studies, project
guidelines, etc., which make the scope fairly wide. The contents that may be of relevance
to a project management practitioner or project management professional or a project
management student could be entirely different. Currently, most of the project management
books available cover one or some of the aspects listed above but miss out on the
comprehensive coverage of the subject from a student’s or a beginner’s perspective. Besides,
authors from the project management practising areas focus on the operational aspects,
those with a finance grooming focus more on the financial aspects of projects and the
optimizing experts focus only on project optimization by including this subject as a chapter
in Decision Sciences books.
Just like the scope for a project is very important for its success, the scope of this book
addresses the learner’s requirement of project management skills more than a practitioner’s
requirement. Having said that, the practitioner of project management could use this
book as a reference for the base topics and concepts on which the framework of project
management exists. Students and faculty will find this book most useful in understanding
the concepts of project management like the optimizing techniques for the various concepts
namely CPM, PERT, Crashing, Resources scheduling, Earned-value analysis along with a
comprehensive coverage of the financial aspects like capital budgeting, future cash flow
statements for project and the ratios that are important for project viability.
Some examples and Indian cases have been added to this book which we hope would
give the practical aspects of project management to the students. This book is appropriate
for MBA students, post-graduate courses in engineering, and senior undergraduate students
undertaking the course of project management for the first time.
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Acknowledgements
For any work as tedious and strenuous as writing a textbook, one needs a constant level of
motivation besides ample support. I am lucky on both these counts and wish to express my
sincere gratitude to everyone who has made the present book possible in its current form.
The primary motivation for this book has been the student fraternity whose requirement
of a comprehensive academic textbook in the subject of project management facilitated
this book and its contents. In fact, the idea for some of the contents of this book like agile
project management and future trends in project management was a result of the students’
assignments and class presentations. I express my gratitude to all my present and past
students for the same.
The environs for writing the book and the support system for referencing is key for good
quality work. My institute NMIMS School of Business Management (SBM) provided me
with all the facility required for producing quality work on the subject. I express my sincere
gratitude to SBM and the parent body SVKM for this opportunity and sincerely hope that
this work will be up to their exacting standards.
I express my gratitude to all my faculty colleagues who were always willing to support
me in this endeavour and helped me immensely in making this work possible. Prominently,
I received encouragement from Prof. Mayank Joshipura on project finance matters,
Prof. Papiya De on the usage of English language, Prof. Harikumar Iyer on chapterization
and Prof. Souvik Dhar in providing lighter moments when the proceedings were stressful.
My special thanks to Provost and Dean SBM Dr Ramesh Bhat for his critique and
encouragement at every stage of the development of this work.
I will be failing in my duty, if I do not acknowledge the support of the Vice Chancellor
of NMIMS University, Dr Rajan Saxena, for his wonderful words of advice and for writing
the foreword for this book.
I take this opportunity to thank Shri Raghunandan Kamath proprietor of Naturals Ice
creams for helping me write the case study on their successful business ventures.
My wife Sujata and daughter Priyanka were instrumental in keeping me awake all night
by providing ample cups of tea while writing this book and I take this opportunity to thank
them for their support always.
My sincere thanks to Partha Bhagowati, Varun Goenka for being extra patient with me
on many occasions and for lending a helping hand in every difficult situation. My gratitude
to everyone at Pearson for the wonderful work in compiling this text.
My prayers and thanks to God Almighty for his blessings for the success of this venture.
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Foreword
I am delighted to write this introduction for Pradeep Pai’s book on Project Management.
Pradeep Pai, who is a faculty at NMIMS School of Business Management, Mumbai, is an
acknowledged academic resource in Project Management and Operations Management. He
combines his understanding of the subject with industry experience. This book, therefore,
benefits from this unique combo experience of the author.
The book is an exhaustive text in the area of Project Management starting with concepts
in project management and defining significant players like government and the world bank
in project planning and execution. This is particularly true for emerging markets like India.
The author has also explained various tools in project analysis, planning and design and
execution. He has also covered the approaches and tools used in project appraisal and
selection. The unique feature of this book, I understand is a detailed section on financial
tools used in appraising the project. This book is suited for management programs of the
University of Mumbai and other Universities in India.
I recommend this book.
Dr Rajan Saxena, Vice-Chancellor of the SVKM’s NMIMS
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About the Author
Professor Pradeep Pai has been in the field of academics for over 28 years, along with
serving the industry parallelly for almost 20 years. His field of work has been in quantitative
subjects like Operations Research, Project Management, Business Statistics and Supply
Chain Management. Presently, he is working as Associate Professor, Decision Sciences and
Chairperson at NMIMS University, School of Business Management (SBM), an AACSB
accredited institute. He started his professional career with M/s Godrej GE Appliances Pvt
Ltd., in their refrigerator division. Besides his academic interests, Prof. Pradeep Pai also
consults organisations in the field of operations and management of projects.
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Chapter
1 INTRODUCTION TO
PROJECT MANAGEMENT
LEarninG OBJECTivES
After studying this chapter, you should be able to:

❍ Explain the project, project management, project life cycle and the fundamentals of project
management.
❍ Describe the ‘S’ curve.
❍ Examine the parameters for success of a project work breakdown structure (WBS).
❍ Enumerate the differences between an EPC company and a company’s own project
organization.
❍ Discuss the case study on project management—The Konkan Railway Corporation Limited.
INTRODUCTION
Mankind’s greatest marvels and landmarks, whether it is the Great Pyramid of Giza, construction of
canals for irrigation in Mesopotamia and Egypt, landing on the moon, building the magnificent the
Eiffel Tower or the Taj Mahal, are examples of successfully executed projects.
Projects are not only related to monuments or engineering feats but are also essential to business
ventures or personal decisions. Consider the following examples:
1. Mahindra & Mahindra Ltd, a $6 billion company is considering acquiring another automo-
bile company.
2. Mukand Ltd is considering an expansion project in its Hospet steel plant.
3. Mustang Engineering Company is considering the establishment of a new centre in India.
4. The Government of India is considering linking major rivers in the country.
5. A business executive is considering to purchase a new flat and has to select the best option
among various available options.
All the above examples comprise processes that are unique and non-repetitive. Each of these
examples explain situations where the schemes of investments can be assessed independently
besides laying out the milestones to be achieved in the process. The basic characteristic of a capex
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2 | Chapter 1
What is a project?
• A set of non-repetitive or an on-off kind of task is referred to as a project. The size of a
project in terms of investments, resources or outcome is not instrumental in describing any
activity as a project. However, a project is defined based on the fact that the set of tasks
should be non-repetitive, sequential and one of a kind.
• Some of the tasks comprising a project can proceed simultaneously, whereas some tasks
cannot happen unless the prior activities are completed. One of the objectives in project
management is to identify the set of tasks that require the longest duration and are termed as
critical path. This critical path defines the duration of the project, and in order to ensure that
the project does not get delayed, these critical path tasks should not be delayed.
• Any set of tasks in a project needs to be controlled within three set of parameters: scope,
time schedule and financial and other non-financial but key resource constraints, such as
manpower, equipment and finance. Proper planning and foresight help in the completion of
the project within the above listed constraints without much delay or confusion.
• At times, when there is a constraint on the availability of resources, knowledge of priority
rules for activities can be helpful in completing projects without affecting the project
schedule.
• Sometimes, there is a possibility of speeding up the project schedule by providing extra
resources at additional costs. The decision to avail of such facility or not is again a managerial
decision, which must be taken on the basis of cost-benefit analysis. This analysis is termed
as crashing.
• During the course of the project, there might be a peak requirement of a limited resource,
and at other times, that particular resource may not be required at all. The skew in the
requirement is ill-advisable and project management techniques help in streamlining these
peak and low demand periods.
• Activity on node (AON) diagrams are gaining popularity rapidly. Although the earlier
form of network, known as activity on arrow (AOA), is immensely popular, the utility
of an AON diagram makes it preferable to AOA. Situations where parallel processing of
preceding and subsequent activities, albeit a time lag is feasible, can be addressed by AON
networks. AOA networks cannot be admissible in place of AON networks involving parallel
processing.
or capital expenditure of a project typically comprises cash outflow (which can be current or
future) and cash inflow, with projects having higher cash inflow preferred over projects having
lower cash inflow.
Inventories are treated as assets in the balance sheet, whereas anyone involved in inventory
management (and, thus, exposed to concepts such as zero inventory) will agree that inventory is
anything but an asset and it would have been better if inventory had been classified as a liability.
Similarly, an expenditure resulting in streams of benefits in the future (some examples include re-
search and development expenses, equipment retrofitting and reconditioning, etc.), should ideally
be classified as capital expenditure but at times, get wrongly classified as revenue expenditure. In
case of projects, project management is concerned with capital expenditure. The manager should
rightfully view any capex expenditure (even if classified as revenue expenditure for accounting
purposes) as an example of project management and thus, apply all the project management evalu-
ation techniques.
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Introduction to Project Management | 3
Projects and project management are not restricted to the private sector or to businesses with
profit-making objectives. Project management is also a vehicle for performing social work and
community services. Endeavours such as providing relief to tsunami victims in Japan or vic-
tims of earthquake devastation in Turkey require the applications of proven project management
techniques.
The Project Management Institute’s (PMI) Project Management Professional (PMP®) credential
is the most important industry-recognized certification for project managers. Globally recognized
and demanded, the PMP® demonstrates that the certificate holder has the experience, education
and competency to successfully lead and direct projects.
DEFINITION OF A PROJECT
Having briefly discussed the various types of projects from pre-historical times and some of the
aspects related to project management, let us define a project.
According to Wikipedia, ‘a project is a temporary endeavour with a defined begining and end
(usually time-constrained, and often constrained by funding or deliverables), undertaken to meet
unique goals and objectives, typically to bring about beneficial change or added value’.
A second definition says, ‘a project is an organized unit dedicated to the attainment of a goal,
which is the successful completion of a development project on time, within budget, in conformance
with predetermined program specifications’.
Another simpler definition as coined by the PMI is as follows: ‘a project is a temporary endeavour
undertaken to create a unique product or service’.
In all the above definitions, a common element is the words ‘temporary endeavour’ and ‘unique
product’. This is the essence of project management, wherein a non-repetitive task is performed every
time an activity is defined as a ‘project’. The major goal of any project is to satisfy the customer’s
need, and in this sense, the project or project management is similar to other functions of any
product or service organization. Beyond this similarity, the features of a project are completely
different from other organizational functions described as follows:
1. An established goal or objective, which when achieved, completes the purpose and hence the
existence of the project. Projects are therefore temporary and need to be disbanded after the
objectives are complete. The organization functions on the other hand continue to exist even
when the goals are achieved.
2. It has a defined lifespan with a start and an end. Another example of temporary existence is
the start and end times, which are predetermined.
3. A project encompasses professionals wearing many hats or personnel with multifarious cre-
dentials, which means more generalists and less of specialists. Multitasking being the need of
the hour, the preference is always a generalist rather than a specialist.
4. It comprises a unique set of activities, which have hitherto not been performed. A company
in the field of construction makes many residential buildings that are not similar. However,
a motorcycle-manufacturing company manufactures the same product repetitively and reaps
the benefits from such a mass production. Similarly, benefits of a learning curve as is appli-
cable in labour-intensive industries performing repetitive jobs are largely lost.
5. Specific scope, duration, cost and quality parameters—The evaluation of project success and
often, the payment(s) related to completion of the project, are linked to the scope, dura-
tion, cost and quality parameters. Some of these are not the requisites for product or service
pricing, which differentiate the projects from other non-project organizations. The four con-
straints account for a higher degree of accountability in a project, which is not so specific for
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4 | Chapter 1
250 2500
200 2000
150 Pile caps Piles
1500
Piers Segment
100 1000
Span erection casting
50 500
0 Total 0 Total
Feb Mar Apr May Jun Jul Feb Mar Apr May Jun Jul
Nos. Nos.
Pile caps 223 118 129 139 151 161 178 Piles 953 708 755 785 822 841 892
Piers 223 53 69 84 96 111 129 Segment
Span erection 223 2 4 11 17 17 33 casting 1929 271 332 405 479 539 616
Figure 1.1 Progress report/status of Bengaluru-based ‘Namma Metro’ as on August 1, 2009
other organizations. The price or configuration of products as in case of laptops may change
frequently or the time to deliver may also be affected due to extraneous reasons. Although
these aspects may be acceptable for products and services, such violations must be strictly
avoided for projects. Figure 1.1 illustrates progress report/status of Bengaluru-based ‘Namma
Metro’ as on August 1, 2009.
DEFINITION OF PROJECT MANAGEMENT

Although projects have been in existence since the beginning of civilization, the concept of proj-
ect management is relatively new. In the early 1900s, the Industrial Revolution eventually led to
understanding the need for an organized skill in managing diverse projects. Although the projects
are unique and non-repetitive, project management, on the other hand, is fairly repetitive and the
techniques used for managing projects are the same whether the projects are large ones (such as
building a dam or a highway) or small projects, typically with short durations like 1 hour lectures.
Project management can be simply defined as ‘an organized venture for managing projects’. A more
detailed definition could be ‘project management is the application of knowledge, skills, tools and tech-
niques’ to project activities in order to meet or exceed stakeholder needs and expectations from a defined
project, thus balancing the following:
1. Scope, time, cost and quality
2. Stakeholders’ expectations
3. Requirements (needs) versus unidentified requirements (expectations)
In other words, project management involves the scientific application of modern tools and
techniques in planning, financing, implementing, monitoring, controlling and coordinating unique
activities or tasks to produce desirable outputs in accordance with the predetermined objectives
within the constraints of time, cost and quality. There are certain institutes such as the PMI which
have courses on various aspects of project management. A PMP® certificate is, at times, mandatory
for working on software projects or for working in engineering procurement and construction
(EPC) companies.
Project management consists of the following stages:
1. Project planning
2. Project scheduling
3. Project implementation, controlling and monitoring
4. Project commissioning
5. Project hand-over to the operations team/client organization
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Project Life Cycle

Concept Development Execution Transfer
Inception Elaboration Construction Transition
Value
Risk
Figure 1.2 Risk reduction (red curve) and value creation (green curve) during the project life cycle
PROJECT LIFE CYCLE

As in the case of a product life cycle, there are four stages and the probability of completing the
projects increases as the stages progress. These are as follows:
1. Project concept stage or inception stage
2. Project development or the elaboration phase
3. Project construction or the execution phase
4. Project transition or the transfer phase
The specific goals of the project team vary over the life of the project. In the beginning, there is
considerable flexibility in the expectations from the project. It may not be clear whether the project
is feasible or if it is even likely to be profitable. At this time, the activities centre around screening of
ideas, feasibility studies, financial modelling for attaining closure of the project, appointment of the
project contractors, etc.
Towards the end of the project, when the product itself is usually complete, the issues of quality,
delivery and completeness then take centrestage. At different times, tasks are undertaken in new
ways and work products will have new content. Another factor that needs to be considered is the
risk element in successful project completion, which reduces as the project progresses. Similarly,
with the passage of time and completion of more phases, the intrinsic value of the project increases
thus depicting higher probability of project completion. These aspects are shown in Figure 1.2.
To coordinate the project team’s effort at various phases of the project life cycle, the broader
activities at each stage are shown in Figure 1.3. For ease of remembering the four phases of a project
life cycle, they can be classified as C ~ D ~ E ~ F or Conceive ~ Develop ~ Execute ~ Finish.
THE ‘S’ CURVE

The ‘S’ curve is a well-known project management tool and consists of ‘a display of cumulative
costs, labour hours or other quantities plotted against time’. The name is derived from the S-like
shape of the curve, flatter at the beginning and end and steeper in the middle, because this is the
way most of the projects look like. The ‘S’ curve is useful as a cost estimation tool because it is
the way most of the projects look like in the real world. It can be considered as an indicator and
is used for many applications related to project management, such as target, baseline, cost and
time.
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6 | Chapter 1
• Indentify need • Develop: • Set up organization • Training operators

• Establish feasibility: - Plan • Working designs & specs • Reviews & acceptances
- Program, process - Block diagrams • Design review • Run up to capacity
- Schematics - Sketches, outline drawings • Procure equipment • Transfer materials
- Prelim budget, - Standards • Procure physical asset(s) • Settle all accounts
Schedule • Conduct studies • Quality assurance/control • Re-assign remaining team
- Project learn • Select equipment(s) • Modify as required • Archive lessons learned
- Financing • Reconfirm economics • Verify performance • Close all records
- Risks - Budget, cash flow • Progress monitoring • Deliver final report & transfer
• Identify alternatives - Financing • Forecasts & reports responsibility
• Present proposal - Schedule • Deliver facility
• Approval to • Re-assess risks, alternatives
proceed • Present project brief
• Obtain approval to
proceed
Figure 1.3 Total effort put in by the project team in various phases of the project life cycle
There are various ‘S’ curves, which are as follows:

Cost versus time ‘S’ curve: Appropriate for projects that contain labour and non-labour
1.
tasks.
Target ‘S’ curve: This ‘S’ curve reflects the ideal progress of the project if all tasks are com-
2.
pleted as currently scheduled.
Value and percentage ‘S’ curves: The percentage of ‘S’ curves is useful for calculating the proj-
3.
ect’s actual percentage completion.
Actual ‘S’ curve: This ‘S’ curve reflects the actual progress of the project to till date.
4.
In order to generate an ‘S’ curve, a baseline and a production schedule are necessary because they
contain important information for each task, which are enlisted as follows:
1. The baseline contains information about actual start redundant and finish date. The baseline
can also contain information about man-hours and costs.
2. The production schedule contains information about the actual percentage completed for the
project.
The ‘S’ Curve Generator is a software package that integrates with MS Projects to automatically
generate ‘S’ curves.
As can be seen from the Figure 1.4, the cost incurred or requirement of finances for the project is
very less at the initiation or concept phase and at the transfer or the closure phase. There is a steep
rise in the requirement of funds during the execution or development phase. Any curtailment of
funds at this stage can lead to project delays.
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Initiation Planning Execution Closure

phase phase and phase
controlling
100%
Cumulative
project cost
Time scheduled
Figure 1.4 Sample project cost ‘S’ curve
TRAITS OF A PROJECT MANAGER

The project manager is an integral part of a project and often, the success or failure of a project is
a result of the project manager’s efforts or the lack of it. For starters, the project manager has an
unenviable task of getting diverse functions to work together on a path that gets scripted as it is tra-
versed. The contributions of the functional specialists should be properly coordinated by the project
manager, who has to necessarily be a generalist. The role of a project manager is in preventing the
untoward and unplanned happenings as depicted in Figure 1.5.
The qualities expected of a project manager for the successful execution of a project are similar
to those required of an entrepreneur, who has to strive hard for the success of his business venture.
Some of the prominent abilities required from a project manager are listed here.
Planning ability: The planning ability is the foremost requirement for the successful execution
1.
of the project. As all projects are dissimilar to a large extent and get completed over long-
time horizons, the ability to set targets and milestones becomes the primary responsibility of
the project manager. A structured and detailed breakdown of the achievable tasks on a time
frame becomes important to monitor the progress of projects and for analysis of variances
in completion at regular time intervals. This breakdown of tasks (later explained under
the heading work breakdown structure) is required to set progress milestones and calls for
extensive planning skills.
Maturity: Due to the uniqueness of the project and involvement of a vast number of functional
2.
specialists, consultants and sub-contractors, there may be complex situations that need to be
handled patiently. This is when the project manager has to exhibit maturity and take things
in his/her stride with a sense of timing to make certain moves in the interest of the project. It
is simple to conclude that there is disagreement between functional specialists and that the
project cannot proceed further, but it is more important to bring these diverse views into con-
vergence in the best interests of the project.
Toughness and willingness: This requires the manager to take contrary positions rather than
3.
taking an easy way out, or to take a path of least resistance or to cave in to the pressure.
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8 | Chapter 1
How the customer How the project How the engineer How the programmer How the sales
explained it leader understood it designed it wrote it executive described it
How the project was What operations How the customer How the helpdesk What the customer
documented installed was billed supported it really needed
Figure 1.5 Situations a project manager has to prevent
At times, unconventional wisdom might have to be used to arrive at unique solutions in which
case, lot of opposition would be faced from many quarters. At these times, the risk-taking
ability of the entrepreneur and the willingness to take tough decisions must be exhibited by
the project manager. However, it must be understood that these contrary positions should be
in the long-term interests of the project and should not be in the form of jugaad, for which
Indians are famous for.
Receptive: A project manager should be open to ideas from different sources and should not
4.
be fixed on his/her own views. This means that he should have the ability to take directions,
suggestions, hints and criticism from various personnel involved in the project and convert
them into positive action. Essentially, since projects are unique, unless complete, the lesson
cannot be derived from the project. Hence, any kind of alternate solutions should be appreci-
ated by the project manager.
Communication skills: Both written and oral instructions and paper work are involved in
5.
the various stages of a project and enough confusion exists as it is. Any further confusion
due to communication errors is certainly undesirable. The project manager should be well
aware about these issues and make additional efforts in improving his/her communication
skills.
Energy: To deal with problems and work hard, unlike office work, which can be performed
6.
under fixed work hours, projects and project management require many more hours of hard
work at. On other occasions, there can be instances of lack of work. Further, inputs received
from global consultants working in different time zones add to the complexity of work. A
project manager should, therefore, possess a lot of energy to meet these requirements.
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Ability to take measured risks: Projects generally face unknown problems and require solu-
7.
tions which are untested. In such situations, there is a fair amount of risk that is involved in
decision-making. Unless the project manager has this risk-taking ability, the progress of the
project would be hindered.
Go-getter attitude: A project manager is like an entrepreneur and unless he/she has an opti-
8.
mistic approach to issues, not much development can happen. Projects require a fair amount
of enthusiasm to make progress under different adverse conditions. It would be much easier
to give reasons for work not being done but it is very difficult to do work surpassing these
obstacles. Hence, unless the project manager has a go-getter attitude, it will be difficult to
attain success in a project.
In addition to these personal qualities, the project manager should also possess the following man-
agerial qualities:
Good interpersonal skills: Project management is more about management of people than
1.
resources. Ability to negotiate your way through seniors and subordinates in a situation as
dynamic, uncertain and overlapping as projects is the key to success of the project.
Conflict-solving ability: With regular overlap of activities and many claimants for limited
2.
resources, conflicts are an inevitable part of projects. Such conflicts, if not resolved amicably,
can lead to costly delays and other problems. Therefore, the conflict-solving ability of a proj-
ect manager is important to the successful completion of a project.
Problem-solving capabilities: In a largely unstructured set-up of projects, unanticipated
3.
problems crop up frequently . The ability to understand problems, place them in perspective
and develop and implement solutions is necessary to achieve the project goals.
Perspective vision: This trait ensures that a backward step is taken to gather an overall view
4.
of the developments, to review the symptoms of problems and to work a way ahead. In some
situations, the problems are so engrossing that finding a solution seems almost impossible.
Looking at the problem with a different lens or perspective helps in addressing the immediate
limitations.
Effective time management/Ability to delegate: Problems and activities are overwhelmingly
5.
complex. Management of time is a vital requirement. No project manager can survive a day
without the ability to delegate tasks and authority effectively. Finding the right activity to
be delegated to the right subordinate and to uphold the decisions of the subordinate in this
regard is an important managerial trait, necessary for a project manager.
Familiarity: The manager’s familiarity with the organization to understanding funding and
6.
decision-making process is paramount. The process of decision-making and the authorities
of the personnel involved in decision-making is an important requirement for proper and
conclusive decision-making process. Decisions made should be such that it is not questioned
by the higher authorities at a later date. Hence, the project manager should be familiar with
the organizational structure and hierarchy so that decisions made are not overruled at a later
stage.
Initiative: Initiative and risk-taking ability to accept/delegate tasks are essential attributes
7.
of a manager. The project manager should encourage decision-making at every stage of the
project from those involved in delivering the stage requirement. Even if decisions involve
some risks related to the project, the project manager should support such measured deci-
sions. This will ensure that everyone in the organization is willing to take the initiative and
help in completing the project on schedule.
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10 | Chapter 1
PARAMETERS FOR THE SUCCESS OF A PROJECT

A project is akin to a three-legged stool. If any of these legs is not up to the mark, a project is not
completely successful. The three legs of project are as follows:
Scope: Deliverables as per the contract. Performance as agreed upon in the contract.
1.
Time: As agreed in the contract.
2.
Cost: As agreed in the contract.
3.
The degree of success of a project is measured by the sum of performance on the above three counts.
In addition to these three key points, the quality of the project must be maintained. Although the
scope would encompass this requirement, it is important that the quality parameters are clearly
defined.
Each project has its own peculiarity. While ‘scope’ is most important in most cas es, there are cases
where time assumes paramount importance. In cases such as the Commonwealth Games conducted
in Delhi in 2010, there was no scope for time over-run. Although there can be minor compromises
on scope and cost of the project in such instances, there can be no compromise on the time or dura-
tion of the project.
In commercial contracts, cost and scope both have equal importance, whereas, cost overruns are
not allowed. Sometimes, due to unavailability of specialized equipment, like the barge-mounted
Hercules crane used in the construction of Bandra-Worli Sea Link (BWSL), there is a possibility
of the project being delayed. Defining the scope is very important. Scope should be defined in a
quantitative manner to the maximum possible extent. Qualitative terms in scope definition only lead
to litigation. For example, saying a ‘big house’ is as vague as it can get. The client must specify the
number of rooms of various dimensions required. Time and cost are functions of scope and will be
quoted as per the definition of scope. Any change in scope at a later date will result in either extra
time or cost over-run or both. Further, if the scope is changed without changing the time and cost,
then, the quality may be impacted. Quality problems could be noticed immediately or can come to
light in the future.
Quality is hard to define, and even more difficult to specify. A broad understanding is required
with the client regarding his quality requirements. Finally, the effects of an economic activity do
not get included in the project statement from the point of view of the main project participants.
Therefore, the financial costs and revenues that accrue to projects as a result of adverse or favourable
economic activities cannot be factored in earlier.
The last point to be considered is the externalities, which represent part of the difference between
private costs and benefits, and social costs and benefits. Externalities should be quantified and
valued and included in the project statement for economic analysis. A viaduct over Pedder Road in
Mumbai would create enormous social benefits for everyone. Hence, in such cases, the economic
analysis should also factor in the social benefits.
WORK-BREAKDOWN STRUCTURE (WBS)

In project management, a work-breakdown structure (WBS) is a fundamental project management
technique for defining and organizing the total scope of a project using a hierarchical tree structure.
It is a deliverable-oriented decomposition process of a project, divided into smaller components. A
WBS defines and groups a project’s discrete work elements in a way that helps organize and define
the total work scope of the project. A WBS also provides the necessary framework for detailed
cost-estimation and control along with providing guidance for schedule development and control.
Simply put, the WBS is a tree structure, which shows a subdivision of effort required to achieve an
objective.
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Aircraft Level 1
system
Peculiar
Air vechicle Training support Level 2
equipment
Receiver Fire control Communication Equipment Services Depot Level 3
Figure 1.6 Defence material item categories from MIL-STD-881C
The first two levels of the WBS (the root node and level 2) define a set of planned outcomes that
represent of the project scope. At each subsequent level, the children of a parent node collectively
represent 100 per cent of the scope of their parent node. A well-designed WBS describes the planned
outcomes instead of planned actions. Outcomes are the desired ends of the project and can be
predicted accurately, whereas actions comprise the project plan and may be difficult to predict
accurately. A well-designed WBS makes it easy to assign any project activity to one and only one
terminal element of the WBS.
The WBS is organized around the primary products of the project (or planned outcomes) instead
of the work needed to produce the products (planned actions). Since the planned outcomes are the
desired ends of the project, they form a relatively stable set of categories in which the costs of the
planned actions needed to achieve them can be collected. A well-designed WBS makes it easy to as-
sign each project activity to one and only one terminal element of the WBS. In addition to its function
in cost accounting, the WBS also helps map requirements from one level of system specification to
another. A requirement’s cross-reference matrix mapping functional requirements to high-level or
low-level design documents is an example in this regard.
The idea of WBS was developed by the United States Department of Defence (DoD) along with
the development of Project Evaluation and Review Technique (PERT), an acronym for PERT for
their Polaris missile project in 1957. While the term ‘work breakdown structure’ was not used, this
first implementation of PERT organized the tasks into product-oriented categories. The WBS for the
Polaris missile project is shown in Figure 1.6.
Some of the essential features of the WBS are as follows:
100 per cent rule: The 100 per cent rule states that the WBS includes 100 per cent of the work
1.
defined by the project scope and captures all deliverables—internal, external and interim—in
terms of the work to be completed, including project management. The 100 per cent rule is
one of the most important principles guiding the development, decomposition and evalua-
tion of the WBS. The rule applies at all levels within the hierarchy: the sum of the work at
the ‘child’ level must equal 100 per cent of the work represented by the ‘parent’ and the WBS
should not include any work that falls outside the actual scope of the project, that is, it cannot
include more than 100 per cent of the work. The same 100 per cent rule also applies to the
activity level. The work represented by the activities in each work package must add up to 100
per cent of the work necessary to complete the work package.
Mutually exclusive elements: The elements of the tree or level 2 should be mutually exclusive
2.
and should, therefore, not have an overlap of activities. This is necessary to ensure that the sum
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12 | Chapter 1
total of all the outcomes is 100 per cent and not more than 100 per cent. To give an example,
the components of the communication tree and the fire control tree shown in Figure 1.4 are
mutually exclusive.
3. Plan outcomes, not actions: The planned outcomes are the desired ends of the project and
they form a relatively stable set of categories in which the costs of the planned actions needed
to achieve them can be collected. If the WBS designer attempts to capture any action-oriented
details in the WBS, he/she will probably include either too many actions or too few actions.
Too many actions will exceed 100 per cent of the parent’s scope and too few actions will fall
short of 100 per cent of the parent’s scope. Therefore, the best way to adhere to the 100 per
cent rule is to define the WBS in terms of results or outcomes.
4. Level of detail: Certain sets of details are required for WBS but the level of detail is not known.
Certain heuristics aid in deciding the level of detail to which we have to work the WBS. One
of the heuristics is the ‘80-hour rule’ which means that no single activity or group of activities
that produce a single deliverable should require more than 80 hours of effort. The second heu-
ristic is that no activity or series of activities should be longer than a single reporting period.
Therefore, if the project team is reporting monthly progress, then no single activity or series
of activities should last for more than a month. The last heuristic is the ‘if it makes sense’ rule.
Applying this heuristic, one can apply ‘common sense’ when creating the duration of a single
activity or a group of activities necessary to produce a deliverable defined by the WBS.
5. Terminal element: A terminal element is the lowest element in a WBS and it cannot be further
subdivided. Terminal elements are the items that are estimated in terms of resource require-
ments, budget and duration—linked by dependencies—and scheduled. At this juncture of the
WBS terminal element and organization unit, control accounts and work packages are estab-
lished and performance is planned, measured, recorded and controlled.
6. Misconceptions: There are some misconceptions in regard to the WBS and it is important that
these misconceptions are cleared. Some misconceptions are as follows:
(a) A WBS is not an exhaustive list of work: It is instead a comprehensive classification of
project scope.
(b) A WBS is not a project plan, schedule or a chronological listing. It specifies what would
be done, and not how or when would the specific task be done.
(c) A WBS is not an organizational hierarchy, although it might be considered as such when
assigning responsibilities.
An example of a WBS for construction of a house is shown in Figure 1.7. As can be seen, all the
characteristics of the WBS such as the 100 per cent rule, mutually exclusive elements, planned
outcomes, level of detail and the terminal elements are incorporated in the example.
Project organization
Typically, the traditional form of an organization is the functional organization or dividing the orga-
nization on the basis of the function. Within each of these functions, there is a well-defined hierarchi-
cal organization. Any organization would, therefore, comprise departments such as manufacturing,
materials, quality, service, finance, human relations, legal, and sales and marketing. Some of these
departments can be further differentiated into line and staff departments on the basis of whether
the costs associated with these departments can be directly apportioned to the product or not. Line
managers have the primary responsibility of achieving the goals of the firm and are vested with key
decision-making authority. Staff mangers have administrative powers within their departments but
by and large serve as advisors to line managers. This traditional form of organization is quite ap-
propriate for handling operations that are established and are characterized by repetitive processes.
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Level 1 (Deliverables) = 100%

Construction of a House Level 2 = 100%
Level 3 (Work package) = 100%
- Work: 100.00%
Budget $215,500.00
1. Internal 2. Foundation 3. External

- Work: 45.60% - Work: 24.00% - Work: 30.40%
Budget: $86,000.00 Budget: $46,000.00 Budget: $83,500.00
1.1 Electrical 2.1 Excavate 3.1 Masonry work

- Work: 11.80% - Work: 18.20% - Work: 16.20%
1.1.1 Rough-in electrical 2.1.1 Pour concrete 3.1.1 Lay masonry

Work: 2.80% Work: 7.90% Work: 9.00%
1.1.2 Install and terminate 2.1.2 Cure and strip forms 3.1.2 Install roof drains
Work: 1.90% Work: 10.30% Work: 3.10%
1.1.3 HVAC equipment 2.2 Steel erection 3.1.3 Install tile in toilet rooms
Work: 7.10% Work: 1.30%
Budget: $15,000.00 - Work: 5.80% Budget: $10,000.00
Budget: $9,000.00
3.1.4 Roofing
2.2.1 Steel columns
1.2 Plumbing Work: 2.80%
Work: 2.80% Budget: $15,000.00
- Work: 33.80% Budget: 5,000.00
Budget: $61,000.00 3.2 Building finishes
2.2.2 Beams
1.2.1 Rough-in plumbing Work: 1.90% - Work: 14.20%
Work: 11.30% Budget: $2,000.00 Budget: $21,500.00
Budget: $22,000.00
2.2.3 Joist 3.2.1 Paint walls
1.2.2 Set plumbing fixtures and trim Work: 1.10% Work: 4.00%
Work: 13.20% Budget: $2,000.00 Budget: $8,000.00
Budget: $31,000.00
3.2.2 Ceiling tile
1.2.3 Test and clean Work: 3.60%
Work: 9.30% Budget: 4,000.00
Budget: $8,000.00
3.2.3 Hang wallpaper
Work: 2.30%
Budget: $1,500.0
3.2.4 Carpet
Work: 1.80%
Budget: $6,000.00
3.2.5 Hardware
Work: 2.50%
Budget: $2,000.00
Figure 1.7 Example of a work breakdown structure

However, this traditional form of organization is not suited for project management due to the
following reasons:
1. A project is a non-repetitive, non-routine undertaking plagued by uncertainties.
2. The responsibilities and relationships in a project are often temporary, dynamic and need to
be flexible.
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14 | Chapter 1
3. The skills required in different phases of the project are different with talent required from
different functions at different points of time.
4. Many external agencies in the form of consultants, sub-contractors, vendors, licensing au-
thorities, etc., are involved in completion of the project.
5. The work content of every functionary in the project organization undergoes changes fairly
frequently. Moreover, there are times when the functionary could be idle and is used for other
responsibilities.
6. The requirements of integrating the different levels of hierarchy below the top management
are often required during various project phases.
7. The requirements of communication, coordination and control are different for the project/
project organization.
Hence, there is a need for entrusting an individual or a group of individuals with the responsibility
of integrating the activities and functions of the various departments and the external organizations
involved in the project work. This aspect gives rise to a matrix organization, where the personnel
working on the project have a responsibility to their functional superior as well as to the project
manager. This further means that the authority is shared between the respective functional managers
and the project manager.
An example of a project management matrix organization is depicted in Figure 1.8. The matrix
organization is an attempt to combine the advantages of the pure functional structure and product
organizational structure. This form is ideally suited for companies, such as construction com-
panies, that are ‘project-driven’. Information sharing is mandatory in such an organization, and
several people may be required for performing the same piece of work. However, in general, the
project manager has the total responsibility and accountability for the success of the project. The
functional departments, on the other hand, have the functional responsibility to maintain technical
excellence on the project. Each functional unit is headed by a department manager whose prime
responsibility is to ensure that a unified technical base is maintained and that all available informa-
tion is exchanged for each project on a regular basis.
Chief Executive
Functional Functional Functional Manager of

manager manager manager project managers
Staff Staff Staff Project Manager
(Black boxes represent staff engaged in project activities) Project coordination

Figure 1.8 A typical project management organization
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The basis for matrix organization is an endeavour to create synergism through shared responsibil-
ity between project and functional management. Other advantages of a pure matrix organizational
form for project management include the following points:
1. The project cost is minimized because key people can be shared and the shared cost is much
less compared to one complete individual.
2. Conflicts are minimal, and those requiring hierarchical referrals are more easily resolved.
3. There is a better balance between time, cost and performance.
4. Authority and responsibility are shared.
5. Stress of timely delivery on commitments is distributed among team members.
PROJECT NOMENCLATURE
At times, we hear schoolchildren speaking about completing their projects in time or getting pun-
ished and at the same time, we hear scientists speak about completing the Mars space probe project
successfully. Similarly, construction companies speak about completing development projects, soft-
ware consultants mention completion of software upgradation project, NGOs speak about social
welfare projects being completed, Metro engineers speak about completing sections of the Metro
project, organizations speak about their expansion projects, etc. What is a project? Can a school
project which can be completed with less investment or a space project that requires a few billions
of dollars be actually a ‘project’?
We, therefore, need some mechanism to differentiate between the various types of projects. One
way of assessing the potential complexity of a project has been suggested by Turner and Cochrane
(1993) who have developed a ‘goals and methods matrix’. The matrix is shown in Figure 1.9.
As can be seen from the matrix, four quadrants are created on the basis of goals being well de-
fined or not and methods being well defined or not. The bottom left side quadrant has the highest
probability of projects being completed because the requirements for completion of a project are
well-defined in that space. As a corollary, the quadrant on the top right side comprises projects that
have a high chance of failure as neither the goals nor the methods required to attain the goals are
well-defined. Therefore, depending upon the characteristics of the projects, we can club them in
either quadrants and the projects within quadrants would, by and large, carry the same features.
Higher
chance of
Type 2 Type 4 failure
No
(e.g., product (e.g., research/
development) organizational change)
Methods
well defined
Type 1 Type 3
Yes
(e.g., Buildings and (e.g., software
IT installations) development)
Higher Yes No
chance of
success Goals well defined
Figure 1.9 Turner and Cochrane’s goals and methods matrix
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16 | Chapter 1
Projects are also classified on the basis of the size of the capital requirement for the company
putting up the project. However, this classification is not based on an absolute value of investment
but on the relative value of investment for an organization. Projects that require investments equal
to the capital of the present organization defined as the money, property and other valuables which
collectively represent the wealth of an individual or business, are termed as major projects. A large
project has a value roughly equal to one tenth of the capital of the parent organization; a medium
project is ten times smaller than the large project and a small project is ten times smaller than a
medium project.
The Government of India primarily classifies projects into four groups—micro-sized projects,
small-sized projects, medium-sized projects and large projects. This classification is done on the ba-
sis of requirements of funds and for computation of incentives for the projects. The investment limit
for different kinds of projects are announced by the government regularly and are based on various
macro-economic factors such as inflation, exchange rate, political compulsions, etc.
At present (as per the Government gazette 311, dated Friday, June 16, 2006), the investment limits
are as follows:
1. An investment on plant and machinery up to a limit of `25 lakhs is classified as a micro en-
terprise.
2. An investment on plant and machinery up to a limit of `5 Crores is classified as small-sized
enterprise.
3. An investment on plant and machinery up to a limit of `10 Crores is classified as a medium
enterprise.
4. An enterprise with investment requirement of more than `10 Crores (`0.1 billion) on plant
and machinery is categorized as large-sized enterprise.
In case of the enterprises engaged in providing or rendering of services, the investment limits are
as follows:
1. A micro enterprise, where the investment in equipment does not exceed `10 lakhs.
2. A small enterprise, where the investment in equipment is more than `10 lakhs but does not
exceed `2 Crores.
3. A medium enterprise, where the investment in equipment is more than `2 Crores but does not
exceed `5 Crores.
4. A large enterprise, where the investment in equipment is more than `5 Crores.
On the basis of need, projects can be further classified into new projects, expansion projects, mod-
ernization projects, replacement projects, diversification projects, forward or backward integration
projects, socio-economic development projects, etc.
COMPONENTS OF A DETAILED PROJECT REPORT (DPr)

Although the discussion on various aspects of a detailed project report (DPR) would be taken
up in later chapters, it is necessary to introduce the components of a DPR. A DPR contains
the information carried out in the feasibility study in detail. The intention of preparing a DPR
is to formally communicate the project promoter’s decision to venture into a new project. A
DPR is also the starting point when approaching financial institutions or lenders for funding
projects. Due to the liberalized industrial licensing policy of the government, an industrial en-
trepreneur’s memorandum (IEM) has to be filed with the government for sanction. Similarly,
a DPR must be filed with the government for their approval, permission and consent for new
projects as well.
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The prominent components of a DPR are as follows:

1. General information about the project.
2. The details of project promoters and their past experience in this field or elsewhere are required
to judge their competence in putting up a project.
3. Details of past projects completed by the promoters or working results of businesses owned
by the promoters.
4. Details of the project should comprise the following:
(a) Product information.
(b) Raw material source and details of raw materials.
(c) Plant capacity.
(d) Manufacturing technology and details on the application of technology in other projects.
(e) Management team responsible for execution of the project or the project management
consultants (PMC).
(f) Details of land, environmental clearances, buildings, plant and machinery, etc.
(g) Details of utilities such as power, water, infrastructure, such as roads, highway connectiv-
ity and the source for these utilities.
(h) Periodicity of raw material availability or confirmed availability of raw materials.
(i) Effluent treatment arrangements and steps proposed to prevent environmental damage.
(j) Requirement and availability of labour and facilities for their welfare.
5. Project implementation schedule.
6. Project financials and calculation of returns. Profitability and cash flow estimates.
7. Means of financing the project.
8. Requirement of working capital and arrangements made for the same.
9. Commercial details relating to marketing and distribution arrangements.
10. Mode of term loan repayment.
11. Government approvals, local body consents and other statutory permission.
12. Details of collateral security that can be offered to the financial institutions, other than the
project.
ROLE OF THE GOVERNMENT OF INDIA IN PROMOTING PROJECTS

In 1991, the Government of India decided to take a series of measures to unshackle the Indian indus-
trial economy from the cobwebs of unnecessary bureaucratic control. These measures complement
the other series of measures being taken by the government in the areas of trade policy, exchange
rate management, fiscal policy, financial sector reform and overall macroeconomic management.
The idea was to promote the growth of the Indian industry and transform the investment climate
into a pro-investor one in order to encourage them to undertake mega infrastructure projects. Some
prominent points of the liberalized industrial licensing policy are as follows:
1. Industrial licensing will be abolished for all projects except for a short list of industries
related to security and strategic concerns, social reasons, hazardous chemicals and overriding
environmental reasons and items of elitist consumption (list attached as Annex II). Industries
reserved for the small-scale sector will continue to be so reserved.
2. Areas, where security and strategic concerns predominate, will continue to be reserved for the
public sector.
3. In projects where imported capital goods are required, automatic clearance will be given
in cases where foreign exchange availability is ensured through foreign equity or if the
cost, insurance and freight (CIF) value of the imported capital goods required is less than
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18 | Chapter 1
25 per cent of the total value (net of taxes) of plant and equipment, up to a maximum value of
`2 Crores. In other cases, import of capital goods will require clearance from the Secretariat
for Industrial Approvals (SIA) in the Department of Industrial Development (DID) according
to availability of foreign exchange resources.
4. In locations other than cities having population of more than 1 million, there will be no
requirement of obtaining industrial approval from the central government except for
industries, subject to compulsory licensing. For cities having population of more than 1
million, industries other than those of a non-polluting nature such as electronics, computer
software and printing will be located outside 25 km of the periphery, except in prior designated
industrial areas. A flexible location policy would be adopted in respect of such cities (with
population more than 1 million) which require industrial regeneration. Zoning, land use
regulation and environmental legislation will continue to regulate industrial locations.
Appropriate incentives and the design of investments in infrastructure development will be
used to promote the dispersal of industry, particularly to rural and backward areas and to
reduce congestion in cities.
In addition to the policy-making, the government also establishes the fiscal policy through budgets
and monetary policy through the Reserve Bank of India (RBI). Apart from fiscal and monetary
policy, the government also uses the following control measures to effect the desired pattern of
resource allocation:
1. Industrial licensing
2. Capital investment control
3. Limits on foreign direct investment (FDI)
4. Export promotion and import tariff to reduce imports
5. Control over monopolies and restrictive trade practices
6. Control over pricing and distribution of commodities
7. Effect of new industries on small-scale sectors
8. Industries reserved for women and home trade
9. Socio-economic effects and environmental decline due to industries such as mining, etc.
Moreover, the government also helps in funding the projects on the basis of merit through the
Industrial Development Bank of India (IDBI), Small Industries Development Bank of India (SIDBI),
National Bank for Agriculture and Rural Development (NABARD) and such other financial insti-
tutions. The lending rate for projects is much lower than the market rates with extended repayment
periods. In addition, many incentives are also made available by the government for projects that
generate rural employment, reduce carbon emissions and projects that bring about socio-economic
welfare.
Some of the benefits offered by state governments for industrialization are as follows:
Sales tax benefits: Central/State value-added tax is either exempt or treated as an interest free
1.
long-term loan. The maximum amount is decided only by the total investment.
Investment subsidy: A specified amount is given as non-refundable subsidy. The incentive
2.
proves to be quite substantial for small-scale industrial (SSI) units. The subsidy amount is
treated as the owner’s equity by the financial institutions for debt equity ratio.
Octroi refunds: Octroi/Entry tax paid to local authority on incoming goods is refunded by
3.
state for a specified number of years.
Refund of electricity duty: Electricity duty is refunded for a specified number of years.
4.
Contribution to cost of project feasibility study: Besides financial incentives, infrastructural
5.
facilities that are offered often reduce capital investments and improve profitability.
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6. Setting up of industrial estates: Basic facilities such as power, water and pre-approved land
for industrial use, banks, communication and other urban infrastructure are provided.
7. Availability of cheap land: Land is made available at attractive rates which is often far below
the actual cost of acquisition and development. It, therefore, reduces many procedural delays
and problems in setting up a new industry and proves to be one of the major factors in decid-
ing industrial location.
DIFFERENCES BETWEEN AN EPC COMPANY AND A COMPANY’S OWN PROJECT

ORGANIZATION
The main business of engineering procurement construction (EPC) companies is construction of
projects. Hence, they develop proficiency in this field. They are able to accurately decide the man
hours required for the content of work envisaged and with this data, they are able to quote for the
projects through the tendering process. Organizations that develop their own project management
teams are not able to envisage all the costs with the fine details as an EPC company, but are content
with the fact that the profit generated by the EPC company is retained in-house. Hence, any cost
estimate or incurred cost is not viewed with suspicion in an own project management organization,
whereas any extra cost incurred by an EPC company comes under intense scrutiny. Some additional
points of difference are enumerated in Table 1.1.
HUMAN ASPECTS IN PROJECT MANAGEMENT

One of the toughest challenges in managing a project is to manage people in the project. People
are the backbone of any organization and its most important resource. A project manager’s
performance is dependent upon the performance of the project team and associated stakeholders.
Project managers must acquire six important types of interpersonal skills: effective communication,
Table 1.1 Comparison between an EPC company and an organization’s own project management team
EPC Project Organization Own Project Organization

Sets up projects for clients. Sets up projects for own requirements.
Project execution is a revenue generation activity and Project is a capital expenditure decision and
profits are booked on completion of the project. profits are generated over a long period of time
only after project completion.
The company is not concerned with future market risk. Future market risks affect project profitability.
No project feasibility report is required. Only accurate Project feasibility report is compulsory for
cost estimation is needed. decision-making and financing.
Only short-term financing required as working capital Long-term financing is required for investment
for project execution. in fixed assets.
Company has expertise in project technology and May not have expertise in project technology
project set-up. and project set-up.
Schedules, costs and performance can be closely Schedules, costs and performance are difficult
controlled due to available expertise and information to control since it is the first project experience.
database.
Regular and experienced contractors and associates New contractors and consultants take time to
make implementation easier. get acquainted.
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20 | Chapter 1
motivation, negotiation, conflict management, stress management and leadership. In order to compete
globally, project companies must emphasize the human factors in project management and create
an environment that provides effective leadership and facilitate open and effective communication.
They must induce an environment in which everyone feels committed to produce their best while
having fun as well.
Interpersonal conflicts are an inevitable part of projects but minimizing them is the key to success-
ful completion of projects. Therefore, it is very important to understand human nature and achieve
satisfactory human relations in the project team. A project manager has to handle problems and chal-
lenges relating to the following HR issues:
Authority: Project managers very often have to be content with split authority and dual
1.
subordination in their set-up (with the exception of divisional form of organization). In
addition, with all the criss-cross and overlap of responsibilities and paucity of resources
and its sharing, assigning blame is rather difficult. In such a difficult situation, a project
manager has to rely on the informal authority, that is, his/her rapport with project person-
nel. His/her skills in resolution of conflicts, skills of communication and persuasion ability
and the ability to act as a link between technical, engineering, financial and commercial
personnel gives him/her the real authority over people.
Personnel orientation: Most project managers are engineers who have a background in
2.
science. In a scientific world, most aspects are well-defined, structured and contain a degree
of certainty. Therefore, managers are accustomed to well-structured and defined forms.
Human psychology plays a very minor role in such set-ups. However, projects are almost
diagrammatically opposite to a typical engineer’s world. It is an unstructured world where
little is defined and is full of uncertainties. And half the uncertainties emanate from people’s
mood. An ego hassle over a total non-issue between two key personnel can hold up the project
for days despite availability of resources. Therefore, personnel management is the key to the
successful execution of projects. Therefore, project manager has to transform the technical
orientation of his/her managers to personnel orientation.
Motivation: Performance of employees is dependent on their motivation. In an unstructured
3.
set-up, where standards of performance are hard to define, motivation assumes further
importance. However, with split authority and dual subordination, as in the case of a
matrix organizational structure, keeping people motivated becomes very difficult. In a dual
subordination set-up, rewarding people is a little difficult and meting out punishment even
more so. His/her other superior, under whom he/she works on permanent basis is always
there to provide an alibi to cover up for his failures. Projects give people a chance to
perform tasks which are clearly defined and visible. If the project manager is appreciative
and gives public applause to performance/contribution, it motivates the personnel to a
great extent.
Team building: Most project activities are interrelated and interdependant and most
4.
problems require interdisciplinary solutions. The successful management of a project,
therefore, is not possible without proper teamwork. Development of mutual trust and
respect for each other, open communication and mutual cooperation must be achieved by
the personnel.
Communication: It is a two-way effort involving the transmission of information and
5.
understanding from one person or group to another through the use of common symbols.
These common symbols can be verbal or non-verbal, written, graphic or multimedia. The
information represented by the symbols, expressed as thoughts, ideas, facts or figures, is
useful only if it conveys meaningful knowledge to the receiver. Therefore, both the sender and
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receiver should seek an exact mutual understanding during the communication process. As a
large part of the communication is based on drawings, standard procedures for drawing and
tracking the progress of the projects should be followed.
CHALLENGES AND IMPORTANCE OF PROJECT MANAGEMENT IN THE PRESENT

WORLD
Project management is rapidly becoming a special way of doing business in the present world.
Accentuating the requirement of the project management professionals is the way businesses
have transformed in the web-enabled era. The PMI, founded way back in 1969, as a body of the
international project managers, has seen an exponential growth of participation in their Certified
Associate in Project Management (CAPM) programme. Other organizations such as Larsen &
Toubro are setting up their own PMIs. Several reasons for this explosion in interest in project
management are illustrated below.
Shorter Product Life Cycles

If we consider new generation products such as iPhones, iPads or smartphones, their extremely
short product life cycle is a common factor. In the earlier years, the products enjoyed a life cycle of
at least 20 years, whereas the organizations consider them fortunate if the life cycle extends to two
years in recent times. ‘Time to market’ has been very crucial in the present time with organizations
such as ZARA Apparel taking no more than four weeks from design to introduction of new fashion
accessories/clothing in their shops. As speed becomes a competitive advantage, more organizations
are insisting on quick completion of projects.
Shrinking World
A new product launched in a developed economy is almost immediately available in developing econ-
omies. This phenomenon repeats when it comes to lack of interest in product categories. The ‘Black-
berry’, a once successful product of Research In Motion (RIM) Company is now facing an increasing
decline in all global economies. Moreover, with web-enabled information flow and social networking
sites becoming opinion formers, fast-paced, new projects become a necessity for organizations.
International Quality Standards

Besides cheaper and faster services, better quality products are the need of the hour. Quality move-
ments, including quality certification programmes such as ISO 9000 cover most products and ser-
vices. These initiatives are like a project with a definite beginning and a confirmed end.
With more global companies outsourcing their work, it offers opportunities for developing coun-
tries to offer projects in these areas, besides launching their own quality control standards. With its
focus on scope, time and cost, project management becomes the preferred technique to handle these
initiatives.
Increased Focus on the Customer

Although the customer was the focus, in the present scenario, the customer has many options and
assumes significance. Increased competition has placed a premium on customer satisfaction. As a
result, there is focus on customized products and services and the product manager is constrained to
act by fulfilling the unique needs and requirements of product differentiators. A common textbook
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22 | Chapter 1
on management topics is now required to be customized as per the requirements of universities

or autonomous institutes. Therefore, the product manager would fail in his/her duty if he/she was
oblivious to the principles of project management.
Commoditization of Products
Nowadays, products are getting increasingly commoditized and are being purchased on the basis of
their price/features, instead of on the basis of brand loyalty. In these circumstances, the company stand
to benefit immensely if the products are brought to the market early. Hence, concepts such as crash-
ing and resources scheduling that are essential components in project management gain prominence.
A business manager, therefore, has to be a project manager before anything else.
Information Explosion
The growth in new technologies and information about these new technologies has increased the
complexity of the projects. Newer methods such as pre-stressed concrete blocks, use of heavy en-
gineering equipment, etc., have considerably reduced project duration. Product complexities have
confounded this problem by adding to the complications of creating a new product. Hence, inte-
grating diverse technologies, with complex equipment has created problems of integration, which
project management techniques can achieve.
Lean Organizations
Corporate downsizing is more of a norm nowadays, with leaner and meaner organizations striv-
ing for excellence. Besides, outsourcing of non-core activities has also increased the complexities
of monitoring processes and their control. Companies outsource a significant amount of project
work, necessitating managers to oversee their employees and the work of the subcontracting orga-
nizations. As sticking to the core competence is a necessity for survival, more importance is laid on
project management skills and techniques.
CASE STUDY
The Konkan Railway Corporation Limited (KRCL)
The Konkan Railway was the missing link provides concrete proof of the skills of Indian
between India’s commercial capital, Mumbai engineers, their discipline, team spirit and cour-
and Mangalore, the fourth largest city in state of age. Mangalore, traversing through a distance of
Karnataka. The 741-km railway line connects 741-km along Western Ghats. The entire stretch
Maharashtra, Goa and Karnataka, and makes entry comprises 91 tunnels and 179 major bridges some
into the southern state of Kerala very conveniently. of which have found mention in the record books.
The entire Konkan region is close to the western The entire 741-km long project was divided
coastline of India and is a region of criss-crossing in seven sectors—each approximately 100-
rivers, plunging valleys and mountains that soar km long, headed by a chief engineer. The sec-
into the clouds. tors were Mahad, Ratnagiri (north), Ratnagiri
The formidable terrain to be conquered and the (south), Kudal, Panaji, Karwar and Udupi. With
short construction period meant that the project the delegation of adequate powers to the chief
could only be completed with the help of several engineers and compact sectors that allowed for
technological innovations. personal attention, KRCL succeeded in over-
Apart from setting a trend for other infrastruc- coming the proverbial ‘red tape’ and kept up the
ture projects in the country, the Konkan Railway pace of work.
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mechanical engineering, stores and finance. They

provided the strategic inputs of design, planning,
tendering and contracting of large works. In the
different sectors, chief engineers were assisted by
deputy chief engineers of the civil, electrical, sig-
nal and telecom disciplines, and by deputy chief
account officers. The field level was manned by
some 400 young engineers recruited from among
fresh graduates belonging to various engineering
colleges—a vital step in keeping the set-up highly
motivated and dedicated to the objectives.
For the project to be a success, the organization
The Konkan region: Spectacular but challeng-
had to be kept lean but effective. At the peak of
ing terrain the construction period, there were no more than
Credit: Kevin Standage.shutterstock.com 2,400 personnel, starting from the CMD to the low-
At the corporate office, there was a team of est rung. The establishment of computer wide area
senior officers specialized in civil engineering, elec- networks (WANs) and local area networks (LANs)
trical engineering, signal and telecom engineering, augmented their efforts, providing instantaneous
Some Engineering Details

Track Materials
Gauge Broad gauge Total quantity 6,00,000 tonnes
(1676 mm) of cement
Route length 741 km Total quantity 85,000 tonnes
Ruling gradient 1:150 (0.67%) of steel
Rails: Ultimate Tensile 52 kg 90 UTS Total quantity 3,160 tonnes
Strength (UTS) (welded rails) of high tensile
Sleepers: Pre-Stressed PSC mono block steel (HTS)
Concrete (PSC) sleepers Total quantity of 2,00,000 tonnes
No. of curves 342 structural steel
Rails 1,00,000 tonnes
Earthwork PSC sleepers 12,87,000 Nos.
Maximum height of 25 m Signalling Panel interlocking with
an embankment colour light signals
Deepest cutting 44 m Telecommuni- State-of-the-art optic
Total earthwork 88 million (m3) cations fiber with digital
communication
Stations
Total No. of Stations 59 Longest Span
For concrete 53.5 m (PSC Box
Bridges bridges girder)
Major bridges 179 (Lineal waterway For steel 124.2 m (open web
19.823 km) bridges steel through girder)
Minor bridges 1,701 (Lineal Longest bridge Across Sharavati river in
waterway 5.58 km) Honnavar (2065.8 m)
Total 1,880 Tallest viaduct Panval Nadi (64 m high)
No. of road 365 (Road over First bridge to Panval Nadi Viaduct
crossings bridges/road under be launched (420 m long) PSC
bridges/Foot over by incremental box girder
bridges) launching
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24 | Chapter 1
fax and voice communication all along the route, pegging out the route on the ground, prepar-
which resulted in quick decision-making and pre- ing land plans, drawings and tender schedules,
vented stalling of work. conducting investigations on the soil, deciding
With such a tight deadline, engineers had to at which point exactly a bridge had to be con-
think fast and creatively. Conventionally, when an structed or a tunnel bored. During this intense
alignment needs to be worked out, several jeeps period, KRCL succeeded in reducing operational
and lots of people to run around are required. benefit to the Railway system.
Rajaram, who was then the chief engineer in Goa The achievement was made possible by the
and later went on to become the managing direc- fact that several senior officials, including E.
tor of KRCL, took satellite images, made topo- Sreedharan, S.V. Salelkar, the engineer-in-chief
graphical maps with high accuracy and then—for (Projects) and A.K. Somanathan, the then engi-
the first time in the history of the Railways—sent neer-in-chief (technical), walked down the entire
out teams on motor cycles. He ordered several route, along with the sectorial chief engineers. It
Kawasaki bikes modified to carry equipments, was not easy, ascending and descending all those
such as levelling instruments and hired young hills and valleys.
boys, fresh with their engineering diplomas, to go A detailed environmental impact assess-
around the state. They were given `100 per day ment study (EIAS) of the alignment was carried
and petrol, neither of which they had to account out in two phases through Rail India Technical
for, so long as they executed a certain amount of and Economic Services Ltd. (RITES), a public sec-
work every day. The targets were given in such a tor undertaking under the Ministry of Railways.
way that they would have to work 14 hours a day. Under phase I, stretches between Udupi and
However, they felt empowered and gave their best. Mangalore were covered. Under phase II, the study
Thirty such teams in Goa worked on 16 differ- was conducted between Veer and Sawantwadi.
ent alignments, and the data was analyzed, often The RITES conducted a separate (EIA) study for
way past midnight, on an assembled computer the balance alignment in Goa. The Goa govern-
that Rajaram bought at a lesser price in Bangalore. ment approved the alignment, which was finalized
Rajaram designed the software for this analysis on in December 1990 after detailed discussions with
his own. This approach meant that survey work state authorities. In March 1991, the new govern-
was done at 10 per cent of the cost that it would ment reconfirmed the alignment.
have normally involved. While working out the plans, many factors
While the alignment was being finalized in such as optimization of earthwork, tunnels and
Goa, hectic activity was going on all along the bridges; least possible interference to habituated
Konkan area. The first working season between areas; minimum damage to horticultural lands,
1990–1991 was utilized for a detailed survey: especially mango and cashew groves; avoiding
reserves and thick forests were considered, while
at the same time, achieving the goals of flatter
gradients and curvatures. In Goa, where people
were particularly emotional about having to give
up ancestral property, KRCL engineers personally
visited each house to see if there was any way it
could be saved. In many cases, the team found
a way out. This explains why Goa has the maxi-
mum number of curves on the alignment; even the
Mandovi bridge is on a curve. As a result of this
careful appraisal, only 35 houses were disturbed
in Goa, where population density was the highest.
They faced with pressure from local residents, but
the Konkan Railway team found their engineering
Tracking its way through: A track through one skills sharpened.
of many tunnels This case highlights some of the following impor-
Credit: aminkorea.shutterstock.com tant project management-related considerations:
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1.
Work breakdown structure: The entire 4. Matrix and a functional organization at
project length of 760 km was divided the corporate headquarters.
into seven sectors, each approximately 5. Environment impact assessment study.
100 km long, headed by a chief engineer. 6. Problem-solving and quick decision-
2.
Innovative solutions: For the first time making: The establishment of computer
in the history of the Railways, teams WANs and LANs augmented their ef-
were sent out on motor cycles. forts, providing instantaneous fax and
3.
Cost cutting: This approach meant that voice communication all along the
survey was done at 10 per cent of the cost route, which resulted in quick decision-
that it would have normally involved. making and prevented stalling of work.
Case Study
Naturals
Naturals (formerly, Natural Ice Creams) was he is happy with his achievements, he is more
launched in 1984 by Raghunandan Kamath. The thrilled to teach the art of entrepreneurship to
company’s growth story is much similar to the budding minds. He advises: ‘Be an entrepreneur
proverbial David in the `10,000 Crores ($148 to bridge the gap between poverty and riches’.
million) Indian ice-cream business with Goliaths Prominent among his awards is the Coca Cola
such as Amul, Mother Dairy, Hindustan Unilever, Golden Spoon Award in 2016, Gold Medal for
Baskin and Robbins, Haagen-Dazs, Vadilal Ice- the most innovative ice cream in the Great Indian
cream, etc. While the success of David in the Ice Cream Contest, Corporation Bank’s National
biblical story is attributed to the backing of God, SME’s Excellence award in Food and Agro Industry
for Naturals, the success can be attributed to the in 2006, a place in the Limca Book of Records for
grit, determination, foresight, innovativeness and the largest ice cream slab weighing 3,000 kg (3.3
quality consciousness of its founder, Raghunandan US tonnes), etc.
Kamath, which were the primary drivers of success. Besides featuring on almost all the promi-
Kamath attributes his success to the divine will and nent Indian business magazines and newspapers,
engages in philanthropic services too. Naturals has been the subject of case studies in
The Naturals chain of ice-cream parlours has management schools locally and globally. The
126 stores across India with 11 stores managed below narrative is in the context of successful
directly and the rest by franchisees. Currently, the project management in every business aspect such
stores are located in key cities of Maharashtra, as product innovation, distribution innovation,
Karnataka, Goa, Telangana, Kerala, Gujarat, process innovation, operations innovation, sourc-
Madhya Pradesh, Chhattisgarh, Punjab, Rajasthan ing innovation and of entrepreneurship in every
and Delhi NCR regions. In the fiscal year 2017– aspect in the business of manufacturing traditional
18, with a total retail area of over 80,000 sq. feet, ice creams. Quality and consistency of the prod-
the chain’s annual turnover crossed `200 Crores ucts offered are other hallmarks of Naturals.
($2.96 million). Presently, Naturals produces over The general process of manufacturing industrial
20 tonnes of ice creams every day from its range ice cream is given in Exhibit II.
of 100 flavours using natural pulp from about 60 At every stage of the ice cream making process,
varieties of fruits, including dry fruits. innovation, engineering and enterprise are mani-
Recognitions and awards have followed fest in Naturals. Let us understand the process in a
Raghunandan Kamath over the years and although stage-wise manner.
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26 | Chapter 1
single supplier of milk for the past 35 years.

At every stage of the procurement process,
commitment to quality and a wonderful
foresight of the effects of minor seasonal
variations in the final product helped Ka-
math perfect the art of making ice creams.
Sitaphal or custard apple ice creams are the
most sought-after flavour. The fruit has a
problem of de-seeding while extracting the
pulp. It was not possible to manually deseed
more than two kilos of fruits by a person
on a day, but the demand was over 500 kgs
of custard apple. Kamath’s used his creativ-
ity and developed an indigenous equipment
which could separate the seed from the flesh
effectively and meet the daily requirements.
2. Blending: The traditional native cooking
on wooden fire uses a long hollow pipe to
blow air in the vessel by heating milk to
prevent milk from overflowing from the pot
and yet continue to simmer. This common
Generic commercial ice cream manufacturing but unique technique enhances the taste of
process the end product, making milk creamier and
tastier. Technically called ‘falling film evap-
1. Ingredients: The basic raw material used oration’, the milk temperature is brought
in the manufacture of ice creams, commer- to 30°C before cooling it to four degrees
cially, is a mixture of milk and/or cream, and then heating it to 90°C within four
sugar, eggs and flavour extracts such as va- minutes. Cooled again to 4°C, it turns into
nilla, emulsifiers and stabilizers. Naturals condensed milk, the way it is needed for ice
does not use eggs, flavours, emulsifiers or cream production.
stabilizers; as a result, the shelf life is ex- Similar to traditional mass cooking, typi-
tremely less—at best, 15 days. The brand cally in temple food preparation, various
name ‘Naturals’ ensures that only naturally vegetables and pulses are added, depending
available products, predominantly organic, upon the exact time required to cook them
are used in the manufacture of these ice right. Naturals has mastered the process of
creams. The products are thus ‘ice-creams’ layered blending of fresh fruits to ensure
and not ‘frozen desserts’. Frozen desserts that the best flavours get captured and the
are made with vegetable oils, whereas ice finished product retains the consistency of
creams are made with only milk and dairy flavours and aroma uniformly from the first
fat. Most offerings in the ice cream cat- scoop to the last scoop. As Naturals uses
egory are factually frozen desserts, whereas a unique process, the standard equipment
Naturals is among the very few ice creams for commercial ice creams was not of much
that are factually ice creams. The fresh help. Kamath used his own proprietary
fruits added in it give the right flavour and technical skills and developed specialized
texture to the products; they are obtained equipment for each stage of their unique
from source and are invariably, of the best manufacturing process.
quality. The milk is procured from just one 3. Homogenization: Homogenization is a pro-
source for consistency. The Toyota produc- cess that gives milk its rich, white colour and
tion systems adopt the process of ‘Keiretsu’ smooth texture. Milk, which has not been
or single supplier for outsourced products homogenized, contains a layer of cream
and Naturals follows the same practices—a that rises to the top of the cup, carrying the
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milk. However, one of the disadvantages of 6. Packaging: After the hardening stage, com-
homogenization is that milk becomes sen- mercial ice creams get transformed into a va-
sitive to light, especially sunlight and fluo- riety of novelty or impulse products through
rescent light, resulting in ‘sunlight flavour’. various filing and forming machines. Natu-
As the delicate flavours of many Naturals rals, however, prefers to deliver over 40,000
ice creams is based on fruits such as tender scoops of ice creams manually on a daily ba-
coconut, any sunlight flavour effect can mar sis rather than packaging the scoops in 50
the natural flavours. Hence, in the process ml or 100 ml containers. This is done to pre-
of manufacturing ice creams, Naturals does serve the texture, flavour and composition
not use the process of homogenization. of ice creams. Furthermore, easy-to-dispose
Cooling and Ageing: The mix is then aged
4. and light weight packaging materials are
for at least four hours which allows time for used in distribution which help reduce the
the fat to cool down and crystallize. Age- requirement of reverse logistics.
ing provides the desired whipping qualities 7. Storage: The ice creams which are kept at
for the mix and body and texture of the ice –22°C are packed into boxes along with a
cream. Most commercial ice creams use air plenty of dry ice to keep it from melting.
to make ice creams voluminous. The grad- 8. Delivery and Distribution: Naturals operates
ing of ice creams is typically super premium from only one manufacturing plant located in
(least air called overrun) to standard (most the northern suburbs of Mumbai and supplies
air or overrun). Naturals ice creams do not to all the outlets from this plant. Transport of
add air into the ice creams; whatever air is ice creams and onwards by road have been
present in the product is the result of the facilitated by the Railways. As the taste and
normal manufacturing process. Therefore, freshness of ice creams depend on a specified
when a customer buys 530 ml of Naturals number of hours before it loses its taste, Nat-
ice cream, he actually gets more than 500 ural’s trucks can cover only a finite distance.
gms of ice cream, whereas in case of most Naturals is in the process of setting up manu-
other competing ice creams, 500 ml could facturing units called ‘mega-shops’ in other
fetch more than 250 gms of ice creams plus locations such as Chandigarh which will
air. provide frozen non-perishable fruit pulp and
Processing and hardening: Processing or
5. processed milk to be blended into ice creams.
freezing/whipping of ice creams is the pro- Once successful, the mega-shops would be the
cess where about 50 per cent of the water launch pad for its global ventures.
is frozen and a considerable amount of air
is blown, giving the product its character- Some unique features of Naturals ice creams
istic lightness. At this stage, the product are as follows:
is a semi-frozen slurry where the particu-
late matter such as fruits, nuts, candies or 1. Taste of traditional home-made and
cookies is added. In case of Naturals, the hand-made ice creams.
particulate matter or fruits are added at a 2. Creamier and richer, distinctly Indian.
much earlier stage, giving it a characteris- 3. 100 per cent vegetarian ice creams, which
tic aroma, which otherwise is lost, should have an acceptance across communities.
these particulate matter be added at this 4. Predominantly fruity flavours, acceptable to
stage. Second, as mentioned earlier, no air is all customers.
blown in the ice creams, giving a thickness 5. Ice creams which are freshly made without
which no other competing brand can offer. any preservatives and are appealing to all
The next stage is to freeze the remaining customers, especially health conscious cus-
water and the commercial process is blast tomers.
freezing at –30°C up to –40°C. Ice creams 6. Constant innovations with fruit combina-
should be maintained at –25 for stability. tions.
In case of Naturals ice creams, the tempera- 7. Only milk and cream used in the manufac-
ture of manufacture is maintained at –22°C. ture of Naturals ice creams.
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28 | Chapter 1
8. Zero advertising expenses and reliance on Project management and entrepreneurship

word-of-mouth publicity. are used synonymously, with most successful en-
9. Value for money pricing strategies. trepreneurs being excellent project managers.
10. More ice cream per scoop due to least over- Innovation and agile project management are the
run (air). other techniques successfully applied at Naturals
11. High quality standards from receiving fruits in every phase of their growth.
and other ingredients to the finished products.
Summary
Projects are unique but Project Management is repetitive. Every exponent of project management
should realize this important aspect. Although we see projects of different types in software devel-
opment or in construction, the factors that drive success in each project remain the same. Scope
definition, cost estimation and duration decisions are vital for project completion. Essential working
features in a project would be Work Breakdown Structure (WBS) which makes it easy to monitor
and track the progress of work. Every project should be characterized by a project life cycle with
the effort required at the various phases of the project life cycle when traced should resemble a ‘S’
shaped curve. These ‘S’ curves can be further classified as cost v/s time ‘S’ curve, Target ‘S’ curve,
Value and Percentages ‘S’ curve and Actual ‘S’ curve. The project manager plays a very key role in
the success of the project, and hence, the traits that would lead to timely execution of the project
become very important.
KEYWORDS
• Project scope management • Project life cycle

• Project time management • Detailed project report (dpr)
• Project cost management • Project management professional (pmp)
• Work breakdown structure • Project management institute (pmi)
• ‘S’ curve • Epc company
• Project organization
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Re v i ew Q u est i o n s
1. Answer in True or False.

(a) Inventories are treated in the asset side of the balance sheet.
(b) Expenditure for long-term returns is classified as revenue expenditure.
(c) Projects are always undertaken for the sake of profits.
(d) Projects are unique but project management is repetitive.
(e) A project is a temporary endeavour with a defined beginning and end.
(f) Project life cycle has six stages.
(g) The risk of completing the project and the value generated for the project work in oppo-
site directions.
(h) The ‘S’ curve is a well-known project management tool which displays cumulative costs,
labour hours or other quantities against time.
(i) The project manager should be a specialist in at least one area of the project.
(j) For the success of a project, the scope, time duration and cost should be within target.
(k) The work breakdown structure is used to prepare planned actions.
(l) The first two levels of the WBS—the root node and level 2—define a set of planned out-
comes that represent 100 per cent of the project scope.
(m) Matrix organization is best suited for project management.
(n) Detailed project report is not required when approaching financial institutions for term
loans.
(o) Human relation aspects are not all critical for project management.
2. Explain the difference between projects and projects management.
3. How would a project organization be different for an EPC company and an organization’s
own project team?
4. Explain the concept of work breakdown structure in detail. Explain the essential features of
a WBS.
5. Why is a project manager termed an entrepreneur?
6. What is the role of the Government of India in promoting projects?
7. What should be the personal traits and managerial traits of a project manager?
8. Explain the concept of ‘S’ curve and its utility in project management.
9. What is the role of HR in project management?
10. What are the components of a detailed project report?
11. Outline the main features and advantages of ‘matrix’ type organization for projects.
Answers
1.
(a) True (f) False (k) False
(b) False (g) True (l) True
(c) False (h) True (m) True
(d) True (i) False (n) False
(e) True (j) True
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Chapter
2 PROJECT NETwORk
ANAlysis–i
learninG obJeCTives

❍ Prioritize the task on the basis of excess time over performance time.
❍ Examine the decisions regarding activities to be stopped and the time period available
to delay these activities for optimum usage of scarce resources.
❍ Establish priority rules for stopping non-essential activities and stoppage duration.
❍ Understand probabilistic projects and the approach to complete such projects on time.
❍ Perform a cost-benefit analysis when reducing project duration.
❍ Reduce the variations in case of resources requirement(s) during the project period so
that periods of extremely high requirement and extremely low requirement(s) are
avoided.
❍ Conduct activity on node (AON) convention for network drawing and analysis.
iNTRODUCTiON
Network techniques are the pictorial representation of various tasks, their interdependencies and
activities that need to be completed for completing the entire project. They also speak about the
interrelationship between the various tasks or activities and this aspect helps in planning, schedul-
ing, monitoring and controlling the project. In case of small projects, perhaps, the requirement of
sophisticated techniques is not all that important, but as the project gets more complex, allocation
of scarce resources becomes difficult, without any scientific aid or technique. At these times, the
project manager is helped by network design and related review techniques.
Henry L. Gantt was a pioneer in the area of pictorial representation of progress of activities
comprising a project. In his memory, the charts constructed are termed as Gantt charts. Although
Gantt charts have limited utility, the pictorial presentation helps in visualizing the work required to
complete the project. Perhaps this is the reason as to why these charts are used even today, almost
60 years after they were first demonstrated.
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32 | Chapter 2
The various topics in network analysis can be grouped into four broad areas as follows:
Critical Path Method (CPM)/Float Analysis: In this case, the network is based on activities,
1.
using the activity on arrow (AOA) convention. It was first developed by DuPont in USA for
their Nylon 6 project and is used in situations where the activity times are known deter-
ministically. The first step is construction of the network diagram and the subsequent steps
include the following: to identify the early start (ES), earliest finish (EF), latest start (LS) and
latest finish (LF). With the help of this information, we can identify the surpluses on activities,
termed as ‘floats’ and the components of floats such as total float, interfering float, free float
and independent floats.
Program Evaluation and Review Technique (PERT): For many probabilistic projects such as
2.
projects in research and development or space projects, it is not possible to predict the exact
time for the activities. In such situations, instead of the activities which track the progress of
a project against time, milestones are established for monitoring their progress against time.
These milestones are termed as ‘events’. Thus, the PERT network is an event-based network.
This technique was first developed by the US Navy for its Polaris missile project. Such situa-
tions where activity times cannot be predicted with confidence are called stochastic or proba-
bilistic situations. Here, we use three estimates of activity durations namely, the optimistic
time (To), most likely time (Tm) and the pessimistic time (Tp). In case of PERT networks, the
average time for completion of an activity is calculated and the sum total of the average times
for all the activities on the critical path is the average time for completion of the project. As,
‘average’ times are involved for project duration, we also consider the standard deviation for
the project completion times, which would help us in arriving at confidence intervals for proj-
ect completion on the basis of available time.
Crashing of a Project: For every project, the cost component may comprise two compo-
3.
nents—direct cost and indirect cost. Although the direct cost occurs irrespective of the time
taken to complete the project, the indirect cost is a function of the project duration and thus
can be targeted for reduction by reducing the project duration. Completing the project in
lesser time than earlier planned is termed ‘crashing’. Crashing is carried out for the twin ben-
efits of reducing indirect costs and thus, the total cost, besides the advantages of reduced time
duration for completing the project. There may be some increase in direct cost as a result of
crashing due to the required additional efforts and resources, but the substantial advantages
offsets this increase.
The second benefit is that the project gets completed before the scheduled time and it is
often advantageous to do so as in most cases, additional rewards/monetary benefits are avail-
able for completing the project early. However, infinite crashing is not possible and is limited
by either the technical limitations, if any, of minimum time for completing an activity, or the
cost considerations.
Network Using the Activity on Node (AON) Convention or Precedence Diagramming Method
4.
(PDM): In this case, the activity is shown at the node and is joined by arrows depending upon
their logical relationship. Much information can be shown in the network using the AON
convention, unlike in the case of an activity on arrow (AOA) network. Second, in most practical
situations, succeeding activities can proceed simultaneously along with the preceding activity
with or without some time delay. This is because it is not absolutely necessary that the entire
predecessor activity is fully complete before the successor activity can start. Such parallel
progress of activities is not possible under AOA convention, where the preceding activity must
be fully completed before the succeeding activity can start. Most software programs use the
PDM method for solving project network problems.
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Project Network Analysis – I | 33
The PERT network uses the events or milestones at nodes and the PDM/AON method uses the
activities at node. This conflict restricts the use of PDM/AON method for probabilistic networks.
However, since a PERT network can also be described using the activities (instead of events/mile-
stones), the software packages solve the PERT networks with activities using the PDM method.
The conclusion that PDM/AON method can be used for PERT networks because the software uses
the same is not correct. If the PERT network is described in nodes/milestones, the software would
be unable to solve the problem.
Network diagram and analysis using the

Activity on Arrow (AOA) convention
While constructing the network diagram using the AOA convention (or the AON convention), the
only criteria is the predecessor or successor relationship. The network diagram is the first stage of
any network analysis, and hence, adequate attention should be paid to the details while constructing
the diagram.
Constructing a Network Diagram

The various tools and techniques of project management are grouped into two heads, namely bar
charts, milestone charts and velocity diagrams and network techniques.
Bar charts or Gantt charts are two-dimensional, pictorial representations of a project, with activi-
ties of the project shown on one axis and their durations represented on the other axis. Milestone
charts are the modified and improved versions of bar charts with a primary difference that a mile-
stone chart is event-based whereas, a bar chart is an activity-based chart. Milestones such as bar
charts cannot show the interrelationships between activities or events and give equal weightage to
all activities, instead of more weightage to the critical path activities. Thus, they possess most of the
drawbacks inherent in a bar chart.
Velocity diagrams are useful for representing the activities which require groups of people work-
ing in a predetermined sequence.
A network comprises a series of activities linked to each other with a single start and a single end.
Figure 2.1 shows a typical network diagram. The start for all the activities is the event or node 1 and
the finish for all the activities is the end node 9.
The activity names are written above the arrows depicting the activities. It may be noted that each
activity has a start node also known as tail event or node and a finish node also known as a head
event or node. Furthermore, no two or more activities can have the same start and the same end.
Figure 2.1 Typical network diagram

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34 | Chapter 2
While two or more activities can have a same start or a same end, none may have the same start and
the same end. There are different paths to go from the start node 1 to the end node 9.
Path 1: A – B – D – G – K – Dummy – L
Path 2: A – B – D – G – H – L
Path 3: A – C – E – G – K – Dummy – L
Path 4: A – C – E – G – H – L
Path 5: A – C – F – K – Dummy – L
Path 6: A – C – F – H – L
One of these paths is the path of maximum duration and is therefore, called the critical path (Path 3
is the critical path in this case and is shown in bold lines in the network). On this path, no delays can
be admissible but on the other non-critical paths, some delays can be permitted. In general, while
constructing a network, we must keep the following points in mind:
1. Every activity must have a start and an end. The direction of activity progression should be
clearly mentioned. On such example is as shown in Figure 2.2.
Figure 2.2 Correct representation of an activity
The figure adjoining the activity is the duration of the activity. Event or node 1 is the start node
and event or node 2 is the end node.
2. In case two (or more) activities have a common start and a common end, then this relation has
to be shown with a dummy activity. A dummy activity does not consume any resource but is
used to show relationships. This is shown in Figure 2.3(a).
Figure 2.3(a) Examples of incorrect and correct network diagram
3. While constructing the network only the predecessor relationships are considered and not the
duration. This means that the length of an activity in the network is not proportional to its
duration.
4. There should not be any loops in the project network. The relationship of the loop which is
not allowed is shown in Figure 2.3(b).
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Figure 2.3(b) Cyclical relationship is not allowed
5. The numbering pattern for events should be such that the head event should have a higher
number than the tail event. In some cases, this may not hold true and it is fine. However, as
far as possible, this rule, known as Fulkerson’s rule devised by D.R. Fulkerson, should be
followed. In general, the numbering pattern is ascending order from left to right and top to
bottom.
Example 2.1
Construct the network for the following predecessor relationship shown in Table 2.1.
Table 2.1 Activities with predecessor relationships
Activity Predecessor(s)
A —
B A
C A
D B
E C
F C
G D, E
H G, F
K G
L H, K
M L
Solution:
While constructing the network, we take one activity at a time and perform it only after the prede-
cessor activity is completed. In fact, the only criteria while constructing a network, is the predecessor
relationship.
1. Activity A has no predecessor, and hence, we start with activity A. We are at liberty to name
the events in any which way and at times, a situation of some activity going from event 3 to
event 2 is also fine. The numbering pattern is ascending order from left to right and from top
to bottom.
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36 | Chapter 2
2. After activity A is complete, two activities namely, B and C can commence simultaneously.
3. Activity D can start after activity B and activities E and F can start after activity C is completed.
4. Activity G depends on the completion of both D and E. Now, D is completed in node 4 and E
is completed in node 5. However, we need a common point where both D and E have ended,
and hence, we make the changes to the network as follows:
5. Activity H depends on G and F, which means for H to start, there has to be a common point
where both G and F end. However, activity K depends only on the completion of activity G,
and hence, there has to be an event where only G is complete and an event where both G and
F are completed. This is shown by a dummy activity.
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6. Activity L depends on the completion of two activities H and K, and hence, we have to end
both activities H and K in one node and show L originating from the common end point. The
last activity is activity M, which depends on activity L. The completed network is as shown in
Figure 2.4.
Figure 2.4 Completed network for Example 2.1
It is rather difficult to conceive an entire network at the start of the problem and even after much
practice, there could be mistakes. It is advisable that the step-by-step method described above be
used for drawing the network. A pencil diagram for rough work and a final sketch with pen would
be most apt while constructing the network.
Example 2.2
Draw a network for the project of erection of a steel warehouse. The various activities involved in
erection of the steel warehouse along with the predecessor relations are outlined below in Table 2.2.
Table 2.2 Steel warehouse erection project relationships
Activity Description Predecessor(s)

A Erect site office —
B Construct boundary —
C Preparatory work for erection A
D Begin piling work B
E Fabrication of piping A
F Install main beams B
G Construct pillars C, D
H Reinforce foundation G, F
I Erect fabrication work E
J Finish the structure H, I
K Paint the structure J
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38 | Chapter 2
Solution:
Activities A and B have no predecessor, and hence, they can commence simultaneously. Similarly,
Activities C and E depend on the completion of A, whereas activities D and F depend on the comple-
tion of activity B. Hence, after completion of activity A and B, these four activities can commence.
Activity G depends on completion of C and D and H depends on the completion of G and F, which
means that there has to be common end points C and D to end, for G to commence and a common
end point where G and F can end to commence H.
Activity I depends on E and activity J depends on H and I. Finally, activity K depends on activity J.
Hence, the completed network is as shown in Figure 2.5.
Figure 2.5 Completed network depicting predecessor relationships
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Example 2.3
The activities of the project along with their inter-relationships are given in Table 2.3. Construct a
network for the same.
Table 2.3 Activities and successor relationships
Activity Successor Activity

A B
B C
C D
D E
E F
F G, H, I
G J
H K
I J
J —
K —
Solution:
In the present problem, the successor relationships are given and although a network can be con-
structed using this relationship, it is preferably to first write the predecessor relationships. Once the
network is completed using the predecessor relationships, it should be checked whether the original
successor relationships are satisfied.
Activity A is not a successor to any activity which means activity A has no predecessor. Similarly,
activities B, C, D, E and F are successors to activities A, B, C, D and E, which inter alia means that
activities A, B, C, D and E are predecessors to activities B, C, D, E and F, respectively. This is shown
below.
Activity Predecessor Activities

A —
B A
C B
D C
E D
F E
Furthermore, activities G, H and I are successors to activity F, which means that activity F is one of
the predecessors to activities G, H and I. Similarly, activity J succeeds activities G and I, which means
the predecessors for activity J is activities G and I. It must be noted that activities G and I have the
same predecessor which means that they cannot have the same end to start activity J and that there
is a need for a dummy activity.
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40 | Chapter 2
Table 2.4 Activities and predecessor relationships

Activity Predecessor Activities
G F
H F
I F
J G, I
K H
Figure 2.6 Completed network
Identifying the critical path

There are two methods by which we can identify the critical path. The first method is to list down all
the paths or options that are available to go from the start node to the end node. Once these paths
are listed down, we compute the time it takes from the start node to the end node in traversing these
paths. The path with the maximum duration or the longest duration is the critical path.
The first method does not help us in performing the analysis of ‘surpluses’ which is also called the
‘float’ analysis. Float is the surplus available in terms of duration on some of the activities. Activities
with positive float can be delayed upto that extent and this delay would not affect the project dura-
tion. Any delay in activities greater than the float would delay the entire project. Some activities in
the network are characterized by ‘zero’ float and these activities are critical path activities. As the
floats are ‘0’, none of the critical path activities can ever be delayed or else the project would be
delayed.
To calculate the float for all activities, we need to compute the earliest start (ES), earliest finish
(EF), latest finish (LF) and latest start (LS) that every activity can have. Furthermore, this informa-
tion can be shown on the network itself or in a table form.
Earliest Finish (EF) = Earliest Start (ES) + Activity Duration
Latest Start (LS) = Latest Finish (LF) - Activity Duration
Computation of earliest start and earliest finish is called ‘forward pass’ as we start from the first
node and proceed towards the last node. In case of forward pass, the information on ES is known
and EF has to be calculated.
Computation of the latest finish and latest start is called the ‘backward pass’ as in this case, we
start with the last activity finish times and work backwards towards the first activity latest start
times. In case of backward pass, the information on LF is known and LS has to be calculated.
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For critical path activities, the earliest start and latest start (or earliest finish and latest finish)
times are the same. For activities on non-critical paths, there is a positive difference between latest
start and earliest start (and the value remains the same if we calculate the difference between latest
finish and earliest finish). This positive difference, known as the ‘FLOAT’ for an activity, indicates
the delay that can be tolerated on these activities without delaying the project. As a corollary, since
this difference is zero for critical path activities, there is no surplus or FLOAT available on critical
path. This, in turn, means that the activities on the critical path need to be constantly monitored
and in case of exigencies such as labour shortages or resource constraints, the critical path activities
should be given higher priority in allocations compared to non-critical path activities.
The surplus available at the nodes or events is known as ‘SLACK’ for the event. If more than one
activity has the same tail event, then the smallest of the activity floats becomes the tail slack. If only
one activity starts from the tail event, then the activity Float becomes the tail event Slack.
We will use the square brackets to describe the ES, EF values, [ES, EF] and curved brackets for
describing the LS, LF values {LS, LF}.
Example 2.4
For the given network relationship (Table 2.5), find the critical path and duration of the project
completion.
Table 2.5 Activity details
Activity Predecessor(s) Duration (Days)

A – 7
B – 13
C A 10
D A 17
E B 3
F D, E 26
G F, C 5
Solution:
The first step is always to construct a network diagram, where the activities are drawn on the basis
of predecessor relationships. At this stage, the activity times or duration is not considered. The net-
work diagram for the problem is shown in Figure 2.7. We write the activity duration times next to
the activity name. This would help us in calculating the ES, EF, LS and LF conveniently.
Figure 2.7 Completed network

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42 | Chapter 2
Finding the critical path by first method:

List down all the paths possible from Start node 1 to reach end node 5
Path 1: 1 – 2 – 5 – 6 or A – C – G
Path 2: 1 – 2 – 4 – 5 – 6 or A – D – F – G
Path 3: 1 – 3 – 4 – 5 – 6 or B – E – F – G
Next, we find the duration taken by each path.
Path 1: 1 – 2 – 5 – 6 or A – C – G = 7 + 10 + 5 = 22 days
Path 2: 1 – 2 – 4 – 5 – 6 or A – D – F – G = 7 + 17 + 26 + 5 = 55 days
Path 3: 1 – 3 – 4 – 5 – 6 or B – E – F – G = 13 + 3 + 26 + 5 = 47 days
Path 2, which is A – D – F – G, takes the maximum time to go from the start node to the end node,
and hence, this is the critical path. The duration of the project is 55 days. The critical path is high-
lighted with bold lines, as shown in Figure 2.8.
Figure 2.8 Network showing critical path
The non-critical path activities are B, E and C. The analysis to address the question how many
days delay is admissible on B, E and C, without affecting the project duration, is called float
analysis.
To identify the floats and activities with zero floats (critical path activities), we first compute the
ES, EF and LS, LF data and present it on the network as shown in Figure 2.9.
Figure 2.9 Network with [ES, EF] and {LS, LF} for each activity
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Forward Pass Calculations

Activity A: It is the starting activity and does not depend on any other activity, hence can start on
day 0, which means ES = 0. EF = ES + activity duration = 0 + 7 = 7.
Activity B: It is also the starting activity which does not depend on any other activity and hence can
also start on day 0, which means ES = 0. EF = ES + activity duration = 0 + 13 = 13.
Activity C: Activity C can start the earliest after the preceding activity, that is, activity A has finished
the earliest. Activity A finishes the earliest by day 7, and hence, activity C can start the earliest by
day 7. ES = 7 and EF = ES + activity duration = 7 + 10 = 17.
Activity D: Activity D can start the earliest after the preceding activity that is activity A has finished
the earliest. Activity A finishes the earliest by day 7, and hence, activity D can start the earliest by
Activity E: Activity E can start the earliest after the preceding activity that is activity B has finished
the earliest. Activity B finishes the earliest by day 13, and hence, activity E can start the earliest by
Activity F: Activity F can start the earliest after both the preceding activities that is activity D and
activity E has finished the earliest. Activity D finishes the earliest by day 24, whereas activity E
finishes the earliest on day 16. As both the activities must complete for activity F to start, the earliest
that activity E can start is the later date amongst the earliest finish times of activity D and activity E.
Activity E finishes earliest by day 16, but activity D finishes earliest by day 24. Hence, the earliest
start for activity F is 24 or ES = 24 and EF = ES + activity duration = 24 + 26 = 50.
Activity G: Activity G depends on the completion of activities C and F. Activity C finishes earliest by
17, whereas activity F finishes earliest by 50, and hence, activity G can start the earliest by 50. Now,
ES = 50 and EF = ES + activity duration = 50 + 5 = 55.
Thus, the project would require minimum 55 days to be completed.
A thumb rule to be followed is that in case you are doing the forward pass and there is a choice for
early start times on the basis of early finish times of the preceding activities, then the highest time
value should be taken. As a corollary, when you are doing the backward pass and there is a choice
for late finish times for the preceding activity, the least of the two (or more) latest start times of suc-
ceeding activities should be selected.
Backward Pass Calculations
In case of backward pass calculations, we start with the last activity and the convention is that the
early finish time for the last activity is the same as the late finish time.
Activity G: Activity G is the last activity and has the earliest finish time as 55 days. Hence, the latest
finish time for activity G is also 55 days. The latest start time or LS = 55 – activity duration = 55 – 5
= 50. This means that the activity G has to start latest by 50 days or the project would be delayed.
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44 | Chapter 2
Activity F: Before activity G starts, the earlier activities must be completed. This means that activ-
ity F (and also activity C) should be completed latest by 50, so that the succeeding activity, that is,
activity G can start the latest by 50. Accordingly, the latest start time or LS = 50 – activity duration
= 50 – 26 = 24.
Activity C: Activity C can also complete latest by 50, because the succeeding activity G does not
commence before day 50. Hence, in case of activity C, latest finish time is 50 days. Accordingly, the
latest start time or LS = 50 – activity duration = 50 – 10 = 40.
Activity D: Activity D can complete latest by 24, because the subsequent activity, which is activity F
that starts the latest by 24 (and not before that). Hence, in case of activity D, latest finish time is 24
days. Accordingly, the latest start time or LS = 24 – activity duration = 24 – 17 = 7.
Activity E: Activity E can complete latest by 24, because the subsequent activity, which is activity F,
starts the latest by 24 (and not before that). Hence, in case of activity E, latest finish time is 24 days.
Accordingly, the latest start time or LS = 24 – activity duration = 24 – 3 = 21.
Activity B: Activity B can complete latest by 21, because the subsequent activity, which is activity E
starts the latest by 21 (and not before that). Hence, in case of activity B, latest finish time is 21 days.
Accordingly, the latest start time or LS = 21 – activity duration = 21 – 13 = 8.
Activity A: Activity A can complete latest by 7, because the subsequent activity, which is activity D
starts the latest by 7 (and not before that) or activity A can complete latest by 40, because the sub-
sequent activity, which is activity C starts the latest by 40 (and not before that). Now while doing a
backward pass, if there is a choice for latest finish, as in this case then we take the smaller of the two
values. Accordingly, the latest finish time for activity A is 7 and latest start time or LS = 7 – activity
duration = 7 – 7 = 0.
The network diagram is reproduced below for further analysis. All the activities having the same
early start and latest start are activities which are critical and the chain of critical activities are called
critical path.
Figure 2.10 Activities on critical path have same [ES, EF] and {LS, LF}
It can be seen from Figure 2.10 that the critical path identified by the second method is exactly same
as the critical path identified by the first method. The tabular form of calculating the ES, EF and LS,
LF is shown in Table 2.6.
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Table 2.6 Tabular format for ES, EF and LS, LF calculations
Activity Predecessor(s) Duration (Days) ES EF LS LF

A — 7
B — 13
C A 10
D A 17
E B 3
F D, E 26
G F, C 5
For activities A and B, there is no predecessor and activity A and B can commence simultaneously
on day 0, and finish the earliest after their respective durations. This is shown in Table 2.7.

A — 7 0 7
B — 13 0 13
C A 10
D A 17
E B 3
F D, E 26
G F, C 5
Activities C and D depend on activity A, and hence, activities C and D will have ES, same as the EF
of predecessor activity A. Similarly, as activity E depends on activity B, the ES for activity E is same
as the EF for predecessor activity B. Once the activity durations are added to the respective ES, then
we can calculate the EF. These workings are shown in Table 2.8.

A — 7 0 7
B — 13 0 13
C A 10 7 17
D A 17 7 24
E B 3 13 16
F D, E 26
G F, C 5
Next, activity F depends on activities D and E, which means the ES for activity F is the larger of the
EF values for activities D and E. Hence, the ES for activity F is 24. Similarly, activity G depends on
activity F and C, which means the ES for activity G, is the larger of the EF values for activities F and
C. Hence, the ES for activity G is @Seismicisolation
50. These calculations are shown in Table 2.9.
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46 | Chapter 2

A — 7 0 7
B — 13 0 13
C A 10 7 17
D A 17 7 24
E B 3 13 16
F D, E 26 24 50
G F, C 5 50 55
Next, we perform the LF and LS = LF – activity duration calculations in a similar manner. Whenever
there is a choice of LS for the predecessor LF times, the smallest value is selected. These workings
are as shown in Table 2.10.

A — 7 0 7 0 7
B — 13 0 13 8 21
C A 10 7 17 40 50
D A 17 7 24 7 24
E B 3 13 16 21 24
F D, E 26 24 50 24 50
G F, C 5 50 55 50 55
The activities which have the same ES and LS (as also EF and LF) are the activities on the
critical path. This is shown in Table 2.11.
Table 2.11 Activities on critical path, A ~ D ~ F ~ G

A — 7 0 7 0 7
B — 13 0 13 8 21
C A 10 7 17 40 50
D A 17 7 24 7 24
E B 3 13 16 21 24
F D, E 26 24 50 24 50
G F, C 5 50 55 50 55
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Example 2.5
A project has the following characteristics as shown in Table 2.12.
Table 2.12 Project characteristics
Activity Predecessor(s) Duration (Weeks)

A — 5
B A 2
C A 6
D B 12
E D 10
F D 9
G D 5
H B 9
I C, E 1
J G 2
K F, I, J 3
L K 9
M H, G 7
N M 8
(a) Draw a network using the AOA convention.

(b) Identify the critical path and the project completion times.
(c) Prepare an activity schedule showing the ES, EF, LS and LF for each activity.
(d) Will the critical path change if activity G takes 10 weeks instead of 5 weeks? If so, what will
be the new critical path?
M. Com., Delhi Univ, 1987
Solution:
The network adopting the activity on arrow (AOA) convention is shown in Figure 2.11. The ES,
EF, LS and LF analysis is shown in Table 2.13. The dummy activity should also be considered while
doing the ES, EF, LS and LF analysis. A general misconception is that as dummy activities have 0
activity times they should not be considered for any calculations. This is incorrect as even though
the dummy activity durations are 0, the ES (and EF) need not be same as LS (and LF). However, in
case of dummy activities, ES = EF and LS = LF.
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48 | Chapter 2
Table 2.13 Project characteristics
Activity Predecessor(s) Duration (Weeks) ES EF LS LF

A — 5 0 5 0 5
B A 2 5 7 5 7
C A 6 5 11 23 29
D B 12 7 19 7 19
E D 10 19 29 19 29
F D 9 19 28 21 30
G D 5 19 24 22 27
H B 9 7 16 18 27
I C, E 1 29 30 29 30
J G 2 24 26 28 30
K F, I, J 3 30 33 30 33
L K 9 33 42 33 42
D’ G 0 24 24 27 27
M H, G 7 24 31 27 34
N M 8 31 39 34 42
(a)
Figure 2.11 Network of activities using the AOA convention
(b) The critical path is one where the activities have the same ES & LS or EF & LF, which in this
case is A~B~D~E~I~K~L and the duration is 42 weeks.
(c) The activity schedule is shown in Table 2.13.
(d) Yes, the path will change if the activity time of activity G is increased to 10 weeks from 5
weeks. One way of reaching this conclusion is by redoing the entire problem or as is shown in
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the next section by considering the surplus time or Float on activity G. If the delay is higher
than the float, the critical path would change. In this problem, the float is three weeks for ac-
tivity G. As the delay in activity G is higher than three weeks, the project path or critical path
would be affected.
Float Analysis
We now know that the difference between the latest start time and early start time for every activity
is the delay permissible in starting the respective activity or the surplus available for that activity or
total float for that activity.
This total float has two components. The first component is called the interfering float and is
defined as that component of float which when consumed reduces the float of subsequent activity.
The second component of float is free float, which is defined as that component of float which when
consumed does not affect the float of the subsequent activity.
Total Float = Interfering Float + Free Float
All the three floats—total float, free float and interfering float are either zero (in case of critical path
activities) or a positive value (in case of non-critical path activities). In AOA convention of drawing
network diagrams, we will not encounter a situation where any of the three floats are negative.
In case of AON networks where succeeding activity can commence parallel with the preceding
activity, we might have a situation of negative float. In such cases, the activity with a negative total
float is known as supercritical activity. Such an activity requires special focus and action. It indicates
an abnormal situation and requires a crashing decision, whereby the activity duration times are suit-
ably reduced to ensure that the floats are atleast zero.
Activities having the least positive non-zero total float is called the sub-critical activity and
allow some freedom of action. The path connecting such sub-critical activities is called the
sub-critical path. A network may have more than one sub-critical path. In order of attention,
we give the maximum attention to the critical path activities and the next maximum attention
to the sub-critical paths. In a small network, like many of the solved problems, the students
may not appreciate the utility of sub-critical paths, but if one was to solve a complex R&D
type of project, then it is, at times, possible that the sub-critical activity can take the shape of
a critical activity. Hence, a lower order of maximum attention is warranted for sub-critical
activities.
The fourth type of float is what is called the Independent Float. This float happens when the
predecessor activity ends by the latest finish date and the succeeding activity starts by the earliest
start date, yet there is some surplus time available on the activity. The definition of the indepen-
dent float is that component of total float which when consumed, does not affect the float of the
preceding and succeeding activities. This independent float can be negative, in which case, it is
equated to zero.
A complete float analysis means finding out the total float, interfering float, free float
and independent float for all activities. A schematic of the various kinds of floats is shown in
Figure 2.12.
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50 | Chapter 2
ES EF LS LF
A A
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Total Available Time
Total Float
Head
Free Float A Slack
A
Head
Tail Slack Slack
Independent Float
(can be negative as in this case)
Figure 2.12 Pictorial view of various floats
The steps involved in calculating the different floats are given below (the schematic in Figure 2.12
would give the reader more clarity).
Total Float = LS – ES or LF – EF
Interfering Float = Head Event Slack
This is the surplus at the head event for the activity for whom the interfering float is being calcu-
lated. It should be noted that in case the head event has one activity succeeding it, then the float of
that activity is taken as the slack of the head event. If the head event has more than one succeeding
activities, then the least float from amongst the succeeding activity floats becomes the head event
slack.
Free Float = Total Float – Interfering Float
Independent Float = Free Float – Tail Event Slack
The following points should be noted:
1. No float analysis to be done on critical path activities, since the float on these critical path
activities is zero.
2. All the nodes in the network are head event for some activities and are tail event for some
other activities, excepting the start node which cannot be head node for any activity and the
end node, which cannot be the tail node for any activity. The slack at the node remains the
same, irrespective of whether it is classified as head event or tail event. This means that if the
event slack is calculated while doing the interfering float analysis, these data can be directly
used for doing independent float analysis, where we need to use tail slacks.
3. Independent float needs to be calculated only in case the free float is not zero. If the free float is
zero, then anything subtracted from it is a negative value, which has to be rounded off to zero.
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This is a redundant step and this is the reason why independent float is calculated only for
activities with non-zero free floats.
4. While noting down the event number for head event or tail event in the float analysis table, it
is preferable to circle the event number. This will ensure that the event number is understood
as a name and not mistaken as a value during later calculations.
Let us perform the float analysis for Example 2.4. This analysis is shown in Table 2.14.
Table 2.14 Float analysis table
Duration Total Head Head Free Tail Tail Independent

Activity (Days) Float Event Slack Float Event Slack Float
A 7 0 — — — — — —
B 13 8 ③ 8 0 — — —
C 10 33 ⑤ 0 33 ② 0 33
D 17 0 — — — — — —
E 3 8 ④ 0 8 ③ 8 0
F 26 0 — — — — — —
G 5 0 — — — — — —
Some Calculation Considerations:
Consider Node ② : After Node 2, there are two activities that commence—that is, activities C
1.
and D. The float for activity C is 33 days and that for D is 0 days. We have to select the lower
value, and hence, at Node 2, the slack is 0.
Consider Node ③ : Ahead of Node 3, we have only one activity, which is activity E. Activity
2.
E has a float of 8 days, and hence, the slack at Node 3 is also 8 days.
Interfering Float ④ : The head slack for each activity is its interfering float. Hence, for activ-
3.
ity E, which has a head event node 4, the interfering float is equal to the head slack for event
node 4 equal to 0.
Example 2.6
Referring to the list of activities as given in Table 2.15 where the activity time in days is mentioned,
draw a network in arrow diagram (AOA) convention. Find out the total time for project completion,
critical path and total floats available on non-critical activities.
Table 2.15 Project activity details
Task A B C D E F G H I J
Time 3 5 7 4 6 4 5 8 2 4
Predecessor(s) — A A B C C D, E G, F G H, I
Solution:
We will first construct the network diagram. As we have to also perform the float analysis, we will
find the critical path by calculating the [ES, EF] and {LS, LF} times.
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52 | Chapter 2
Figure 2.13 Completed network using AOA convention
To complete the network, we have to construct a dummy. The complete network with the neces-
sary data is shown in Figure 2.13. D’ is dummy activity with duration of 0 days. We will do the ES,
EF and LS, LF analysis next and this is shown in Figure 2.14.
Figure 2.14 Network showing the [ES, EF] and {LS, LF} activity times
The set of activities where the early start and latest start are same are the critical path activities.
In this case, path 1 – 2 – 4 – 5 – 6 – 7 – 8 – 9 is the critical path, which means the activities A – C –
E – G – D’ – H – J are critical path activities.
As explained earlier, many times, the dummy activities (D’ in this case) are ignored by students for
analysis of any kind or for the float analysis. This is incorrect. Even though the dummy activity has
duration zero, it can have different ES (or EF) and LS (or LF). The ES would be the same as EF and
LS would be same as LF but it is not necessary that EF and LF (which also means ES and LS) be the
same. In Example 2.6, the ES for D’ was 24 and LS was 27. However, in the present case, since D’
is on the critical path, all the values of ES, EF, LS and LF are the same.
While doing the forward pass in case of choice for ES for subsequent activity, take the highest
value possible. In Figure 2.14, consider Node 5. Activity G can have ES 12 (as activity G succeeds
activity D) or activity G can have ES 16 (as activity G succeeds activity E). We take the higher value,
which, in this case, is 16.
Similarly, in case of activity H, there are two choices for early start, ES of 21 (EF of D’) or ES of
14 (EF of F). We will take 21 as it is larger of the two values. Similarly, in case of activity J, there
are two choices of early start, ES of 23 (EF of I) or ES of 29 (EF of H). We will take 29 as it is larger
value than 21.
While doing the backward pass in case of choice for LF for preceding activity, take the lowest value
possible. In Figure 2.14, consider Node 4. Activity C can have LF 10 (as activity E succeeds activity
C) or activity C can have LF 17 (as activity F succeeds activity C). We take the lower value, which, in
this case, is 10. The next step is to perform the float analysis and this is shown in Table 2.16.
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Table 2.16 Float analysis table

A 3 0 — — — — — —
B 5 4 ③ 4 0 — — —
C 7 0 — — — — — —
D 4 4 ⑤ 0 4 ③ 4 0
E 6 0 — — — — — —
F 4 7 ⑦ 0 7 ④ 0 7
G 5 0 — — — — — —
D’ 0 0 — — — — — —
H 8 0 — — — — — —
I 2 6 ⑧ 0 6 ⑥ 0 6
J 4 0 — — — — — —
Consider Activity D:
Total Float = LS – ES = 12 – 8 = 4 days
Interfering Float = Head Slack, which is slack for node ⑤
= 0 days
Free Float = Total Float – Interfering Float = 4 – 0
= 4 days
Independent Float = Free Float – Tail Slack, which is slack for node ③
= 4 – 4 = 0 days
Consider Activity F:
Total Float = LS – ES = 17 – 10 = 7 days
Interfering Float = Head Slack, which is slack for node ⑦
= 0 days
Free Float = Total Float – Interfering Float = 7 – 0
= 7 days
Independent Float = Free Float – Tail Slack, which is node ④
= 7 – 0 = 7 days
Example 2.7
For the below set of activities, as given in Table 2.17 and their successor relationships, construct a
network, identify the critical path and perform a complete float analysis. The duration of the activity
is in days.
Table 2.17 Data showing successor relationships
Activity A B C D E F G H I J
Days 8 7 6 8 4 8 5 6 6 10
Successor C D, E, F G G H I J J J —
MMM, VI Sem, Mumbai Univ, 1999

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54 | Chapter 2
Solution:
In this problem, the successor activities are given, which are very similar to predecessor relation-
ships. One method is to write the predecessor relationships from the given problem and solve it nor-
mally. The other method is to construct the network with the given successor relationships, which is
slightly more difficult than constructing the network with predecessor relationship. A and B are not
successors to any activities, which imply that A and B can start simultaneously.
After activity A completes, C starts as C is shown as successor to A. Similarly, activities D, E and F

are successors to activity B and must start after activity B has been completed.
Activity G can start after both activities C and D are completed. Similarly, activity H can start after
activity E and activity I after activity F. Now, since J is a successor to activities G, H and I, we will
construct a common node where the activities G, H and I end.
The completed network is shown in Figure 2.15.
Figure 2.15 Network constructed using successor relationships
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If we construct a table with predecessor relationships, the same would be as shown in Table 2.18.
Table 2.18 Predecessor relationships for Example 2.7
Activity A B C D E F G H I J
Days 8 7 6 8 4 8 5 6 6 10
Predecessor(s) — — A B B B C, D E F G, H, I
It can be observed that the network constructed in Figure 2.15 also satisfies the predecessor relation-
ship shown in Table 2.18. This is expected as the problem is stated differently and there is no change
in the problem specifications.
Next, we proceed to find out the critical path using [ES, EF] and {LS, LF} activity times.
This working is shown in Figure 2.16.
Figure 2.16 Network with [ES, EF] and {LS, LF} activity times
Path 1 – 3 – 6 – 7 – 8 is the critical path and activities B – F – I – J are the critical path activities.
While doing the forward pass in case of choice for ES for subsequent activity, take the highest
value possible. In Figure 2.19, consider Node 4. Activity G can have ES 14 (as activity G succeeds
activity C) or activity G can have ES 15 (as activity G succeeds activity D). We take the higher value,
which, in this case, is 16.
Similarly, in case of Activity J, there are three choices of ES, ES = 21 (EF of I), or ES = 20 (EF of G)
or ES = 17 (EF of H). We will take 21 as it is the largest value.
While doing the backward pass in case of choice for LF for preceding activity, take the lowest
value possible. In Table 2.29, consider Node 3. Activity B can have LF = 8 (as activity D succeeds
activity B), or LF = 11 (as activity E succeeds activity B) or activity B can have LF = 7 (as activity F
succeeds activity B). We take the lower value, which, in this case, is 7.
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56 | Chapter 2
The next step is to perform the float analysis. This is shown in Table 2.19.
Table 2.19 Float analysis

A 8 2 ③ 2 0 — — —
B 7 0 — — — — — —
C 6 2 ④ 1 1 ② 2 -1'0
D 8 1 ④ 1 0 — — —
E 4 4 ⑤ 4 0 — — —
F 8 0 — — — — — —
G 5 1 ⑦ 0 1 ④ 1 0
H 6 4 ⑦ 0 4 ⑤ 4 0
I 6 0 — — — — — —
J 10 0 — — — — — —
Notes:
Consider Activity C:
Total float = LS - ES = 10 - 8 = 2 days
Interfering float = Head slack, which is slack for Node ④
= 1 day
Free float = Total float - interfering float = 2 - 1
= 1 day
Independent float = Free float - tail slack, which is node ②
= 1 - 2 = - 1 ~ 0 days
Consider Activity H:
Total float = LS - ES = 15 - 11 = 4 days
Interfering float = Head slack, which is slack for Node ⑦
= 0 days
Free float = Total float - interfering float = 4 - 0
= 4 days
Independent float = Free float - tail slack, which is node ⑤
= 4 - 4 = 0 days
Program Evaluation and Review Technique (PERT) analysis

As a method of network analysis, PERT originated from research and development-oriented proj-
ects where the activity duration times cannot be estimated with certainty due to the inherent char-
acteristics of developmental projects. Developmental projects or probabilistic projects deal with
the uncertainties involved in performing various activities and therefore, encounter difficulties in
determining the exact duration of project activities. Hence, the model adopts a statistical weighted
average time estimate based on three time estimates—optimistic (to), pessimistic (tp) and most likely
times (tm) – criteria. The total project duration worked out on this basis is also prone to probabilistic
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variations. Therefore, a PERT network is not based on uncertain activities but on certain event(s) or
milestones. It is always simpler to define a milestone rather than duration between milestones. This
method was first used by the US Navy for its Polaris Missile project.
The random variable which defines the time estimate for each activity is characterized by some
probability distribution, which is usually the b – distribution. The parameters of the b – distribution,
that is, mean and the standard deviation are estimated using the three estimates provided. Later,
when we find the probability of completion of project under various possibilities, we will make use
of the central limit theorem, which states that all distributions tend towards normal distribution,
if the sample size is sufficiently large. In project management, whenever the numbers of critical
path activities are greater than 30, we can use the normal approximation to the b – distribution.
In practice, even if the number of critical path activities is less than 30, we will still use the normal
distribution approximation.
In the PERT solution methodology, the first step is to find the value of the time estimate for
each activity considering the three-time estimates, namely the optimistic, pessimistic and most likely
times. The second step is to find out the critical path by listing down all possible paths and the likely
estimate of completion times by each of these paths. The set of activities with the longest path is
the critical path. The critical path times is estimated as the sum total of all the estimated times of
activities on this path. The standard deviation for the project is computed next and this is equal to
the standard deviation of the critical path.
The standard deviation of the critical path is the root of sums of variances (squares of standard
deviation) of every activity on the critical path. With the data on the estimated time and standard de-
viation/variance, we can calculate the probability that a project gets completed in a certain period of
time. Adding one standard deviation to the critical path duration gives project completion duration
with 84.1% probability. Adding two standard deviation duration to the critical path duration gives
the duration for project completion with 97.7% probability. Adding three standard deviation dura-
tion to the critical path duration gives the duration for project completion with 99.8% probability.
The following formulae are used:
1. Estimated time (Te) for completion of the project,
Te = teA + teB + teC +……….+ teZ, where activities A, B, C, .... Z are the activities on the critical
path.
2. Standard Deviation (s) for the project,
σ = σA2 + σB2 + σC2 + σD2 + + σZ2

where activities A, B, C, D, ..... Z are the activities on the critical path.
3. Standard normal variate (z) for finding the probability of project completion is
t − Te
z=
σ

Area corresponding to the z value is obtained from normal distribution tables.
4. The time estimate for each activity (consider activity A) is given by the formula, teA = (to + 4tm + tp) / 6,
where to, tm and tp are the optimistic, most likely and pessimistic time estimates for activity A.
Similarly, the time estimates for all the other activities are calculated.
5. The standard deviation for each activity (consider activity A) is given by the formula, sA = (tp - to) / 6,
where to and tp are the optimistic and pessimistic time estimates for activity A. Similarly, the
standard deviations for all the other activities are calculated.
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58 | Chapter 2
Example 2.8
Table 2.20 lists down the activities from one event to the other, along with the three time estimates
in days. Find out the critical path, duration required for project completion time with 84.1% prob-
ability. In case there are only 34 days available to the project due to some problem, what is the
probability of completion of the project?
Table 2.20 PERT data for a project
Activity to tm tp
1−2 3 6 15
1–6 2 5 14
2–3 6 12 30
2–4 2 5 8
3–5 5 11 17
4–5 3 6 15
6–7 3 9 27
5–8 1 4 7
7–8 4 9 28
Solution:
The first step is to find the value of the time estimate for each activity and construct a network with
these time estimates.
Note: In some of the Mumbai University Question Papers, I have come across a different formula
for the estimated time (te) and it is specifically asked to use this formula. If nothing is stated, then
the standard formula for estimating the individual activity times must be used. In this problem (and
others), we will use the standard formula,
to + (4 × t m ) + t p
te =
6
The estimated times for each activity are calculated in Table 2.21.
Table 2.21 Estimated time calculation for activities
Activity to tm tp te
1–2 3 6 15 7
1–6 2 5 14 6
2–3 6 12 30 14
2–4 2 5 8 5
3–5 5 11 17 11
4–5 3 6 15 7
6–7 3 9 27 11
5–8 1 4 7 4
7–8 4 19 28 18
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We need not calculate the standard deviation for all activities as this information is needed only for
critical path activities, which is not known yet. Hence, after calculating the estimated times for each
activity, we construct the network, identify the critical path and later, calculate the standard devia-
tion only for the critical path activities. Constructing the network is easier in this case as the node
numbers are given. The network diagram is shown in Figure 2.17.
Figure 2.17 Completed PERT network
The next step is to identify the critical path. We will compute the time taken to traverse all possible
paths from the start node to the end node and identify the longest duration path. Table 2.22 shows
the working.
Table 2.22 Duration of various paths
Path Activities on Path Duration (Days)

1 1–2–3–5–8 7 + 14 + 11 + 4 = 36
2 1–2–4–5–8 7 + 5 + 7 + 4 = 23
3 1–6–7–8 6 + 11 + 18 = 35
The longest duration path or critical path is path 1, with duration of 36 days, and hence, the project
duration is 36 days. The network with the critical path is shown in Figure 2.23.
Figure 2.18 PERT network with critical path

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60 | Chapter 2
Next, for the critical path activities, that is 1-2, 2-3, 3-5 and 5-8 we will find the standard deviation
and then the standard deviation of the entire critical path/project duration.
σ1−2 : (t p − t o ) / 6 = (15 − 3) / 6 = 2
σ2−3: (t p − t o ) / 6 = (30 − 6) / 6 = 4
σ3−5: (t p − t o ) / 6 = (17 − 5) / 6 = 2
σ5−8: (t p − t o ) / 6 = (7 − 1) / 6 = 1
The combined standard deviation of the critical path, and hence, the project is given by,
σ = σ12−2 + σ22−3 + σ32−5 + σ52−8
σ = 22 + 42 + 22 + 12 = 5
Hence, the mean project completion time is 36 days and the standard deviation is five days for this
project. The spread of normal distribution about the mean is shown in Figure 2.19.
Figure 2.19 Spread of normal distribution about the mean
The project completion time with 84.1% probability is the mean duration plus one times standard
deviation = 36 + 5 days = 41 days. (The z value for the area under the normal curve with 84.1%
probability can also be collaborated with the normal distribution values given).
In the second case, when only 34 days are available, the standard normal variate
t − Te
z= (z value is obtained from normal distribution tables.)
σ
z = (34 – 36)/5 = – 0.4 and the area under the normal curve from -∞ to z corresponding to z = – 0.4
is 0.3446 or 34.46%.
Thus, the project completion possibility when 34 days are available is 34.46% (or 0.3446 probability).
Note: When the number of days is given, the z value is to be calculated and the area corresponding
to the z value in the normal table found out giving the possibility of project completion. When the
possibility of project completion is given, the z value corresponding to the area/probability must be
identified from the normal table and this z value should be used to calculate the number of days. In
other words, if days are given, find the probability and if the probability is given, find the days by
using the normal table in either case.
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Example 2.9
A construction company is preparing a PERT network for laying the foundation of a new art gallery.
Table 2.23 gives the following set of activities, their predecessor requirements and three estimates
of completion times in weeks.
Table 2.23 Data on activities and activity times (weeks)
Activity Predecessor(s) To Tm Tp
A — 2 3 4
B — 8 8 8
C A 7 9 11
D B 6 6 6
E C 9 10 11
F C 10 14 18
G C, D 11 11 11
H F, G 6 10 14
I E 4 5 6
J I 3 4 5
K H 1 1 1
(i) Draw the PERT network.

(ii) Compute the float for each activity and determine the critical path.
(iii) The contract specified `5,000 per week penalty for each week if the completion of the project
extends beyond 37 weeks. What is the probability that this company will have to pay a maxi-
mum penalty of `15,000?
Solution:
At the first stage, we will calculate the estimated time for each activity (Table 2.24), construct the
network (Figure 2.19), identify the critical path and find out the float for each activity. The formula
for the estimated time is
To + 4Tm + Tp
Te =
6
Table 2.24 Estimated time for each activity (weeks)
Activity Predecessor(s) To Tm Tp Te
A — 2 3 4 3
B — 8 8 8 8
C A 7 9 11 9
D B 6 6 6 6
E C 9 10 11 10
F C 10 14 18 14
G C, D 11 11 11 11
H F, G 6 10 14 10
I E 4 5 6 5
J I 3 4 5 4
K H 1 1 1 1
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62 | Chapter 2
We will now construct the network diagram as shown in Figure 2.20.
Figure 2.20 PERT network diagram
Next, we identify the critical path and the duration of the critical path as shown in Table 2.25.

1 1 – 2 – 4 – 6 – 8 – 10 3 + 9 + 10 + 5 + 4 = 31
2 1 – 2 – 4 – 5 – 7 – 9 – 10 3 + 9 + 0 + 11 + 10 + 1 = 34
3 1 – 2 – 4 – 7 – 9 – 10 3 + 9 + 14 + 10 + 1 = 37
4 1 – 3 – 5 – 7 – 9 - 10 8 + 6 + 11 + 10 + 1 = 36
Path 3, 1 – 2 – 4 – 7 – 9 – 10 requiring a total duration of 37 days is the longest path, and hence, the
critical path. The standard deviation, s for the critical path is given by,
2 + σ 2 + σ 2 + σ 2 + σ 2 = 2.028
σ = σA C F H K
Next, we will calculate the floats for each activity by the tabular method as shown in Table 2.26.
Table 2.26 Float analysis for various activities
Activity Predecessor(s) Te ES EF LS LF Total Float

A — 3 0 3 0 3 0
B — 8 0 8 1 9 1
C A 9 3 12 3 12 0
D B 6 8 14 9 15 1
E C 10 12 22 18 28 6
F C 14 12 26 12 26 0
G C, D 11 14 25 15 26 1
H F, G 10 26 36 26 36 0
I E 5 22 27 28 33 6
J I 4 27 31 33 37 6
K H 1 36 37 36 37 0
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Penalty over 37 days is `5,000 per day and a maximum penalty of `15,000 means that the project
should be completed within 40 days. The probability of completing the project within 40 days is
given by the area under the normal curve corresponding to z variate for 40 days.
t − Te
z=
2.028
t − 37 40 − 37
z= = = 1.48
σ 2.028
The area under the normal curve from -∞ to z corresponding to z = 1.48 is 0.9306 or 93.06%.
Thus, we can conclude that there is a 93.06% chance that the project penalty would be less than
`15,000.
Example 2.10
Table 2.27 gives a list of project activities, their predecessor relationships and their durations using
three-time estimation method. The average time ta for the activity is given by the formula:
2 to + 3 t m + t p
Average time = t a =
6
Table 2.27 Activity information and duration in days
Activity Immediate Predecessor(s) to tm tp

A — 1 3 7
B — 1 2 4
C A 2 4 8
D A 2 5 11
E B 3 6 12
F C, D 3 7 15
G D, E 1 4 10
H F, G 2 6 14
Find the probability of completing the project in 25 days.

Solution:
The first step is to calculate the estimated time or the average time of completion of each activity.
The formula to be used for this particular problem is
2 to + 3 t m + t p
Average time = t a =
6
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64 | Chapter 2
The estimated time calculations are shown in Table 2.28.
Table 2.28 Estimated time calculations
Activity Immediate Predecessor(s) to tm tp ta

A — 1 3 7 3
B — 1 2 4 2
C A 2 4 8 4
D A 2 5 11 5
E B 3 6 12 6
F C, D 3 7 15 7
G D, E 1 4 10 4
H F, G 2 6 14 6
The network diagram for the problem using the activity on arrow (AOA) convention is shown in
Figure 2.21.
Figure 2.21 Network diagram
The next step is to identify the various paths and the path times to go from the start node 1 to the
end node 8. The path with the longest duration is the critical path. Subsequently, we will calculate
the standard deviation of activities on critical path and later, the standard deviation for the entire
project. Table 2.29 shows the working of path duration times.

1 1–2–5–7–8 3 + 4 + 7+ 6 = 20
2 1–2–4–5–7–8 3 + 5 + 0 + 7 + 6 = 21
3 1–2–4–6–7–8 3 + 5 + 0 + 4 + 6 = 18
4 1–3–6–7–8 2 + 6 + 4 + 6 = 18
Path 2, that is, 1 – 2 – 4 – 5 – 7 – 8 or A ~ D ~ D1 ~ F ~ H is the path with the longest duration

and is the critical path. The duration of the project is 21 days.
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The standard deviation, s for every activity on the critical path is (tp – to)/6 and thus for the
activities on the critical path, we have,
sA = (tp – to)/6 = (7 – 1)/6 = 1
sD = (tp – to)/6 = (11 – 2)/6 = 1.5
sD1 = 0
sF = (tp – to)/6 = (15 – 3)/6 = 2
sH = (tp – to)/6 = (14 – 2)/6 = 2
The project standard deviation,
σ is 2 + σ 2 + σ 2 + σ 2 + σ 2 = 3.354
σA D D1 F H
When we have 25 days to complete the project, then the standard normal variate (z value) for this
case is
t − Te 25 − 21
z= z= = 1.19
σ 3.354
The area under the normal curve from -∞ to z corresponding to z = 1.19 is 0.8830 or 88.30%. Thus,
we can conclude that there is an 88.30% chance that the project would be completed in 25 days.
Example 2.11
The data for the PERT network is given in Table 2.30.
Table 2.30 Activity data for PERT network
Activity Nodes Optimistic Time (Days) Most Likely Time (Days) Pessimistic Time (Days)
1–2 2 4 6
1–3 6 6 6
1–4 6 12 24
2–3 2 5 8
2–5 12 14 28
3–4 15 24 45
3–6 3 6 9
4–6 9 15 27
5–6 4 10 16
(a) Draw a network and estimate the earliest and latest event times for all nodes and hence derive
critical path.
(b) Estimate the expected duration of the project and corresponding variance.
(c) What is the probability that the project duration will exceed 60 days?
(d) What is the chance of completing the project between 45 and 54 days.
(e) What is the probability of completing the project within 30 days?
MBA, Rohilkhand Univ, 2003
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66 | Chapter 2
Solution:
The network is shown in Figure 2.22.
Figure 2.22 PERT network diagram
Next, we find the estimated time for all the activities and the standard deviation and the working is
shown in Table 2.31.
Table 2.31 Estimated duration and standard deviation
Activity Optimistic Time Most Likely Pessimistic Estimate Standard

Nodes (Days) Time (Days) Time (Days) Time (Days) Deviation s
1–2 2 4 6 4 2/3
1–3 6 6 6 6 0
1–4 6 12 24 13 3
2–3 2 5 8 5 1
2–5 12 14 28 16 8/3
3–4 15 24 45 26 5
3–6 3 6 9 6 1
4–6 9 15 27 16 3
5–6 4 10 16 10 2
Estimated time = (a + 4m + b)/6,

where a = Optimistic time
b = Pessimistic time
m = Most likely estimate
s = (b - a)/6
The duration of the various paths in going to the finish node from the start node are calculated as
follows:
Path 1: 1 – 2 – 5 – 6, duration = 30 days
Path 3: 1 – 2 – 3 – 4 – 6, duration = 51 days
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Path 4: 1 – 3 – 6, duration = 12 days

Path 6: 1 – 4 – 6, duration 29 days
Path 3, 1 – 2 – 3 – 4 – 6 with duration 51 days is the longest duration path and hence the critical
path. The standard deviation for the critical path and hence for the project is:
σ = σ12−2 + σ22−3 + σ32−4 + σ42−6
= {(2/3)2 + 12 + 52 + 32 }1/2 = 5.954

The variance is s = 35.44
2
(iii) Probability of the project exceeding 60 days

= 1 – Probability of project completing in 60 days
Probability of project completing in 60 days is the area under the normal curve from - ∞ to
z corresponding to (t - T)/s, which in this case is (60 - 51)/5.954 or 1.51. This area is 0.9345,
and hence, the answer to the question Probability of the project exceeding 60 days is 0.0655
or 6.55%.
(iv) The chance of completing the project between 45 and 54 days is the area under the normal
curve between z45 and z54.
Now, z45 = (t – T)/s, which in this case is (45 – 51)/5.954 or -1.01. The area under
the normal curve from - ∞ to z45 is 0.1562. Similarly, z54 = (t – T)/s, which in this case
is (54 – 51)/5.954 or 0.50. The area under the normal curve from - ∞ to z54 is 0.6915.
Thus, the chance of completing the project between 45 and 54 days is 0.6915 – 0.1562
= 0.5353 or 53.53%.
(v) The chance of completing the project less than 30 days is z30 = (t – T)/s, which in this case is
(30 – 51)/5.954 or −3.53. The area under the normal curve from − ∞ to z30 is 0.0002. Thus,
the chance of completing the project in less than 30 days is 0.02%.
Example 2.13
ABC Company has split their schedule of implementation into the following six activities and has
estimated time duration under three scenarios as given in Table 2.32.
Table 2.32 Project details
Activity Optimistic Time Estimate Pessimistic Time Estimate Most Likely Time Estimate
1–2 5 11 8
1–3 18 26 22
2–4 15 25 20
3–4 4 12 8
4–5 8 12 10
3–5 12 24 20
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68 | Chapter 2
You are required to do the following:

(a) Compute the expected time of completion and variance in respect of each activity.
(b) Construct a network diagram showing the activity schedule and determine the critical
path.
(c) Indicate the floats available for each activity.
(d) What is the probability of completing the project within 36 weeks?
Solution:
(a) Network diagram (Refer to Figure 2.23)
Table 2.33 Estimated time and variance calculations
Optimistic Time Pessimistic Time Most Likely Time

Activity Estimate Estimate Estimate Te s2
1–2 5 11 8 8 1
1–3 18 26 22 22 1.78
2–4 15 25 20 20 2.78
3–4 4 12 8 8 1.78
4–5 8 12 10 10 0.44
3–5 12 24 20 19.33 4.00
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Paths and Path durations:

1 – 2 – 4 – 5: 8 + 20 + 10 = 38 weeks
1 – 3 – 4 – 5: 22 + 8 + 10 = 40 weeks
1 – 3 – 5: 22 + 19.33 = 41.33 weeks (Critical Path)
Project variation, s2 = 1.78 + 4.00 = 5.78 weeks2
Project Standard Deviation, σ = 5.78 = 2.404 weeks
z = (36 – 41.33)/2.404 = – 2.22
From the normal tables, we have the area corresponding to z = – 2.22 as 0.0132 or there is a
1.32% probability that the project gets completed in 36 weeks.
Table 2.34 Float analysis
Total Independent Free

Activity Te ES EF LS LF Float Float Float
1–2 8 0 8 3.33 11.33 3.33 3.33 0
1–3 22 0 22 0 22 0 0 0
2–4 20 8 28 11.33 31.33 3.33 1.33 2
3–4 8 22 30 23.33 31.33 1.33 1.33 0
4–5 10 30 40 31.33 41.33 1.33 0 1.33
3–5 19.33 22 41.33 22 41.33 0 0 0
Example 2.14
The TaCo Iron and Steel Company is expanding its operations in Maharashtra to include a new
drive-in weigh station. The weigh station will be a heated/air-conditioned building with a large floor
and small office. The large room will have the scales, a 15-feet counter and several display cases
for its equipment. Before erection of the building, the project manager evaluated the project using
PERT/CPM analysis. The activities with their corresponding times were recorded as per Table 2.35.
Table 2.35 Data table
Activity Description Optimistic Pessimistic Most Likely Preceding Tasks

A Lay foundation 6 30 12 —
B Dig hole for scale 4 28 10 —
C Insert scale bases 12 60 24 B
D Erect frame 4 16 10 A, C
E Complete building 10 34 22 D
F Insert scales 66 66 66 E
G Insert display cases 6 54 18 E
H Put in office equipment 2 14 8 G
I Finishing touches 8 56 38 E, H
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70 | Chapter 2
(a) Determine the critical path and project duration.

(b) Determine the free float for all activities.
(c) Determine the project duration so that the project completion probability will be 85%.
MMS, IV Sem, Mumbai Univ, 2018
Solution:
Figure 2.25 gives the network diagram and the critical path(s). As there are two critical paths, the
path with more standard deviation (s) is taken for further calculations.
Table 2.36 Estimated times and s for all activities
Activity Preceding Tasks Optimistic Pessimistic Most Likely Te s

A — 6 30 12 14 4
B — 4 28 10 12 4
C B 12 60 24 28 8
D A, C 4 16 10 10 2
E D 10 34 22 22 4
F E 66 66 66 66 0
G E 6 54 18 22 8
H G 2 14 8 8 2
I E, H 8 56 38 36 8
(a) There are two critical paths, namely B – C – D – E – G – H – I and B – C – D – E – F with

duration 138 time units. The standard deviation for the paths is 15.23 and 10, respectively,
and hence, we select the higher standard deviation, that is, 15.23 for further analysis.
D 10 H8
2 4 6 7
I 36
14
A
G 22
E 22
1 C 28
8
6
B F6
12
3 5
A–D–E–G–H–I = 14 + 10 + 22 + 22 + 8 + 36 = 112
A – D – E – D1 – I = 14 + 10 + 22 + 0 + 36 = 82
A–D–E–F = 14 + 10 + 22 + 66 = 112
B–C–D–E–G–H–I = 12 + 28 + 10 + 22 + 22 + 8 + 36 = 138
Critical B – C – D – E – D1 – I = 12 + 28 + 10 + 22 + 0 + 36 = 108
Path
B–C–D–E–F = 12 + 28 + 10 + 22 + 66 = 138
Figure 2.24 Network diagram and critical path calculations
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(b) The free float calculations are as shown in Table 2.37.
Table 2.37 Free float calculations
Preceding Early Early Late Late Total Head Head Event Free
Activity Tasks Te Start Finish Start Finish Float Event Slack Float
A – 14 0 14 26 40 26 ② 0 26
B – 12 0 12 0 12 0 – – 0
C B 28 12 40 12 40 0 – – 0
D A, C 10 40 50 40 50 0 – – 0
E D 22 50 72 50 72 0 – – 0
F E 66 72 138 72 138 0 – – 0
G E 22 72 94 72 94 0 – – 0
H G 8 94 102 94 102 0 – – 0
I E, H 36 102 138 102 138 0 – – 0
(c) For 85% probability, the value of z corresponding to area 0.35 from the centre line is 1.04.
Therefore, the value of time unit (x) is calculated using z = 1.04 = (x – 138)/15.23.
The answer is 153.84 time units or 154 time units.
Important Notes on PERT

1. PERT network is subjected to standard deviation, because of probabilistic estimates of time.
If we attempt crashing on the critical path, then the effect of crashing may be negated because
of a large standard deviation. Hence, crashing is not undertaken on the PERT network.
2. The difference between the critical path and sub-critical path is not much in some cases and
in case the sub-critical path has a higher standard deviation, it could result in the sub-critical
path having a larger duration then the critical path.
3. PERT is an event-based or milestone-based network, and hence, only the activity on arrow
(AOA) convention is applicable for constructing this network. Activity on node (AON) method
discussed later cannot be used for PERT network and analysis.
4. The normal distribution values in the table are given from z = – ∞ to different values of z.
Many normal tables give the values from z = 0 to different positive values of z, because the
normal table is symmetrical about the mean or the centre line. If such tables are given (as is the
practice in Mumbai university exams on project management), the students should remember
the following thumb rules:
(a) If the value of z is positive, then add 0.5 to the area value obtained from the chart.
(b) If the value of z is negative, then obtain the corresponding area value for positive z (as
negative z values are not given) and subtract this value from 0.5. The resultant is the ac-
tual answer of probability upto negative z.
(c) If the duration is to be calculated from the probabilities that are greater than 50%, then
subtract 0.5000 from the given probability and identify the z value corresponding to the
residual area. This z value can be then be used for calculating the ‘Time’ value.
(d) If the duration is to be calculated from the probabilities which are lesser than 50%, then
subtract the given probability value from 0.5000 and identify the z value corresponding
to the residual. The negative of this z value can be used for calculating the ‘time’ value.
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72 | Chapter 2
Crashing Analysis
Crashing analysis, as the name suggests, means reducing the project duration, whenever technically
viable or when economically feasible. For every project, there are two types of costs. The first cost
is the direct cost, which will remain the same irrespective of the project duration. For example, the
requirement of concrete (and hence cost of concrete) in construction of a structure would remain
the same whether the structure is completed in more days or less days. Similarly, the labour content
in man hours would remain same irrespective of the duration of the construction.
The second cost is the project indirect cost. This can be subdivided into two parts—fixed indirect
cost and variable indirect cost. The fixed indirect cost is due to the general and administrative ex-
penses, license fees, insurance costs and taxation and does not depend upon the progress of the proj-
ect or the project time saved by crashing. The variable indirect cost depends on the time consumed
by the project and consists of overhead expenditure, supervision, interest on capital, depreciation,
etc. With an assumption that the indirect cost, increases linearly with time, we attempt reduction of
the project times, to gain economic benefits.
It goes without saying that the process of crashing will incur additional costs, but the economic
benefits of reduced indirect cost, offsets the increase in crashing cost. ‘Crashing’, in other words,
is a process of reducing the normal estimated duration of an activity by adopting a more efficient
process, equipment or person at a nominal ‘extra cost’. At other times, early project completion
incentives such as completion bonuses are available and to avail these bonuses, it is beneficial to
spend additional money in reducing the activity time. Overall saving may be higher than the cost
incurred, either through incentive money for completing the project by a certain date or by avoid-
ing a hefty penalty for overshooting the deadline. Figure 2.25 shows the plot of total project cost
and project cost trade-off point. (Remember that as the project duration is reduced, we move from
right to left. When we do so, the indirect cost reduces but direct cost increases due to additional
crashing cost.)
Total Project Costs

Cost
Direct Costs
Indirect Costs
0
Optimum
Project Duration
Figure 2.25 Project cost trade-off point
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A project has hundreds of activities and the cost of crashing of each activity is different. Obviously,
we would like to crash activities only on the critical path and select an activity from among the
critical path activities whose cost of crashing is minimum. During crashing, it is possible that there
would be more than one critical path. In this case, the benefit of reduction in project times can only
be achieved when the duration times of both/all the critical paths are reduced. One way of attempt-
ing crashing when more than one critical path is present is to identify the common activities and
crash them, if it makes economic sense. A reduction of time in common activities has the benefit of
reducing the path times on all critical paths.
As mentioned earlier, crashing is not possible in a PERT network. This is so because each of the
paths in the PERT network has a standard deviation, which means dispersion around the average
path times. Even if we reduce the critical path times, the deviation possibilities of the critical path
or other near critical path/sub-critical path can offset the benefits of crashing due to their dispersion
spreads.
The considerations in crashing are as follows:
Time-cost Trade Off: When we do crashing, we incur extra cost which gets compensated
1.
by the savings in indirect cost or the bonuses we receive due to early project completion.
However, the benefits are not in direct proportion to the extra costs. Initially, the total cost
comprising the direct cost, additional crashing cost and indirect cost reduces but after a point,
starts increasing again. This point where the total cost is the least is termed as the time cost
trade off point or the optimum project cost point.
Maximum Possible Crashing or Minimum Project Duration Time: In this case, we continue
2.
with the crashing process till technology constraints/feasibility constraints prevent any
further crashing. The total costs associated with this maximum possible crashing is also
simultaneously calculated. It is termed minimum or crash project time and the cost as
maximum possible crashing cost. This situation arises when important deadlines have to be
met and the cost is no consideration. Completion of the games village during the recently
concluded Common Wealth Games is one such example. Supercritical activities which
require special focus and action and which indicate an abnormal situation would require a
crashing decision, whereby the activity duration times are suitable reduced without any cost
considerations.
Cost Slope: The choice of the critical path activity to crash depends on the cost of crashing per
3.
day for every critical path activity, if this data is available. The activity with the least crashing
cost is selected. When this data is not available, we calculate the crashing slope for each activ-
ity and then select the critical path activity with the least cost slope for crashing first.
∆C (C c − C n )
Cost slope = =
∆T (Tn − Tc )
where, Cc = Maximum crashing cost

Cn = Normal activity cost
Tn = Normal activity time
Tc = Minimum project duration (after all possible crashing)
∆ C = Difference in the crashing cost and normal cost
∆ T = Difference between the normal time and crash time
Procedure for Crashing: The procedure for crashing is a recursive process, wherein a few
4.
steps have to be repeated at each stage. Although short-cuts or grouping of crashing stages
is possible, and we have also used similar grouping of stages as shown in Example 2.22, it is
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74 | Chapter 2
not recommended. Crashing by one time period (day or week as the case is) at every stage is
preferable to avoid any errors.
(a) Step 1: Calculate the path duration times for all the paths. Identify the path(s) for crash-
ing. This step is required because critical path activities are crashed; it also reduces the
project duration of other non-critical path activities. Unless this information is updated,
there is a possibility of mistake.
(b) Step 2: Identify the activity to be crashed on the critical path on the basis of the economic
considerations. Once the activity to be crashed is decided, this information must be up-
dated on the network. This updating informs us whether the saturation point (maximum
crashing possible) for a particular activity is reached and whether further crashing is pos-
sible.
(c) Step 3: The project cost table must be updated after every crashing. This cost table con-
tains direct and indirect cost columns along with a total cost column. The crashing cost
is a cumulative figure of additional crashing cost at every stage and the crashing cost
incurred till that stage. The total cost is the sum of the direct cost and the indirect cost.
Example 2.15
Table 2.38 gives activities, their normal estimated durations and their relationships for a small
project. It also indicates the minimum possible durations if crashed and extra cost incurred for such
crashing. The management desires the project to be completed in a shorter duration than normally
expected, but the extra funds available for this purpose is limited to `5,00,000 only. What would be
the shortest duration of the project after crashing under the budget limitations?
Table 2.38 Cost and time data on activities
Duration (Days) Cost (`’000)

Activity Immediate Predecessor(s) Normal Crash Normal Crash
A — 5 3 400 600
B — 5 1 300 500
C A 10 5 400 700
D B 7 2 400 600
E A 6 2 300 500
F C, D 11 5 600 930
G C, D 6 4 300 600
H E, F 5 1 200 400
I G 4 1 200 500
Solution:
Before performing the crashing, we must construct the network and identify the critical path, us-
ing normal duration times. Next, we find the duration of all paths if all the activities are crashed to
the fullest extent. On crashing all the activities to the fullest, the longest duration path becomes the
critical path. This will give us the minimum time required to complete the project considering the
feasibility restrictions. Any further reduction in duration times is not possible.
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Figure 2.26 Network with the relevant data
In the present problem, there is an additional constraint of availability of funds for crashing, and
hence (perhaps), we may not be able to reach the minimum project duration or optimum project
duration (project cost trade-off point) as the available funds may be exhausted. Along with the ac-
tivity normal duration times, we will also mention the crash times (in parenthesis) for each activity
on the network. The crash time is the minimum time required for completion of the activity. The
data is as shown in Figure 2.26.
Table 2.39 Path duration for normal time and crash time
Path Activities on Path Normal Time (Days) Crash Time (Days)

1 1–2–5–7 5 + 6 + 5 = 16 3+2+1=6
2 1–2–4–5–7 5 + 10 + 11 + 5 = 31 3 + 5 + 5 + 1 = 14
3 1–2–4–6–7 5 + 10 + 6 + 4 = 25 3 + 5 + 4 + 1 = 13
4 1–3–4–5–7 5 + 7 + 11 + 5 = 28 1 + 2 + 5 + 1 = 10
5 1–3–4–6–7 5 + 7 + 6 + 4 = 22 1+2+4+1=8
Path 2, that is, 1 – 2 – 4 – 5 – 7 has the longest duration when normal time is considered and is the
critical path. Activities A – C – F – H are critical path activities. The duration of the critical path and
hence the project is 31 days.
If we consider the crash times for all the paths, then after crashing, Path 2 requires 14 days, which
is the longest duration on crashing. This means that the project can be completed in a minimum of
14 days if there is no constraint of resources.
The normal time for completion of all projects is 31 days and the normal cost for completion of
the project is the sum of all the activity normal costs, which, in this case, is `31,00,000. The cost
slope for activities on the critical path is calculated below.
∆C (C c − C n ) (600 − 400)
Activity A: Cost slope = = = = `100/- per day
∆T (Tn − Tc ) (5 − 3)
∆C (C c − C n ) (700 − 400)
Activity C: Cost slope = = = = `60/- per day
∆T (Tn − Tc ) (10 − 5)
∆C (C c − C n ) (930 − 600)
Activity F: Cost slope = = = = `55/- per day
∆T (Tn − Tc ) (11 − 5)
∆C (C c − C n ) (400 − 200)
Activity H: Cost slope = = = = `50/- per day
∆T (Tn − Tc ) (5 − 1)
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76 | Chapter 2
We construct the total cost analysis as given in Table 2.40.

Table 2.40 Total cost analysis table
Duration Normal Crashing Cumulative

Crash No. (Days) Cost Cost Crashing Cost Total Cost
Total
In this problem, the indirect cost is not given, and hence, the column for indirect cost is not con-
structed. Since there is a cap on the funds available for crashing, we have row for computing the
total crashing cost. Total cost = normal cost + cumulative crashing cost. At the initial stage, the total
cost analysis table would be updated as shown in Table 2.41.
Table 2.41 Total cost analysis table after first updation
Duration Normal Crashing Cumulative Total Cost

Crash No. (Days) Cost Cost Crashing Cost (’000)
0 31 3100 0 0 3100
Total
After this initial work, we will perform the crashing analysis in a stepwise manner.
Stage I: First Crashing

Step 1: Calculate the path duration times for all the paths. Identify the path(s) for crashing.
Table 2.42 Path duration times at stage I
Path Activities on Path Normal Time (Days)

1 1–2–5–7 16
2 1–2–4–5–7 31
3 1–2–4–6–7 25
4 1–3–4–5–7 28
5 1–3–4–6–7 22
Path 2, that is, 1 – 2 – 4 – 5 – 7 is taken for crashing at this stage as the duration is the longest.
Step 2: Identify the activity to be crashed on the critical path on the basis of the economic consid-
erations. Once the activity to be crashed is decided, this information must be updated on
the network. This updating informs us whether the saturation point (maximum crashing
possible) for a particular activity is reached and whether further crashing is possible.
On this path, the cost slope is the least for activity H (5 – 7), and hence, we choose to crash activity
H. Activity H can be crashed by four days as the minimum time required is one day. The next sub-
critical path, that is, path 4 requires 28 days, which means we can crash activity H by three days at this
stage. However, in path 4, activity H is also present, and hence, we can crash activity H by four days.
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Once this decision is made, the network should be updated to reflect the changes due to crashing.
This is shown in Figure 2.27.
Figure 2.27 Network with revised activity times at stage I
Step 3: The project cost table must be updated after every crashing. This cost table contains
direct and indirect cost columns along with a total cost column. The crashing cost is a cu-
mulative figure of additional crashing cost at every stage and the crashing cost incurred till
that stage. The total cost is the sum of the direct cost and the indirect cost.
Table 2.43 Total cost analysis table after second updation
Duration Normal Crashing Cumulative Total

Crash No. (Days) Cost Cost Crashing Cost Cost
0 31 3100 0 0 3100
1 27 3100 200 200 3300
Total 200
After this step, we proceed to stage 2 and repeat steps 1, 2 and 3.

Stage II: Second Crashing
Table 2.44 Path duration times at stage II

1 1–2–5–7 12
2 1–2–4–5–7 27
3 1–2–4–6–7 25
4 1–3–4–5–7 23
5 1–3–4–6–7 22
Path 2, that is, 1 – 2 – 4 – 5 – 7 is taken for crashing at this stage as the duration is the longest.
Step 2: Identify the activity to be crashed on the critical path on the basis of the economic con-
siderations.
On this path, the cost slope is the least for activity F (4 – 5), and hence, we choose to crash
activity F. (The least cost slope activity, i.e., activity H cannot be considered because it has reached
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78 | Chapter 2
saturation point and cannot be crashed further). Activity F can be crashed by six days as the
minimum time required is five days.
The next sub-critical path, that is, path 3 requires 25 days, which means we can crash activity F
by two days at this stage. The updated network diagram is shown in Figure 2.28.
Figure 2.28 Network with revised activity times at stage II
Step 3: The project cost table is updated next. The updated project cost in Table 2.45 is shown
below.
Table 2.45 Total cost analysis table after third updation
Duration Normal Crashing Cumulative Total

Crash No. (Days) Cost Cost Crashing Cost Cost
0 31 3100 0 0 3100
1 27 3100 200 200 3300
3 25 3100 110 310 3410
Total 310
Stage III: Third Crashing

Table 2.46 Path duration times at stage III

1 1–2–5–7 12
2 1–2–4–5–7 25
3 1–2–4–6–7 25
4 1–3–4–5–7 21
5 1–3–4–6–7 22
Path 2, that is, 1 – 2 – 4 – 5 – 7 and path 3, that is, 1 – 2 – 4 – 6 – 7 are taken for crashing at this
stage as the duration is the longest for both these paths.
Step 2: Identify the activity to be crashed on the critical paths on the basis of the economic con-
siderations.
Since there are two critical paths, identify the common activities and consider them for crashing.
Next, pair uncommon activities and@Seismicisolation
crash them to reduce the project duration.
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Crash 1 – 2: Cost slope 100.

Crash 2 – 4: Cost slope 60.
∆C (C c − C n ) (600 − 300)
Activity G: Cost slope = = = = `150/- per day
∆T (Tn − Tc ) (6 − 4)
∆C (C c − C n ) (500 − 200)
Activity I: Cost slope = = = = `100/- per day
∆T (Tn − Tc ) (4 − 1)
Crash 4 – 5 and 4 – 6: Cost slope is 55 + 150 = 205

Crash 4 – 5 and 6 – 7: Cost slope is 55 + 100 = 155
The least cost option is to crash 2 – 4.
The next sub-critical path, that is, path 5 requires 22 days, which means we can crash activity C
by 3 days at this stage.
The updated network diagram is shown in Figure 2.29.
Figure 2.29 Network with revised activity times at stage III
Step 3: The project cost table is updated next. The updated project cost in Table 2.47 is shown
below.
Table 2.47 Total cost analysis table after third updation
Crashing Duration Normal Crashing Cumulative Total

Stage (Days) Cost Cost Crashing Cost Cost
0 31 3100 0 0 3100
I 27 3100 200 200 3300
II 25 3100 110 310 3410
III 22 3100 180 490 3590
Total 490
The cumulative crashing cost is `4,90,000 and the limit of funds available for crashing is `5,00,000.
Hence, due to constraint of resources, further crashing is not possible.
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80 | Chapter 2
Example 2.16
The total normal cost for a project is `5,000, the cost of supervision is `300 per day; penalty for
delayed project is `100 per day, for every day delayed beyond 16 days. Crash the duration of the
project and find (a) the duration of the project with optimal cost and (b) the minimum possible du-
ration for the project and the associated cost. The predecessor relationships and other requirements
are tabulated in Table 2.48.
Table 2.48 Cost, duration and predecessor data
Normal Time Crash Time Incremental Crashing

Activity Predecessor(s)
(Days) (Days) Cost (`/day)
A — 3 1 600
B — 4 3 200
C B 3 2 400
D B 5 4 500
E B 6 3 300
F A, C 4 3 200
G E 5 4 500
H A,C 3 2 400
I F,D 5 4 300
J H, I, G 2 2 —
Solution:
We will complete the preliminaries before performing the crashing. In the preliminaries, we need to
perform the following:
(a) Find the cost slope or incremental crashing cost for all activities. In this problem, this informa-
tion is given, and hence, there is no need to find the cost slope.
(b) Find the total normal cost for completing all the activities which is the sum of activity normal
costs.
(c) Draw the network.
(d) Write all the required information such as normal duration, crash duration and cost slope/
incremental cost on the network for future easy reference.
The total normal cost for completing the project is `5,000. In addition, there is an indirect cost
of `300 per day, besides penalty and bonus, which have to be accounted for in the cost table. The
network is constructed as shown in Figure 2.30.
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Figure 2.30 Completed network with all data
Next, we calculate the path duration times and identify the critical path for both normal duration
and crash duration. This is shown in Table 2.49.
Table 2.49 Calculating the path duration and critical path

1 A–H–J 3+3+2=8 1+2+2=5
2 A–F–I–J 3 + 4 + 5 + 2 = 14 1 + 3 + 4 + 2 = 10
3 B–C–H–J 4 + 3 + 3 + 2 = 12 3+2+2+2=9
4 B–C–F–I–J 4 + 3 + 4 + 5 + 2 = 18 3 + 2 + 3 + 4 + 2 = 14
5 B–D–I–J 4 + 5 + 5 + 2 = 16 3 + 4 + 4 + 2 = 13
6 B–E–G–J 4 + 6 + 5 + 2 = 17 3 + 3 + 4 + 2 = 12
Path 4, B – C – F – I – J with 18 days is the longest path and hence critical path with normal ac-
tivity times. If all the activities are crashed as much as technically feasible, then path 4 with 14 days
still remains the critical path. Thus, the minimum project duration is 14 days.
Step 1: Calculate the path duration times for all the paths and identify the path(s) for crashing.
Path 4, that is, B – C – F – I – J is the longest duration paths at this stage.
siderations.
Crash Activity B: Incremental crashing cost is `200
Crash Activity C: Incremental crashing cost is `400
Crash Activity F: Incremental crashing cost is `200
Crash Activity I: Incremental crashing cost is `300
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82 | Chapter 2
The least cost option is to crash activity B or activity F by 1 day. Let us consider activity B for crashing.
On making this decision, the network diagram should be updated and as shown in Figure 2.31.
Step 3: The project cost table is updated next. The updated project cost table is shown in
Table 2.50.
Table 2.50 Total cost analysis table after first updation
Cumulative Cost of Supervision Bonus (–) Total Cost

Crashing Duration Normal Crashing `300 per day or Penalty (+) (i) + (ii) + (iii)
Stage (Days) Cost (i) Cost (ii) (iii) (iv) + (iv)
0 18 5,000 0 5,400 200 10,600
I 17 5,000 200 5,100 100 10,400
Note: Penalty is a cost and bonus is a benefit. The table is a cost table and hence bonus, whenever
available, is taken as minus. There cannot be a situation where both bonus and penalty are appli-
cable and hence one common column would suffice.
Table 2.51 Path duration for all the paths

1 A–H–J 3+3+2=8
2 A–F–I–J 3 + 4 + 5 + 2 = 14
3 B–C–H–J 3 + 3 + 3 + 2 = 11
4 B–C–F–I–J 3 + 3 + 4 + 5 + 2 = 17
5 B–D–I–J 3 + 5 + 5 + 2 = 15
6 B–E–G–J 3 + 6 + 5 + 2 = 16
Path 4, that is, B – C – F – I – J continues to be the longest duration path at this stage.
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siderations. Activity B cannot be crashed any further and hence is not considered.
Crash Activity C: Incremental crashing cost is `400
Crash Activity F: Incremental crashing cost is `200
Crash Activity I: Incremental crashing cost is `300
The least cost option is to crash activity F by one day. On making this decision, the network
diagram should be updated and is shown in Figure 2.32.
Step 3: The project cost table is updated next. The updated project cost Table 2.52 is shown
below.
Table 2.52 Total cost analysis table after second stage crashing
Cumulative Cost of Supervision Bonus (–) or Total Cost

Crashing Duration Normal Crashing `300 per day Penalty (+) (i) + (ii) +
Stage (Days) Cost (i) Cost (ii) (iii) (iv) (iii) + (iv)
0 18 5,000 0 5,400 200 10,600
I 17 5,000 200 5,100 100 10,400
II 16 5,000 400 4,800 — 10,200
After this, we proceed to the next crashing and follow the steps involved in crashing.
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84 | Chapter 2


1 A–H–J 3+3+2=8
2 A–F–I–J 3 + 3 + 5 + 2 = 13
3 B–C–H–J 3 + 3 + 3 + 2 = 11
4 B–C–F–I–J 3 + 3 + 3 + 5 + 2 = 16
5 B–D–I–J 3 + 5 + 5 + 2 = 15
6 B–E–G–J 3 + 6 + 5 + 2 = 16
Path 4, that is, B – C – F – I – J and Path 6 have the longest duration paths at this stage, and hence,
to reduce the project duration, the path durations of both these paths must be reduced.
siderations. Common activities cannot be considered as activity B cannot be crashed any
further and activity J cannot be crashed in the first place. Furthermore, activity F has
also saturated and cannot be considered any further.
Crash Activity C and Activity E: Incremental crashing cost is `400 + `300 = `700
Crash Activity C and Activity G: Incremental crashing cost is `400 + `500 = `900
Crash Activity I and Activity E: Incremental crashing cost is `300 + `300 = `600
Crash Activity I and Activity G: Incremental crashing cost is `300 + `500 = `800
The least cost option is to crash activity I and activity E by 1 day each. On making this decision, the
network diagram should be updated and is as shown in Figure 2.33.
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Step 3: The project cost table is updated next. The updated project cost is given in Table 2.54.
Table 2.54 Total cost analysis table after third stage crashing

Crashing Duration Normal
Crashing `300 per day Penalty (+) (i) + (ii) +
Stage (Days) Cost (i)
Cost (ii) (iii) (iv) (iii) + (iv)
0 18 5,000 0 5,400 200 10,600
I 17 5,000 200 5,100 100 10,400
II 16 5,000 400 4,800 — 10,200
III 15 5,000 1000 4,500 — 10,500
Note: The total cost was reducing upto crashing stage II, that is, 16 days and has started increasing
again from crashing stage III, that is, 15 days. Hence, the duration of the project for the least cost
is 16 days and the least cost is `10,200. This point is also known as the project cost trade off point.
The second question asks us to identify the minimum possible duration of the project and associated
cost. Hence, we continue with the crashing process further.
Stage IV: Fourth Crashing

1 A–H–J 3+3+2=8
2 A–F–I–J 3 + 3 + 4 + 2 = 12
3 B–C–H–J 3 + 3 + 3 + 2 = 11
4 B–C–F–I–J 3 + 3 + 3 + 4 + 2 = 15
5 B–D–I–J 3 + 5 + 4 + 2 = 14
6 B–E–G–J 3 + 5 + 5 + 2 = 15
Path 4, that is, B – C – F – I – J and Path 6 have the longest duration paths at this stage, and hence,
to reduce the project duration the path durations of both these paths must be reduced.
siderations. Common activities cannot be considered as activity B cannot be crashed any
further and activity J cannot be crashed in the first place. Activities F and I have also
saturated and cannot be considered any further.
Crash Activity C and Activity E: Incremental crashing cost is `400 + `300 = `700
Crash Activity C and Activity G: Incremental crashing cost is `400 + `500 = `900
The least cost option is to crash activity C and activity E by 1 day each. On making this decision,
the network diagram should be updated and is shown in Figure 2.34.
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86 | Chapter 2
Step 3: The project cost table is updated next. The updated project cost is shown in Table 2.56.

Crashing Duration Normal Crashing `300 per day Penalty (+) (i) + (ii) + (iii)
Stage (Days) Cost (i) Cost (ii) (iii) (iv) + (iv)
0 18 5,000 0 5,400 200 10,600
I 17 5,000 200 5,100 100 10,400
II 16 5,000 400 4,800 — 10,200
III 15 5,000 1,000 4,500 — 10,500
IV 14 5,000 1,700 4,200 — 10,900
The project cannot be crashed any further as one of the critical paths, B – C – F – I – J has reached
saturation. The answer to part b is that the project can be crashed upto 14 days and the cost for
completing the project is 14 days is `10,900.
Example 2.17
Table 2.57 gives data on normal time, crash time, normal cost and crash cost for a project.
Table 2.57 Activity data
Normal Time Crash Time Normal Crash

Activity Node (Days) (Days) Cost (`) Cost (`)
A 1–2 3 2 8,000 10,000
B 1–3 3 2 4,000 7,000
C 2–5 1 1 4,000 4,000
D 2–6 6 4 40,000 60,000
E 3–4 2 1 4,000 6,400
Dummy 4–5 — — — —
F 4–6 5 3 30,000 38,000
G 5–6 7 6 24,000 30,000
H 6–7 4 3
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(a) Draw the network and find out the critical path and the normal project duration.
(b) What is the minimum project length and corresponding cost when all the critical activities are
crashed to the maximum extent?
(c) If the indirect costs are `6,000 per day then what is the project cost trade-off point?
Solution:
Before starting the crashing process, let us complete the preliminaries. In the preliminaries, we need
to perform the following:
(a) Find out the cost slope or incremental crashing cost for all activities. In this problem, this
information is given, and hence, there is no need to find the cost slope.
costs.
(d) Write all the required information like normal duration, crash duration, cost slope/incremen-
tal cost on the network for future easy reference.
∆C (C c − C n ) (10 − 8)
Activity 1 – 2: Cost slope = = = = `2,000/- per day
∆T (Tn − Tc ) (3 − 2)
∆C (C c − C n ) (7 − 4)
∆T (Tn − Tc ) (3 − 2)
Activity 2 – 5: Crashing is not technically feasible
∆C (C c − C n ) (60 − 40)
∆T (Tn − Tc ) (6 − 4)
∆C (C c − C n ) (6.4 − 4)
∆T (Tn − Tc ) (2 − 1)
∆C (C c − C n ) (38 − 30)
∆T (Tn − Tc ) (5 − 3)
∆C (C c − C n ) (30 − 24)
∆T (Tn − Tc ) (7 − 6)
∆C (C c − C n ) (39 − 32)
∆T (Tn − Tc ) (4 − 3)
The total normal cost for completing all the activities is sum of all the activity normal costs and
is `1,46,000. The network is as constructed in Figure 2.35.
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88 | Chapter 2


1 A–D–H 3 + 6 + 4 = 13 2+4+3=9
2 A–C–G–H 3 + 1 + 7 + 4 = 15 2 + 1 + 6 + 3 = 12
3 B – E – D’ – G – H 3 + 2 + 0 + 7 + 4 = 16 2 + 1 + 0 + 6 + 3 = 12
4 B–E–F–H 3 + 2 + 5 + 4 = 14 2+1+3+3=9
Path 3, i.e., B – E – D’ – G – H is the critical path with duration 16 days.

siderations. Activity B cannot be crashed any further and hence is not considered.
Crash Activity B: Incremental crashing cost is `3,000
Crash Activity E: Incremental crashing cost is `2,400
Crash Activity G: Incremental crashing cost is `6,000
Crash Activity H: Incremental crashing cost is `7,000
The least cost option is to crash activity E by 1 day. On making this decision, the network diagram
should be updated and is as shown in Figure 2.36.
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Table 2.59 Total cost analysis table after first stage crashing
Crashing Duration Normal Cumulative Indirect Cost Total Cost

Stage (Days) Cost (i) Crashing Cost (ii) 6,000 per day (iii) (i) + (ii) + (iii)
0 16 1,46,000 0 96,000 2,42,000
I 15 1,46,000 2,400 90,000 2,38,400
II
After this third step, we proceed to the next crashing and repeat all the steps involved in crashing.
Table 2.60 Path duration times for all the paths

1 A–D–H 3 + 6 + 4 = 13
2 A–C–G–H 3 + 1 + 7 + 4 = 15
3 B – E – D’ – G – H 3 + 1 + 0 + 7 + 4 = 15
4 B–E–F–H 3 + 1 + 5 + 4 = 13
Path 3, that is, B – E – D’ – G – H is the critical path along with path 2, that is, A – C – G – H with
duration 15 days.
Step 2: Identify the activity to be crashed on the critical path on the basis of the economic
considerations. Activity E cannot be crashed any further and hence is not considered.
Activity C cannot be crashed and hence is not considered. Activities G and H are com-
mon activities on both the paths and should be considered first. We should also consider
grouping of uncommon activities and choose the least cost alternative.
Crash Activity A and Activity B: Incremental crashing cost is `2,000 + `3,000 = `5,000
The least cost option is to crash activities A and B by 1 day each. On making this decision, the net-
work diagram should be updated as shown in Figure 2.37.
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90 | Chapter 2
Crashing Duration Normal Cumulative Crashing Indirect Cost 6,000 Total Cost
Stage (Days) Cost (i) Cost (ii) per day (iii) (i) + (ii) + (iii)
0 16 1,46,000 0 96,000 2,42,000
I 15 1,46,000 2,400 90,000 2,38,400
II 14 1,46,000 7,400 84,000 2,37,400
After this second stage crashing step, we proceed to the next crashing and repeat all the steps
involved in crashing.

1 A–D–H 2 + 6 + 4 = 12
2 A–C–G–H 2 + 1 + 7 + 4 = 14
3 B – E – D’ – G – H 2 + 1 + 0 + 7 + 4 = 14
4 B–E–F–H 2 + 1 + 5 + 4 = 12
duration 14 days.
siderations. Activity E, A, B cannot be crashed any further and hence is not considered.
Activity C cannot be crashed and hence is not considered. Activity G and H are common
activities on both the paths and should be considered first.
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The least cost option is to crash common activity G by 1 day. On making this decision, the network
diagram should be updated as shown in Figure 2.38.
Crashing Duration Normal Cumulative Indirect Cost Total Cost

Stage (Days) Cost (i) Crashing Cost (ii) 6,000 per day (iii) (i) + (ii) + (iii)
0 16 1,46,000 0 96,000 2,42,000
I 15 1,46,000 2,400 90,000 2,38,400
II 14 1,46,000 7,400 84,000 2,37,400
III 13 1,46,000 13,400 78,000 2,37,400
After this third stage crashing step, we proceed to the next (and last) crashing and repeat all the steps
involved in crashing.

1 A–D–H 2 + 6 + 4 = 12
2 A–C–G–H 2 + 1 + 6 + 4 = 13
3 B – E – D’ – G – H 2 + 1 + 0 + 6 + 4 = 13
4 B–E–F–H 2 + 1 + 5 + 4 = 12
duration 14 days.
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92 | Chapter 2
siderations. Activities E, A, B, G cannot be crashed any further and hence is not consid-
ered. Activity C cannot be crashed and hence is not considered. Activity H is the only
common activity on both the paths that can be crashed.
The only option is to crash common activity H by 1 day. On making this decision, the network
diagram should be updated and is shown in Figure 2.39.
Figure 2.39 Network with revised activity times at stage IV
Step 3: The project cost table is updated in Table 2.65.
Crashing Duration Normal Cost Cumulative Indirect Cost 6,000 Total Cost
Stage (Days) (i) Crashing Cost (ii) per Day (iii) (i) + (ii) + (iii)
0 16 1,46,000 0 96,000 2,42,000
I 15 1,46,000 2,400 90,000 2,38,400
II 14 1,46,000 7,400 84,000 2,37,400
III 13 1,46,000 13,400 78,000 2,37,400
IV 12 1,46,000 20,400 72,000 2,38,400
No further crashing is possible as both the critical paths are saturated. The project cost trade-off
point or minimum cost point is duration 14 days with cost `2,37,400. The minimum project dura-
tion is 12 days with the cost `2,38,400.
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Example 2.18
Table 2.66 shows the details of a project.
Table 2.66 Activity details for a project
Immediate Normal Time Normal Crash Time Crash

Task Predecessor(s) (Weeks) Cost (`) (Weeks) Cost (`)
A — 3 18,000 2 19,000
B — 8 600 6 1,000
C B 6 10,000 4 12,000
D B 5 4,000 2 10,000
E A 13 3,000 10 9,000
F A 4 15,000 4 15,000
G F 2 1,200 1 1,400
H C, E, G 6 3,500 4 4,500
I F 2 7,000 1 8,000
(a) Draw the project network diagram and find the critical path.
(b) If a deadline of 17 weeks is imposed for completion of the project, what activities would be
crashed, what would be the additional cost and what would be the critical activities of the
network after crashing?
Solution:
information is given and hence no need to find the cost slope.
costs.
∆C (C c − C n ) (19 − 18)
Activity A: Cost slope = = = = `1,000/- per week
∆T (Tn − Tc ) (3 − 2)
∆C (C c − C n ) (1 − 0.6)
Activity B: Cost slope = = = = `200/- per week
∆T (Tn − Tc ) (8 − 6)
∆C (C c − C n ) (12 − 10)
Activity C: Cost slope = = = = `1,000/- per week
∆T (Tn − Tc ) (6 − 4)
∆C (C c − C n ) (10 − 4)
Activity D: Cost slope = = = = `2,000/- per week
∆T (Tn − Tc ) (5 − 2)
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94 | Chapter 2
∆C (C c − C n ) (9 − 3)
Activity E: Cost slope = = = = `2,000/- per week
∆T (Tn − Tc ) (13 − 10)
Activity F: Crashing is not feasible
∆C (C c − C n ) (1.4 − 1.2)
Activity G: Cost slope = = = = `200/- per week
∆T (Tn − Tc ) (2 − 1)
∆C (C c − C n ) (4.5 − 3.5)
Activity H: Cost slope = = = = `500/- per week
∆T (Tn − Tc ) (6 − 4)
∆C (C c − C n ) (8 − 7)
Activity I: Cost slope = = = = `1,000/- per week
∆T (Tn − Tc ) (2 − 1)
The total normal cost for completing all the activities is sum of all the activity normal costs is
`62,300 The network is constructed in Figure 2.40.

Path Activities on Path Normal Time (Weeks) Crash Time (Weeks)

1 A–F–I 3+4+2=9 2+4+1=7
2 A–F–G–H 3 + 4 + 2 + 6 = 15 2 + 4 + 1 + 4 = 11
3 A–E–H 3 + 13 + 6 = 22 2 + 10 + 4 = 16
4 B–C–H 8 + 6 + 6 = 20 6 + 4 + 4 = 14
5 B–D 8 + 5 = 13 6+2=8
Path 3, that is, A – E – H is the critical path with duration 22 weeks.

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considerations.
Crash Activity A: Incremental crashing cost is `1,000

Crash Activity H: Incremental crashing cost is `500
The least cost option is to crash activity H by two weeks. It should be noted that the sub-critical
path has duration of two weeks less than the critical path, and hence, we can take two crashing at
stage 1. Moreover, activity H is also on the sub-critical path which also reduces the sub-critical path
duration.
Once the crashing decision is made, the network diagram should be updated as shown in
Figure 2.41.
Figure 2.41 Network after stage I
Crashing Duration Normal Cost Cumulative Crashing Total Cost

Stage (Weeks) (i) Cost (ii) (i) + (ii)
0 22 62,300 0 62,300
I 20 62,300 1,000 63,300
II
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96 | Chapter 2

Path Activities on Path Normal Time (Weeks)

1 A–F–I 3+4+2=9
2 A–F–G–H 3 + 4 + 2 + 4 = 13
3 A–E–H 3 + 13 + 4 = 20
4 B–C–H 8 + 6 + 4 = 18
5 B–D 8 + 5 = 13
Path 3, that is, A – E – H continues to be the critical path with duration 20 weeks.
considerations. Activity H cannot be crashed any further and hence is not considered.
Crash Activity A: Incremental crashing cost is `1,000

The least cost option is to crash activity A by 1 week. Once the crashing decision is made, the
network diagram should be updated as shown in Figure 2.42.
Figure 2.42 Network after stage II
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Crashing Duration Normal Cost Cumulative Crashing Cost Total Cost

Stage (Weeks) (i) (ii) (i) + (ii)
0 22 62,300 0 62,300
I 20 62,300 1,000 63,300
II 19 62,300 2,000 64,300


1 A–F–I 2+4+2=8
2 A–F–G–H 2 + 4 + 2 + 4 = 12
3 A–E–H 2 + 13 + 4 = 19
4 B–C–H 8 + 6 + 4 = 18
5 B–D 8 + 5 = 13
Path 3, that is, A – E – H continues to be the critical path with duration 19 weeks.
considerations. Activity H or A cannot be crashed any further, and hence, they are not
considered.
Figure 2.43 Network after stage III @Seismicisolation

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98 | Chapter 2
Crash Activity E: Incremental crashing cost is `2,000. The only option is to crash activity E
by 1 week. Once the crashing decision is made the network diagram should be updated as
shown in Figure 2.43.
Duration Normal Cost Cumulative Crashing Total Cost

Crashing Stage (Weeks) (i) Cost (ii) (i) + (ii)
0 22 62,300 0 62,300
I 20 62,300 1,000 63,300
II 19 62,300 2,000 64,300
III 18 62,300 4,000 66,300
We are required to crash to meet the deadline of 17 days, and hence, we will undertake one more
crashing.

1 A–F–I 2+4+2=8
2 A–F–G–H 2 + 4 + 2 + 4 = 12
3 A–E–H 2 + 12 + 4 = 18
4 B–C–H 8 + 6 + 4 = 18
5 B–D 8 + 5 = 13
Path 3, that is, A – E – H continues to be the critical path with duration of 18 weeks. Additionally,
path 4, that is, B – C – H also has a duration of 18 weeks, which means to reduce the project dura-
tion, we need to crash activities on both the critical paths.
considerations. Activity H or A cannot be crashed any further, and hence, they are not
considered.
Crash Activity E and Activity B: Incremental crashing cost is `2,000 + `200 = `2,200
Crash Activity E and Activity C: Incremental crashing cost is `2,000 + `1,000 = `3,000
We will select the first option and crash activity E and activity B by 1 week each. Once the crash-
ing decision is made, the network diagram should be updated as shown in Figure 2.44.
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Figure 2.44 Network after stage IV
Table 2.74 Total cost analysis table after fourth stage crashing
Crashing Duration Normal Cost Cumulative Crashing Total Cost

Stage (Weeks) (i) Cost (ii) (i) + (ii)
0 22 62,300 0 62,300
I 20 62,300 1,000 63,300
II 19 62,300 2,000 64,300
III 18 62,300 4,000 66,300
IV 17 62,300 6,200 68,500
The additional cost incurred for crashing the project to 17 weeks is `6,200.
Example 2.19
Table 2.75 gives the activities in a construction project and other relevant information.
Table 2.75 Activity details for a project
Immediate Normal Time Crash Time Normal Cost Crash Cost

Task Predecessor(s) (Days) (Days) (`) (`)
P — 8 6 6,000 9,000
Q — 12 8 15,000 25,000
R — 4 2 3,000 6,000
S P 10 6 15,000 25,000
T R 4 4 10,000 10,000
U P 14 10 11,500 17,500
V S, Q, T 8 4 10,000 24,000
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100 | Chapter 2
(a) Draw an arrow diagram of the project.

(b) Determine the project duration which will result in minimum total direct cost.
(c) If indirect costs are `4,000 per day, then determine the optimum duration of the project.
Solution:
information is given, and hence, no need to find the cost slope.
costs.
∆C (C c − C n ) (9 − 6)
Activity P: Cost slope = = = = `1,500/- per day
∆T (Tn − Tc ) (8 − 6)
∆C (C c − C n ) (25 − 15)
Activity Q: Cost slope = = = = `2,500/- per day
∆T (Tn − Tc ) (12 − 8)
∆C (C c − C n ) (6 − 3)
Activity R: Cost slope = = = = `1,500/- per day
∆T (Tn − Tc ) (4 − 2)
∆C (C c − C n ) (25 − 15)
Activity S: Cost slope = = = = `2,500/- per day
∆T (Tn − Tc ) (10 − 6)
Activity T: Crashing is not feasible
∆C (C c − C n ) (17.5 − 11.5)
Activity U: Cost slope = = = = `1,500/- per day
∆T (Tn − Tc ) (14 − 10)
∆C (C c − C n ) (24 − 10)
Activity V: Cost slope = = = = `3,500/- per day
∆T (Tn − Tc ) (8 − 4)
The total normal cost for completing all the activities is the sum of all the activity normal costs and
is `70,500. The project network is constructed in Figure 2.45.
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Figure 2.45 Project network


1 P–U 8 + 14 = 22 6 + 10 = 16
2 P–S–V 8 + 10 + 8 = 26 6 + 6 + 4 = 16
3 Q–V 12 + 8 = 20 8 + 4 = 12
4 R–T–V 4 + 4 + 8 = 16 2 + 4 + 4 = 10
Path 2, that is, P – S – V is the critical path with duration of 26 days.
siderations.
Crash Activity P: Incremental crashing cost is `1,500
Crash Activity S: Incremental crashing cost is `2,500
Crash Activity V: Incremental crashing cost is `3,500
The least cost option is to crash activity P by two days. It should be noted that the sub-critical path
has a duration of four days less than the critical path, and hence, we can take two crashing at stage 1.
Moreover, activity P is also on the sub-critical path and any crashing on activity P also reduces
the sub-critical path duration. Once the crashing decision is made, the network diagram should be
updated as shown in Figure 2.46.
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102 | Chapter 2
Figure 2.46 Project network after first updating
Crashing Duration Normal Cost Cumulative Crashing Indirect Cost Total Cost
Stage (Days) (i) Cost (ii) 4000 per day (iii) (i) + (ii) + (iii)
0 26 70,500 0 1,04,000 1,74,500
I 24 70,500 3,000 96,000 1,69,500
II


1 P–U 6 + 14 = 20
2 P–S–V 6 + 10 + 8 = 24
3 Q–V 12 + 8 = 20
4 R–T–V 4 + 4 + 8 = 16
Path 2, i.e., P – S – V is the critical path with duration 24 days.
siderations. Activity P is saturated and cannot be crashed any further.
Crash Activity S: Incremental crashing cost is `2,500
Crash Activity V: Incremental crashing cost is `3,500
The least cost option is to crash activity S by 4 days. It should be noted that the sub-critical path has
duration of four days less than the critical path, and hence, we can take crashing of four days at stage II.
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Once the crashing decision is made, the network diagram should be updated as shown in Figure 2.47.
Figure 2.47 Project network after second updation
Step 3: The project cost table is updated in Table 2.79.
Crashing Duration Normal Cumulative Crashing Indirect Cost Total Cost

Stage (Days) Cost (i) Cost (ii) 4000 per day (iii) (i) + (ii) + (iii)
0 26 70,500 0 1,04,000 1,74,500
I 24 70,500 3,000 96,000 1,69,500
II 20 70,500 13,000 80,000 1,63,500
After the third step, we proceed to stage III crashing and repeat all the steps involved in crashing.
Stage III: Third Crashing.


1 P–U 6 + 14 = 20
2 P–S–V 6 + 6 + 8 = 20
3 Q–V 12 + 8 = 20
4 R–T–V 4 + 4 + 8 = 16
Path 2, that is, P – S – V is the critical path with duration 20 days. Additionally, path 1, that is, P – U
and path 3, that is, Q – V also become critical. We need to crash the duration times on all these paths
to effectively reduce the project duration.
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104 | Chapter 2
siderations. Activities P and S are saturated and cannot be crashed any further. Crash
activity V and activity U: Incremental crashing cost is `3,500 + `1,500 = `5,000. The
only option is to crash activity V and activity U by four days each. The sub-critical path
R – T – V has duration four days less than the critical path(s), and hence, we can take
crashing of four days at stage III.
Figure 2.48 Project network after third updation
Once the crashing decision is made, the network diagram should be updated as shown in Figure 2.48.
Crashing Duration Normal Cumulative Crashing Indirect Cost Total Cost

Stage (Days) Cost (i) Cost (ii) 4000 per Day (iii) (i) + (ii) + (iii)
0 26 70,500 0 1,04,000 1,74,500
I 24 70,500 3,000 96,000 1,69,500
II 20 70,500 13,000 80,000 1,63,500
III 16 70,500 33,000 64,000 1,67,500
After this third step, we cannot do any further crashing as two paths P – U and P – S – V have satu-
rated. Thus, the minimum project duration is 16 days and the cost is `1,67,500. The project cost
trade-off point or the optimum project duration is 20 days with the cost `1,63,500.
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Example 2.20
Table 2.82 shows the details of a project.
Table 2.82 Project related details
Normal Time Normal Cost Crash Time Crash Cost

Activity Predecessor(s) (Weeks) (`’000) (Weeks) (`’000)
1–2 — 21 175 20 400
1–3 — 21 500 18 900
1–4 — 11 1100 10 1300
2–6 1–2 16 2400 12 3200
3–6 1–3,1–4 11 1925 7 2075
3–7 1–3,1–4 15 2400 13 2850
3–5 1–3,1–4 5 1050 4 1225
4–5 1–4 12 3600 10 4000
5–7 3–5,4–5 9 3150 7 3750
6–7 2–6,3–6 19 7600 3 14800
(a) Draw the network and find out the critical path and the nominal project duration.
(b) What is the minimum length of the project and the corresponding cost when all the critical
path activities are crashed to the maximum extent?
(c) If the indirect cost is `3,000 per day (Note: In the question paper, it is erroneously given as
`3,000 per week, which would make it very insignificant), what is the project cost trade-off
point of the project?
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106 | Chapter 2
Solution:
The first step is to construct the network diagram, calculate the cost slope and write all these details
on the diagram.
Figure 2.49 Network diagram for Example 2.20
Table 2.83 Cost slope calculations
∆C
Normal Time Normal Cost Crash Time Crash Cost Cost Slope
Activity (Weeks) (`’000) (Weeks) (`’000) ∆T
1–2 21 175 20 400 225
1–3 21 500 18 900 133.33
1–4 11 1100 10 1300 200
2–6 16 2400 12 3200 200
3–6 11 1925 7 2075 38
3–7 15 2400 13 2850 225
3–5 5 1050 4 1225 175
4–5 12 3600 10 4000 200
5–7 9 3150 7 3750 300
6–7 19 7600 3 14800 450
Total 23,900
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Figure 2.50 Network diagram with updated information
The path duration calculations are shown in Table 2.84.
Table 2.84 Path duration in weeks after each crashing
Path Path Activities Crash No. 0 Crash No. 1 Crash No. 2 Crash No. 3 Crash No. 4
1 1–2–6–7 56 52 51 36 35
2 1–3–6–7 51 51 51 36 34
3 1–3–7 36 36 36 36 35
4 1–3–5–7 35 35 35 35 34
5 1–4–3–6–7 41 41 41 26 25
6 1–4–3–7 26 26 26 26 26
7 1–4–3–5–7 25 25 25 25 25
8 1–4–5–7 32 32 32 32 32
Path 1 is the critical path with duration of 56 weeks. The indirect cost is `3,000 per day, which
means `21,000 per week. The total cost at the initial stage is shown in Table 2.85.
Table 2.85 Cost table at initial stage
Duration Normal Cumulative Indirect Total

Crash No. (Weeks) Cost Crashing Cost Cost Cost
0 56 23,900 0 1,176 25,076
Crashing 1: Duration = 52 weeks

Crashing cost for 1 – 2 = 225 per week
Conclusion: Crash activity 2 – 6 by 4 weeks
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108 | Chapter 2
Figure 2.51 Network diagram with updated information
Note: We crash the duration by four weeks because the activity that is being crashed (2 – 6) can be
crashed for a maximum of 4 weeks. Moreover, the next sub-critical path has duration difference of
more than four weeks when compared with the critical path. The updated network is as shown in
Figure 2.50. The updated cost table is shown in Table 2.86.
Table 2.86 Cost table after crashing no. 1

0 56 23,900 0 1,176 25,076
1 52 23,900 800 1,092 25,792
After this, we will update Table 2.86 for path durations and whichever path has activity 2 – 6, the
duration would reduce by four weeks.

Crashing cost for 2 – 6 = Cannot be crashed
Conclusion: Crash activity 1 – 2 by 1 week
Note: We crash the duration by one week because the activity that is being crashed (1 – 2) can
be crashed for a maximum of one week. Moreover, the next sub-critical path has duration differ-
ence of one week less when compared with the critical path. The updated network is as shown in
Figure 2.51.
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Figure 2.52 Updated network diagram after Crashing 2
The updated cost table is shown in Table 2.87.

0 56 23,900 0 1,176 25,076
1 52 23,900 800 1,092 25,792
2 51 23,900 1,025 1,071 25,996
duration would reduce by one week.

Conclusion: Crash activity 6 – 7 by 15 weeks
Note: We crash the duration by 15 weeks because the activity that is being crashed (6 – 7) can be
crashed for a maximum of 16 weeks. Moreover, the alternate critical path, that is, path 2 1 – 3 – 6 –
7 has activity 6 – 7 common with the critical path. The next sub-critical path (1 – 3 – 7) has duration
difference of 15 weeks less when compared with the critical path(s). Path 5, 1 – 4 – 3 – 6 – 7 with
duration 41 weeks has activity 6 – 7 common with critical paths and hence cannot be considered as
the next sub-critical path.
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110 | Chapter 2
The updated network and table are shown in Figure 2.53 and Table 2.88, respectively.

0 56 23,900 0 1,176 25,076
1 52 23,900 800 1,092 25,792
2 51 23,900 1,025 1,071 25,996
3 36 23,900 7,775 756 32,431
duration would reduce by 15 weeks.

Crashing cost for 6 – 7 = Can be crashed by 1 week only
Conclusion:
Crash activity 6 – 7 by 1 week. In this case, there are three critical paths and crashing only 6 – 7
would not reduce path 3, 1 – 3 – 7 by one week. Hence, we also crash activity 1 – 3 by 1 week, as it
is the cheapest option. The outcome after these simultaneous crashing(s) is as follows:
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The updated network is shown in Figure 2.54.
The updated cost table is shown in Table 2.89.

0 56 23,900 0 1,176 25,076
1 52 23,900 800 1,092 25,792
2 51 23,900 1,025 1,071 25,996
3 36 23,900 7,775 756 32,431
4 35 23,900 8,358 735 32,993
After this, we will update Table 2.89 for path durations and whichever path has activity 1 – 3 or
6 – 7, the duration would reduce by one week. In case some paths have both these activities, then
their duration would reduce by two weeks, as is the case with path 2, 1 – 3 – 6 – 7. No further crash-
ing is possible as the first critical path, 1 – 2 – 6 – 7 has got saturated.
Conclusion:
(a) The nominal project duration is 56 weeks.
(b) The minimum length of the project is 35 weeks and the cost associated with this minimum
project duration is `3,29,93,000.
(c) The indirect costs are much less as compared to the crashing cost and as such, there is no
project cost-trade off point. The nominal project duration is the least cost option, where the
total cost is `2,50,76,000.
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112 | Chapter 2
Example 2.21
ABC Co Ltd has obtained a contract to build and deliver nine extruding presses to Zaveri Ltd.
The contract price is contingent on meeting a specified delivery time, a bonus being given for early
delivery. The following costs and time information have been gathered:
Activity Normal Normal Crash Crash

Time (Weeks) Cost (`’000) Time (Weeks) Cost (`’000)
1–2 6 30 2 38
1–3 8 36 6 48
2–4 6 28 4 32
3–4 16 30 14 32
3–5 8 26 6 30
4–6 12 24 8 27.2
5–6 10 40 6 48
6–7 6 34 2 41.2
The normal delivery time is 42 weeks for a contract price of `2,48,000. Based on the calculated
profitability for each of the following specified delivery time, recommend the delivery schedule that
ABC Co Ltd. should follow.
Contract Delivery Time (Weeks) Contract Amount (`)

41 2,85,000
40 2,90,000
39 3,00,000
38 3,05,000
Solution:
There is a marked difference in this problem and that is there is benefit in reducing the project dura-
tion in the form of bonus and not in saving of indirect cost. In case of indirect cost savings, as we
crash, the duration multiplied by the project durations gives us the revised indirect cost, which is
actually a cumulative benefit. In the present problem, we need to calculate the cumulative benefit
and compare it with cumulative crashing cost. In all the earlier problems, we were, in any case,
calculating the cumulative crashing cost and unknowingly comparing it with cumulative savings in
indirect cost. The other steps remain the same.
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The path duration calculations are shown in Table 2.90.

Table 2.90 Path durations before crashing
Path Path Activities Crash No. 0

1 1–2–4–6–7 30
2 1–3–4–6–7 42
3 1–3–5–6–7 32
Path 2 is the critical path with duration of 42 weeks. The contract price for 42 weeks is `2,48,000.
The total cost at the initial stage is shown in Table 2.91.
Table 2.91 Cost table at initial stage
Duration Normal Cumulative Contract

Profit
Crash No. (Weeks) Cost Crashing Cost Price
0 42 2,48,000 0 2,48,000 0
Crashing No. 1: Crash the critical path which comprises activities, 1–3, 3–4, 4–6 and 6–7. The least
cost option is 4–6. Furthermore, this activity can be crashed by four weeks and the sub-critical path
is 32 weeks. Hence, we crash activity 4–6 by four weeks in one go. The revised network (Figure
2.56), duration and cost calculations (Table 2.92) are shown below.
Figure 2.56 Network diagram after first crashing
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114 | Chapter 2
Table 2.92 Path durations after crashing 1
Path Path Activities Crash No. 0 Crash No. 1

1 1–2–4–6–7 30 26
2 1–3–4–6–7 42 38
3 1–3–5–6–7 32 32
Duration Normal Cumulative Contract

Crash No. (Weeks) Cost Crashing Cost Price Profit
0 42 2,48,000 0 2,48,000 0
1 38 2,48,000 3,200 3,05,000 53,800
As the contract amount for delivery time(s) less than 38 weeks is not given, we stop at this stage.
Conclusion: ABC Co should go for crashing and complete the contract in 38 weeks.
Example 2.22
A company is in assembly production and costs are wages of operators required are given in
Table 2.94.
Activity Preceding Activity NT (Days) CT (Days) Blenders Packers Fillers

A — 4 3 3 — —
B — 3 3 1 — 1
C A, B 3 2 — 2 1
D A 6 4 1 2 —
E C, D 5 4 — 1 2
F A, B 10 6 2 1 1
G E, F 3 2 — -- 2
The operators work for eight hours/day. The normal wage rate for different skills are as follows: Blender
`250 per hour, packer `50 per hour and filler `200 per hour. The cost of manpower resource is as-
sumed to be equally spread over entire duration for each activity. The duration of each activity can
be reduced by using equal number of operators with better skills. Better skilled operators are paid at
double the normal rate. The reduced duration of each activity is given as crash time (CT). Determine
the normal project duration.
Determine what activities need to be crashed to reduce project duration by two days. Determine
the project cost.
MMM, IV Sem, Mumbai Univ, 2018
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Solution:
In this case, we will have to first work out the normal cost (NC) and the crash cost (CC) on the basis
of the given information and then calculate the cost slope. The same is as given in Table 2.95.
Table 2.95 Data for solving problem
Activity Preceding Activity NT (Days) NC CT (Days) CC Cost Slope

A — 4 24,000 3 36,000 12,000
B — 3 10,800 3 10,800 —
C A, B 3 7,200 2 9,600 2,400
D A 6 16,800 4 22,400 2,800
E C, D 5 18,000 4 28,800 10,800
F A, B 10 60,000 6 72,000 3,000
G E, F 3 9,600 2 12,800 3,200
Total 1,46,400
The network diagram along with normal time and crash time in brackets besides the cost slope is
shown in Figure 2.57. The cost allocation table is shown in Table 2.96 and the route distances are
Table 2.96 Cost allocation table
Crash No. Duration (Days) Normal Cost (`) Crash Cost (`) Total Cost (`)
0 18 1,46,400 — 1,46,400
Table 2.97 Route distances table
Routes Distances Crash No. 1 Crash No. 2

A–D–E–G 18
A–C–E–G 15
A–F–G 17
B–C–E–G 14
B–F–G 16
Crash No. 1: In the critical path A – D – E – G, activity D is the least crash cost activity, and hence,
we crash activity D by 1 day. The resultant cost allocation table and route distances table are as
shown in Tables 2.98 and 2.99, respectively.
0 18 1,46,400 — 1,46,400
1 17 1,46,400 2,800 1,49,200
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116 | Chapter 2
D 6 (4)
2 4
2,800
A 4 (3) E 5 (4) 10,800

12,000
C 3 (2)
2,400
G 3 (2)
1 5 6
3,200
B 3 (3) F 10 (6)
I 3,000
Figure 2.57 Network diagram with all data


A–D–E–G 18 17
A–C–E–G 15 15
A–F–G 17 17
B–C–E–G 14 14
B–F–G 16 16
Crash No. 2: In the critical path A – D – E – G and A – F – G, activity G is the common and least
crash cost activity, and hence, we crash activity G by one day. The resultant cost allocation table and
route distances table are shown in Tables 2.100 and 2.101, respectively.
0 18 1,46,400 — 1,46,400
1 17 1,46,400 2,800 1,49,200
2 16 1,46,400 6,000 1,52,400

A–D–E–G 18 17 16
A–C–E–G 15 15 14
A–F–G 17 17 16
B–C–E–G 14 14 13
B–F–G 16 16 15
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As the problem requires us to crash by two days for a duration of 16, we conclude the solution at
this point by stating that the project can be completed within 16 days at a cost of `1,52,400.
Notes:
1. It is generally advisable to crash 1 unit of time (day or week) at one time. However, with prac-
tice and in case of simple problems, crashing of more than one unit of time can be considered.
However, two conditions govern multiple crashing options. The first is that the activity identi-
fied to be crashed should have the higher crashing possibility and the second is that the next
sub-critical path should be sufficiently behind the critical path.
2. The unit for normal time and crash time should be the same and the unit for direct cost and
indirect cost should also be same. If the problem states these units differently, it is advisable
to construct the problem with common units at the start of the solution.
3. At every stage, we have calculated the path durations, which may not be required while solv-
ing problems in the exam. A combined path duration, which should be updated regularly and
a single network diagram which should also be updated regularly, should be sufficient.
4. At times, the indirect cost data is not given. In such cases, project cost trade-off point or
the optimum duration point cannot be identified. However, in such problems, the maximum
crashing or minimum project duration and the costs associated with it can be calculated.
5. While crashing, we must keep an eye on the sub-critical paths, which can become critical later.
In such cases, where there are more than one critical paths, the activity duration on both these
paths should be reduced to reduce the project duration times.
Activity on Node convention

Consider a project where the first task is digging the road, the second task is laying an electrical cable
and the third task is filling up the dug up road, and constructing a patch up road over it. The rate of
digging is 1 km/day, the rate of laying the electrical cable is 1 km/day and the rate of filling up/patch
work is 5 kms/day. The stretch of the road where this work is to be carried out is 5 kms. This means
that it will take five days to dig the road, five days to lay the cable and one day to do patch work.
As per the AOA convention, the succeeding activity of laying the electrical cable can happen only
after the preceding activity of digging the road is fully complete. Similarly, the activity of patch up
road can happen only when the cable laying is complete. Thus, the total time for project completion
is five days for digging, five days for laying the cable and one day for patch up or in all, 11 days.
If we look at the chain of events, it will be clear that the process of laying the electrical cable need
not wait till the entire process of digging is complete and that the process can go parallely along with
the process of digging, albeit with some delay. If the delay is one day, then the project completion
time is five days for digging, one extra day for laying the electrical cable as the electrical cable laying
process can start from day 2 (delay of one day) and one day for patch up or in all, seven days. Now,
this possibility is ruled out in AOA convention, where the minimum time required is 11 days. Such
relationships necessitate AON diagrams, where we can explicitly work with parallel processing, al-
beit with a lag, in spite of precedence requirement(s). the AON method is also known as precedence
diagram method (PDM).
Advantages of AON networks

The advantages of AON networks are as follows:
1. The AON network can have more than one starts and more than one end. This feature of the
AON network is distinctly different from the AOA convention of constructing network dia-
grams where we are constrained to have one start node and one end node.
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118 | Chapter 2
2. Dummy activities are not required in AON networks. As the activities are shown on nodes
and links are drawn from the nodes, there is no necessity of the dummy activity. This is a
unique advantage as the requirement of dummy activities in an AOA network makes the net-
work clumsy and increases the working.
3. Crossing of activity connectors is not disallowed. This does not mean that crossing is always
acceptable. As far as possible, the crossings have to be avoided. In case of AOA, the crossing
of activities is disallowed.
4. The AON convention provides space to write a lot of information such as total float, free
float, early start, early finish, late start and late finish on the network itself, without making it
cluttered. There is a limit to the information that can be shared on an AOA network.
5. One of the key advantages on the AON network is the possibility of simultaneous working
of preceding and succeeding activities with a lead/lag. It is also possible to represent different
types of relationships between activities with their lead–lag time restraints such as finish start
(FS), start start (SS), finish finish (FS) and start finish (SF). It is because of this ability of AON
to represent these relationships, it is preferred over AOA for construction projects or deter-
ministic projects.
Disadvantages of AON networks

The disadvantages of AON networks are as follows:
1. AOA diagrams continue to enjoy popularity among the users of network techniques because
of their early development. AON diagrams have been in active use over the past seven to
eight years. Clarity of AON concepts and thereby its utility will take some more time to be
acceptable.
2. In case of PERT, the emphasis is on events which form the nodes of network diagrams, and
hence, AOA diagrams become the basis of the PERT network. AON network uses the nodes
to represent activities and hence is unable to explain a network which requires events to be at
nodes. This means that all probabilistic projects such as R&D projects cannot be shown using
the AON network.
3. In case of AOA, the numerical numbering renders it easy for computer programming. AON
networks use alphabets for nodes, and hence, computer programming can become cumbersome.
4. Application of AON networks is prevalent in deterministic projects such as construction proj-
ects, whereas due to its limitations in drawing, it cannot be used in stochastic applications or
applications where there are different time estimates and standard deviation as result of dif-
ferent time estimates.
5. It is easy to perform float analysis very conveniently using the AON network. However, analy-
sis such as crashing or resource scheduling is cumbersome with AON network.
AON Representation
ES (FF)EF
TF
ActivityDuration
LSLF
where, ES = Early Start, EF = Early Finish

LS = Late Start, LF = Late Finish
TF = Total Float, FF = Free Float
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AON Lead/Lag Network Relationships

There are essentially four types of AON network relationships.
1. Start to Start (SS): Start of the successor activity depends upon the start of the predecessor
activity. In an SS relationship, there can be a lag, that is, SS + 3, meaning the successor starts
three days after the start of the predecessor activity. It can also be represented as %, that is,
SS + 20%, meaning the successor starts after 20% of the predecessor activity is completed.
2. Finish to Start (FS): Start of the successor depends upon the finish of the predecessor. In an FS
relationship, there can be lag or a lead.

3. Finish to Finish (FF): The finish of the successor depends upon the finish of the predecessor.
In an FF relationship, there can be only lag.
4. Start to Finish (SF): The finish of the successor depends upon the start of the predecessor. In
this relationship, there can only be a lag as the successor can finish only after the predeces-
sor has finished. The lag should be sufficient to cover the activity times of the predecessor. At
times, if there is a choice of early start times due to two or more predecessor activities, then
the later of the times is to be taken. Similarly, if there is a choice of late finish times for pre-
decessor activity, then lesser of the choices must be selected. The selection of early start times
and late finish times follows the thumb rule of forward pass calculations and backward pass
calculation, respectively.
Example 2.23
Table 2.102 mentions the activity, activity times, the predecessor and their relationships. Construct
an AON network and find the ES, EF, LS and LF times.
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120 | Chapter 2
Table 2.102 Activity and related lead/lag data
Activity Duration (Days) Predecessor Relationship Lead/Lag

A 5 — — –
B 3 A FS –2
C 4 A FS +3
D 7 C SS –
E 5 C FF +4
B FS –
F 3
D FS –1
G 2 E FS –
F FS –
H 6
G FS –2
I 3 G FS –
J 4 H SS +4
I FS –
K 2
J FF +1
Solution:
Activity A has no predecessor. Hence, activity A can commence first. After activity A, two activities,
that is activities B and C can commence simultaneously. This is as shown in Figure 2.58.
Figure 2.58 Stages in constructing the AON Network
The activities are shown progressing column-wise and the connectors are a combination of hori-
zontal and vertical straight lines. Diagonal lines are not used. While constructing the network, only
the predecessor relationships are considered and not the lead/lag relationships. After activity C, two
activities—activities D E—can commence simultaneously. This is shown in Figure 2.59.
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Figure 2.59 Stages in constructing the AON network
Activity F depends on completion of activities B and D, whereas activity G depends on completion

of activity E. This development is shown in Figure 2.60.
Figure 2.60 Stages in constructing the AON network
Similarly, we construct the remaining activities on the basis of their precedence relationships. The
final network is shown in Figure 2.61.
The next step is to mention the lead lag relationships on the network. This is shown in
Figure 2.62. We now calculate the ES and EF times for all the activities as shown in Figure 2.63.
Early finish for all activities is ES + duration. Early start for other than first activity is based
on the lead/lag relationship.
Forward Pass Calculations:
For activity B: ES = EF (activity A) – 2 days = 5 – 2 = 3
For activity C: ES = EF (activity A) + 3 days = 5 + 3 = 8
For activity D: ES = ES (activity C) = 8
For activity E: EF = EF (activity C) + 4 = 16
ES = EF (activity E) – duration = 16 – 5 = 11
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122 | Chapter 2
Figure 2.61 Constructing the AON network
Figure 2.62 AON network with lead/lag relationship
Figure 2.63 AON network with ES ~ EF calculations
For Activity F: ES = EF (activity B) = 6 (or)

ES = EF (activity D) – 1 = 15 – 1 = 14
While doing the forward pass, we take the higher of the two options, and hence, for activity F, the
early start is taken as 14.
For Activity G: ES = EF (activity E) = 16
For Activity H: ES = EF (activity F) = 17 (or)
ES = EF (activity G) – 2 = 18 – 2 = 16
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While doing the forward pass, we take the higher of the two values, and hence, for activity H,
the early start is 17.
For Activity I: ES = EF (activity G) = 18
For Activity J: ES = ES (activity H) + 4 = 17 + 4 = 21
For Activity K: ES = EF (activity I) = 21 or
EF = EF (Activity J) + 1 = 25 + 1 = 26
ES = EF (Activity K) – duration = 26 – 2 = 24
While doing the forward pass, we take the higher of the two values, and hence, for activity K, the
early start is 24. The backward pass calculations are as shown in Figure 2.64.
Figure 2.64 Backward pass calculations for AON network
Backward Pass Calculations:

For Activity K: LF = EF (activity K) = 26
For Activity J: LF = LF (activity K) – 1 = 25
In general,
1. The LS for all activities is LF – duration time.
2. The lead/lag relationships are given for forward pass calculations, and hence, for backward
pass calculations, the equations change sign. If the relationship between activities J and K is
FF + 1, then the relation between activity K and activity J (backward pass) is FF – 1.
3. If there is a choice of LF times for the predecessor activity, then the lower value should be taken.
For Activity I: LF = LS (activity K) = 24
For Activity H: LS = LS (activity J) – 4 = 21 – 4 = 17
LF = LS + activity duration = 17 + 6 = 23
For Activity G: LF = LS (activity I) = 21 or
LF = LS (activity H) + 2 = 17 + 2 = 19
While doing the backward pass, we take the lower of the two values. Hence, for activity G, the late
finish is 19.
For Activity F: LF = LS (activity H) = 17
For Activity D: LF = LS (activity F) + 1 = 14 + 1 = 15
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124 | Chapter 2
For Activity E: LF = LS (activity G) = 17

For Activity C: LF = LS (activity E) – 4 = 17 - 4 = 13 or
LS = LS (activity D) = 8
LF = LS + 4 = 8 + 4 = 12
While doing the backward pass, we take the lower of the two values, and hence, for activity C, the
late finish is 12.
For Activity B: LF = LS (activity F) = 14
For Activity A: LF = LS (activity C) - 3 = 8 - 3 = 5 (or) LF = LS (activity B) + 2 = 11 + 2 = 13
While doing the backward pass, we take the lower of the two values, and hence, for activity A, the
late finish is 5. The critical path is shown in Figure 2.65.
Figure 2.65 AON network critical path
The critical path activities are A – C – D – F – H – J – K

Project duration is 26 days.
If we had followed the AOA convention, which does not allow parallel working, then the project
duration would have been 31 days. In addition, there would have been a requirement of a dummy
activity. The AOA convention and analysis are shown in Figure 2.66.
Figure 2.66 Network in AOA convention
Path 1: 1 – 2 – 3 – 7 – 8 – 9 – 10 = 23 days
Path 2: 1 – 2 – 4 – 3 – 7 – 8 – 9 – 10 = 31 days
Path 3: 1 – 2 – 4 – 5 – 6 – 7 – 8 – 9 – 10 = 28 days
Path 4: 1 – 2 – 4 – 5 – 6 – 9 – 10 = 21 days
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The critical path activities in AOA and AON networks are the same, although the duration of crit-
ical path activities is different. This is because we cannot incorporate the lead/lag relationships be-
tween activities in AOA network, whereas this relationship can be incorporated in an AON network.
Float calculations in AON network

The total float is the difference between the late start (LS) and the early start (ES) for an activity; this
is written inside the activity box, above the activity duration. The free float is the difference between
the early start time of succeeding activity and the early finish time of the preceding activity. In case
there is more than one option for the choice of free float, then the lowest of the options is selected.
If the free float turns out to be negative, a value of zero is taken. It is interesting to note that the free
float is always zero or positive in an AOA network, whereas in an AON network, negative free float
is possible, which is equated to zero.
Example 2.24
For the given relationships as shown in Table 2.103, where duration is in days, find out the critical
path and perform a float analysis using an AON network.
Table 2.103 Activity duration times and predecessor relationship
Activity A B C D E F G H K L
Duration 3 5 7 4 6 4 5 8 2 4
Predecessor(s) — A A B C C D, E G, F G H, K
Solution:
We will first construct the network diagram and compute the ES, EF, LF and LS times for all the
activities. This part of the analysis is shown in Figure 2.67.
Figure 2.67 AON network with critical path identified

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126 | Chapter 2
The critical path activities are A – C – E – G – H – L and the project duration is 33 days. The early
start and early finish and late start and late finish are as shown on the network.
Early start (forward pass) for activity G is the larger of late finish times for predecessor activity D
(12) and E (16). Hence, we select 16 as early start for activity G.
Late finish (backward pass) for activity C is smaller of the late start times for succeeding activi-
ties E (10) and F (17). Hence, we select 10 as the late finish time for activity C. The float analysis,
which comprises total float (LS – ES) and free float (ES of subsequent activity – EF), is as shown
in Figure 2.68.
Figure 2.68 AON network updated with float analysis
Whenever there is more than one option for the choice of free float, the lowest of the options must
be selected. In case the free float turns out to be negative, it should be equated to zero.
The total float is shown within the activity box and the free float in parenthesis between ES
and EF.
Float calculations for activity G: Total float = LS – ES = 0.
Free float = ES of subsequent activity (Activity K and H) – EF (Activity G) = 0
Float calculations for activity C: Total float = LS – ES = 0.
Free float = ES of subsequent activity (Activity E and F) – EF (Activity G) = 0 or 7. We will select
the lower value 0.
Example 2.25
Table 2.104 defines the various activities in a small project.
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Table 2.104 Various activities and their precedence relationships
Activity Duration (Weeks) Predecessor(s) Relationship Constraints

A 4 — —
B 3 A Should finish atleast one week after finish of A
C 4 A Should start atleast two weeks after start of A
D 9 C Can start immediately on completion of C
B, Cannot start within two weeks after starting of B
E 5
D Can start simultaneously with D
F 6 C Can start after a minimum gap of four weeks after completion of C
G 4 D, F Can be started immediately on completion of D and F
H 7 E Can be started atleast three weeks prior to completion of E
I 6 G Should finish after a lag of two weeks after finish of G
J 7 A Can start after a lag of atleast 10 weeks after finish of A
K 6 H, I, J Can be started as soon as possible on completion of H, I and J
Draw the network diagram using precedence diagramming (AON) convention and find the expected
completion time for the project by performing a forward pass.
Solution:
A lag means a delay and a lead means an early start to the succeeding activities. It is important to un-
derstand the relationships between successor and predecessor and the attended lead/lag relationship to
solve these kinds of problems. The first step in these problems is to construct an AON network diagram,
as shown in Figure 2.69. Once this step is completed, we write the lead/lag relationships and perform
the forward pass, as required in the problem. The expected completion time of the project is 28 weeks.
Figure 2.69 AON network with lead/lag relationships

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128 | Chapter 2
Example 2.26
Construct the network using the AOA and AON convention for the following activity data.
(a) Activity A B C D E F G H I
Predecessor(s) – – B A C C F F H
Activity J K L M
Predecessor(s) I D, E, G, J I K, L
(b) Activity A B C D E F G H
Predecessor(s) – – A B, C D E B, C F
Activity I J K L
Predecessor(s) F, G H, I B F, G, K
Solution:
(a) The network using the AOA convention is shown in Figure 2.70 and the AON convention is
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Figure 2.71 Network in AON convention
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(b) The AOA convention is shown in Figure 2.72 and the AON convention is as shown in Figure 2.73.
E
2 5 6 9
C F H J
A D
1 4 7 11
I
B G
3
8
L
K
10
A C D E F H J
B G I
K L
Figure 2.73 Network in AON convention
Example 2.27
Table 2.105 gives the list of project activities, their estimated duration in weeks and the relation-
ships by defining the successor activities.
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130 | Chapter 2
Table 2.105 Project data
Activity Duration (Weeks) Successor Activity

A 5 D, E
B 4 F
C 6 G
D 4 I
E 4 J
F 6 J
G 5 H, K
H 2 J
I 5 L
J 11 N
K 4 M
L 6 N
M 9 N
N 6 —
(a) Identify the critical path and find the project completion time.
(b) Find the project completion time in the following cases:
(i) If activity I is delayed by three weeks.
(ii) If activity K is delayed by two weeks.
(iii) If activity M is crashed by one week.
(iv) If activity G is crashed by three weeks.
Use the AON convention to construct the network.
Solution:
(a) Activities D and E can commence after activity A, whereas activity F can commence after the
completion of activities B and G can commence after the completion of activity C, respec-
tively. The network diagram with AON convention is shown in Figure 2.74.
(b)
(i) If activity I is delayed by three weeks, there would not be any effect on the project dura-
tion. This is so because the total float on activity I is four weeks. However, the float of
subsequent activities would be affected.
(ii) If activity K is delayed by two weeks, then the project would be delayed by two weeks.
The project completion times will now be 32 days and there will be only one critical path,
that is, C – G – K – M – N.
(iii) If activity M is crashed by one week, there will not be any effect on the project duration
as the other critical path C – G – H – J – N will still require 30 weeks to be completed.
(iv) If activity G is crashed by three weeks, the project duration would reduce by three weeks
since G is the common activity to both the paths. Now, in addition to the two critical
paths, a third path B – F – J – N would also be critical.
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Figure 2.74 Network in AON convention showing the critical path
The critical path(s), C – G – H – J – N and C – G – K – M – N is shown in bold lines.
Example 2.28
Draw a network with AON convention and perform a complete float analysis for the activities
Activity A B C D E F G H K L M N
Predecessor(s) — A A B C C D, E G, F G H, K H K
Duration (Days) 3 5 7 4 6 4 5 8 2 4 5 7
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132 | Chapter 2
Solution:
The network is as shown in Figure 2.75.
Figure 2.75 Float analysis for a network constructed in AON convention
The bold line shows the critical path, which comprises activities A – C – E – G – H – M. The total
float and free floats for all activities are shown on the network diagram itself. The interfering float
is total float – free float.
Common Avoidable Mistakes while solving Network Analysis Problems
1. In the AOA method of constructing networks, dummy activities should be used only when
absolutely necessary. In general, dummy activities would be required if two activities have the
same predecessor and additionally, one of the activities depends on some other predecessor.
2. Although dummy activities have no duration, the early start times (ES) and latest start times
(LS) could be different, if the dummy activity is not on the critical path. When this happens
there would be a positive float for the dummy activity. Therefore, for all analysis such as float
analysis, dummy activities must be considered. The floats of dummy activity get passed on to
the next activities.
3. The float analysis results using the AON network and AOA network can be different when
dummy activities are involved. However, it must be remembered that the float for dummy activ-
ity is actually the float of the preceding or succeeding activity. As AON Networks do not have
dummy activities, the free float of certain activities preceding a dummy activity can be different.
4. During crashing, it is possible that there would be more than one critical path, in which case
further crashing should have the effect of reducing duration by equal time units on all the
critical paths. If crashing a common activity is not feasible or commercially unviable, then
combination of uncommon activities must be considered.
5. In case of forward pass calculations, if there is a choice of early start times the higher value
amongst the options must be selected. For all backward pass calculations, whenever there is a
choice for late finish times the smaller of the options must be selected.
6. In case of choice for surpluses at events, known as slacks, the smallest of the slacks must be
selected.
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U n s o lv e d P r o b l e m s
Example 2.29
A project has the following activities as given in Table 2.107 and other activity-related characteristics.
Activity Predecessor(s) To (Weeks) Tm (Weeks) Tp (Weeks)

A — 4 7 16
B — 1 5 15
C A 6 12 30
D A 2 5 8
E C 5 11 17
F D 3 6 15
G B 3 9 27
H E, F 1 4 7
I G 4 19 28
(a) Draw the PERT network.

(b) Identify the critical path.
(c) Determine the mean project completion times.
(d) Find the probability that the project is completed in 36 weeks.
(e) If the project manager wishes to be 99% sure that the project is completed, how many days
should be provided for the project work?
Solution:
(b) A – C – E – H (c) 37 weeks (d) 42.07% (e) 48.63 ~ 49 weeks
Example 2.30
For a small project of 12 activities, the details are given below. Draw the network and find earliest
occurrence time, latest occurrence time, critical activities and project completion time. Perform a
complete float analysis. The duration is in days.
Activity A B C D E F G H I J K L
Predecessor(s) — — — B,C A C E E D, F, H E I, J G
Duration 9 4 7 8 7 5 10 8 6 9 10 2
CA, May 1986

Solution:
A – E – H – I – K is the critical path and duration is 40 days for the project. The total float, free float
and interfering float for all the activities are given against the activity name in the same sequence,
A(0,0,0), B(12,0,12), C (9,0,9), D(12,12,0), E(0,0,0), F(12,12,0), G(12,0,12), H(0,0,0), I(0,0,0),
J(5,5,0), K(0,0,0), L(12,12,0).
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134 | Chapter 2
Example 2.31
A project plan is given in Table 2.108. Construct a CPM network and perform a complete float
analysis.
M. Com., Delhi Univ, 1983
Activity Predecessor(s) Time (Days)

A — 8
B — 2
C A 1
D B 9
E B 4
F C, D 5
G E 6
H E 3
I G 3
J H 5
K I, J 2
L F 3
Solution:
Critical Path B – D – F – L and the duration of the critical path is 19 days. The total float, free
float and interfering float for all the activities are A(2,0,2), B(0,0,0), C(2,2,0), D(0,0,0), E(2,0,2),
F(0,0,0), G(2,0,2), H(3,0,3), I(2,0,2), J(3,1,2), K(2,2,0), L(0,0,0).
Example 2.33
Consider the project, details of which are given in Table 2.109, and having the following activities
and their time estimates.
A — 3 4 5
B — 6 8 10
C B 4 6 8
D A, C 5 10 15
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E B 4 6 8
F D, E 3 4 5
G D, E 4 6 8
H D, E 2 3 4
I G 3 4 5
J F, I 6 8 10
K G 4 5 6
L H 8 9 10
M J, K, L 6 7 8
(a) Draw a network with AOA convention.

(b) Compute the expected project completion time.
(c) How many days should be provided for 80% project completion probability?
(d) Find the total float and free float for all the non-critical activities.
MBA, Delhi Univ, 1987
Solution:
The critical path activities are B – C – D – G – I – J – M and the duration of the critical path is 49
days. For a probability of 80% project completion, the number of days to be provided is 50.84 ~
51 days. The total float and free float for all the non-critical activities are given against the activity
name in the same sequence, A (10, 10), E (10, 10), F (6, 6), H (6, 0), K (7, 7), L (6, 6).
Example 2.33
Table 2.110 gives data on normal time and cost along with the crash time and cost for a project.
Activity Normal Time Days Normal Cost (`) Crash Time Days Crash Cost (`)
1–2 6 1,400 4 1,900
1–3 8 2,000 5 2,800
2–3 4 1,100 2 1,500
2–4 3 800 2 1,400
3–4 Dummy — — —
3–5 6 900 3 1,600
4–6 10 2,500 6 3,500
5–6 3 500 2 800
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136 | Chapter 2
The indirect cost for the project is `300 per day.

(a) Draw the network of the project.
(b) What is the normal duration and the cost of the project?
(c) If all activities are crashed, what will be the minimum project duration and corresponding
cost?
(d) Find the optimal duration and minimum project cost.
BE (Mech.), Karnataka Univ, 1998
Solution:
(b) 20 days, `15,200/- (c) 12 days, `16,534/- (d) 17 days, `15,000/-
Example 2.34
The utility data for a network is given in Table 2.111. Crash the network to minimum possible dura-
tion and find the associated cost. The total normal cost of the project is `9,00,000.
Activity Normal Time (Weeks) Crash Time (Weeks) Cost Slope (`’000)
1–2 4 2 7
1–3 7 4 4
2–3 7 4 3
2–4 5 3 12
3–5 6 3 6
4–5 4 1 8
4–6 10 6 10
5–6 6 6 --
5–7 8 6 10
6–8 6 4 12
7–8 5 2 7
Note: The indirect cost is not given, and hence, the optimal project duration and associated optimal
cost cannot be found.
Solution:
Minimum project duration is 19 days and the total cost for crashing up to 19 weeks is `10,74,000.
Example 2.35
A computer software implementation project has the following activities as given in Table 2.112.
Find the total and free floats for all the activities in the project.
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Table 2.112 Activity relationships and duration
Activity Duration (Days) Predecessor(s)

A 5 —
B 6 A
C 1 A
D 4 B
E 1 B
F 2 C
G 3 C
H 1 B
I 5 D, E
J 1 D, E
K 4 F, G, H, I
L 2 E
M 2 G
N 2 J, K, L, M
Solution:
The duration of the project is 26 days. Critical path is A~B~D~I~K~N. The total float and free float
of all the activities are as given in Table 2.113.
Table 2.113 Total and free floats for all the activities
Activity Duration (Days) Predecessor(s) Total Float Free Float

A 5 — — —
B 6 A — —
C 1 A 11 0
D 4 B — —
E 1 B 3 0
F 2 C 12 12
G 3 C 11 0
H 1 B 8 8
I 5 D, E — —
J 1 D, E 8 8
K 4 F, G, H, I — —
L 2 E 10 10
M 2 G 13 13
N 2 J, K, L, M — —
Example 2.36
Given the following data in Table 2.114, draw the CPM diagram, find out the critical path and com-
pute the total float, free float and independent floats for activities E, D, G, H and L.
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138 | Chapter 2
Table 2.114 Data on predecessor and duration for activities

A — 9
B — 20
C — 10
D A 11
E C 10
F B, C 4
G F 2
H D, F 5
I E, F, K 18
J G, H 14
K — 24
L K 6
Solution:
The critical path is B~F~H~J and the duration is 43 days. The floats for all the activities are given
in Table 2.115.
Table 2.115 Total, free and independent floats
Activity Predecessor(s) Duration (Days) Total Float Free Float Independent Float
A — 9 2 0 —
B — 20 — — —
C — 10 5 5 5
D A 11 2 2 0
E C 10 5 4 4
F B, C 4 — — —
G F 2 3 3 3
H D, F 5 — — —
I E, F, K 18 1 1 0
J G, H 14 — — —
K — 24 13 0 —
L K 6 13 13 0
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Example 2.37
Consider a project with the following activities. The normal duration and cost, crash duration and
cost and the precedence of activities are given in Table 2.116.
Activity Predecessor(s) Normal Time Crash Time Normal Cost Crash Cost (Per Day)
A — 4 4 4,000 —
B — 8 6 8,000 1,500
C F, D 3 3 600 —
D B 6 5 900 150
E — 7 5 350 100
F A 15 12 9,000 900
G B 12 10 1,200 200
H G 10 8 1,000 150
J L 5 4 1,000 300
K E 9 7 900 150
L G, K 11 8 2,200 350
Fixed overhead costs per day is `500. Identify the project cost trade-off point or minimum cost
point and the duration. Also, identify the minimum project cost and associated cost.
Solution:
The fixed overhead cost is the indirect cost.
The cost analysis table is shown in Table 2.117.
Table 2.117 Cost analysis table
Crash Duration Activity Normal Cumulative Indirect Total

Number Days Crashed Cost Crash Cost Cost Cost
0 36 – 29,150 0 18,000 47,150
1 34 G – 2days 29,150 400 17,000 46,550
2 33 J – 1 day 29,150 700 16,500 46,350
3 30 L – 3 days 29,150 1,750 15,000 45,900
4 28 B – 2 days 29,150 4,750 14,000 47,900
Example 2.38
A team of chemists is planning to undertake an applied research project to test a formula for a new
material. The project can be separated into 12 distinct activities. The relationship amongst the ac-
tivities and the time estimates in weeks are as given in Table 2.118.
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140 | Chapter 2
Table 2.118 Project-related details (Duration in weeks)
A — 2 2 2
B — 1 3 5
C A 4 7 10
D A 3 5 7
E B 3 6 9
F B 7 9 11
G C, D 3 6 9
H E 3 6 9
I C, D 3 5 7
J G, H 1 3 5
K F 5 8 11
L J, K 3 5 7
Draw a network and identify the expected completion time of the project. What is the probability
of completing the project in 25 weeks? What is the probability of completing the project in less than
or equal to 23 weeks? What is the probability of completing the project in more than or equal to 26
weeks? What is the time estimate for project completion at 95% confidence level?
Solution:
Te = 25 weeks, s = 1.53 weeks
(a) The probability of completing the project in 25 weeks is 0.5 or 50%.
(b) Probability of completing the project in less than 23 weeks is 0.0951 or 9.51%.
(c) Probability of completing the project in more than or equal to 26 weeks is atleast 0.7422 or
74.22%.
(d) 28 weeks must be provided if the project should be completed with 95% probability.
Example 2.39
Table 2.119 provides normal and crash times as well as normal and crash costs for the activities of
a project.
Activity Normal Time (Weeks) Normal Cost (` Lakhs) Crash Time (Weeks) Crash Cost (` Lakhs)
1–2 3 5 1 9
2–3 4 8 3 14
2–4 3 4 2 6
2–5 8 5 7 6
3–6 4 3 2 5
4–6 6 2 4 3
5–7 5 10 4 14
6–7 3 7 1 10
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(a) Draw the network and find the critical path.

(b) Using the above information, crash or shorten the activities step by step until the shortest
duration is reached.
Note: The indirect cost is not given which means we cannot find the optimal project cost and
associated duration. We will be required to crash till crashing is feasible.
Solution:
The path 1 – 2 – 5 – 7 with duration 16 weeks is the critical path. The cost of completing the project
in normal time is `44 lakhs. The project can be crashed up to 12 weeks and the total cost associated
with this minimum project duration of 12 weeks is `54.5 lakhs.
Su m m a r y
Konkan Railway project or the Delhi Metro project are some live examples of complexities involved
in completing a major infrastructure project. However, a project need not necessarily be a large
complex construction-related project. A new HR process or implementation of IT upgrades such as
SAP can also be termed as a project. Essentially, a non-repetitive set of tasks, different from anything
done so far with different levels of complexities can be defined as a project. All functional areas of
management—HR, finance or supply chain management—involve projects of different types. Man-
agers are, therefore, required to understand project management skills and every manager should be
a good project team member as well as a good project leader.
Many software packages are available for calculating project completion times, but understand-
ing of the project management logic is a key requirement for successful use of the available software.
Projects involve two types of cost, namely direct cost and indirect cost. The direct cost or normal
cost is the cost of raw materials, tools and equipments and labour. The indirect cost is the cost of
project supervision, penalties for late completion and rewards for early completion, if any. The re-
wards are benefits and not a cost. Hence, a project manager should be able to maintain a balance
between the increase in direct cost and a decrease in indirect cost when considering crashing.
Another point to be noted is that resource smoothing and resources allocation/resources levelling
are two methods by which scarce resources can be efficiently utilized.
Activity on node (AON) diagrams are considerably better and easier than activity on arrow (AOA)
diagrams. Hence, an attempt must be made to make greater use of the AON convention. It must be
remembered that AON convention of network analysis cannot be used for stochastic situation, in
which case PERT is best.
K EY W ORDS
• CPM • Float
• PERT • Slack
• AOA convention • Crashing
• AON convention • Dummy activity
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142 | Chapter 2
Review Questions
1. Why is the scope change important to be monitored and controlled during implementation of
projects? What are the reasons for the project needing ‘scope change’ and explain the process
of incorporating the ‘scope change’ in the project?
2. Explain how uncertainties related to time duration of project activities as well as project
completion are handled in PERT approach to project planning.
3. What are the different types of dependencies that exist between two project activities and how
are they represented in network diagrams?
4. Define project management and state the scope of the project management.
5. How is managing a project different from managing a factory?
6. Explain any two uses of dummy activities with the help of examples.
7. Write short notes on activity on node technique.
8. Bring out the difference between activity on arrow method and activity on node methods of
network analysis.
9. Define total float of an activity. State its uses in resources allocation.
10. Write short notes on finish to start and start to finish relationship.
11. What do you understand by three time estimates method for network scheduling and under
what circumstances is it used? What is the probability of completing the project within the
total scheduled time calculated on the basis of this method?
12. What are the floats or slacks in project schedules and how are they used in effective manage-
ment of projects? How do the terms ‘total float’ and ‘free float’ differ in their significance?
When can project schedule calculations show ‘negative floats’?
13. ‘PERT network will act as only wall decorators in a business enterprise since there are slip-
pages of the project despite the entire PERT chart’. Do you agree with this view? Explain.
14. What are the advantages of the AON network? What are its limitations?
15. AON network cannot be used for PERT analysis. Why?
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Chapter
3 pROJeCT NeTWORK
ANALYSIS–II
learninG obJeCTives

❍ Understand the importance of resources in a project and the best utilization of these scarce
resources.
❍ Understand the differences between resources smoothing and resources leveling.
❍ Use the Gantt Chart in identifying the problem days in the project.
❍ Understand the intricacies in resources scheduling / levelling and the effect of negative
total float.
INTRODUCTION
In the analysis done in Chapter 2, it was sufficiently presumed that there were no constraints of
raw materials for various activities. It should be remembered that besides raw materials, there are
other key inputs required for executing projects. These key requirements may be in the form of
labour, machinery or specialized equipment for carrying out specific tasks. The requirements of
sufficient funds at appropriate times could also be one of the constraints. Critical path analysis
and the duration of the project can be adversely affected if any of the constraints are in short sup-
ply and the role of the project manager gets extended to allocation of scarce resources, besides
monitoring the progress of various activities and groups of activities as per the work breakdown
structure (WBS).
Another complication while dealing with resources is that the requirement of resources is not
uniform and there are periods when there is a heavy or less, as the case may be. This kind of
skewed demand for raw materials can be managed with the help of inventory but skewed demand
for manpower or heavy machinery, like the Hercules crane for lifting girders on the Bandra-Worli
sea link in Mumbai, is difficult to be handled. In such cases, it is preferable to have a constant or
uniform demand for services. At any point in time, the demand for a resource is the cumulative
demand for the resource on all the activities requiring it. This means that the demand for resources
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144 | Chapter 3
can be more or less at certain points in time. If infinite resources are not available when there is
peak demand, we can have a situation where the requirement exceeds the availability. At other
times, the requirements might be low, keeping resources idle. One method of handling such peaks
and troughs in demand is by using the float of various non-critical path activities to streamline the
demand, wherein we can delay the requirement of the resource by delaying the activity or advance
the requirement of the scarce resource by advancing some activities. Resource scheduling is, thus,
the process of maintaining a uniform requirement of resources, wherever possible and in case of
inevitable delays, keeping the project delays to a minimum.
These two scenarios are explained as follows:
Resource smoothing: In this case, project delay is not acceptable and whenever additional
1.
resources are required, the same must be provided. However, the attempt in this case is to
‘smoothen’ out periods of peak demand and periods of no demand to maintain uniform
resource requirements. Resource scheduling only smoothens the demand for resources in a
uniform manner to the extent possible. During the smoothing process, the start times of the
non-critical path activities are shifted and the shift on the time-scaled network is on the basis
of a load histogram. On a time-scaled version, cumulative resource requirement for each
time period (days/weeks) is plotted and this gives an idea about the requirement pattern of
resources per time period. The start times of critical path activities are never shifted, whereas
those activities having the largest float times are shifted first. Generally, when the resources
comprise labour, manpower or of finances, we resort to resource smoothing. It should be re-
membered that these resources can be made available albeit at a higher cost, if required, but
delaying the project and the attendant complications is not an option at all.
Resource levelling: Resource levelling could result in a delay in the project finish date if the
2.
tasks affected due to non-availability of resources are critical path activities. In this situa-
tion, the project duration is not treated as an invariant, as demand on certain specified re-
sources cannot be met over a specified time unit. These situations arise when the resources
in question comprise resources such as heavy machinery or large equipment such as road
rollers which cannot be made available even at higher costs. Hence, the delay in completion
of the project is inevitable, but the project manager must ensure that the delay due to non-
availability of resources is kept at a minimum.
Therefore, in conclusion, we can state that in a resource smoothing operation, the project duration
is kept constant and the required additional resources are outsourced. In case of resource levelling,
the project duration can get extended and the requirement of resources is limited to what can be
made available.
Note: There is considerable confusion in the application of the term ‘resource levelling’ as it is
often synonymously used with ‘resource smoothing’. Resource levelling is a project management
technique used to examine [the] unbalanced use of resources (usually people or equipment) over
time, and for resolving overallocations or conflicts. When performing project planning activities,
the manager will attempt to schedule certain tasks simultaneously. When more resources such
as machines or people are needed than are available, or perhaps a specific person is needed in
both tasks, the tasks will have to be rescheduled concurrently or even sequentially to manage
the constraint. Project planning resource levelling is the process of resolving these conflicts. It
can also be used to balance the workload of primary resources over the course of the project[s],
usually at the expense of one of the traditional triple constraints (time, cost and scope). In either
case, levelling could result in a later project finish date if the tasks affected are in the critical
path’.
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Project Network Analysis–II | 145
Resource levelling is confused with resource smoothing in the objective of minimizing the peak
and the trough requirement of resources. However, in case of resource smoothing, a delay of the
project duration is inadmissible; in case of resource levelling, project duration delay is admissible.
Hence, we conclude that resource smoothing is a subset of resource levelling. Students must,
however, note the distinction in approaches to solve resource smoothing and resources allocation
problems. The best way to remember the correct approach for a given problem is to ask whether
project delay is acceptable or not and then work out a solution accordingly.
GANTT CHART
Henry L. Gantt has done pioneering work in the field of project management. The chart devising
method of the early 20th century is still being used, albeit with modifications, to monitor the progress
of the project. A Gantt chart, commonly used in project management, is one of the most popular and
useful ways of showing activities (tasks or events) displayed against time. There is a list of the activi-
ties on the left side of the chart and a suitable timescale along the top. Each activity is represented by
a bar: the position and length of the bar reflecting the start date, duration and end date of the activity.
The chart allows you to examine the following at a glance:
1. What are the various activities?
2. When does each activity begin and end?
3. How long each activity is scheduled to last?
4. Do the activities overlap with other activities and to what extent ?
5. What are the start and end dates of the project?
A simple Gantt chart is as shown in Figure 3.1.
Q1 2009 Q2 2009 Q3 2009

Task Name
Dec. 08 Jan. 09 Feb. 09 Mar. 09 Apr. 09 May. 09 Jun. 09 Jul. 09 Aug. 09
Planning
Research
Design
Implementation
Follow Up
Figure 3.1 Simple Gantt chart
Although the first Gantt chart was devised in the mid-1890s by Karol Adamiecki, a Polish engineer,
who ran a steelworks factory in southern Poland and had become interested in management ideas
and techniques, the credit for developing this technique lies with Henry Gantt. Some 15 years
after Adamiecki, Henry Gantt, an American engineer and management consultant, devised his own
version of the chart. The chart became popular in western countries. Consequently, it was Henry
Gantt whose name was to become associated with charts of this type. Originally, Gantt charts were
prepared laboriously by hand; each time a project changed, it was necessary to amend or redraw
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146 | Chapter 3
Planned Actual % Show Gantt for Actual

Start Start
# S.No. Duration Duration Done 1 2 3 4 5 6 7 8 9 10 11 12
1. Activity 1 1 5 1 2 0%
2. Activity 2 1 5 1 6 58%
3. Activity 3 2 4 2 5 35%
4. Activity 4 4 8 2 6 10%
5. Activity 5 4 1 3 8 0%
6. Activity 6 4 3 4 6 0%
7. Activity 7 5 4 4 3 0%
8. Activity 8 5 2 4 5 0%
9. Activity 9 5 2 4 6 0%
Figure 3.2a Example of a Gantt chart
the chart and this limited their usefulness, with continual change being a feature of most projects.
Nowadays, however, with the advent of computers and project management software, Gantt charts
can be created, updated and printed easily. Figures 3.2(a) and (b) show some additional examples
of the Gantt chart.
Steps INVOLVED IN SOLVING RESOURCES SMOOTHING PROBLEMS

Some ways to solve resource smoothing problems are summarized as follows:
1. The first step is to construct the network diagram using the activity on arrow (AOA) convention.
2. The second step is to identify the critical path and duration of the project.
0
1
00
/0
/0
/0
01
01
01
/0
/0
02
02
02
/1
/1
31
/2
/2
1/
2/
2/
2/
1/
3/
3/
10
12
10
12
8/
1/
4/
6/
8/
2/
4/
6/
Task 1
Task 2
Task 3
Task 4
Task 5
Completed Remaining
Figure 3.2b Example of Gantt chart

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3. The third step is to construct a time-scaled version of the project. The resources required
on activities at every specific point in time are then summed up. This process is repeated for
every time unit from the start node to the finish node. At the end of this step, we have the
resource requirement for every time unit.
4. These resource requirements are plotted against the time duration for project completion and
this plot is called a load histogram. This load histogram identifies the time slots when there
is a peak demand for resources and the time slots when there is no demand for resources.
These days of extreme requirement must be either pushed forward or backward by utilizing
the floats on some of the activity chains.
5. The critical path is next drawn as a straight line from the start node to the end node. The
other paths originating from different nodes and ending at other nodes are drawn either
above or below the critical path. On the non-critical paths, the activity floats are shown as
dotted lines.
6. The activity floats are moved along the length of the non-critical paths to reduce (or increase)
the requirements of resources on those particular time slots.
It should be noted that this process adopts the trial and error method and that there is no unique
method of working out solutions. Therefore, there is no one best solution in this case and any solu-
tion that makes the resource requirements uniform is acceptable.
Example 3.1
A network with the following activity duration in weeks and manpower requirement is given in
Table 3.1. Analyze the project from the point of view of resources to bring out the necessary steps
involved in the analysis and in smoothing of resources.
Table 3.1 Activity details with resource requirements
Activity 1–2 2–3 2–4 3–5 4–6 4–7 5–8 6–8 7–9 8–10 9–10
Duration 2 3 4 2 4 3 6 6 5 4 4
Men 4 3 3 5 3 4 3 6 2 2 9
Solution:
Figure 3.3 Project network in AOA convention

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148 | Chapter 3
We will first identify the critical path by constructing the network, as shown in Figure 3.3 and
path durations in Table 3.2.
Note: The activity durations are written above the arrow and the resource requirements below the
arrow for future references. It is prudent to write an alphabet for the resource so that this value is
not confused with the path duration at a later stage.
Path Activities on Path Length of Path (Weeks)

1 1 - 2 - 3 - 5 - 8 - 10 17
2 1 - 2 - 4 - 6 - 8 - 10 20
3 1 - 2 - 4 - 7 - 9 - 10 18
Path 2, that is, 1 - 2 - 4 - 6 - 8 - 10 with duration of 20 weeks is the longest path and hence the critical
path.
Next, we construct the time-scaled version of the network. Here, we draw the critical path in a
straight line and the other paths parallel to the critical path with dotted lines representing the float.
Figure 3.4 Gantt chart for activities
The daily requirement of manpower up to the end of the project is tabulated and a load histo-
gram is constructed next to analyze the loading pattern. The manpower requirement is summarized
in Table 3.3 and the load histogram is shown in Figure 3.5.
We find that the requirement of manpower is the highest from day 14 to day 18, whereas in the
earlier time periods, the maximum requirement is only 12. For the non-critical paths 1 - 2 - 3 - 5 -
8 - 10 and 1 - 2 - 4 - 7 - 9 - 10, we can utilize the floats to smoothen these variations in demand.
We will postpone both the paths by their float times. The resultant Gantt chart and load histogram
are as shown in Figures 3.6 and 3.7, respectively.
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Table 3.3 Every day requirement of manpower
Day 1 2 3 4 5 6 7 8 9 10
Men 2 2 6 6 6 8 12 12 10 8
Day 11 12 13 14 15 16 17 18 19 20
Men 11 11 11 8 15 15 11 11 2 2
Number of Men Required
Figure 3.5 Plot of requirement of men versus project duration
Figure 3.6 Gantt chart with revised float schedule
It must be noted that the steps involved in resource smoothing are basically trial and error methods
and the only option is to either utilize the entire float at the beginning or split it, as in case of 1 - 2
- 4 - 7 - 9 - 10 over two-periods.
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150 | Chapter 3
Number of Men Required
Figure 3.7 Requirement of men on a day-to-day basis
With this realignment, the maximum requirement of men is 11. Moreover, the peak and the
least requirement of men is considerably reduced and a more uniform requirement is possible. The
duration of the project remains 20 days.
Example 3.2
For the problem given in Table 3.4, identify the days of maximum requirement of manpower. Plot
a Gantt chart for resource requirements and a resource graph over time. If the available manpower
is limited to 20, find out the days of overall location.
Table 3.4 Data relating to activities
Activity Predecessor(s) Duration Manpower

A – 8 4
B – 7 8
C A 6 5
D B 8 4
E B 4 8
F B 8 6
G C, D 5 5
H E 6 4
I F 6 5
J G, H, I 10 6

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Solution:

This is a resource smoothing problem, but the problem does not ask even for this. It asks to
merely state the days of overallocation. We will first construct the network diagram which is shown
in Figure 3.8.
The float analysis or network analysis table is shown in Table 3.5.
Table 3.5 Network analysis table
Activity Predecessor(s) Duration ES EF LS LF TF Manpower

A – 8 0 8 2 10 2 4
B – 7 0 7 0 7 0 8
C A 6 8 14 10 16 2 5
D B 8 7 15 8 16 1 4
E B 4 7 11 11 15 4 8
F B 8 7 15 7 15 0 6
G C, D 5 15 20 16 21 1 5
H E 6 11 17 15 21 4 4
I F 6 15 21 15 21 0 5
J G, H, I 10 21 31 21 31 0 6
The Gantt chart is plotted next and this is shown in Figure 3.9.
Day
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31
Activity
A 4 4 4 4 4 4 4 4
B 8 8 8 8 8 8 8
C 5 5 5 5 5 5
D 4 4 4 4 4 4 4 4
E 8 8 8 8
F 6 6 6 6 6 6 6 6
G 5 5 5 5 5
H 4 4 4 4 4 4
I 5 5 5 5 5 5
J 6 6 6 6 6 6 6 6 6 6
Total 12 12 12 12 12 12 12 22 23 23 23 19 19 19 14 14 14 10 10 10 5 6 6 6 6 6 6 6 6 6 6
Figure 3.9 Gantt chart for activities showing resource requirements

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152 | Chapter 3
Note: This is the classical form of plotting the Gantt chart and can be resorted to, if the students
find it easy.
The everyday manpower requirement can be easily calculated by this method.
Gantt Chart
The last step is to plot the load histogram and this is shown in Figure 3.10.
Resource Graph/Load Histogram
If the resources are limited to 20 workers, the days of overallocation of resources are on the eighth
day, ninth day, tenth day and eleventh day.
Resources
1 4 7 10 13 16 19 22 25 28 31
Time
Figure 3.10 Load histogram
Example 3.3
A project consists of nine activities for which the relevant data is given below in Table 3.6.
Table 3.6 Data on activities

A – 5
B – 5
C A 10
D B 7
E A 6
F C, D 8
G C, D 6
H E, F 5
I G 4
(i) Draw the network and find the project completion time.
(ii) Compute total float for each activity.
(iii) Draw the Gantt chart for the project.
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Solution:
We will first construct the network diagram and identify the critical path. Next, we will perform
the float analysis. Finally, we will plot the Gantt chart and resources loading chart. These details
are as shown in Figure 3.11.
(i)
Path 1: 1 - 2 - 5 - 7, duration = 16 days.

Path 2: 1 - 2 - 4 - 5 - 7, duration = 28 days.
Path 2, 1 - 2 - 4 - 5 - 7, is the critical path and A - C - F - H are the critical path activities. The
duration of the project is same as the duration of the critical path and is 28 days.
(ii) The total float analysis is shown in Table 3.7.
Table 3.7 Estimation of floats for all activities
Activity Duration ES EF LS LF TF
A 5 0 5 0 5 0
B 5 0 5 3 8 3
C 10 5 15 5 15 0
D 7 5 12 8 15 3
E 6 5 11 17 23 12
F 8 15 23 15 23 0
G 6 15 21 18 24 3
H 5 23 28 23 28 0
I 4 21 25 24 28 3
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154 | Chapter 3
(iii) The Gantt chart is shown in Figure 3.12.
I
22 25
H
23 28
G
15 21
F
15 23
E
5 11
D
1 12
C
5 15
B
1 5
A
1 5
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
Figure 3.12 Gantt chart
Example 3.4
Table 3.8 gives the activity schedule and resource requirement for a project. Draw a Gantt chart
representing the schedule and resource loading chart. What is the peak requirement of the re-
source and on which day does it occur?
Table 3.8 Activity schedule and resources requirement
Activity Duration (Days) Start Finish Number of Workers Required Each Day
A 3 1 3 30
B 2 2 3 20
C 4 4 7 40
D 5 4 8 50
E 3 7 9 30
F 2 8 9 20
G 2 10 11 60
H 3 10 12 30
I 2 12 13 20
J 3 12 14 50
K 1 15 15 30
Note: Assume start at the beginning and finish at the end of the day.
Solution:
This is a simple problem where only the Gantt chart has to be plotted and subsequently, the load or
resources histogram. On the basis of the load histogram, we can determine the day that has the peak
requirement of resources. @Seismicisolation
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The Gantt chart is shown in Figure 3.13. The requirement of labour on each of the days is
shown in Table 3.9.
Table 3.9 Requirement of resources on each day
Day 1 2 3 4 5 6 7 8
Men 30 50 50 90 90 90 110 110
Day 9 10 11 12 13 14 15
Men 50 90 90 100 100 50 80
The resources loading chart or the load histogram is shown in Figure 3.14.
Manpower Requirement
Figure 3.14 Resources loading chart
The peak requirement is for 110 men and this happens on day 7.
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Example 3.5
A project consists of nine activities for which the relevant data is given in Table 3.10.
Table 3.10 Project and relevant data
Total Cash Flow Required

Activity Immediate Predecessor(s) Duration (Days) for Activity (` Lakhs)
A – 5 25
B – 5 30
C A 10 40
D B 7 28
E A 6 12
F C, D 8 24
G C, D 6 15
H E, F 5 10
I G 4 12
(i) Draw the network and find the project completion time.
(ii) Compute total float for each activity.
(iii) Draw the Gantt chart and resources loading chart for the project.
(iv) What is the maximum requirement of cash and on which day does it occur?
Solution:
The first step is to construct the network (Figure 3.15) and identify the longest duration path or the
critical path. Along with this, we will also calculate the total float for the activities. The ES, EF, LS, LF
and total float calculations are shown in Table 3.11.

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Table 3.11 Total float calculations
Activity Duration ES EF LS LF Total Float (Days)

A 5 0 5 0 5 0
B 5 0 5 3 8 3
C 10 5 15 5 15 0
D 7 5 12 8 15 3
E 6 5 11 17 23 12
F 8 15 23 15 23 0
G 6 15 21 18 24 3
H 5 23 28 23 28 0
I 4 21 25 24 28 3
The next step is to plot the Gantt chart, which is as shown in Figure 3.16. The resources loading
chart is shown in Figure 3.17.
The maximum requirement of cash is ` 80 lakhs and this happens from day 5–11.
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158 | Chapter 3
Example 3.6
Draw a Gantt chart and resource graph or the project schedule based on the Table 3.12 and find
out the following:
(i) Total time for completion.
(ii) Days of overallocation of resources if maximum workers available are 20.
Table 3.12 Activity-related details
Activity Predecessors(s) Duration (Days) Allocated Workers
A – 8 4
B – 7 8
C A 6 5
D B 8 4
E B 4 8
F B 8 6
G C, D 5 5
H E 6 4
I F 6 5
J G, H, I 10 6
Solution:
The first step is to construct the network and find out the project completion times, along with the
ES and EF dates. The network is shown in Figure 3.18 and the ES, EF times in Table 3.13.

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Table 3.13 ES and EF calculations
Activity Predecessors(s) Duration (Days) ES EF LS LF Total Float
A – 8 0 8 2 10 2
B – 7 0 7 0 7 0
C A 6 8 14 10 16 2
D B 8 7 15 8 16 1
E B 4 7 11 11 15 4
F B 8 7 15 7 15 0
G C, D 5 15 20 16 21 1
H E 6 11 17 15 21 4
I F 6 15 21 15 21 0
J G, H, I 10 21 31 21 31 0
The longest duration path or critical path is B ~ F ~ I ~ J with duration 31 days. Hence, the total
time of completion of project is 31 days. The Gantt chart should have provision for 31 days and is
Figure 3.19 Gantt chart showing activity progress

The requirement of men for each of these 30 days is shown in Table 3.14.
Table 3.14 Day-wise requirement of resources
Day 1 2 3 4 5 6 7 8
Men 12 12 12 12 12 12 12 22
Day 9 10 11 12 13 14 15 16
Men 23 23 23 19 19 19 14 14
Day 17 18 19 20 21 22 23 24
Men 14 10 10 10 10 6 6 6
Day 25 26 27 28 29 30 31
Men 6 6 6 6 6 6 6
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160 | Chapter 3
The load histogram or the resources loading chart is shown in Figure 3.20.
It can be observed from the load histogram that the maximum requirement of men is 23 and this
happens from day 9–to day 11. Therefore, when the maximum workers available are 20, the days of
over allocation are three.
Note: The question does not ask to plot the load histogram/resources loading chart. Hence, the
students can draw the above inference from Table 3.14.
Example 3.7
Consider following data of a small project given in Table 3.15.
Activity Preceding Activity Duration (Days) Number of Men Required per Day
A – 5 4
B – 7 2
C A 3 2
D A 3 4
E B 2 6
F B 2 3
G D, E 2 3
H F, G 3 4
(i) Calculate the critical path and project duration.

(ii) Plot the resources graph and Gantt chart and determine the requirements of the maximum
number of men and time interval. Assume all activities begin at the earliest.
(iii) Suggest means to reduce the above maximum requirement of men.
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Solution:
The network diagram is shown in Figure 3.21 and the early start (ES), early finish (EF), late start
(LS) and late finish (LF) calculations, along with total float (TF), are as shown in Table 3.16.
2
C3
A5 4m
D3 2m
4m
G2 H3
1 4 5 6
3m 4m
F2
B7
E2 6m 3m
2m
Figure 3.21 Network diagram for Example 3.7
Table 3.16 Total float calculations
Activity Predecessor(s) Duration ES EF LS LF TF

A – 5 0 5 1 6 1
B – 7 0 7 0 7 0
C A 3 5 8 11 14 6
D A 3 5 8 6 9 1
E B 2 7 9 7 9 0
F B 2 7 9 9 11 2
G D, E 2 9 11 9 11 0
H F, G 3 11 14 11 14 0
(a) The critical path is B - E - G - H and the duration of the project is 14 days.
(b) The maximum requirement of men is 15 men on the eighth day (i.e., seventh to eighth day).
(c) The peak requirement of the eighth day can be reduced by delaying activity F by two days,
its total float and starting it on day 11 instead of day 9. As a result, the peak requirement
of men is reduced to 12. We have used the concept of resources smoothing and Figure 3.23
shows the same.
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162 | Chapter 3
Gantt Chart
4 4 4
H
3 3
G
3 3
F
6 6
E
4 4 4
D
2 2 2
C
2 2 2 2 2 2 2
B
4 4 4 4 4
A
0 2 4 6 8 10 12 14 16
Number 6 6 6 6 6 8 8 15 9 3 3 4 4 4
of men
Maximum
men
Figure 3.22 Gantt chart and problem day identification
Gantt Chart after rescheduling Activity F
4 4 4
H
3 3
G
3 3 Activity F
F Delayed by
6 6
E 2 Days Float
4 4 4
D
2 2 2
C
2 2 2 2 2 2 2
B
4 4 4 4 4
A
20 4 6 8 10 12 14 16
Number 6 6 6 6 6 8 8 12 6 6 6 4 4 4
of men
Maximum
men
Figure 3.23 Gantt chart with solution
STEPS INVOLVED IN RESOURCES LEVELLING PROBLEMS

Some steps involved in resources levelling problems are explained in the examples solved below.
The major steps and the reasoning for these steps are listed as follows:
1. The project network needs to be drawn and the total floats for each activity must be calculated.
2. We define a term called ‘halt time’. Halt time refers to the time duration when we have to
assign resources to activities. This means that it is applicable only when allocable resources
are available. If the resources are already allocated to some activity and are fully engaged,
there is no halt time in that period.
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3. The next column is ‘available resources’. It is not that all the resources are available at all halt
times, and hence, this column is required.
4. When resources are available and there is more than one allocable activity, there are certain
priority rules to be observed in making the allocation of resources. The first priority rule is
the total float for each activity under consideration. Activities with the least total float are
given the highest priority for allocation of resources. Unallocated activities are reconsidered
for allocation at the next halt time. It must be remembered that if there is any unallocated
activity waiting for resources allocation, the total float of that activity and subsequent
activities dependent on that particular activity keeps on reducing. Hence, at the next halt
time, the reduced float should be considered for decision-making.
5. Sometimes, there could be activities with the same total float times or a situation might
arise when one of the floats is negative. In such situations, the total float times cannot be
considered for choosing priority of allocation of resources to activities. When this occurs,
we choose priority rule number 2, which states that the activity requiring higher man-days
(product of number of men and activity times) should be allocated the resources first.
6. When there is a tie to apply priority rule 2, the priority rule states that the activity requiring
a higher number of men/resources should be allocated resources first. Suppose activity A
has a duration of five days and requires four men, and activity B has a duration of four days
but requires five men. The man-days required in both the cases are equal and is 20. In such
cases, we will allot the resources to activity B, because it requires more resources (five men)
as compared with activity A which requires less resources (four men).
7. Even if priority rule 3 cannot be applied because of a tie (say activity A has a duration of
four days and require four men, and activity B has a duration of four days and require four
men), the activity lower down in the network sequence is given the higher priority in making
allocations.
8. Finally, if the allocable resources are less than that required by a higher priority activity at
any halt time, the next higher priority activity can be considered for allocations, provided the
available resources are sufficient for the next priority activity.
9. This approach to solve the resources levelling problem is basically a trial and error method.
It has proven to be very useful in most similar problems.
Example 3.8
Draw a Gantt chart and a resource graph for the project schedule based on Table 3.17 and find
out the following:
(a) Total time for completion if activity duration is given in days.
(b) Days of overallocation of resources if maximum available workers are 20.
(c) Within the constraints of 20 workmen, work out the best possible allocations.
Activity A B C D E F G H I
Predecessor(s) – – A B B B C, D E F
Duration 8 7 6 8 4 8 5 6 6
Workers 4 8 5 4 8 6 5 4 5
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164 | Chapter 3
Solution:
In this case, there is a constraint on available workmen, which means that there is a possibility of
the project getting extended. This is a problem of resource levelling (and not resource smoothing). A
heuristic approach is made for resource allocation and the steps are as follows:
1. Allocate resources serially in time. Start on the first day and schedule all jobs possible, then do
the same for the second day and so on.
2. When several jobs compete for the same resources, give preference to jobs with the least float.
In case of a tie between two jobs with the same least float, select the job with higher man-days.
In case of a further tie, select the job which requires maximum men. For further tie, select activity
with the least identification number.
3. If possible, reschedule non-critical jobs to free resources for scheduling critical or non-float
jobs.
Some procedural points are as follows:
1. Whenever resources are allotted to an activity, mark an * symbol next to the activity in the
network analysis table. This will keep a tab on activities that have been allocated resources
and those activities which have so far not been allocated.
2. Halt when resources are available for allocations. This means that some of the past activities
have been recently completed and resources can be allocated to subsequent activities.
3. Prior to allocation at a halt, update the ES, EF and float of the activities not allotted at earlier
halt times and their succeeding activities. It should be remembered that a non-critical activity
when delayed up to its total float time, can become critical. The repercussions of the delay
in a non-critical activity start times must be traced right to the last event as it generally has a
cascading effect. Once the float of any activity becomes negative, the priority rule ‘least total
float’ cannot be further applied.
4. Priorities are assigned on the basis of floats, with higher priority given to jobs with least float
times as long as the total floats are positive or zero. In case of a tie on float times, priority is
given to an activity that requires higher man-days (M * D). In case of a further tie in float and
in man-days, higher priority is given to the activity which requires more men (M). If activity
A requires two men and has a duration of 5 days, then the man-days required is 10. If activity
B has a requirement of five men and has a duration of 2 days, then the man-days required is
again 10.
5. Since activity B requires more men (5), it is given priority over activity A. For the sake of
argument, if the duration of activity A was six days, which means 12 man-days, then activity
A would be given priority when compared to activity B.
6. In case all the three priority rules cannot be applied due to a tie, then the activity which is
ranked earlier (or lower) is given precedence over the activity with higher rank or which
comes later. For example, activity 1-2 would be preferred ahead of activity 2-3 for allocating
resources.
7. It might happen during allocation that the activity requires more persons than available.
In such cases, the resources are allocated to the job with next priority for which they are
sufficient.
8. When the float of any activity becomes negative, it means that the project duration is going to
be extended beyond the initial estimate of project duration. Once the float becomes negative,
therefrom, the float criteria for ascertaining priorities is invalidated. The priorities are then
fixed on the basis of M * D, gang size (M) and lower rank criteria.
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The first step in the solution is to construct the network and to identify the critical path.
Figure 3.24 Network in AOA convention and critical path
The second step is to compute the ES, EF, LS, LF and total floats in a network analysis table, as
Activity Duration (D) Men (M) Man-days (M * D) ES EF LS LF Float

A 8 4 32 0 8 2 10 2
B 7 8 56 0 7 0 7 0
C 6 5 30 8 14 10 16 2
D 8 4 32 7 15 8 16 1
E 4 8 32 7 11 11 15 4
F 8 6 48 7 15 7 15 0
G 5 5 25 15 20 16 21 1
H 6 4 24 11 17 15 21 4
I 6 5 30 15 21 15 21 0
Step 1:
Path 1: 1 - 2 - 4 - 7, Duration = 19 days.
Critical path: 1 - 3 - 6 - 7.
Critical Path activities: B - F - I.
Critical path duration: 21 days. The duration of the project (to start with) is 21 days.
Step 2: Network analysis table. The total man-days required are 309 and critical path duration is
21 days. Hence, the number of men required is 309√21 = 14.71 ~ 15. In the present problem, we have
20 workmen, and hence, adequate resources are available.
The question also asks for days of overallocation, which means we have to plot a Gantt chart,
calculate day-wise resource requirement table and (not necessarily) the load histogram.
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166 | Chapter 3
The Gantt chart is shown in Figure 3.25, the resources requirement table in Table 3.19 and the
load histogram in Figure 3.26.
As only 20 men are available for allocation on days 8, 9, 10 and 11, when we require 22, 23, 23
and 23 men, respectively, we have a situation of overallocation.
Table 3.19 Daily resources requirement
Day 1 2 3 4 5 6 7
Men 12 12 12 12 12 12 12
Day 8 9 10 11 12 13 14
Men 22 23 23 23 19 19 19
Day 15 16 17 18 19 20 21
Men 14 14 14 10 10 10 5
Figure 3.26 Load histogram/resources requirement plot

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Step 3: The completed resources allocation table is shown in Table 3.20. (This step is required for
resources levelling problems. From 2010, Mumbai University papers on Project Management have
included these problems).
Table 3.20 Resources allocations table
Halt Time Resources Available Activity M:D Float Priority Allocation

0 20 M A 4*8 2 II 4M
B 8*7 0 I 8M
7 16 M D 4*8 1 II 4M
E 8*4 4 III 0
F 6*8 0 I 6M
8 10 M E 8*4 3 II 0
C 5*6 2 I 5M
14 10 M E 8*4 – I 8M
15 12 M G 5*5 – II 5M
I 5*6 – I 5M
18 10 M H 4*6 – I 4M
20 11 M
21 16 M
24 20 M
Notes:
1. At halt time 7, activity E cannot be allotted any resources because it requires eight men,
whereas after allocating to higher priority activities, that is, F and D, resources left for alloca-
tion is only 6.
2. At halt time 8, there are 10 men available, but activity C can also be considered for allocating
resources that has float 2, which is less than float of activity E. It should be further noted that
at halt time 7, float for activity E was 4, which is reduced to 3 at halt time 8. This is because
one day of the float is consumed from halt time 7 to halt time 8.
3. At halt time 14, activity E is being considered because it is the only activity which can be
processed. Although activity C is completed, activity G cannot commence till activity D is
completed.
4. At halt time 15, activity I is given preference over activity G because activity I requires more
man-days. However, because of availability of resources, both the activities G and I get the
required resources.
The project duration will now be for 24 days (and not 21 days as calculated earlier). This is
because activity E gets delayed and can start only on day 14. On day 7, activity E gets the least
priority and as it requires eight men, we cannot allot anyone as only six men are remaining for
allocation. Similarly, on day 8, activity C with a float of two days (compared to activity E’s now
reduced three days float) gets priority and once again, activity C suffers as there are only five
allocable workmen.
If we plot a Gantt chart, the project extension is clearly seen. The maximum requirement is, how-
ever, limited to 20 men. This is shown in Figures 3.27 and 3.28.
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168 | Chapter 3
Figure 3.27 Gantt chart for extended project

Figure 3.28 Daily resource requirement diagram

It can be seen from the load histogram that the maximum requirement of men is 18 men, but the
duration of the project is 24 days.
If we are told that we have to use minimum number of resources (and not 20), let us see how to
optimize the use of these resources. Steps 1 and 2 would not change and are reproduced here.
Figure 3.29 Network in AOA convention and critical path

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Step 1:
Critical Path: 1 - 3 - 6 - 7.
Critical Path activities: B - F - I.
Critical Path duration: 21 days.
Step 2: Network analysis table. The sum total of all the man-days required is 309 and critical
path duration is 21 days. Hence, the minimum number of men required to complete all the tasks,
presuming that the task requirement of men is uniform, is 309/21 = 14.71 ~ 15.
Activity Duration (D) Men (M) Man-days (M : D) ES EF LS LF Float

A 8 4 32 0 8 2 10 2
B 7 8 56 0 7 0 7 0
C 6 5 30 8 14 10 16 2
D 8 4 32 7 15 8 16 1
E 4 8 32 7 11 11 15 4
F 8 6 48 7 15 7 15 0
G 5 5 25 15 20 16 21 1
H 6 4 24 11 17 15 21 4
I 6 5 30 15 21 15 21 0
Step 3:
The resources allocation table is shown in Table 3.22.
Table 3.22 Resources allocation table
Halt time Resources Activity M:D Float Priority Resources Allocated

0 15M A 4*8 2 II 4
B 8*7 0 I 8
7 11M D 4*8 1 II 4
E 8*4 4 III 0
F 6*8 0 I 6
8 5M E 8*4 3 – –
C 5*6 2 I 5
14 5M E 8*4 – – –
15 15M E 8*4 – I 8M
G 5*5 – III 0
I 5*6 – II 5M
19 10M G 5*5 – I 5M
H 4*6 – II 4M
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170 | Chapter 3
Table 3.22 Resources allocation table (Continued)

21 6M
24 11M
25 15M
Notes:
1. At halt time 8, activity E cannot be considered for allocation because it requires eight men,
whereas only five men are available.
2. Again, at halt time 14, five men are available and hence, activity E cannot be considered for
allocation. Activity G cannot be considered for allocation because the prior activity D is not
yet completed.
3. The project will be complete in 25 days but requires a maximum of only 15 men.
The project would be completed in 25 days, as activity H commences on day 19 and requires six
days. It can be seen that in the earlier case with 20 men, we could finish the project in 24 days but
with a resource of 15 men, we can complete the project in 25 days. Hence, at the cost of one extra
day for the project, the cost of employing five men for 24 days can be avoided. The revised Gantt
chart and load histogram are shown in Figures 3.30 and 3.31, respectively.
Figure 3.30 Revised Gantt chart for project with duration of 25 days
Figure 3.31 Daily requirement of resources

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Example 3.9
A project with the following activities, duration in days and manpower requirements is given in
Table 3.23.
(a) Draw the network diagram of the project indicating the earliest start, earliest finish, latest
start, latest finish and the float of each activity.
(b) There are 11 persons who can be employed for the project. Carry out the appropriate man-
power levelling so that the fluctuation of workforce requirement from day-to-day is as small
as possible.
ICWA, June 1979
Table 3.23 Project-related data
Activity 1–2 1–3 1–4 2–5 2–6 3–7 4–8 5–9 6–9 7–8 7–9
Duration 2 2 0 2 5 4 5 6 3 4 6
Men 5 4 0 2 3 6 2 8 7 4 3
Solution:
The three steps for solving the resource levelling problem are: constructing a network, constructing
a network analysis table and constructing a resource allocation table. All these are as shown in
Figure 3.32 and Tables 3.24 and 3.25, respectively.
Figure 3.32 Project network diagram
In the end, we plot the activity loading Gantt chart and the load histogram for the daily require-
ment of resources. These are shown in Figures 3.33 and 3.34, respectively.
Step 1: Critical Path calculations

Path 3: 1 - 3 - 7 - 8 - 9, Duration = 16 days.
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172 | Chapter 3

Path 3: 1 - 3 - 7 - 8 - 9 is the longest duration and hence critical path with duration of the project
as 16 days.
Step 2: We now construct the network analysis table as shown in Table 3.24.
Activity Duration Men M:D ES EF LS LF Total Float

1–2 2 5 5*2 0 2 6 8 6
1–3 2 4 4*2 0 2 0 2 0
1–4 0 0 0 0 0 5 5 5
2–5 2 2 2*2 2 4 8 10 6
2–6 5 3 3*5 2 7 8 13 6
3–7 4 6 6*4 2 6 2 6 0
4–8 5 2 2*5 0 5 5 10 5
5–9 6 8 8*6 4 10 10 16 6
6–9 3 7 7*3 7 10 13 16 6
7–8 4 4 4*4 6 10 6 10 0
8–9 6 3 3*6 10 16 10 16 0
Step 3: To complete the resource allocation table in Table 3.25.

0 11M 1–2 5*2 6 III 5M
1–3 4*2 0 I 4M
4–8 2*5 5 II 2M
2 9M 2–5 2*2 6 III 0
2–6 3*5 6 II 3M
3–7 6*4 0 I 6M
5 2M 2–5 2*2 3 I 2M
6 6M 7–8 4*4 0 I 4M
7 7M 6–9 7*3 6 I 7M
5–9 8*6 3 –
10 11M 8–9 3*6 0 II 3M
5–9 8*6 0 I 8M
16 11M
Note: At halt time 7, we cannot allot men to activity 5–9 despite having lesser float. This is because
activity 5–9 requires eight men and there are only seven men available for allocation.
The project gets completed in 16 days without any delay.
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The Gantt loading chart is shown in Figure 3.33 and the load histogram is shown in Figure 3.34.
Figure 3.33 Gantt Chart

Figure 3.34 Daily requirement of resources
In conclusion, we can state that the maximum requirement of men for the various tasks is capped
at 11.
Example 3.10
Table 3.26 gives the manpower requirements of each activity in a project.
(a) Draw the network and find out the total float and free float for each activity.
(b) The contractor stipulates that during the first 26 days, only four to five men would be available
and during the remaining days, only eight to 11 men would be available. Rearrange the activi-
ties suitably for levelling the resources and to satisfy the above predecessor requirements.
Solution:
We will first construct the network and identify the critical path. At the second stage, we will do
the network analysis. At the third stage, we will complete the resources allocation table. This is
shown in Figure 3.35 and Tables 3.27 and 3.28, respectively.
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Activity Normal Time Days Manpower Required per Day

1–2 10 2
1–3 11 3
2–4 13 4
2–6 14 3
3–4 10 1
4–5 7 3
4–6 17 3
5–7 13 5
6–7 9 8
7–8 1 11
Figure 3.35 Network showing all the details

Path 2: 1 - 2 - 4 - 6 - 7 - 8, duration = 50 days.
Path 2, 1 - 2 - 4 - 6 - 7 - 8 with duration 50 days is the critical path.
Next, we will complete the network analysis table as shown in Table 3.27.
Activity Duration (D) Men (M) Man-days (M : D) ES EF LS LF Float

1–2 10 2 20 0 10 0 10 0
1–3 11 3 33 0 11 2 13 2
2–4 13 4 52 10 23 10 23 0
2–6 14 3 42 10 24 26 40 16
3–4 10 1 10 11 21 13 23 2
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4–5 7 3 21 23 30 29 36 6
4–6 17 3 51 23 40 23 40 0
5–7 13 5 65 30 43 36 49 6
6–7 9 8 72 40 49 40 49 0
7–8 1 11 11 49 50 49 50 0
The total number of man-days is 377 and for a project duration of 50 days, we would require
377/50 = 7.54 ~ 8 men. However, in the first 26 days, we have only five men and from the 27th day
onwards, 11 men are available.
The next step is to complete the resource allocation table. This is shown in Table 3.28.
Halt Time Resources Available Activity M:D Float Priority Resources Allocated
0 5M 1–2 2 * 10 0 I 2M
1–3 3 * 11 2 II 3M
10 2M 2–6 3 * 14 16 – Cannot
2–4 4 * 13 0 – allot
11 5M 2–4 4 * 13 –ve I 4M
2–6 3 * 14 16 II –
3–4 1 * 10 2 III 1M
21 1M 2–6 3 * 14 – – –
24 5M 2–6 3 * 14 – II –
4–5 3*7 – III –
4–6 3 * 17 – I 3M
27 8M 2–6 3 * 14 – I 3M
4–5 3*7 – II 3M
34 5M 5–7 5 * 13 – I 5M
41 6M 6–7 8*9 – I Cannot
allot
47 11M 6–7 8*9 – I 8M
56 11M 7–8 11 * 1 11M
57 11M
Notes:
1. At halt time 10, only two men are available, which means neither of the two activities 2–6
(requiring three men) and 2–4 (requiring four men) can be allotted the resources.
2. From halt time 11 onwards, the float becomes negative for one of the activities (2–4), and
hence, from this point onwards, we cannot consider floats for assigning priorities in alloca-
tions. For the priority II activity, sufficient men are not available and hence, the available men
are allotted to priority III (3–4) activity.
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176 | Chapter 3
Figure 3.36 Gantt chart showing progress of project
Figure 3.37 Daily resource requirements
3. At halt time 24, activity 4–6 gets the highest priority as its requirement of M * D is the high-
est. Once the three men are allotted to this activity, the remaining two men are insufficient for
the remaining two activities, 2–6 and 4–5.
4. At halt time 27, additional six men (total 11 men) are made available for the project, and
hence, the total available men are eight.
5. At halt time 41, activities 4–6 and 2–6, each requiring three men, are completed, and hence,
six men are available for allocation. However, the activity which can be considered at this
stage—activity 6–7 requires eight men and hence cannot be allotted with the available men.
The project duration is of 57 days. The Gantt chart is shown in Figure 3.36 and the daily resource
requirement graph is shown in Figure 3.37.
Note: This problem was also repeated in MMM, VI Semester, Mumbai University, 2010 question
paper with a small difference. The activity 4–6 and 5–7 require five and three men, respectively,
instead of the above-mentioned three and five men, respectively. As a result of this change, the
solution to problem in 2010 is 51 days.
Example 3.11
A project has the activities as given in Table 3.29. The maximum resource of men available is
40. Prepare an activity resource allocation schedule under the given resource constraints. Find the
duration of the project.
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Activity Predecessor(s) Duration (Days) Required Men

A – 3 20
B – 7 10
C – 6 10
D A 4 30
E A 5 20
F A 4 10
G B, F 5 10
H B, F 4 20
I C, G 2 10
J C, G 4 30
Solution:
Step 1 is to construct the network diagram and identify the total float. The second step is to construct
the network analysis table and the third step is to construct the resources allocation table. The
network diagram is shown in Figure 3.38. The network analysis table is shown in Table 3.30. The
resource allocation table is shown in Table 3.31.
Activity Duration (Days) M M:D ES EF LS LF Total Float

A 3 20 20 * 3 0 3 0 3 0
B 7 10 10 * 7 0 7 0 7 0
C 6 10 10 * 6 0 6 6 12 6
D 4 30 30 * 4 3 7 12 16 9
(Continued)
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178 | Chapter 3
Table 3.30 Network analysis table (Continued)
Activity Duration (Days) M M:D ES EF LS LF Total Float

E 5 20 20 * 5 3 8 11 16 8
F 4 10 10 * 4 3 7 3 7 0
G 5 10 10 * 5 7 12 7 12 0
H 4 20 20 * 4 7 11 12 16 5
I 2 10 10 * 2 12 14 14 16 2
J 4 30 30 * 4 12 16 12 16 0
Resources Resources
Halt Time Available Activity M:D Total Float Priority Allocated
0 40M A 20 * 3 0 II 20M
B 10 * 7 0 I 10M
C 10 * 6 6 III 10M
3 20M D 30 * 4 9 III
E 20 * 5 8 II
F 10 * 4 0 I 10M
6 20M D 30 * 4 6 II
E 20 * 5 5 I 20M
7 20M D 30 * 4 5 II
G 10 * 5 0 I 10M
H 20 * 4 5 III
11 30M D 30 * 4 1 I 30M
H 20 * 4 1 II
12 10M H 20 * 4 0 II
I 10 * 2 2 III 10M
J 30 * 4 0 I
14 10M H 20 * 4 –ve II
J 30 * 4 –ve I
15 40M H 20 * 4 II
J 30 * 4 I 30M
19 40M H 20 * 4 20M
23 40M
Next, we will plot the Gantt chart and the load histogram. The Gantt chart is shown in Figure 3.39
and the load histogram are shown in Figure 3.40, respectively.
We can conclude that the maximum requirement of resources is of 40 men and the project dura-
tion is 23 days, due to the constraint of resources. If there were no resource constraints, the project
could have been completed in 16 days.
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Figure 3.40 Daily requirement of resources chart
Example 3.12
Table 3.32 gives the activity schedule and manpower requirement for a project. Draw the Gantt
chart representing the schedule and resource loading chart. What is the peak requirement of the
resource and on which days does it occur?
Activity Predecessors(s) Duration (Days) Manpower Required

A – 3 60
B – 4 84
C A 2 22
D A 3 36
E B 6 72
F D, E 3 18
G C 5 35
H F 6 42
I G, H 7 56
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180 | Chapter 3
Solution:
The requirement of men is as follows:
Day 1 – Day 3: 144 men
Day 6 – Day 10: 107 men
Day 10 – Day 13: 18 men
Day 13 – Day 19: 42 men
Day 19 – Day 26: 56 men
The peak requirement of 144 men is from day 1 to day 3 and from day 5 to day 6, 143 men are
required. The load histogram is shown in Figure 3.41.
No. of Men Required
Figure 3.41 Daily resource requirement
Example 3.13
For a project consisting of several activities, the durations and required resources for carrying out
each of the activities and their availabilities are given in Table 3.33.
(a) Draw the network, identify the critical path and compute the total float for each of the
activities.
(b) Find the project completion time under the constraints of resource availabilities.
Resources available are operators 50, X = 1, Y = 1, Z = 1.
CA (Final), Nov. 1985
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Activity Equipment Operators Duration (days)

1–2 X 30 4
1–3 Y 20 3
1–4 Z 20 6
2–4 X 30 4
2–5 Z 20 8
3–4 Y 20 4
3–5 Y 20 4
4–5 X 30 6
Solution:
Path 1 - 2 - 4 - 5 is the critical path with duration 14 days. Due to resources constraint, the project
gets completed in 21 days.
Su m m a r y
Resources scheduling by far is the most complex and important aspect of Project Management to
successfully complete the project in time. While planning most projects, the constraints of resources
are generally not considered, and hence, the problems related to ‘scarce’ resources are encountered
during the execution phase. At times, the mechanical equipment like Fork-lift trucks, Cranes, earth
moving equipment can suffer breakdown or may need repairs resulting in their unavailability. As
most projects are executed in remote places, it is not always possible to find alternate equipment
or solutions and this results in unexpected project delays. How well the scheduled can be altered
quickly during such unforeseen circumstances helps the project manager minimize the impact of
these sudden unplanned resource constraints.
It could also happen that the project could be well served by reducing the haphazard requirement
of resources for their better utilization. Although software programs like MS Projects have inbuilt
sub-routines that can alter the project execution schedules when faced with resources constraint,
it is expected that the student of project management and the practitioner is well aware about the
procedures involved therein.
KeyWords
• Total float • Independent float

• Free float • Resources smoothing
• Interfering float • Resources levelling
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182 | Chapter 3
Review Questions
1. Write a short note on resources levelling and resources smoothing.

2. How do resource constraints affect the production schedule? Discuss various problems encoun-
tered in resource allocation to activities under a situation of multiple resource requirement with
limited availability. What are the different alternatives to allocate resources without affecting
the final completion date?
3. What are the ‘driving’ and ‘non-driving’ resources for a project? What do you understand by
the term ‘resource levelling’? What are the different methods used for resource levelling in a
project?
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Chapter
4A DEMAND FORECASTING
FOR COMMERCIAL
APPRAISAL OF PROJECTS
learninG obJeCTives

❍ Understand the role of forecasting as a key input for evaluating the commercial viability of
the projects.
❍ Use the various forecasting methods and understand their suitability for specific situations.
❍ Understand the limitations of each of the forecasting techniques and the concept of ‘errors’
in forecasting.
❍ Use the appropriate excel applications on a case by case basis.
INTRODUCTION
A project is commissioned to create a unique outcome that can be exploited for commercial gains.
The success of the outcome depends on the success of assessment of the macro factors that may,
at a later stage, affect the success of the project. A long-term forecast is, therefore, essential for the
assessment of these macro factors followed by scenario analysis. Forecasting is often characterized
by three key properties as under:
1. Forecasting is always wrong. Predicting the future is never probable without an element of
error. The error component, though inevitable in a forecast, must preferably be at a bare mini-
mum. The forecasting technique which has the least error is, therefore, preferred.
2. Long-term forecast is more erroneous than near term forecast. This is plausible because the
factors that may affect the correctness of the forecast could change over a longer period of
time but are expected to be constant over a short period of time.
3. Forecasting of aggregates is less erroneous than forecasting of individual components. For
example, if a motorcycle manufacturing company wants to predict the demand for each model
it manufactures, it could be more error-prone when compared to predicting the demand for
motorcycles as a whole. Again, this is quite understandable because when we forecast the
aggregate product, over-and under-forecasting get nullified and the picture that emerges is
more correct.
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184 | Chapter 4A
As the long-term demand estimates are key to deciding the size of the project, a clear understanding
of the process of ‘forecasting’ and the resultant errors, termed as residuals must be understood. This
chapter discusses the various forecasting techniques, their limitations and applications, the method
of calculating the residuals (errors) and the interpretation of the errors.
Forecasting concepts can be broadly classified into qualitative and quantitative methods.
Qualitative methods are basically judgmental methods and are applied when there is no past data
available or the past data is considered not indicative of the future. Quantitative forecasting meth-
ods analyze past data which can be cross-sectional or longitudinal data.
FORECASTING MODELS
The diagram in Figure 4.1 below highlights the various Forecasting models and techniques.
QUALITATIVE FORECASTING TECHNIQUES

Qualitative forecasting techniques are subjective techniques where an individual’s discretion plays
an important role in making judgments. As the emphasis is on individual decision, the analysis
Methods in
Forecasting
Qualitative Quantitative
Models Models
Survey using Time Series

Causal Methods
Questionnaire Methods
Sales Force Simple Moving Simple Regression

Composite Average Analysis
Weighted Moving Multiple Regression

Expert Opinion
Average Analysis
Simple Exponential
Delphi Technique
Smoothing Method
Double Exponential
Past Sales Analogy
Smoothing Method
Figure 4.1 Some frequently used forecasting techniques

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Demand Forecasting for Commercial Appraisal of Projects | 185
and conclusions can vary across decision-makers. This is not true in cases where data is available
as the results of the analysis are the same, irrespective of the individual performing the analysis.
Furthermore, due to the individualistic nature of analysis and results, the error component in these
techniques is the highest. These techniques are used when predictions are to be made in a hurry,
when past data is not available or the available past data is considered insufficient to make quantita-
tive assessments.
Customer Surveys
As products are consumed or used by customers, it is imperative to seek the customers’ opinion
about what they desire in the product and how much they are likely to consume. This is done by
means of a survey through a questionnaire about consumer preferences. The survey questionnaires
are either open-ended or close-ended. While the open-ended questionnaires can gather much in-
formation, close-ended questionnaires help in quickly summarizing the data. Both methods have
their share of advantages and disadvantages and based on situations, the appropriate method is
adopted.
A major disadvantage of this technique is that the validity of the survey depends, to a large ex-
tent, on the mindset of the surveyor and the respondent. As this aspect is highly unpredictable, the
outcomes of such surveys can be very vague and not of much use. The exit polls conducted by many
market survey agencies and their widely differing results from the actual reality are an example of
the limitation of this method. To minimize the chances of human error, the survey questionnaire
being designed must pay attention to framing of the questions, the sequence of the questions, the
ranking of questions, etc. A short and crisp questionnaire with pointed questions without personal
questions could be more effective.
Sales Force Composite

This difference from the survey method here is that the target audience for answering the questions
comprises people with knowledge about the market and often, the field sales force. This method is
also considerably less expensive than the elaborate customer survey method. In the survey method,
there is no obligation for the consumer to reply or respond but in case of a sales team, there is an
obligation to fill in the questionnaire as the information is sought from the management. One of the
limitations of this method is that the respondent is concerned whether the estimates offered by him/
her could then be used to set his/her sales target for the next accounting period. Therefore, there is a
tendency to give very conservative estimates. Another disadvantage is that the sales force not being
the end user of the product, their responses could be biased and at best, an opinion of what suits the
end user. In the survey questionnaire method, the end user is the respondent and this helps garner
important information.
Expert Opinion Jury

Sometimes, the opinions of the subject experts matter and are considered more relevant than the
opinion of the end user. The Board of Study (BoS) member in the University who decides on the
course curriculum is considered the subject experts in their respective fields. The course content can
never be decided on the basis of the end user or students in this case. For design of the curriculum,
the BoS members deliberate on the contents of the syllabus and after several debates, finalize the
same in the best interests of the students. While some of the members may insist on more emphasis
on contemporary topics, others might feel that the basics deserve more focus. This is typically the
expert opinion process and the attendant limitation of disagreements can weaken the process of
prediction.
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186 | Chapter 4A
Delphi Technique
In this method, expert opinion is sought from many experts with the condition that the members
are unaware about who the other members are. Delphi technique could be applied if we want to
find the answer to the question, ‘By which year would 4G mobile phones completely replace 3G
mobile phones in India?’ The responses of many subject experts are independently collected and
then analyzed. The summary results can then be circulated to all the members for a second round
of opinion or consensus building. The advantage of this method is two-fold. Since the experts
are unaware about other panelists, their opinions tend to be true to their beliefs. Second, diverse
views on certain topics, if any, could bring more creativity on the subject. The disadvantage of
this method is that the responses being anonymous, the accountability for the views cannot be
fixed on any one member and neither do individual members assume ownership for the outcome
of such an exercise.
Past Sales Analogy

One might get confused here that qualitative techniques are applied when past data is not available,
yet this qualitative technique uses past sales data. However, past sales data is not of the same
product but a similar product. Here, we estimate the sales of one product on the basis of past sales
of similar category of products. These products could be substitute products or complementary
products.
For example, platinum card sales pattern can be similar to gold card sales pattern which was
launched earlier, the pattern of sales for expensive designer watches could be similar to the sales
pattern of expensive sunglasses, both termed lifestyle products, etc.
FORECASTING USING TIME SERIES

Time series is a set of data taken after specific and uniform time space or in common time intervals
such as months, years or weeks. Essentially, a series of data indexed in time order is used to plot
graphs and give a pictorial image of the trends therein. A time series analysis comprises methods
to analyze the time series data in order to extract meaningful characteristics and statistics from the
data. Similarly, time series forecasting is the use of a model to predict future values based on previ-
ously observed values. Time series data differs from cross-sectional data in that time series data has
an ‘order’ whereas cross-sectional data, generally, lack natural order.
Simple Moving Average

The simple moving average method of forecasting is suitable under situations where there is neither
growth nor any positive or negative trend. In this case, the forecast values are based on the average
of the values of some periods as defined. If the average is a four-period moving average, then the
average of the recent four time periods is taken as the forecast for the next period. If the average is
a five-period moving average, then the average of the recent five-period data is taken as the forecast
for the next period. In general, forecast using ‘n’ time periods is given by:
Ft = (At–1 + At–2 + ... + At–n)/n
where A denotes actual sales data and F denotes forecasted sales data. Example 4.1 explains the
method.
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Example 4.1
Data in Table 4.1 comprise actual sales for the past 14 years. Find the forecast for the 15th year
using ‘two years’ as well as ‘three years’ moving averages. Which of the two forecasts is more reliable
on the basis of mean squared error (MSE) criterion?
Table 4.1 Data on sales for 14 years
Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Sales 2.3 2.2 2.0 2.25 2.60 3.0 3.5 4.1 3.8 4.0 4.3 4.2 4.8 5.2
Solution:
Forecast for year 15 (F15),
Three-year Moving Average Two-year Moving Average

F15 = (A14 + A13 + A12)/3 F15 = (A14 + A13)/2
F15 = (5.2+4.8+4.2)/3 F15 = (5.2 + 4.8)/2
F15 = 4.733 F15 = 5
Therefore, we can see that the forecast based on three years and two-year period is different.
The second part of the question is: which of the forecasts is better. This is obtained by computing
the mean squared error (MSE). MSE analyzes the forecasting error and is explained in the following
section along with other forecasting error calculation methods.
Errors in Forecasting
Forecasting and thus, prediction, are never completely correct. This is because no one other than
God can forecast the future. Although this may be true, we can use errors in identifying the forecast-
ing techniques which are more correct than others. It must be noted that the success of methods also
depends on the data to a large extent, and we cannot generalize observations on the basis of a few
numerical data. This means we cannot conclude that a three-period moving average is always better
than a two-period moving average or vice versa. It all depends on the data. Some common errors
are summarized here.
Running Sum of Forecast Errors (RSFE): The forecast error is the difference between the
1.
actual data computed at the end of the period and the forecast data made for the period
earlier. The sum of all these differences is known as RSFE.
n
RSFE = ∑ (A − F )
t t
t =1
where n is the number of observations.

Mean Forecast Error (MFE): The mean forecast error is the average error for all the past data.
2.
For the purpose of calculating errors, we use the forecasting model to make forecasts for past
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188 | Chapter 4A
time periods. The difference between the actual figure and the forecasted figure is the error.
The average error is a comparison tool for deciding the better forecasting model. The model
with lower MFE is preferred.
n
1
MFE =
n ∑ (A − F ) t t
t =1
where n is the number of observations.

The MFE, also known as BIAS, needs to be as close to zero as possible for minimum bias.
A large positive (or negative) MFE means that the forecast is lower than the actual (or higher
than the actual) figures. It may be noted that zero MFE does not imply that forecasts are per-
fect (zero error), but only that the ‘mean’ is on target, which could also be because the positive
error nullifies the negative error.
3. Mean Absolute Deviation (MAD): In the MFE method, extreme variations (variations on the
plus side and variations on the minus side) even out each other, and hence, the correct quan-
tum of error is unknown. To overcome this limitation, we take the modulus value of the dif-
ference between actual and forecasted values, thus obtaining only positive error. The average
of all these errors is termed MAD.
n
1
MAD =
n ∑ A −F t t
t =1
Mean Squared Error (MSE): Another method to overcome negation of extreme values is
4.
to average the squares of their differences so that there would be only positive values for
forecasting error at each time period. In addition to this advantage of retaining the extreme
values, larger differences get exemplified and thus it recognizes the fact that large errors are
more ‘expensive’ than small errors. The average of all the squared errors is termed MSE.
n
1
∑(A − F )
2
MSE = t t
n t =1
Root Mean Square Error (RMSE): This is the square root of mean square error (MSE calcu-
5.
lated by the following formula.
Symbolically, RMSE = MSE

Mean Absolute Percentage Error (MAPE): This is somewhat similar to MAD; MAPE is the
6.
mean of absolute differences between the actual and the forecasted values expressed as a
percentage of the actual values.
n
100 At − Ft
MAPE =
n ∑ At
t =1
Let us consider Example 4.1 and explain the computation of all these error terms. Forecast
error analysis for two-period moving average is given in Table 4.2.
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Table 4.2 Forecast error analysis for two-period moving averages
2 At − Ft
Year Sales At Forecast Ft At − Ft At − Ft ( At − Ft ) At
1 2.3
2 2.2
3 2 2.25 –0.25 0.25 0.06 0.13
4 2.25 2.1 0.15 0.15 0.02 0.07
5 2.6 2.125 0.475 0.475 0.23 0.18
6 3 2.425 0.575 0.575 0.33 0.19
7 3.5 2.8 0.7 0.7 0.49 0.20
8 4.1 3.25 0.85 0.85 0.72 0.21
9 3.8 3.8 0 0 0.00 0.00
10 4 3.95 0.05 0.05 0.00 0.01
11 4.3 3.9 0.4 0.4 0.16 0.09
12 4.2 4.15 0.05 0.05 0.00 0.01
13 4.8 4.25 0.55 0.55 0.30 0.11
14 5.2 4.5 0.7 0.7 0.49 0.13
© 4.25 4.75 2.81 1.34
RSFE 4.25
©/n MFE 0.35
©/n MAD 0.40
©/n MSE 0.23
©/n RMSE 0.05
©/n MAPE 11.17
The forecast error analysis for a three-period moving average is given in Table 4.3.
Table 4.3 Forecast error analysis for three-period moving averages
2 At − Ft
1 2.3
2 2.2
3 2
4 2.25 2.17 0.08 0.08 0.01 0.04
5 2.6 2.15 0.45 0.45 0.20 0.17
6 3 2.28 0.72 0.72 0.51 0.24
(Continued)
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190 | Chapter 4A
Table 4.3 Forecast error analysis for three-period moving averages (Continued)
2 At − Ft
7 3.5 2.62 0.88 0.88 0.78 0.25

8 4.1 3.03 1.07 1.07 1.14 0.26
9 3.8 3.53 0.27 0.27 0.07 0.07
10 4 3.80 0.20 0.20 0.04 0.05
11 4.3 3.97 0.33 0.33 0.11 0.08
12 4.2 4.03 0.17 0.17 0.03 0.04
13 4.8 4.17 0.63 0.63 0.40 0.13
14 5.2 4.43 0.77 0.77 0.59 0.15
© 5.57 5.57 3.88 1.48
RSFE 5.57
©/n MFE 0.51
©/n MAD 0.51
©/n MSE 0.35
©/n RMSE 0.12
©/n MAPE 13.44
It must be noted that there are 12 forecasts in a two-period moving average and 11 forecasts in a
three-period moving average method. The denominator for average/mean calculations must be suit-
ably modified.
Example 4.2
Following data in Table 4.4 is available about the actual sales quantities for the past 12 years.
Table 4.4 Yearly sales data
Year 1 2 3 4 5 6 7 8 9 10 11 12
Sales 75 80 98 128 137 119 102 104 100 102 82 73
Find the forecast for the year 13 using five years as well as four years moving averages. Which of the
two forecasts is more reliable using the MSE criterion?
Solution:
This analysis is shown in Table 4.5. Remember that the forecast using four time periods method is
as follows:
F13 = (A12 + A11 + A10 + A9)/4
or Ft = (At–1 + At–2 + At–3 + At–4)/4
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Table 4.5 Four-period moving averages method
Year Sales At Forecast Ft Error (At - Ft) (At – Ft)2

1 75
2 80
3 98
4 128
5 137 95.25 41.75 1743.06
6 119 110.75 8.25 68.06
7 102 120.5 –18.5 342.25
8 104 121.5 –17.5 306.25
9 100 115.5 –15.5 240.25
10 102 106.25 – 4.25 18.06
11 82 102 –20 400.00
12 73 97 –24 576.00
13 89.25
Sum 3693.94
MSE 461.74
Similarly, the forecast for a five time period method is given in Table 4.6.
F13 = (A12 + A11 + A10 + A9 + A8)/5
or Ft = (At–1 + At–2 + At–3 + At– 4 + At–5)/5
Table 4.6 Five-period moving averages method
Year Sales At Forecast Ft Error (At – Ft) (At – Ft)2

1 75
2 80
3 98
4 128
5 137
6 119 103.6 15.4 237.16
7 102 112.4 –10.4 108.16
8 104 116.8 –12.8 163.84
9 100 118 –18 324
10 102 112.4 –10.4 108.16
11 82 105.4 –23.4 547.56
12 73 98 –25 625
13 92.2
Sum 2113.88
MSE 301.98
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192 | Chapter 4A
The MSE is 301.98 for the five-period moving averages and it is less than MSE of 461.74 calculated
for the four-period moving averages method. This tells us that the five-period moving averages
method gives a better forecast for this data. The forecast for year 13 as obtained by five-period mov-
ing averages is 92.2, which is less erroneous and hence suitable.
Example 4.3
Following data (Table 4.7) is available about the actual sales quantities for the past 12 years. Find
the forecast for year 13 using five years as well as four years moving averages. Which of the two
forecasts is more reliable on the basis of mean square criterion?
Table 4.7 Annual sales data for 12 years
Year 1 2 3 4 5 6 7 8 9 10 11 12
Sales 40 45 35 30 40 50 55 60 65 50 45 50
Solution:
The simple moving averages formula for five years (or five-periods) and for four years (or four-
periods) is given in Table 4.8.
Table 4.8 Formulae for moving averages
Five-Period Four-Period
( A12 + A11 + A10 + A9 + A8 ) ( A12 + A11 + A10 + A9 )

F13 = F13 =
5 4
( A t−1 + A t−2 + A t−3 + A t−4 + A t−5 ) ( A t−1 + A t−2 + A t−3 + A t−4 )
Ft = Ft =
5 4
The analysis for the four-period moving averages method is shown in Table 4.9.
Table 4.9 Four-period moving averages
Year Actual Sales At Forecast Sales Ft Error (At – Ft) Error2 (At – Ft)2
1 40
2 45
3 35
4 30
5 40 37.5 2.50 6.25
6 50 37.5 12.50 156.25
7 55 38.8 16.25 264.06
8 60 43.8 16.25 264.06
9 65 51.3 13.75 189.06
10 50 57.5 –7.50 56.25
11 45 57.5 –12.50 156.25
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12 50 55.0 –5.00 25.00

13 52.5
MSE 139.65
The forecast using the four-period averages method is 52.5 for year 13. The mean squared error
(MSE) for this method is 139.65.
The analysis for the five-period moving averages method is shown in Table 4.10.
Table 4.10 Five-period moving averages
1 40
2 45
3 35
4 30
5 40
6 50 38.0 12.00 144.00
7 55 40.0 15.00 225.00
8 60 42.0 18.00 324.00
9 65 47.0 18.00 324.00
10 50 54.0 – 4.00 16.00
11 45 56.0 –11.00 121.00
12 50 55.0 –5.00 25.00
13 54.0
MSE 168.43
The forecast for year 13 using the five-periods moving average method is 54. The MSE for this
method is 168.43, which is higher than the MSE for the four-periods moving average method, and
hence, the forecast using the four-periods moving average method is more accurate.
Example 4.4
Following data (Table 4.11) is available about actual sales quantities for the past 10 years.
Table 4.11 Actual sales data
Year 1 2 3 4 5 6 7 8 9 10
Sales 230 220 200 240 230 260 300 240 280 320
Find the forecast for year 11 using two years as well as three years moving averages method. Which
of the two forecasts is more reliable on the basis of MSE criterion?
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Solution:
The simple moving averages formula for two years (or two-periods) and for the three years (or
three-periods) is given in Table 4.12.
Two-Period Three-Period
( A10 + A9 ) ( A10 + A9 + A8 )
F11 = F11 =
2 3
( A t−1 + A t−2 ) ( A t−1 + A t−2 + A t−3 )

Ft = Ft =
2 3
The analysis for the two-period moving averages method is shown in Table 4.13.
Table 4.13 Two-period moving averages
1 230
2 220
3 200 225.0 – 25.00 625.00
4 240 210.0 30.00 900.00
5 230 220.0 10.00 100.00
6 260 235.0 25.00 625.00
7 300 245.0 55.00 3025.00
8 240 280.0 – 40.00 1600.00
9 280 270.0 10.00 100.00
10 320 260.0 60.00 3600.00
11 300.0
Total 10575.00
MSE 1321.88
The forecast using the two-period averages method is 300 for year 11. The MSE for this method
is 1321.88.
The analysis for the three-period moving averages method is shown in Table 4.14.
Table 4.14 Three-period moving averages
1 230
2 220
3 200
4 240 216.7 23.33 544.44
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5 230 220.0 10.00 100.00

6 260 223.3 36.67 1344.44
7 300 243.3 56.67 3211.11
8 240 263.3 – 23.33 544.44
9 280 266.7 13.33 177.78
10 320 273.3 46.67 2177.78
11 280.0
Total 8100.00
MSE 1157.14
The forecast using the three-period averages method is 280 for year 11. The MSE for this method is
1157.14, which is lower than the MSE for the two-periods moving averages, and hence, the forecast
of 280 is more accurate.
Example 4.5
Following data (Table 4.15) is available about actual sales for the past 10 years.
Table 4.15 Sales data for 14 years
Year 1 2 3 4 5 6 7 8 9 10
Sales 330 320 300 340 330 360 400 340 380 420
Find the forecast for year 15 using two years as well as three years moving averages. Which of the
two forecasts is more reliable on the basis of MSE criterion?
Solution:
The simple moving averages formula for the two years (or two-periods) and for the three years
(or three-periods) is as given in Table 4.16.
Two-Period Three-Period
( A10 + A9 ) ( A10 + A9 + A8 )
F11 = F11 =
2 3
( A t−1 + A t−2 ) ( A t−1 + A t−2 + A t−3 )

Ft = Ft =
2 3
The analysis for the two-period moving averages method is shown in Table 4.17.
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196 | Chapter 4A
Table 4.17 Two-period moving averages
1 330
2 320
3 300 325.0 – 25.0 625.0
4 340 310.0 30.0 900.0
5 330 320.0 10.0 100.0
6 360 335.0 25.0 625.0
7 400 345.0 55.0 3025.0
8 340 380.0 – 40.0 1600.0
9 380 370.0 10.0 100.0
10 420 360.0 60.0 3600.0
11 400.0
Total 10575.0
MSE 1321.9
The forecast using the two-period averages method is 400 for year 11. The MSE for the two time
period method is 1321.9. The analysis for the three-period moving averages method is shown in
Table 4.18.
Table 4.18 Three-period moving averages
1 330
2 320
3 300
4 340 316.7 23.3 544.4
5 330 320.0 10.0 100.0
6 360 323.3 36.7 1344.4
7 400 343.3 56.7 3211.1
8 340 363.3 –23.3 544.4
9 380 366.7 13.3 177.8
10 420 373.3 46.7 2177.8
11 380.0
Total 8100.0
MSE 1157.1
As can be seen from the above analysis, the MSE for the two-period moving averages method is
higher than the MSE for the three-periods moving averages method. Hence, the accurate forecast for
period 11 is based on the three time periods moving average and is 380.
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Example 4.6
Following data is available about actual sales quantities for the past 12 years.
Table 4.19 Sales data for 12 years
Year 1 2 3 4 5 6 7 8 9 10 11 12
Sales (Units) 225 240 294 384 411 357 306 312 300 306 246 219
Find the forecast for the year 13 using five years as well as four years moving averages. Which of the
two forecast is more reliable on the basis of MSE criterion?
Solution:
The moving averages formula for four years (or four-periods) and five years (or five-periods) is given
in Table 4.20.
Four-Period Five-Period
( A12 + A11 + A10 + A9 ) ( A12 + A11 + A10 + A9 + A8 )

F13 = F13 =
4 5
( A t−1 + A t−2 + A t−3 + A t−4 ) ( A t−1 + A t−2 + A t−3 + A t−4 + A t−5 )
Ft = Ft =
4 5
The forecast for year 13 using the four-period moving averages is shown in Table 4.21.
Table 4.21 Four-period moving averages method
1 225
2 240
3 294
4 384
5 411 285.75 125.25 15687.56
6 357 332.25 24.75 612.5625
7 306 361.50 – 55.50 3080.25
8 312 364.50 – 52.50 2756.25
9 300 346.50 – 46.50 2162.25
10 306 318.75 – 12.75 162.5625
11 246 306.00 – 60.00 3600
12 219 291.00 – 72.00 5184
13 267.75
MSE 4155.68
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198 | Chapter 4A
The forecast for year 13 using the five-period moving averages is shown in Table 4.22.
Table 4.22 Five-period moving averages method
1 225
2 240
3 294
4 384
5 411
6 357 310.80 46.20 2134.44
7 306 337.20 –31.20 973.44
8 312 350.40 –38.40 1474.56
9 300 354.00 –54.00 2916
10 306 337.20 –31.20 973.44
11 246 316.20 –70.20 4928.04
12 219 294.00 –75.00 5625
13 276.60
MSE 2717.846
The MSE is less for the five-period moving averages method, and hence, the forecast for year
13 using the five-period moving averages, which is 276.6 is more accurate.
Example 4.7
The following data is available about actual sales quantities for the past 14 years.
Table 4.23 Sales data is ` ’000
Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Sales 46 44 40 45 52 66 70 82 76 80 86 84 96 104
Find the forecast for year 15 using ‘three years’ as well as ‘four years’ moving average. Which of the
two forecasts is more ‘reliable’ on the basis of MSE criterion?
Solution:
Three-Period Four-Period
( A14 + A13 + A12 ) ( A14 + A13 + A12 + A11)

F15 = F15 =
3 4
( A t−1 + A t−2 + A t−3 ) ( A t−1 + A t−2 + A t−3 + A t−4 )
Ft = Ft =
3 4
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Table 4.24 Three-period and four-period moving averages
Year Sales At Three-Period Ft Three-Period (At – Ft)2 Four-Period Ft Four-Period (At – Ft)2
1 46
2 44
3 40
4 45 43.33 2.78
5 52 43.00 81.00 43.75 68.06
6 66 45.67 413.44 45.25 430.56
7 70 54.33 245.44 50.75 370.56
8 82 62.67 373.78 58.25 564.06
9 76 72.67 11.11 67.50 72.25
10 80 76.00 16.00 73.50 42.25
11 86 79.33 44.44 77.00 81.00
12 84 80.67 11.11 81.00 9.00
13 96 83.33 160.44 81.50 210.25
14 104 88.67 235.11 86.50 306.25
15 94.67 92.50
MSE 144.97 MSE 215.43
The MSE for three-period moving averages is less when compared with a four-period moving
averages, and hence, the forecast for year 15 using three-period moving averages, i.e., ` 94,670
would be more reliable.
Weighted Moving Average

One of the disadvantages of the simple moving average method is that it gives equal weightage
to all the past periods. However, if a recent happening has more effect on the demand for the
next period, then it is prudent to give more weightage to the most recent data rather than equal
weightage to all the past data. We assign weightage to the recent time periods and the estimate
or forecast is the sum of the product of the weightage and the actual data of the corresponding
period.
Let us assume that we will consider weights for four-periods starting from the most recent
period for which data is available as w1, w2, w3 and w4. Then, the forecast for the 15th period is
as follows:
F15 = A14 * w1 + A13 * w2 + A12 * w3 + A11 * w4
where A denotes actual demand and F denotes the forecast.

In general terms, the forecast for period t obtained using the weighted average method is as follows:
Ft = At–1 * w1 + At–2 * w2 + At–3 * w3 + At–4 * w4

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200 | Chapter 4A
Simple Exponential Smoothing

The drawback of both the earlier methods is that in case of an error in forecast, the models are
not self-correcting. In this simple exponential smoothing method, the forecast error is calculated
at every stage and a factor (percentage) of this error is added into the forecast for the next period.
This percentage depends on the exponential smoothing constant ‘a’ and the value of this is between
0 and 1. Therefore, the value of the exponential smoothing constant is always 0 … a … 1.
Since this element gets incorporated at every stage which results in an exponential effect, as we
proceed to later periods, this method is called exponential smoothing method. In general, the expo-
nential smoothing constant is taken as 0.3.
Symbolically, Ft + 1 = Ft + a (At – Ft) or Ft + a (forecast error)
which is the same as
Ft +1 = a At + (1 – a) Ft
The exhibit in Figure 4.2 describes the concept of exponential smoothing. The recent data gets
a higher weightage of a, the next recent most data, a weightage of (1 – a), the third most data
2
the weightage of (1 – a) and so on.
Exponential Smoothing Component is Past Data
6
5
4
Weightage
a
3
2 a (1 – a)
1
0
1 2 3 4 5 6 7 8 9 10
Data Time Period
Figure 4.2 Concept of exponential smoothing
Example 4.8
The demand for a particular item during the 12 months of a year is as given in Table 4.25. The
manager is considering how well the exponential smoothing serves as an appropriate technique in
forecasting the demand of the item. Five values of the smoothing constant a, 0.15, 0.25, 0.3, 0.5 and
0.75 are considered. Calculate the forecasted values using each of the five values of the smoothing
constant if the initial forecast (F0) is 208. Calculate the MAD for the five series of estimates and sug-
gest which one is most appropriate on the basis of least MAD.
Table 4.25 Demand data for a 12-month period
Month 1 2 3 4 5 6 7 8 9 10 11 12
Demand 213 201 198 207 220 232 210 217 212 225 221 228
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Table 4.26 Forecast and MAD for period 13 for different values of a
0.15 0.25 0.3 0.5 0.75

Month Demand a Ft At − Ft a Ft At − Ft a Ft At − Ft a Ft At − Ft a Ft At − Ft
1 213 208 5.00 208 5.00 208 5.00 208 5.00 208 5.00
2 201 208.8 7.75 209.3 8.25 209.5 8.50 210.5 9.50 211.8 10.75
3 198 207.6 9.59 207.2 9.19 207.0 8.95 205.8 7.75 203.7 5.69
4 207 206.1 0.85 204.9 2.11 204.3 2.74 201.9 5.13 199.4 7.58
5 220 206.3 13.72 205.4 14.58 205.1 14.91 204.4 15.56 205.1 14.89
6 232 208.3 23.66 209.1 22.94 209.6 22.44 212.2 19.78 216.3 15.72
7 210 211.9 1.89 214.8 4.80 216.3 6.29 222.1 12.11 228.1 18.07
8 217 211.6 5.40 213.6 3.40 214.4 2.60 216.1 0.95 214.5 2.48
9 212 212.4 0.41 214.4 2.45 215.2 3.18 216.5 4.53 216.4 4.38
10 225 212.4 12.65 213.8 11.16 214.2 10.77 214.3 10.74 213.1 11.91
11 221 214.2 6.75 216.6 4.37 217.5 3.54 219.6 1.37 222.0 1.02
12 228 215.3 12.74 217.7 10.28 218.5 9.48 220.3 7.68 221.3 6.74
13 217.2 220.3 221.4 224.2 226.3
MAD 8.37 MAD 8.21 MAD 8.20 MAD 8.34 MAD 8.69
Expectedly, we observe that the values of F13 for different values of exponential smoothing con-
stant, a, is different. To identify the best forecast, we need to calculate the error of each option.
The formulae for the various stages are by using the formula,
Ft +1 = a At + (1 – a) Ft
F2 = a A1 + (1 – a) F1
F3 = a A2 + (1 – a) F2
F4 = a A3 + (1 – a) F3
.. .. .. ..
.. .. .. ..
.. .. .. ..
F13 = a A12 + (1 – a) F12
The MAD is the least for the exponential smoothing constant, a = 0.3, and hence, the forecasted
value, i.e., 221.4 is the best estimate for the forecast.
Example 4.9
An initial forecast for the given series is known and is 28. If the exponential smoothing constant,
a = 0.1, find the forecast for the ninth-period.
Table 4.27 Actual data for eight-periods
Period 1 2 3 4 5 6 7 8
Series 30 30 23 28 25 24 29 25
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202 | Chapter 4A
Solution:
The simple calculations are tabled below:
The equation used is Ft = a A t–1 + (1 – a) F t– 1
F2 = 0.1 * A1 + 0.9 * F1
F3 = 0.1 * A2 + 0.9 * F2
… … … ….
… … … ….
F9 = 0.1 * A8 + 0.9 * F8
Table 4.28 Ninth-time period forecast calculations
Period Actual At Forecast Ft

1 30 28
2 30 28.2
3 23 28.38
4 28 27.84
5 25 27.86
6 24 27.57
7 29 27.21
8 25 27.39
9 27.15
Forecast for the ninth-time period is equal to 27.15.
Example 4.10
An initial forecast for the given series is known and is 30. If the exponential smoothing constant,
a = 0.2, find the forecast of sales for the 9th period using the data available in Table 4.29. Is
this method better than Moving Averages Method using 3 periods moving average? Justify your
argument by calculating mean squared error (MSE) for both the methods.
Table 4.29 Actual sales data for Eight-time periods
Period 1 2 3 4 5 6 7 8
Actual Sales 32 34 25 28 24 22 29 25
Solution:
We will first calculate the forecast for the ninth-period using the three-period moving averages
method. This is shown in Table 4.30. The formula to be used for three-period moving averages is
as follows:
( A t−1 + A t−2 + A t−3 )

Ft =
3
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Table 4.30 Three-period moving averages method
1 32
2 34
3 25
4 28 30.33 –2.33 5.44
5 24 29.00 –5.00 25.00
6 22 25.67 –3.67 13.44
7 29 24.67 4.33 18.78
8 25 25.00 0.00 0.00
9 25.33
Total 62.67
MSE 12.53
The forecast for period 9 using the three-period moving averages method is 25.33 with MSE equal
to 12.53. Next, we will make the forecast using the exponential smoothing method with exponen-
tial smoothing constant, a = 0.2. This is shown in Table 4.31.
Table 4.31 Forecast using exponential smoothing method
1 32 30.00 2.00 4.00
2 34 30.40 3.60 12.96
3 25 31.12 – 6.12 37.45
4 28 29.90 – 1.90 3.59
5 24 29.52 – 5.52 30.44
6 22 28.41 – 6.41 41.13
7 29 27.13 1.87 3.49
8 25 27.50 – 2.50 6.27
9 27.00
Total 139.34
MSE 17.42
The forecast for period 9 using the exponential smoothing method is 27, but the MSE is 17.42. We
prefer the three-periods moving average method as the MSE is less there. Therefore, the forecast for
period 9 is 25.33.
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Example 4.11
The past demand for six months is for a given product, shown in Table 4.32.
Table 4.32 Monthly demand data
Month 1 2 3 4 5 6
Demand 32 29 27 36 34 32
(a) Calculate the mean squared error and sales for month 7 using moving average method with
period 3.
(b) Calculate the mean absolute deviation and estimated sales for month 7 using exponential
smoothing method with smoothing constant 0.1. Assume forecast for month 2 as initial value
of 32.
(c) Calculate the mean absolute percentage error for both the forecasting methods.
Solution:
(a) The forecast for time period 7 using the moving averages method with time period 3 is shown
in Table 4.33.
Table 4.33 Three-period moving averages method and MSE
Month Demand Ft (At – Ft)2

1 32
2 29
3 27
4 36 29.33 44.44
5 34 30.67 11.11
6 32 32.33 0.11
7 34.00
MSE 18.56
(b) The forecast for time period 7 using the exponential smoothing method with smoothing con-
stant, a = 0.1, is as shown in Table 4.34.
Table 4.34 Exponential smoothing method and MAD
Month Demand Ft At − Ft
1 32 32.00
2 29 32.00 3.00
3 27 31.70 4.70
4 36 31.23 4.77
5 34 31.71 2.29
6 32 31.94 0.06
7 31.94
MAD 2.97
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(c) The mean absolute percentage error for both the forecasting methods is shown in Table 4.35.
Table 4.35 MAPE calculations for both forecasting methods
At − Ft At − Ft
Month Demand Ft Month Demand Ft
At At
1 32 1 32 32.00 0.00%
2 29 2 29 32.00 10.34%
3 27 3 27 31.70 17.41%
4 36 29.33 18.52% 4 36 31.23 13.25%
5 34 30.67 9.80% 5 34 31.71 6.74%
6 32 32.33 1.04% 6 32 31.94 0.20%
7 34.00 7 31.94
MAPE 9.79% MAPE 7.99%
As the mean absolute percentage error (MAPE) is less for the exponential smoothing method for the
given problem, exponential smoothing method is better.
Simple Regression Analysis

Regression analysis is used when the performance of the dependent variable can be entirely explained
by the performance of the dependent variable. When either of the two variables is not a time series,
this analysis is referred to as regression analysis. If a time series is involved, the same analysis or
method of analysis is termed a fitting a trend line. In both situations, the relationship between
variables is expressed as a linear straight line with a slope (b) and a y-intercept (a). The dependent
variable is expressed in terms of independent variable in case of regression. In case of time series,
the independent variable is always ‘time’ and the other variable is expressed in terms of the ‘time’
variable.
Example 4.12
Table 4.36 shows the average rainfall in Mumbai (in cm per day) and the corresponding sale of
umbrellas (in `’000 per day). Using trend analysis, determine the forecast for the sale of umbrellas
corresponding to the average rainfall in Mumbai at 40.8, 45.2 and 50.4, respectively.
Table 4.36 Data on rainfall and sales of umbrella
Average Rainfall 5.2 9.8 15.4 20.2 25.5 30.6 35.1

Sales of Umbrella 0.65 0.93 2.74 2.56 2.85 4.25 4.42
Solution:
The line of regression or the trend line is given by the equation y = a + bx, where y is the dependent
variable and x is the independent variable.
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206 | Chapter 4A
The other constants are given by the formula:
∑ XY − n XY
b= and a = Y − bX
∑ X2 − n X2
XY − n XY
and a = Y is
where − bXmean of y (dependent) variable,
X 2 − nand
X 2 a = Y − bX
is mean of x (independent) variable,
n is the number of observations.
Remember that while solving these problems, only two additional columns, one each for X2 and XY
is required.
464.27 − 7 × 20.26 × 2.63

b= = 0.128
3586.9 − 7 × 20.262
and a = 2.63 − 0.128× 20.26 = 0.033
The equation of the regression line is y = 0.033 + 0.128x.

Table 4.37 Calculations for slope ‘b’ and y intercept ‘a’
Average Rain, (X) Umbrella Sales, (Y) XY X2

5.2 0.65 3.38 27.04
9.8 0.93 9.11 96.04
15.4 2.74 42.20 237.16
20.2 2.56 51.71 408.04
25.5 2.85 72.68 650.25
30.6 4.25 130.05 936.36
35.1 4.42 155.14 1232.01
Sum 464.27 3586.90
Average 20.26 2.63
Substituting value of x as 40.8, 45.2 and 50.4, we get the values of sales estimate (y) as 5.26, 5.824
and 6.49, respectively.
Example 4.13
Following data (Table 4.38) is available about the actual sales quantities for the past 12 years.
Year 1 2 3 4 5 6 7 8 9 10 11 12
Sales 75 80 98 128 137 119 102 104 100 102 82 73
Find the forecast for year 13 by fitting a trend line.

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Solution:
The required columns and the calculations are shown in Table 4.39.
Table 4.39 Regression analysis
Year (X) Sales (Y) XY X2

1 75 75 1
2 80 160 4
3 98 294 9
4 128 512 16
5 137 685 25
6 119 714 36
7 102 714 49
8 104 832 64
9 100 900 81
10 102 1020 100
11 82 902 121
12 73 876 144
Sum 7684 650
Average 6.5 100
The constants a and b are given by the following formula:
∑ XY − n XY
b= and a = Y − b X
∑ X2 − n X2
7684 − 12 × 6.5 ×100

b= = −0.8112
650 − 12 × 6.52
and a = 100 − (−0.8112) × 6.5 = 105.28
The regression line (or line of good fit in this case as the independent variable is a time series)
is y = a + bx and substituting the values of a and b, we have:
y = 105.28 – 0.8112 x
The forecast for period 13 is
y13 = 105.28 - 0.8112 * 13 = 94.73 ~ 95 units.
Example 4.14
The following hypothetical data (Table 4.40) represents the demand for a particular product (Y)
and its price (X) over a 10-year period.
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208 | Chapter 4A
Demand (Y) 20 30 33 40 15 13 26 38 35 43
Price (X) 7 9 8 11 5 4 8 10 9 10
Establish a linear relationship between demand and price and forecast the demand if the price is 6.
Solution:
The price is the independent variable and the demand is the dependent variable. The required
columns and the calculations are shown in Table 4.41.
Table 4.41 Computation for regression analysis
Demand (Y) Price (X) XY X2

20 7 140 49
30 9 270 81
33 8 264 64
40 11 440 121
15 5 75 25
13 4 52 16
26 8 208 64
38 10 380 100
35 9 315 81
43 10 430 100
Sum 2574 701
Average 29.3 8.1
The constants a and b are given by the following formula:

∑ XY − n XY
b= and a = Y − b X
∑ X2 − n X2
2574 − 10 ×8.1× 29.3

b= = 4.47
701 − 10 ×8.12
a = 29.3 − 4.47 ×8.1 = −6.91

The regression line is y = a + bx and substituting the values of a and b, we have,
Y = - 6.91 + 4.47 X
The forecast of demand when the price is 6, is:
Y6 = - 6.91 + 4.47 * 6 = 19.91 ~ 20 units.

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Tracking Signal
Tracking signal is a method by which the correctness of the forecasting model can be judged after
every time period, and hence, it is a dynamic measure. This method not only helps in selecting the
better forecasting technique but also ensures that the selected method remains correct over a period
of time.
RSFE
Tracking Signal =
MAD
A good forecasting method should have tracking signal near 0. A tracking signal indicates if the
forecast is consistently biased on the higher side or on the lower side. The tracking signal is recom-
puted each period, with updated, running values of cumulative error and MAD. The movement of
the tracking signal is compared to control limits; as long as the tracking signal is within these limits,
the forecast is in control. Control limits of ; 2 to ; 5 are used most frequently. If the tracking signal
is within these limits, then the forecasting errors are within control and the forecasting method gives
satisfactory results.
GENERATION OF PROJECT IDEAS

Projects are undertaken to meet the requirements of consumers for goods and services, which means
that the gap that exists between the requirement and availability of products or services is fulfilled
by undertaking projects. The need for self-sufficiency of natural gas, petroleum products drove
Reliance Petroleum to explore the Krishna Godavari basin and undertake major oil and gas projects
there. The need to modernize airports in major metros was the driving force for the formation of
Mumbai International Airport Ltd., a joint venture between a consortium led by GVL Projects Ltd.,
and other private players. Mumbai Metro One Private Limited (MMOPL), a joint venture com-
pany formed by Reliance Infrastructure, Veolia Transport and the Mumbai Metropolitan Region
Development Authority (MMRDA) is responsible for the construction and running of the metro
railway in Mumbai, which is required to reduce the city’s travel woes. Hence, the concept of a proj-
ect can be generated from the gap between the customer needs for products and services and the
existing available facilities.
Role of Government in promoting projects

In any planned economy, the government has a major role in promoting the ‘thrust area’ for
the development of the country. To that extent, the projects in these areas are supported by the
government by allocating resources, spelling out priorities for the economy, laying out the framework
for development, etc. In the fiscal year 2011–12, the Government of India decided to clamp down
on iron ore exports promote value addition by converting iron ore into pellets (or higher value-
added products) and promote exports of value-added products in iron and steel. Therefore,
many companies hitherto in the business of iron ore exports found it convenient to diversify into
pelletization projects.
It is always profitable to venture into projects that fit into the framework of development laid out
by the government. If export promotion and import substitution are the priority areas identified
by the government, then projects in these sectors would be worthy of being pursued successfully.
If the government announces its policy of development of backward areas, entrepreneurs may find
it advantageous to set up their projects in such backward areas to avail of monetary benefits. Just
as government encourages growth in certain industrial sectors, it also demotivates growth in such
sectors where there is much saturation or where national interests may be harmed. The government
adopts industrial licensing to control new investments in these areas.
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210 | Chapter 4A
The fiscal policy influences the economic activity of a country through a budget, wherein the
government presents details of public revenue and public expenditure to produce desirable effects
on national income, GDP, employment generation, resources allocation, etc. The monetary policy
governed by the Reserve Bank of India manages the quantity of money and the regulation of the
money by increasing or decreasing the cash reserve ratio (CRR), statutory liquidity ratio (SLR), repo
rate (the rate at which the RBI lends short-term money to banks against securities) and reverse repo
rates (the rate at which banks park their short-term excess liquidity with the RBI). As the monetary
policy regulates the volume of money in circulation, it, in turn, regulates the credit policy of banks
which lend finance to projects. Therefore, project execution and timing of project execution are
equally important and influence the project ideas.
Project Identification
There are many ways to identify worthwhile projects for execution. As has been explained in the
earlier sections, the government plays a major role in the process of project identification. If we con-
sider the role of government to be neutral in promoting projects, some of the following factors may
be considered as inputs for project ideas.
1. Success of existing industries: An analysis of the various existing industries provides adequate
information about the financial health of the industry and the major players in this sector.
Although the first mover advantage is lost, the markets are aware about the products/services
and to that extent, the products/services are well received. The boom in the construction
industry witnessed a few years ago was a result of extremely lucrative valuations of business
propositions. Similarly, in the late 1990s, there was a boom in the software industry and every
large organization found it compelling to diversify into software business. The timing of such
projects becomes crucial and the entrepreneur should ensure that the industry is in the growth
phase when a project is launched.
2. Raw material availability: When good quality raw materials are available and are required by
the project in large quantities, the projects are located near the raw material source. Hence,
major textile industries are located in Maharashtra or Gujarat which have cotton in abundance,
iron and steel mills are located in Jharkhand, Bihar and Orissa which have large reserves of
iron ores, the sugar industry is based in and around Maharashtra and Uttar Pradesh as the
major raw material—sugarcane is available in large quantities in these areas.
3. Availability of skilled labour: Skilled and non-militant labour is the requirement of any large
manufacturing industry. Due to extreme unionism in states such as West Bengal and Kerala,
not many industries are willing to set up their base in those states. Based on the locally
available skilled labour force, suitable cottage industries can be identified.
4. Import substitution projects: When products are imported, valuable foreign exchange has to
be spent. Furthermore, the skill sets of the local populace are not being utilized. In such situa-
tions, projects which can be a substitute for imports are advisable. Automobile companies and
automobile spare parts manufacturing companies are good examples of import substitution
and industrialization projects.
5. Product price trends: As per the basic laws of economics, a higher price for a product/
service gives an indication about the demand-supply relationship. A steep rise in price level
indicates a demand-supply gap and hence an opportunity to the entrepreneur for setting up
a project.
6. Research laboratories: Research laboratories that are engaged in the process of identifying
new products or manufacturing systems offer opportunities for exploitation to the entre-
preneur. However, sufficient care should be taken to assess the market potential and scale of
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operations to ensure that the conditions under which laboratory trials were conducted are not
much different than practical conditions.
Unfulfilled psychological needs: At times, there may be unsatisfied psychological needs
7.
although physical needs might have been satisfied. The yoga camp promoted by Baba Ramdev
is one such example. A need for good health was always felt and everyone would subscribe to
it. However, good health with yoga captured the imagination of the masses and the product
‘Baba Ramdev’ became a success so much so that the Patanjali Chikitsalaya promoted by
Baba Ramdev diversified into herbal and ayurvedic treatments and medicines.
Reviving sick units: At any given time in an economy, there could be many industrial units
8.
that might have become sick or are in the path of becoming sick. Such an industry may still
be viable and an entrepreneur having the required skills can take over such units, revive and
turn them around. The takeover of Dunlop Industries by the Kolkata-based Pawan Kumar
Ruia group in 2005 is one such example. Dunlop Industries came out of the Board for Indus-
trial and Financial reconstruction ambit on 19 December, 2007, almost two years after it was
taken over by the Ruia group. However, the subsequent years were not good for Dunlop and
by early 2013, the company faced a winding up notice over unpaid dues.
Wilbur L. Ross, Jr. (born 28 November, 1937) is an American investor known for restructuring
failed companies in industries such as steel, coal, telecommunications, foreign investment and tex-
tiles. He specializes in leveraged buyouts and distressed businesses. In 2011, Forbes magazine listed
Ross as one of the world’s billionaires with a net worth of $1.9 billion. Wilbur Ross is an investor
in Spicejet, the Indian low-cost carrier.
Example 4.15
A motorcycle manufacturer organizes a three-day mela in 10 different areas. The number of sales
staff employed at each of these centres and the number of motorcycle sales booked have a causal
relationship. If the number of salesmen for the next mela is kept at 15, what would be the expected
sales bookings for motorcycles? Use regression analysis for making the prediction.
Table 4.42 Sales data
Salesmen 13 15 11 17 19 14 15 17 13 11
Motorcycles Sold 138 156 123 172 174 148 153 171 141 128
Example 4.16
You are given the following information about demand of an item:
Table 4.43 Sales data
Month 1 2 3 4 5 6 7 8 9 10 11
Demand 220 228 217 219 258 241 239 244 256 260 265
Calculate the forecasted values for period 12 using (i) two-period moving averages, (ii) three-period
moving averages. Which of these two methods is better on the basis of MAD criterion?
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212 | Chapter 4A
Example 4.17
Obtain the profit forecasts for year 2007 using (i) four yearly moving averages and (ii) five yearly
moving averages from the following data (Table 4.44) relating to profits (in `’000).
Table 4.44 Yearly profit data
Year 1991 1992 1993 1994 1995 1996 1997 1998

Profit 50 55 57 58 60 65 70 62
Year 1999 2000 2001 2002 2003 2004 2005 2006

Profit 63 70 60 65 72 78 85 90
Which method has the least mean squared error (MSE)?
Solution:
The MSE for four-period moving average is lower, and hence, this method should be adopted for
making the forecast.
Example 4.18
The port of Baltimore has unloaded large quantities of grain from ships during the past eight
quarters. The port’s operations manager wants to test the use of exponential smoothing to see how
well the technique works in predicting tonnage unloaded. The manager assumes that the forecast of
grains unloaded in the first quarter was 165 tonnes. Two values of a are examined: a = 0.15 and
a = 0.30. Table 4.45 shows the quarterly grain loads in tonnes.
Table 4.45 Quarterly grains tonnage data
Quarter 1 2 3 4 5 6 7 8
Tonnage 175 163 154 170 185 200 175 177
What is the forecast for the ninth quarter? Using the mean absolute deviation (MAD) method, iden-
tify the better exponential smoothing constant.
Example 4.19
The actual demand in ’000 units is known for 10 periods for a particular garment for a Delhi-based
organization. Using the trend line method, predict the demand for the 11th period. The forecast for
the first period is 18. If the exponential smoothing constant, a = 0.25 and a = 0.45, what would be
the forecast for period 11? Which of the methods has a lower MAD?
Table 4.46 Sales data for ten time periods
Period 1 2 3 4 5 6 7 8 9 10
Sales 23 26 20 24 29 25 23 27 29 20
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Example 4.20
A life insurance company wants to use the data of past 12 months to predict the likely sales of
insurance policies in the 13th month. Using the trend line method, help the company in making the
right prediction.
Table 4.47 Insurance policies sold in the past ten months
Month 1 2 3 4 5 6 7 8 9 10 11 12
Policies Sold 130 143 154 135 150 163 171 177 165 184 175 190
Su m m a r y
Forecasting plays a very important role in planning for every activity. In case of projects, it is used
for the commercial and financial viability aspects, an essential part of any Detailed Project Report
(DPR). The application of forecasting techniques is thus limited to the DPR application in case of
projects. However, the key elements of error in forecasting should be understood and adequately
covered by students and practitioners of Project Management for the commercial viability aspects
of projects. Essentially, a pre-work before considering a project, forecasting has limited scope once
the project gets a green light to proceed. We seldom come across forecasting techniques used in the
execution of projects as the resources planning using Gantt charts adequately covers the require-
ment planning.
K EY W ORDS
• Forecasting • Exponential smoothing

• Simple moving averages • Regression analysis
• Weighted moving averages • Tracking signal
Review Questions
1. Explain the usefulness of forecasting errors. How is tracking signal better than MAD or MSE?
2. How are MAD and MSE calculated?
3. What are the limitations of the moving averages method of making a forecast?
4. If you are an entrepreneur, what are the ways or means by which you will identify project
opportunities?
5. What is the role of the government in project ideation? How does the government promote
investments in projects?
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Chapter
4B DECISION TREE ANALYSIS
LearninG oBJeCTiveS

❍ Understand the process of making the right decisions in case of projects and elsewhere.
❍ Apply the learnings of decision-making to real-life problems, by choosing the best option
at each stage of the process.
❍ Understand the sequential decision-making process at a ‘chance’ node and at a ‘firm’ node.
❍ Construct a decision tree listing down the various possible options at each stage.
❍ Consider the expected values of each probabilistic outcomes.
INTRODUCTION
A decision-maker is often confused with several alternatives and with the probabilistic outcomes of
certain decisions. At such times, a structured step-by-step evaluation helps in cancelling the non-via-
ble options and selecting the best options available. Decision tree analysis is suitable when sequential
decision options are considered one at a time and all possible options get evaluated. Decision tree
approach is a diagrammatic technique used for analyzing the gains and losses of alternate decisions
and then choosing the best possible option. In practice, many decisions are much more than simple
single stage types. For such multistage sequential decision-making problems, we must construct
separate decision trees or extensions to the earlier constructed decision trees. A decision tree is, thus,
a pictorial representation of various alternatives and sequence of events in these multistage decision
problems. In case of projects, many alternatives and scenario analysis need to be considered; thus,
the concept of decision tree analysis is very useful in project management.
A decision tree is also a diagrammatic representation of the logical relationship between the
different parts of a complex situation and the possible outcomes of different decisions. A decision
tree diagram comprises two types of nodes or symbols. The node where the decision is in our hands
is known as the decision node and the node where the outcome is not in our hands is known as the
outcome node. The decision node is shown as a rectangle and the outcome node is shown as a circle.
The outcome node is also known as a chance node. Different alternatives available for the given
situation emerge from the decision point. At each chance point, the different possible outcomes of
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216 | Chapter 4B

Decision Node Outcome Node
each alternate decision are marked. Generally, the outcome options for an outcome node are proba-
bilistic and options for a decision node are deterministic.
The financial analysis using numbers in the decision tree is done by using the roll-back technique.
This technique proceeds from the last decision in the sequence and works back to the first for each
of the possible decisions. There are two broad rules to be considered while performing the rollback
process. The first one occurs when the branches emanate from a circle. Here, we must calculate the
total expected payoff value as a result of all the branches. The second rule states that if the branches
emanate from the rectangle, we should select the branch with the highest pay-off and strike-off the
other alternatives.
Example 4.21
A manufacturer of sports cycles is interested to know whether he should launch a deluxe model or a
popular model of the cycle. If the deluxe model is launched, the probabilities that the market would
be excellent, fair or poor are given by 0.45, 0.35 and 0.2, respectively, with payoffs `1,80,000,
`1,00,000 and `20,000 (loss). If the popular model is launched, the probabilities for excellent, fair
and poor markets are given by 0.25, 0.45 and 0.3 with payoffs `2,00,000, `1,50,000 and `20,000
(loss). Decide which model should be launched.
Solution:
The first step is to construct the diagram reflecting the decision nodes and chance/outcome nodes.
This is as shown in the Figure 4.3.
The second step is to make the evaluations for each option. At the chance node I, there are three
possible outcomes, which means, the outcome at I is 0.45 * 1,80,000 + 0.35 * 1,00,000 + 0.2 *
(−20,000) = `1,12,000.
Similarly, at the chance node II, there are three possible outcomes, that is, the outcome at I is
0.25 * 2,00,000 + 0.45 * 1,50,000 + 0.3 * (−20,000) = `1,11,500.
At the decision node, the two options are to take path which leads to chance node I or to take the
path which leads to the chance node II. As the first option yields `1,12,000 we select the first option.
It is pertinent to note that the difference between the two options is very marginal; nevertheless, the
option which gives better returns is preferred.
Example 4.22
‘Tasty corner’ is a popular fast food centre at Ballygunge, Kolkata. It has a heavy rush of custom-
ers during lunch and dinner hours on all days. The proprietor is considering expansion of space
in the restaurant so that more tables may be accommodated, in the neighbouring Swinhoe street.
This will require an investment of `0.7 Million. Another option being considered is opening a new
fast food centre ‘Souvik Refreshments’ near Ashutosh College, Hazra road in Kolkata. The new
fast food centre is located in a prime location and it is assumed that the demand for its products
is pretty high. This option requires an investment of `0.8 Million. Both the investments cannot
be made simultaneously at it stretches the investments and focus on business. Only one option is
possible at a time and should it result in strong demand from the customers, they can go ahead
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Decision Tree Analysis | 217
Payoffs (`)
Excellent Market 45% Chance

180,000
Fair Market 35% Chance

I 100,000
Introduce Deluxe Model

Poor Market 20% Chance
– 20,000
Excellent Market 25% Chance

200,000
Introduce Popular Model
Fair Market 45% Chance
II 150,000
Poor Market 30% Chance

– 20,000
Figure 4.3 Decision tree diagram
with the other option or in case of a weak demand, forgo the remaining alternative. There is a
65% chance of strong demand after capacity expansion of the existing facility and it will result in
a profit of `1.1 million (over investments). After creating a new facility, there is a 75% chance of
strong demand and it will result in a profit of `1.0 Million (over investment). Give your advice to
the management about the best course of action using decision tree analysis.
Solution:
The decision tree is shown in Figure 4.4. The analysis of returns for each option can also be performed
on the network itself and need not be done separately. We add an option of ‘not doing anything’
g
Failure, Prob 0.35

in
Success, Prob 0.75

th
No
Loss, – 0.7 M Profit, + 1.0 M

Do
Open
Profit, + 1.1 M Node New Outlet
I Success, Prob 0.65 B III
Loss, – 0.8 M
nd
pa
Failure, Prob 0.25

Ex
Do Nothing
Node A
Failure, Prob 0.35

Ne
Op Out
w
Loss, – 0.7 M
en let
Success, Prob 0.75 Node Expand

II Profit, + 1.0 M C IV
Do
Loss, – 0.8 M N Profit, + 1.1 M
ot
Failure, Prob 0.25 hi Success, Prob 0.65
ng

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218 | Chapter 4B
just in case the two initial options give negative returns. This additional option is not required in
problems where there is a cost alternative equivalent of ‘not doing anything’.
We will use the rollback technique for evaluation of the various options.
Consider Outcome Node III: There is a 75% chance of making a profit of 1.0 or a 25% chance of
losing 0.8. Hence, the expected payoff or outcome is 0.8 * 1.0 - 0.25 * 0.8 = `0.55 M.
Consider Decision Node B: At this point, there are two decision options. The option of doing noth-
ing will yield 0 returns; whereas the option of going for a new outlet will give a return of `0.55 M.
Hence, this option is selected.
Consider Chance Node I: At this point, there is a 35% chance of losing `0.7 M and 65% chance of
making a profit of `1.1 M. In addition, ahead of this option, there is a gain of `0.55 M. Hence, the
net worth of this option is 1.1 + 0.55 = 1.65. Therefore, the expected payoff at chance node I is 0.65
* 1.65 - 0.35 * 0.7 = `0.8275 M.
Consider Outcome Node IV: There is a 65% chance of making a profit of `1.1 M or a 35% chance of
losing `0.7 M. Hence, the expected payoff or outcome is 0.65 * 1.1 - 0.35 * 0.7 = `0.47 M.
Consider Decision Node C: At this point, there are two decision options. The option of doing noth-
ing will yield 0 returns, whereas the option of going for expansion will give a return of `0.47 M.
Hence, this option is selected.
Consider Chance Node II: At this point, there is a 25% chance of losing `0.8 M and 75% chance of
making a profit of `1.0 M. In addition, ahead of this option, there is a gain of `0.47 M. Hence, the
net worth of this option is 1.0 + 0.47 = `1.47 M. Therefore, the expected payoff at chance node I is
0.75 * 1.47 - 0.25 * 0.8 = `0.9025 M.
Consider Decision Node A: There are three options at this stage. The expand option would give a
return of `0.8275 M, the do-nothing option would give return of 0 and the opening new option
would give a return of `0.9025 M. Hence, the option of opening a new outlet (and later expansion)
is the best alternative.
Example 4.23
The R&D division of a pharmaceutical firm based at Pune has invented a molecule for curing
Type-II diabetes. It has three options—to manufacture the drug, to sell the formulation to another
company or to conduct a market study before taking any action. If it decides to manufacture the
drug outright, then the drug has a 65% chance of success with a profit of `1.1 million, whereas
its failure will result in a loss of `0.25 million. If the company conducts a market study, then there
is a 75% chance that the study will give a positive report which will be favourable to launch the
drug. After the positive report of the study, if the company manufactures the drug, then there
are 70% chances that the drug will be a success, leading to a profit of `1.2 million, whereas, a
failure will result in a loss of `0.35 million. After the negative report of the study, if the company
manufactures the drug, then there are 20% chances that the drug will be a success, leading to a
profit of `1.2 million, whereas a failure will result in a loss of `0.35 million. A competitor firm
is willing to pay `0.5 million if the company sells the formulation before the market study, `0.65
million, if the market study results are positive and `0.45 million, if the market survey results are
negative. What course of action should the company follow? Give your advice using the decision
tree analysis.
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Solution:
The decision tree is shown in Figure 4.5(a) and the calculations in Figure 4.5(b). The analysis of
returns for each option is also performed on the network itself and is shown on the network.
Success
1.1 m
0.65
ug g
Dr urin Success
0.35 1.2 m
– 0.25 m 0.7
th fact
Failure
u
an
e
M
ng
Sell the Drug 0.3
D turi
+0.5 m –0.35 m
to Competitor Failure
ac
g
ru
uf
an
e
M
th
Success Sell the
Te
0.65 m
M
Success
s
ar
Drug
t
0.75 1.2 m
ke
0.2
t
cturing
Manufa
ug
0.25 the Dr
0.8
Failure Sell t –0.35 m
he Failure
Drug 0.45
m
Figure 4.5a Decision tree diagram without calculations
Success
1.1 m
0.65
0.6275
✘ Success
ug g
Dr urin
0.35 1.2 m
– 0.25 m 0.7
th fact
Failure
u
an
e
M
0.735
ng
Sell the Drug ✔ 0.3

0.6638 ✘
D turi
+0.5 m –0.35 m
to Competitor Failure
th fac
g
ru
u
an
e
M
Success Sell the

Te et
0.735 ✘ 0.65 m
M
Success
st
✔
ar
0.75 Drug 1.2 m

k
0.2
0.6638 cturing
Manufa –0.04
✘ ug
0.25 the Dr
0.45 0.8
Failure Sell t –0.35 m
he Failure
Drug
✔
0.45
m
Figure 4.5b Decision tree diagram with calculations
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220 | Chapter 4B
It must be noted that the market survey report can either be positive or negative, but in each case,
the outcome is positive; hence, the outcome of market study option is 0.8 * 0.61 + 0.2 * 0.4 = 0.568.
Many times, just because the market survey is negative, students end up subtracting the returns of
that branch which is incorrect and could lead to wrong conclusions.
Example 4.24
A company has an investible surplus of `100 Crores. Investing this amount in an existing business
will give an assured return of 8%. Alternatively, this amount can be invested in diversification,
which if,
1. Successful, will give an estimated return of 17%.
2. Unsuccessful, will give an estimated return of 2%.
What should be the probability of success of the diversification alternative to make it worthy of
consideration?
Solution:
The decision tree showing the alternatives is shown in Figure 4.6.
s
es
sin 8%
bu
i ng
ist
Ex
D1 Successful
17%
Di
ve
r sifi
ca
tio
n C1
Unsuccessful
2%
Let ‘b’ be the chance of success, then the chance of failure is (1 - b).
Evaluation of chance C1 = b * 17% + (1 - b) * 2%.
Minimum of amount of risk to diversify would be to equalize C1 to assured return of investible
surplus in old business, which is 8%.
Hence, 17 b + 2 * (1 * b) = 8, which gives b = 0.375.
Hence, the probability of success should be at least 0.375 (and probability of failure should be
0.625), in case the diversification alternative is to be considered worthwhile.
Example 4.25
Motor City Auto Co. must decide whether or not they would introduce a new car which features a
radically new pollution control system. They must also analyze the results of test marketing a lim-
ited production and scrutinize if it shows promise or not. The test marketing of limited production
will cost `4 Crores.
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The marketing department has estimated the following:

1. If the new car achieves high acceptance by the public, company profits will increase by `25 Crores.
2. Low acceptance will reduce company profits by `15 Crores.
3. Not introducing the car will not affect the profit.
Probabilities for different outcomes through alternate actions are as follows:
1. If test marketing is not done, the possibility of high acceptance is 0.40.
2. The assumed probability for a favourable result from test marketing is 0.50.
3. The conditional probability for high acceptance after a favourable result is 0.64.
4. If the car is introduced despite unfavourable test marketing results, probability for low
acceptance is 0.84.
Construct a decision tree and determine the optimal course of action.
Solution:
The decision tree is shown in Figure 4.7.
ce HA (0.64)
Introdu C2
LA (0.36)
D2
Favourable (0.5)
Not-In
troduc
e
C1
ce HA (0.16)
st Unfavourable (0.5) Introdu C3
Te LA (0.84)
D3
D1
Not-In
troduc
e
No
Tes HA (0.40)
t ce
Introdu C4
LA (0.60)
D4
Not-In
troduc
e
Evaluation of chance points:
C2 = (0.64 * 25) + (0.36 *15) = +10.6; hence, D2 = +10.6
C3 = (0.16 * 25) + (0.84 * −15) = - 8.6; hence, D3 = 0
C4 = (0.40 * 25) + (0.60 * −15) = + 1.0; hence, D4 = + 1.0
C1 = (0.50 * D2) + (0.50 * D3) = (0.50 * 10.6) + (0.50 * 0) = +5.3
Decision point D1: If decision for test marketing is taken, then revenue for this option is:
Profit - test marketing cost = 5.3 - 4.0 = `1.3 Crores
If test marketing is not undertaken, then the profit is `1.0 Crores. Hence, it is ideal to go for test
marketing and expect a return of `1.3 Crores.
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222 | Chapter 4B
Example 4.26
Zigma Industries has to decide whether to set up a large, medium or a small plant for its new range
of refrigerators. A large plant will cost the company `25 lakhs, whereas a medium plant will cost
`18 lakhs and a small plant will cost `12 lakhs to the company. An extensive market survey and a
cost profit volume analysis carried out by the company reveal the following outcomes:
High demand probability = 0.5
Moderate demand probability = 0.3
Low demand Probability = 0.2
(a) A large plant with high demand will yield an annual profit of `100 lakhs.
(b) A large plant with moderate demand will yield an annual profit of `60 lakhs.
(c) A large plant with low demand will lose `20 lakhs annually because of production
inefficiencies.
(d) A medium plant with high demand will yield an annual profit of `75 lakhs.
(e) A medium plant with moderate demand will yield an annual profit of `45 lakhs.
(f) A medium plant with low demand will lose `25 lakhs annually because of production
inefficiencies.
(g) A small plant with high demand would yield `25 lakhs annually, taking into account the cost
of lost sales due to inability to meet demand.
(h) A small plant with moderate demand will yield `35 lakhs, as the losses due to lost sales will
be lower.
(i) A small plant with low demand will yield `45 lakhs annually, as the plant capacity and
demand will match.
Draw a decision tree and find the optimum solution.
Solution:
The expected monetary value for the large plant option is `39 lakhs, `28 lakhs for medium plat
and `20 lakhs for a small plant. Hence, we will select the large plant option.
High Demand
100 Lakhs
0.5
Medium Demand
t
64 0.3
60 Lakhs
P lan
Low Demand
ge hs
r – 20 Lakhs
La k 0.2
9 La
+3 5
–2 High Demand
75 Lakhs
0.5
+28 Medium Plant Medium Demand
46 0.3
45 Lakhs
–18 Lakhs
+2 Low Demand
0 – 25 Lakhs
Sm 0.2
–1 all
2 Pl High Demand
La an 25 Lakhs
kh t 0.5
s
Medium Demand
32 0.3
35 Lakhs
Low Demand
– 45 Lakhs
0.2
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Example 4.27
XYZ Company is evaluating four alternative single-period investment opportunities whose returns
are based on the state of the economy. The possible states of the economy and the associated prob-
ability distribution are as follows:
State Fair Good Great

Probability 0.25 0.55 0.2
The returns for each investment opportunity and each state of the economy are as follows:
Alternative Fair Good Great

W `1,500 `3,500 `6,600
X ` 800 `4,800 `6,900
Y `2,600 `5,400 `8,100
Z `4,200 `6,200 `8,600
Using the decision tree approach, determine the expected return for each alternative. Which alterna-
tive investment proposal would you recommend if the expected monetary value criterion is to be
employed?
Solution:
Fair
1,500
0.25
Good
3,620 3,500
0.55
0.2
6,600
Great
Fair
ate
800
0.25
ern
✘
Alt
Good
4,220 4,800
0.55
✘ 0.2
6,900
Great
6,180
Fair
2,600
✘ 0.25
Good
5,240 5,400
0.55
✔ 0.2
8,100
Great
Fair
4,200
0.25
Good
6,180 6,200
0.55
0.2
8,600
Great
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224 | Chapter 4B
The returns from alternative Z are the highest (`6,180), and hence, this is the best decision alternative.
Example 4.28
Thanda Cool Company has developed a new cold drink. A total of `25 lakhs is spent on the new
product. One plan is to market it in small cans with other products of the company. The plan will
cost `8 lakhs and it might result in high, moderate or low market response with probabilities 0.3,
0.5 and 0.2, respectively, with revenue of `55 lakhs, `35 lakhs and `15 lakhs for the corresponding
market responses. The second marketing plan is to fully concentrate on television advertisements
with a cost of `20 lakhs. The resulting market response can be either excellent or very good, with
probabilities 0.4 and 0.6, respectively. The revenues in these cases will be `50 lakhs and `35 lakhs,
respectively. Draw a decision tree to determine the plan the company should follow to maximize
the profit.
Solution:
High Response
55 Lakhs
0.3
Moderate Response
37 L 35 Lakhs
0.5
l C in
s
al ket
Low Response
an
15 Lakhs
Sm ar
s
M
kh
0.2
La
8
–
29 L
TV
Ad
ve
Excellent Response
–
20
rti
50 Lakhs
sin
La
0.4
g
kh
s
41 L
Very Good Response

35 Lakhs
0.6
The option of marketing in small cans yields a return of 37 - 8 = `29 lakhs. The option of televi-
sion advertising yields a return of 41 - 20 = `21 lakhs. Moreover, the cost of `25 lakhs is already
spent on the product. Hence, marketing in small cans will result in a net gain of `12 lakhs, whereas
television advertising option will result in a loss of `4 lakhs. We will select the option of marketing
in small cans.
Example 4.29
A company has the opportunity of marketing a new package of computer games. It has two possible
courses of action: to test market on a limited scale or to give up the project completely. A test
market would cost `160,000, and current evidence suggests that consumer reaction is equally likely
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to be positive or negative. If the reaction to the test marketing were to be positive, the company
could either market the computer games nationally or still give up the project completely. Research
suggests that a national launch might result in the following sales:
Sales Contribution (` Million) Probability

High 1.2 0.25
Average 0.3 0.50
Low –0.24 0.25
If the test marketing were to yield negative results, the company would give up the project. Giving
up the project at any point would result in a contribution of `60,000 from the sale of copyright,
etc., to another manufacturer.
You are required to do the following:
(a) Draw a decision tree to represent this situation including all relevant probabilities and finan-
cial values.
(b) Recommend a course of action for the company on the basis of expected values.
Solution:
ct +0.06
roje
upP
ve
Gi
Positive
0.39
0.5 Ma High
rke +1.2
tP
Ma rod 0.25
nu uc
65 et 0.225 ally t
0.0 ark Average
t M
s 0.39 +0.3
Te .16 0.50
–0 0.5
+0.06
+0.065 Negative Low
Gi –0.24
ve 0.25
u pP
roj
ec
t
+0.06
The test marketing option gives a return of `0.065 Million which is higher than the project aban-
donment option and is, therefore, selected.
Example 4.30
A company is developing a new product through its own R&D efforts. A proposal for an expendi-
ture of `1.0 Crore during the next year is received for budgetary sanction. The R&D manager feels
that there is a 70% chance that the project would be successfully completed in one year.
If the project is not completed in the first year, it can be abandoned. Abandoning a project after
one year will get `15 lakhs as scrap value for the equipment. Alternatively, a foreign collaborator is
offering proven technical know how for the product at a total cost of `1.75 Crores. The finalization
of agreements and start of production will, however, take another year.
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226 | Chapter 4B
The marketing division has projected that the new product can be sold for a maximum of five
years, if introduced after one year. The expected annual cash inflows after successful completion till
the end of project life are as follows:
(a) `40 lakhs p.a. with a probability of 0.40
(b) `50 lakhs p.a. with a probability of 0.50
(c) `55 lakhs p.a. with a probability of 0.10
If the opportunity cost of capital for the company is 12%, construct the decision tree and recom-
mend if the company should sanction R&D budget or go ahead with a collaboration agreement.
Solution:
Although this problem looks very complex and confusing, it is not so. Furthermore, a closer
examination of the problem tells us that the returns after one year are the same, irrespective of
whether the product was introduced by own R&D or developed with technical know how from
a foreign collaborator. Hence, the present value of returns over the five year period need be calcu-
lated once. Let us term these returns as cash inflows. Inflow for one year is 0.4 * 0.4 + 0.5 * 0.5
+ 0.1 * 0.55 = 0.465.
Table 4.48 Cash flow calculations
Year Inflows PV Factor at 12% Present Value

0
1 0.8929
2 0.465 0.7972 0.371
3 0.465 0.7118 0.331
4 0.465 0.6355 0.296
5 0.465 0.5674 0.264
6 0.465 0.5066 0.236
Total 1.498
{
R&D Complete PV of
1.498 In Flow
70% In Year 0
t
duc 1.09
w Pro wn
Ne ho
wit 0
{
o p . PV of
vel –1 30%
De R&D, 0.134 Scrap
0.09 R&D Incomplete In Year 0
Kn
ow
For -Ho
eig wF
nC rom
olla
{
–1. bor PV of
75 ato 1.498 In Flow
r
In Year 0

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The returns from own R&D option are positive, whereas the returns from the knowhow of for-
eign collaborator are negative. Hence, we will choose the own R&D option.
Example 4.31
Suppose you have `5,00,000 to invest in the share market. Your broker has suggested investing in
either company A or company B. Shares in company A are risky but could yield a 40% return on
investment during the next year if stock market conditions are favourable (bull market). If stock
market conditions are not favourable (bear market), the stock may lose 20% of its value. Company
B provides a safe investment with 15% return in bull market and only 5% in bear market. The
chance of a return in the bull market is 55%. Draw the decision tree and specify the optimum course
of action.
Solution:
In this problem, the amount invested is not of any consequence as the same amount is being invested
in either company A or company B. We will just evaluate the returns (in value) from investing in
either option. The decision tree and evaluations are shown in Figure 4.13.
Bull Market
40%
0.55
13%
In
e st A
Inv a ny 0.45
mp –20%
Co Bear Market
13%
Bull Market
Inv 15%
Co es 0.55
t In
mp
an
yB
10.5%
0.45
5%
Bear Market
Investing in Company ‘A’ is preferable.

Example 4.32
A company has to decide whether to set up a large plant or a small plant. Each plant has a life of
five years. A large plant will cost the company `50 lakhs with no salvage value. A small plant will
cost the company `24 lakhs with no salvage value. A marketing agency has predicted the following
level of demand with respective probability:
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228 | Chapter 4B
Table 4.49 Demand probabilities
Demand Probability
High 0.60
Medium 0.30
Low 0.10
The yearly payoff values for both the plants will be as follows:
Table 4.50 Yearly payoff values for both plants
Demand Large Plant (in Lakhs) Small Plant (in Lakhs)

High 20 10
Medium 15 8
Low 10 6
Draw a decision tree and decide whether the company should build a large plant or a small plant,
ignoring the time value of money.
Solution:
The cost of both plants must be apportioned over a five-year period and since the rate of deprecia-
tion is not mentioned, we will take the straight line method of depreciation. The decision tree is
shown in Figure 4.14 along with Figure 4.13.
The yearly returns from the large plant are `7.5 lakhs and the returns from the small plant are
`4.2 lakhs. Hence, we will select the large plant option.
Yearly
Pay-off
High Demand
20 L
0.6
Med. Demand
17.5 L 15 L
nt 0.3
Pla ars
rge Ye ar)
La r 5 e Low Demand
Fo er Y 10 L
5 0L LP 0.1
– 10
(–
7.5 L
(–
–2 4.8 High Demand
4L LP
F er 10 L
Sm or 5 Yea 0.6
all Y r)
Pla ears
nt Med. Demand
9L 8L
0.3
Low Demand
6L
0.1

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Example 4.33
The Unique Candles company has developed and patented a unique process for manufacturing
ornamental candles. The firm has three options as follows:
1. Sell the patent.
2. Produce and market the product nationally at once.
3. Test market the product in one area and decide either to sell the patent or go in for a national
launch.
The following information is available:
1. Gross margin (thousand)
Good market: 400
Fair market: 100
Poor market: 10
2. Marketing costs (thousand)
Test marketing: 15
National promotion: 50
3. Sale of patent (thousand)
Without test marketing: 30
Following favourable test: 60
Following unfavourable test: 10
4. Probability of test market results
Favourable test: 0.60
Unfavourable test: 0.40
5. Probability of market results
Table 4.51 Probability of market results
Good Market Fair Market Poor Market

Without test 0.30 0.40 0.30
Following favourable test 0.60 0.30 0.10
Following unfavourable test 0.10 0.30 0.60
What strategy should the firm follow?

Solution:
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230 | Chapter 4B
Good Market
400
0.3
t Fair Market
ke
ar 163 100
M l 0.4
&
c e ona
u ti e +60
od Na 0 Poor Market ll th Good Market
Pr –5 10 Se t 400
0.3 ten 0.6
✘ Pa
Sell the
128 ✘ +30 Favourable National Fair Market
Patent 221 271 100
Te 0.60 Launch –50 0.3
s tM
ar Poor Market
–1 ke 10
5 t
0.1
Good Market
400
143 0.1
Fair Market
76 100
l
na 0.3
Natio 0
–5
ch
un Poor Market
La 10
0.40 0.6
26
Unfavourable
Se
✘ ll th
e
Pa
te nt
+10
The test marketing result is either favourable (0.6) or unfavourable (0.4) but in either case, the
returns are positive. Hence, students should take care to add (and not subtract) the outcome of an
unfavourable test marketing option. At the first stage, the option of a national launch would give a
return of 113 (163 - 50), the option of selling the patent to the competitor would fetch a return of
30 and the test marketing option would give a return of 128 (143 - 15). Therefore, we select the test
marketing option as the best option.
Example 4.34
X Ltd has to decide between rentals of two types of machine manufacturing the same product.
Machine A, an economy model, rents for `1,000 per month but the variable production cost is `0.25
per unit. Machine B rents for `3,000 per month, but the variable production cost is only `0.10 per
unit. The monthly demand varies between 10,000 and 19,000 units to the following probabilities:
Table 4.52 Probabilities for demand
Demand (Units) Probabilities

10,000 0.12
12,000 0.17
15,000 0.41
17,000 0.24
19,000 0.06
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Draw a comparison of two machines to help X Ltd decide on which machine to rent. If the demand
is definitely known to be 10,000 units, would the decision vary?
Solution:
Demand
0.12
10,000
0.17
12,000
0.41
14,610 15,000
e A 0.24
chin ×] 17,000
Ma 0 .25 0.06
0+ 19,000
00
[1,
Machine
B
[3, 0.12
00 10,000
0+
Ma 0.1 0.17
ch
ine 0×] 12,000
B 0.41
14,610 15,000
0.24
17,000
0.06
19,000
The expected demand is 14,610 units and for this volume, machine B option is cheaper compared
to machine A option. Hence, we will select machine B. If the demand is known with certainty to be
10,000 units, then machine A option is better as the cost associated for this quantity is lower for
machine A.
Example 4.35
You are considering starting your own project consultancy outfit. There is a 60% chance that the
demand will be high in the first year. If it is high, there is an 80% chance that it will continue indefi-
nitely. If the demand is low in the first year, there is a 60% chance that it will continue to be low
indefinitely.
If demand is high, then the forecasted revenue is `270,000 a year. If demand is low, then the
forecasted revenue is `210,000 a year. You can cease to offer the service at any point, in which case
revenues are zero. Costs other than computing or forecasted at `150,000 a year regardless of de-
mand. These costs can also be terminated at any point. You have a choice on computing cost. One
possibility is to buy your own computer with related software. This involves an initial outlay of
`6,00,000 and no subsequent expenditure. It has an economic life of 10 years and no salvage value.
The alternative is to rent a computer as per your need. In this case, computers cost 40% of revenue.
Assume that the computing decision cannot be reversed, that is, if you buy a computer, you cannot
resell it without substantial loss. If you do not buy it today, you cannot do so later.
There are no taxes and the opportunity cost of capital is 10%. Draw a decision tree showing the
alternatives. Is it better to buy a computer or to rent it? (State clearly any additional assumptions
you need to make.)
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232 | Chapter 4B
Solution:
In this case, there are two outcomes which further branch into two more outcomes. Therefore, we
have four combinations as shown in Figure 4.17.
There are four possibilities—high-high (0.48), high-low (0.12), low-high (0.16) and low-low
(0.24). Subsequent analysis is shown in Table 4.53.
High
%
80
20
%
Low
d
%
an
60
em
D
h
ig
H
New Project
Consultancy
Lo
w
De
m
40
an
High
d
%
40
60
%
Low
Figure 4.17 Schematic decision tree diagram
Revenue for each year— expenses of `150,000 is either `120,000 or `60,000, depending on

whether demand is high or low. The assumption made here is that if in the second year, the demand
is low, then it remains low up to the tenth year and if the demand is high, then it remains high up
to the tenth year.
Option 1: Buy own computer: In this case, the present value of revenues - cost of computer = `2,465
Option 2: Rent a computer: In this case, the present value of revenues - hiring cost of computer every
year works out to `7,208. Note that renting expenses are 40% of the revenues. Hence, revenue of
270,000 * probability of high revenue + 210,000 * probability of low revenue is taken as the net
revenue for each year and 40% of this net revenue is the renting cost of computer.
The first option of buying computer gives a positive return and hence should be selected.
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M04B_PRAD30856_01_C04B.indd 233
Table 4.53 Financial analysis
Option Probability Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
High-High 0.48 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000
High-Low 0.12 1,20,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000
Low-High 0.16 60,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000
Low-Low 0.24 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000
Revenue 96,000 98,400 98,400 98,400 98,400 98,400 98,400 98,400 98,400 98,400
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
PV 87,273 81,322 73,929 67,209 61,099 55,498 50,479 45,953 41,722 37,982
Option 1: Buy Own Computer 2,465
Option 2: Rent Computer
Revenue 96,000 98,400 98,400 98,400 98,400 98,400 98,400 98,400 98,400 98,400
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Renting Expenses 98,400 99,360 99,360 99,360 99,360 99,360 99,360 99,360 99,360 99,360
Nett Revenue –2,400 –960 –960 –960 –960 –960 –960 –960 –960 –960
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
PV of Revenues –2,182 –793 –721 –656 –596 –541 –492 –448 –407 –371
Cumulative PV –7,208
233
06/02/19 11:30 AM
234 | Chapter 4B
Summary
Decision trees are a useful management technique, especially when every decision could have further
options. They allow the management to consider the options and the possible consequences of those
options. Moreover, when the parameters included in the decision tree have been correctly estimated,
managers can select the best option and thus, save money for their organizations. One limitation of
decision tree is that the calculation of probabilities is highly subjective and on occasions, even a small
error in the calculation of probabilities or expected values could lead to taking incorrect decisions.
Decision trees are useful in giving a simple diagrammatic representation of the various options
open to management, and the possible outcomes of each option therein. They also draw attention
to the immediate decisions to be made and may help management avoid wasting unnecessary time
in later deliberations. A decision tree might also help the management eliminate decision options
which are not worth considering further and to focus attention on more viable options.
It should, however, be remembered that a decision tree is a simplified representation of reality
which might omit some possible decision options. It could also end up simplifying the possible
outcomes than required. For example, typically question, ‘success’ and ‘failure’ are two extreme
outcomes, whereas a variety of outcomes between success and failure could be possible. The decision
tree is, therefore, likely to be a simplification of reality.
Decision trees, or expected value calculations, are the most useful where decisions are of a
recurring nature, where the long-run average profit should, approximately, be the expected value of
the profit of a single decision. Examples of such situations could be as follows:
1. Decisions on test drilling for oil, where a company carries out many tests each year.
2. Decisions on whether or not to launch a new product in the market, where a large number of
new products are considered each year.
3. Decisions on whether or not to obtain market research information for a particular project,
when market research is widely used throughout the organization.
K EYWOR D S
• Decision node • Decision tree diagram

• Outcome node • Expected value of outcome
R e v i e w Q u e st i o n s
1. List the advantages and disadvantages of the decision tree diagrams

2. How are Decision Tree diagrams useful in Project Management?
3. Explain the differences between a Decision Node and a Chance node.
4. Does a decision node always lead to a chance node and vice versa? Explain in detail.
5. Explain the advantages of stage by stage decision-making process.
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Chapter
5 PROJECT SELECTION
AND SCREENING
LearninG oBJeCTiveS

❍ Understand how project ideas are considered and shortlist the most favourable project
ideas.
❍ Understand the various methodologies available to help in shortlisting of ideas.
❍ Understand the various aspects to be considered before conceptualizing a project.
❍ Understand why detail screening is necessary to prevent any deficiencies in project

planning or conceptualization to prevent project failures at a later date.
INTRODUCTION
Project selection and screening is a process of detailed examination of several aspects of a given
project before recommending them. Financial institutions which are going to fund a project must
be certain of the project viability and ability of the project to generate sufficient funds to refund
the finances provided by the financial institution with reasonable profits. The earlier lending
concepts of security-oriented lending are now replaced with purpose-oriented lending, wherein the
lending of funds is acceptable only if a detailed project appraisal is done before committing funds
to a project. Organizations should, therefore, have a formal process for deciding projects to pursue
and for ensuring that projects are supportive of the organization’s strategic objectives. In many
organizations, some type of senior management steering committee or program management office
(PMO) performs the project evaluation and selection process.
The two methods of project selection are benefit measurement (comparative approach) and
constrained optimization (mathematical approach). Table 5.1 summarizes the key points of these
two method types:
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Table 5.1 Project selection methods
Method type Examples Notes

Benefit measurement Scoring models, cost-benefit analysis, Benefit measurement is the most
(comparative approach) review board, economic models. common approach.
Constrained optimization Linear programming, non-linear Constrained optimization makes
(mathematical approach) programming, integer programming, use of math models and complex
dynamic programming, multi-objective criteria and is often managed as
programming. a distinct project phase.
An example of the benefit measurement method and the issues therein can be envisaged by
considering the Environment Impact Assessment (EIA) project for the Nepal-based Upper Modi
Hydropower. This assessment is similar to a socio- benefit analysis assessment.
There are four decision-making points in the sequence of EIA implementation. The nature and the
extent of baseline information required at each of the decision points are quite different. The follow-
ing example of a hydroelectric development project, in relation to likely having an impact on fish
population, will illustrate the four critical decision points and the requirement baseline information
at each stage.
A series of potential sites for generating hydropower have been identified at different stretches of
the Modi river in Nepal. It is a promising project, where preliminary investigation has suggested a
possibility of 42 MW of hydropower generation.
1. Decision on Project Approval
Tor-tor (Hamilton, 1822) (species of cyprinid fish also known as Sahar), a long-distance migratory
fish known for its taste, is available in plenty in the entire stretch of the Modi river. This species of fish
has been reported to migrate upstream for breeding in summer and downstream for feeding during
the winterseason. Most fishermen living on the riverside adopt traditional technology to catch the
fish and sell their harvest to the local market.
One of the major environmental concerns of damming of the river is to impose an obstruction to
the upstream and downstream migration of fish, which is likely to create a number of issues.
(a) The population of fish has declined recently due to excessive fishing and the obstruction to be
created by damming would further reduce the population and may destroy the fish-spawning
area.
(b) The Sahar fish (Tor-tor sp) is considered the most delicious hills stream fish by the locals and
damming might very well bring down its population.
(c) Fish resources come under the jurisdiction of the Fisheries Department of the government; the
current legislation does not account for the regulation of river fish resources in Nepal. How-
ever, in the absence of such a regulatory mechanism, it would be highly relevant to consult
local fishermen and the local government on their consensus to proceed with the project that
is likely to produce adverse effects for fish resources of the area.
For justification of the issues, it is necessary to have sufficient information on the following parameters:
(a) Data on current abundance of fish
(b) Fish migratory pattern
(c) Spawning characteristic
(d) Localities
(e) The current rate of fish exploitation
(f) The economic benefits of fishing
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Project Selection and Screening | 237
If information on the above parameters is available, the second aspect is to design mitigation
measures as follows:
(a) Carry out a feasibility study in order to establish a fish hatchery to replace the possible loss of
fish production.
(b) Examine the feasibility of installing a fish ladder in order to facilitate fish migration.
(c) Explore the possibility of opening up the potential habitat and spawning ground by removing
obstacles in the tributary river.
On the basis of the availability of the above justifications, the project should be approved by the
authority.
2. Decision on Location of the Project

If the project is approved for implementation, then the second decision would be to find out an
appropriate location for the construction of a dam. Engineering feasibility might have proposed
several sites for dam construction, and on the basis of technical and economic consideration, the best
site might have been identified. However, from the point of view of the environment, particularly in
the case of fish resources, a more detailed and focused baseline study should be conducted at every
alternative site proposed, mainly on the following:
(a) Site for damming which is likely to have less effect on fish spawning grounds.
(b) Site which is likely to create more area for spawning.
(c) Site which is likely to impose minimum obstruction for fish migration.
3. Decision on Project Design

At this stage, decisions and recommendations should be incorporated into the project design.
Primarily, the following aspects must be considered:
(a) The hydrological regime of the river should be well understood.
(b) A coordinated mechanism in the project design is necessary for maintaining the regular water
flow downstream.
(c) The design must incorporate all recommended mitigation measures, and a fish ladder must be
included in the design, if necessary.
All considerations at the design stage should be backed by baseline information and examined
whether all measures recommended in previous decisions have been taken into consideration in the
project design or not.
4. Decision on the Operation of the Project
Consideration at this stage of project establishes monitoring and operational feedback system to
ensure that the design features built into the project are properly implemented. A number of studies
should be carried out at this stage. For example, survival rate of juvenile fish above the dam should
be compared with unaffected parts of the river to examine whether the newly developed habitat
is being used to the extent predicted; the relationship between fish production in the river and
commercial catch should also be studied.
PROJECT SCREENING
Annually, many projects are considered by public and private agencies. Development projects have
bio-physical as well as social and economic impact. Sufficient understanding of these factors is
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necessary for the initial screening decision. Broadly, the following areas should be covered in the
process of project screening, also referred to, at times, as project appraisal.
1. Technical appraisal, which involves the selection of technology, scale of operations, technical
know-how, location parameters, etc.
2. Commercial appraisal, which looks at the commercial viability or the marketability of the
product, including the life of the product. If we are putting a detergent manufacturing plant,
then the volume of manufacture as compared with the selling price and the duration of utility
of product ‘detergent’ becomes the decision parameter for considering the commercial viability
of the project.
3. Economic appraisal, which measures the effect of the project on the whole economy.
4. Financial appraisal, which comprises working out the cost of the project and the means of
financing the project. The financial viability and the ability of the project to pay sufficient
returns to the lenders are assessed in this appraisal. Ratios such as the debt service coverage
ratio (DSCR) are considered at this stage. The financial appraisal and the considerations
therein are discussed in detail in Chapter 6.
5. Social cost-benefit analysis—Projects undertaken for social benefits do not offer returns
similar to the commercial projects. However, this does not mean that such projects should
not be taken up. These projects that have social implications, like the Konkan-Railway
project, are evaluated differently. The United Nations Industrial Development Organiza-
tion (UNIDO) and Little-Mirrlees approach are the two methods for social cost-benefit
analysis.
TECHNICAL APPRAISAL
Technical appraisal should broadly cover the following important considerations:
1. Appropriate technology and process of manufacture.
2. Volume of operations or output that is envisaged for the project.
3. Availability of raw material on a long-term basis.
4. Technical know-how and prompt service from collaborators.
4. Licensing and technology usage agreements.
6. Product mix.
7. Selection of proper utilities and support equipment such as material handling equipment,
railroads, etc.
8. Plant layout.
9. Location of the plant.
10. Effluent treatment and waste water treatment.
11. Availability of sufficient power from the grid or provisioning for a mini power plant.
12. Schedule of the project phases and implementation stages.
Let us focus on each of these considerations.
Appropriate Technology and Process of Manufacture

For the manufacturing of pig iron, there are two technologies available—rotary kiln technology
and travelling straight grate technology. Each of the processes offers some distinct advantages. The
advantages of both the processes is given in Table 5.2.
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Table 5.2 Comparison of two technologies for manufacturing pig iron pellets from iron ore
Straight Grate Solution Rotary Grate Kiln Solutions

Suited for hematite and magnetite ores. Preferably suited for magnetite ores.
Drying, preheating, induration and cooling cycle Drying, preheating, induration and cooling cycles
are carried out in a single unit. are carried out in different units.
Generation of fines is bare minimum as double
Sufficient transfer points for generation of fines.
deck roller screen is installed for screening
Fines create accretion problems and affect
No ring formation/accretion
productivity.
Power and fuel consumption higher because of seal
Power and fuel consumption lower
leakage.
Efficient thermal process Less efficient thermal process
Waste heat recovery system is a feature of the
Difficult waste heat recovery system
process.
Less maintenance-oriented More maintenance-oriented
Higher wear of refractories because kiln
More installations over the world. refractories are subjected to thermal cycling from
each revolution and abrasion from pellets.
All repairs of the grate component occur ‘off line’.
Refractory life is longer because refractory line
The complex chain grate in the grate kiln process
hood is stationary and at a constant temperature.
must be shut down and cooled for maintenance.
Modular design of travelling grate allows
removal and replacement of single pellet in about
five minutes while process temperatures are
maintained.
Lower dust loading in the gas handling system. Higher dust loading in the gas handling system.
Therefore, we see that both these processes offer some advantages and the vendors of these tech-
nologies would insist that each one has a better technology to offer. The choice of technology also
depends upon the quality and quantity of the product proposed to be manufactured. Therefore, if
the output being planned is large (7.2 million tonnes per annum), the straight travelling grate tech-
nology is preferable and if the planned capacity of the pelletization plant is less than two million
tonnes per annum, then the rotary kiln technology is more preferable. If the product is for pharma-
ceutical use, then the quality of the product takes predominance over any other factors. Therefore,
in such cases, the process with a higher quality output would be preferred. Similarly, there is no
point in choosing a sophisticated technology meant for producing high-quality products which are
used for commercial applications where high quality is not required.
The choice of a suitable technology for a project calls for identifying ‘appropriate’ technology.
It refers to technology that is suitable for local conditions and locally available raw materials. A
pelletization process that is suitable only for haematite ore is unsuitable if the iron ore contains
magnetite. Textile yarn and garments manufacturing business is another example. Prominent gar-
ment manufacturers such as Blackberry have manufacturing plants located in the north where the
climate is dry and less humid. Although the markets are located in Mumbai and other prominent
western centres, a manufacturing set-up here would be difficult due to thread breakage as a result
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240 | Chapter 5
of high humidity. Similarly, textile yarn manufacturing plants in Europe require less manpower but
consume more power, whereas, in the Indian scenario, cheap labour and relatively expensive power
render this technology unsuitable.
Life of the Project

It is common knowledge that fixed cost, when apportioned over a large volume of output, reduces the
per unit fixed cost component. However, the periodicity of the project or life of the project decides
the final volume for apportioning the fixed cost. The project team should decide on the appropriate
life of the project, considering these facts. If the product being manufactured is assured of good
demand, then a longer period for the project can be sought, whereas if the product is a general
product which could face intense competition, then a proportionately shorter period project can
be pursued. Whenever a project is proposed to be set up, at a size below its economic size, it must
be carefully analyzed as to whether the project will be viable for this size. A benchmark with some
existing projects and their operating volumes can throw some light on the viability of the small size
project life.
Availability of Raw Materials on a Long-term Basis

Cauvery Pellets Pvt. Ltd has put up an iron ore pelletization plant in Chitradurga district of
Karnataka and depends on iron ore available exclusively in Chitradurga, Tumkur and Hospet dis-
tricts of Karnataka. With mining activities being banned in Karnataka, the supply of iron ore to the
project would be severely hampered and the viability of such a project could be under question.
However, if iron ore linkages can be tied up with neighbouring Andhra Pradesh or Goa, the project
could still be viable.
Since the manufacturing process and the machinery/equipment to be used, to a large extent, de-
pend upon the raw material, the type of raw material to be used should be chosen after considering
the type of raw material that is available. The availability of the raw material becomes a singular
constraint in industries/products which are dependent on the uninterrupted supply of raw mate-
rial. Iron and steel processing industries are found in the eastern part of the country; cotton and
textile industries are located close to the cotton growing areas in Gujarat and Maharashtra; sugar
processing industries are located close to the sugarcane (the raw material) growing areas in west-
ern Maharashtra and eastern Uttar Pradesh; aluminium industries are located close to areas where
bauxite is available in abundance, etc.
Technical Know-how and Prompt Service from Technical Collaborators

Care should be exercised to avoid self-styled, inexperienced consultants while appointing consul-
tants for technical know-how. Past experience of erecting and commissioning similar projects would
be an added advantage while appointing consultants. Necessary agreement should be executed be-
tween the project promoter and the know-how supplier, incorporating all essential features of the
know-how transfer. The agreement should be specific as to the part played by the know-how sup-
plier and should include penalty charges for non-performance of any of the conditions stipulated
in the agreement. Payment of fees to the technology provider should be in phases and be linked to
completion of the project phases. Time-bound payments must be replaced with progress-bound
payments. The final tranche of the payment to technical collaborators should be paid only after the
plant has commenced commercial operations and any initial bottleneck has been resolved. Once
the plant output reaches the rated output and the issues therein have stabilized along with proper
training to the plant personnel, the technical collaborator’s role can be considered as completed.
Expansion projects can now be considered with the help of the same technical collaborators.
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Collaboration Agreements
Although collaboration agreements are required for the organization putting up a project in its
interest, the presence of such an agreement adds substantial weight to the technical appraisal of the
project and indicates the commitment of the technical provider to the viability of the project. It is
operated under the premise that an established player would not invest in a project unless it makes
commercial sense. Hence, wherever possible, the technology provider should be made party to the
project and such collaboration agreements must be made available during the technical appraisal.
While signing the collaboration agreements, the following additional points should be considered:
1. The technology proposed to be imported should be suitable to the local conditions. The tex-
tile industry depends highly on the right humidity factor to prevent thread breakage during
weaving of cloth and in preventing shrinkage in clothes. The pelletization process of iron ore
depends, to a large extent, on the metallurgical properties of the iron ore, more specifically,
the haematite or magnetite orientation of the ore. The process being imported should be able to
work in the local conditions.
2. The collaboration agreement should be approved by the Government of India. In case of
agreements with organizations based in hostile countries, approval becomes very important.
The Chinese telecom company, Huawei, has a sizeable presence in India with its collaborator,
Tata Photon. However, due to Chinese linkage, many questions on potential threats due to
hostile intent of China continue to be raised in the Parliament.
3. Any restrictive clauses in collaboration agreements are not a positive sign. Although the col-
laborator may, at times, be right in insisting on importing of spares from their own source,
this limits the freedom of the project promoter. General Electric Co., which had provided the
turbines for power generation to Enron, promoted Dabhol Power project, (now Ratnagiri
Power Ltd) and has insisted on using their own spares for replacement of worn out parts.
4. The collaboration agreements should have a clause to resolve any conflicts in the competent
courts in India. Any reference to international arbitration courts is expensive.
5. Finally, a buyback option by the collaborator ensures that the technical collaborator is serious
about the transfer of the correct know-how and would ensure the quality of output.
Location of Projects
Many factors must be considered while selecting the location of a project. The financial cost of
the land required for the project has an overbearing influence on the decision of project location.
However, other tangible and intangible factors also play a significant role in the choice of a suitable
location for the project.
The tangible factors affecting the project location decision include the following:
1. Availability of raw materials: For process plants, raw materials can constitute up to 60% of
the cost of the final product. Locating the plant close to the availability of such raw materials
becomes very critical in reducing transport costs. Not all raw materials are available in one
place, and hence, priority is given to the raw material that is required more than others. For
making steel, iron ore and coking coal are two important raw materials, but the requirement
of iron ore is more than coking coal. Therefore, most steel producing industries are closer to
iron ore supplies and coal gets transported to places of steel manufacturing plants. Sugar fac-
tories are located close to areas growing sugarcane and textile mills are located close to areas
growing cotton. Therefore, when the raw material is bulky and undergoes volume reduction
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2. Proximity to market: This is the most common factor to be considered while locating
a manufacturing unit, but it is not feasible if the market is bigger than a regional market. If
transportation of the finished product is more difficult, as in case of a pizza, which has to be
delivered hot or ice-cream which has to be delivered as such, it is advantageous to locate the plant
close to the consumer. In case of soft drinks, the concentrate is easier to transport in place of the
finished soft drink, and hence, it is advantageous to locate a soft drink project near the market.
3. Availability of skilled labour: Many regional factors are responsible for the growth of skills
in different traits. While it is not impossible for anyone to develop skills in any area, there are
certain communities which gather expertise in certain specific skills. Deepwater exploration
and working at high sea pressure is a skill developed by some communities from Haryana.
Skills in jewellery design and the fine art of crafting gold ornaments are perfected by artisans
of West Bengal and Orissa. The Panchal community of north Gujarat is skilled in developing
designs in carpentry, machine tools, engineering tools, smithy tools, etc. Skilled textile workers
are available in Tirupur, near Coimbatore, and hence, locating a cloth manufacturing unit
near Tirupur makes more economic sense. We can, thus, conclude that although there are
unemployed people aplenty in India, it does not mean that the required labour force with
specific skill sets is available for the project. Moreover, with similar type of industry in certain
geographical areas, the mass movement of skilled workers from one organization to another
is possible and this factor should also be considered. If the project needs skills of a general
nature, local people can be recruited and trained, whereas if the project requires specific skill
sets, then locating the project where such talent is available makes more sense.
4. Availability of ancillary industry: Automobile manufacturing depends, to a large extent, on
the availability of components, sub-assemblies and products which get assembled on the main
assembly line. These supporting industries, also known as ancillary industries, are key to suc-
cessful running of the automobile assembly line and therefore, the business of manufactur-
ing automobiles. The Pune–Nashik area in Maharashtra, Pithampur–Devas area in Madhya
Pradesh and Faridabad and Gurgaon locations near New Delhi are examples of abundant
auto-ancillary industries. Proximity to these industries helps in reducing the inventory levels
required to be maintained at the factory. Hero Motors Ltd., a two-wheeler manufacturing
company, maintains not more than 2.5 hours of inventory at any of its manufacturing locales
due to vendor proximity. All their vendors are within a 40 km radius of their assembly plant.
The low-cost car—Tata Nano—is able to reduce its cost of manufacture due to the proximity
of all its sub-component manufacturers.
5. Availability of infrastructure facilities: Availability of uninterrupted power, water, roads, proper
drainage and transport facility are some supporting requirements for setting up a project. Unless
the project is sufficiently large like the Government of India promoted Steel Authority of India
(SAIL) plants in Bhilai, Bokaro, Durgapur and Salem, where the infrastructure gets developed
as the project progresses, it is prudent to establish a project where the development work
is already complete. The industrial development zones, promoted by most state governments,
are complete with all the necessary infrastructure facilities and thus, it would be prudent to
establish projects in these areas.
The intangible factors that affect the project location include the following:
1. Labour attitude and unionism: In certain states such as West Bengal and Kerala, there is a
lot of union activity, which can hamper the smooth working of any industry. This does not
mean that union activity is absent in other states but it is generally more involved in resolu-
tion rather than confrontation. Furthermore, there are many state-supported hartals or bandhs
which result in loss of production and productivity and vitiate the working climate, in general.
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These factors cannot be quantified and so they are part of the intangible factors affecting the
location of the project.
2. Availability of education facilities: Proximity to major cities with good educational facilities
acts as a motivator for employees seeking jobs. Moreover, the availability of proper recreation-
al and community facilities also acts as a positive influence while making job changes. If the
project location is conducive to these requirements, then employing and retaining personnel
becomes easy. Mahindra and Mahindra Ltd has a manufacturing facility at Zaheerabad, about
80 km west of Hyderabad. However, Zaheerabad is within 25 km of Bidar, a major city in
Karnataka. Children of employees stationed in Zaheerabad have company-maintained bus facility
for daily commute to schools/colleges in Bidar. Furthermore, there is a weekly bus service orga-
nized by the company to visit Hyderabad for shopping and leisure activities.
3. Climatic condition: A pleasant climate for the most part of the year is desirable for employees
and their family members. Hence, project locations where climatic conditions are harsh find
it difficult to attract personnel. Although employees make the required adjustments, there are
situations where prospective employees have rejected job offers due to these very specific rea-
sons. At times, the project is located in such areas where lack of personal security becomes a
threat. This could happen in districts where Naxalite activities are rampant. Warora, in Chan-
drapur district of Maharashtra, has a refrigerator manufacturing plant belonging to a leading
industrial group and getting suitable managerial employees in this location for this plant has
always been difficult.
Additional factors to be considered for locating facility overseas.
With economic liberalization setting in, many Indian companies are making overseas acquisitions and
are opening new plants globally. Bharat Forge, one of the top producers of automobile and engineering
forgings, has had many overseas acquisitions to its credit; the Tata Group has acquired industries in
the automobile and steel making businesses; the Aditya Birla Group has made global acquisitions
in Carbon Black businesses, to name a few. Setting up Greenfield or Brownfield industries globally
has many other considerations for location, besides the above listed tangible and intangible factors.
Some of them are listed here.
1. Government policies: T h e h ost country’s government restrictions and inducements influence
location decisions. The governments would prefer to base industries in backward areas for
developing those areas, but whether such a location is conducive for long-term gains should
be ascertained before going ahead with the proposal. An exit time-frame should be clear before
venturing into projects globally. The existing laws on pollution control could also have a
forbearing influence on the choice of location.
2. Stability of government: A change in a government, along with a change in policy towards
investments by foreigners, could be detrimental for long-term survival of overseas projects.
This factor should be considered before making substantial investments in such locations.
The fast-changing geopolitical scenes across several nations present exciting and challenging
opportunities. However, the extended phase of transformation that many countries are
undergoing makes the decision to locate in those areas extremely difficult. Political risks in the
country of location and the host country influence location decisions.
3. Free trade zones: A foreign trade zone or a free trade zone is typically a closed facility (under
the supervision of the customs department) into which foreign goods can be brought without
being subject to the normal customs requirements. There are about 170 such free trade zones in
the United States today. Such specialized locations also exist in other countries. Manufacturers
in free trade zones can use imported components in the final product and delay payment of
customs duties until the product is shipped into the host country.
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4. Trading blocs: The world of trading blocs gained a new member with the ratification of the
North American Free Trade Agreement (NAFTA). Such agreements influence location deci-
sions, both within and outside trading bloc countries. Firms typically locate or relocate within
a bloc to take advantage of new market opportunities or lower total costs afforded by the
trading agreement. Other companies (those outside the trading bloc countries) decide on loca-
tions within the bloc so as not to be disqualified from competing in the new market. Examples
include the location of various Japanese auto manufacturing plants in Europe before 1992 as
well as recent moves by many communications and financial services companies into Mexico
in a post-NAFTA environment.
5. Difference of cultures: The work culture in different countries is substantially different and
this factor should be considered in-depth before making any long-term decisions for investing
in overseas locations. Employing the locally available managerial talent becomes imperative
to grasp the working styles. When Nike, the American sneaker industry major, decided to open
up manufacturing sites in the Philippines, it had to reckon with a big culture shock and it took
time to adjust to the cultural differences.
Size of the Project

The output that is planned for the project would include the decision on plant capacity, product mix
and scope for future expansion. The decision on plant capacity and product mix also gets addressed
during the commercial appraisal, when the volume versus the output of profit-volume chart is pre-
pared. This is presented in the form of break-even analysis and related sensitivity analysis. However,
at this stage, during the technical appraisal, the concepts are limited to availability of input, tech-
nological limitations on production output, availability of utilities in setting up the supply chain,
distribution limitations of the manufactured product, etc. For example, if Amul would want to set
up a processing unit with additional capacity of 1,00,000 litres of milk per day, then the choice of
location should also consider the availability of 1,00,000 litres of milk locally. If it is more viable to
set up two plants each having 50,000 litres of milk per day processing capability in different loca-
tions due to limited availability of the raw material, the same could be considered.
Several factors such as technology requirements, input constraints, investment cost, market condi-
tions, resources of the firm and government policies have a bearing on the plant capacity. Process
manufacturing like cement has a minimum batch size for a particular technology. If the batch size
is less than the minimum size, then the process or technology must be changed. Input constraints
could be raw material constraints water availability constraint, power availability constraint or
foreign exchange constraint, that is, the requirement of foreign exchange for capital-intensive proj-
ects may be controlled by the government. The relationship between the fixed cost and the capacity
is an important consideration, too. Large capacity plants can apportion the larger fixed cost over
many products, provided the manufactured volumes find markets. If the market for large capacity
plants is not commensurate with the breakeven volumes, then heavy losses can be encountered and
there might be a thought come that a smaller plant with perhaps higher component of the fixed cost
would have incurred a lesser loss.
Environmental Aspects
A project involving processes would be releasing a lot of effluents in the form of gaseous waste,
liquid waste or solid waste by means of dust or particulate matter. All these may cause environmen-
tal pollution in many ways. Besides noise pollution, heat pollution and vibrations generated in the
process of manufacturing would add to environmental decay. A detailed study of such emissions
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and its harmful effects on the environment steps taken to reverse such harmful effects and measures
taken to treat effluents must be made adequately clear while conducting technical analysis. A proj-
ect which involves deforestation should take steps to sow and maintain new areas of cultivation to
compensate for the loss of green cover due to deforestation. Rainwater harvesting should be under-
taken for all new projects to preserve rainwater and prevent it from flowing away. Further projects
involving processing natural resource endowments such as iron ore, bauxite, etc., are likely to cause
more environmental damage than manufacturing processes involving assembly line operations. The
key issues that need to be considered in case of environmental pollution are as follows:
1. The different types of effluents and emissions being generated.
2. The process of adequate and sufficient disposal of effluents and treatment of emissions.
3. Whether the process of effluent treatment is acceptable according to the rules and regulations
laid down by the government in such regard.
4. The global norms and benchmarks for treating effluents and emissions of similar type.
5. Whether the processes are capable to maintain the requirements of the government pollution
control requirements for a long time.
COMMERCIAL APPRAISAL
A commercial appraisal is concerned with the financial viability or commercial success of a project.
This means that it is concerned with the study of the market potential for the product or service
being envisaged. There is a possibility that commercial appraisal is confused with financial appraisal
because of the term ‘commercial’. It should rather be ‘market’ appraisal to reflect the true concerns
at this stage. The very purpose of providing a product through a new project is to address the
requirements of the market or consumers of the product and through this process of satisfying
the consumer, the company needs to gain profits. If this very purpose is defeated, then there is no
need for the project. Therefore, commercial appraisal occupies a prime place in project appraisal.The
following business aspects are explored in detail:
1. Demand for the product.
2. Establishment of the supply chain for the product distribution.
3. Product pricing and sensitivity of demand to the pricing of the product.
4. Competition for the product and the government policies on pricing, if any.
Product Demand
Chapter 4 describes in detail the various forecasting techniques that can be utilized to predict the
demand for any product. However, the demand for a product is also dependent extensively on mac-
roeconomic factors such as the GDP growth of the country, the disposable income of the population,
the preferences of consumers and the changes in lifestyle which could adversely affect the product
demand.
Every product has a life and the product life cycle would clearly identify the stages in which any
product would be present. Manual typewriters are required for legal work and for some government
work. Now, there are no manufacturers of manual typewriters, and hence, we can say that there ex-
ists a demand for this product. However, does this demand merit a project to manufacture manual
typewriters? The answer is a clear and an unambiguous ‘no’. There is a great interest in vintage cars,
so should this mean that a project to manufacture vintage cars as per old designs be considered?
Again, the answer would be a characteristic ‘no’. In either case, the product is in the final stage of
the product life cycle, and hence, the decisions are easy to make. What about a business proposal
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246 | Chapter 5
Product Sales
Introduction Growth Maturity Decline
Figure 5.1 Stages in product life cycle
to manufacture mobile phones or to manufacture steel products? The demand for these products is
growing forever. Does it mean that we should definitely go ahead with these projects? Once again,
the decision would depend on many factors with one of them being the product life cycle.
Figure 5.1 shows the stages in a typical product life cycle.
The second aspect is the macro-economic factors which determine, to a large extent, the spending
power of the consumers. Generally, when the economy is booming, more products are purchased
and when the economy is in recession, the spending on purchases falls drastically.
The third aspect refers to the likes and preferences of the consumers. In the present Internet era, the
product information details are disseminated very fast along with opinions, recommendations and
forums to discuss the various product features. Besides, the shelf life of any product is relatively less.
These factors must be considered while estimating the demand for the products.
The final aspect in demand analysis is the effect of competition on the product. If the product is
likely to be launched in a mature market, then there would be intense competition and the demand
forecasts should reflect this eventuality. A distinction should be made between industry demand and
the company’s product demand. Industry demand refers to the demand for a particular line of product
or for a generic product. When a project is being planned, it is of interest to us to know how much
of this generic product demand can be converted into demand for the company’s product.
Break-even Analysis for Deciding the Product Volume

Concept
Break-even analysis is a simple but highly effective form of analysis. Here, we study the effect of
volume on cost dynamics for the product, and hence, it is also, at times, known as ‘cost volume profit
analysis’. The break-even analysis provides a relationship between revenues and costs with respect to
the number of sales. The break-even point represents the level of sales at which the total costs equals
the total revenue and as such, there is no profit or loss. Any output quantity less than the break-even
point would result in a loss and consequently, any output quantity more than the break-even quan-
tity would result in a profit. In case of project management, although the break-even analysis does
not speak about the demand, it speaks about the minimum demand that is required to earn no profit
and also not lose any money.
While using the break-even analysis for the make or buy decision, any quantity requirement less
than the break-even point quantity merits a buy decision and any quantity more than the break-even
point merits a make decision. Therefore, if the demand envisaged is less than the break-even point,
the company should not undertake the project and look at alternate ways of manufacturing the
product like subcontracting or buying the product from other manufacturers. In the initial phase
of launching washing machines, a hitherto unchartered territory for Godrej GE Appliances Ltd, it
preferred to source its requirement of washing machines from Videocon rather than manufacture its
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BEP – Break Even Point

BEQ – Break Even Quantity
BEC – Break Even Cost
Sales Revenue
Cost & Revenue

ke)
(Ma Total Cost
ion
fit Reg
Pro
BEC BEP
Variable Cost
y)
(Bu
ion Fixed Cost
Reg
ss
Lo
BEQ Quantity
Figure 5.2 Break-even point explained graphically
own products. Once the test marketing was successful, the company went ahead with its own manu-
facturing plant for washing machines.
The graphical representation of the break-even point analysis is shown in Figure 5.2.
Assumptions in Break-even Analysis
While performing the calculation of break-even point and break-even analysis, it should be remem-
bered that certain assumptions are presumed. In practical situations, such assumptions may or may
not be true but nevertheless, some adjustments on account of relaxed assumptions could always be
considered. The assumptions made are as follows:
1. The fixed cost components and the variable cost components can be properly computed and
correctly apportioned to the new project.
2. There are no quantity discounts or lower per piece price(s) for higher sales quantities.
3. On the input cost per product, which determines the variable cost, there are no price breaks or
quantity discounts.
4. The project is considered to manufacture only one product and the volume change in one
product (if there is more than one product) does not affect the other product.
5. There is no capacity constraint and the required units for a certain level of profit can be manu-
factured. Similarly, materials required for any volume of manufacture are also available.
6. The system is static and is not subjected to dynamic variations in costs, volume and profits over
the project life.
7. All the items projected to be manufactured can be sold and there are no unsold items.
Calculations of BEP
From the graph given in Figure 5.2, we can define the following:
Fixed cost = F, for a period of time, say one year.
Variable cost = V, per unit.
Selling price = S, per unit.
If x is the number of units being manufactured (and sold),
the total cost = fixed cost + variable cost (of manufacture)
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248 | Chapter 5
Or
Total cost = F + V : x
Sales revenue = S : x
At break-even point, the total cost is equal to the sales revenue,
Or F + Vx = Sx or x = F/(S – V) Equation 5.1
The contribution margin (CM) is the excess of selling price over the variable cost. Hence, Equation
5.1 transforms into:
x = F/CM Equation 5.2
Now, x is the break-even quantity (BEQ) and this can also be expressed in monetary terms, which
is called the break-even sales (BES).
BES = BEQ : S = (F/CM) : S
BES = F/(1 – V/S) Equation 5.3
Example 5.1
A reputed manufacturer of electronics is considering an expansion project which can produce a
certain component sold at a uniform price of ` 100 each. The variable cost of producing this com-
ponent works out to ` 60 per unit and the yearly fixed cost apportioned to this project and process
for manufacturing this product is ` 3,00,000. Answer the following questions:
(a) How many units of the component must be produced and sold so that the company breaks
even?
(b) How much rupee value of sales must be made at the break-even level?
(c) If the company has a target to achieve a profit of `1,00,000, then how many units should be
sold?
Solution:
In this problem, the fixed cost, F = `3,00,000, the variable cost, V = `60 per unit and the selling price,
S = `100 per unit.
Contribution margin (CM) = S – V = 100 – 60 = `40
Profit/Volume ratio or P/V ratio = CM/S = (S – V)/S
P/V ratio = 0.4
(a) BEP = F/CM = 3,00,000/40 = 7,500 units.
(b) BES = F/(P/V) = 3,00,000/0.4 = `7,50,000
Hence, the break-even point is 7,500 units and the rupee value of sales required to achieve
this break-even target is `7,50,000.
(c) Profit = Sales revenue – (fixed cost + variable cost)
Profit required is `1,00,000, therefore
1,00,000 = 100 * Q – {3,00,000 + 60 * Q}
where, Q is the quantity which will give this profit.
Solving this equation, we have Q = 10,000 units.
Thus, to achieve a profit of `1,00,000, the company must produce 10,000 units.
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Note: This estimate of sales of 10,000 units is an ideal case scenario which must be maintained for
the life of the project. If the project life is expected to be five years, then the project should have esti-
mated sales of at least 37,500 units for breaking even.
Example 5.2
A manufacturer of motorcycles requires a special type of seat for a deluxe motorcycle, of which sales
are not expected to be a significant amount. He has two options—one of them is to buy the product
which is available in the market for ` 1,000 each. In case, he decides to undertake a project to manu-
facture it on his own, then the yearly fixed cost apportioned to the manufacturing process required
for manufacturing the seat is `7,50,000. The fixed cost and the requirements are given for one year.
The variable cost is `750 per seat. Should the manufacturer make or buy the sidebox if the demand
is expected to be around 5,000 seats per year?
Solution:
In this case, let us calculate the break-even point or the break-even quantity in units. If the required
quantity is less than the break-even quantity, then it is advisable to buy the product and if the
quantity desired is more than the break-even quantity, it is advisable to make the product.
BEP = Fixed cost/(selling price – variable cost)
In this case, the selling price is not known but we can assume that as the product is available for
`1,000 each, the selling price could be at least `1,000.
BEP = 7,50,000/(1,000 – 750) = 3,000 units
As the yearly requirement of motorcycle seats is more than the break-even quantity, the company
must manufacture this product.
Example 5.3
There are three alternatives to meet the demand of a particular product. They are as follows:
1. Make the product using process P.
2. Make the product using process Q.
3. Buy the product.
The following additional details are available:
Cost Element Make Using Process P Make Using Process Q Buy the Product
Fixed cost (`/year) 3,50,000/- 7,50,000/- –
Variable cost (per unit) 60/- 50/- –
Purchase price (per unit) – – 70/-
The annual demand for the product is 20,000 units.

(a) Should the company make the product using process P, make the product using process Q or
buy the product?
(b) At what annual volume should the company switch from buying to making using process P?
(c) At what annual volume should the company switch from process P to process Q?
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250 | Chapter 5
Solution:
(a) The requirement of the company is 20,000 units. To decide which of the three options must be
selected, let us find out the total cost for all the three options.
Option 1: Make the product using process P. If Z is the number of products required, then,
Total cost = Fixed Cost + Variable cost
= 3,50,000 + 60 : Z
= 3,50,000 + 60 : 20,000 = 15,50,000
Option 2: Make the product using process Q. If Z is the number of products required, then,
Total cost = Fixed cost + Variable cost
= 7,50,000 + 50 : Z
= 7,50,000 + 50 : 20,000 = 17,50,000
Option 3: Buy the product. If Z is the number of products to be purchased, then,
Total cost = Purchase price : Z
= 70 : 20,000 = 14,00,000
Hence, when the requirement is for 20,000 units, the option of buying the product provides
the lowest total cost and hence should be preferred.
(b) The company would switch from buying to manufacturing using process P when the total
cost of manufacturing using process P is less compared to the buying option. Thus, for this to
happen,
(Total cost)Option A … (Total cost)Option C
3,50,000 + 60 : Z … 70 : Z
or Z Ú 35,000 units.
(c) The company would switch from manufacturing using process P to manufacturing using pro-
cess Q when the total cost of manufacturing using process Q is less compared to the total cost
of manufacturing using process P. Thus, for this to happen,
(Total cost)Option B … (Total cost)Option A
7,50,000 + 50 : Z … 3,50,000 + 60 : Z
or Z Ú 40,000 units.
We can thus conclude that when the requirement is less than 35,000 units, buying the product
is preferable. When the requirement is between 35,000 units and 40,000 units, manufacturing
the product using process P is preferable and when the requirement is above 40,000 units then
manufacturing the product using process Q is preferable.
Margin of Safety
No project can be planned to work at break-even levels because the primary motive of any business
enterprise is to make profits. Additionally, there is always a risk that the estimated fixed costs and
variable costs are higher than initially estimated or that the sales volume is lesser than predicted.
Hence, every project becomes viable when the output is substantially above break-even level and this
aspect is known as margin of safety.
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We can define the margin of safety as excess of sales over break-even sales to ensure that any
minor variations in estimates do not push the project in a loss zone. At times, the entire feasible
output (maximum plant capacity) above the break-even point is taken as the safety margin to decide
how much farther we are from the break-even point. When this is expressed in a percentage form,
it tells the manager on the percentage decrease in sales that can be tolerated before the project
becomes unviable.
Margin of safety can be expressed either in number of units or in relative terms, in which case, it is
known as margin of safety ratio.
Margin of safety = Actual sales − Break even sales

(Actual sales − Break even sales)
Margin of sfety ratio = ×100
Actual sales
In Example 5.2, the break-even point is 3,000 and the requirement is 5,000 units. The company,
therefore, opts to manufacture the product. The margin of safety for the company is actual output
– break-even output = 2,000 units.

Margin of safety ratio = ×100
Actual sales
(5000 − 3000)
= ×100 = 40%
5000
The margin of safety can also be similarly computed if the break-even point is expressed in rupee
terms. The only factor that must be remembered in this case is that the actual sales must also be
calculated in rupee terms.
Similarly, if we would want to know the demand for a 20% safety margin ratio, then the same
can be addressed as follows:

Margin of safety ratio = ×100 = 0.20
Actual sales
Break-even sales is 3,000 units, and hence, actual sales required for 20% safety margin ratio is 3,750
units.
Sensitivity Analysis
Sensitivity analysis means the effect of change or variations in any input parameters, whether
favourable or unfavourable on the output. If the calculations have to be reworked, then it is not
sensitivity analysis in the true sense. In case of linear programming problems, sensitivity analysis
is performed to prevent resolving the problem again, or to identify a range of variations for the
input variables which would not require resolving the problem. Many books on project manage-
ment explain the concept of sensitivity analysis for break-even point calculations, but it can be
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252 | Chapter 5
said that since resolving the problem is involved, the process cannot be called sensitivity analysis.
However, it must be noted that whenever there is a change in the fixed costs or variable costs or
the sales volume, the value of break-even point, contribution margin, etc., have to be recalculated.
Thus, strictly speaking, there is no sensitivity analysis, but a resolving of the problem once again
with changed parameters.
Volume Profit graph
This is another way of representing the break-even analysis with other utilities. In break-even
analysis, we know that for the quantities greater than the break-even point, there is a profit, which
is the difference between the sales revenue and the total costs. If the company wants to know
how much quantity needs to be produced to target a specific profit objective, the same has to be
worked out. However, if we plot the profit volume chart, then the analysis of break-even point
and the volume for specific profit can be easily obtained. This analysis is called the profit graph or
volume profit graph. In this graph, the profit is shown on the Y-axis and the volume or quantity
is shown on the X-axis. The point, where the graph touches the X-axis, is the break-even point.
Thus, the amount of profit (or loss) corresponding to any output level can be directly read from
this graph.
Profit = Sales revenue - {Fixed cost + Variable cost}
If X is the quantity, then, Profit = S : X – {Fixed cost + V : X}, which is a function of X.
For different values of X, we have a straight line relationship for profit.
The volume profit graph for Example 5.2 is shown in Figure 5.3.
Break-even analysis for Multiproduct projects

At times, a firm may produce more than one product or is engaged in multiple products, each of which
has its own contribution margin. Any changes in the contribution of margin of any product would
reflect in the total contribution margin. In order to assess the impact of the product mix on the overall
contribution margin, knowledge of the break-even sales is desirable. This analysis is also useful when
fixed costs cannot be apportioned accurately to a product. The weighted summation of individual con-
tribution margins is calculated and is known as the overall contribution margin ratio.
Volume Profit Graph for Example 5.2
1000000
500000
Break Even
Point
Profit
0
500 1000 1500 2000 3000 3500 4000 4500 5000 5500 6000 6500
2500
-500000
-1000000
Quantity
Profit
Figure 5.3 Volume profit graph for Example 5.2

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∑ X (S − V )
i i i
Overall CM ratio = i=1
n
∑S X i i
i=1
where, n = Number of products

Xi = Sales volume for the ith product
Si = Unit selling price for the ith product
Vi = Unit variable cost for the ith product
The overall break-even sales = Fixed cost /Overall CM ratio
It must be noted that we will have the break-even sales in rupee terms and not unit terms.
Example 5.4
A manufacturer considers project A which is to manufacture three products with the following data:
Product Price Variable Cost (per unit) Percentage of Sales

Book cases ` 6,000/- ` 4,000/- 30%
Tables `10,000/- ` 6,000/- 20%
Chairs `20,000/- `12,000/- 50%
Total fixed costs = `75,00,000/-

Sales = `2,50,00,000/-
The manufacturer has another alternative project B, the data for which is as follows:
Product Price Variable Cost (per unit) Percentage of Sales

Book cases ` 6,000/- ` 4,000/- 44%
Double beds `21,600/- `18,000/- 16%
Chairs `20,000/- `11,000/- 40%
Total fixed costs = `75,00,000

Sales = `2,70,00,000
Which of the two projects would be recommended and why?
Solution:
The total rupee sales are given which has to be converted into the number of units for each product,
appropriately, for further review.
Project 1: Total sales = `2,50,00,000
Product Sales (`) Number of Units

Book cases 30% of 2,50,00,000 = 75,00,000 75,00,000/6,000 = 1250
Tables 20% of 2,50,00,000 = 50,00,000 50,00,000/10,000 = 500
Chairs 50% of 2,50,00,000 = 1,25,00,000 1,25,00,000/20,000 = 625
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254 | Chapter 5
Contribution margin of book cases = 1250 (6,000 – 4,000) = 25,00,000

Contribution margin of tables = 500 (10,000 – 6,000) = 20,00,000
Contribution margin of chairs = 625 (20,000 – 12,000) = 50,00,000
Fixed cost = 75,00,000
Profit = Overall contribution – Fixed cost
= 95,00,000 – 75,00,000 = 20,00,000
Project 2: Total sales = `2,70,00,000
Product Sales (`) Number of Units

Book cases 44% of 2,70,00,000 = 1,18,80,000 1,18,80,000/6,000 = 1980
Double beds 16% of 2,70,00,000 = 43,20,000 43,20,000/21,600 = 200
Chairs 40% of 2,70,00,000 = 1,08,00,000 1,08,00,000/20,000 = 540
Contribution margin of book cases = 1980 (6,000 – 4,000) = 39,60,000

Contribution margin, double bed = 200 (21,600 – 18,000) = 7,20,000
Contribution margin of chairs = 540 (20,000 – 11,000) = 48,60,000
Fixed cost = 75,00,000
Profit = Overall contribution – Fixed cost
= 95,40,000 – 75,00,000 = 20,40,000
The second project gives a higher profit by `40,000. Hence, the second option is selected.
Example 5.5
A plant is manufacturing 5,000 CNC machine sub-assemblies per year and is operating at 80% of its
capacity. The annual sales is `3,00,00,000. The fixed cost of the plant is `60,00,000 and the variable
cost is `4,000 per unit.
(a) Is the process economical? Justify your answer.
(b) If the selling price of the product is reduced by `500 the capacity utilization can be increased
up to 90%. Is the proposal worthy?
Solution:
Present plant capacity is 5,000 units.
Profit = (S – V) : Q – F
= {3,00,00,000/5,000 – 4,000} : 5,000 – 60,00,000
= 1,00,00,000
Break-even point = Fixed cost/Contribution margin
= 60,00,000/(6,000 – 4,000) = 3,000
(a) Full plant capacity = 5,000/0.8 = 6,250 units
Selling price is `6,000, Variable cost = 4,000 and Fixed cost = 60,00,000
= {6,000 – 4,000} : 6,250 – 60,00,000
= 65,00,000
Thus, the proposal is economical since it increases the profit.
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(b) At 90% capacity utilization, the plant would be producing (5,000/0.8) : 0.9 = 5,625 units.
Selling price is `5,500 (Reduction of `500 on the sale price of `6,000), Variable cost = 4,000
and Fixed cost = 60,00,000.
= {5,500 – 4,000} : 5,625 – 60,00,000
= 78,37,500
This option is also acceptable as the profit contribution due to this option is more than what
it would be without this option.
Establishment of the Supply Chain for Product Distribution

In the early 1990s, one of the leading new generation Indian steel companies in the business of
making hot-rolled (HR) coils established a manufacturing facility at Hazira, near Surat. The distance
of the manufacturing plant from the nearest railhead was about 26 km. Once the HR coils were
manufactured, transporting the coils by road to the nearest railhead was the biggest challenge. The
roads were not in good condition and frequent breakdown of heavy haulage multi-axle trucks was
a nightmare. Therefore, the company began the construction of a railway line from its plants to the
nearest railhead. Had this been thought of earlier, perhaps in the initial period, movement of finished
goods would not have been a problem. Therefore, it is very important to first set up the distribution
channel before venturing out for the manufacturing process. The distribution system, therefore,
becomes a key input for evaluating the project proposal.
Distribution refers to the steps taken to move and store a product from the supplier stage (in this
case the project) to a customer stage in the supply chain. Distribution is a key driver of the overall
profitability of a firm because it affects both the supply chain cost and the customer experience
directly. Distribution-related cost make up for almost 20% of the cost of manufacturing, whereas
in case of commodities such as cement in India, the distribution cost is almost 30% of the cost of
producing and selling cement.
What is true for the distribution of finished products is also true for the input resources. Processes
using natural resources would require a lot of processing which, in turn, means requirement of
water, power and other inputs such as coal, refractory, etc. If the area is prone to droughts or is
a dry area, then the success of the project is questionable as the essential requirement—water is
unavailable. If water is drawn from canals such as canals of the Sardar Sarovar project, then the
priority of water distribution using the canals could also adversely affect the success of the project.
Industrial development zones are equipped with all these requirements because they have an efficient
distribution system for these resources.
Estimation of Demand using the Macroeconomic Factors

We have earlier studied the various forecasting methods using available data or by using qualitative
methods. At times, the forecast is made using a logical sequence of available data evaluation. This
available data is taken from macroeconomic processes such as the census, industrial growth figures,
GDP growth data, etc. Some of these extrapolative methods are as follows:
1. Chain ratio method
2. Consumption level method
3. Bass diffusion model
4. Econometric method
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256 | Chapter 5
Chain Ratio Method

The chain ratio method is a series of logical steps to identify the consumption potential. However, the
reliability of this method depends on the ratios and the rates of usage used in the process of making
judgments. Further, the impartiality of the process leader is important while making assumptions.
At times, like in most research projects, the conclusion is already made and the process gets designed
to substantiate the conclusion. The chain ratio method gives ample scope for such manipulation
as deductions are necessarily based on assumptions. An example of the chain ratio process is as
described in Table 5.3.
Let us consider the example of hosiery garments for men in the age group 21–40 years. The
project is to be established close to Mumbai, with Mumbai being the prominent market.
Table 5.3 Example of chain ratio method
Population of adults purchasing new hosiery Approximately 2,00,00,000 (approx 10% of

garments every year total population 200 million/2 Crores)
Ratio of males/females 1,000/865 (as per census data)
Population of males Approximately 1,15,60,000
Ratio of adults to children 1/0.2 (as per census data)
Population of adult males Approximately 92,48,000
Population of adult males in age group 21–40 Approximately 46,24,000 (assuming 50% below
40 years and 50% above 40 years)
Percentage of adult males preferring to wear hosiery 50% (approximation)
garments similar to our product
Target market requirement 23,12,000
Total manufacturing capacity of competitors 10,00,000
Market potential for our product (per year) 13,12,000
As is evident from the above analysis, some of the ratios and rates of usage are based on objective
proportion and some include results of a subjective proportion. Furthermore, the data so obtained
could not be of much use as there are other factors such as durability, pricing, branding and availabil-
ity affecting the demand.
Consumption Level Method
This method uses the income elasticity of demand and the price elasticity of demand for deciding the
consumption pattern for a direct consumption product. A refrigerator or a car is a direct consump-
tion product, but the components that go into the manufacture of either product (and which can
theoretically be used to manufacture other products) are known as intermediate products. A car
horn can be used in any make of car or in a motorcycle, and hence, a car horn is termed as an inter-
mediate product. Income elasticity of demand is the product of ratios of differences between the
quantities demanded in two years and the income differences in those two years and the sum of the
incomes divided by the sum of the quantities demanded in the two years.
{D2 − D1} {I1 + I2 }

Symbolically, E1 = ×
{I2 − I1} {D1 + D2 }
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where, EI is the income elasticity of demand, D1 is the quantity demanded in the base year, D2 is the
quantity demanded in the following year, I1 is the income in the base year and I2 is the income level
in the following year.
The information on income elasticity of demand, coupled with the projected income (which could
be a growth in GDP), can be used to make a forecast.
Consider an example of demand for residential houses. Let us say that the per capita demand for
residential house is 1 and the present per capita annual income is `70,000 for a particular segment
of population. The income elasticity for demand for house is 2.5. The projected per capita income of
this segment is expected to grow to `1,00,000 in 5 years. What would be the projected per capita
demand of houses for this segment after five years?
The projected per capita demand for houses after five years is given by:
Present per × q1 +Per Capita Change × Income Elasticityr

Capita Demand in Income Level of Demand
 [100,000 − 70,000] 
= 1× 1 + × 2.5
 70,000 
= 2.07
When multiplied by the projected population for the segment, it will give the demand for houses
after five years for this particular segment.
Price elasticity of demand measures the responsiveness of demand to the variation in prices and is
symbolically defined as follows:
{D2 − D1} {P1 + P2 }

EP = ×
{P2 − P1} {D1 + D2 }
where, EP is the price elasticity of demand, D1 is the quantity demanded in the base year, D2 is the
quantity demanded in the following year, P1 is the price per unit in the base year and P2 is the price per
unit in the following year.
It is well known that the demand is inversely proportional to the price, which means that higher
the price, lesser the demand for the goods. This inverse proportion is more apparent when the base
price and base demand are known. The price elasticity of demand is used to predict the future volume
of sales on the basis of price rise in the input parameters over a period of time. It must, however,
be remembered that the price elasticity coefficient works well for small changes and that the price
elasticity measure presumes that the pattern of consumer behaviour remains unchanged.
Bass Diffusion Model
The Bass diffusion model on the adoption and diffusion of new products and technologies by
Frank M. Bass (a new product growth model for consumer durables, 1969, Management Science,
15, 215–227) and the later extensions of diffusion theory are used for market analysis and demand
forecasting of new technologies. The Bass diffusion model is one of the tools to describe and
sometimes, predict, the number or purchases for new consumer durables products. This factor is
very important when the project is to manufacture a product that is adopting a new technology or
is a product that has hitherto not been launched in the market. New technology products such as
mobile phones, iPads, electric cars, etc., would fall in this category.
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258 | Chapter 5
The spread of the new product can be characterized by the Bass formula:
N t−1
N t = N t−1 + p (m − N t−1 ) + q (m − N t−1)
m
where, Nt is sales in the period t,
Nt–1 is sales in the period t – 1,
m is the market potential or total number of people who would opt to use the product.
p is the coefficient of innovation or which is also known as the external influence. This factor
denotes the likelihood of someone not using the product would start using the product due to
mass media coverage or external factors.
q is the coefficient of imitation or which is also known as the internal influence. This factor
denotes the likelihood of someone not using the product would start using the product due
to word-of-mouth coverage or internal factors such as influence of others who are already
using the product.
Bass diffusion theory is simple enough to allow a first assessment without the need for any further
complex modelling. Some variations of basic Bass diffusion theory have been developed over time
and claim to deliver more precise information in certain areas. Diffusion of innovation models are
important tools for effectively assessing the merits of investing in technologies that are new or novel
and do not have predictable patterns of user uptake. This subject could be of interest to venture
capital firms which primarily invest in businesses having new technologies.
Econometric Model
An econometric model is a mathematical presentation of relationships between economic indicators,
based on the economic theory and somewhat similar to the multiple regression analysis models. The
single equation model describes the relationship between one dependent variable and one or more
than one independent variables. Similar to the cause and effect analysis, the relationship between
the independent variable(s) and dependent variable is a result of the influence of the independent
variables (cause) on the dependent variable (effect). If we consider price (P) and the purchase power
parity (Q) as two influencers on demand (D), then we can express the linear relationship for demand
in time period, t, as:
Dt = a + b * Pt + c * Qt
where a, b and c are constants.
At times, the single equation model of portraying the economic relationship is insufficient in
conveying the true relationship. In such cases, we can use the simultaneous equation model of
econometrics which portrays the economic relationships with the help of two or more equations. In a
bid to bolster the economy, the government undertakes investments in infrastructure. Simultaneously,
the growth in the economy fuels growth in the construction industry, giving rise to demand for
cement. Therefore, the growth in the demand for cement arises due to government investments in
infrastructure, growth in construction and growth in construction due to better economy. A simple
three equation econometric model for demand of cement is as follows:
Dt = Gt + It + Ct
where, Gt is the government purchases in the year t,
It = a + b * Gt is the gross investment for the year t,
Ct = c + d * Gt is the consumption for the year t
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The limitations of the econometric model include projecting the behaviour trend of the independent
variable and the requirement of extensive data for the same.
MANAGEMENT APPRAISAL
People who are behind the project or those involved in running the project can give a lot of confi-
dence to the investors about the successful completion of the project. The Reliance Industries Ltd
group has shown that any project undertaken by the group has been successfully completed ahead
of the project schedule consistently. The quarterly earnings guidance of Infosys Ltd has always
been conservative and the results have been better than forecast every time. In both the examples,
the trend of decision-making and completion is an established norm and any investor can easily
make decisions. This decision-making on the basis of past trends is termed management appraisal.
An effective management is instrumental in the successful completion of the project and as a cor-
ollary, an ineffective management may result in a project failure. Hence, an important aspect of
project appraisal is the appraisal of the management team, their past records of project comple-
tion, the strength and depth of the team, collectively termed as management appraisal.
For a project financer or an investor, the key data sought is not just the economic viability of the
project but the managerial viability of the project. The American Institute of Management, which
conducts a management appraisal as a means of ascertaining the company’s health and progress, as-
signs a weight of 22% to the quality of executives manning the affairs of the company. A much lesser
weight of 6% is assigned to the earnings data.
Why conduct a Project Management Appraisal?

A periodic project management appraisal should be viewed as a useful, constructive and necessary
diagnostic tool available for augmenting the capability of the sponsoring organization’s project
management team. It can be used to provide information ranging from an informal enquiry to an
extensive analysis of the effectiveness of every aspect of the project management process. In the
latter context, it can be conducted to ferret out common failings of many project management
arrangements. In the initial stages of review, since the project proposal is only on paper, a
comprehensive review of the past performances of the management team on similar projects is
undertaken. The process of management appraisal is subjective unlike other appraisals such as
financial appraisals which are quantitative appraisals. Whenever there is ‘subjectivity’ involved,
impartial and rationale evaluation are required.
Some of these common failings identified during periodic management appraisal include the
following:
1. Management on the project may be unable to see the bigger picture and long-term ramifica-
tions of their actions or ‘the wood from the trees’.
2. Decisions may be made to favour existing contractual commitments rather than being made
in the best interests of the final project results.
3. Decisions may be similarly biased unduly by corporate policies.
4. Short-term political expediency may be overwhelming (crisis management).
5. Key individuals on the project may be under the influence of some form of illegal pressure.
6. Management on the project may simply be naive, inexperienced, lack sufficient training in
project management skills or otherwise ill-prepared for difficult tasks at hand.
7. The management may be focusing on short-term goals rather than long-term objectives.
A project requires substantial time to complete and, therefore, merits a lot of patience.
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260 | Chapter 5
Project management appraisal can also be used for the following:

1. Identify the strengths of current practices in a project management organization or on an
existing project.
2. Establish how various groups within the organization perceive the organization’s effective-
ness in managing projects.
3. Examine the effectiveness of project communication and documentation and clarify the rela-
tionships between project scope, quality, time and cost.
4. Identify barriers to better performance or critical skills needed by project managers or their
supporting teams to increase their effectiveness.
5. Identify specific aspects which require quick improvement and hasten the achievement of
results.
6. Provide for an exchange of ideas, information, problems, solutions and strategies with proj-
ect team members and develop a plan of action for carrying out improvements.
7. Help create a supportive environment, focusing on project success and the professional
growth of project team members.
Therefore, by conducting a project management appraisal in a timely and correct manner, poten-
tial difficulties can be identified and exposed for taking appropriate corrective actions. Better still,
potential problems may be circumvented altogether if the concept and timing of a project manage-
ment appraisal is built into the project plan from the outset.
The methodology involved is really quite simple. The project management appraisal involves the
following steps:
1. Establish the goal and scope of management appraisal.
2. Acquire the required information.
3. Examine and correlate the information and in the light of the reviewer’s experience, deter-
mine its relevance, completeness and reliability.
4. Draw conclusions on the current status of the project.
5. Develop recommendations affecting the future project status.
6. Discuss the preliminary draft of the findings and recommendations with those interviewed
and modify as appropriate.
7. Present the final results for discussion with those who commissioned the appraisal.
8. Discharge the appraisal team until recalled.
As noted earlier, the potentially adverse effects on the project organization of conducting a manage-
ment audit must be recognized from the outset. Consequently, a constructive and humane approach
must be maintained which focuses on enabling the project organization improve performance in
the future. The process should be more of fact-finding and less of fault-finding and identifying the
concerned personnel for the fault. Any suggestion of attempting to pinpoint responsibility for past
short-comings should be strictly avoided. In fact, any issues identified during the appraisal which,
as a result, have already been corrected should obviously be noted or omitted altogether from the
report. Therefore, management appraisal must be carefully prepared and conducted with tact and
discretion in the interests of continuing harmony.
Nowadays, the importance of periodic management appraisal is being increasingly felt in view of
several units being rendered sick due to mismanagement. With globalization, the space for error is
minimum and any unintentional mistake on the part of the management could result in long-term
repercussions for the company.
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Economic Appraisal
Economic appraisal measures the effect of the project on the entire economy. Scarce resources must
always be put to the best use. This aspect is more critical for developing countries as they generally face
scarcity of capital and foreign exchange. Policy makers concerned with the best utilization of scarce
resources can direct their resources to maximize the economic growth of the country. Hence, in case of
alternative options, the policy maker could make a choice on the basis of economic returns. A project
by an individual or a business entity would be driven more by profit motives, whereas any project by
the government would be more concerned with the economic returns brought by the project.
Indian iron ore fines have a huge market in China and thus exports of this commodity have been
booming for the past many years. The government realized that just an export of the iron ore fines
without any value addition would not be in the interest of the economy, as it does not generate
employment or investments in the value addition process. Furthermore, there is a problem of iron ore
value addition in China and dumping of this value-added iron ore back in India. Indian entrepreneurs
were aware of the possibility of value addition but hesitated to make the necessary investment and were
content with exporting iron ore fines. In other words, a private entrepreneur may not be interested
in studying the economic or social cost-benefit analysis of a project. To change this scenario, the
government has imposed duties on iron ore exports and reduced the duties on export of value-added
iron ore pellets. Consequently, many Indian iron ore exporters are setting up pelletization plants and are
making the necessary investments. The investments not only provide employment opportunities but
would also support the project construction and execution industry.
Therefore, in order to regulate the deployment of scarce resources for the economic upliftment
of the country by channelizing the use of scarce resources to the best possible use, the government
enforces control through its policies and regulations. The term ‘loan lending’ financial institutions
also exercise restraint in lending to the projects not supported by the government policies.
SOCIAL COST BENEFIT APPRAISAL

Public benefit projects such as bridges linking villages to main roads, railways, irrigation projects,
power projects, building of dams, etc., do not offer attractive commercial returns unlike projects
undertaken by private firms and entrepreneurs. In the latter case, evaluation of the project proposal
becomes comparatively simpler as the objective of making profit is a quantitative parameter easily
obtainable with some assumptions. However, the former group of projects which are undertaken for
socio-economic considerations play a significant part in the development of the region, much more
than mere commercially viable projects. Does it, therefore, mean that there are no yardsticks to
measure projects which fall under the social benefit head? Or, are there no guidelines or benchmark
for such projects in terms of the cost involved? The Sardar Sarovar project on Narmada and the
Upper Modi hydropower project in Nepal could be as different as chalk and cheese. Therefore, in
such case, how do we ensure that the investment of funds in various stages is made wisely? Such
appraisals are termed as social cost-benefit appraisals and are generally carried out for projects
managed by government and for the good of the general populace. In recent times, even private
projects using natural resources such as ores are covered under the gambit of social cost-benefit
appraisal with a premise that natural resources are also owned by the populace affected by the
project and those affected by the displacement of populace.
In one project in Rayagada, an Odisha-based, alumina projects rehabilitation and resettlement
plans (R and R plans) that I was privy to, three categories of project-affected persons were drawn.
The first category comprised landowners who were to lose land due to the project; the second
category comprised labourers who were working on these lands that would eventually be lost to
the project and the third category comprised those people who made a livelihood by serving the
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262 | Chapter 5
landowners and labourers. Therefore, besides the social cost benefit appraisal, even issues such as
the R and R plan are considered for mega projects. The events at Singur in West Bengal where Tata
Motors were to set up the manufacturing plant for its Nano car project are well documented. This
is an example of a project being opposed at the local level, despite elaborate R and R plans along
with social cost-benefit appraisal.
All projects involving government participation incur costs, which have to be borne by the nation
through appropriate budgetary allocations. These are the direct costs which are apportioned to the
project. There are several other indirect costs such as cost of facing protest, delays due to protests,
R and R, constructing access roads, developing infrastructure, etc. Similarly, there are two types of
benefits: direct benefits and indirect benefits. For a commercial profitability, assessment of only the
direct cost and direct benefits are considered.
In case of social benefit analysis, the following two differences are important to be noted:
1. As against the market prices for direct costs and direct benefits in a commercial project,
the real costs of inputs and the real benefits of outputs are measured. If the input of power
is considered, then the commercial project would take into account the subsidized price as
applicable. A social cost benefit project would cost this input of power without the subsidy
element. Similarly, if the output price is controlled by regulations and government, then the
real price of the output without any such regulations is considered. Accordingly, the required
adjustments to direct costs of inputs and outputs are made for all inputs and outputs.
2. Indirect costs and indirect benefits also get considered in case of social cost-benefit analysis.
However, this part of the analysis requires substantial qualitative inputs which are always the
subject matter of debate. Consider a case where a bridge is constructed over a river, which
reduces the commute time by over 60 minutes for every individual wanting to reach the op-
posite ends of the river. The direct cost in this case is the cost of constructing the bridge and
the direct benefit is the saving in fuel in circumventing a longer distance. However, the indirect
costs could be the cost of land acquisition for constructing the bridge and access ways while
the effort saved in commute could be the indirect benefit.
Social cost-benefit analysis is, thus, regarded as a refinement over commercial appraisal, taking hidden
factors into account. However, the application of the social cost-benefit analysis is limited to the
public investment projects.
Benefits of Social Cost-benefit Appraisal

The social cost-benefit appraisal aims to estimate the total impact a project would have on the
economy and the benefits that would accrue due to this project. Accordingly, the appraisal focuses
on the following objectives that a social obligation project is supposed to fulfil.
1. Contribution of the project to the gross domestic product (GDP) of the economy.
2. Contribution of the project towards maintaining parity between the poor sections of the so-
ciety and in attempting to bridge the gap between the regional imbalances in terms of growth
and development. Thus, in general, the social obligation projects are carried out in the poorest
districts or the backward districts of the country.
3. Justification of the use of scarce resources of the economy for such projects. The mid-day
meal scheme in all government-run institutes for schoolchildren is one such example of a so-
cial obligation project. The budgetary support for such schemes justifies the support to social
obligation projects.
4. Contribution of the project towards reducing the pollution and in improving the environmen-
tal conditions.
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UNIDO Approach to Social Cost-benefit Appraisal

There are two main approaches to the social cost-benefit appraisals—the UNIDO method, postulat-
ed by famous economist Amartya Sen along with Stephen Marglin and Partha Dasgupta (Guidelines
for Project Evaluation, 1972) and the Little-Mirrless approach. UNIDO subsequently brought out
another manual titled ‘Guide to practical project appraisal’ to simplify the cost-benefit analysis of
projects for practical application. The UNIDO approach places emphasis on ‘aggregate consump-
tion’ as it is an indication of betterment in living standards. The betterment of living standards is
one of the primary targets of UNIDO. ‘Aggregate consumption’, although easy to define, is difficult
to compute because consumption levels of populace differ. An effective way of measuring the con-
sumption level is, therefore, a measure of ‘consumer’s surplus’ and ‘consumer’s willingness to pay’.
UNIDO method involves the following five stages:
1. Calculation of financial profitability measured at market prices.
2. Obtaining the net benefit of the project measured in terms of economic (efficiency) prices.
3. Adjustment for the impact of the project on savings and investment.
4. Adjustment for the impact of the project on income distribution.
5. Adjustment for the impact of the project on merit goods and demerit goods.
The net benefit is expressed in terms of economic efficiency prices which are also referred to as
‘shadow prices’. Again, referring to the bridge across the river which reduces the commuting time,
not only would the daily commuters benefit but the ease and convenience of the bridge would also
motivate more users to commute and thus bring about an economic growth. The mid-day meal
scheme has enhanced learning because children from the poor sections attend school because they
are served the meal. After several years, the literacy rate is going to increase by leaps and bounds
due to the mid-day meal scheme.
It should be understood that the market prices represent shadow prices only under conditions of
perfect markets, which means that the shadow prices need to be developed and subsequently, the
economic benefits must be measured in terms of these prices. Shadow prices are the corrected prices
of the inputs and outputs reflecting the ‘real’ prices. If any industry in the small-scale sector is getting
subsidized power, then the price of unsubsidized power is taken as the real cost of input.
Some of the issues connected with shadow pricing are as follows:
1. Choice of numéraire: Numéraire is the unit of account in which the value of inputs or outputs
is expressed. The Numéraire used in the UNIDO approach is the domestic accounting rupee.
The definition of UNIDO Numéraire is ‘net present consumption in the hands of people at
the base level of consumption in the private sector in terms of constant price in domestic
accounting unit’.
2. Concept of tradability: A deciding factor in shadow pricing is the tradability of goods or
services. For tradable goods, the international price is a measure of its opportunity cost to the
country. This is because it is possible to substitute import for domestic production and vice
versa, where we can substitute export for domestic consumption. Hence, the international
price is also referred to as the border price, which represents the ‘real’ value of the good in
terms of economic efficiency. In case of non-tradable goods, the shadow price is the marginal
economic value which is the amount the domestic customers are willing to pay for an
additional unit.
3. Shadow prices source: Any project that consumes resources can result in the following: (i)
An increase or decrease in the consumption in the country, (ii) increase or decrease in the
production in the country, (iii) increase or decrease in imports and (iv) increase or decrease in
exports. If the project impacts the consumption pattern in a country, then the basis of shadow
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264 | Chapter 5
pricing is the consumer’s willingness to pay. If the project impacts the production in a country,
then the basis of shadow pricing is the cost of production and if the project impacts the inter-
national trade of a country, then the basis of shadow pricing is the foreign exchange value.
Taxes: The guidelines with regard to taxes as per the UNIDO approach is as follows: (i) If
4.
the project results in diversion in limited supply non-traded inputs from other producers or
results in additions to non-traded consumer goods taxes should be included, (ii) when a proj-
ect adds value to the domestic production of other producers, taxes should be excluded, (iii)
for fully traded goods, taxes should be ignored. Consider the output of natural gas from the
Krishna-Godavari belt by Reliance Industries. Some part of the output has to be committed
to the plants manufacturing Urea at a government fixed price, some part of the output can
be sold to domestic power manufacturing companies at a price and the balance can be sold
globally. Now, this particular project is not exactly a project for social cost benefit analysis
but just in case we consider it to be one, then we can consider the international price of the
natural gas as the shadow price.
Consumer’s willingness to pay: If the project alters the consumption in the economy, then the
5.
basis of shadow pricing is the consumer’s willingness to pay. With an increase in supply, the
demand for the product reduces, thus forcing a reduction in the price of the product. If one
considers the cost of mobile telephony when it was launched and at present, this point would
be understood well.
Externalities: Certain results due to a project do not impose a cost element or give a documented
6.
benefit, but have a bearing on the country’s objectives. Hence, these results should be taken
into consideration for the social cost-benefit analysis. The Mumbai–Goa highway, NH 4, is
prone to many accidents. Quadrupling of the road would reduce the commute time, save fuel
and also reduce instances of accidents. The first two results can be accurately measured but
the last result that of reducing the instances of accidents cannot be measured accurately.
Even after quadrupling the road, there could be accidents and someone may argue that due
to higher speed, more instances of accidents may occur, as is the case with the Mumbai–Pune
expressway. However, a reduction in the instances of accidents is definitely the objective of the
government. Such effects that are external to the project domain but have an impact on the
social objectives are known as ‘externalities’.
Capital inputs: A project requires substantial capital input; using these capital input, projects
7.
create assets, which are valued as per the shadow prices discussed earlier. One factor that needs
to be also considered is that the project capital could have been deployed for additional uses,
which means the cost of letting go of the additional use or the opportunity cost of capital
inputs must also be considered. While calculating the NPV or the IRR, a base discount rate
is presumed or taken as a yardstick for approving projects. In case of social benefit analysis,
choosing a suitable rate of discount can be tricky. If a low rate is chosen, socially inefficient
projects will be taken, whereas if a high rate is chosen, then projects that are worthy would be
rejected. The UNIDO approach uses the consumption rate of interest (CRI) as this rate is based
on the consumption objective. The CRI is given by the following relationship:
Parameter of Growth Rate of per Rate of pure time

CRI = : :
utility function capita consumption preference
* Additional details on this subject can be obtained from ‘Economic Analysis of Projects’, a World Bank research
publication, authored by Lyn Squire and Herman G Van der Tak.
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If the IRR is above the CRI, the project gets rejected and if the IRR is less than the CRI, then
the project gets accepted. Generally, for all social benefit projects, the Planning Commission is
the decision-making authority.
Shadow wage rate: Like the consideration for capital input, the opportunity cost of engaging
8.
labour in a particular project (due to which the labour cannot be employed on other projects)
must also be considered. This is known as shadow wage rate. The formula suggested by the
UNIDO to arrive at an SWR is as follows:
Labour’s foregone Net Social cost
Shadow Social cost of
= Marginal product + of increased +
Wage Rate reduced leisure
at accounting prices consumption
Foreign exchange: As the UNIDO approach uses the domestic currency as the Numéraire, the
9.
following guidelines have to be applied for foreign exchange:
10. For imports:
CIF + Clearing charges + Internal transport charges to the destination
11. For exports:
(a) FOB price when the FOB prices are higher than the domestic price.
(b) Domestic price, if it is higher than the FOB price.
(c) If the FOB price and the domestic price are the same, then either can be used, provided the
FOB price does not include export promotion incentive. If there is a subsidy component,
then this subsidy component must be added to the FOB price and this revised price should
be considered.
(d) If there is an export duty levied by the government and the FOB price is equal to the domes-
tic price, then the FOB price minus the export duty should be considered for calculations.
Little-Mirrlees Approach
An alternative to the UNIDO approach for social cost-benefit analysis is the Little and Mirrlees ap-
proach (LM), which lays down a stepwise procedure for undertaking benefit-cost studies of public
projects. The mathematical formulation is similar to the UNIDO method except for differences in
assigning value to discount rates and accounting for imperfections and other market failures and
social considerations. Like UNIDO guidelines, the LM method considers the shadow price of re-
sources to correct the limitations due to domestic market protectionism. The major difference in the
LM approach is that the numéraire for border prices is expressed in foreign currencies and there
are guidelines specifying how to convert the foreign exchange values in terms of domestic currency.
LM elaborates the methodology for calculating shadow prices for non-tradable commodities. To
trace down the chain of all non-traded and traded inputs which go into the production of projects,
use of detailed input-output tables is suggested. If such detailed tables are not available, a conver-
sion factor based on the ratio of domestic costs of representative items to world prices of these
items is used as an approximation of the shadow prices of non-traded resources. The LM approach
postulates that in all under-developed countries, one of the major criteria for the choice of a project
should be its ability to generate savings, and hence, the LM method suggests the use of ‘accounting
rate of interests’ to calculate the present worth of future annuities of savings and consumption.
LM guidelines, on the other hand, do not make any adjustment for the consumption and saving
impact of project investment. Unlike the five stages of UNIDO, the LM procedure is relatively more
practical although unlike guidelines, it does not provide sufficient insight by examining the project
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266 | Chapter 5
The following discussion summarizes the key points of the LM approach:

The numéraire: LM’s numéraire is the ‘present uncommitted social income measured in
1.
convertible foreign exchange of constant purchasing power’ and rejects the ‘consumption’
numéraire of the UNIDO approach. The LM approach recognizes only the uncommitted social
income or the government’s income for social projects which has not been earmarked for some
specific application. Every year, there is budgetary support for schemes such as rural health,
minimum work commitment, food security, etc. Funds other than these committed funds are
considered for the numéraire under the LM approach. Full conversion of rupee is not allowed
which means that when the income is in domestic currency, unless allowed, only the convertible
part must be considered for this numéraire. Many social cost-benefit projects are funded by
global aid and loans from institutions such as the World Bank, International Monetary Fund
(IMF), etc., and hence, the LM numéraire makes the accounting rate of interest comparable
with interest on loans payable in foreign currency. In case the country is a developed country
and lends to another developing country’s social cost-benefit projects, then the lending rate is
considered as accounting rate of interest. To factor in the purchasing power of the domestic
currency, the term ‘constant purchasing power’ is used.
LM’s shadow price: The shadow price of a traded good is its border price, which means
2.
the FOB price if the goods are exported or the CIF price if the goods are imported. The
border price is a correct indicator of the value of goods because it represents the intrinsic
worth in the global scene. Some goods such as land-building transportation and services
such as electricity, water supply and sewerage are not actually tradable at foreign prices.
In such cases, the shadow price is arrived at by computing the marginal social cost and
marginal social benefit. The marginal social costs and marginal benefits are estimated in
terms of border prices. Since even the non-tradable goods are evaluated at the border prices,
the LM approach ensures that a common yardstick is used for valuation of tradable and
non-tradable entities. The difficult part, though, is measuring the marginal social cost and
marginal social benefit in terms of border prices and to do so, some complex subjective
methods are available.
LM’s Standard Wage Rate (SWR): As per the LM method, the following is suggested:
3.
SWR = C – 1/s [c – m]
where, C = Additional resources devoted to consumption.
1/s = Social value of a unit of consumption so committed.
c = Consumption of wage earner.
m = Marginal productivity of wage earner.
Comparison between the Little-Mirrlees approach and UNIDO approach to Social Cost
Benefit Analysis
Both the methods of social cost-benefit analysis are somewhat similar in their operational aspects,
but one of the important difficulties is that the methods have been devised in the late 1970s and
the early 1980s, which means the application of these methods in the current scenario needs to be
modified. Both the methods use the concept of ‘shadow’ price and discounted cash flow technique
besides the concept of equity. However, there are a few differences, which are as follows:
1. The UNIDO approach measures shadow price in domestic value, whereas the LM approach
measures shadow price in international value, also termed as the border price.
2. The UNIDO approach measures costs and benefits in terms of consumption, whereas the LM
approach measures these parameters in terms of uncommitted social income. In developing
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countries, the level of savings is low, which means future investments in any projects would be
low. This, in turn, would have the effect of not generating sufficient consumption in the future.
It would be better if the present consumption is sacrificed for more savings, resulting in future
higher consumption levels. Since the present savings level is more valuable than present con-
sumption, the LM approach uses the measure ‘uncommitted social income’ as the yardstick for
measuring costs and benefits.
3. The UNIDO approach uses the domestic currency as the numéraire, whereas the LM approach
uses convertible foreign exchange as the numéraire.
Social Cost Benefit Appraisal by Indian Financial Institutions

The Indian loan lending financial institutions such as the IFCI, IDBI and erstwhile ICICI give
considerations for the social aspects of the projects funded by them. This analysis is made besides
appraising the projects from the financial perspective and is no way connected to the financial
viability of the project. We will not come across cases where the project has been approved because it
is socially viable, even it is financially not viable. For such exclusively socially viable projects, either
the government takes up the project or the funding is received from funding organizations such as
the International Monetary Fund. The method followed by Indian financial institutions is at best
termed the partial LM approach because it uses international prices for valuing tradable goods but
does not use the cumbersome method laid down by the LM method for valuing non-tradable assets.
In case of non-tradable goods, the valuation is done by social conversion methods. The following
criteria are used by Indian financial institutions:
1. All tradable inputs are valued at the frontier prices.
2. Transfer cost items such as value-added tax and duties are ignored.
3. Indirect costs on non-tradable items such as power and movement of goods are evaluated by
marginal cost measures.
4. FOREX involved in case of inputs and outputs are valued at a specific premium.
5. Shadow wage rates are applied to skilled and unskilled labour employed in the process of
conversion.
6. The numéraire is defined as savings in domestic currency rather than foreign exchange.
The primary objective of the entire exercise is to ensure that the protection offered is factored in
adequately for real benefit evaluation.
Summary
Project selection after screening is the most decisive phase in the process of ensuring successful proj-
ects. Several assumptions are required at this stage as complete information is not available. This
can, therefore, lead to reckless and deliberate attempts at making the ‘pet’ project very workable,
often with disastrous consequences. The optimism of the evaluation committee must be tempered by
hard facts and someone who can play the ‘devil’s advocate’ effectively. The systems and procedures
adopted by term lending institutions are often very elaborate but are also weak in places. The broad
processes that need to be carried out are as follows:
1. Evaluation of the project team and their track record
2. Technical appraisal
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268 | Chapter 5
3. Commercial appraisal
4. Financial appraisal
5. Social cost benefit appraisal
6. Environmental appraisal
Environmental appraisal is an important feature for any project to ensure that the project is not
harmful to the environment and does not leave a carbon footprint that is not acceptable. Use of any of
the ozone-depleting gases is not encouraged; besides untreated effluents, discharge to the soil or any
natural resources must be strictly controlled.
K EYWOR D S
• Project selection • Break even analysis

• Project screening • Margin of safety
• Project appraisal • Sensitivity analysis
• UNIDO • Chain ratio method
1. Explain the UNIDO approach for social cost benefit analysis

2. How is the Little and Mirrlees approach for social cost benefit analysis different than the
UNIDO approach?
3. Explain the role of project screening in successful completion of the project.
4. What are the typical appraisals required for complete Project appraisal?
5. What is the role of the Government of India in promoting projects?
6. Explain the concept of break-even analysis and sensitivity analysis.
7. Explain the extrapolative methods for making product forecasts.
8. What are the limitations of the Chain ratio method?
9. Explain the working of the consumption level method
10. What are the advantages of the Bass Diffusion model?
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Chapter
6 PROJECT FINANCIAL
APPRAISAL
LearninG oBJeCTiveS

❍ Understand how critical it is to look at the financial viability of the project, before funds
are lent to it.
❍ Apply the various techniques of capital budgeting and financial ratio analysis.
❍ Understand the limitations of each of the financial appraisal methods and how new
methods were developed to overcome these shortcomings.
❍ Understand the need to ignore certain established accounting and financial practices while
evaluating a project cash flow statement.
❍ Critically evaluate the project revenue projections from the lender’s perspective.
INTRODUCTION
An important aspect of a successful project is the viability of the project in terms of the returns on
money being invested in the project. Other than social cost-benefit projects where the social benefit
is more important than the commercial benefits, all projects must have sufficient returns to make
them worthy of financial investment. Furthermore, the worthiness of the project must be evaluated
before commencing the project. One of the aspects of project financial appraisal is to work out a
futuristic balance sheet and cash flow statements and the second aspect is to see the worthiness of
these cash flows. The first aspect, that is, of generating the futuristic balance sheet is dealt later in
this chapter, whereas the analysis of the cash flows and the methods for this analysis are addressed
first. After going through the financial appraisal section, the reader would be able to perform the
following:
1. Calculate the future value and present value of a single amount of return.
2. Calculate the future value and present value of annuity.
3. Understand the benefits and limitations of widely used analysis methods such as net present
value (NPV) and internal rate of return (IRR).
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270 | Chapter 6
4. Examine the differences between the methods used for rejecting project proposals and selecting
project proposals.
5. Assess investment evaluation methods in terms of theoretical and practical considerations.
6. Describe the investment evaluation practice.
It is essential to know the basics related to the evaluation criteria and the same is discussed later.
TIME VALUE OF MONEY

The common-sense solution to an investment problem is that if the returns or inflows would be more
than the money invested or outflows, then it makes sense to go ahead with the project proposal.
Furthermore, if the returns on the project are less than the returns obtained by investing the surplus in
the minimum yield bank deposits, then it does not make sense to venture into the project. Therefore,
not only should the project generate sufficient inflows, it should be higher than the bank rate of
interest paid on parked funds to justify investment in the project. At times, projects are financed with
borrowed funds, in which case the returns should be of a particular minimum amount which has to
be greater than the cost of borrowing to ensure that the project is viable. One major issue is related
to the timing of investment inflows and project outflows. Although investments have to be made
at the beginning of the project, the returns are generated over the life of the project or at a much
later date. This means that when we are matching the inflows with the outflows, the time factor of
inflows must be considered. A rupee today is worth more than a rupee at a later date; or a rupee at
a later date is worth less than a rupee today. The various methods for capital budgeting decisions
using the time factor of money are known as ‘discounted cash flow techniques.’ These techniques are
elaborate, cumbersome and time-consuming, and hence, simpler ‘back of the envelope’ calculation
methods that do not require discounted cash flow techniques are used for rejecting the project
proposals. Discounted cash flow techniques are also used to compare the project options or to select
the better project option and for ranking of the various project options.
It should be noted that in the practical world, one has to also consider uncertainties or ‘risks’ besides
the appropriate rate of exchange of having a certain amount of money now and the expectation of
having a larger sum of money at a later date. Therefore, this analysis will include not just the time value
of money but an additional factor in monetary terms to cover the uncertainty or the risk involved.
Time Preference or Rate of Interest

The time preference of money may be expressed by means of an interest rate. If the time preference
for a project company is 10%, then it would be indifferent to `100 now or `110 after 1 year. If the
investment in a project is going to give a return of 10% or less, then the company may not go ahead
with the project as it offers no incentive. Moreover, due to future uncertainties, even the 10% return
from the project may not be practical. Hence, not only should the returns be above the time prefer-
ence rate, they should be sufficiently above the rate to justify the project investment after factoring
in uncertainties and various risks.
Compound Value
When the interest rate for a period is known, the amount available after the end of the period can
be easily calculated. However, the life of the project involves more than one period. In such cases,
the interest received at the end of the first period can be invested along with the principal amount
for one more period and could generate additional interest. This is known as compounding
and whenever more than one time period is involved, the compounded rate of interest must be
considered.
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Project Financial Appraisal | 271
To illustrate this concept further, consider an investment of `1000 for a one-year period where the
rate of interest is 10%. After the first period, an interest of `100 is generated which gets added to the
principal. The investible amount now is `1100, and thus, the interest generated after another one-
year period is `111 (and not just `100). This method and reasoning can be extended for subsequent
periods as well.
Therefore, if P is the original amount or principal invested, i is the rate of interest per period, n is
the number of investment periods and M the maturity amount received at the end of n periods, then
we can give a mathematical equation for the above relationship as follows:
M = P (1 + i)n
The factor (1 + i)n is called the accumulation factor. The values of the accumulation factor for
various combinations of rate of interest, i and the number of accounting periods, n as a ready reck-
oner can be calculated).
Example 6.1
1. Find the compound value of `10,000 at the end of 5 years when the interest rate is 12% per
annum.
2. Find the compound amount at the end of 9 months if `10,000 is borrowed at 10% rate of
interest and interest is compounded quarterly.
3. Find the compound amount at the end of 9 months if `10,000 is borrowed at 10% rate of
interest and interest is compounded monthly?
4. Are the answers different? Why?
Solution:
1. In this case, P = 10,000, n = 5, i = 12%,
M = P (1 + i)n = 10,000 (1 + 0.12)5 = `17,623/40.
As mentioned earlier, the factor (1 + i)n is known as the accumulation factor and the value of
the accumulation factor can be now calculated. The value corresponding to period 5 in the
column for i = 12% is 1.7623. Therfore, M = 10,000 * 1.7623 = 17,623. This value is exactly
similar to value obtained by calculating the compounding factor.
2. In this case, the rate of interest is 10% per annum, which means 2.5% per quarter. The
accumulation factor for period n = 3 is 1.0769, and hence, M = 10,000 * 1.0769 = 10,769.
3. The problem in 2 above is modified and the interest is calculated monthly. Thus, n = 9 and
i = 10/12 = 0.833%.
M = P (1+i)n = 10,000 (1 + 0.00833)9 = 10,775
4. We observe that for the same period and same overall rate of interest, the maturity amount
is different when interest is compounded monthly and annually. We can conclude that if
the compounding period is more, then the interest paid is also more. Hence, whenever
there is a flexibility of choosing the period for compounding interest, a borrower should
prefer longer compounding period(s), whereas a lender should prefer smaller compound-
ing period(s).
Present Value
The discussion in the heading under Compound Value brings us to an important deduction. Just as
we can calculate the maturity value of principal for a certain period at a particular rate of interest,
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272 | Chapter 6
we can also calculate the present value of a future sum of money when the discounting rate (or the
interest rate) is known along with the period for compounding the interest. To discount a given
amount due in future means to find its present value at the rate of discount. In this case, the maturity
amount M, is known; rate of discount, i is known and the number of periods for discounting, n is
also known. Only the principal amount (which in this case would be the present value) needs to be
found.
M
Since, M = P(1 + i)n , P = = M(1 + i)−n
(1 + i)n
The factor, (1 + i)–n is known as the present value factor in discounting. The table values give the
present value of `1 receivable at the end of n time periods.
Example 6.2
A nationalized bank wants to take over one particular loan portfolio of a private bank. On that
portfolio, the private bank is to receive `10,000 after 3 years and the present rate of interest is 10%
per annum. What is the present value of this receivable to the private bank?
Solution:
We know that P = M (1 + i)–n, where P is the present value, M is the maturity value = 10,000, i is the
rate of interest = 10% per annum and n, the number of time periods, which, in this case, is 3. The
present value factor for the above combination of interest rate and period is 0.7513. Hence,
P = 10,000 * 0.7513 = `7,513
Hence, the present value of receivable `10,000 after 3 years, when the discounting factor is 10%,
is `7,513. (In other words, if `7,513 is invested @ 10% rate of interest per annum for a period of
3 years, this amount will grow up to `10,000).
Annuities and Maturity Value of Annuity

An annuity refers to series of payments in equal amounts at the end of specific time periods.
This periodic payment is of utility in many practical situations, examples of which include
equated monthly installments (EMIs) for purchase of residential flats, home appliances, motor
cars, machinery, lease payments on land and equipment, etc. The amount of annuity refers to the
cumulative sum of payments including principal and compound interest at the end of the term
or period of annuity. To obtain the final amount, we add up the compounded amounts of the
individual periodic payments.
If A represents the periodic payments, n represents the term of annuity (or the number of pay-
ments, like 24 EMIs or 48 EMIs) and i the rate of interest, then Q, the amount of annuity, is given
by,
Q = A(1+i)n–1 + A(1+i)n–2 + A(1+i)n–3 + … + A(1+i)2 + A(1+i)1 + A(1+i)0
This equation sums up the fact that the first annuity or periodic payment earns interest for n – 1
periods, the second periodic payment earns interest for n – 2 periods till the last periodic payment,
which does not earn any interest. Let us replace (1+i) with R, so that the above equation becomes:
Q = ARn–1 + ARn–2 + ARn–3 + … + AR2 + AR1 + AR0
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Multiplying both sides by R, we have

QR = ARn + ARn–1 + ARn–2 + ... + AR3 + AR2 + AR
Subtracting the second equation from the first, we have
QR – Q = ARn – A
or Q (R – 1) = A (Rn – 1)
A(Rn − 1)
Q= = A × Amount Factor
(R − 1)
(Rn − 1)
where we define Amount Factor =
(R − 1)
Example 6.3
A company wants a fund of `10,00,000 at the end of 5 years and is willing to set aside a fixed sum
at the end of each year for that purpose. If the funds can fetch a uniform interest rate of 10%, then
how much should the company set aside each year?
Solution:
In this case, the maturity amount, Q is given and is equal to 10,00,000. The rate of interest is 10%
and the number of time periods is 5.
A(Rn − 1)
Q= = A × Amount Factor
(R − 1)
Therefore, A = Q/Amount factor

Amount factor is 6.1051. Therefore, A = 10,00,000/6.1051 = 1,63,797. This means that the
company has to invest `1,63,797 at the end of every year for 5 years at the interest rate 10% to
generate `10,00,000 after 5 years.
Present Value of Annuity

The present value of annuity equals the sum of present values of all the equal periodic payments.
Using the same symbols as in the case of Section on Annuities and Maturity value of annuity, we have
The present value, V = AR–1 + AR–2 + AR–3 + … + AR–n
Multiplying both sides by R, we get
VR = A + AR–1 + AR–2 + AR–3 + … + AR– (n – 1)
Subtracting the first equation from the second, we have
VR – V = A – AR – n
V(R – 1) = A(1 – R–n)
A(1 − R−n )
or V = = A × Present value factor for annuity
(R − 1)
The present value factor for annuity for different periods, n and for different rates of interest, i then
calculated.
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274 | Chapter 6
Example 6.4
A project organization obtained a heavy duty crane on a lease rental of `15,000 per month for a
period of 24 months. If the interest charged is 12% per annum compounded monthly, then what is
the present value of this financial commitment?
Solution:
In this case, the periodic payment or annuity is `15,000 per month. The interest charged is 12% per
annum, which means 1% per month (as the period payments are monthly payments) and there are
24 monthly payments.
The present value, V of this commitment is
V = A * Present value factor for annuity

The present value factor for 1% rate of interest and 24 installments is 21.2434.
V = 15,000 * 21.2434 = `3,18,651

The present value factor of annuity is useful in calculating the internal rate of return (IRR).
INVESTMENT ANALYSIS AND CAPITAL BUDGETING

A project is worthwhile only when it is worth more than it costs the organization to put up. The com-
pany’s investments in tangible assets such as plant and machinery, or in intangible assets such as re-
search patents, etc., are worthwhile only if they provide a sufficient return on capital which would have
otherwise not been possible by investments in assets such as bank deposits, stocks and other investment
avenues. While performing the investment analysis, the manager would require the following data:
1. Estimates of the net capital outlay and fair estimates of the cash inflows at future point in time.
2. Estimate of the cost of capital or the interest rate that would have been availed by the com-
pany if the investments were made in other available options.
3. Estimate of a minimum cut-off or expected returns from a project to make the correct selec-
tion from the options available.
4. A correct set of tools or techniques to be used for selecting the right option for investment.
This requires understanding the limitation of the available tools of evaluation and under-
standing situations where the most appropriate tool/ technique could be best used.
In all the methods used for evaluating the worthiness of investments, the preference for right options
is based on two fundamental principles. The first principle which gives a higher return or a better
return is preferred and the second one chooses projects which give early benefits (or returns) as
against projects giving returns after a long duration.
Some project evaluation methods discussed in this chapter are as follows:
1. Payback period method
2. Accounting rate of return method
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Profitability index
6. Benefit cost ratio and net benefit cost ratio
7. Discounted payback period method
8. Equivalent annual annuity method
9. Common time horizon method
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Payback Period Method

Payback period is one of the most popular traditional methods for evaluating investment proposals.
It is more popular due to its simplicity rather than its effectivness. This method is more like a ‘back
of envelope’ calculations method and can be used effectively for rejecting investment proposals
rather than selecting them. Evaluation of project proposals is a time-consuming and back-breaking
exercise. It is prudent to carry out a detailed evaluation of proposals only when the project proposals
pass muster on broad areas. If the project proposals are not worthy of further considerations, then
a simple and fast method to eliminate options would be extremely useful.
Broadly, payback period method is defined as the number of years required to recover the
investment in the project. If Co is the initial investment and Ct the cash flow in the tth year, then the
payback period would be the value k such that:
k
∑C − C t o =0
t =1
The payback period need not be a whole number with a fraction representing a part year. When
the payback period is less than some minimum acceptable period, then the proposal is not rejected
and considered for detailed evaluation; otherwise, it is rejected. For two or more mutually exclusive
projects, we can rank them on the basis of their payback periods with the project having a smaller
payback period ranked higher than the project having a longer payback period. Therefore, we can
conclude that the project having shortest payback period is ranked the highest and the project with
longest payback is ranked the lowest.
The demerits of this method are as follows:
1. It does not take into account the time value of money and also the value of future outflows on
the project.
2. It fails to recognize the value of the cash flows that accrue after the payback period is over.
3. It is not an appropriate method of measuring the profitability of an investment project. At the
most, this method measures the recovery of the project’s cash outflows and the time period it
takes to recover this amount.
4. It fails to consider the magnitude and timing of cash inflows as it gives equal weightage to
returns of equal amounts even though they take place in different periods.
Example 6.5
The cash flows of two project investment options are given in Table 6.1. The investment required
for both these projects is `10,000. Determine which of the projects is acceptable on the basis of the
payback period method.
Table 6.1 Cash flows for two investment options
Year Cash Flow for Project A Cash Flow for Project B

0 `10,000 `10,000
1 `4,000 `3,000
2 `3,000 `1,000
3 `4,000 `2,000
4 `2,000 `3,500
5 `1,000 `4,000
6 – `4,000
7 –
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276 | Chapter 6
Solution:
The recovery of `10,000 will not happen in the 1st or 2nd year but will happen in the 3rd year as
the cumulative total till the end of year 3 exceeds the target of `10,000. Moreover, after recovering
`7,000 in the first 2 years, a sum of only `2,000 needs to be recovered in the 3rd year to equal the
initial investment of `10,000.
3,000
Therefore, the payback period for project A is 2 + = 2.75 years. (It is advisable to retain the
4,000
period in years, else the fraction needs to be multiplied by 12 to convert it into months).
The investment of `10,000 is recovered in 2.75 years if invested in Project A. In case of project B,
the cumulative total of returns exceeds `10,000 in the 5th year.
500
Hence, the payback period for Project B is 4 + = 4.125 years. (or 4 years + 0.125 * 12 months)
4,000
The payback period method would select project A that has a payback period of 2.75 years over
project B that has a payback period of 4.125 years, even though the life of project B is more than
life of project A (with project B having substantial inflows in the later years).
Accounting Rate of Return

The accounting rate of return (ARR) method, also known as the average rate of return method,
is calculated by dividing the average annual net income (after deducting taxes and depreciation)
by the average cash outflow, that is, the average book value. The accounting rate of return is,
thus, an average rate and one of the ways by which it can be determined is by using the following
equation:
Average Income
ARR =
Average Investment
A variation of the ARR method is to divide the average earnings after taxes by the cost of the
project instead of average book value. This method accepts all those projects where ARR value is
higher than the rate required set by the management for accepting proposals. The ranking reserves
the highest rank for project with maximum ARR and lowest rank for project with minimum ARR.
The merits of the ARR method are its simplicity, its consideration of benefits over the entire life
of the project and the fact that it is based on accounting information that is readily available. The
demerits of ARR are that it uses accounting profits and not cash flows besides neglecting the time
value of money. If a new project is being considered, then the profit calculations in future years
would be very subjective. The only merit it has is that the entire stream of income (and expenses) is
considered in calculating the ARR besides introducing relativity to the assessment. When the ratio
of outputs to inputs is considered, the decision-making is relative to the investment rather than an
absolute value like the payback period method where the investment is not considered.
However, this method does not consider the all-important time value of money and should, there-
fore, be considered for rejection analysis rather than selection analysis.
Example 6.6
A machinery costs `80,000 and has a scrap value of `20,000. The company’s stream of income
using this machinery before depreciation and taxes during the first 5 years is `12,000, `15,000,
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`16,000, `18,000 and `11,000 respectively. Assume depreciation on straight line basis and 40% tax
rate. Calculate the accounting rate of return for the project.
Solution:
Depreciation calculation for the 5 years is done first.
Depreciation = Investment - Scrap Value

= 80,000 – 20,000 = 60,000
The period of depreciation is 5 years, and hence, depreciation per year = 60,000/5 = 12,000.
Table 6.2 Steps in ARR calculations
Period (Years) 1 2 3 4 5 Average

EBITDA 12,000 15,000 16,000 18,000 11,000 14,400
Depreciation 12,000 12,000 12,000 12,000 12,000 12,000
EBIT – 3,000 4,000 6,000 –1,000 2,400
Taxes – 1,200 1,600 2,400 – 1,040
Net income – 1,800 2,400 3,600 –1,000 1,360
Book value start 80,000 68,000 56,000 44,000 32,000
End 68,000 56,000 44,000 32,000 20,000
Average 74,000 62,000 50,000 38,000 26,000 50,000
` 1,360
Accounting Rate of Return = ×100 = 2.72%
` 50,000
Net Present Value Method

The methods discussed so far did not consider the time value of money and were for rejection of
project proposals. A prerequisite for rejection was simplicity. However, when a method has to be
used for selection purposes, then it must consider the time factor of money. Simply put, if project A
has returns of `50,000 in the 1st year and `20,000 in the 2nd year, whereas project B has returns
of `15,000 in the 1st year and `55,000 in the 2nd year, then by the methods considered till now,
both the projects give similar returns. However, after some thought, we can agree that project A is
better than project B because the money received after the 1st year can be invested again to gain
more returns.
Methods that fully recognize the time value of money are called time-adjusted methods, discount-
ed cash flow methods or present value methods. The net present value method considers the differ-
ence in values of earnings at different points in time and compares these earnings at their equivalent
present values (when the outflows are incurred). The cash outflows are generally made at the start
of the project and the present values of future earnings are calculated at the start of the project.
The present value of future inflows is summed up and the cash outflows subtracted from this
value. The residual value is the net present value (NPV).
Therefore, NPV = Present Value of Inflows - Present Cash Outflows

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278 | Chapter 6
n
 Ct 
Symbolically, NPV = ∑ (1 + i)  − C
t 0
t =1
where, t is the time period,

i is the discounting factor or generally the interest rate at which funds are available.
C0 is the cash outflow or initial investment.
Ct is the cash inflow in time period t
In NPV 7 0, the proposal is acceptable as the project gives higher return than the bank rate of
return, and in case NPV 6 0, the project proposal is rejected. If the NPV method is used to rank the
projects, then the projects with the higher NPV’s are ranked highest.
The demerits or limitations of NPV method are as follows:
1. It is computationally more difficult than any of the other methods discussed thus far. Ready
reckoners are available that give present value of `1 for different combinations of time pe-
riods and interest rates. In case the discount rate is a fractional value for which the present
value factor is not available in the ready reckoner then the entire computations would have to
be worked out which could be tedious.
2. This method assumes that the discount rate which is usually the firm’s cost of capital (or the
prevailing bank rate of capital) is known and is constant. The discount rate varies with Reserve
Bank of India’s periodic monetary policy, and hence, assuming the cost of capital to remain
constant may not be correct. A higher factor of safety must be considered in such cases.
3. The NPV method calculates the absolute value and would select a project with higher
NPV irrespective of the initial investment. For the sake o f argument, if a project requiring
investment of `1 million gives an NPV of `10,000 and a project requiring investment of
`0.1 million gives an NPV of `8,000, the NPV method would prefer the first project because
`10,000 is greater than `8,000. However, it would be prudent to select the second proposal
as with lesser investment (and a slightly less NPV), the requirement of capital is also less.
4. If two projects with different period of inflows are considered, then the NPV method is not
the best method as after one of the projects has exhausted the inflows, what happens to the
investment is not clear. Therefore, if the expected lifespan of the projects is different, the NPV
method fails.
Example 6.7
Calculate the NPV for a project where the project cost outflow is `30,000 and generates a year-end
cash inflow of `7,000, `6,000, `8,000, `9,000 and `8,000. Assume the discount rate as 8% per
annum. What would the answer be if the rate of return is 10%? Draw appropriate conclusions.
Solution:
Let us first calculate the present value of `1, if it is received after 1 year, 2 years, 3 years, 4 years
and 5 years. The present value = 1/(1 + i)n, where n is time period and i is the rate of interest. In our
problem we require these values for i = 8% and for i = 10%.
Table 6.3 Present value for different rate of interest
Period Formula i = 8% i = 10%

1 1/(1 + i)1 0.9259 0.9091
2 1/(1 + i)2
0.8573 0.8264
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3 1/(1 + i)3 0.7938 0.7513

4 1/(1 + i)4
0.7350 0.6830
5 1/(1 + i)5
0.6806 0.6209
The present values for various combinations of interest rate and time periods are as given in
Table 6.3.
Table 6.4 Net present value for i = 8% and i = 10%
Cash Present Value Factor PV of Cash Flow Present Value Factor PV of Cash Flow
Period Flow (i = 8%) (i = 8%) (i = 10%) (i = 10%)
0 `(30,000) (30,000) (30,000)
1 `7,000 0.9259 6,481 0.9091 6,364
2 `6,000 0.8573 5,144 0.8264 4,959
3 `8,000 0.7938 6,350 0.7513 6,010
4 `9,000 0.7350 6,615 0.6830 6,147
5 `8,000 0.6806 5,445 0.6209 4,967
NPV 35 –1,553
When the discounting rate is 8%, the NPV is positive and in case the discounting factor is 10%, then
the NPV is negative. This tells us that in case the funds could have been invested at 8%, it would be
better to invest in the project and in case the returns from investment were 10%, then it would not
be profitable to invest in the project.
We could also present the same analysis graphically as shown in Figure 6.1. Using different rates
of discounting the project, the NPV is obtained and plotted on a graph paper to obtain present value
profile.
Table 6.5 NPV for different discount factors
Period 0 2% Discount 4% Factor 6% 8% 10% 12%

0 –30,000 -30,000 -30,000 -30,000 -30,000 -30,000 -30,000
1 7,000 6,863 6,731 6,604 6,481 6,364 6,250
2 6,000 5,767 5,547 5,340 5,144 4,959 4,783
3 8,000 7,539 7,112 6,717 6,351 6,011 5,694
4 9,000 8,315 7,693 7,129 6,615 6,147 5,720
5 8,000 7,246 6,575 5,978 5,445 4,967 4,539
NPV 8,000 5,729 3,659 1,768 36 -1,553 -3,014
The NPV for various discounting factors are shown in Table 6.5.
Example 6.8
A company is considering four proposals for investment and the 10-year funds flow/cash inflow is
given in Table 6.6. Use the payback period criteria and the NPV method criteria, advise the company
on the best course of action. The discount rate is 14%.
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280 | Chapter 6
Present Value Profile
10000
8000
8000
5729
6000
Net Present Value
3659
4000
1768
2000
36
0
0 2 4 6 8 10 12
-2000 -3014
-1553
-4000
Discount Rate
Net Present Value (NPV)
Figure 6.1 Plot of NPV for various discount factors
Table 6.6 Cash outflow and inflow data for four proposals
Proposal Y0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10
A –200 40 40 40 40 40 40 40 40 40 40
B –300 40 40 40 40 40 30 30 20 20 20
C –210 80 50 80 60 80 50 40 40 40 40
D –320 200 20 0 0 0 0 0 0 200 50
MMM, VI Sem, Mumbai Univ, 1998.
Solution:
We will first identify the best option by using the payback period method. We will compute the
cumulative total for each decision option and whichever year the cumulative total becomes 0, that
is the payback period. This is shown in Table 6.7.
Table 6.7 Payback period for all options
Proposal Y0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10
A -200 -160 -120 -80 -40 0 40 80 120 160 200
B -300 -260 -220 -180 -140 -100 -70 -40 -20 0 20
C -210 -130 -80 0 60 140 190 230 270 310 350
D -320 -120 -100 -100 -100 -100 -100 -100 -100 100 150
Hence, proposal C has the shortest payback period, and hence, as per the payback period method,
we should prefer the proposal C.
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Next, we will calculate the NPV for each proposal with the discount rate of 14%. The working of
NPV are shown in Table 6.8. Once again, it is seen that proposal C has the highest NPV and hence
must be selected for investment.
Table 6.8 NPV calculations
Proposal Y0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 NPV
PV @
0.8772 0.7695 0.6750 0.5921 0.5194 0.4556 0.3996 0.3506 0.3075 0.2697
14%
A -200 35 31 27 24 21 18 16 14 12 11 9
B -300 35 31 27 24 21 14 12 7 6 5 -118
C -210 70 38 54 36 42 23 16 14 12 11 106
D -320 175 15 0 0 0 0 0 0 62 13 -54
Example 6.9
National Electronics Ltd, an electronic goods manufacturing company, manufactures a large range
of electronic goods. It has under consideration two projects X and Y, each costing `120 lakhs. The
projects are mutually exclusive and the company is considering the question of selecting one of the
two projects. Cash flows have been worked out for both the projects and the details are given in
Table 6.9. Project X has a life of 8 years and Project Y has a life of 6 years. Both will have zero sal-
vage value at the end of their operational lives. The company is already making profits and its tax
rate is 50%. The cost of capital of the company is 15%.
Table 6.9 Cash flows associated with Project X and Y
Net Cash Inflow

at the End of Year Project X Project Y Present Value
1 25 40 0.8696
2 35 60 0.7561
3 45 80 0.6575
4 65 50 0.5718
5 65 30 0.4972
6 55 20 0.4323
7 35 – 0.3759
8 15 – 0.3269
The company follows straight-line method of depreciating assets. Advise the company regarding
selection of the project.
Solution:
Computation of net present value of the Project X, and Project Y, is shown in Tables 6.10 and
6.11, respectively. The company follows a straight line depreciation method and the equipment
has zero salvage value, which means the `120 lakhs has to be written off over a period of 8 years
for project X.
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282 | Chapter 6
Table 6.10 Analysis for project X. Values in ` Lakhs
Period Cash Inflows Depreciation PBIT Tax PAT PAT + Depreciation PV Factor PV of Inflows
0 –120 –120
1 25 15 10 5 5 20 0.8696 17.39
2 35 15 20 10 10 25 0.7561 18.90
3 45 15 30 15 15 30 0.6575 19.73
4 65 15 50 25 25 40 0.5718 22.87
5 65 15 50 25 25 40 0.4972 19.89
6 55 15 40 20 20 35 0.4323 15.13
7 35 15 20 10 10 25 0.3759 9.40
8 15 15 0 0 0 15 0.3269 4.90
NPV 8.21
The company follows straight line depreciation method and the equipment has a zero salvage value,
which means `120 lakhs has to be written off over a period of 6 years for project Y. Hence, depre-
ciation is `20 lakhs per year.
Table 6.11 Analysis for project Y (Values in ` Lakhs)
PAT + PV of
Period Cash Inflows Depreciation PBIT Tax PAT Depreciation PV Factor Inflows
0 –120 –120
1 40 20 20 10 10 30 0.8696 26.09
2 60 20 40 20 20 40 0.7561 30.25
3 80 20 60 30 30 50 0.6575 32.88
4 50 20 30 15 15 35 0.5718 20.01
5 30 20 10 5 5 25 0.4972 12.43
6 20 20 0 0 0 20 0.4323 8.65
NPV 10.30
The NPV of project Y is higher than the NPV of Project X and hence the company should select
project Y for investment.
Example 6.10
Calculate the NPV of the following investment proposals and decide on the acceptance/rejection of
these proposals. Discount rate is 10%.
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Table 6.12 Cash inflows/outflows for four proposals
Cash Inflows (`)

Proposal Investment (`) 1 2 3 4
A 20,000 8,000 8,000 8,000 8,000
B 20,000 6,000 8,000 10,000 10,000
C 20,000 4,000 8,000 10,000 10,000
D 20,000 10,000 10,000 10,000 5,000
Calculate the internal rate of return (IRR) for these proposals.

Solution:
We will solve the IRR part of the problem later, after explaining the procedure for finding IRR.
For discount rate 10%, the present value factor is shown in Table 6.13.
Table 6.13 Present value for 10% discount rate
Period 1 2 3 4
PV Factor 0.9091 0.8264 0.7513 0.6830
The NPV for each of the proposals is as shown in Table 6.14.

Table 6.14 NPV calculations for various proposals
Period 1 2 3 4 NPV
PV Factor 0.9091 0.8264 0.7513 0.683
A –20,000 7,272.8 6,611.2 6,010.4 5,464 5,358.4
B – 20,000 5,454.6 6,611.2 7,513 6,830 6,408.8
C – 20,000 3,636.4 6,611.2 7,513 6,830 4,590.6
D – 20,000 9,091 8,264 7,513 3,415 8,283
The NPV for proposal D is the highest, and hence, this proposal must be selected. Furthermore, the rank-
ing of various proposals on the basis of NPV is Proposal D 7 Proposal B 7 Proposal A 7 Proposal C.
Example 6.11
A company has to select between two investment opportunities, A and B, both of which require an
initial investment of `25,000. The expected net returns and cash flows for each of the investment
options is as given below:
Year Investment A Investment B

1 `8,000 `6,500
2 `6,000 `8,500
3 `5,000 `6,000
4 `6,000 `5,000
5 `5,000 `4,000
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284 | Chapter 6
The company’s cost of capital is 10%. Calculate the NPV for each investment option. If NPV is the
basis for selecting the investment option, then which option is preferable?
Solution:
At first glance, both the investment options give an overall return of `30,000 in 5 years, which
means an average of `6,000 per annum. As per the ARR method, both the options would have given
similar returns, thus making a choice would have been inconclusive. Now, from the present value
in Table 6.15, we have the present value of `1 for the 5 periods, when the cost of capital is 10% as
follows:
Table 6.15 Present value for 10% discount rate
Period 1 2 3 4 5
PV Factor 0.9091 0.8264 0.7513 0.6830 0.6209
The calculations of NPV are given in Table 6.16.
Table 6.16 NPV calculations
Investment A Investment A Investment B Investment B

Year PV Factor (Cash Flow) (Present Value) (Cash Flow) (Present Value)
0 0 - 25,000 - 25,000
1 0.9091 8,000 7,272.8 6,500 5,909.15
2 0.8264 6,000 4,958.4 8,500 7,024.4
3 0.7513 5,000 3,756.5 6,000 4,507.8
4 0.6830 6,000 4,098 5,000 3,415
5 0.6209 5,000 3,104.5 4,000 2,483.6
NPV - 1,810 - 1,660
It is abundantly clear from the above calculations that both the proposals give a negative NPV,
which means that it would be better to invest in bank deposits and avail 10% returns rather than
investing in either proposal.
Net Present Value when Annuities are Involved

Annuities refer to a series of payments, usually in equal instalments. EMI, the most commonly
used term for repayment of car loans or house loans, is an annuity. For annuities, the payments are
computed by the compound interest method and are made at fixed intervals in time. The annuity
payment terminal value called the amount of annuity and the present value of annuity is calculated
by the formula as given below:
(Rn − 1) (1 − R−n )
Q = A× V = A×
(R − 1) (R − 1)
where, Q = Amount of annuity on maturity
V = Present value of maturity value when annuities are involved
R = 1 + i, where i is the rate of interest
n = Number of periodic @Seismicisolation
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(Rn − 1) (1 − R−n )
Now the values of and
(R − 1) (R − 1)
called the amount factor for annuity and present value factor for annuity is available from
ready reckoners.
Example 6.12
A company is deciding to choose between two mutually exclusive projects A and B. Project A
requires an initial investment of `5,00,000 and is expected to generate a cash flow of `2,00,000 per
annum for the 4 years of its life. Project B, on the other hand, requires `7,00,000 and has a lifespan
of 7 years, where it is expected to generate a return of `1,50,000 every year. If the cost of capital is
12% per annum, then which of the proposals should be accepted?
Solution:
In this case, both the projects have fixed returns in every time period and hence, this is an annuity
problem. The present value factor for annuity for rate of interest 12% and time period 4 and 7 is
3.0373 and 4.5638, respectively.
NPVProject A = 2,00,000 * 3.0373 – 5,00,000 = 1,07,460
NPVProject B = 1,50,000 * 4.5638 – 7,00,000 = – 15,430
The NPV of project A is positive, whereas the NPV of project B is negative. Hence, we would select
project A as this proposal gives higher returns.
Equivalent Annuity Method

Suppose in Example 6.12, project B generated a revenue of `1,80,000 per year, then NPVProject B of
project B would have been 1,80,000 * 4.5638 – 7,00,000 = `1,21,484 and we would have probably
concluded that as the NPV of project B is higher, it should be preferred for investment. However,
an important shortcoming of this decision is that the lives of the projects are not equal and we have
discussed earlier that NPV method is not the best method under such conditions.
Project A has a lifespan of 4 years and project B has a lifespan of 7 years. The NPV generated for
project A is, therefore, over a 4-year period and the NPV generated for project B is over a 7-year
period. In such situations, we should somehow try and equalize the project lives. One method of
equalizing the project lives is the equivalent annuity method where we restate the NPV as an annual
NPV which is calculated using the equation,
Equivalent annual annuity = NPVn / PV factor for n (and i)
Therefore, equivalent annual annuityProject A = 1,07,460/3.0373
= `35,380.11
and equivalent annual annuityProject B = 1,21,484/4.5638
= `26,619.04
The project with higher equivalent annuity contributes more to maximization of wealth of the
owner. Since the equivalent annual annuity for project A is higher than the equivalent annual annu-
ity for project B, we will select project A.
However, this method of equalizing the lives of the product is applicable only when equal periodic
inflows or annuities are involved.
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286 | Chapter 6
Internal Rate of Return (IRR)

The internal rate of return is the rate at which the investment for the project is repaid by the returns
from the project. The present value of future inflows changes with the discount factor, and hence,
that particular discount factor, which equalizes the cash inflows with cash outflows, is the internal
rate of return, IRR. Simply put IRR is that discount rate when the net present value is zero.
It can be symbolically represented as:
C1(1 + IRR)-1 + C2(1 + IRR)-2 + C3(1 + IRR)-3 + ... - C0 = 0
or
n
∑ C (1 + IRR)
t
−t
− Co = 0
t =1
where n = Number of time periods
C0 = Initial cash outflow
Ct = Cash inflows in time period t
The computed IRR is compared with the required rate of return. If the computed rate is in excess of
the rate set by the organization, then the project proposal is accepted. IRR method can also be used
to rank the projects with projects having higher IRR being ranked higher. For projects with different
lifespans, IRR method gives a viable option as compared to the NPV method. The calculations of
IRR are, at times, very recursive because there is no direct way of finding the IRR.
The starting point is always by trial and error method and one way to start solving the problem
is by considering the discount rate as the rate at which capital is being raised. If the NPV with this
rate of capital (also called the bank rate) is positive, then it means that the project is giving returns
at a higher rate. In general, if the NPV is positive, then the discounting rate is increased till such
time that we have a negative NPV. The IRR is the rate when NPV = 0, which means the IRR lies
between the values of the discount rate when NPV is positive and negative. If the NPV is negative,
then the discounting rate is reduced to determine the rate where NPV is positive. Once again, IRR
lies between the values of discount rate when NPV is negative and positive.
If the NPV is negative at the bank rate, then the proposal is rejected because the IRR would be
less than this bank rate, which, in any case, is the threshold rate to consider a project. If the NPV is
positive, then the discounting rate is progressively increased till the NPV becomes zero or negative.
If the NPV is zero at a particular discount rate, then that rate is the IRR. If the NPV is negative for
some discount rate and positive for the earlier discount rate, then the IRR lies between these two
rates. The exact value of IRR is then calculated by simple extrapolation method.
If the bank rate is not known, then the starting point can always be a discount rate of 10%.
There is an elaborate procedure to find the average cash inflow for every year and consider it to
be the annuity. Once the annuity value is calculated, we find the ratio of cash outflow divided by
annuity and identify the value closest to this ratio in the present value of annuity table in the row
corresponding to the number of time periods. The column corresponding to this closest value is the
starting discount rate for calculation of IRR. The column rate of interest is taken as the starting
point and the first NPV is calculated. Once the initial NPV is calculated, the subsequent trial and
error procedure remains the same as enumerated earlier.
Extrapolation Process
Consider a case where the NPV for 12% is 200 and NPV for 14% is - 100. Hence, the IRR (when
NPV = 0) would be between these two values.
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200
Thus, IRR = 12% + ×(14 − 12) = 13.33%
(200 + 100)
Alternately, we could also use the outflows and inflows for computing the IRR. Suppose the outflow
is 10,000, present value of inflow at 12% is 10,200 and present value of inflow at 14% and discount
rate is 9,900.
(10,200 − 10,000)
IRR = 12% + ×(14% − 12%) = 13.33%
(10,200 − 9,900)
The same value of IRR can be obtained by considering starting point as 14%:
(10,000 − 9,900)
IRR = 14% − ×(14% − 12%) = 13.33%
(10,200 − 9,900)
The second element should be multiplied by the class interval, that is, if the interval is 12% and
14%, then a difference of 2% should be multiplied to the second element. Similarly, if the interval is
10% and 20%, then a difference of 10%, i.e., (20 - 10) should be multiplied to the second element.
We will now calculate the IRR for the problem 6.10.
Table 6.17 Cash inflows/outflows for four proposals
Cash Inflows (`)

Proposal Investment (`) 1 2 3 4
A 20,000 8,000 8,000 8,000 8,000
B 20,000 6,000 8,000 10,000 10,000
C 20,000 4,000 8,000 10,000 10,000
D 20,000 10,000 10,000 10,000 5,000
1. For proposal A, let us consider a discount factor of 10%, 15%, 20% and 25%. (The PV factor
for discount rate 10%, 15%, 20% and 25% is as given in Table 6.18.
Table 6.18 PV factor for different discount rate(s)
Period 1 2 3 4
Present value @ 10% 0.9091 0.8264 0.7513 0.6830
Present value @ 15% 0.8696 0.7561 0.6575 0.5718
Present value @ 20% 0.8333 0.6944 0.5787 0.4823
Present value @ 25% 0.8000 0.6400 0.512 0.4096
The PV at 10% discount factor is `25,358.40.

The PV at 15% discount factor is `22,840.
The PV at 25% discount factor is `18,892.8 (less than `20,000).
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288 | Chapter 6
Hence, the IRR is between 20 and 25% discount factor.

(20,709.6 − 20,000)
IRR = 20% + ×(25% − 20%) = 21.95%
(20,709.6 − 18,892.8)
Alternately,
(20,000 − 18,892.8)
IRR = 25% − ×(25% − 20%) = 21.95%
(20,709.6 − 18,892.8)
Note: Since IRR is greater than 20%, if 20% is taken as the base, then IRR would be higher, and
hence, the next fraction should be added. Similarly, if 25% is considered the base, then IRR is
less than 25% and hence, the next fraction should be subtracted. The fraction would be different
if we choose 20% as base or 25% as base but, in either case, the calculated IRR would remain
the same.
2. IRR for proposal B:
(21,165 − 20,000)
IRR = 20% +
×(25 − 20) = 22.87%
(21,165 − 19,136)
3.
IRR for proposal C:
The PV at 10% discount factor is 24,590.6.
(21,820.2 − 20,000)
IRR = 15% + ×(20 − 15) = 18.92%

(21,820.2 − 19,498.4)
4. IRR for proposal D:
The PV at 10% discount factor is 28,283.
(21,568 − 20,000)
IRR = 25% + ×(30 − 25) = 29.73%

(21,568 − 19,911.5)
Proposal D has the highest IRR = 29.73% and the company must invest in this proposal. Further
ranking of proposals on the basis of IRR is as follows:
Proposal D 7 Proposal B 7 Proposal A 7 Proposal C
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Example 6.13
For the project with the given data, calculate the internal rate of return.
Table 6.19 Cash flow data
Year Cash Outflow Cash Inflow

0 `10,00,000/- —
1 — `4,00,000
2 — `3,00,000
3 — `2,50,000
4 — `2,00,000
5 — `2,00,000
6 — `1,50,000
Solution:
The average inflow per year is `2,50,000. If we consider this as the annuity received for 6 years, then
the present value of annuity is given by the equation:
Present value
Present value of annuity = Amount of annuity * factor for
annuity of `1
The present value factor for annuity for time period 6, the closest table value to calculated present
value of 4 is in the column of 13% (The choice is between 4.0538 for column of i = 12.5% and
3.9975 corresponding to column of i = 13%).
Hence, we find out the NPV for i = 13%. The calculations are as shown in Table 6.20.
Table 6.20 NPV calculations with 13% rate of interest
Period PV Factor Cash Flow Present Value of Cash Flow

0 – - 10,00,000 - 10,00,000
1 0.8850 4,00,000 3,54,000
2 0.7831 3,00,000 2,34,930
3 0.6931 2,50,000 1,73,275
4 0.6133 2,00,000 1,22,660
5 0.5428 2,00,000 1,08,560
6 0.4803 1,50,000 72,045
NPV 65,470
The NPV is positive, and hence, we will increase the discount factor by 2%. The rate of interest being
considered now is 15%. The calculations are shown in Table 6.21.
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290 | Chapter 6

0 – - 10,00,000 - 10,00,000
1 0.8696 4,00,000 3,47,840
2 0.7561 3,00,000 2,26,830
3 0.6575 2,50,000 1,64,375
4 0.5718 2,00,000 1,14,360
5 0.4972 2,00,000 99,440
6 0.4323 1,50,000 64,845
NPV 17,690
The NPV is still positive, and hence, we will increase the discount factor by 1%. The rate of
interest being considered now is 16%. The calculations are shown in Table 6.22.

0 – -10,00,000 -10,00,000
1 0.8621 4,00,000 3,44,840
2 0.7432 3,00,000 2,22,960
3 0.6407 2,50,000 1,60,175
4 0.5523 2,00,000 1,10,460
5 0.4761 2,00,000 95,220
6 0.4104 1,50,000 61,560
NPV - 4785
The NPV is negative which means that the IRR is between 15% and 16%. We will use the extrapo-
lation method to get the exact IRR.
17,690
IRR = 15% + ×(16 − 15)
(17,690 + 4,785)
= 15.79%
Limitations of the IRR Method

The limitations of the IRR are as follows:
1. The IRR method decides the ranking of projects on the bases of percentage, which is, at
times, difficult to work with. If project A has an IRR of 18% and project B has an IRR of
16% and we want to know how much is project A better than project B, then the answer
is not 2%. NPV is an absolute number and in case of NPV, such information can be easily
calculated.
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2. The PV factors are always positive, which means that to find the PV factor, the ratio of cash
flow and present value of cash flow must be positive. However, if the future cash flows are
negative for some period, calculating IRR is not possible.
3. IRR also does not consider the inputs or the initial investment and hence is not able to dif-
ferentiate between projects having different initial investments.
Profitability Index Method

One of the limitations of the NPV method (and the IRR method) was that the projects outflows
were not compared relative to the project inflows since the NPV method was based on an absolute
value of return. The NPV simply gave the excess of present values over cash outflows in absolute
terms. The profitability index method seeks to rectify this anomaly in that the inflows are compared
with outflows and a measure of relativity is added. Therefore, the profitability index is used as a
measure for comparing the inflows vis-à-vis the outflows.
Present value of cash inflow

Profitability index (PI) =
Initial cash outflow
Benefit Cost Ratio and Net Benefit Cost Ratio

This method is somewhat similar to the profitability index method. Under this method, the benefits
from the various options are discounted to their present value at a specified rate of discount (usually
the cost of capital) and this figure is then divided by the present value of the cost of the option being
considered. The difference between BCR and PI is that in calculating BCR, the cash outflows that
occur over a period are also reduced to their present value. In case of PI, the period over which cash
outflows occur are ignored and it is assumed that the entire cash outflow occurs at the initial period.
This is the reason why BCR method has an advantage over the PI method.
Present value of cash inflows

BCR =
Present value of cash outflows
An extension of the BCR method is the net benefit cost ratio (NBCR) and NBCR = BCR - 1.
If the BCR is greater than one (or if NBCR is greater than zero), then it indicates that the benefits
from this option are more than the costs incurred for this option. Similarly, a project with the high-
est BCR (and NBCR) is preferred over other projects with lesser BCR (and NBCR).
Discounted Payback Period Method

This method is similar to the first payback period method but with a significant advantage. In this
case, we consider the discounted present values of future cash inflows and determine the number of
years required to recover the initial investment. If discounted payback period is less than the desired
payback period, then the project is accepted; otherwise, it is rejected. Projects with lesser discounted
payback period are given higher ranking.
Common Time Horizon Period Method

This is a method which is used when the projects being considered have different lifespans. It is
necessary for the projects to have the same lifespan for effective comparison. The comparison is,
therefore, made over multiples of the lives of each product. For example, if project A has a lifespan
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292 | Chapter 6
of 3 years and project B has a lifespan of 4 years, then we compare the projects for a lifespan of
12 years (3 * 4). Therefore, the investment and returns for project A get considered four times
and the investments and returns for project B get considered three times. This is akin to repeating
project A (and all the inflows/outflows) four times and repeating project B (and all the inflows/
outflows) three times.
The demerit here is that the method implicitly assumes that the investment being replaced will
produce cash flows of a similar pattern as it has been done in the past, which may or may not be
correct. Second, competing projects may have a larger time span like 15 years for project A and 16
years for project B in which case, we will have to study the NPV of 15 * 16 = 240 years. Not only
is this physically difficult but perhaps practically also improbable.
Points of Comparison between NPV and IRR Methods

There have been many discussions on the merits and demerits of IRR vis-à-vis` the NPV method.
Both the methods maximize the owners’ profit but are not in complete correspondence with each
other. It is possible to have contradictory conclusions with IRR and NPV methods. In such scenari-
os, organizations exercise their preferred option. Each method has some advantages over the other
and the following points may be considered:
1. IRR is a percentage, whereas NPV is a unit value. Many a time, a unit value is easier to under-
stand and comprehend than a percentage. Extrapolating the conclusions for further analysis
is simple if a unit value is involved and rather complex when a percentage, as in the case of
IRR, is involved.
2. The NPV assumes that the rate of discount is stable over the period of the project or investment.
In practice, this may not be true and the conclusions drawn from the NPV may be incorrect,
if the discount rate increases significantly. In case of IRR, there is no relationship with the
discount rate and only the mark-up of IRR over the discount rate may change if the discount
factor increases significantly.
3. IRR considers cash flows over the entire life of the project and this may be advantageous
when ranking projects with different lifespans.
4. NPV is an absolute value method which will work well when the initial investment for
projects being considered is same. If we have to compare two projects with different initial
cash outflows, then IRR method would give better results. Furthermore, if the discounting
rates change, then the project which has higher future cash flows would be more impacted
then the project with lower future cash flows.
5. In case of negative cash inflows at a future date (which happens when project requires additional
funding or when outflows are more than inflows in particular year), the IRR method fails
because it would have a situation which cannot be mathematically comprehended. (Like −1 ).
6. In the discounted cash flow methods, we use the concept of reinvestment of funds to gain
compounded interest. The question now is at what rate the compound rate should be calculated.
In case of NPV, since the discount rate is the cost of capital, it is more correct. In case of IRR,
the compounding rate is assumed to be the IRR, which could be much higher than the cost of
capital, and getting investment returns at this higher rate may not be feasible. Therefore, in case
of NPV, the opportunity rate of investment is the prevailing rates, whereas in case of IRR, the
opportunity rate of investment is same as IRR.
7. The IRR may be different for different projects (and hence the reinvestment rate) but the
discount rate applied under the NPV method is the same for all the projects being considered.
Therefore, in case of IRR calculations, different projects will have different reinvestment rates,
whereas under NPV methods, all the projects would be compared with same reinvestment rates.
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Example 6.14
A company is planning to buy a new machine and has received two competitive offers. Both the
machines have the same manufacturing capacity but differ in their initial price and annual operating
costs. The details of both the offers are given in Table 6.23. If the marginal cost of capital for the
company is 12.0%, then recommend which machine to be purchased?
Table 6.23 Details of machine costs
Estimated Operating and Maintenance Costs

Initial
Life Cost Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10
M/c A 6 years 500 80 100 120 150 150 150 – – – –
M/c B 10 years 700 90 120 150 150 150 150 175 175 175 175

Solution:
In this problem, the costs are given, which means we will have to calculate the present value of the
costs and add to the initial cost. The machine with the least total cost should be preferred. This is un-
like the NPV problem where the present values of all inflows are calculated and outflows subtracted
from them. The present value factor for a discounting rate 12% is given in Table 6.24.
Table 6.24 Present value factor for discount rate 12%
Period 1 2 3 4 5
PV Factor 0.8929 0.7972 0.7118 0.6355 0.5674
Period 6 7 8 9 10
PV Factor 0.5066 0.4523 0.4039 0.3606 0.3220
The present value of all the expenses incurred on machine A are, 80 * 0.8929 + 100 * 0.7972 + 120
* 0.7118 + 150 * 0.6355 + 150 * 0.5674 + 150 * 0.5066 = `492.99 ~ `493.
Therefore, the total cost for machine A including the initial cost and the estimated operating and
maintenance cost = 500 + 493 = `993. Average per year cost = 993/6 = `165.5 per year. Similarly,
the total cost for machine B including the initial cost and the estimated operating and maintenance
cost = 700 + 808 = `1508. Average per year cost = 1508/10 = `150.8 per year.
Hence, machine B is a better option to be purchased.
Example 6.15
A company with a 10% cost of funds and limited investment of `160 lakhs is evaluating the desir-
ability of several investment proposals:
Table 6.25 Data on several investment proposals
Project Initial Investment (` Lakhs) Life (Years) Annual Cash Flow (` Lakhs)
P 120 5 30
Q 80 3 32
R 80 4 25
S 40 7 8
T 120 9 15
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294 | Chapter 6
(a) Rank the projects according to the profitability index and NPV methods.
(b) Determine the optimal investment package.
Solution:
Annual cash flows are assumed to be constant over the life of the project, which means this is a
problem of annuity. Hence table for present value of annuity (PVFA) should be used. The NPV cal-
culations are shown in Table 6.26.
(a) Ranking the projects on the basis of NPV and PI.
Table 6.26 NPV calculations and ranking
Initial Investment Life Annual Cash PV of

Project (` Lakhs) (Years) PVFA Flow (` Lakhs) Cash Flow NPV Rank
P 120 5 3.791 30 114 –6 IV
Q 80 3 2.487 32 80 0 I
R 80 4 3.170 25 79.25 –0.8 II
S 40 7 4.868 8 39 –1 III
T 120 9 5.759 15 86 –34 V
Table 6.27 Profitability index calculations and ranking
Initial Investment Life Annual Cash Flow PV of

Project PVFA PI Rank
(` Lakhs) (Years) (` Lakhs) Cash Flow
P 120 5 3.6048 30 108 0.95 IV
Q 80 3 2.4018 32 77 1.0 I
R 80 4 3.0373 25 76 0.99 II
S 40 7 4.5638 8 37 0.98 III
T 120 9 5.3282 15 80 0.72 V
(b) The optimal investment package could be investing `80 lakhs in project Q and `40 lakhs in
project S.
Example 6.16
Compute the internal rate of return (IRR) from the following data (Table 6.28).
Table 6.28 Cash flow data
Year 0 1 2 3 4 5
Cash Flow (`) –10,000 5,000 4,000 3,000 2,000 1,000
Solution:
Let us first consider a discount rate of 10%. The present value factors for a discount rate 10% are
as given in Table 6.29.
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Table 6.29 PV factor for 10% discount rate
Period 1 2 3 4 5
PV Factor 0.909 0.826 0.751 0.683 0.621
NPV10% = 5000 * 0.909 + 4000 * 0.826 + 3000 * 0.751 + 2000 * 0.683 + 1000 * 0.621
– 10000 = 2089
Next, we will consider a discount rate of 15%. The present value factors for a discount rate 15%
are as given in Table 6.30.
Period 1 2 3 4 5
PV Factor 0.870 0.756 0.658 0.572 0.497
NPV15% =
5000 * 0.87 + 4000 * 0.756 + 3000 * 0.658 + 2000 * 0.572 + 1000 * 0.497 – 10000
= 989
As the NPV15% is greater than 0, we will consider a discount rate of 20%. The present value fac-
tors for a discount rate 20% are as given in Table 6.31.
Period 1 2 3 4 5
PV Factor 0.833 0.694 0.579 0.482 0.402
NPV20% =

5000 * 0.833 + 4000 * 0.694 + 3000 * 0.579 + 2000 * 0.482 + 1000 * 0.402 – 10000
= 44
The NPV is still greater than 0, and hence, let us consider a discount rate of 22%. The present
value factors for a discount rate 22% are given in Table 6.32.
Period 1 2 3 4 5
PV Factor 0.820 0.672 0.551 0.451 0.370
NPV22% = 5000 * 0.820 + 4000 * 0.672 + 3000 * 0.551 + 2000 * 0.451 + 1000 * 0.370 – 10000
= – 287.
44
IRR = 20% + ×(22 − 20) = 20.27%
(44 + 287)
The internal rate of return for the above project proposal is 20.27%.
Example 6.17
A company is considering investing surplus funds in a project. Four projects are being considered.
The projected cash flow for the projects is given below. Based on the NPV and profitability index
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296 | Chapter 6
criteria, rank the projects. Based on the profitability index criteria which project will you recommend
for execution? Assume discount rate of 8%.
Table 6.33 Projected cash flow
Year Y0 Y1 Y2 Y3 Y4 Y5 Y6
Project A (400) 100 100 100 100 100 100
Project B (600) 120 120 100 180 180 160
Project C (400) 160 140 100 180 60 40
Project D (640) 400 100 120 0 0 200
Solution:
The present value factor for discount rate 8% is shown in Table 6.34. The formula for PV factor is
(1 + i)–n.
Table 6.34 Present value factor for 8% discount rate
Period 1 2 3 4 5 6
PV Factor 0.926 0.857 0.794 0.735 0.681 0.630
NPVProject A = 100 * 0.926 + 100 * 0.857 + 100 * 0.794 + 100 * 0.735 + 100 * 0.681 + 100 *
0.630 – 400 = 62.3
Similarly,
NPVProject B = 49.04,
NPVProject C = 145.9,
NPVProject D = 37.38.
Ranking on the basis of NPV criteria is Project C – I, Project A – II, Project B – III, Project D – IV.
Present Value of Cash Inflow

Profitability Index =
Cash Outflow
PIProject A = 462.3/400 = 1.16

PIProject B = 649.04/600 = 1.08
PIProject C = 545.9/400 = 13.65
PIProject D = 677.38/640 = 1.06
Ranking on the basis of profitability index criteria is Project C – I, Project A – II, Project B – III,
Project D – IV.
We should recommend project C for execution on the basis of profitability index method.
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Example 6.18
ABC Ltd is considering three projects. The expected cash flows are as follows:
Year A B C
0 (1,00,000) (1,00,000) (1,00,000)
1 50,000 10,000 10,000
2 50,000 10,000 50,000
3 10,000 50,000 40,000
4 10,000 30,000 70,000
5 10,000 1,00,000 10,000
1. Assuming the company’s cost of capital as 10%, determine (i) payback, (ii) the internal rate
of return (approximate) and (iii) the NPVfor each project.
2. Rank the projects by payback, NPV and IRR methods of capital budgeting.
Solution:
The NPV for 10% is asked and this is also the starting point for IRR. Hence, we should address part
(iii) earlier than part (ii).
1. Payback period and ranking: the cumulative returns for the three projects are shown in
Table 6.36.
Table 6.36 Payback period calculations
Year A Cumulative B Cumulative C Cumulative

0 - 1,00,000 - 1,00,000 - 1,00,000
1 50,000 50,000 10,000 10,000 10,000 10,000
2 50,000 1,00,000 10,000 20,000 50,000 60,000
3 10,000 1,10,000 50,000 70,000 40,000 1,00,000
4 10,000 1,20,000 30,000 1,00,000 70,000 1,70,000
5 10,000 1,30,000 1,00,000 2,00,000 10,000 1,80,000
2. The payback period for project A is 2 years, for project B is 4 years and project C is 3 years.
Hence, ranking of projects on the basis of payback period method is:
Project A – I, Project C – II and Project B – III.
3. NPV assuming the cost of capital as 10%. The present value factor for 10% discount rate is
obtained from the ready reckoner table given in the question as follows:
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298 | Chapter 6
Period 1 2 3 4 5
PV Factor 0.909 0.826 0.751 0.683 0.621
The NPV calculations are shown in Table 6.38.
Table 6.38 NPV calculations for 10% discount rate
Year A B C PV Factor PVA PVB PVC

0 - 1,00,000 - 1,00,000 - 1,00,000
1 50,000 10,000 10,000 0.9091 45,455 9,091 9,091
2 50,000 10,000 50,000 0.8264 41,322 8,264 41,322
3 10,000 50,000 40,000 0.7513 7,513 37,566 30,053
4 10,000 30,000 70,000 0.6830 6,830 20,490 47,811
5 10,000 1,00,000 10,000 0.6209 6,209 62,092 6,209
NPV 7,329 37,504 34,486
1. The ranking of projects on the basis of NPV is:
Project B – I, Project C – II, Project A – III.
2. IRR calculations
The NPVs for all the projects are positive, and hence, we increase the discount factor to 15% and
calculate the NPV’s again. The NPV calculations are shown in Table 6.39.
Year A B C PV Factor PVA PVB PVC

0 - 1,00,000 - 1,00,000 - 1,00,000
1 50,000 10,000 10,000 0.8696 43,478 8,696 8,696
2 50,000 10,000 50,000 0.7561 37,807 7,561 37,807
3 10,000 50,000 40,000 0.6575 6,575 32,876 26,301
4 10,000 30,000 70,000 0.5718 5,718 17,153 40,023
5 10,000 1,00,000 10,000 0.4972 4,972 49,718 4,972
NPV - 1,450 16,003 17,798
NPV for project A is negative at 15%, and hence, the IRR for project A is in between 10% and 15%.
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7329
IRR Project A = 10% + ×(15 − 10)% = 14.17%
(7329 + 1450)
Now, we find out the NPV for project B and project C with discount factor 20%.
Year A B C PV Factor PVB PVC

0 - 1,00,000 - 1,00,000
1 50,000 10,000 10,000 0.8333 8,333 8,333
2 50,000 10,000 50,000 0.6944 6,944 34,722
3 10,000 50,000 40,000 0.5787 28,935 23,148
4 10,000 30,000 70,000 0.4823 14,468 33,758
5 10,000 1,00,000 10,000 0.4019 40,188 4,019
- 1,132 3,980
NPV for Project B is negative at 20% and hence, the IRR for Project B is in between 15% and 20%.
16003
IRR Project B = 15% + ×(15 − 10)% = 19.67%
(16003 + 1132)
IRR for Project C is greater than 20%.

Hence, the ranking of projects on the basis of IRR method is
Project C – I, Project B – II and Project A – III.
Example 6.19
Your company is considering two mutually exclusive projects A and B. Project A involves an outlay
of `100 million and will generate an expected cash inflow of `25 million per year for 6 years. Project
B calls for an outlay of `50 million which will produce an expected cash inflow of `13 million
per year for 6 years. The company’s cost of capital is 12%. Suggest with appropriate reasons your
choice of the project.
Solution:
Since the inflows are same for the entire period, this is a problem involving annuities. Hence, the
present value for annuity should be considered.
PVFA for 12% and period 6 is 4.111.
NPVProject A: 25 * 4.111 – 100 = 2.775
NPVProject B: 13 * 4.111 – 50 = 3.443
As the NPV for project B is higher than the NPV for project A, we would prefer project B.
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300 | Chapter 6
Example 6.20
A company with a cost of capital of 12% is considering two projects X and Y. The details pertaining
to these two projects are given in Table 6.41.
Table 6.41 All values in `
Particulars Project X Project Y

Initial Investment 15,00,000 15,00,000
Cash Inflows Year 1 2,00,000 10,00,000
Select the most appropriate project based on the payback period, ARR, discounted payback period,
NPV, IRR and profitability index methods.
Table 6.42 Present value factor @ 12%
Year 1 Year 2 Year 3 Year 4 Year 5

0.893 0.797 0.712 0.636 0.567

Solution:
1. Payback period: The cost of the project is `15,00,000, and hence, the time taken to recover
this amount is the payback period.
For Project X, cumulative income is 2,00,000 + 4,00,000 + 6,00,000 + 5,00,000 (out of
10,00,000), which means, payback period is 1 + 1 + 1 + 5,00,000/10,00,000 years = 3.5 years.
For Project Y, cumulative income is 10,00,000 + 5,00,000 (out of 8,00,000), which means,
payback period is 1 + 5,00,000/8,00,000 years = 1.625 years.
Hence, by payback period method, project Y is a better project as the investment can be
recovered earlier.
2. Accounting rate of return method: The accounting rate of return, ARR is given by the formula:
Average income
ARR =
Average investment
In case of project X, we have,
ARR = [2,00,000 + 4,00,000 + 6,00,000 + 10,00,000 + 11,00,000]
, 5/[15,00,000] , 5 = 2.2
Similarly, in case of project Y, we have,
ARR = [10,00,000 + 8,00,000 + 4,00,000 + 2,00,000 + 2,00,000]
, 5/[15,00,000] , 5 = 1.733
The ARR of project X is higher than that of project Y, and hence, as per the ARR method, we
should prefer project X.
3. Discounted payback period: In this case, the methodology is similar to the payback period
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ARR Calculations for Project X

Table 6.43 All values in ` lakhs

PV factor 0.893 0.797 0.712 0.636 0.567
Project X cash inflows 2 4 6 10 11
PV of project X cash inflows 1.786 3.188 4.272 6.36 6.237
Cumulative inflows 1.786 4.974 9.246 15.606 21.843
The cumulative value exceeds `15,00,000 the expenditure on the project in the year 4. Hence, the
exact payback period is 3 + (15 – 9.246)/6.36 = 3.90 years for Project X.
ARR Calculations for Project Y


PV factor 0.893 0.797 0.712 0.636 0.567
Project Y cash Inflows 10 8 4 2 2
PV of project Y cash inflows 8.93 6.376 2.848 1.272 1.134
Cumulative Inflows 8.93 15.306 18.154 19.426 20.56
The cumulative value exceeds `15,00,000, the expenditure on the project in the year 2. Hence, the
exact payback period is 1 + (15 – 8.93)/6.376 = 1.95 years for project Y.
The discounted payback period of project Y is lesser than that of project X, and hence, as per the
discounted ARR method, we should prefer project Y.
NPV method:
4.
Year 1 Year 2 Year 3 Year 4 Year 5 NPV

PV factor 0.893 0.797 0.712 0.636 0.567
PV of project X cash inflows 1.786 3.188 4.272 6.36 6.237 6.843
Project Y cash inflows 10 8 4 2 2
PV of project Y cash inflows 8.93 6.376 2.848 1.272 1.134 5.56
The NPV of project X is higher than that of project Y, and hence, as per the NPV method, we should
prefer project X.
IRR calculation:
5.
For project X: The NPV at 12% discount factor is 6,84,300. We will calculate the NPV at
20% discount factor.
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302 | Chapter 6

PV factor @ 20% 0.833 0.694 0.579 0.482 0.402
PV of project X cash inflows 1.666 2.776 3.474 4.82 4.422 2.158
As the NPV at 20% discount factor is positive we will consider NPV at 25% discount factor.

PV factor @ 25% 0.800 0.640 0.512 0.410 0.328
PV of project X cash inflows 1.6 2.56 3.072 4.1 3.608 -0.06
The NPV at 25% discount factor is negative, which means the IRR (when NPV = 0) is between 20
and 25%.
Hence, project X IRR = 20 + [2.158 , (2.158 + 0.06)] * 5 = 24.86%
For Project Y: The NPV at 12% discount factor is `5,56,000. We will calculate the NPV at 20%
discount factor.

PV factor @ 25% 0.833 0.694 0.579 0.482 0.402
PV of project Y cash flows 8.33 5.552 2.316 0.964 0.804 2.966
As the NPV at 20% discount factor is positive, we will consider NPV at 25% discount factor.

PV factor @ 25% 0.800 0.640 0.512 0.410 0.328
PV of project Y cash flows 8 5.12 2.048 0.82 0.656 1.644
NPV at 25% discount factor is positive, and hence, we will consider NPV at 30% discount factor.
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PV factor @ 30% 0.769 0.592 0.455 0.350 0.269
PV of project Y cash flows 7.69 4.736 1.82 0.7 0.538 0.484
NPV at 30% discount factor is positive, and hence, we will consider NPV at 35% discount factor.

PV factor @ 35% 0.741 0.549 0.406 0.301 0.223
PV of project Y cash flows 7.41 4.392 1.624 0.602 0.446 - 0.526
NPV at 35% discount factor is negative, which means the IRR (when NPV = 0) is between 30 and
35%.
Hence, project Y IRR = 30 + [0.484 , (0.484 + 0.526)] * 5 = 32.4%
The IRR of project Y is higher than that of project X, and hence, as per the IRR method, we should
prefer project Y.
Profitability Index (PI) method:
6.
PI = Present value of inflows , outflows.
PIProject X = 21.843 , 15 = 1.456
PIProject Y = 20.56 , 15 = 1.371
The PI of project X is higher than that of project Y, and hence, as per the PI method, we should
prefer project X.
GENERATION OF CASH FLOW STATEMENTS FOR PROJECTS

The cash flow statement relating to long-term funds should be prepared after the following
considerations:
1. The profit (or earnings) before interest, depreciation and tax (PBDIT or EBIDTA) is first cal-
culated. The ‘A’ in earnings before interest, depreciation, taxation and amortization (EBIDTA)
is related to depreciation of intangible assets. In case of projects, there are no intangible assets,
and hence, we would be concerned only with the depreciation of real assets. Contribution is
sales revenue—variable cost and contribution—fixed cost is PBDIT.
2. Depreciation is calculated by written down value method or by straight line depreciation
method. In case of straight line depreciation method, the depreciation per year is equal to the
cost of asset less salvage value, if any, divided by the life of the asset. In case of written down
value method, the rate of depreciation is specified and the value of assets reduces by this rate
every year. Depreciation is an accounting entry for reducing the taxable profits and is in the
form of provisioning. This amount is not actually paid to anyone, and hence, for calculation
of cash flows, this depreciation is added back to the profit after tax (PAT).
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304 | Chapter 6
3. When depreciation is deducted from PBDIT, we have profit before interest and tax or PBIT,
which is the operating profit.
4. The interest component is also deducted at this stage and PBIT - interest = profit before tax or
PBT. Interest cover ratio is PBIT/interest. The interest component has two parts. The first part is
the interest paid on working capital and the second part is the interest accrued on term loans.
The term loan interest component must be added to the PAT (along with depreciation) for cal-
culating the cash profit or cash flow. The term loan interest component which has to be added
to PAT must factor in the tax rate and is given by {interest * (1 - tax rate)}. Interest on working
capital is not added to PAT for calculation of cash profit or for calculation of interest cover ratio.
In case the problem is silent about the interest component, then this part should be ignored.
PBIT
Interest Cover Ratio =
Interest
5. The tax component is then calculated and deducted from PBT to get profit after tax (PAT).
6. The cash flow (also called cash profit) for any year, except the terminal year of the project is
PAT + depreciation + interest * (1 - tax rate).
7. In the terminal year, the salvage value of the equipment is added to the cash flow. Further
working capital, if required exclusively due to the project, is also added to PAT in the terminal
year. The additional working capital required due to the project is considered as part of the
project cash outflow for calculation of the NPV and is considered as inflow at book value in
the terminal year. The accounting phrase used for adding back the project working capital is
the past year is ‘working Capital is liquidated at book value in the terminal year’.
8. If there is a difference between the value of the capital equipment and the salvage value, then
the same should be accounted for in the terminal year’s cash flow calculations as profit (if
salvage value is more than depreciated value) or loss (if salvage value is less than depreciated
value).
9. Debt service coverage ratio (DSCR) is an important tool for studying project viability. It calcu-
lates the ability of the project to generate sufficient funds to service debt. In corporate finance,
DSCR refers to the amount of cash flow available to meet annual interest and principal pay-
ments on debt which would also include sinking fund payments. In case of personal finance,
DSCR refers to a ratio used by bank loan officers in determining the individual’s debt servicing
ability. In case of commercial real estate finance, DSCR is the primary measure to determine if
a property will be able to sustain the debt on the basis of the project’s ability to generate suf-
ficient cash flow. A DSCR greater than 1 means that (in theory, as calculated to bank standards
and assumptions) the entity generates sufficient cash flow to pay its debt obligations. A DSCR
below 1.0 indicates that there is no sufficient cash flow to cover loan payments.
PAT + Depreciation + Interest on Term Loan
DSCR =
Interest on Term Loan + Term Loan Component Repaid
Term loan component repaid could be the principle amount of term loan or some installments
of the principle term loan amount.
10. The cash flows are then multiplied by the present value factor, as is applicable to the discount
rate under consideration and the net present value (NPV) is calculated. When the NPV is
positive it is worthwhile to consider investing in the project. A format of cost of project/
production and cash flow estimate template for a project having a 3-year lifespan is shown in
Table 6.52. It should be noted that this is a general template trying to incorporate all possible
heads of consideration. It is, however, possible that on case-to-case basis, some refinements,
additions or deletions may be required.
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Table 6.52 Cash flow estimation template
Capacity Utilization Year I (100%) Year II (100%) Year III (100%)

A. Sales realization
B. Cost of production
C. Direct cost
D. PBDIT = A - B - C
E. Depreciation
F. PBIT = D - E
G. Interest on term loan
H. PBT = F - G
I. Tax
J. PAT = H - I
K. Cash flow = J + E + I(1 - tax rate) K K K
+ Salvage value
+ Working capital
In case of cash flows related to equity, contributions made and benefits received by the equity
shareholders should also be reflected. This analysis requires information on three components as
follows:
Initial investment Equity funds committed to the project

Operating cash flows PAT - preference dividend + depreciation + other non-cash charges.
Liquidation and retirement cash Net salvage value of fixed assets - repayment of term loans -
flow redemption of preference capital - repayment of working capital
advances - retirement of trade credit and other dues.
Example 6.21
A company is considering a capital project about which the following information is available:
1. The investment outlay on the project will be `200 million. This consists of `150 million on
the plant and machinery and `50 million on net working capital. The entire outlay will be
incurred in the beginning.
2. The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a net
salvage of `48 million, whereas the net working capital will be liquidated at its book value.
3. The project is expected to generate a revenue of `250 million per year. The increase in costs
on account of the project is expected to be `100 million per year. (This includes all items on
cost other than depreciation, interest and tax). The tax rate is 30%.
4. Plant and machinery will be depreciated at the rate of 25% per year as per the written down
method.
Estimate the post-tax cash flows of the project, assuming cost of capital 12%.
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306 | Chapter 6
Solution:
The step-by-step cash flow calculations are shown in Table 6.53.
Table 6.53 Values in ` million
S.No. Particulars 0 1 2 3 4 5
1 Fixed Assets 150
2 Working Capital 50
3 Revenues 250 250 250 250 250
4 Expense 100 100 100 100 100
5 PBDIT 150 150 150 150 150
6 Depreciation 37.50 28.13 21.09 15.82 11.87
7 PBIT 112.5 121.875 128.9063 134.1797 138.1348
8 Interest 0 0 0 0 0
9 PBT 112.5 121.875 128.9063 134.1797 138.1348
10 Tax 33.75 36.56 38.67 40.25 41.44
11 PAT 78.75 85.31 90.23 93.93 96.69
PAT + depreciation +
12 116.25 113.44 111.33 109.75 108.56
interest
13 Salvage value 48
14 Working capital 50
Cash flow 116.25 113.44 111.33 109.75 206.56
PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674
PV of cash flow 103.79 90.43 79.24 69.75 117.21
NPV 260.42
Example 6.22
1. The investment outlay on the project will be `400 lakhs. This consists of `300 lakhs on
the plant and machinery and `100 lakhs on net working capital. The entire outlay will be
incurred at the beginning of the project.
2. The life of the project is expected to be 5 years, fixed assets will fetch a net salvage value of
`96 lakhs, whereas net working capital will be liquidated at its book value.
3. The project is expected to increase the revenue of the firm by `440 lakhs per year. The increase
in costs on account of the project is expected to be `250 lakhs per year (This includes all items
of cost other than depreciation, interest and tax). The tax rate is 30%.
value method.
5. Cost of capital 10%.
Using the net present value (NPV) method, determine whether the company should undertake the
above proposal or not.
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Solution:
The NPV calculations and other calculations are shown in Table 6.54.
Table 6.54 NPV and cash flow calculations (` Lakhs)
1 Fixed assets 300
3 Revenues 440 440 440 440 440
4 Expense 250 250 250 250 250
5 PBDIT 190 190 190 190 190
6 Depreciation 60.00 48.00 38.40 30.72 24.58
7 PBIT 130 142 151.6 159.28 165.424
9 PBT 130 142 151.6 159.28 165.424
10 Tax 39.00 42.60 45.48 47.78 49.63
11 PAT 91.00 99.40 106.12 111.50 115.80
12 PAT + depreciation + interest 151.00 147.40 144.52 142.22 140.37
13 Salvage value 96
Cash flow 151.00 147.40 144.52 142.22 336.37
PV factor at 10% 0.9091 0.8264 0.7513 0.6830 0.6209
PV of cash flow 137.27 121.82 108.58 97.14 208.86
NPV 273.67
The net present value is positive and is `273.67 lakhs. The company should go ahead with the project.
Example 6.23
1. The investment outlay on the project will be `600 lakhs. This consists of `400 lakhs on the
plant and machinery and `200 lakhs on net working capital. The entire outlay will be in-
curred at the beginning of the project.
2. The life of the project is expected to be 5 years, fixed assets will fetch a net salvage value of
`196 lakhs, whereas net working capital will be liquidated at its book value.
in costs on account of the project is expected to be `350 lakhs per year (This includes all items
of cost other than depreciation, interest and tax). The tax rate is 25%.
value method.
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308 | Chapter 6
Solution:
The NPV calculations and cash flow calculations are shown in Table 6.55.
Table 6.55 NPV and cash flow calculations (` Lakhs)
1 Fixed assets 400
3 Revenues 540 540 540 540 540
4 Expense 350 350 350 350 350
5 PBDIT 190 190 190 190 190
6 Depreciation 80.00 64.00 51.20 40.96 32.77
7 PBIT 110 126 138.8 149.04 157.232
9 PBT 110 126 138.8 149.04 157.232
10 Tax 27.50 31.50 34.70 37.26 39.31
11 PAT 82.50 94.50 104.10 111.78 117.92
13 Salvage value 196
Cash flow 162.50 158.50 155.30 152.74 546.69
PV factor at 10% 0.9091 0.8264 0.7513 0.6830 0.6209
PV of cash flow 147.73 130.99 116.68 104.32 339.45
NPV 239.17
The net present value is positive and is `239.17 lakhs. The company should go ahead with the project.
Example 6.24
XYZ Enterprises is contemplating a new investment project for which it is considering the following
information.
1. Total cash outflow of the project will be `10 Crores, which consists of `6 Crores on plant and
machinery and `4 Crores on gross working capital. The entire outflow will be incurred at the
beginning of the project.
2. The project has a life of 5 years at the end of 5 years, plant and equipment would fetch a
salvage value of `2 Crores. Working capital will be liquidated at end of 5 years which will be
equal to its book value (`4 Crores).
3. The project will entail incremental revenues for the firm to the tune of `8 Crores per annum,
the incremental expenses on account of the project will be `4 Crores per annum, which in-
cludes all items of expenses excluding depreciation and taxes.
4. The effective tax rate is 50%.
6. Depreciation is charged at 33.33% on the basis of written down value method.
7. Decide if the enterprise should undertake the project or not on the basis of NPV criterion.
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Solution:
The working of NPV and cash flow calculations are shown in Table 6.56.
Table 6.56 NPV and cash flow calculations (` Crores)
1 Fixed assets 6
2 Working capital 4
3 Revenues 8 8 8 8 8
4 Expense 4 4 4 4 4
5 PBDIT 4 4 4 4 4
6 Depreciation 2.00 1.33 0.89 0.59 0.40
7 PBIT 2.00 2.67 3.11 3.41 3.60
9 PBT 2.00 2.67 3.11 3.41 3.60
10 Tax 1.00 1.33 1.56 1.70 1.80
11 PAT 1.00 1.33 1.56 1.70 1.80
13 Salvage value 2
14 Working Capital 4
Cash Flow 3.00 2.67 2.44 2.30 8.20
PV factor 0.8772 0.7695 0.6750 0.5921 0.5194
PV of Cash Flow 2.63 2.05 1.65 1.36 4.26
NPV 1.95
Example 6.25
A company is considering a proposal to install new equipment. The equipment would involve a
cash outlay of `40 lakhs and an additional working capital of `2.4 lakhs. The expected life of
the project is 5 years with a salvage value of `2.8 lakhs. The company charges depreciation on a
written down value method at the rate of 25% per annum. The cost of capital is 12%. The income
tax rate is 40%.
The project is expected to generate revenue of `32 lakhs in the 1st year and it will increase by
15% every year on its previous year’s value. The aggregate cost for the 1st year is `18 lakhs ex-
cluding depreciation and tax. It will increase by `3 lakhs every year. The working capital will be
liquidated at the end of the life of the project. Using the above information, develop the cash flow
for the proposal and using the NPV method, determine whether the project should be undertaken
or not.
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310 | Chapter 6
Solution:
Refer to Table 6.57 for the solution.
Table 6.57 NPV and cash flow calculations
1 Fixed assets 40
2 Working capital 2.4
3 Revenues 32.00 36.80 42.32 48.67 55.97
4 Expense 18 21 24 27 30
5 PBDIT 14.00 15.80 18.32 21.67 25.97
6 Depreciation 10.00 7.50 5.63 4.22 3.16
7 PBIT 4.00 8.30 12.70 17.45 22.80
9 PBT 4.00 8.30 12.70 17.45 22.80
10 Tax 1.60 3.32 5.08 6.98 9.12
11 PAT 2.40 4.98 7.62 10.47 13.68
13 Salvage value 2.8
14 Working capital 2.4
Cash flow 12.40 12.48 13.24 14.69 22.05
PV factor 0.8929 0.7972 0.7118 0.6355 0.5674
PV of cash flow 11.07 9.95 9.43 9.33 12.51
NPV 9.89
The NPV is a positive value, and hence, the company must go ahead with the proposal to install a
new machine.
Example 6.26
A company is considering a capital project for which the following information is available:
1. The initial outlay of the project would be `50 lakhs with salvage value `5 lakhs.
2. The cost of capital is 12%.
3. The working capital required would be `4 lakhs which will be liquidated at the book value
when the project is terminated.
4. The life of the project is 6 years.
5. The yearly cost is `12 lakhs which exclude depreciation and tax.
6. The revenue generated in the 1st year is `24 lakhs which will increase by `4 lakhs every year.
7. The depreciation will be charged at the written down value method and the rate is 25%.
8. The income tax rate is 40%.
Using the above information, develop the cash flow for the project and using the net present value
(NPV) method and determine whether the project should be considered or not.
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Solution:
S.No. Particulars 0 1 2 3 4 5 6
1 Fixed assets 50
2 Working capital 4
3 Revenues 24 28 32 36 40 44
4 Expense 12 12 12 12 12 12
5 PBDIT 12 16 20 24 28 32
6 Depreciation 12.50 9.38 7.03 5.27 3.96 2.97
7 PBIT – 0.5 6.63 12.97 18.73 24.04 29.03
8 Interest 0 0 0 0 0 0
9 PBT – 0.5 6.63 12.97 18.73 24.04 29.03
10 Tax 0.00 2.65 5.19 7.49 9.62 11.61
11 PAT – 0.50 3.98 7.78 11.24 14.43 17.42
12 PAT + depreciation + interest 12.00 13.35 14.81 16.51 18.38 20.39
13 Salvage value 5
Cash flow 12.00 13.35 14.81 16.51 18.38 29.39
PV factor 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066
PV of cash flow 10.71 10.64 10.54 10.49 10.43 14.89
NPV 13.71
The NPV is a positive value, and hence, the company must go ahead with the capital proposal.
Example 6.27
A cosmetics company is considering an investment in a new beauty preparation for which the
following information is available:
1. Investment in new machinery required for manufacture will cost `1,50,000
2. A part of the present machinery that is lying idle for the last 2 years is also to be used for
manufacturing the new product.
(a) The machinery was purchased 5 years ago for `75,000 and its depreciated value today is
`37,500.
(b) It can be used at least for another 5 years with normal maintenance and can be sold at
`5,000 after 5 years.
3. Increase in working capital on account of the new product will be as follows:
(a) Increase in sundry debtors `75,000
(b) Increase in inventories `1,00,000
(c) Increase in current liabilities `1,00,000
4. Sales revenue for new product is estimated at `7,50,000 per year.
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312 | Chapter 6
5. Manufacturing cost (including allocation of `30,000 fixed costs from service departments) is
estimated to be `3,40,000 per year.
6. Selling and administrative expenses directly associated with the product are `3,00,000 per year.
7. The new machinery will have trouble-free service for 8 years but will require over-hauling in
the 4th year which will cost `10,000. Its estimated resale value at the end of 5 years will be
`20,000.
8. Introduction of a new product will slightly affect the production schedules of existing products
resulting in a loss of profit contribution on other products to an extent of `25,000 per year.
9. Bad debts to be written off on account of a new product are `10,000 per annum.
10. Step up promotional expenses in the 3rd year are `70,000.
11. All new investments and additional working capital requirements would be financed by rais-
ing term loan to be paid in 4 years of equal instalments. Interest on term loans @ 15% p.a.
works out to `29,500, `21,000, `12,500 and `4,500, respectively, in the 1st, 2nd, 3rd and 4th
years.
12. Depreciation being charged on straight line basis @ 10% is acceptable for income tax purposes.
13. Rate on income tax is 40%.
14. Expected project life is 5 years.
Compute the project cash flows from long-term funds point of view and find the present value of
the investment using discounted cash flow (DCF) technique.
Solution:
This is a very complex problem, and hence, students are advised to refer to working notes and
Table 6.59 gives the solution.
1. The idle machinery cost of `37,500 is added to the new machinery cost of `1,50,000 to get
the final cost of machinery as `1,87,500. The combined salvage cost is `5,000 + `20,000 =
`25,000.
2. The additional working capital is current assets – current liabilities which is 75,000 + 1,00,000
– 1,00,000 = 75,000.
3. Expenses involving selling and administrative expenses are 3,40,000 + 3,00,000 + 25000 +
10000 = 6,75,000.
4. Depreciation is calculated by straight line method. Hence, yearly depreciation = (1,87,500 –
25,000)/5 = 32,500 per year for the life of the project which is 5 years.
1 Fixed assets 1,87,500
2 Working capital 75,000
3 Revenues 7,50,000 7,50,000 7,50,000 7,50,000 7,50,000
4 Expense 6,75,000 6,75,000 6,75,000 6,75,000 6,75,000
Additional expense 70,000 10,000
5 PBDIT 75,000 75,000 5,000 65,000 75,000
6 Depreciation 32,500 32,500 32,500 32,500 32,500
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7 PBIT 42,500 42,500 - 27,500 32,500 42,500

8 Interest 29,500 21,000 12,500 4,500 0
9 PBT 13,000 21,500 - 40,000 28,000 42,500
10 Tax 5,200 8,600 0 11,200 17,000
11 PAT 7,800 12,900 - 40,000 16,800 25,500
12 PAT + depreciation + interest 69,800 66,400 5,000 53,800 58,000
13 Salvage value 25,000
14 Working capital 75,000
Cash flow 69,800 66,400 5,000 53,800 1,33,000
PV factor 0.8929 0.7972 0.7118 0.6355 0.5674
PV of cash flow 62,324 52,934 3,559 34,190 75,464
NPV - 34,028
The NPV is a negative value, and hence, the company must not go ahead with the capital proposal.
The present value of cash flows is `34,028.
Example 6.28
The following data pertains to a project in which `40,000 is invested.
Y1 Y2 Y3 Y4 Y5
PBDIT 10,000 13,000 18,000 20,000 20,000
Depreciation 2,000 2,000 2,000 2,000 2,000
Interest 3,000 3,000 3,000 2,000 1,000
Principal repayment – – – 10,000 10,000
The applicable tax rate is 30%. Calculate the following:

1. Interest cover rate per year
2. Debt service cover ratio per year
Solution:
The applicable tax rate is not of any consequence for calculating the interest cover rate.
PBIT
Interest Cover Ratio =
Interest
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314 | Chapter 6
Table 6.61 Project data analysis for interest cover ratio
Y1 Y2 Y3 Y4 Y5
PBDIT 10,000 13,000 18,000 20,000 20,000
Depreciation 2,000 2,000 2,000 2,000 2,000
PBIT 8,000 11,000 16,000 18,000 18,000
Interest 3,000 3,000 3,000 2,000 1,000
Interest cover ratio 2.67 3.67 5.34 9 9
PAT + Depreciation + Interest on Term Loan

DSCR =
Interest on Term Loan + Term Loan Component Repaid
Table 6.62 Project data analysis for DSCR
Y1 Y2 Y3 Y4 Y5
PBDIT 10,000 13,000 18,000 20,000 20,000
Depreciation 2,000 2,000 2,000 2,000 2,000
Interest 3,000 3,000 3,000 2,000 1,000
PBT 5,000 8,000 13,000 16,000 17,000
Tax 1,500 2,400 3,900 4,800 5,100
PAT 3,500 5,600 9,100 11,200 11,900
DSCR 2.833 3.53 4.7 1.27 1.35
Example 6.29
1. The investment outlays on the project will be `800 lakhs. This consists of `600 lakhs on the
plant and machinery borrowed from the bank and `200 lakhs on net working capital. The
entire outlay will be incurred at the beginning of the project.
2. The life of the project is expected to be 5 years; fixed assets will fetch a net salvage value of
`192 lakhs per year, whereas the net working capital will be liquidated at its book value.
in costs on account of the project is expected to be `500 lakhs per year. (This includes all items
of cost other than depreciation, interest and tax rate). The tax rate is 30%.
4. Plant and machinery will be depreciated at the rate of 20% per year as per the WDV method.
5. Cost of capital is 10%.
Year 1 2 3 4 5 6 7
PV@10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513
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Solution:
1 Fixed assets 600
3 Revenues 880 880 880 880 880
4 Expense 500 500 500 500 500
5 Difference of salvage - 4.61
Value and depreciated value
6 PBDIT 380 380 380 380 375.39
7 Depreciation 120 96 76.8 61.44 49.15
8 PBIT 260 284 303.2 318.56 326.24
9 Interest on term loan 60 60 60 60 60
10 Interest on working capital 20 20 20 20 20
11 PBT 180 204 223 239 246
12 Tax 54 61.2 66.96 71.568 73.872
13 PAT 126 143 156 167 172
14 PAT + depreciation + interest (1 - 0.3) 288 281 275 270 264
15 Salvage value 192
16 Working capital liquidated 200
Cash flow 288 281 275 270 656
PV factor 0.9091 0.8264 0.7513 0.683 0.6209
PV of cash flow 262 232 207 185 407
NPV 492
As the NPV is positive, the company should accept the proposal.
Example 6.30
A company intends to purchase a single product whose estimated demand in year 1 is 1700 units.
It is expected to increase by 85 units in each subsequent year. Estimate price for year 1 is `600/unit
which is expected to increase by `15/unit in each subsequent year. Operating expenses excluding
depreciation and interest on term loan in year 1 are estimated to be `1,78,000 which are expected
to increase by `20,000 each subsequent year. At the beginning of the project (at end of year 0), the
liabilities include equity capital of `6 lakhs and term loan of `12 lakhs. Assets include land worth `1
lakh and other fixed assets worth `17 lakhs. Term loan is to be repaid in 5 years with equal annual
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316 | Chapter 6
installments and carries 12% rate of interest charged on opening balance of that year. Other fixed
assets are depreciated at 10% per year by written down value method. Calculated the debt service
coverage ratio and interest coverage ratio for years 1 and 2.
Assume income tax rate is 35%. All units produced are sold in the same year. All payments and
expenses are realized in the same year.
Solution:
1. Let us first calculate the term loan installment as follows:
Loan = 12,00,000
Interest (k) = 12% per annum
Loan repayment period = 5 years
Loan × k × (1 + k)n
Installment/year =
(1 + k)n − 1
1200,000 × 0.12 × (1.12)5
= 5
(1.1) − 1
= 332,892
Note: In Excel, we have a function known as PMT which will calculate the installment per year
if the data on interest rate, present value (loan amount), future value (taken as 0, when the entire
amount has to be returned) and the time periods is given.
2. We then calculate the interest repaid in 2 years as given in Table 6.64.
Table 6.64 Repayment amount calculations
Year Opening Loan Installment Interest Principal Repaid Closing Loan

1 12,00,000 3,32,892 1,44,000 1,88,892 10,11,108
2 10,11,108 3,32,892 1,21,333 2,11,559 7,99,549
3. We will calculate the depreciation as given in Table 6.65.
Table 6.65 Depreciation calculations
Year Opening Block Depreciation @10% Closing Block

1 17,00,000 1,70,000 15,30,000
2 15,30,000 1,53,000 13,77,000
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4. We now compute the cash flow statement and ratios as given in Table 6.66.
Table 6.66 Depreciation calculations
Year 1 2
Units sold 1,700 1,785
Selling price 600 615
Total revenue 10,20,000 10,97,775
Less operating expenses 1,78,000 1,98,000
EBDIT 8,42,000 8,99,775
Less depreciation 1,70,000 1,53,000
EBIT 6,72,000 7,46,775
Less interest 1,44,000 1,21,333
EBT 5,28,000 6,25,442
Less tax 1,84,800 2,18,905
PAT 3,43,200 4,06,537
DSCR 1.97 2.05
Interest cover ratio 4.67 6.15
PAT + Depreciation + Interest and Interest Cover Ratio

DSCR =
Interest + Principal Repaid
EBIT
=
Interest
Summary
The funding of projects and the returns on the investments made therein are key factors for making
decisions related to investments. Even a one-off expenditure on installation of a new equipment or
machinery would have the same issues as involved in decision-making for big projects. In general,
whenever there is a one-time investment or investment valid over a long period of time, the long-
term principles for making capital investment decisions have to be applied. Primarily, the cash flows
generated from these investments are more important than the profitability of the project. If the cash
flows are able to address all evaluation ratios such as the NPV or debt service coverage ratio, then
the viability and profitability of these investments is assured.
In analyzing the cash flows or in comparing the various options or in assessing the viability
of the investment, the methods using the discounted cash flow techniques are useful. The non-
discounted cash flow methods are simpler to apply but do not convey the time value of money
and hence are used for preliminary screening or for rejecting the mass of investment proposals.
From the discounted cash flow techniques, methods such as NPV and internal rate of return (IRR)
are widely used for analysis. Although both the methods have some distinct advantages, there are
also some shortcomings which must be fully understood before using these methods. Projects in-
volving periodic returns of fixed amounts known as annuity can also be assessed for NPV values.
Profitability index method or benefit cost ratio methods offer distinct advantages as against the
NPV or the IRR methods.
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318 | Chapter 6
Finally, financial institutions are concerned with the ability of the project to pay back the project
funding, and hence, ratios such as interest cover ratio and debt service coverage ratio gain promi-
nence. Funding is generally available to projects which have a DSCR of greater than 1.2.
Financial appraisal basically deals with the financial viability of the project, which is presently in
the proposal stage only. The statements worked out on the basis of estimates can be very far from
the correct position, and hence, much effort in detailing is not required. The basic principles of writ-
ing the cash flow statement should be followed and the ratios calculated like DSCR and Interest
cover ratio should be sufficiently high. Each of the capital budgeting techniques was developed to
plug some limitations of the earlier methods. If the students understand the limitations of the other
methods than working of the newer methods is simple. One of the most widely used and easy to
understand capital budgeting technique is the Net Present Value method (NPV).
At times, the project entrepreneur has no shortage of funds and is therefore not keen to pursue
funding options from lending institutions. The due diligence done by the financial institutions is
very thorough and regardless of the fact that funding is not required, the entrepreneur should get his
project ratified by the financial institutions. This will help identify any biases of pet projects.
K EYWOR D S
• Capital budgeting • Benefit cost ratio

• Time value of money • Net benefit cost ratio
• Present value factor • Internal rate of return
• Present value factor of annuity • Common time horizon
• Payback period • Equivalent annuity method
• Net present value • Debt service coverage ratio
• Profitability index • Interest coverage ratio
1. Explain the basis and justification for deciding the ‘basic rate of discounting’ to be used in
the present value calculations using DCF techniques. How do you compare two projects that
have different risk perceptions, given the basic rate of discounting?
2. Explain the rationale for considering ‘cash flows’ instead of ‘profits’ as a measure to be used
for investment appraisal. What are the adjustments to be made to ‘profit after tax’ figures to
calculate ‘operating cash flows’?
3. What is the incremental principle for measurement of cash flows for a project? What are the
main guidelines to be followed while using the incremental principle?
4. Write short notes on the following:
(a) Components of capital cost of a project
(b) Discounted cash flow techniques
(c) Advantages of profitability index method over NPV and IRR methods
(d) Limitations of payback period method
5. Discuss the various DCF techniques for evaluation of cash flows for comparing mutually ex-
clusive investment proposals.
6. What are the main differences between NPV and IRR? Discuss the limitations of NPV and IRR.
7. Explain the various methods that financial institutions use to calculate cost of capital.
8. Explain the utility of the debt service coverage ratio and the significance of what it conveys in
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Chapter
7 DETAILED PROJECT REPORT
LEARninG OBJECTivES

❍ Understand the importance of a Detailed Project Report (DPR).
❍ Understand the components and stages of a DPR.
❍ Understand the relevance of each stage of a DPR.
❍ Understand the purpose, expectations and deliverables of a DPR.
❍ Sources of finance for the project.
❍ Understand Bridgeman’s Dimensional Analysis for selecting project location.
INTRODUCTION
Projects that require finance from leading term-lending institutions such as IDBI, SIDBI, banks and
other government bodies must put up a project proposal in a particular format. The format is
designed to cover various aspects which are of the highest interest during active consideration of
a project and should depict the firm interest and commitment of the project promoters towards
completion of the project. In short, any attempt for a serious commitment to proceed with the project
is conveyed to term-lending institutions by means of a detailed project report. Two standard templates
for preparing a detailed project report (DPR) are attached as an appendix to this chapter. The formats
must be suitably moderated for different project proposals. In case of services, suitable amendments
to the DPR contents can be undertaken and topics such as technical appraisal can be avoided.
Finally, it is our endeavour that students are aware of the broad framework of a DPR rather than
any project organization developing project proposals in the given format. Many changes may have
to be carried out in case of practical projects and as per definition, since no two projects are similar,
it would naturally mean that every project proposal be unique. The proposal of getting approvals
for project funding is principally the same as in the case of any loans or advances issued by a bank. A
preliminary interest in the proposal (for any bank loan/advance) is the information and track record
in repayment of advances by project promoters, besides the moot question of purpose/reason for
the proposal. The difference between loans to individuals and loans to projects offered by the same
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320 | Chapter 7
lending institution is that the former is a security-oriented lending, whereas the latter is a purpose-
oriented lending. In case of purpose-oriented lending, there is no underlying security or collateral
as in the case of security-oriented lending, thus making the business of project financing very risky.
Purpose-oriented lending can be successful only if a detailed appraisal of the project is done before
committing funds for the project. The lending institution has to ensure that the investment on the
proposed project is ‘safe’ and that it would be repaid with interest within a reasonable period of
time.
Some important aspects of a project proposal are as follows.
Contents of a Detailed Project Report
1. General Information
(a) Preamble or the motivation for the project
(b) Name
(c) Constitution and sector
(d) Location
(e) Nature of industry and product
(f) Promoters and their contribution
(g) Cost of project and means of finance
2. Promoter’s details
3. Marketing and selling arrangement
4. Project particulars
(a) Product mix and capacity
(b) Scale of operations
(c) Location and site
(d) Plant and machinery
(e) Raw materials
(f) Utilities
5. Technical arrangements
6. Production process
7. Environmental aspects
8. Schedule of implementation
9. Cost of the project
10. Means of finance
11. Profitability estimates
(a) Assumptions
(b) Projected income statement
(c) Projected balance sheet
(d) Projected cash flow statement
12. Appraisal based on profitability statement
13. Economic considerations
14. Appendices
(a) Estimates of cost of production
(b) Calculation of depreciation
(c) Calculation of working capital and margin money for working capital
(d) Repayment/Interest schedule of term loan and bank finance
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(e) Calculation of tax

(f) Coverage ratios
(g) NPV, IRR workings
(h) Sensitivity analysis
PROJECT GENERAL INFORMATION

General information about the project should sound interesting to the reader and speak about the
necessity for the project along with the advantages of the project in a subtle manner. A very loud and
bombastic introduction to catch eyeballs may be extremely counter-productive and the reader may not
believe in the project from the beginning. Even if the project is viable and beneficial to all concerned,
a tempering of the proposal at the initial phase is desirable. It should be remembered that every single
project proposal received by a term-lending institution speaks generously about itself and not a single
proposal speaks about non-viability or a flop show.
Preamble
A preamble should speak about the purpose of the project in a convincing manner. Unless there is
a strong motivation for a project, the venture would not be of interest to anyone other than the
project promoter. The Government of India supports projects in key areas such as infrastructure and
if any such support has opened up new vistas for projects, the same should be highlighted.
Example 7.1
During the 2011 budget, the Government of India levied export tax on iron ore exports, resulting
in pressure on margins, thus making the export trade expensive. At the same time, the export of
processed iron ore, that is, iron ore pellets, was incentivized with the idea to encourage value addition
besides generating investments in iron ore pelletization projects. As a result, many organizations
such as the Mangalore-based Cauvery Coffee Traders embarked on a pelletization project.
Example 7.2
In April 2005, the Government of India launched the ‘Rajiv Gandhi Grameen Vidyutikaran Yojana
(RGGVY) Programme’ for creation of rural electricity infrastructure and household electrifica-
tion for providing access to electricity to rural households. Under the RGGVY, unelectrified BPL
households are provided with free electricity service connection. Infrastructure created under the
RGGVY can be used for providing connections to people belonging to above poverty line (APL)
by respective distribution utilities. APL households are required to pay for prescribed connection
charges and no subsidy is available for this purpose. All projects under this scheme are eligible
for support and benefits. Appendix II given in this chapter gives a template for projects under the
RGGVY programme.
Project Name
Every project is unique and different from past/present projects. This facet of the project must be used
in identifying projects in a unique way. Hence, a unique project name or nomenclature is essential.
Reliance Industries Ltd promoted KGD6, a project to explore natural gas from the Krishna-Godavari
belt and D6 refers to the drill rig 6. Every project will be referred to by its name, and hence, some
thought must be applied before naming a project. A Nylon 6-6 project would describe the project as
one manufacturing Nylon 6-6 enzyme, but if the capacity is also added like 250 tonnes per day (tpd)
Nylon 6-6 project, it would be more specific.
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322 | Chapter 7
Project Constitution and Sector

The products being manufactured can be classified by the process of manufacture or the type of
manufacture. Process plants work continuously and cannot stop. Their capacity is measured in terms
of inputs (tonnes of sugarcane crushed per day) or output (tonnes of steel produced per day). Although
a manufacturing plant is of the semi-continuous type, it can be referred to as stop-start process.
Furthermore, the products are grouped on the basis of sectors that they operate in as ferrous, non-
ferrous, chemical, pharmaceutical, engineering, automobile, auto-ancillary, oil and gas, etc. A write-
up about the sector is required during the introduction of the project to term-lending institutions.
Location
Sometimes, the location of the project is helpful in jurisdiction assessment of the term-lending
institution. A project in the western part of Maharashtra needs to be evaluated by the branch office
of the term-lending institution nearest to the site of the project. We cannot have a scenario where a
Delhi-based project is evaluated by a Kolkata-based term-lending institution. Moreover, there are
certain ‘No-Go’ sites; hence, mentioning the location is very important during the initial phase of
assessment. The requirements of utilities for the project such as power, water and effluent treatment
vary from one location to another and may adversely affect the project. The climatic conditions for
certain industries such as textiles need to be considered before funds are sanctioned for the project.
‘Blackberry’, a reputed brand of trouser and apparel manufacturer, is based in Ludhiana, although
its markets are located in Mumbai. This is because the excess moisture/humidity in Mumbai is not
conducive for the apparel manufacturing unit, whereas the dry climate in Ludhiana suits the process.
Nature of Industry and Product

The next natural line of interest would be the product and the type of industry that the product
falls into. Certain projects such as power generation using nuclear energy (industry reserved for the
Government in India) generate large-scale opposition and lenders would not be interested in them.
Other projects such as infrastructure which get the support of the government would be preferred
by lenders. Projects involving import substitution products or projects wherein the products are
liked by masses such as ‘Shiv Vada pav’ or ‘Jumbo Vada pav’ would get lender’s consent and inter-
est immediately. It is, therefore, crucial that the product nomenclature and the industry profile be
defined at the onset of the project.
Promoters and their Contribution

A specific interest for lending institutions would be the promoters of the project and their track
record in completion of projects. The project’s viability would depend much on the project pro-
moter’s ability to successfully complete the projects. If the promoters are new to the business of
projects, the proposals would be reviewed with scepticism, whereas if it is an existing renowned
business group such as Godrej or Mahindra & Mahindra, the proposals would be quickly accepted
for detailed review. Therefore, project promoters must use this platform to speak about completed
projects and their performance in fulfilling repayment commitments to generate confidence in lend-
ing institutions.
Cost of Project and Means of Finance

The project outlay often weighs on the minds of the lender. Just as an industry can be classified
as micro, small, medium or large, the requirements of funds for a project can be used to classify
the projects. Furthermore, if only a small percentage of the funds requirements is sought to be
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borrowed, it is a welcome sign for the lending institutions. Conversely, if the equity component or
the owner’s own funds is small as against the debt component, then the interest in these projects
naturally abates. Finally, every term-lending institution or venture capital financer would be keen
to know the exit options available to them. In case of ‘Islamic’ banking organizations, where the
concept of interest on principal is unacceptable, the bank owns the project which is later sold to
the project promoter at a price. In case the project promoter is unable to buy the project from the
Islamic bank, the project is sold to other suitable bidders
PROMOTER DETAILS
Although the term ‘promoter’ finds its place in Company law, it has not been defined anywhere
under the Companies Act, 1956. This is because the term does not have any legal connotation
but contains a business element. Promotion is a term of wide import, denoting the preliminary
steps taken for the purpose of registration and floatation of the company. Persons who assume
the task of promotion are called promoters. A promoter may be an individual, association,
partner or company. In view of the above, a promoter is a person who exercises substantial
control over the company or a person who undertakes all necessary steps in the floatation of
the company. The relationship between a promoter and a company which he/she has floated
must be deemed to be a fiduciary relationship from the day of floating the company. The status
of the promoter is generally terminated when the Board of Directors is formed and they start
governing the company.
In this section, the details of all the promoters, joint venture partners, project consultants with
equity participation or Government of India’s direct participation by means of equity or subsidy,
the nature of participation with the public-private partnership (PPP) mode or build own operate
transfer (BOOT) mode are provided. The solvency of the private promoters, their credit wor-
thiness and other business balance sheets are also provided in this section. If the promoter is a
known organization, then there is some degree of comfort and additional details are not required.
However, if the promoter is a new entity, then additional information must be provided for the
lender’s comfort. It should be noted that personal loans are backed up with mortgages, whereas
in case of the term loans for projects, there is not much mortgage, and hence, due diligence should
be exercised.
MARKETING AND SELLING ARRANGEMENTS

Although commercial appraisal takes aspects related to marketing and sales into account, the lender
would want to know at the very onset about the arrangements, including distribution and supply
chain for the project outputs being conceived. The customer, who is the last link in the supply chain,
is the only link which ‘pays’ for the product. All the other links only distribute the funds available
to them once the customer pays. There have been instances where the project and the products are
ready but no thought had been provided to transport the finished goods. In one particular new gen-
eration steel plant, established in 1992 in Jamnagar, Gujarat, the nearest rail head was over 35 km
away and the roads linking the plant to the railhead and other trunk routes were so bad that almost
every third vehicle had a breakdown during the transport of finished hot rolled (HR) coils. It was
only after the company built a railway line from their plant to the mainline, the problem of smooth
movement of finished goods was solved. The other point of interest in this section is the marketing
plan for the output: whether it is for exports, in which case the distance to the nearest all-weather
port would be of interest or whether it is for domestic consumption, and whether the distribution is
company-owned or franchisee-owned, etc. Each organization has its own game plan for introducing
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324 | Chapter 7
and launching products and whether it makes a successful opportunity or not is to be evaluated.
Hindustan Coca Cola beverages and Bharat Coca Cola beverages were two ventures of the Coca
Cola group in India for distributing their projects, whereas PepsiCo had a different approach for
their products.
In India, McDonald’s has two Indian entrepreneurs—Amit Jatia of Hardcastle Restaurants Pvt.
Ltd, which spearheads the McDonald’s operations in west and south India and Vikram Bakshi of
Connaught Plaza Restaurants Pvt. Ltd, which spearheads McDonald’s operations in the northern
and eastern parts of the country. If Hardcastle Restaurants considers an expansion project, then the
location should be limited to the areas it is authorized to operate in.
PROJECT PARTICULARS
In this section, the details related to the project such as product mix capabilities, scale of
operations, location and size of operations at each location (in case the production facility is
in more than one location), availability and requirement of raw materials, requirement and
quantum of requirement of utilities such as water, power, etc., are discussed in detail. Although
the assessment here cannot be termed as ‘technical assessment’ as the technological aspects
Figure 7.1 Image of McDonald’s restaurant in Delhi

Credit: Snehal Jeevan Pailkar.shutterstock.com
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are not evaluated, it is more on the operational requirement and the readiness of operational
capabilities of the project.
Product Mix Capabilities

As discussed earlier in this chapter, projects can be classified on the basis of their manufacturing
capability in case of a manufacturing process or their ‘utility’ capability on the basis of their usage.
A project to manufacture detergents would be classified as a continuous process plant producing
the same product (may be in different formats such as powder, cake, liquid, etc.) for a long period
of time. The capacity in this case is the output measured in tonnes per day (tpd). A highway project,
on the other hand, is defined by the number of vehicles that would ply per day on the highway.
Similarly,, a metro project would define the load (passengers) carrying capability per day. An oil and
gas project would define the capacity in terms of ability to handle the daily output. The reserves
(shale gas or shale oil) would be in large volume and tapping of the reserves is capped by the
capability to handle the volume. Output is measured in million barrels of crude per day or million
standard cubic feet per day (mmscfd) of natural gas. A social benefit project like a bridge across a
river or sea would project the benefits and savings over a period of time. Refer to Appendix III on
Honshu-Shikoku Bridge Authority, Japan.
Figure 7.2(a) Honshu–Shikoku Bridge, Japan

Credit: Rujipart.shutterstock.com
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326 | Chapter 7
Figure 7.2(b) Honshu–Shikoku Bridge Project, Japan
Expressway Profile
Kobe-Awaji-Naruto Seto-Chuo Nishi-Seto
Contents Expressway Expressway Expressway Total
Length 89.0 km 37.3 km 46.6 km 172.9km
Design speed 100 km/hr 100 km/hr 80 km/hr –
Lane number 6 or 4 4 4 or 2 –
Number of long-
span bridges 2 6 9 17
Open to traffic April, 1998 April, 1988 May, 1999 –
Project cost JPY 1470 billion JPY 670 billion JPY 730 billion JPY 2.87 trillion
Figure 7.2(c) Honshu–Shikoku Bridge Project Cost Structure, Japan
Scale of Operations
Continuing the discussion from the earlier section which focused on maximum capacity, we now
discuss planned progress as capacity utilization. A 100% capacity utilization in the first few years
of operations is not possible due to teething troubles and only a gradual full-scale of operations is
viable. The term-lending institution would want to know the entire work schedule. Besides, every
project makes some provision for future capacity expansion or for forward and backward integra-
tion. The Mukand–Kalyani joint venture Hospet Steels Ltd. consists of an iron making division,
steel making division and rolling mill division. The first phase of the project was establishing the
iron-making unit, the second phase was the steel-making division and the third phase was the roll-
ing mill division.
The scale of operations also depends on the market for the product. Capacity expansion decisions
take much time to fructify, and hence, the initial project is planned with higher capacities. Although
teething problems can be overcome with time, whether the plant can run at 100% capacity or not is
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decided by market conditions. Hence, the term-lending institution which is concerned with returns
from the project to affect the recovery of project advances wants to ensure that per unit price of
the product is within the prevailing market rates. If the loading of fixed costs is high due to lower
capacity utilization, then the product may not be saleable. Similarly, if excess production is done to
reduce fixed costs, higher inventory would again be undesirable. A comparison with similar projects
and their scale of operations would give the lender some confidence about the viability of project
proposal. The availability of raw materials could also hamper the scale of operations and this factor
must also be considered while preparing the project proposal.
Location and Site

The location for the project has two phases. The first phase selects the region to develop the project
and the second phase selects the site within the overall region to base the project. The first phase
looks at the macro factors that aid the running of the project and the second phase looks at the mi-
cro factors, after the macro factors are satisfied. Therefore, it is safe to say that only when the macro
factors are satisfied, we can consider the micro factors and not vice versa.
Macro Factors: The foremost macro factor is the availability of raw material if the manufacturing
process reduces the raw material substantially to create the end product. This explains the location
of all iron and steel plants in the eastern region of the country where the primary raw material, that
is, iron ore is available in abundance. Similarly, the cotton growing areas of Gujarat and western
Maharashtra have the maximum textile companies, the sugarcane growing areas of Maharashtra
and northern Karnataka along with eastern Uttar Pradesh have sugar manufacturing plants, etc. The
Steel Authority of India (SAIL) plants at Bhilai in Chhattisgarh, Rourkela in Orissa and Durgapur
in West Bengal bear testament to the fact that proximity to raw materials develops industrial and
residential areas.
Proximity to markets is another factor to be considered while identifying the location of a proj-
ect. At times, products such as food items which are perishable can best be manufactured closest
to the place of consumption. In such cases, transporting the raw material is more convenient than
transporting the finished goods over long distances. The dairy industry is one such example where
milk plants are located close to the city centres. Soft drink bottling plants are another example of
locating the plant closest to the consumption regions. The soft drink concentrate, which is much
less in quantity to be transported, can be moved to sites nearer to major cities and then bottled into
products. These bulky readymade products can be shipped over smaller distances.
Availability of labour is another issue that requires careful consideration. Although labour can be
mobile, labourers would prefer to remain in their comfort zones. The diamond polishing industry,
which depends to a large extent on skilled labour for sizing and polishing precious stones, is con-
centrated in and around Surat and Mumbai. Similarly, Tirupur near Coimbatore has skilled labour
in the field of hosiery manufacture as hosiery manufacturing units are located nearby. Although it is
not impossible to hire skilled labour from far-off places, the cost for such proposals becomes very
high and unless there is a significant advantage as in the case of the iron and steel industry, projects
should be based closer to availability of labour.
Availability of the ancillary industry is also helpful in most cases. The ancillary industry performs
the subcontracted work or produces parts which are required as inputs for the final product. The
Pune belt, Indore–Pithampur–Dewas belt, besides the Gurgaon belt, has the most auto-ancillary
companies as there are many prominent automotive manufacturers in these belts. Similarly,, in case
of chemical or pharmaceutical processing zones like Ankleshwar in Gujarat, all the maintenance
and repair companies for equipments besides the intermediary manufacturing companies are avail-
able nearby.
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Plant and Machinery

The machinery and all the related equipment depend on the production technology and the output
capacity being planned for the project. The next step of the erection and commissioning of machin-
ery and equipment depends on the layout being planned, which, in turn, depends on the plant and
machinery. Some of the salient points to be considered at this juncture are as follows:
1. The present and future needs of the organization and the related outputs.
2. Provision for machines under repairs or breakdowns. Unless the equipment and process are
very expensive like the steel processing plant, a spare machine within the work area would
always be useful in case of breakdown of machines. Even in the case of steel processing plant,
contingency steps in case of breakdown should be planned.
3. The choice of the equipment suppliers should be limited to the closest supplier of repute so
that technical help is available at hand.
4. Other than the main set of process equipments, requirements of support facilities such as
power generators, chillers, effluent treatment plants, fixed and movable material handling
equipments should be properly planned. Sometimes, equipments in ‘working’ condition, a eu-
phemism for second-hand equipments, are also available. Before selecting these second-hand
equipments, careful inspection of the workability and residual life of the equipment needs to
be considered.
5. Apart from the raw material, the quality of output of any process depends on the equipment,
machinery and system of manufacturing products. Hence, no compromise should be made
with regard to quality of the machine and the project promoter should consider the best avail-
able equipment.
Raw Materials
The process of manufacturing the output varies, to a large extent, on the input, which means the
raw material. Iron ore is available in lumps and fines. While the lumps can be used in the next stage
of processing, it is difficult to use only fines in the processing. However, the Chinese have developed
extensive usage of iron ore fines and these were the only export in large numbers from India. This
means that a product can be manufactured with alternate raw material and alternate process. The
process of making iron ore pellets from iron ore fines can be done either by using the rotary kiln
method or the traveling grate method. The choice of the process depends on the size of the output.
For large output, typically greater than 0.6 million tonnes per annum, the rotary kiln method is
preferred and for lesser output plants, the grate kiln technology is used.
The manufacturing of industrial grade kyanite for refractory applications is another example. If
kyanite is crystalline, then it has to be powdered without any requirement of calcining, whereas if
kyanite is granular, it has to be calcined. All these factors have to be considered before zeroing in on
the raw material to be used and the process of manufacture is finalized.
Utilities
Power, water, roads and effluent discharge system are important factors to be considered before
selecting a location. Maharashtra has shortage of power but the neighbouring state of Gujarat
has abundant power. Hence, if power-intensive units are being planned, which would be the ideal
location for the same? At times, power is only available for irrigation purposes and this means
only for few hours in a day. Power generators on stand-by can be an alternative but this only
adds to the project cost. In some cases of power-intensive units, setting up a captive power plant
is mandatory.
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Water requirement for the project should be determined by assessing if the ground water available
is sufficient to meet the requirement. Besides the quantity of water, the quality of water is also very
important and in case the quality is not satisfactory, water purifiers of the industrial type should be
factored in. For example, the dyeing industry requires soft water and if the available water is hard,
then it must be processed and converted into soft water. Steam boilers are also designed for soft
water.
The state government-promoted industrial development zones offer the required infrastructure
for industry and should be the preferred location for small- to medium-scale industries. The trans-
port network is the most important for procuring raw materials and distribution of finished goods.
Further, the linkages to the main arterial roads are also very important. All these facilities are pro-
vided in case of special economic zone (SEZ) or industrial development zones.
Micro Factors Having chosen the broad region which would be suitable for the project, narrowing
down on the actual site requires the consideration of many factors such as cost of land, availability
and suitability of ground water, effluent disposal mechanisms, absence of industry restrictions by the
local governing body, etc. When the qualitative factors are similar, we need to consider quantitative
factors before arriving at a choice of location. Although it is easier said than done, quantifying the
qualitative factors between locations such as attitude of workers or connectivity of locations with
major residential areas is difficult. Such assessment of intangible factors is known as dimensional
analysis, a technique devised by P. W. Bridgeman and hence called Bridgeman’s dimensional analysis.
This is applicable when the choice of location has been narrowed down to two.
If P and Q are two short-listed locations and CP1, CP2, CP3, ... represent the costs associated with
various tangible and intangible factors or scores (between 1 and 10, with 1 being excellent and
10 being the worst), for location P, CQ1, CQ2, CQ3, ... represent the costs associated with various
tangible and intangible factors or scores (between 1 to 10, with 1 being excellent and 10 being
worst) for location Q, then the relative merit of the location is given by:
 CP   CP   CP   CP 
 1 × W1 × 2 × W2 × 3 × W3 × 4 × W4 × …
 CQ   CQ   CQ   CQ4 
1 2 3
where W1, W2, W3, W4, ... are the weightage given to each of the factors 1, 2, 3, 4, ..., respectively.
When the value of the above equation is greater than 1, it indicates that location P is costlier, and
hence, location Q is selected. Similarly, if the value of the above equation is less than 1, then it
indicates that location Q is costlier, and hence, location P is selected as the ideal location to set
up the project.
Example 7.1
A company has identified two sites for locating the project and the comparable factors are given
in Table 7.1 The weightage to each of the factors is also given adjacent to the factors. Using the
dimensional analysis, indicate the best location for the project.
Note: For tangible factors where the comparison is possible on the basis of cost, the weightage fac-
tor is 1, whereas for intangible factors, the weights vary.
Solution:
We assign scores from 1 to 10 to the intangible factors judiciously so that comparison is possible.
An excellent gets a score of 1, whereas a poor gets a score of 8. Fair gets a score of 4 and bad gets
a score of 6.
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330 | Chapter 7
Table 7.1 Comparable data on location A and B
S.No. Factors Weightage Location A Location B

1 Cost of land and development 1 `10,00,000 `7,00,000
2 Cost of construction 1 `70,00,000 `80,00,000
3 Cost of equipment and erection 1 `1,00,00,000 `1,05,00,000
4 Running expenses per year 1 `7,00,00,000 `3,00,00,000
5 Availability of labour 2 Good Poor
6 Housing cost of labour 3 Fair Very good
7 Travel time to place of work 2 Fair Bad
The dimensional analysis is given by the equation:

 CA   CA   CA   CA 4 
 1  2  3 
 CB × W1 × CB × W2 × CB × W3 × CB4 × W4 × …
1 2 3
which, in this case, works out to:

{1,000,000 , 700,000}1 * {7,000,000 , 8,000,000}1 * {10,000,000 , 10,500,000}1
* {70,000,000 , 30,000,000}1 * {3 , 8}2 * {4 , 2}3 * {4 , 6}2 = 1.388 ' 1.40
As the value is higher than 1, we select location B as the suitable location for the project.
TECHNICAL ARRANGEMENT
Protective coating, typically industrial paints, car paints and marine coatings have a function of
protecting the structures more than the decorative element. The resale value of merchant ships or
manufacturing plants coated with protective coatings of reputed manufacturers are much higher than
those without them. The business of protective coatings depends to a large extent on the paint tech-
nology, application methodology, curing procedure, etc., which means that paint companies which
invest in these processes or in R&D of these coating get a higher price. Moreover, there is also the
question of performance-linked incentives or penalties which can be a substantial amount. Similarly,
in case of process plants or projects involving high-end technology, the support received from tech-
nology providers is important for the success of the project. The term-lending institutions would be
keen to know about these arrangements and whether there is back-up support from these organiza-
tions once the project is complete. In case there is a partnership or commitment to train the personnel
in operations by the technology providers, the comfort of the term-lending institution is high.
The next thing to ascertain is the track record of the technology being considered and whether
plants with similar processes are running with success elsewhere. Sometimes, technology gets evolved
and the project envisaged is the first user of the technology. In such cases, it must be ascertained
whether consultants have requisite knowledge in development of these new technologies and cau-
tion should be exercised to avoid self-styled, inexperienced consultants. An agreement between the
technology provider and the project promoter must be signed, explicitly incorporating all the essen-
tial features of the know-how transfer. Further details such as successful trial run, quality of the final
output, training to personnel, performance guarantee, non-compete agreement should be explicitly
mentioned. Payment of fees for technical know-how should be spread out and paid in phases. The
technology know-how provider should also provide a list of equipments that are required for the
project, their repair and maintenance schedule and the internal drawings of components/parts for
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future replacements, so that once the plant becomes operational, these aspects which come at a
much later date are already planned out.
PRODUCTION PROCESS
The efficiency of the manufacturing operation depends on the layout of the plant and machinery.
Although in case of processing plants or chemical plants, the need for processing decides the se-
quence of operations/machines, some flexibility is available in case of manufacturing plants such as
automobile, white goods, etc. In such systems, plant layout is the arrangement of various produc-
tion facilities within the manufacturing area. The Japanese have always used a single-flow system,
wherein a unidirectional assembly process with stage-wise value addition is carried out. A steady
sequence of operations, minimal transportation and agile manufacturing should be the preferred
mode of manufacturing. Some additional points should be considered as listed here.
1. In case of subsequent expansion of the project, the present production process should not be
disrupted.
2. Monitoring of work should be simple and easy. Adequate quality checkpoints should be
factored in.
3. In case of high temperature processes where there could be release of polluting gases or efflu-
ents, sufficient precautions should be taken to conduct these processes at an extreme corner.
4. In case of noise polluting equipments like power generator, the generator house should be in
a separate shed away from the main plant.
5. Proper aisles for movement of material and labour should be planned to ensure smooth flow
of material, equipment and personnel between stages of operations.
6. Adequate ventilation, lighting and safety measures should be incorporated in the plant from
the very beginning.
7. Utilities such as pressurized air, water and power should be conveyed to all sections of the man-
ufacturing unit using the appropriate overhead space and not the floor space to avoid tripping.
8. Effluent treatment plants and the layout for flow of effluents should be adequately addressed.
ENVIRONMENTAL ASPECTS
ISO 14000 is an important initiative to ensure that all the manufacturing plants comply to the en-
vironmental norms and join the global endeavour in reducing the release of harmful gases which
deplete the ozone layer in the atmosphere. Over a period of time, the focus on preventing untreated
harmful effluents being released into nature has rightfully reached a high crescendo, and hence, all
projects are expected to comply with these considerations. ISO 14000 is a family of standards re-
lated to environmental management that exists to help organizations ensure the following:
1. Minimize how their operations (processes, etc.) negatively affect the environment (i.e., cause
adverse changes to air, water or land).
2. Comply with applicable laws, regulations and other environmentally-oriented requirements.
3. Continually improve in the above.
ISO 14000 is similar to ISO 9000 quality management in that both pertain to the process of how a
product is produced rather than to the product itself. As with ISO 9000, certification is performed
by third-party organizations rather than being awarded by ISO directly.
Environment means the surroundings within which humans exist and is made up of the following:
1. The land, water and atmosphere of the earth.
2. Micro-organisms, plant and animal life.
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332 | Chapter 7
3. Any part or combination of the (1.) and (2.) and the inter-relationships among and between
them,
4. The physical, chemical, aesthetic and cultural properties and conditions of the foregoing that
influence human health and well-being.
The guiding principle of the appraisal process is to ensure that funding by term-lending institutions
are intended for economically, socially and environmentally sustainable projects and are in
accordance with the principles of sustainable development. Integral to these principles, particularly
the precautionary principle, is the requirement that the environmental risk of a proposed project
must be properly assessed and managed.
IMPLEMENTATION SCHEDULE
The schedule of project implementation may be considered a part of the technical appraisal process
and has a lot to do with the sequencing of tasks for the same. For preparing the project implementa-
tion schedule, the following information is required:
1. A complete list of all activities that comprise the project.
2. The chain of activities that needs to be completed earlier and a network of all the activities
that comprise the project.
3. The duration of each of these activities—sometimes, it is possible to have some parallel pro-
cessing of activities and perform subsequent activities only after prior activities have been
completed. A Gantt chart can be helpful in this case.
4. The requirement of resources for performing various activities.
5. The implications of availability of limited resources and whether the floats can be used to
overcome resources constraint.
6. A bar chart for a small project and an elaborate Gantt chart for a complex project using the
available software is presented in this case.
7. PERT analysis in case of probabilistic projects and CPM analysis in case of deterministic proj-
ects are conducted.
8. Further analysis of project cost time trade-offs is also performed so that lenders are aware
about the cost time trade-off benefits.
A work schedule is prepared on the basis of work breakdown structure (WBS) as explained in an
earlier chapter. The WBS reflects the plan of work during the installation and commissioning phase
of the project. The commissioning of the plant should be synchronized with the availability of raw
materials. Mining is generally affected during monsoon, especially if it is open-cast mining. Hence,
production of iron ore pellets, which depends on availability of raw material, should generally be
targeted in post-monsoon periods and the inventory of raw materials built up over time.
COST OF THE PROJECT

The cost of the project should encompass all the items of outlay associated with a project that are
supported by long-term funds. Some of the heads of the project cost can be classified as follows:
1. Outlay on land and site development, meaning levelling, fencing, etc.
2. Outlay on building, civil works, support services sheds, erection of equipments, etc.
3. Outlay on plant, machinery, equipments, utilities, consumables such as welding electrodes,
etc.
4. Technical know-how and project consultancy fees.
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5. Outlay on accommodation and residence for project construction personnel plus the provi-
sion for cafeteria, etc.
6. Working capital for the project. At times, the margin money for working capital has to be
provided for in the project and the balance is provided by the commercial banks or trade
creditors. The margin money at times can be used to offset the project cost over-runs.
7. One-time pre-operative expenses.
8. Provision for initial losses in the project.
It is advisable that all conceivable costs for projects be considered at this stage because once the
project cost is frozen, additional funding would not be easy. Most projects experience cost over-runs
and have to search for last mile funding. Concepts such as bridge loan to tide over such shortfalls
are available but the subsequent funding is always difficult.
SOURCES OF FINANCE FOR A PROJECT

It should be mentioned here that the project proposal discussed till now is made for presentation
to the term-lending institution for funding, and hence, the project funding (in this case) is done by
the method of long-term term funding. There are some preliminary differences between project
financing and conventional financing as follows:
1. In case of conventional financing, the cash flows from different sources of inflows are added
to make an assessment of the repayment capabilities. In case of project financing, the repay-
ment capabilities of only the project are considered. Hence, the computation of ratios such
as debt service coverage ratio (DSCR) or the interest cover ratio is undertaken. The project
viability study considers the repayment capability of the project and not the repayment capa-
bility of the project promoter.
2. In case of conventional financing such as personal loans or cash credit facility, the end use of
funds is not monitored. In case of project funding, the end use of funds is strictly monitored and
it is ensured that the funds released are actually used for the project and not diverted elsewhere.
3. In case of conventional financing, the financer is not interested in monitoring the performance
of the investment and focuses only on whether there is repayment of funds or not. In case of
project financing, the organization has its nominees on the Board to ensure that the perfor-
mance of the project is as per the original plan. Therefore, project finance also entails project
performance monitoring.
There can be innumerable ways by which finances in the form of equity or debt can be raised for a
project. Although equity capital does not impose an obligation of repayment, the debt capital en-
forces upon the organization an obligation to repay the principal amount and interest. Some of the
common sources of finance are enumerated here.
Promoter’s own funds: This is the basic or the simplest source of funding the project.
1.
Generally, the project is considered the promoter’s own dream and in case, the promoter
has the wherewithal to go ahead with his/her own funds, it is the best option for the project.
When funding is required from other sources, the promoter has to dilute his/her holdings (and
subsequent returns) and also sell the concept to other fund sources. In some cases, promoters
use their own funds to start an enterprise and after it has reached sufficient standing, they
reach out to other equity participants by way of initial public offering (IPO). For example,
Mahindra Forgings Ltd., acquired the company AmForge Pvt Ltd., and their Chakan plant
with its own funds. After a few years of successfully expanding their capacity and making a
very viable business proposition, they offered equity participation to the public.
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334 | Chapter 7
Ordinary equity shares: Equity shares or ordinary equity shares are the source of permanent
2.
capital for a project until the life of the project with equity shareholders being proportional
legal owners of the company. The equity shareholders are entitled to dividends as returns for
their investment besides having an opportunity to sell their shares at any time in the future on
equity exchanges such as National Stock Exchange. The equity shareholders also run the risk
of ownership and if the project does not do well, they will have to write off their holdings as
a total loss. The price appreciation of their shares is the only tangible return for a shareholder,
and hence, before investing in an organization’s IPO, the anticipation of handsome returns
drives demand for these shares.
Preference shares: Preference shares are different from equity shares in that the holders of
3.
preference shares have a priority claim in the matter of payment of dividends. The holders
of preference shares also have a priority over equity shares on the assets of the company in
case of liquidation. Dividends on preference shares, if not paid in any year for any reason, get
carried forward to the next year. In case the preference shares are of the non-cumulative type,
then the unpaid dividends cannot be carried forward to the following year.
There is, however, a moratorium on the sale of preference shares for a particular period,
which is not so in the case of equity shares. Preference shares can be further classified as re-
deemable preference shares or non-redeemable preference shares.
Debentures: Debenture instrument is a form of debt and is a means to raise a long-term debt
4.
capital. As the debenture is a form of debt, the debenture holder is a creditor with the organiza-
tion having an obligation to pay interest on debenture besides redeeming debenture after cer-
tain fixed time periods. In case of preference shares, dividend is payable if the company makes
profit, but in case of debentures, the interest is payable whether the company makes profit or
not. Convertible debentures are debentures which get converted into equity shares at the op-
tion of the debenture holder. At times, there is much appreciation in the value of the equity
shares, and hence, the debenture holder may prefer to convert the holdings into equity shares.
There are some merits of debentures for the organization issuing them listed as follows:
(a) The rate of interest on debentures is only slightly higher than that of the bank, and
hence, the issue of debentures is a low-cost option to raise funds. The risks attached with
debentures are less, and hence, debenture holders are not very demanding in terms of
returns unlike equity shareholders who would like to get very high returns.
(b) The interest paid to debenture holders is considered as a cost to company which reduces
the tax liability of the company and in turn increases the profit. In case of equity, the divi-
dend is paid from after tax profits of the company which reduces the profits retained with
the company.
(c) There is no dilution of ownership by issuing debentures as debenture holders do not have
voting rights.
(d) In case of extraordinary profits, the debenture holders cannot ask for more returns,
whereas the equity shareholders can ask for more dividend.
The demerits of debentures are as follows:
(a) Debenture holders’ claim to the assets of the company in case of liquidation are higher
than those of preference shareholders or equity shareholders. Additionally, there is a legal
obligation for payment of interest and return of principal which is not so in the case of
preference shares or equity shares.
(b) In case there are losses in any particular year the obligation to debenture holder aggra-
vates the losses.
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Fixed deposits or bonds: Bonds are also similar to fixed deposits in all respects except that the
5.
bonds are issue by the government or government owned public sector undertakings and fixed
deposits are issued by private companies. In both cases, a fixed return generally higher than
the bank rate of interest is offered to the holder. In the event of liquidation of the company, the
claims of the holder of the fixed deposit or bonds are higher than even the debenture holder.
The periodicity or tenure of these instruments is at the most three years after which they can
be renewed by the holder. The maximum deposit that a public limited company can mobilize is
restricted to 25% of the share capital and free reserves, which also means that this mode of gen-
erating funds is only available to public listed companies. New start-ups or projects cannot avail
of this mode of financing unless the organization supporting the project is a listed company.
Government subsidy: To promote projects in focused areas, the government offers many sub-
6.
sidies to the project. These subsidies are then considered as the equity capital of the promoter
for the project. As the subsidy given by the government is meant for creation of fixed assets
for the project, it is considered as a source of finance for the project. The subsidy is in the
form of area subsidy or product subsidy and only one subsidy can be availed by the project.
Area subsidy is the subsidy for setting up projects in the notified backward area as it furthers
the government’s plan for ‘industrialization’ of backward areas. Product subsidy is available
for the manufacture of specific products identified by the government as key to the economic
development of the country.
Venture capital financing: Venture capital financing is financing the initial seed capital for
7.
products or ideas that have a huge potential but cannot find financing by the traditional
route. The traditional route of seeking approvals is a time-consuming and lengthy process.
Moreover, there is a requirement that the promoter’s own funds are invested in the initial
stages which is difficult in case of a start-up venture. Venture capital funds are willing to make
investments in such projects in spite of the high risks involved. Moreover, the venture capital
funds do the required ‘hand-holding’ till the project is working successfully. A host of BPOs
received venture funds for their initial start-up from firms such as Chrysalis Capital, who are
amongst the leading venture funds. Venture funds would want to cash in on their investments
after about three to five years and generally exit the company during the IPO. Angel investors
are private investors who use their own capital to finance the requirements of a project or
venture. The Azim Premji foundation is one such angel investor in India. After the round of
‘seed funding’, there could be a round of ‘growth funding’ by the venture capital fund.
Private equity funds: Private equity (PE) is equity capital that is not quoted on a public ex-
8.
change. Private equity consists of investors and funds that make investments directly into
private companies or conduct buyouts of public companies that result in a delisting of public
equity. The PE funds invest in existing companies which are in some sort of cash crunch or
financial troubles. Wilbur Ross-promoted PE fund bought a stake in the low-cost carrier
SpiceJet in 2008 and sold the entire stake to Kalanithi Maran of the Sun TV Network group
in 2011. The capital for private equity is raised from retail and institutional investors and can
be used to fund new technologies, expand working capital within an owned company, make
acquisitions, or to strengthen a balance sheet. The majority of private equity consists of in-
stitutional investors and accredited investors who can commit large sums of money for long
periods of time. Private equity investments often demand long holding periods to allow for
a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public
company. The difference between PE funds and venture capital funds is that the former gener-
ally invests in distressed companies whereas the later invests in start-up companies.
Lease financing: Lease is a contract whereby the lessee gets the right to use an asset for a period
9.
of time for which he pays a consideration to the lessor. Generally, the lease rent is payable
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336 | Chapter 7
immediately after the lease deal is signed, and hence, this method of financing is suitable for
projects which are already generating revenues. Expansion projects or modernization projects
may consider the option of lease financing. New projects take time to generate funds and
unless the lessor is ready to wait for lease rentals at a later date, the lease financing option may
not work for the new project.
10. Unsecured loans: Unlike secured loans where the promoter pledges his/her property or asset,
an unsecured loan is a loan that is only issued and supported by the buyer’s credit worthi-
ness. There is no collateral in case of unsecured loans. These unsecured loans are also called
personal loans or signature loans and are contingent to the borrower’s credit worthiness as
defined by their CIBIL score. The CIBIL score is a three-digit numeric summary of the bor-
rower’s credit worthiness. The score is derived using the credit history found in the CIBIL re-
port. The credit scores range from 300 to 900 and if the score is closer to 900, then the credit
institution will have more confidence in the ability to repay their loan.
11. Internal accruals: The internal accruals for any business are the retained earnings and depre-
ciation charges which are debited for reducing tax burden but are factually retained by the
business. The depreciation amount is considered as internal source of funds and is a non-cash
charge. The retained earnings which would otherwise be distributed to the owners of business,
namely the equity holders, are thus a sacrifice made by the shareholder. A general norm is to
retain up to 30 to 80% of the after-tax profits of an organization to invest in further growth
opportunities.
The advantages of using internal accruals for funding a project are as follows:
(a) Retained earnings are easily available to the business and require no consultation with
lenders or shareholders. The shareholders are required to ratify the management decision
of investing and this is never a problem in the Indian context wherein shareholder activ-
ism is almost non-existent.
(b) As the Board is not answerable to the lenders of internal accruals, the control of business
or deployment of internal accrual funds is not weakened.
(c) Stock markets generally value companies that retain earnings more than those that dis-
tribute such earnings, with the assumption that the retained earnings are used for further
growth and the business gets far superior valuation.
The disadvantages of using internal accruals for funding a project are as follows:
(a) There is always a limit on how much risk a firm can take by investing the retained earn-
ings. At times, it is also dictated by the firm’s dividend policy.
(b) At times, the opportunity cost of retained earnings is not considered which may lead the
company to invest in sub-marginal projects.
12. Bridge loans: A bridge loan is a type of loan used by a company to bridge a gap in financ-
ing until the company obtains more permanent funding for the project. It is essentially a
short-term measure, often required in project funding when the main funds are delayed. The
advantages of bridge loan are that it is easier and quicker to obtain than term loans, lesser
requirement of documentation and no early repayment penalty.
FINANCIAL APPRAISAL
Financial appraisal of a project requires the following details:
1. Projections of performance and profitability
2. Projected cash flow statement
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3. Projected balance sheet

4. Calculation of margin money for working capital and assessment of working capital
5. Calculation of depreciation
6. Calculation of interest for term loan from bank
7. Break-even point
8. Debt service coverage ratio (DSCR)
9. Calculation of IRR and NPV
10. Cost of capital
11. Return on capital employed
12. Tax provision
As most of the above have been adequately covered in Chapter 6, they are not discussed here.
ECONOMIC CONSIDERATIONS
The objective of any project is not just to benefit the project promoter but to benefit the society in
the vicinity of the project as well. Sanand in Gujarat is an example of the economic benefits of the
automobile hub extending to the entire city, its residents and the neighbouring areas. Therefore, the
main objective of conducting a project’s economic analysis is to ascertain the role of the project as
a sustainable improvement in the welfare or project beneficiaries and the entire region besides the
country. This is especially true about projects that fall in the socio-economic improvement sectors.
The objective of this economic consideration is to analyze whether it makes sense to improve region
A or region B on a long-term basis. Economic analysis is a means to help bring about a better al-
location of resources that can lead to enhanced incomes for investment or consumption purposes.
The Gabonese Republic, a sovereign state on the west coast of Africa, is inviting investment proj-
ects from global businesses in order to promote economic development in the country. Economic
analysis is best undertaken before the start of the project to take an informed decision on whether
to undertake a particular investment or not.
The process of economic analysis helps answer various question about the project’s overall effect
on society, the risk to the society and its sustainability. The Vedanta group (formerly Sterlite)-
promoted copper project phase II in Tuticorin has been scrapped for the time being because of
environmental damage that is feared to be caused. The existing plant was also shut down as a result
of the related social unrest. Different projects have different sets of problems but the principles of
economic analysis are applicable to all.
The addendum I, II and III at the end of this section present examples of DPR for different projects.
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338 | Chapter 7
Appendix I
Detailed Project Report
Proposal for Term loan of `…… lakh and Working Capital Limit of `…….lakh
for setting up a new project for manufacture of ………..
I. INTRODUCTORY, PROMOTERS AND MANAGEMENT

1. Particulars of the Enterprise:
1.1 Name of the Enterprise
1.2 Constitution (Proprietorship/Partnership/ Private Limited
Company/Public Limited Company/ Limited Liability
Partnership/Cooperative Society
1.3 MSME Status
1.4 MSME Registration Number/Date of Registration
1.5 Date of Incorporation/Commencement of Business
1.6 ROC Number if Applicable
1.7 Address
Registered Office
Administrative Office
Factory
(Whether backward area)
1.8 Industry Status
Industry Products Installed Capacity Number of Days/Shifts End Uses Export Orientation
2. Promoters
2.1. Brief Biodata of the Promoters
A brief background of promoters may be furnished as under. Write up on other companies, if any,
promoted by them with which they are associated may be added.
Name of the Promoter

Father’s/Husband’s Name
Age (years)
Residential Address
Educational Qualification
Passport Number, Valid Till, Place of Issue
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Permanent Account Number

Relationship with the Chief Promoter
Experience in what Capacity/Industry/Years
Net Worth As On………………….
Income Tax/Wealth Tax Status
Other Concerns Interest/in which Capacity/Financial Stake
Detailed biodata may be furnished as per Appendix I and net worth statement of promoters and
guarantors may be furnished as per Appendix II.
2.2 Brief Financial Position/Working Results of Each Associate Concern

Brief financial position/working results of the associate concern(s) for the past …. years is furnished
below:
(` lakh)
Name of the Concern/

Location/Established in Product Year/Period Sales Net Profit Net Worth
Details of associate concern(s) may be given as per Appendix III.
2.3 Brief History

Brief history of the unit may be given.
3. Management and Proposed Shareholding Pattern

3.1 Management
Brief comments on the management be given.
3.2 Proposed Shareholding Pattern

The authorized share capital of the company is ` ….. lakh. The shareholding pattern of the company
is given below:
Shareholding
S.No. Name of the Directors (Shri) Number of Shares
` Lakh %
1
2
3
4
Total 100
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340 | Chapter 7
or
The unit is a partnership firm. The profit/loss of the firm shall be shared by the partners in the
following proportion:
S.No. Name of the Partners (Shri) Percentage (%) in Case of Profit/Loss

1
2
3
Total 100.00
II. TECHNICAL ASPECTS

4.1 Scope of the Project
Briefly mention scope of the project, that is, what the project is supposed to accomplish to deliver a
product or service with the specified features and functions.
4.2 Location Availability of Infrastructural Facilities

Locational advantages of premises with reference to absence of civic restrictions, proximity to the
source of raw materials, market for the product, availability of power, water, labour and transport
may be mentioned. Mention whether there are backward area benefits, if any.
4.3 Technology
Selection of technology, comments on alternative production process, comments on technology (lat-
est/appropriate/proven) are included here. Discuss the impact of possible changes in technology in
future. Indicate technical process—whether it is a continuous process. In case of technical collabora-
tion, furnish a brief write-up on the period of collaboration agreement, the name of the collaborator
company, indicating the activities, size, turnover, particulars of the existing plants and other projects
in India and abroad set up with same collaboration. A brief manufacturing process involved may
also be given.
4.4 Raw Materials/Components

Details of raw materials required and their sources may be indicated.
4.5 Utilities
4.5.1 Power
Requirement of power depending upon plant and machinery and its availability from the state
electricity board may be mentioned. Back-up arrangement of power by way of DG Set may also be
furnished.
4.5.2 Water
Requirement of water for process/human consumptions and its availability from the municipality/
borewell may be mentioned.
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4.5.3 Fuel
Details of fuels required depending upon production process and its arrangement of supply may be
mentioned.
4.5.4 Others Such as Steam/Compressed Air, etc.
Details of steam/compressed air required depending upon the production process and its arrangement
in the project may be mentioned. Capacity of boiler/compressor may be furnished.
4.6 Effluent Disposal

Mention whether the unit falls under green, orange or red categories as per guidelines of State
Pollution Control Department. Type of pollutants generated under the process and pollution control
and measures being taken in the project may be mentioned. Mention whether the unit has applied/
will apply to the State Pollution Control Department for getting consent to establish.
4.7 Implementation Schedule

Based on the progress already made and other arrangements made by the unit, the implementation
schedule for following may be mentioned.
Particulars Date of Commencement Expected Date of Completion

Acquisition of land
Development of land
Civil works for
— factory building
— machinery foundation
— administrative building
Plant and machinery
— imported
— indigenous
Arrangement for power
Arrangement for water
Erection of equipment
Commissioning
Initial procurement
of raw material
Trial runs
Commercial production
4.8 Manpower
The requirement of proposed manpower in various cadres, which is, executives, technical persons,
supervisors, administrative staff, skilled and unskilled labour and their arrangements being made to
be commented upon, keeping in view the location of the unit, industry, etc.
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342 | Chapter 7
III. PROJECT COST AND MEANS OF FINANCE

5. The Broad Break-Up of Cost of Project is as Under
(` lakh)
To be Incurred
S.No. Particulars Already Incurred Firm Non-Firm Total Cost
1 Land and site development
2 Buildings
3 Plant and machinery—imported
Plant and machinery—indigenous
4 Miscellaneous fixed assets
5 Preliminary expenses
6 Pre-operative expenses
7 Contingencies
8 Margin money for working capital
Total
5.1 Land and Site Development

Location, area, purchase price, adequacy, availability for future expansion, comment if land acquired
is in proportion to requirement, whether non-agricultural (NA) permission is obtained, freehold or
leasehold, if leasehold, who owns, period of lease, whether lease deed registered, whether mortgage
of leasehold rights possible, period of lease and adequacy thereof, price and reasonableness thereof,
when acquired, land in the name of whom, if not then steps taken for transfer to the company,
break-up of site development cost viz. levelling and filling, internal roads, barbed wire compound,
etc. and reasonableness thereof.
Details of site development required and cost may be given in the following table. It may be
supported by the estimate from the architect.
S.No. Description of Building Cost (` Lakh)

Cost of levelling and development of ………..acres/sq.m of land
(a)
@ ` ……per acre/sq.m
Cost of laying roads
(i) Approach road connecting the factory site to main road ……. running
meters @ ` …… per running meters.
(b)
(ii) Internal roads for the factory ……. running meters
@ ` …… per running meters.
Cost of fencing/compound wall ……. running meters
(c)
@ ` ……per running meters.
(d) Cost of ….. gates
Total Cost of Site Development
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5.2 Buildings
Details may be furnished in the following table:
(` lakh)
Cost. per
Estimated Area sq. mt. or
Type of Cost (sq. mts. sq. ft.
S.No. Description of Building Construction (` Lakh) or sq. fts.) (` Lakh)
(a) Factory building for the main plant and
equipment
(b) Factory building for auxiliary services like steam
supply, water supply, laboratory, workshop, etc.
(c) Administrative building
(d) Godowns, warehouses and open yard facilities.
(e) Misc. non-factory buildings like canteen, guest
house, time office, excise house, etc.
(f) Quarters for essential staff
(g) Silos, tanks, wells, chest, basin, cisterns, hoopers
bins and other structures which are necessary
for installation of plant and equipment and
which may be constructed in RCC and such
other structural civil engineering materials
(h) Garages
(i) Cost of sewers drainage
(j) Civil engineering works not included above
(k) Architect fees
Total Cost of Building
Please furnish the particulars of the architect such as name and address of the architect firm,
scope of work, rates quoted and detailed estimate of expenses, fee payable and manner in which
payable, time schedule, penalties and past experience of the architect in similar work.
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344 | Chapter 7
5.3 Plant and Machinery (Imported and Indigenous)

The details of plant and machinery (imported and indigenous) proposed to be acquired may be
furnished in following table:
IMPORTED
(` lakh)
Name of Unit Cost Import
Machinery and in Foreign Foreign Exchange Total Cost Duty Import Duty
S.No. Specification Quantity Supplier Currency (CIF) Currency Rate (` Lakhs) (%) (Amount)
1
2
3
4
5
6
7
Total Cost of Imported Machinery
INDIGENOUS
Unit Cost (`) Total Cost

S.No. Name of Machinery and Specification Quantity Supplier (Including Taxes) (` Lakhs)
1
2
3
4
5
6
7
Total Cost of Indigenous Machinery
The basis of selection of the suppliers, whether based on recent competitive quotations or otherwise,
reputation of suppliers and guarantees regarding performance may be mentioned. In case of fabri-
cated equipment, cost should be reasonable and justifiable. In case of imported machinery, details
of customs duty may also be given. If second-hand machinery, enclose valuation report regarding
age, performance and value from an approved chartered engineer. Indicate reasons for going in for
second-hand machinery. Separate mention may be made about transportation/ erection/installation
of plant and machinery.
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If any consultant is engaged, the following details may be furnished:

(a) Name and address of the consultants
(b) Fees payable and the manner in which payable
(c) Scope of work assigned to them
(d) Brief particulars of consultants including organizational set-up, biodata of senior personnel,
names of directors/partners, particulars of work done in the past and work on hand.
5.4 Miscellaneous Fixed Assets

The details of miscellaneous fixed assets proposed to be acquired may be furnished in following
table.
Unit Cost Total Cost

S.No. Name of MFA and Specification Quantity Supplier (` Including Taxes) (` Lakhs)
1
2
3
4
5
6
7
Total Cost of MFAs
The basis of selection of the suppliers, whether based on recent competitive quotations or otherwise,
reputation of suppliers and guarantees regarding performance may be mentioned.
5.5 Preliminary Expenses

Expenses before incorporation of the company may be furnished in the following table.
S.No. Nature of Expenses ` Lakhs

(a) Brokerage and commission on capital
(b) Other capital issue expenses (legal, advertisement, printing stationery, etc.)
(c) Other preliminary expenses (company flotation and other initial expenses)
Total Preliminary Expenses
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346 | Chapter 7
5.6 Pre-operative Expenses

Pre-operative expenses may be furnished in the following table.
S.No. Nature of Expenses ` Lakhs

(a) Establishment
(b) Rent, rate and taxes
(c) Traveling expenses
(d) Miscellaneous expenses
(e) Interest during construction period
(f) Insurance during construction including erection insurance
Mortgage expenses (stamp duty, registration charges
(g)
and other legal expenses) (….% on loan of ` …. lakh)
(h) Upfront fee for sanction of term loan
(i) Security deposit with electricity board and charges for power connection
Total Pre-operative Expenses
5.7 Contingencies
Contingencies may be related to non-firm cost on building, plant and machinery and miscellaneous
fixed assets.
5.8 Margin Money for Working Capital

Margin money for working capital for the first full year of projections either based on the Nayak
Committee Method (up to working capital limit of `5 Crores in respect of SSI units) or second
method of lending may be mentioned.
6. Means of Finance

The proposed means of finance is as under:
(` lakh)
Amount
Amount Proposed Total
S.No. Particulars Already Raised to be Raised Amount
1 Share capital/Partner’s capital/ Proprietor’s capital
2 Subsidy from central/state government
3 Interest free unsecured loans
4 Term loan from bank
Total
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IV. ARRANGEMENTS MADE/PROPOSED TO BE MADE FOR WORKING CAPITAL

Proposed arrangement for sanction of working capital limit from bank or own sources may be
mentioned.
V. INDUSTRY/MARKET AND SELLING ARRANGEMENTS

8.1 Industry Overview and Future Outlook
Prospects of the industry may be mentioned here. Government policies and regulations, WTO-
related issues, demand-supply scenario, competitor analysis, etc., may be covered.
8.2 Marketing and Selling Arrangements

Details regarding main markets (locations), competitors, how the unit proposes to meet the com-
petition, how the unit’s product compares with those of its competitors, any USP or specific market
strength, whether the product has multiple applications, distribution channels (e.g., direct sales,
retail network, distribution network), details of the marketing team, if any, firm tie-up, orders on
hand, details of marketing study done, if any, may be mentioned here.
VI. FINANCIAL VIABILITY

Detailed profitability assumptions may be given as per Appendix IV. Detailed profitability estimates,
projected cash flow statements, projected balance sheet, break-even analysis, working capital com-
putation, debt service coverage ratio and internal rate of return calculations may be prepared as per
Excel file (Profitability_ Projections) and be attached as Annexures I to XIV. Indicate the critical as-
sumptions and give meaningful comments on projected capacity utilization, selling prices assumed
for finished products/raw materials, gross profit percentage compared to industry average and indi-
cate the critical factors based on which viability is ascertained.
VII. STRENGTH/WEAKNESS
Strengths and weaknesses such as market standing, product/service differentiation, technical exper-
tise, infrastructure facilities, etc., are mentioned.
VIII. FINANCIAL ASSISTANCE SOUGHT FROM BANK

Amount of term loan and/or working capital limit sought from the bank may be mentioned.
Repayment period in respect of term loan sought from the bank, including repayment holiday may
be mentioned.
IX. DETAILS OF SECURITIES OFFERED TO THE BANK

(a) Primary (working capital and term loan securities to be indicated separately)
(b) Collateral (full details)
(c) Details of personal and corporate guarantees, if any
Signature of the Borrower

Date:
Place:
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348 | Chapter 7
List of Enclosures
APPENDIX I Bio-data of the promoter
APPENDIX II Net worth statement of the promoter
APPENDIX III Details of the associate concern (if applicable)
APPENDIX IV Assumptions underlying profitability estimates
ANNEXURE I Cost of project and means of finance
ANNEXURE II Projections of performance and profitability
ANNEXURE III Projected cash flow statement
ANNEXURE IV Projected balance sheet
ANNEXURE V Calculation of margin money for WC and assessment of WC
ANNEXURE VI Calculation of depreciation
ANNEXURE VII Calculation of interest on term loan from bank
ANNEXURE VIII Break-even point
ANNEXURE IX DSCR
ANNEXURE X Calculation of IRR and NPV
ANNEXURE XI Cost of capital
ANNEXURE XII Return on capital employed
ANNEXURE XIII Tax provision
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Other Documents
1 Audited financial statements for the last three years of all the associate
concerns of the applicant unit (if applicable)
2 Certified copy of Memorandum and Articles of Association/Certificate of
Incorporation/Certificate of Commencement of business/Partnership Deed/
Trust Deed/Bye-laws/Registration Certificate from Registrar of firms/Societies,
as the case may be
3 IT/Wealth tax assessment orders/returns/certificates for the last three years in
the respect of the promoters
4 Photocopy of PAN card of all the promoters/directors/guarantors
5 Know Your Customer (KYC) Documents of all the promoters/directors/
guarantors
6 Photograph of all the promoters/directors/guarantors with signatures duly
certified by their bankers/as per extant guidelines
7 MSME registration certificate
8 Collaboration agreement, if applicable
9 Agreement with technical consultants, if any
10 Title documents such as sale/lease deed/agreement for the land and buildings
on which the project is to be operated/set up and of collateral securities, if any
11 Government order/permission converting the land into industrial land, if
required
12 Agreement with the electricity board for sanction of requisite power load
13 No objection certificate/Consent to establish obtained from the Pollution
Control Board
14 Orders/enquiries in hand for the output of the proposed project
15 Invoices/quotations for each item of plant and machinery and miscellaneous
fixed assets proposed to be purchased under the project along with a write-up
on the technical specifications, advantages, etc., of the machinery
16 Detailed estimates for civil construction with bio-data of the builder/architect
17 In-principle letter of sanction for working capital assistance to the applicant
unit given by a bank
18 In case some portion of the expenditure has already been incurred, please
furnish necessary proofs (cash receipts) along with a CA certificate with regard
to sources of finance, items of expenditure, etc.
19 In case the applicant unit has been promoted by a company, please furnish
the Memorandum and Articles of Association and Audited Balance Sheet and
Trading and Profit and Loss A/cs for the past three years of the promoter
company
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350 | Chapter 7
APPENDIX I
Bio-data of the Promoter
Details of Proprietor/Partners/Managing Partner/
Promoters/Directors/Managing Director
(Please indicate inter-relationship, if any, among the partners/directors/promoters)
Full name
Name of the father/husband
Relationship with the chief promoter:
Residential address
State
Telephone number
Mobile number
Permanent address
Personal details
Age
Sex
Academic qualification
Passport number, place of issue, validity period
Pan card number, date of issue
IT/wealth tax status
Mention, if belong to scheduled castes/ scheduled
tribes/minority community)
Mention, if ex-serviceman
Mention, if first generation entrepreneur
Experience in similar line of activity
Experience in any other line of activity
Functional responsibilities in the unit
Shareholding in the unit (existing)
Shareholding in the unit (proposed)
Any other relevant information
(Continued)
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If associated as proprietor/partner/director/shareholder with firms other than the applicant unit,

please furnish name and address of the branch/associates/identical firms (details to be furnished
separately).
Capacity in which Dealing Bank Details

Name of the Unit Associated Address of the Unit (Name and Address)
Details of credit facilities enjoyed with other banks in personal capacity
Type of Dealing Bank details Account Amount of Outstanding Rate of

Facility (Name and Address) Number Facility Balance Interest (%)
Place:
Date:
Signature
_____________________________________________________________________________________
Bio-data of each promoter/director to be furnished in the above format.
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352 | Chapter 7
APPENDIX II
Net Worth Statement of the Promoter

(All amounts in ` lakh unless otherwise specified)
1 Name
2 Address:
Residential
Office
3(a) Details of Assets

(i) Cash on hand
(ii) Bank balance
(iii) Stock in trade
(iv) Details of other securities such as Govt. bond/shares
(v) Investment in business
(vi) Others
Total
3(b) Immovable Properties
Type of property
Location and (Agri./Industrial/ Area/ Self/ Value Details of
S.No. Address Residential, etc. Extent Ancestral (` Lakh) Encumbrance
(i)
(ii)
(iii)
Total
Note: Basis of valuation may be indicated.
3(c) Liabilities
S.No. Borrowings from Secured by Amount still to be Paid

(i)
(ii)
(iii)
Total liabilities
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4. Summary
Value of liquid assets
Value of immovable properties
Total assets
Less: Total liabilities
Net assets
Profit in business
Note: Guarantees/Acceptances given to banks may also be indicated.
I declare that the above particulars are true to the best of my knowledge and belief.
Place:
Date:
Signature
_____________________________________________________________________________________
Net worth statements of all promoter directors to be furnished in the above format.
Mention if any government enquiry, proceedings or prosecution has been instituted against the pro-
moters/directors for any offenses. If yes, please give details.
Please indicate whether any of the promoters or directors have at any time declared themselves as
insolvent.
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354 | Chapter 7
APPENDIX III
Details of the Associate Concern
Name of associate concern

Address
Nature of activity/product
Location
Established in
Names of the promoters who are interested in associate concern
(please indicate in what capacity) and their financial stake
Financial Position and Working Results
FY…… FY…… FY…….

Share capital
Reserves and surplus
Net worth
Total income
Gross profit
Interest
Depreciation
Net profit
Dealing with Bank
Dealing Bank Date of Details of Security

Details (Name, Sanction/ Purpose Amount/Limit (incl. Collateral, if any) Outstanding Interest Defaults
Address, etc.) Last Renewal of Loan Sanctioned and Value as on Date Rate (%) (if any)
Associate Concern: B
Associate Concern: C
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APPENDIX IV
Assumptions Underlying Profitability Estimates
S.No. Particulars Assumptions

The project would commence commercial operation from and would operate
1
days a year on shift basis.
2 Installed Capacity per annum would be as under Units/MTs
(i) Product I
(ii) Product II
(iii) Product III
3 The capacity utilization has been assumed as under Percentage
FY (1st year)
FY (2nd year)
FY (3rd year)
FY (4th year) onwards
4 The selling prices have been assumed as under ` per Kg/MT
(i) Product I
(ii) Product II
(iii) Product III
5 The raw material prices have been assumed as under ` per Kg/MT
(i) Raw material A
(ii) Raw material B
(iii) Raw material C
Power consumption is estimated at KVA. Power tariff from Electricity Board has
6
been assumed at ` per KW.
Fuel consumption is estimated at and charges per unit has been estimated
7
at `
Repairs and maintenance have been assumed at % of building, % of Plant
8
and Machinery and % of MFAs with % percentage increase every year
9 Selling expenses have been assumed at % of net sales.
10 Administrative expenses have been assumed at % of net sales.
Interest rates for the term loan and working capital have been assumed at % and
11
% respectively.
Depreciation has been provided for on straight line method for profitability estimates and written
12
down value method as per Income Tax rates for tax purpose.
Working capital has been computed based on Nayak Committee Method or Second Method
13
of Lending.
The above format is a sample which will vary depending on type of industry, product, etc.
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356
KYC Documents
Features Documents for Identity Proof Documents for Proof of Correct Permanent Address
M07_PRAD30856_01_C07.indd 356
(I) Accounts of Individuals 1. Passport 1. Latest telephone bill
(a) Legal name and another 2. PAN card 2. Latest certified original bank account statement.
name used 3. Voter’s identity card 3. Letter from any recognized public authority
(b) Current address and contact 4. Valid driving license 4. Latest electricity bill.
telephone/mobile numbers 5. Photo identity card (subject to the bank’s satisfaction) 5. Ration card
and e-mail address, if any. 6. Photo credit card 6. Latest certified original demat account statement.
7. Letter from a recognized public authority or public 7. Letter from employer from corporates and other
servant verifying the identity and residence of the entities of repute (subject to satisfaction of the
customer to the satisfaction of the bank. Bank)
(Any one of the above documents to the satisfaction of the (Any one of the above documents to the satisfaction
bank along with recent passport size photographs) of the bank)
(II) Accounts of Proprietorship 1. Registration certificate (in case of a registered concern) (All the following documents to be obtained)
concerns 2. Certificate/License issued by the Municipal authorities 1. Latest telephone bill/utility bill in the name of
(a) Proof of the name, existence, under Shops and Establishment Act the concern/proprietor.
mailing address and activity 3. Sales and income tax returns 2. Any document, as given above for accounts of
of the concern and 4. CST/VAT certificates individuals, for address proof of the proprietor,
(b) Proof of the name and 5. Certificate/registration document issued by sales tax/ viz. (1) Latest telephone bill, (2) Latest
address of the proprietor. service tax/professional tax authorities certified original bank account statement, (3)
(c) Telephone/mobile/fax 6. License issued by the Registering authorities such as Letter from any recognized public authority,
numbers/e-mail address Certificate of Practice issued by Institute of Chartered (4) Latest electricity bill, (5) Ration card,
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of the concern and the Accountants of India, Institute of Cost Accountants of (6) Latest certified original demat account
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proprietor, if any. India, Institute of Company Secretaries of India, Indian statement, (7) Letter from employer from
Medical Council, Food and Drug Control Authorities, etc. corporates and other entities of repute (subject
7. Registration/Licensing document issued in the name of to satisfaction of the Bank).
the proprietary concern by the central government or
state government authority/ department
8. IEC (Importer Exporter Code) issued to the proprietary
concern by the office of DGFT.
(Any two of the above documents would suffice. These
documents should be in the name of the proprietary concern).
(Continued)
06/02/19 11:32 AM
9. Any document, as given above for accounts of
individuals, to identifying the proprietor, viz.
M07_PRAD30856_01_C07.indd 357
(1) Passport, (2) PAN card, (3) Voter’s Identity Card, (4)
Driving license, (5) Photo Identity card (subject to the
Bank’s satisfaction), (6) Photo credit card, (7) Letter from a
recognized public authority or public servant verifying the
identity and residence of the customer to the satisfaction of
the Bank.
(III) Accounts of Partnership (All the following documents to be obtained) (All the following documents to be obtained)
Firms 1. Latest telephone bill/utility bill in the name of
1. Registration certificate, if registered
(a) Name, existence and legal firm/partners
2. Partnership deed
status 2. Any document, as give above for accounts of
3. Power of Attorney granted to a partner or an employee
(b) Mailing address of the firm individuals, for address proof of each of the
of the firm to transact business on its behalf.
(c) Object clause partners and the persons holding the power of
4. Identification of authorized signatories should be based
(d) Ownership and control attorney, viz. (1) Latest telephone bill, (2) Latest
on photographs and signature cards duly attested by
structure certified original bank account statement, (3)
the firm/their banker.
(e) Names of all partners and Letter from any recognized public authority, (4)
5. Any document, as given above for accounts of
their addresses Latest electricity bill, (5) Ration card, (6) Latest
individuals, identifying the partners and the persons
(f) Names of authorized certified original demat account statement,
holding the Power of Attorney, viz. Passport, (2) PAN
signatories and their (7) Letter from employer from corporates and
card, (3) Voter’s Identity Card, (4) Driving license, (5)
addresses other entities of repute (subject to satisfaction
Photo Identity card (subject to the Bank’s satisfaction),
(g) Telephone/mobile/fax of the Bank).
(6) Photo credit card, (7) Letter from a recognized
numbers/e-mail addresses
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public authority or public servant verifying the identity
of the firm/its partners/
and residence of the customer to the satisfaction of the
authorized signatories
Bank.
6. Copy of PAN allotment letter in the name of the firm/
PAN proof.
Additional document to be obtained in case of medium
and high-risk customers
7. Any business registration document/certificate – Shops
and Establishment Registration/Sales Tax Registration/
Service Tax Registration/Factory Registration/SEBI
Registration.
(Continued)
357
06/02/19 11:32 AM
358
KYC Documents (Continued)
Features Documents for Identity Proof Documents for Proof of Correct Permanent Address
M07_PRAD30856_01_C07.indd 358
(IV) Accounts of companies (All the following documents to be obtained) (All the following documents to be obtained)
(a) Name of the company, 1. Certificate of Incorporation and Memorandum and 1. Telephone bill/utility bills in the name of
existence and legal status Articles of Association the company showing principal address/
(b) Principal place of business 2. Certificate of commencement of business. mailing address of the company as the case
(c) Mailing address of the 3. List of Directors and the Form 32 supporting their may be.
company director status. 2. Any document, as given above for accounts
(d) Object Clause 4. Resolution of the Board of Directors to open the of individuals, for address proof of the
(e) Ownership and control account/make the investment/avail the facility and chairman, managing director and all other
structure identification of those who have authority to operate directors and authorized signatories, viz.
(f) Power to borrower/offer the account and identification of those who have (1) Latest telephone bill, (2) Latest certified
security authority to accept the facility on behalf of the original bank account statement, (3) Letter
(g) Names of all Directors/ company through resolution. from any recognized public authority, (4)
principal functionaries/ 5. Power of Attorney, if any, granted to its managers/ Latest electricity bill, (5) Ration card, (6)
main promoters and their officers/employees to transact business on its behalf. Latest certified original demat account
addresses 6. Identification of authorized signatories should be based statement, (7) Letter from employer from
(h) Names of authorized on photographs and signature cards duly attested by corporates and other entities of repute
signatories and their the company/their banker. (subject to satisfaction of the Bank).
addresses 7. Any document, as given above for accounts of
(i) Telephone/mobile/fax individuals, for identity proof of the chairman,
number/e-mail addresses of managing director and all other directors, authorized
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the Company/its Directors/ signatories, viz. (1) Passport, (2) PAN card, (3) Voter’s
Authorized Signatories Identity Card, (4) Driving license, (5) Photo Identity
card (subject to the Bank’s satisfaction), (6) Photo credit
card, (7) Letter from a recognized public authority or
public servant verifying the identity and residence of the
customer to the satisfaction of the Bank.
8. Copy of PAN allotment letter in the name of the
Company/PAN proof.
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Appendix II
Decentralized Distribution Generation (DDG)
Projects under Rajiv Gandhi Grameen
Vidyutikaran Yojana
Format for Preparation of Detailed Project Report (DPR)
June 2009
Reference No. (DPR No.): ___________________ (for official use)
Date of preparation of DPR: ______________________ (month/year)
Name of the State: _________________________________
Name of the district: _________________________________
Name of the villages/hamlets: _________________________________
Technology chosen: _________________________________
Estimated project cost (` Lakhs): _________________________________
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360 | Chapter 7
Contents
1.0 Executive summary 1
2.0 Introduction (Village profile) 3
3.0 Village energy plan 5
4.0 Estimation of load demand and energy demand 7
5.0 Technology selection decision 9
6.0 Design details of the power plant and estimated costs 12

7.0 Project management and monitoring plan 15
8.0 Baseline information for calculating emission reductions

from carbon trading schemes 16
9.0 Check list for detailed project reports (DPRS) 18
10.0 Bar/PERT chart for project erection and commissioning 23
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This document provides a format to be followed for preparing the detailed project report (DPR)
for the DDG projects to be established under the Rajiv Gandhi Grameen Vidyutikaran Yojana.
1.0 Executive Summary

A brief about the project, including the technology chosen, system configuration and cost
parameters
1.1 Name of the villages selected (1)___________________________

(2)___________________________
(…)__________________________
1.2 Number of villages selected _____________________________
1.3 Village GPS coordinates ________ latitude _______ longitude
1.4 Name of the hamlets selected (1)___________________________

(2)___________________________
(…)__________________________
1.5 Number of hamlets selected _____________________________
1.6 Name of the district _____________________________
1.7 Name of the state _____________________________
1.8 Implementing agency _____________________________

_____________________________
1.8.1 Address of implementing agency Address: _____________________

_____________________________
_____________________________
Tel. __________________________
Fax: _________________________
Mob: ________________________
Email: ________________________
1.8.2 Name of contact person at implementing agency _____________________________
1.8.3 Contact details Designation: _________________

____________________________
Address: _____________________
____________________________
____________________________
Tel. _________________________
Fax: _________________________
Mob: ________________________
Email: _______________________
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362 | Chapter 7
1.9 Number of households:

1.9.1 Number of BPL households
1.9.2 Number of non-BPL households
1.9.3 Total number of households
1.9.4 Total population (as per Census 2001)
1.10 Estimated load demand:
1.10.1 Household–lighting and other
1.10.2 Community services, including streetlights
1.10.3 Non-domestic/productive
1.10.4 Total estimated load demand
1.11 Type of technology selected:
1.11.1 Small hydro/Diesel generating sets powered by Technology selected
biofuels/Diesel generating sets/gas engine powered _____________________________
by producer gas generated through biomass _____________________________
gasification/Diesel generating sets/ gas engine _____________________________
powered by biogas (animal waste)/Solar photo
voltaic/Wind hybrid systems/Other hybrid options,
including any new technology, etc.
1.12 Proposed DDG capacity (in kW) ___________________________kW
1.13 Estimated project cost (in ` Lakhs):

1.13.1 A. Capital cost
1.13.2 B. Cost of spare parts
1.13.3 C. Cost of providing power minus cost of recovery
for 5 years
1.13.4 (i) Cost of preparing DPR

(ii) Cost of social engineering
D. Total soft cost (i + ii)
1.13.5 Total (A + B + C + D) (` Lakhs)
1.14 Tariff
1.14.1 Proposed tariff

(i) Per households
(ii) Per non-households (streetlight, non-domestic/
productive, common facilities, etc.)
1.14.2 Present grid tariff in neighbourhood

(i) For domestic households (`/unit)
(ii) Non-households (streetlight, non-domestic/
productive, common facilities, etc.) (`/unit)
1.15 Cost of power supply for 5 years (` Lakhs)

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2.0 Introduction (Village profile)

This section should provide a brief description of the village area and population details. The
geographical location of the village within the State and District should be shown on map
as an attachment. This section should cover the village-level information obtained through
focused group discussions (FGD) and village survey. The FGD should generate the social and
resource map of the village and these maps should be attached with the DPR.
Note: If more than one village/hamlet has been selected for the project, the consultant prepar-
ing the DPR is required to fill Section 2.0 for each village/ hamlet selected.
Name of the village/hamlet

2.1 Name of the village/hamlet _____________________________
_____________________________
2.2 Village census code _____________________________
2.3 Village GPS coordinates _______ latitude _______ longitude
2.4 Name of the gram panchayat
2.5 Name of block
2.6 Whether it is tribal block Yes/No
2.7 Name of district
2.8 Name of the state
2.9 Approach to the village:
2.9.1 Distance from block HQ (Km)
2.9.2 Type of road (tar road or katcha road)
2.9.3 If katcha road: distance from tar road head (km)
2.9.4 Distance from nearest 11 kV line (Km)
2.9.5 Distance from nearest 0.4 kV line (km)
2.10 Total area of village (ha)
2.11 Number of hamlets in Village
2.12 Total population (as per 2001 census):
2.12.1 A. Number of BPL households
Number of SC households
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364 | Chapter 7
Number of ST households
Number of other households
2.12.2 B. Number of non-BPL households
Number of SC households
Number of ST households
Number of other households
2.12.3 Total (A + B)
2.13 When is grid power supply expected (Mark ✓) (Within 1 year)

(1 to 2 years)
(2 to 3 years)
(3 to 5 years)
(more than 5 years)
2.14 Details of common facilities:
2.14.1 Number of schools
2.14.2 Number of public health centres
2.14.3 Number of panchayat bhawans
2.14.4 Number of community buildings
2.14.5 Others (specify)

(i) (i)
(ii) (ii)
(iii) (iii)
2.15 Is clustering with other villages/hamlets (outside the Yes/No

village selected) possible?
2.15.1 Name of village (s) where clustering is possible (1)___________________________

(2)___________________________
(…)__________________________
2.15.2 Distance of these villages from the village/hamlet (1)___________________________

selected (in km)
(2)___________________________
(…)__________________________
2.15.3 Name of hamlet (s) (outside the village selected) (1)___________________________

where clustering is possible
(2)___________________________
(…)__________________________
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2.15.4 Distance of these hamlets from the village/hamlet (1)___________________________

selected (in km)
(2)___________________________
(…)__________________________
2.16 Socio economic details:
2.16.1 Type of Land ownership in which DDG is proposed Gram Panchayat

(Mark ✓) Government
Community
Private Land
Others (Specify) _____________
2.16.2 Main lively hood activity (1)___________________________

(2)___________________________
(…)__________________________
2.16.3 Main employment (1)___________________________

(2)___________________________
(…)__________________________
2.16.4 Average household annual income (`)
2.16.5 Average household annual expenditures (`)
2.17 Any local NGOs already associated with the village/ Yes/No
hamlet
(If Yes, Name of the NGO)
2.18 Whether renewable energy systems already installed Yes/No

in the village (including solar home lighting systems) Type Numbers
_____________ ________
_____________ ________
_____________ ________
3.0 Village Energy Plan

This section should give the load for the village and estimate the capacity of the power plant
and shall also estimate the energy required to be generated for five years from the date of com-
missioning. While computing the load, provision of two light points (2 x 11/18 W) and one
socket (80W) may be considered for each household, unless the households demand different-
ly. This section should provide the details of the energy consumption pattern for the domestic/
commercial uses within the village. It should also provide the details (type and quantity) of
the availability of renewable energy resources in the village including the seasonal variation, as
also the possibility of generating such resources in future like plantation activity for biofuel/
biomass projects. To assess the load and energy demand household and village survey should
be conducted based on FGD. Data has to be captured for the entire village/hamlet (kerosene,
firewood, animal waste, solar devices, batteries, etc.)
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366 | Chapter 7
3.1 Existing energy consumption sources, quantity and prices paid for them
3.1.1 Domestic (lighting) (Kerosene)

Source
Total number of households
Quantity (Lts)
Average ` /month spent by household
3.1.2 Domestic (lighting) (Solar)

Source
Quantity
3.1.5 Domestic (entertainment/TV/

Music system/Radio) (battery/solar)
Source
3.1.6 Non-domestic/productive (Diesel)

Source
Quantity (Lts)
3.1.7 Any other (Specify)

Source
Quantity
3. 2 Willingness to pay for monthly energy bill (`/month) Percentage willing to pay
30-40
40-60
60-80
80-100
>100
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4.0 Estimation of Load Demand and Energy Demand

This section addresses the load demand, the energy demand and the daily operational hours. It
also focuses on anticipated yearly percentage increase in energy demand and five years energy
demand for the village.
4.1 Estimation of load:

4.1.1 A. Number of households No.:
Average Load KW
Total load _______________ kW
4.1.2 B. Number of streetlights No.:
Average Load KW
Total load _______________ kW
4.1.3 C. Non-domestic/Productive load No.:
Average Load KW
Total load _______________ kW
4.1.4 D. Common facilities (Total load for schools, public
health centres, panchayat bhawans, community Total load _______________ kW
buildings, etc.)
4.1.4.1 Schools load No.:
Average Load KW
Total load _______________ kW
4.1.4.2 Public health centres load No.:
Average Load KW
Total load _______________ kW
4.1.4.3 Panchayat bhawans load No.:
Average Load KW
Total load _______________ kW
4.1.4.4 Community buildings load No.:
Average Load KW
Total load _______________ kW
4.1.5 E. Any other load (Specify) No.:
Average Load KW
Total load _______________ kW
4.1.6 F. Total load (A + B + C + D + E) Total load _______________ kW
4.2 No. of operational hours per day
Total hours __________ per day
(Min. 6–8 hours/day)
4.3 Anticipated peak load ________________________ kW
4.4 Attach hourly load curve Attached
4.5 Suggested DDG capacity
(1.5 : peak load as per load curve) ________________________ kW
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368 | Chapter 7
4.6 Estimated Annual Energy demand for 5 years:

4.6.1 (a) Annual energy demand for 1st year ________________________ kWH
(Covered area as per load curve : 365)
4.6.2 (b) Anticipated annual percentage increase in energy ______________________ %age
demand
4.6.3 (c) Annual energy demand for 2nd year (a + b%) # ______________________ kWH
4.6.4 (d) Annual energy demand for 3rd year (c + b%) # ______________________ kWH
4.6.5 (e) Annual energy demand for 4th year (d + b%) # ______________________ kWH
4.6.6 (f) Annual energy demand for 5th year (e + b%) # ______________________ kWH
4.6.7 Total energy demand for 5 years (a + c + d + e + f) ______________________ kWH
4.7 Suggested DDG capacity = annual energy demand
for 5th year/(365 days : Number of operational ______________________ kW
hours per day)
4.8 Proposed DDG capacity (among 4.5
and 4.7 which ever has higher value) ______________________ kW
4.9 Generation voltage (Mark ✓) (a) 440 V, 3 phase
(b) 220 V, 1 phase
5.0 Technology Selection Decision

This section captures data for selection of appropriate technology options best suited for the
village and shall consider the sustainability of such DDG projects. The decision flow chart as
mentioned in the DDG guidelines may be referred for a better understanding on the selection
of technology.
Provide the methodology and calculation to show how estimated generation capacity available has
been arrived at only for selected technology (if required, please attach an annexure to the DPR).
5.1 Option 1: Small-hydro
5.1.1 Availability of water throughout the year. If ‘No’, mention Yes/No

the number of months per year water availability ________________________
5.1.2 GPS coordinates of upstream water head ____________ latitude

____________ longitude
5.1.3 Head
Maximum ___________________ m
Minimum ___________________ m
Average ___________________ m
# Next annual energy demand would be current annual energy demand plus the anticipated percentage increase in energy demand.
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5.1.4 Discharge
Maximum ___________________ lps
Minimum ___________________ lps
Average ___________________ lps
5.1.5 Whether power can be made available for at least 6–8 Yes/No
hours per day throughout the year If No, how many days can it
provide power for at least 6–8
hours per day ______________
5.1.6 Estimated power generation capacity available _____________________ kW
5.1.7 Whether power generation project capacity available is Yes/No

sufficient to meet the load
5.2 Option 2: Biofuels based DDG
5.2.1 Quantity of biofuel seed available within the village and ____________________ Tons
nearby
5.2.2 Availability of degraded lands/wastelands where energy Yes/No

plantations like Jatropha/ Pongamia, etc., can be
undertaken
5.2.3 Area available under degraded lands/ wastelands where ______________________ ha

energy plantations such as Jatropha/Pongamia, etc., can
be undertaken
5.2.4 Whether power can be made available for 6–8 hours per Yes/No
day throughout the year If No, how many days can it
provide power for 6–8 hours per
day _______________

5.3 Option 3: Biomass based DDG
5.3.1 Availability of biomass Yes/No
5.3.2 Type and quantity of biomass available Type Quantity

(i) (Tons/year)
(ii)
(iii)
(…)
Total quantity
5.3.3 Land available for energy plantations ______________________ ha
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370 | Chapter 7
hours per day __________

5.4 Option 4: Biogas based DDG
5.4.1 Number of cattle available and quantity of dung available Number of cattle Quantity (tons/
year)
Cows ________
Buffaloes _____
Goats ________
Sheep ________
Pigs _________
Other cattle ___ Total quantity
5.4.2 Common grazing Yes/No
hours per day ______________
5.4.4 Estimated power generation capacity available _______________________ kW

5.5 Option 5: SPV based DDG
5.5.1 Availability of land for setting of SPV power plant Yes/No
5.5.2 Area of land available _______________________ ha
5.5.3 Insolation level (KWH/sq.m/day)
5.5.4 Number of sunny days available per year __________________ days/year
hours per day ______________
5.5.6 Estimated power generation capacity available _______________________kW

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5.6 Option 6: Wind farm
5.6.1 Average wind speed _____________________ m/s
5.6.2 Number of days available for wind power generation per __________________ days/year
year
5.6.2 Availability of land for wind farm Yes/No
5.6.3 Area of land available ________________________ ha
hours per day _______________
5.6.7 Estimated power generation capacity available ________________________kW

5.7 Option 7: Standby option
5.7.1 Vicinity of closest diesel station ________________________ km
5.8 Option 6: Hybrid option (wind/diesel, wind/solar

or any other newer technological option)
5.8.1 Hybrid Estimated power generation Number of days/year

options capacity (kW) power available
(i) (i)
(ii) (ii)
(iii) (iii)
(..) (..)
5.8.2 Estimated total power generation capacity available

________________________kW
hours per day _______________

5.9 Technology selected*

___________________________
* Provide the methodology and calculation to show how estimated generation capacity available has been arrived at only
for selected technology (if required, please attach as annexure to the DPR).
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6.0 Design Details of the Power Plant and Estimated Costs

This section provides the system design details, including energy plantation requirements, the
intended energy services as also any value addition in terms of setting up micro enterprises that
may be established on account of availability of electricity. All the costs of the project have to
be estimated to cost of completion. All the cost figures mentioned in this section should be
‘Estimated Cost of Project Completion’
6.1 Description of the selected technology ______________________

______________________
6.2 Schematic diagram indicating the location of Yes/No

the power plant, the distribution network,
common facilities, non-domestic/productive,
etc., on village map
6.3 GPS coordinates for proposed power plant ___________ Latitude ___________ Longitude
Item Description Quantity Number Unit Rate (`) Cost (`)
6.4 Capital cost
6.4.1 Engine/generator name and cost

(i)
(ii)
(iii)
(a) Estimated sub-total cost
6.4.2 Auxiliary systems name and cost

(i)
(ii)
(iii)
(b) Estimated sub-total cost
6.4.3 All associated civil works

(i)
(ii)
(iii)
(c) Estimated sub-total cost
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6.4.4 Distribution network with necessary control

equipments cost
Poles
Conductor/cables
Insulators
LT switch gear
MCB
Others Items:
(i)
(ii)
(iii)
(d) Estimated sub-total cost
6.4.5 Initial estimated capital cost for plantation for

bio-mass gasification/bio fuel projects only
(a) Land type for plantation
(degraded land, waste land, etc.)
(b) Plantation area available (ha)
(e) Estimated sub-total cost
6.4.6 Initial capital cost for non-domestic/

productive load
(i)
(ii)
(iii)
(f) Estimated sub-total cost
6.4.7 A. Estimated capital cost

(a + b + c + d + e + f)
6.5 Spare parts for five years
(i)
(ii)
(iii)
(iv)
B. Estimated sub-total cost
6.6 Cost of power supply for five years

Year 1 2 3 4 5
6.6.1 (a) Number of units to be supplied each year
6.6.2 (b) Unit cost of power generation
(cost of generation calculated based on only O&M
cost)
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374 | Chapter 7
6.6.3 (c) Total cost of power supply for each year (a * b)

6.6.4 Proposed tariff
(i) Per household
(ii) Per non-household (streetlight, non-domestic/
productive, common facilities, etc.)
6.6.5 Revenue collection from household
1. Number of households
2. Proposed tariff per household
(d) Total revenue collection (1 * 2)
6.6.6 Revenue collection from non-household
3. Number of non-households
4. Proposed tariff per non-household (streetlights, non-
domestic/productive, common facilities, etc.)
(e) Total revenue collection (3 * 4)
6.6.7 (f) Revenue collection for each year (d + e)
6.6.8 (g) Cost of power supply for each year (f - c)
6.6.9 C. Cost of power supply for five years (sum of five years)
Quantity
Item Description Number Unit Rate (`) Cost (`)
6.7 Estimated soft cost
(i)
(ii)
D. Estimated sub-total cost
6.8 Estimated total project cost*
(A + B + C + D) (in `)
6.9 Mention the source of 10% Own Funds
of the project cost (Mark ✓) Loan from REC
Any other source (specify)
7.0 Project Management and Monitoring Plan

This section should provide the overall management plan and implementation schedule for all
the project activities. It should mention the project monitoring mechanism and try to estimate
probable impacts of the DDG project in the village and also develop the probable parameters
and indicators that could be monitored for ex-post impact analysis of the project. This section
should also describe any possible constrains for successful project implementation.
Implementation Methodology: Based on the DPR document, the implementing agency has
to prepare the bid document for successful implementation. In case the implementing agency
does not have in-house expertise to prepare the bid document, for project implementation
and management, they can avail the services of a consultant to prepare the bid document. The
suggested BAR/PERT chart to be enclosed as part of the DPR is as follows.
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*All the cost figures mentioned should be ‘Estimated Cost for Project Completion’
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7.1 Roles and responsibilities of major stakeholders:

7.1.1 Name of project implementation agency
7.1.2 Any other project implementation agency (i)
(ii)
(iii)
7.2 Brief about the institutional and management structure of project
implementation agency
7.3 Suggest activity bar/PERT chart for project erection and
commissioning.
7.4 Describe tendering and procurement procedures to be followed
7.5 Provide the civil construction plan
7.6 Duration of project (months)
7.7 Suggest monitoring mechanism during erection and
commissioning of the project
7.8 Suggest the social and environmental impact
7.9 Greenhouse gas abatement
7.10 Effect on local economy and commerce from the project
7.11 Improvements of quality of life from the project
7.12 Possible constraints for successful implementation of the project
8.0 Baseline Information for Calculating Emission Reductions from Carbon Trading Schemes
This section should provide the baseline information for calculating the baseline emissions
for the project activities. This information would be used for calculating the total emission
reductions in terms of tones of CO2 for market-based carbon trading mechanisms like the
Clean Development Mechanism. Even in the case of the voluntary market, baseline data is
available to use directly.
8.1 Grid in which the project activity is located 1. North, East, West, North East (NEWNE)
(Mark ✓) Grid
2. Southern Grid
8.2 Build Margin (EFBM)
This is the emission factor (in t CO2/MWh)
of power plants under construction/ planned for
construction that would be affected by the CDM
project activity. The standard value is available
from with the Central Electricity Authority (CEA)
and can be used as such for CDM purposes.
8.3 Operating Margin (EFOM)
This is the emission factor (in t CO2/MWh) of
existing power plants in the selected grid whose
electricity generation would be affected by
the CDM project activity. The standard value
is available from with the Central Electricity
Authority (CEA) and can be used as such for
CDM purposes.
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8.4 Weighting of operating margin emissions factor, The following default values can be used:
WOM (in %) Small hydro – 0.5
Biofuels – 0.5
Biomass gasification – 0.5
Biogas – 0.5
Solar photovoltaic – 0.75
Wind – 0.75
8.5 Weighting of build margin emissions factor, WBM The following default values can be used:
(in %) Small hydro – 0.5
Biofuels – 0.5
Biomass gasification – 0.5
Biogas – 0.5
Solar photovoltaic – 0.25
Wind – 0.25
8.6 Combined Margin (in t CO2/MWh) = EFOM * WOM + EFBM * WBM
9.0 Checklist for Detailed Project Reports (DPRs) of DDG Projects to be Implemented

under RGGVY
S.No. Item Status as per DPR Remark

Administrative clearances and village energy plan
1. Certificate from state government indicating the implementing
agency for the state (indicative format enclosed Annex 1) Yes/No
2. Selection of village/hamlet:
Whether the list of the village/hamlet has been selected in Yes/No
consultation with MNRE/SREDA (indicative format enclosed
Annex 2)
3. Village/hamlet map consisting of:
(a) Location of the power plant and energy source or energy a. Yes/No
plantation
(b) Location of the houses and line diagram of distribution b. Yes/No
network
(c) Roads, bridges, community centres, cultivation area, forest, etc. c. Yes/No
4. Land ownership for power plant Gram Panchayat
Government
Community
Private Land
Others (Specify)
No objection certificate from the owner in case Yes/No

the land is private land
5. Certificate by implementing agency towards surrender of service Yes/No
charges @ 8%/9%
(indicative format enclosed Annex 3)
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S.No. Item Status as per DPR Remark

System Details
1. The chosen technology option shall be able to Yes/No

supply power for 6–8 hours per day throughout
the year
2. Details of sourcing balance 10% of the capital Yes/No

cost: certificate stating that the implementing
agency will meet the balance 10% capital
cost on their own or will take loan from any
financial institution or REC
3. A Bar/PERT chart indicating time schedule Yes/No

commensurate with activity.
(Format enclosed Annex 4)
Cost Details
4. Proposed Project Cost (capital cost, revenue

cost and soft cost) (` Lakhs) ____________ Ref. DPR at
page number
______________
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378 | Chapter 7
Annex 1
Indicative format for certifying Implementing Agency by the State Government
<Date>
<Ref. No.>
To,
_____________________
_____________________
_____________________
_____________________
Subject: Certificate Identifying the Implementing Agency
This is with reference to the Guidelines for Decentralized Distributed Generation (DDG) launched
by the Ministry of Power, Government of India under Rajiv Gandhi Grameen Vidyutikaran Yojana
(RGGVY) on 12 January, 2009.
This is to certify that <State Renewable Energy Development Agency>/<departments promoting

renewable energy>/<State Utility>/<CPSU> will be the implementing agency for the village(s)/
hamlet(s).
Name of the Village(s) Name of the Hamlet(s)
Thanking you,
Yours truly,
For State Government
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Annex 2
Indicative format for certifying that the village (s)/hamlet (s) have been selected in consultation
<Date>
<Ref. No.>
To,
_____________________
_____________________
_____________________
_____________________
Subject: Certificate Selection of Village(s)/Hamlet (s)
This is to certify that the list of village (s)/hamlet (s) to be electrified through DDG have been final-
ized by the <State Renewable Energy Development Agency>/<departments promoting renewable
energy> in consultation with the State utilities and Ministry of New and Renewable Energy. Please
enclose documentary evidence.
Name of the Village(s) Name of the Hamlet(s)
Thanking you,
Yours truly,
Authorized Representative
<State Renewable Energy Development Agency>
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380 | Chapter 7
Annex 3
Indicative format for certificate towards surrendering service charges @ 8% / 9%
<Date>
<Ref. No.>
To,
_____________________
_____________________
_____________________
_____________________
Subject: Certificate for Surrendering Service Charges
We hereby agree to surrender the service charges @ 8%/ 9% of the project cost as charges for imple-
menting the scheme towards financing the scheme for five years refer clause Nos. 7 (i) and 16 (iv).
Thanking you,
Yours truly,
Authorized Representative
<State Implementing Agencies or Central Public Sector Undertaking>
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Annex 4
10.0 BAR/PERT Chart for Project Erection and Commissioning
M07_PRAD30856_01_C07.indd 381
Fill up the proposed activity duration, start date, finish date and complete the bar chart.
Activity Activities Maximum Proposed Start Finish 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

No. Activity Activity Date Date
Duration Duration
(Months)^ (Months)
1 Preparation 3
of DPR
2 Approval of DPR by 2
ISG/MC
3 Bid document 1
preparation and
approval
4 Bidding period (NIT 3
to LOA)
5 Supply of 6
equipments
6 Erection, installation 3
and commissioning
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Total duration 18
(Months)
^ Maximum activity duration is 18 months, if possible, try to reduce the duration.
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382 | Chapter 7
Appendix III
Honshu-Shikoku Bridge Authority (HSBA)
1. Summary of operations implemented using FILP funds

Toll road projects by Honshu-Shikoku Bridge Authority (HSBA) include the world-class long
bridge arterial highway connecting Honshu and Shikoku and aim to support the regional devel-
opment of Kinki, Chugoku and Shikoku, and to promote the balanced development of national
land and national economy. The project cost is partly shared by direct users. The HSBA is respon-
sible for construction, renovation, maintenance and management of general toll roads connecting
the main island of Honshu to Shikoku.
2. Amount of lending under FY 2001 FILP

(unit: billion yen)
FY 2001 FILP Estimated outstanding amount of FILP lending at end of FY 2000
122.8 2,144.8
3. Outcome and social and economic benefits of operations

1. Traffic volume
Total service kilometrage: 172.9 km
Number of passing vehicles (FY 2000)
Akashi Kaikyo Bridge 24,901 cars/day
Ohnaruto Bridge 17,334 cars/day
Seto Ohashi Bridge 14,664 cars/day
Innoshima Bridge 11,313 cars/day
Tatara Bridge 4,021 cars/day
Kurushima Kaikyo Bridge 6,141 cars/day
More active exchange between Honshu and Shikoku
–– Number of people going back and forth between Honshu and Shikoku was 50 million
per year. The number has increased by 70% from 1984–1998 (40% nationwide). The
Honshu-Shikoku Bridge accounts for two thirds of such traffic.
–– Traffic volume of cars has increased by 160% from 1984–1999 (50% nationwide)
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2. Benefits
Qualitative benefits:
–– Provision of rapid and stable traffic services
(e.g. Time reduction)
Between Kobe and Tokushima: 270 minutes u 100 minutes
Between Kurashiki and Sakaide: 120 minutes u 40 minutes
Between Onomichi and Imabari: 160 minutes u 80 minutes
–– Improved convenience of inhabitants living in related areas
(e.g., more options of transportation and the expansion of the three-hour traveling
zone = increased convenience in commuting to work and school, improved
transportation of wide area emergency medical treatment)
–– Industrial development in related areas
(e.g., Number of plants in Shikoku had increased by 25% for 12 years after
the opening of the bridges in comparison to 12 years before the opening (13%
nationwide). Number of assembling companies has been steadily increased).
–– Number of large retail stores in Shikoku increased by 190% (Since 1985, 20% in
Japan)
–– Number of track service operators increased by 56 and 42% in Okayama and Kagawa
respectively (37% nationwide).
–– Balanced development of national land
Quantitative benefits:
–– Benefits generated by reduced traveling costs and time through the use of Honshu-
Shikoku Bridges is estimated to be ¥250.0 billion a year (FY 2000), and after 40 years
have passed since all three routes opened, total benefits will reach ¥8.7 trillion. Benefit
and cost ratio is 1.7.
–– Effects estimated by macro model
–– Benefits on a basis of gross production value is estimated to be ¥1.2144 trillion
nationwide, and ¥889.0 billion in areas affected by the Bridge (FY 2000).
–– Affected areas now have 120,000 more jobs (FY 2000).
Note: Quantitative benefits were calculated by the Authority.
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384 | Chapter 7
4. Estimated policy (subsidy) cost of the project

Outline of estimate
1. An estimate has been made for toll road projects undertaken by the HSBA. (Railway
projects are excluded).
2. An estimate has been made for the roads connecting Honshu to Shikoku (Planned service
kilometrage: 185.7 km) in basic plans.
Project costs are estimated on Basic Plans (Total construction cost: about ¥2.84 trillion).
3. Traffic volume has been adjusted downwards in the latest redemption plan and capital
investment would be continuously granted. It is assumed that a new interest-free loan will
be made in FY 2001 and the redemption period will be prolonged.
4. An analysis has been made for the 54-year period during which all debts are redeemed.
5. Based on these assumptions, simulations were made for future operations and opportunity
costs, such as capital investments required to carry out projects were calculated.
Policy (subsidy) cost—(Analysis period: 54 years)
(unit million yen)
1. Subsidies from the national treasury —
2. Opportunity cost of capital investment and interest-free loan from the national 1,299.5
treasury
Subtotal (1 + 2) 1,299.5
3. Money transfer to the national treasury —
Subtotal (1 + 2 + 3) 1,299.5
4. Decreased cost of loss –668.9
Total (1 + 2 + 3 + 4 = policy cost) 630.6
(Reference)
Budgeted amount of subsidies and capital investment in FY 2001
Subsidies: —
Capital investment: ¥53.3 billion
Interest-free loan: ¥80.0 billion
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5. Projections in the analysis

The Honshu-Shikoku Bridge Authority (HSBA) will construct and manage bridge roads (185.7 km)
as directed in the Basic Plans. Loans for construction will be redeemed by toll revenues by FY 2054.
1. The Nishi-Seto Expressway opened in 1999, and three routes have been completed. The
HSBA will now operate and manage sections in service.
2. It is assumed that operating costs in the existing redemption plan will be further reduced.
3. Future toll revenue was calculated on the traffic volume estimated with a downward ad-
justment of traffic volume in the existing redemption plan, after all three routes become
fully accessible, and also with consideration to recent economic trends (Use about 1.4%
for the subsequent five years and about 3.3% for the period from 2006–2016, not 4% as
assumed about the traffic volume growth until 2010).
(Trends of operational FY 1999 FY 2000 FY 2001
revenue) (Result) (Estimated) (Estimated)
¥86.7 billion ¥87.9 billion ¥87.0 billion
6. Reasons for granting of subsidies, mechanism and underlying laws

(Reasons)
The national and local governments provide capital investments for the HSBA to facilitate the
construction and/or improvement of general toll roads connecting Honshu to Shikoku in a
planned manner based on adequate fares. Since roads connecting Honshu to Shikoku are toll
roads, it was decided that expenses needed for the construction and operation of roads should
be financed by bonds and borrowing, while the principal and interest of such debts should be
redeemed by toll revenues.
In FY 2001, the national government will offer interest-free loans to facilitate the reduction of
interest-bearing debts and further ensure the redemption.
(Mechanism)
Calculation was made for less than 50 years of the redemption period of interest-bearing debts.
— Continuous implementation of capital investment of ¥80.0 billion/year (National/Local = 2:1)
— Interest-free loan is ¥80.0 billion/year (about for 10 years)
(Underlying laws and regulations)
<Capital investment>
–– The Honshu-Shikoku Bridge Authority Act (Law No. 81 of 1970)

1. Article 4 Capital of the Authority shall be the sum of ¥200 million and the investments
by local governments specified by an applicable government ordinance at the time of
Authority establishment.
2. The national government shall invest ¥200 million for the establishment of the Authority.
3. The Authority may increase its capital with the approval of the Minister of Land,
Infrastructure and Transport if necessary.
4. National government and local governments as specified by an applicable government
ordinance may invest the Authority when the Authority increases its capital under the
aforementioned provision.
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386 | Chapter 7
— Ordinance specifying local governments as referred to in Clause 1, Article 4 of the Honshu-

Shikoku Bridge Authority Act (Ordinance No. 152 of 1970)
Local governments specified in the above ordinance shall be Osaka, Hyogo, Okayama,
Hiroshima, Tokushima, Kagawa, Ehime, Kochi, Osaka-City and Kobe-City.
<Interest-free loans>
(Capital loan)
–– Supplementary provisions to the Honshu-Shikoku Bridge Authority Act (Law No. 81 of

1970)
Article 14 The national government, for a time being, may offer interest-free loans to the
Authority, from part of the funds appropriated to expenses of projects specified in Clause
1-1, Article 29 and within the budgeted limit.
(Redemption method)
–– Supplementary provisions of the Regulations for the execution of the Honshu-Shikoku
Bridge Authority Act (Ordinance No. 209 of 1970) Article 3 The redemption period of
loans as specified in Clause 1, Article 14 of the Schedule shall be less than 20 years (Incl.
the period of deferment up to five years). Redemption shall be made on an equal semi-
annual instalment basis.
7. Special remarks

1. The HSBA’s toll road construction projects, which are a set of government projects and road
improvement projects, have brought about both social and economic effects by reducing
traffic congestion, increasing convenience and promoting the growth of industries.
2. The interest rate used here is the rate commonly adopted in this policy (subsidy) cost
analysis. Therefore, it should be noted that the interest rate used here is different from
assumed interest rates usually used by the HSBA when preparing a redemption plan.
3. The assessed value of road assets (about ¥4 trillion) is not reflected in this policy (subsidy)
cost analysis.
4. It should be noted in the cost analysis that retained loss at the beginning of the term is
treated as a negative retained surplus, and a reduction in retained loss during the term
subject to this analysis is treated as an increase in retained surplus, thus decreasing policy
(subsidy) cost.
5. Policy cost analysis this time has increased ¥599.2 billion from ¥31.4 billion in FY 2000,
because calculation was made on the assumption of increased public assistance and a longer
redemption period.
6. Capital investment from local governments is excluded in this cost analysis.
7. Policy cost will increase by ¥176.3 billion if annual toll revenue declines by 10%.
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(Reference) Financial Statements
Balance Sheet
(Unit: million yen)
Assets Liabilities and Capital
End of FY End of FY 2000 End of FY 2001 End of FY End of FY 2000 End of FY 2001
Item Item
1999 (Result) (Estimated) (Planned) 1999 (Result) (Estimated) (Planned)
Current assets 10,523 8,157 2,995 Current liabilities 27,351 22,453 17,639
Fixed assets 39,83,277 39,88,430 39,82,867 Fixed liabilities 42,08,569 42,15,416 41,93,419
Business assets 38,85,650 38,95,555 38,92,021 Bonds and borrowings 38,39,150 38,57,982 38,47,431
Construction in progress 54,724 55,565 56,343 Reserves 5,673 5,402 5,087
(Business assets) Miscellaneous 3,63,746 3,52,032 3,40,902
Intangible fixed assets 25,974 24,627 23,496 Reserves under special laws 10,949 11,671 12,449
Intangible fixed assets 15 15 15 (Total liabilities) 42,46,869 42,49,541 42,23,507
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Investments and other assets 16,914 12,669 10,992 Capital 6,85,516 7,65,516 8,45,516
Deferred assets 15,408 12,898 10,384 Deficits –9,23,177 –10,05,572 –1,072,776
Carried over deficits –8,37,748 –9,23,177 –1,005,572
Net loss –85,428 –2,395 –67,204
(Total capital) –2,37,661 –2,40,056 –227,260
Total assets 40,09,208 40,09,485 39,96,247 Total liabilities and capital 40,09,208 40,09,485 39,96,247
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Balance Sheet
(Unit: million yen)
Expenses Revenues
FY 1999 FY 2000 FY 2001 FY 1999 FY 2000 FY 2001

Item (Result) (Estimated) (Planned) Item (Result) (Estimated) (Planned)
Ordinal expenses 1,85,852 1,84,993 1,67,563 Ordinary profits 1,00,424 1,02,598 1,00,359
Operating expenses for business 15,653 18,263 16,586 Operating revenues 88,503 90,020 89,029
assets Non-operating revenues 259 730 155
General administrative expenses 9,690 12,341 11,529 Miscellaneous 11,662 11,848 11,174
Provisions for reserves 271 723 778 Net loss 85,428 82,395 67,204
Non-operating expenses 1,48,687 1,41,875 1,27,558
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Miscellaneous 11,552 11,791 11,112
Total 1,85,852 1,84,993 1,67,563 Total 1,85,852 1,84,993 1,67,563
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SUMMARY
One of the key aspects in any project is getting approval for the project and achieving financial clo-
sure. The complete readiness of the project and the project promoter’s commitment to the project is
known when a DPR gets prepared. In fact, the DPR is the level of readiness of the projects, which is
only waiting for funding support. All aspects of the project planning and risk assessment is complete
when a project DPR is prepared. Although many assumptions are made during preparation of the
DPR, most of these estimates are conservative estimates. When the project finally kicks off, the con-
servative estimate being the base case scenario, the project gives returns higher than the estimates. A
conservative estimate is like the pessimistic estimate and nothing worse should happen.
Another aspect of preparing the DPR which is not generally understood is that it helps in project
due diligence by an external party. Most of the times the entrepreneur who is favourably biased
towards the project evaluates it with a lot of optimistic scenarios. When the same proposal is pre-
sented to a funding house who has to provide the funds for the project, they view the DPR dispas-
sionately and critically to see the viability of the same. The funds provided for the project has to be
eventually returned to the funding house with interest and in case the project is not viable at a later
date, the funding house would be facing losses. The critical due diligence by a third party is in the
best interest of the project because any points that could have been missed while preparing the DPR
can be considered. So for the third party or the funding house to be even interested in assessing the
viability of a project, it should be presented in a particular standard format. The appraisal stages
and the descriptions covered in this chapter along with the annexures provide a fair estimate of
what needs to be covered in a general DPR. The final contours of a DPR could be modified on the
basis of the requirement at hand.
The DPR ensures that all the aspects of a project viability, be it technical or commercial or finan-
cial or environmental is looked into properly before launching the project.
KEYWORDS
• Technical appraisal • Environmental appraisal

• Commercial appraisal • Financial ratios
• Financial appraisal • Dimensional analysis
R e v i ew Q uest i o n s
1. Explain the importance of detailed project report and its contents.

2. What role does economic analysis play while assessing a project proposal? Is economic
analysis also considered for commercial projects?
3. How is economic analysis different from environment impact analysis?
4. What are the factors to be considered while deciding on the location for a project?
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chapter
8 InternatIonal Project
aPPraIsal
LearninG oBJeCtiveS

❍ Understand the need for additional checks and cautions while doing international
projects.
❍ Understand the risks associated with currency fluctuations, political environment,
globalization and logistics associated with global projects.
❍ Understand the implications of cultural diversity and time zone complications associated
with global projects.
❍ Understand the requirements of compulsory global tendering for International Monetary
Fund (IMF) and World Bank funded projects.
IntrodUctIon
The success of any project depends, to a large extent, on the correct cost and duration estimates. While
an ‘estimate’ is forgiven if incorrect to a reasonable extent, currency fluctuations can make a project
cost estimate a nightmare for the planner. This happens because, besides the factor of escalating
costs, there is also the factor of valuation of the unit of currency being used to estimate project
costs. The long duration of a project schedule also adds to the difficulty of the estimate validity. The
second aspect is the logistical difficulties encountered at the place of execution. To give an extent
of complications in a global project, consider the case of ONGC, a Navratna Government of India
enterprise. The oil and natural gas extraction rig at Bombay High is designed by Engineers India
Limited, another Government of India enterprise. The enterprise is based in NCR and is executed
by Larsen & Toubro Ltd, which plays the role of a project management consultant. The equipment
is provided by Hyundai Heavy Engineering Company based in South Korea and fabrication is
executed at Hazira, near Surat, which is the manufacturing facility of Larsen & Toubro.
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392 | Chapter 8
Figure 8.1 Broad global project management flowchart
International Projects Unique considerations

Some additional barriers to international projects can be broadly identified as follows:
1. Unknown project team members
2. Language, cultural and local beliefs
3. Geographical distance
4. Infrastructure for information
5. Varied goals for different organizations
6. Management support
7. Documentation standards
8. Breakdown in communication due to different time zones
According to Ralph Levene (1999), on reaching the performing mode, multi-cultural teams do
exceptionally well and at times, better than local teams. To overcome some of the disadvantages
listed above, the following measures can be practised:
Effective communication: Communication removes the feeling of alienation among project
1.
team members. A successful communication strategy can bridge the cultural and geographical
distance. In communication, a face-to-face meeting conveys more information than a formal
written communication. This happens because in a personal meeting, the body language and
non-verbal communication help in conveying the information in an appropriate manner. A
communication strategy like video conferencing at an appointed time at regular intervals
would be more effective than group mails with similar information. In international projects,
small talk during coffee breaks or lunch breaks is missing, which must be adequately com-
pensated by regular informal teleconferences. Differences in time zones further burden the
communication strategy as real-time data, especially in software projects, is not available or
not tested.
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International Project Appraisal | 393
Overcoming the cultural divide: The information available and required while working on
2.
projects has to be accessed by team members. However, across cultures, this information may
or may not be freely available. Knowing this major cultural lacuna, the information sharing
policy must be robustly defined and the norms of the least obtrusive culture must be con-
verted into a norm. Generous use of web-based tools should be encouraged in order to bridge
cultural differences. Furthermore, financial and economic control should be handed over to
local team members, whereas qualitative measures should be monitored at the global level.
A concept of ‘traffic light’ reporting system and progress monitoring of projects is preferred.
In this case, just as the traffic light is visible to the faraway motorist, the project progress and
goals should be visible to all concerned. A common term used is ASAP—an acronym for ‘as
soon as possible’. Now, this might mean ‘yesterday’ in some cultures or ‘whenever convenient’
in some other cultures. Such ambiguity should be avoided.
Adopting the best practices: It is common to have the best practices across different organiza-
3.
tions participating in the project. The adoption of best practices of each of these organizations
helps in improving the work culture and invokes a sense of pride for the organizations whose
practices have been adopted.
INTERNATIONAL PROJECTS FACING PROMINENT CHALLENGES

Some international projects facing major challenges are summarized here.
1. An American company working in India will not have a common point of reference while
working with Indians in terms of operations style or overarching common culture. It is generally
the cultural minority (Americans, in this case) that will be empowered with special powers in
the Indian project because of ownership or because of special knowledge. The majority of
employees (Indians in this case) feel an understandable entitlement for getting things done in
their style in their own country. This is the primary difficulty in international projects.
2. The vast distance from headquarters and, in turn, their families can be an added difficulty for
expatriates. Not only does it lower their morale but can give rise to serious misunderstandings
in communicating with their erstwhile colleagues back in the US. In general, a perennial
disharmony of purpose between headquarters and field operations make international projects
extra challenging.
3. A third challenge is one of accurately assessing and predicting trends in the economic, social
and political environment that could affect the success of the projects. This was experienced
by Canadian firms while operating on projects in China, as mentioned by Abramson and
Ali in 1999. In 1998, as per some statistics, there were over 140,000 Chinese joint venture
projects with foreign collaboration.
In conclusion, we can state that the skills required for such international projects are not uncommon,
but the challenges are more than any local project. The international project organization should take
additional pain to make people ready and prepare the organization while carrying out such projects.
TEN MOST COMMON CAUSES OF FAILURE

OF INTERNATIONAL PROJECTS
Some common causes of failure of international project are listed here.
Motivation: Failure to examine, clarify and prioritize one’s motives and strategic goals—
1.
To understand this, we must understand why organizations go for international projects.
One reason could be the welfare of the partner organization and the projects in this sphere
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394 | Chapter 8
could be technology-transfer projects to their subsidiaries or in ramping up of operations

in countries where the parent organization already has a presence. An example of one such
organization is the Suzuki Motor Company’s interest in Maruti Suzuki India Ltd.
Journey of Maruti Suzuki in India

• Maruti Suzuki India Ltd. (after September 2007) was incorporated on 24 February 1981, as
Maruti Udyog Ltd.
• The company was formed as a government company with Suzuki as a minor partner to make
a people’s car for middle-class India.
• 2 October 1982—Maruti Suzuki India Ltd signed the license and joint venture agreement with
Suzuki Motor Corporation, Japan.
• 1983—The company started their production and launched Maruti 800.
• 1984—Maruti Omni was introduced.
• 1985—Maruti Gypsy was launched in the market.
• 1987—First lot of 500 cars were exported to Hungary.
• 1990—The company launched India’s first three-box car Sedan.
• 1992—Suzuki Motor Corporation Japan increased their stake in the company to 50%.
• 1993—Maruti Zen was introduced
• 1994—Maruti Esteem was launched.
• 1995—The company commenced production at their second plant in Gurgaon.
• 1999—The third plant with new press paint and assembly shops became operational.
• 2000—Launched Maruti Alto in the market.
• 2002—Suzuki Motor Corporation increased their stake in the company to 54.2%.
• 2005—The company launched the first world strategic model from Suzuki Motor Corporation,
‘Swift in India.
• 2006—Launched Wagon-R Duo with LPG and the New Zen Estillo.
• 2007—The company commenced operations in the new car plant and the diesel engine facility
at Manesar, Haryana.
• 2007—Launched the new Grand Vitara, a stylish muscular and five-seater in the MUV segment.
• 2008—Launched a new A2 segment car, branded the A-star in India and in Europe as the new
Alto.
• 2009—The company revealed the new Ritz K12M engine at Gurgaon plant.
• 2011—The company started work to commission another diesel engine plant of 3,00,000
annual capacity in Gurgaon.
• 2014—Maruti launched a sedan, Ciaz.
• 2017—The third plant in Gujarat commenced operations.
• 2020 and beyond—Has plans to triple the manufacturing capacity in Gujarat and target about
1.5 million vehicles in all three facilities by 2025. Its target for 2030 is five million passenger
vehicles.
The second motivation could be a ‘mutually cooperative’ and mutually beneficial
venture where both the partners enhance their performance. Hero Honda Motors Ltd, a
joint venture between Hero Cycles and Honda Motors of Japan established in 1984 is an
example. Although, post-2010, the joint venture partners embarked on separate journeys
as Hero MotoCorp Ltd, and Honda Motorcycle and Scooter India Ltd, from 1984 to 2010,
Hero Honda Motors Ltd, was a leader in its segment. The third motivation is in the pursuit
of cheap manufacturing due to cheap labour availability without building any sustained
presence in the host country.
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Figure 8.2 Robotized assembly plant

Credit: Jenson.shutterstock.com
The third type of involvement is where the projects will face maximum hurdles as the motives
of organizations taking up these projects are always seen as opportunistic. Distrust could emerge,
leading to the destruction of the project and the probability of such an occurrence is high. At
times, a distrust amongst partners and untimely closure of project is imminent. The other causes
of failures where organizations possess cooperative motivations occur due to not doing the right
things in allaying any misgivings that might result due to different operation styles.
Incorrect partner selections: Basic aspects in partner evaluation such as sound financial stand-
2.
ing, experience in similar projects or lines of businesses and technical and business competen-
cies get overlooked. In case of projects in China, successful ventures are those where USA-
headquartered companies have leveraged their financial and technological contributions with
the Chinese partner’s local marketing expertise, distribution channels and general business
and government contacts. Around 2006, Dell, the second largest personal computer manufac-
turer in the world, decided to expand its business to China. Dell’s marketing and distribution
strategy was executed through online sales without any investments in the retail or distribut-
ing its products. This direct sales model was perhaps not the best way to market its products
in China. Having realized this, Dell decided to tie up with Chinese business GOME Electrical
Appliances Holdings in expanding its network beyond the direct sales model. In such a proj-
ect, the compatibility of organizational goals, motivation and cultural compatibility become
important. The compatibility of personal practices, management practices and information
systems can be a source of mutual strength and also, at times, a source of potential problems.
The potential problems could be like a North American organization being a naturally aggres-
sive and risk-taking one, whereas an Asian company being generally conservative and careful.
These problems of hybrid organizations can also be seen when the parent company is differ-
ent and the employees are local natives.
Setting and delivering on goals: This complication can be due to failure in clarifying the
3.
operational objectives and in achieving a clear and shared understanding of work objec-
tives, performance targets and individual responsibilities. A higher degree of understanding
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396 | Chapter 8
of common steps, targeted milestones in delivery and expected contribution from each party
is essential here. Oman India Fertilizer company (OMIFCO), a joint venture with Oman Oil
company (50% ownership), IFFCO (25%) and KRIBHCO (25%), is an example of a pro-
ject that was delayed for a very long time. The project in the Sultanate of Oman, in Sur, first
mooted in 1993, was later approved by the Indian cabinet in 1997 and finally cleared in 2000.
The work commenced in 2003 and the project was commissioned (first phase) in 2006. The
delay was attributed to fixing the natural gas price, a key input required in the manufacture
of urea and on the finished product off-take price by the Government of India. In the interim,
the initial joint venture partner, Rashtriya Chemicals and Fertilisers (RCF), backed off and
was replaced by Indian Farmers Fertilizers Cooperative Limited (IFFCO) and Krishak Bharti
Cooperative Limited (KRIBHCO). The problem can, at times, be due to miscommunication
of operational goals and sometimes, in the persistence of vested interests that undermine the
project goals. Not understanding the international developments and the political scenario
could be an added limitation for such joint venture projects. Even if the objectives and targets
are clear and shared in the foundation agreements, they have a way of slipping over time. Such
mega-projects could alter their scope due to normal developments such as the availability of
better technology, etc., but any changes due to lack of clarity on operational goals is serious.
Setting realistic goals: It is often very important to set realistic goals for projects. This is natu-
4.
rally true for all projects but for global projects, this aspect becomes very important. Trying
to achieve too much too quickly can be fatal when cultural differences or variations in orga-
nizational capabilities are wide. Besides deciding on realistic project time scales, the project
organization should also set a realistic pace of doing work. The experience of pace of work
in one country cannot be used as a yardstick in another country. The paperwork involved
and the infrastructure network in transporting equipment over long distances can affect the
desired pace of work. Taking the time to get things right in the first place before moving on
to the next stage is crucial. It is imperative that both the joint venture partners agree on the
state of progress and their expectations in the future. Building trust along the way helps a lot
in achieving the realistic goals set for the global project.
India’s first solar power park at Charanka village in Gujarat, operational since 2013, has
19 different projects by different developers such as Alex Astral, US-based Sun Edison, Lanco
Solar, Roha Dyechem and GMR.
Lack of governance issues: It is quite common to have multiple bosses and decision-makers
5.
in a joint venture project which could result in multiple solutions to one problem. To a large
extent, the reason for such issues at a later date is that the international projects leave a lot of
ambiguity or vagueness in keeping up with negotiations at the initial stages with a caveat that
the issues could be resolved at a later date. Such vagueness between the parent organizations
puts an extra burden on decision-makers at a later date. Therefore, the degree of autonomy at
the decision-makers level or decision-making mechanisms or avoiding double staffing at senior
positions is important for resolving governance issues. In case of 100% subsidiaries, such gov-
ernance issues are not a problem as there is sufficient clarity on the chain of command.
Lack of consensus building and consultations: Failure to consult with and integrate the sub-
6.
stantive and process view of local colleagues and stakeholders is another concern for global
projects. Sometimes, it is disheartening to note the tendency of western companies and their
agents to ignore the policy views and managerial experiences of local participating organi-
zations. These lead to embarrassing situations and serious problems too. In 1992, General
Electric (GE) had a joint venture with Godrej & Boyce Manufacturing Company and the
joint venture was called Godrej GE Appliances Ltd. In one of the review meetings, an expat
employee of GE promised T-shirts for the management staff at the expense of the organization
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for achieving a certain goal. This scheme was restricted to only the management cadre person-
nel but word got around and the labour class or workers class got fairly agitated at not getting
this largesse. This was a problem which the expat had not envisaged and the Indian counter-
parts’ views, who were fairly aware of the worker’s reactions, were ignored. Ultimately, the
T-shirts were given to the management cadre, with a request that the same should not be worn
in the manufacturing complex or anywhere where workers could see them. One of the reasons
for the lack of consultation process is because of the seemingly greater resources and exper-
tise of the western partner organizations. Other factors abound such as the western partner
is roped in to bring about technological advances and managerial changes in moribund local
institutions. Needless to say, these very moribund institutions oppose any changes so vehe-
mently that it can result in unnecessary project delays. Similar issues can arise in the areas
of management practices in hiring policies, promotion policies, compensation and rewards
policies, punishment policies, corporate values and ethics. The challenge is to find a delicate
balance between corporate or project policies and local traditions. A middle path which may
not fully implement the unfamiliar management practices and also not succumb to the dys-
functional local traditions is the best way forward.
Project-related commitment: Projects are characterized by long gestation periods and many
7.
changes could happen at the corporate level such as changed priorities, changed key personnel,
exciting projects, etc. Further obstacles may arise and expected results might be coming in
slowly. Additionally, the political and economic environment could become adverse. In such
scenarios, it is quite likely that the interest in the project wanes and one could engage in
self-fulfilling defeatism. One survey observed that the joint venture projects of the USA with
Japan were more successful than the USA-UK joint venture projects. This was considerably
paradoxical because, in terms of cultural fitment, working styles and legacy issues, the fitment
of USA and UK was more prominent that USA and Japan. One explanation that seemed
plausible was the fact that the Japanese organizations had more commitment to the project
than the UK organizations. Organizations take the extra effort in relocating the families of the
project personnel and help them settle down in new environs quickly. Such interventions help
in increasing employee morale and in turn, their commitment to the project.
Economic
Political Social
PESTEL
Technological Legal
Environmental
Figure 8.3 PESTEL analysis

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398 | Chapter 8
8. A comprehensive PESTEL analysis (political, economic, social, technological, environmental

and legal analysis and failure in being proactive to manage these factors): Inadequate attention
to the assessment and management of the local and world economy and political conditions
will inevitably affect the project adversely. POSCO India Private Ltd, a subsidiary of the
South Korean company POSCO (formerly Pohang Steel and Iron Company Limited) was
established in 2005 to construct a $12 billion steel plant at Jagatsinghpur district of Odisha.
After many obstructions to their project and opposition from the local populace, POSCO
suspended its plan to set up the steel plant in Odisha in 2017. Without judging the merits of
this particular case, the example well illustrates the effect of a variety of political, economic
and social conditions that can affect the global projects today. As in the case of POSCO, the
environmental challenges involving the views of the local stakeholders like project-affected
people must be considered in depth to obtain their consent or at least non-opposition. UTKAL
Alumina was initially promoted by ALCAN (Alcan Aluminium Limited, Canada), Hydro
(formerly Norsk Hydro), Tata Industries and INDAL (Indian Aluminium). The project is
set up in Rayagada district, Odisha, with bauxite mines in Baphlimali. The initial partners,
ALCAN and Hydro, were much troubled by the local NGOs and the NGO counterparts
in their respective countries, resulting in their withdrawing from this project around 1998.
Subsequently, the project was taken over by Hindalco industries and completed. This is
another example of inadequate environmental analysis.
Companies have been overconfident in assuming that the success at home in adapting to
and managing environmental conditions can be easily duplicated in global projects. However,
as is often seen, the same is not the case and organizations must constantly seek information
on all these aspects regularly and periodically review their implications. Companies need
to depict modesty in their approach to these PESTEL norms in their own interests. Project
managers of such global projects are well advised to develop contacts and rapport with the
local communities and engage in much development work. This will help them in getting
some advance signals and gauge the mood of the locals.
9. Train personnel adequately on the local customs and norms: Although this aspect has been
covered in the earlier sections, it is important to reiterate that the maxim ‘When in Rome, do
as the Romans do’, has to be always followed. Most Muslim countries practise day-time fasting
during the holy month of Ramadan. The project personnel should be sensitive to these aspects
and although they themselves need not follow these rituals, eating in public places is a strict ‘No’.
10. Trust—The Tipping ‘Point’: While it is a foregone conclusion that there must be 100% trust
between partners in an international project, any form of misgivings or doubts can upset
the apple cart. A considerable amount of maturity must be exhibited here and trust until
proven must be practised by all the partners in the interest of the project. According to Cullen,
Johnson and Sakana (2000) the use of contractual arrangements, the sending of expatriates
in key positions, double-staffing of positions are inefficient and expensive. The willingness
to trust as demonstrated by the willful exchange of information and technology can help in
building this trust element in global projects.
Some examples of very successful Indian projects with either international collaboration or techni-
cal knowhow are as follows:
1. Cochin International Airport Limited: The first airport in the world to run only on solar energy
2. Magnificent Metro Projects: Kolkata Metro, Delhi Metro, Mumbai Metro, Jaipur Metro,
Lucknow Metro, Hyderabad Metro, Bengaluru Metro and Chennai Metro
3. Yamuna Expressway
4. Gujarat International Financial Tec-City (GIFT city) Gujarat
5. Ahmedabad and Indore Bus Rapid Transit System (BRTS)
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Summary
In chapter 7, we looked at the key requirements for a project in a domestic location. In this chapter,
we extended the study to cover some essential requirements of an international project Both in
terms of benefits and risks, the international projects experience an elevated level of challenges
than a domestic project. It is quite understandable because of the logistical and operational
requirements and to add to this, the complications due to externalities of a foreign location and
the requirement of a long-term stability. There are many examples of failures and many examples
of the success of international projects yet there exists the opportunity to explore projects across
domestic boundaries.
The well-known and well-researched PESTEL analysis provides the framework for assessing
the risk to the projects which are external to the project per se. It must be remembered that in
case of international projects, the risk to the project is not just from the project uncertainties
but also the non-project related uncertainties. At times, the scale of non-project relate uncer-
tainties is much higher and hence the vulnerability of the projects in spite of best project man-
agement practices.
International project management day (IPM) is always celebrated on the first Thursday of
November each year, and is intended to encourage project-based organizations worldwide to re-
ward and recognize the project management professionals within their organization.
Amongst the four pitfalls of International project management namely language barriers, com-
munication barriers, cultural dimension’s and time zones, the last one is never possible to over-
come. We may employ local employees and try and contain the first three pitfalls but the last one
is insurmountable. The project managers are better advised to focus on the limitation of this time
zone pitfall for successful completion of international projects. An efficient project management
software that automatically converts project deadlines according to the time zone settings of the
user would help overcome some drawbacks of the time zone pitfall.
K EYWOR D S
• Navratna organization • PESTEL analysis

• Language barriers • Solar energy
• Cultural divide
Review Questions
1. List down the additional requirements or considerations when putting up an international

project.
2. What are the ten most causes for the failure of international projects?
3. Trace the journey of Suzuki Corporation in India from its starting days to the present day.
4. What do you understand by PESTEL analysis? Is it only applicable to international projects?
Discuss with reasons.
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400 | Chapter 8
5. Using the PESTEL analysis, identify the reason for the failure of POSCO project in Orissa,
India.
6. Identify some successful international projects setup in India and the reasons for their success.
7. What is so intriguing about the Cochin International airport? Explain in depth the reasons.
8. What are the exceptional features about the Ahmedabad and Indore Metro projects?
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Chapter
9 PROJECT FINANCE
AND CASH FLOWS
LEARninG OBJECTivES

❍ Understand the process of preparing cash flow statements for various end users.
❍ Calculate cash flow statement for projects under long-term funds perspective.
❍ Appreciate the reasons and the processes of cash flow statement preparation by financial
institutions.
❍ Comprehend the differences between the company cost of capital and project cost of
capital.
❍ Realize the concept of weighted average cost of capital (WACC), its advantages and
limitations.
❍ Recognize capital budgeting techniques of extended internal rate of return (XIRR) and
modified internal rate of return (MIRR).
INTRODUCTION
Among the most critical factors in the success of a project, project finance has many hues and
must be at the forefront of all criteria. ‘The importance of finance is felt in every business and so
in project management. What is so great about it?’ may be a point in view. However, the difference
in project management and other businesses is that the projects involve long gestation periods,
with an added complexity of project risk being the highest. Funds made available for the project
have to be returned with interest to the stakeholders so that their interest in the project is taken
care of. The bigger question is whether the funds deployed in a project could have been better
utilized in some other project or investment option. Most often, the returns from a project get
compared with the prevalent discount rate or the hurdle rate, which may not be entirely correct.
The opportunity cost of utilizing these funds in a higher paying project is not considered. For
estimating project returns, the cash flows in a project must be considered as return on debt can
be made only after other more important expenses are paid. Figure 9.1 gives a schematic picture
of the cash flow management.
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402 | Chapter 9
Revenues
Project Operation & Maintenance
Senior Debt Service
Senior Debt Service Reserves
Debt Service
Various Other Project Reserves
Returns to Project Sponsor

Figure 9.1 Cash flow in projects
Estimating cash flows after the project is sanctioned is complex due to the presence of forecasting
errors. The data from the Centre for Monitoring Indian Economy (CMIE), which tracks the project
status of Central and state governments and undertakings independently, show a total of 962 proj-
ects at a cost of over `150 Crores have been delayed, of which 36 projects were delayed beyond 20
years, and 67 projects were delayed between 10 and 20 years. Most of these projects were in the
water and irrigation areas. The CMIE further states that the total investments in these projects were
`32.7 lakh Crores and the cost overrun stood at `14.35 lakh Crores. This means that over 40% of
the cost escalation is due to project delays.
Forecasting project cash flows involves numerous variables with revenue projections being pro-
vided by the marketing team. As these values are mere estimates, working out detailed cash flow
statements can become quite complex. The finance team should take efforts to minimize any per-
sonal biases. The cash flow statements were explained in Chapter 6 under the financial appraisal
requirements and it might appear a repeat to the discerning reader. It is clarified that the context
being discussed in this chapter is an advanced working of the statement and considers the major
aspect of the cost of capital. The capital budgeting techniques such as the extended internal rate
of return (XIRR) and modified internal rate of return (MIRR) are, therefore, discussed in this
chapter.
COMPONENTS OF CASH FLOW STATEMENT

The project cash flow is termed incremental as this is going to add on to the existing cash flows of
an organization. Incremental after-tax cash flows associated with the project are considered. The
three basic components of any project cash flow statement would be the initial investment or the
project outflow, operating cash inflows and the inflows of cash after the project is terminated. The
time horizon for a project is generally the physical life of the project.
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Project Finance and Cash Flows | 403
FUNDAMENTAL PRINCIPLES OF CASH FLOW ESTIMATION

Before preparing the project cash flow statement, the following principles should be understood.
Separation Principle
The cash flows associated with the financing side (liabilities) and the investment side (assets) should
be separated. The financing side should factor in the cost of capital and the investment side should
be used to compute the rate of return. The cost of capital on the financing side is the hurdle rate
against which the rate of return is judged. An important aspect is that when considering the invest-
ment side cash flows the financing costs should not be considered. The financing side cost of capital
is anyway reflected in the outflows. Operationally, this means that the interest on debt is ignored
while computing profits and taxes thereon. In case the interest is deducted to reduce the tax liability,
the interest on debt is added back to the cash flow as Interest × (1 - Tax rate).
Incremental Principle
The cash flows of a project must be measured in incremental terms; this means that all the adverse
and favourable effects of the project on the parent organization should be considered. At times, the
profits of a competing product of the same organization might improve because of this project and
at other times, there might be a cannibalizing effect on the competing product. The effect of product
cannibalization and considerations are very interesting. If it can be clearly established that the exist-
ing product is being cannibalized and there is a loss of sales entirely due to the new product, the loss
of profit should be taken as the cost of the new project. However, if it is not clearly established that
the cannibalization effect is because of the new product entirely, then such losses should be ignored.
A sunk cost or a cost incurred in anticipation of the project being considered should be at best sunk
cost. It should not be added to the project cost estimates. However, the opportunity cost of not in-
vesting in an alternative, favouring the current project should be considered. The use of resources
for the project inhibits their use for something else. All potential gains of using these resources for
other applications should be considered. Incremental overhead cost is the overheads portion be-
ing apportioned to the project in hand and must be considered. While fixed assets investments are
made during the early years of the project and depreciated over time, the net working capital (gross
working capital – noninterest bearing current liabilities) is renewed periodically and not subject to
depreciation. The net working capital at the end of the project life is assumed to have a liquidation
value equal to its book value.
Post-tax Principle
Cash flows should be measured on an after-tax basis. The average tax rate is the total tax burden
as a proportion of the total income of the business. As the tax rates are progressive, the marginal
tax rate which is higher than the average tax rate is applicable to the projects. In case of losses for a
standalone project, the tax savings are deferred till the project makes profits.
Consistency Principle
Cash flows and discount rates applied must factor in the investors and inflation. Demarcation is
made for cash flows available for all investors after paying taxes and meeting investment needs of
the project.
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404 | Chapter 9
Cash flow to all investors = PAT

+ Depreciation and noncash charges
+ Interest x (1 – Tax Rate)
- Capital expenditure
- Change in net working capital
Cash flow to equity shareholders = PAT
+ Depreciation and noncash charge
- Preference dividend
- Capital expenditure
- Changes in net working capital
- Repayment of debt
+ Proceeds from debt issues
- Redemption of preference capital
+ Proceeds from preference issue
The discount rate applicable to cash flow for all investors is weighted average cost of capital and for
the cash flow to all equity shareholders is the cost of equity. To consider the effect of inflation, a real
discount rate should be considered if real cash flows are considered and a nominal discount rate in
case the nominal cash flows are considered.
CASH FLOW FROM DIFFERENT PERSPECTIVES

A project cash flow can be viewed from four different perspectives. Consider the break-up given in
Figure 9.2. Long-term funds comprise equity and long-term debt. The explicit cost fund has short-
term debt part of the current liabilities, whereas the non-interest-bearing current liabilities (NIBCL)
part is added to total resources. The explicit cost funds comprise long-term funds and short-term
debt and is therefore, also known as investor claims. All cash flow statements worked out in Chapter
6 are on the basis of investor claims or explicit cost funds. Besides this perspective, three other
perspectives can be considered for reviewing project cash flows as follows:
1. Equity point of view
2. Long-term funds perspective
3. Total resources perspective
The cash flows relating to equity should comprise the following components:
Initial investment Equity funds committed to the project

Operating cash inflows PAT
- Preference dividend
+ Depreciation
+ Other non-cash charges
Liquidation and retirement cash flows Net salvage value of fixed assets
+ Net salvage value of current assets
- Repayment of Term Loans
- Redemption of preferential capital
- Repayment of working capital advances
- Repayment of trade credit and other dues
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Total
Resources
100
NIBCL Explicit Cost

20 Funds 80
Short Term Long Term

Debt 15 Funds 65
Long Term
Equity 40
Debt 25
Figure 9.2 Broad break-up of project financing cost
The cash flows relating to long-term funds should comprise the following components:
Initial investment Long-term funds invested in the project

= Fixed assets + Working capital margin
+ Depreciation
+ Interest on term loans (1 - tax rate)
Terminal cash flows Net salvage value of fixed assets
+ Net recovery of working capital margins
The cash flows relating to total resources should comprise the following components:
Initial investment Total project outlay

= Fixed assets + Gross working capital
+ Depreciation
+ Interest on term loans (1 - Tax rate)
+ Interest on short-term loans (1 - Tax rate)
Terminal cash flows Net salvage value of fixed assets
+ Net salvage value of current assets
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406 | Chapter 9
CONCEPT OF WEIGHTED AVERAGE COST OF CAPITAL

The various sources of funds for a project are equity capital, preference share capital, long-term debt,
and short-term debt. Each of these sources of funds is available at different costs. Furthermore, the
proportion of these funding components in the entire project cost structure also matters. Consider
a project that has the following project funding components: 40% equity capital, 10% preference
share capital, 40% long-term debt and the remaining 10% short-term debt. Let us also assume that
the cost of equity is 18%, preference share cost is 12%, long-term debt cost is 10% and the cost of
short-term debt is 12%. The weighted average cost of capital (WACC) will be as follows,
WACC = Proportion of equity * equity cost + Proportion of preference shares * preference share
cost + Proportion of long-term debt * debt cost + Proportion of short-term debt * debt
cost
= 0.4 * 18 + 0.1 * 12 + 0.4 * 8 + 0.1 * 12 = 12.8%

The WACC is then used as the hurdle rate for further analysis and naturally when the firm’s rate of
return is higher than the hurdle rate it is beneficial to the equity holders.
FACTORS AFFECTING THE WEIGHTED AVERAGE COST OF CAPITAL

While there are many factors affecting the WACC, we can make a broad demarcation of the factors
as external factors over which the firm has no control and internal factors which result from the
decision of the firms, like its dividend policy.
1. External factors could be the level of the interest rate, the market risk premium and the tax
rate.
2. Internal factors could be the organization’s investment policy, capital structure policy and the
dividend policy.
The Reserve Bank of India (RBI) tries to control the availability of funds in the system for lending
purposes with its monetary policy. Consequently, the cost of funds also changes. If the interest
rates in the economy rise, the cost of debt will naturally increase. Along with the increase in cost
of debt, the cost of equity and preference share equity raising costs will also increase. Similarly, if
the interest rates in the economy reduce, it will have a beneficial effect on all the components of
raising capital.
The market risk premium is the difference between expected market return and the risk-free rate.
It is generally observed that most initial public offerings (IPOs) come during the bull phase and not
during the bear phase. It is known that when there is a lot of euphoria in the market place, investors
are interested in equity, and when there is a gloom in the market, the investors are risk-wary. Now,
these market cycles are beyond the control of the individual firms. The market risk premium directly
affects the equity cost and indirectly the debt costs.
The tax rate decided by the government of the land has a direct effect on the cost of capital.
Similarly, the capital gains tax has an indirect effect on the cost of equity.
The rates of returns required on the outstanding equity and debt of the firm reflect the riskiness
of the existing assets of the firm. This becomes a base for further considerations. The marginal
cost of risky investments is the additional rate over and above the existing rate of returns. The
computation of WACC assumed that the proportion components of the capital structure remain
static. However, this structure might change over a period of time which would necessitate a
change in the WACC. Finally, the dividend policy of the firm also affects the cost of equity and
thus the WACC.
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METHODS ADOPTED BY FINANCIAL INSTITUTIONS

IN CALCULATING COST OF CAPITAL
There are differences in calculating cash flow by financial institutions. Financial institutions have the
onerous task of lending funds to projects and then receiving their funds back after a long gestation
period. The long gestation period is a characteristic of projects, since it does take a long time for the
project to get implemented. This elongated time duration brings in a lot of uncertainties and this is
a cause of concern for the lending houses.
September 2018 was the 10th anniversary of the collapse of Lehman Brothers which triggered the
global financial crisis in September 2008. In September 2018, India’s leading infrastructure finance
company IL&FS defaulted on payments to lenders triggering panic in the markets. IL&FS Ltd, or
Infrastructure Leasing & Finance Services, is a core investment company and serves as the holding
company of the IL&FS Group, with most business operations spanning an ecosystem of expertise
across infrastructure, finance and social and environmental services projects.
IL&FS Financial Services, a group company, defaulted in payment obligations of bank loans (in-
cluding interest), term and short-term deposits and failed to meet the commercial paper redemption
obligations due on 14 September 2018. With infrastructure being the dominant theme in India for
the past two decades, IL&FS used its first mover advantage to lap up infrastructure projects. The
areas in which IL & FS funded projects were road, power and water. At the pinnacle of its working,
IL&FS operated with 24 direct subsidiaries, 135 indirect subsidiaries, six joint ventures and four
associate companies. Its debt rose to `91,000 Crores ($13.67 billion) with almost 67% of this debt
being at project level. IL&FS then reported a debt to equity ratio of 18.7 and servicing this debt
became the major issue. Another reason behind the troubles of IL&FS was the complications in land
acquisition with the 2013 land acquisition law, making many projects unviable. Furthermore, cost
escalation led to incomplete projects and lack of timely action exacerbated the problems.
It could be this very reason as to why the project finance lending financial institutions look at
projects from the point of view of total resources. The residual value of the capital assets is conser-
vatively defined by financial institutions, whereas in the total resources cost of funds approach, it is
based on expected net salvage value. The broad points of difference are given below.
Table 9.1 Points of difference in calculating cash flows by financial institutions and when using the total
resources method
Cash Flow by Financial Institutions Cash Flow Using the Total Resources Method
Initial investment Capital expenditure on the project Capital expenditure on the project
+ Outlay on gross working capital + Outlay on gross working capital
Operating cash PAT PAT
inflow + Depreciation + Depreciation
+ Interest + Interest (1 - tax rate)
Terminal cash Flow Recovery of gross working capital at Recovery of gross working capital at book
book value value
+ Residual value of capital assets, + Expected net salvage value of other
with land at 100% and capital assets
assets at 5% of initial cost
The cost of capital is also calculated differently by the financial institutions. Financial institutions
consider post-tax weighted average cost of the mix of funds employed for the project.
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408 | Chapter 9
The cost for different sources of funds are taken as follows:

Sources of funds Interest rate
Equity share capital 15%
Cash accruals/retained earnings 15%
Preference share capital Preference dividend rate
Subsidy/incentive loan Zero cost
Debt (any) Post-tax rate of return,
i.e., Interest rate (1 - tax rate)
Convertible debentures Convertible portion at 15%
Non-convertible portion at post-tax interest rate
The tax rate for calculating tax is the average applicable tax rate calculated by using the following
 Total tax liability during project lifetime 
formula   . The average tax rate is always lower than the
 Operating profit over the life of the project 
prevailing statutory tax rate, as the projects generally get many tax incentives.
Example 9.1
PQR firm is considering a capital project about which the following information is available:
1. The initial project outlay will be `60 lakhs with salvage value of `6 lakhs.
2. The cost of capital is 12%.
3. The working capital would be `6 lakhs which will be liquidated at the book value when the
project is terminated.
4. The life of the project is 6 years.
5. The yearly cost is `15 lakhs which excludes depreciation and tax.
6. The revenue generated in the first year is `28 lakhs which will increase by `4 lakhs every year.
7. The depreciation is done by straight line method and will be depreciated fully.
8. The income tax rate is 35%.
Using the above information, develop the cash flow statement for the project.
Solution:
The commonly applied separation principle is applied in working out the cash flow statement for
explicit cost funds (investor claims) point of view. The means of project finance, whether equity or
preference or debt does not matter under separation principle.
Figures (` Lakhs)
S.No. Particulars 0 1 2 3 4 5 6
1 Fixed assets (60)
2 Working capital (6)
3 Revenues 28 32 36 40 44 48
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Costs (other than

4 15 15 15 15 15 15
Depreciation and Interest)
5 Depreciation 9 9 9 9 9 9
6 Profit before tax 4 8 12 16 20 24
7 Tax 1.4 2.8 4.2 5.6 7 8.4
8 PAT 2.6 5.2 7.8 10.4 13 15.6
9 Net salvage value 6
Recovery of Net working
10 6
capital
11 Initial investment (66)
12 Operating cash flow 11.6 14.2 16.8 19.4 22 24.6
13 Terminal flow 12
14 Net cash flow (11 + 12 + 13) (66) 11.6 14.2 16.8 19.4 22.0 36.6
Cash flow 11.6 14.2 16.8 19.4 22 36.6
Book value of investment 66 57 48 39 30 21 12
Example 9.2
A cosmetics company is considering an investment in a new beauty preparation for which the fol-
lowing information is available:
1. Investment in new machinery required for manufacture will cost `1,50,000.
2. A part of the present machinery that is lying idle for the last two years is also to be used for
manufacturing the new product:
(i) The machinery was purchased five years ago for `75,000 and its depreciated value today
is `37,500.
(ii) It can be used at least for another 5 years with normal maintenance and can be sold at
`5,000 after five years.
3. Increase in working capital on account of the new product will be as under:
(i) Increase in sundry debtors `75,000
(ii) Increase in inventories `1,00,000
(iii) Increase in current liabilities `1,00,000.
4. Sales revenue for the new product is estimated at `7,50,000 per year.
5. Manufacturing cost (including allocation of `30,000 fixed costs from service departments) is
estimated to be `3,40,000 per year.
6. Selling and administrative expenses directly associated with the product are `3,00,000 per
year.
7. The new machinery will have trouble-free service for 8 years but require overhauling in the
fourth year which will cost `10,000. Its estimated resale value at the end of 5 years will be
`20,000.
8. Introduction of a new product will slightly affect the production schedules of existing products
resulting in a loss of profit contribution on other products to an extent of `25,000 per year.
9. Bad-debts to be written off on account of a new product are `10,000 per annum.
10. Step-up promotional expenses in the third year are `70,000.
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410 | Chapter 9
11. All new investments and additional working capital requirements would be financed by
raising term loan to be paid in four years of equal installments. Interest on term loans @ 15%
p.a. works out to `29,500, `21,000, `12,500 and `4,500, respectively, in the first, second,
third and fourth years.
12. Depreciation being charged on straight line basis @ 10% is acceptable for income tax purposes.
13. Rate on income tax is 40%.
14. Expected project life is 5 years.
Compute the project cash flows from long-term funds point of view
Solution:
Investment Outlay
1 Cost of new asset (1,50,000)
Salvage value of old
2 37,500
asset
Increase in net
3 (75,000)
working capital
4 Total net investment (1,87,500)
Operating Inflows
over Project Life
5 Revenues 7,50,000 7,50,000 7,50,000 7,50,000 7,50,000
6 Manufacturing cost 3,40,000 3,40,000 3,40,000 3,40,000 3,40,000
Selling and
7 administrative 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
expenses
Additional
8 10,000
maintenance cost
9 Loss of contribution 25,000 25,000 25,000 25,000 25,000
10 Depreciation 8,750 8,750 8,750 8,750 8,750
11 Bad debt loss 10,000 10,000 10,000 10,000 10,000
12 Promotional expenses 70,000
13 Interest on term loan 29,500 21,000 12,500 4,500
Interest on working
14 11,250 11,250 11,250 11,250 11,250
capital
15 PBT 25,500 34,000 (27,500) 40,500 55,000
16 Tax 10,200 13,600 0 16,200 22,000
17 PAT 15,300 20,400 (27,500) 24,300 33,000
Net salvage value of
18 25,000
equipment
Recovery of net
19 75,000
working capital
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20 Capital investment (1,50,000)

Operating cash
21 inflow 34,050 39,150 (8,750) 43,050 51,750
(17 + 10 + 11)
22 Net working capital (75,000) 25,000
Terminal cash inflow
23 1,00,000
(18 + 19)
Net cash flow
24 (2,25,000) 34,050 39,150 (8,750) 43,050 1,76,750
(20 + 21 + 22 + 23)
Example 9.3
Modern Pharma is considering the manufacture of a new drug, Floxin, for which the following
information has been gathered.
1. Floxin is expected to have a product lifecycle of seven years and after that, it would be with-
drawn from the market. The sales from this drug are expected to be as follows:
Year 1 2 3 4 5 6 7
Sales (` Million) 80 120 160 200 160 120 80
2. The capital equipment required for manufacturing Floxin is `120 million and it will be
depreciated at the rate of 25% per year as per the WDV method for tax purposes. The expected
net salvage value after seven years is `25 million.
3. The working capital requirement for the project is expected to be 25% of sales. The work-
ing capital level is adjusted at the beginning of the year in relation to the expected sales for
the year. At the end of 7 years, working capital is expected to be liquidated at par, barring an
estimated loss of `4 million on account of bad debt, which of course will be tax deductible
expenses.
4. The accountant of the firm has provided the following estimates for the cost of Floxin:
(i) Raw Material cost 30% of Sales
(ii) Variable manufacturing cost 10% of Sales
(iii) Fixed annual operating and
Maintenance cost `10 million
(iv) Variable selling expenses 10% of Sales
(v) Overhead allocation 10% of Sales
(excluding depreciation, maintenance and interest)
The incremental overheads attributable to the new products are however expected to be
only 5% of the sales.
5. The manufacture of Floxin will cut into the sales of an existing product, thereby reducing its
contribution margin by `10 million per year.
6. The tax rate for the firm is 30%.
Estimate the post-tax incremental cash flows for the project to manufacture Floxin.
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412 | Chapter 9
Solution:
Figures (` Million)
S.No. Particulars 0 1 2 3 4 5 6 7
1 Capital investment (120)

2 Level of net working capital 20 30 40 50 40 30 20 0
(ending)
3 Revenues 80 120 160 200 160 120 80
4 Raw material cost 24 36 48 60 48 36 24
5 Variable manufacturing cost 8 12 16 20 16 12 8
6 Fixed annual operating and 10 10 10 10 10 10 10
maintenance cost
7 Variable selling expense 8 12 16 20 16 12 8
8 Overhead allocation
9 Incremental overheads 4 6 8 10 8 6 4
10 Loss of contribution 10 10 10 10 10 10 10
11 Depreciation 30 22.5 16.88 12.66 9.49 7.12 5.34
12 Bad debt loss 4
13 Profit before tax (14.00) 11.50 35.12 57.34 42.51 26.88 10.66
14 Tax 0.00 3.45 10.54 17.20 12.75 8.06 3.20
15 Profit after tax (14.00) 8.05 24.58 40.14 29.76 18.82 7.46
16 Net salvage value 25
17 Recovery of net working capital 16
18 Capital investment (120)
19 Operating cash Inflow 16.00 30.55 41.46 52.80 39.25 25.94 16.80
(15 + 11 + 12)
20 Net working capital 20 10 10 10 –10 –10 –10
21 Terminal cash inflow (16 + 17) 41
22 Net cash flow (140) 6 21 31 63 49 36 58
(18 + 19 - 20 + 18)
Notes:
1. The loss of contribution is an opportunity cost (item 10).
2. Overhead expenses allocated to the project have been ignored but the incremental overhead
expenses due to the project are considered.
3. It is assumed that the level of net working capital is adjusted at the beginning of the year in
relation to the expected sales for the year.
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EXTENDED INTERNAL RATE OF RETURN (XIRR)

AND MODIFIED INTERNAL RATE OF RETURN
In Chapter 6, we extensively discussed capital budgeting techniques and listed their advantages and
disadvantages. The internal rate of return (IRR) was also discussed and like other cash flow tech-
niques, IRR takes an investment view of the expected financial returns. By ‘investment’ view, we mean
that IRR compares the magnitude and timing of cash flow returns to cash flow costs. The XIRR and
MIRR are two capital budgeting techniques that address some of the limitations of the IRR method.
Among the IRR assumptions, the following were notable:
1. The investments are held till maturity.
2. All intermediate cash flows are reinvested at the IRR.
3. The cash flows would be periodic, that is to say, that the time interval between two cash flows
is equal.
In case of projects, the first and the last assumptions are valid because the investments in the project
are held till the life of the project and the cash flows are considered on a yearly basis. The second as-
sumption is a little inapt for projects. Projects with higher IRR mean that the returns generated are
higher than the hurdle rate or WACC. In fact, the attractiveness of these projects is because no other
investments avenues provide this high rate of return. How can we assume that the reinvestment of the
cash flow in the project also generates a return at IRR? Should not the reinvestment returns be capped
at best at the WACC? Practically, it is common to reinvest yearly cash flows at the organization’s cost
of capital. The computation of IRR also requires that the cash flows be always positive. In case they
are not, then there exists a possibility of more than one IRR which could further confuse the investor.
If the periodicity of cash flows is not uniform, then it is difficult to compute the IRR. A better
way for analysis is the concept of compounded annual growth rate (CAGR) where the compound-
ing happens on an annual basis. We have one initial amount and one final amount after some years
which is getting compounded at CAGR. The concept of CAGR is extended to include investments
and redemptions at different time periods which we call extended internal rate of return or XIRR.
Loosely put, we can state that XIRR is multiple CAGR. The calculations of XIRR manually are not
possible and we use Excel for calculating it.
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414 | Chapter 9
The XIRR formula is XIRR (value, dates and guess), where values are the transaction amounts,
dates are the transaction dates and guess is the approximate return, which could also be kept blank.
Example 9.4
Calculate the XIRR for the following problem:
Dates Amount
21 January 2016 - 20,000
10 April 2016 10,000
15 August 2016 - 10,000
24 November 2016 10,000
18 February 2017 14,000
10 May 2017 - 20,000
06 July 2017 12,000
02 January 2018 10,000
XIRR 26.03%
Note: Payments (Cash outflows) are taken as negative values and receipts (cash inflow) are taken as
positive values. Dates must be valid Excel dates in chronological order. The ‘date’ function can be
used to enter dates.
Interpretation: The investments and returns from 21 January 2016 to 2 January 2018 gave a CAGR
of 26.03%
MIRR or modified internal rate of return addresses the issue of reinvestment rate and the cost of
financing rate. All positive cash flows are reinvested at the reinvestment rate (and not the IRR) and
the negative cash flows are discounted to the present value at the start of the project by applying
the cost of financing (typically the WACC) rate. The negative cash flows also include the outflows in
year 0, which will carry a present value factor of 1. MIRR thus also addressed the issues of negative
cash flows if any during the project life.
 Future value of positive cash flows 

MIRR =  n  −1
 − Present values of negative cash flows 
where n is the number of time periods.

Example 9.5
The reinvestment rate of cash flows (given in ` million) is 10% and the cost of capital is 15% for two
projects Alpha and Beta:
Year Project a Project b

0 - 220 - 220
1 120 60
2 100 70
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3 80 60
4 55 65
5 35 70
6 25 85
7 30 100
Find out which project is better. Use IRR and MIRR methods for making your choice.
Solution:
Year Project a Project b

IRR 31.72% 24.38%
MIRR 17.09% 17.28%
Excel Screen shot of the MIRR function
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416 | Chapter 9
Solution:
Project a Project b
Present Value Future Value PV of Future Value PV of Future Value
Factor Factor Negative of Positive Negative of Positive
Year Project a Project b @ 15% @ 10% Cash Flow Cash flow Cash Flow Cash flow
0 -220 -220 1.000 -220 -220
1 120 60 0.870 1.772 212.64 106.32
2 100 70 0.756 1.611 161.10 112.77
3 80 60 0.658 1.464 117.12 87.84
4 55 65 0.572 1.331 73.21 86.52
5 35 70 0.497 1.210 42.35 84.70
6 25 85 0.432 1.100 27.50 93.50
7 30 100 0.376 1.000 30.00 100.00
Total -220 663.92 -220 671.65
Notes:
1. The future values are taken in the reverse order because the cash flows received in year 1
would be invested for 6 years.
2. The project is a seven-year one, but when using the MIRR function including Year 0, there
will be eight entries. While calculating manually, a confusion would arise whether it is a seven-
year project or a eight-year project because there are eight entries. It is a seven-year project
and therefore the 7th root or 7 should be taken.
 663.92 
MIRR α =  7
3.  − 1 = 0.1709 or 17.09%

 −(−220) 
 671.65 
MIRR β =  7
4.  − 1 = 0.1728 or 17.28%

 −(−220) 
5. It can also be observed that the IRR conclusion was that Project a is better, whereas the MIRR
conclusion is that Project b is better. The reason for the change is because Project a has front
loading by which we mean the initial period cash flows are more than the later period cash
flows. In IRR, the initial period higher cash flows get the benefit of higher returns for a longer
period and while this is also true in MIRR, due to the moderating effect of lower reinvestment
returns, the analysis becomes practical.
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SUMMARY
The capital required for a project is a cost and the components of the capital help in computing
the cost of capital. As the weighting is done on the basis of proportion of capital components, it is
called weighted average cost of capital (WACC). It is often observed that the cost of short-term debt
is ignored by companies while calculating the WACC. This is not correct simply because the short-
term debt lenders also have a claim on the operating earnings of the company. As a result of ignoring
this short-term debt cost, the company might be misrepresenting the rate of return requirements
of the investors. The applications of WACC are beyond the project appraisal in that regulated
organizations such as the utility providers base their customer charges using WACC. Although the
WACC is extensively used as a hurdle rate, its application is more correct when the risk of new
investments is the same as the average risk of existing investments and when the capital structure of
the firm will not be affected by new investments.
Estimating the cash inflows and outflows after the project is commissioned is a complex but
interesting process. The three factors in cash flow streams for a conventional project are initial
investment, operating cash inflows and terminal cash inflows. The principles adopted for the cash
flow estimation is separation principle, incremental principle, post-tax principle and consistency
principle. The separation principles stresses on the fact that cash flows associated with the
investment side and the financing side must be separated. The incremental cash flow concepts help
in ascertaining the firm’s standing with and without the project. The opportunity cost should be
necessarily considered while estimating the incremental project cash flows.
IRR, XIRR and MIRR have applications in decision-making process for project investment
evaluations. However, before applying these concepts, one should understand the advantages and
limitations of each of these capital budgeting techniques.
KEYWORDS
• WACC • Cash flows from equity perspective

• IRR • Cash flow from long term funds
• XIRR perspective
• MIRR • Cash flows from total funds perspective
• Separation principle • Financial institutions
• Incremental principle • Operating cash flows
• Post-tax principle • Terminal cash flows
• Consistency principle • Depreciation
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418 | Chapter 9
R e v i ew Q uest i o n s
1. Explain the concept of WACC and list down the conditions for its correct usage.
2. What are the broad components of WACC?
3. What are the three elements of the cash flow stream of a project?
4. What are the principles of the ‘separation’ principle used in project cash flow analysis?
5. Why do we ignore the tax impact of losses of a project?
6. What are the differences between cash inflow for all investors and cash flow to equity
shareholders?
7. Explain one or two major differences in cash flows from the point of equity, long-term funds
and total funds?
8. Why is the terminal benefit of a project underestimated by financial institutions in their
analysis?
9. What are the reasons for differences in conclusions when using the IRR and MIRR analysis?
10. Explain the concept of XIRR and the occasions when it would be advantageous to use it in-
stead of the CAGR.
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chapter
10 PRoJecT Risk AnAlysis

And MAnAgeMenT
LEArninG OBJECTivES

❍ Understand the risk management process.
❍ Develop a risk response strategy.
❍ Understand the concept of contingency planning.
❍ Explore the concept of change control management.
❍ Examine the concepts of sensitivity analysis, scenario analysis and risk perspectives.
❍ Explain simulation analysis and the steps involved in risk simulation analysis.
Good Judgement comes from Experience and lot of that comes from bad judgement.
—Will Rogers
inTRoducTion
Although the above statement is true, we cannot say the same simply about Project Management,
because we cannot afford projects to go wrong to learn from them. Rather we procrastinate on
what could go wrong and then do not allow them to go wrong! Hence, in a nutshell, this is known
as project risk analysis and management.
Many would say that risks are everywhere and that is also true to some extent. In today’s
changing times, there is no business without having its fair share of risk. The important aspect
in project management is that the success and failure of the entire project depend on risks that
were not anticipated, and as the risks were not anticipated, the risk response strategy was also
not planned.
The Polar Satellite Launch Vehicle (PSLV) designed and operated by Indian Space Research
Organization (ISRO) had its maiden launch on 20 September 1993. In the maiden launch, the first
and second stages performed as expected, but an altitude control problem led to the collision of
the second and the third stages at separation. As a result, the payload failed to reach its targeted
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420 | Chapter 10
Figure 10.1 Project risk management—a schematic presentation
geosynchronous orbit. At end of 2014, the PSLV had launched 34 payloads with no further failures;
however, the 41st launch in August 2017 resulted in a failure. With an experience of 40 successful
launches, why should the 41st launch not be a success? Similar to the case of PSLV, risks are inherent
in project management and no amount of foresight or planning can avoid this risk. If the risk
has a positive effect on the project, then it gets ignored. A deviation from a process is a ‘problem’
only if the deviation is unfavourable. Similarly a project completing early (than scheduled) is not
investigated for reasons.
The risks described so far did not consider the financial risks or risks associated with the capital
investments in the project. In an organization like M/s Godrej & Boyce Ltd., two projects are
considered: one, an expansion project of an existing product line like the Interio furniture business
and the second, where investments in expansion of the aerospace division are considered. If the
capital returns on the average cost of capital basis is to be considered, then which investment seems
less of a risk? Obviously, the research and development-based aerospace business appears to be
more risky. Yet the aerospace investments would be giving a higher return to the organization than
the investments in their furniture (Interio) business. Hence, when it comes to capital budgeting
decisions, risk analysis and later the management of risk become complex.
Some potential risks can be identified before the project commences like equipment breakdown
or changes in technical requirements, but the risks like 2008 global financial meltdown are beyond
identification. Many examples of failed risk management abound, with the notable being NOKIA
mobile phones being unable to assess the impact of android systems or the blackberry being unable to
anticipate that consumers (and not just business customers) would drive the smartphone revolution.
In this chapter, the first part will consider the risk analysis techniques as applicable to capital
budgeting and the second part will focus on the non-capital budgeting risk analysis.
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Project Risk Analysis and Management | 421
alysis
tion An
Simula
del
Hiller Mo
Analysis
Decision Tree
Stand-alone
Risk Scenario Analysis
Techniques
Break-even Analysis
Contextual Market Risk Analysis

Risk
Corporate Risk
Analysis
Figure 10.2 Capital budgeting risk analysis techniques
Techniques of Risk Analysis

Although risk is prevalent in all business decisions, the risk associated with the capital budgeting
decisions is more impacting. Capital budgeting decisions are long-term decisions that naturally
involve huge costs and the benefits of whom are realized over a long period of time. At times, the
benefits of capital budgeting are derived over the life-time of the project. The capital budgeting risk
can be broadly classified into a standalone risk and a contextual risk. The various approaches to risk
under each of these headings are given in Figure 10.2.
A standalone risk analyzes the risk to a project when the risk is viewed in isolation.
Standalone Risk Analysis

Analyze the risk of a project when it is viewed in isolation against the back drop of project-specific
risk, competitive risk, industry-specific risk and Market risk. When the estimation of the project
cost structure could be incorrect, it is called project-specific risk. The competitive risk is where the
assessment of competitor’s actions in the market place was underestimated. The industry-specific
risk is the risk of unexpected technological advancement (pager industry problems with the advent
of mobile phones) or government regulations (doubling of duties by Narendra Modi’s Government
in 2018 on imports of beauty aids, watches, toys, furniture, footwear and surprisingly, kites and
candles). The market risk relates to the unexpected macroeconomic changes in GDP, interest rate,
inflation and the international risks (like the USA–China trade war, Brexit, OPEC, etc.).
Macro and Micro Risks

From the risk perspectives, we could broadly classify the risks as internal risk (over which the firm
can exercise some control) and external risks (over which the firm cannot have any control). The
internal risks are known as standalone risks and the external risks are known as systemic risk.
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422 | Chapter 10
Generally, we can develop risk mitigation strategies for the standalone risk, but a risk response
strategy is needed for the systemic risk. A third risk can be in the form of Firm risk where the effect
of the project gets reflected in the organization’s performance. In terms of project management risk
control strategy, we are more concerned with the standalone risk, which be dealt in detail here. The
corporate risk and market risk put together is termed as contextual risk.
Measures of Risk
For capital budgeting, risks referred are complex and multi-faceted problem. The most commonly
used measure of risk is variance (or standard deviation), or in some cases, semi-variance and co-
efficient of variation are used. The coefficient of variation is a measure that is devoid of any unit
and hence can be used to compare across projects. For example, if an Indian project with an initial
investment of `10 lakhs and with a standard deviation of `0.5 lakhs is to be compared with a proj-
ect in USA having an investment of $12 lakhs with a standard deviation of $0.5 lakhs, then which
has the higher risk? The standard deviations are not comparable because the units are different.
However, when we consider the coefficient of variation, it has no units and can be used for com-
parison. The standard deviation considers all the positive and negative variations, which may not be
correct as we might be interested only in the negative variations. In such case, we use the concept of
semi-variance where the deviations on only one side of the mean are considered. Another point that
needs to be noted is that we assume all risks to be normally distributed, which can be a fair assump-
tion, given the scale of projects.
Stand Alone Risk Analysis Techniques

Many estimates related to the cost and revenues are after all estimates on the basis of certain as-
sumptions. These assumptions are mostly made on the basis of some broad expectations and the
expectations need not be necessarily met. As a result, the assumptions will be proved wrong, result-
ing in adverse changes to the cost and revenue measures. How then do the project deliverables or
benefits change is known as the sensitivity analysis. The robustness of our model to the changes in
the inputs and outputs is of interest and this is the ‘what-if’ analysis or sensitivity analysis. A power
plant is expected to run at 50% efficiency in the first year of commissioning and gradually increase
to 80% efficiency by the third year of the project. What if these estimates don’t hold true? In this
case, we can consider three situations instead of one. The situations are pessimistic or the worst sce-
nario, the expected or the most likely scenario, and the best case or optimistic scenario. The effect
of all these scenarios on the NPV of the project or the IRR of the project or any such parameter of
interest is then computed.
The process of sensitivity analysis broadly consists of the following four basics steps:
1. Selection of one or more uncertain variables.
2. Construction of a model for analyzing changes in the calculation depending on the accepted
uncertain variables.
3. Determination of an acceptable range of fluctuations in the uncertain variables.
4. Determination of an acceptable range of fluctuations in the profitability of the investment
project.
Among the advantages of the sensitivity analysis is that it establishes a linear relationship between
changes in the values of the underlying variable and the robustness or vulnerability of the project. If
the situation is unclear or the criticality of some parameters likely to change is unknown, then these
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Figure 10.3 Scenario analysis using Microsoft Excel
areas are identified for further analyzes. Finally, as it considers the various possibilities, the analysis
adds to the robustness of the project.
The disadvantage of this method is that it merely identifies the outcome for a change in some pa-
rameter but not about the probability of the change happening. How likely the pessimistic event or
the optimistic event to happen is not considered. In the case of sensitivity analysis, a change to only
one parameter is considered at a time. Simultaneous changes to different input and output param-
eters are not considered. The outcome of the sensitivity analysis might be construed differently by
different people. Suppose a worst case scenario gives an NPV of `5 lakhs on an investment of `25
lakhs, then a risk averse person may accept the project, whereas a risk-favouring person may reject
the proposal.
Scenario Analysis
A first question comes to the mind is how the scenario analysis is different from the sensitivity
analysis, especially when the scenarios are considering different inputs and outputs much like the
sensitivity analysis. There are two major differences: the first is that the scenario analysis does not
classify a scenario as a best case or a worst case scenario. Secondly, simultaneous changes to the
input parameters are considered as against a change in single variable while doing the sensitivity
analysis. Scenarios such as a 10% increase in input costs, 15% increase in input costs and so on are
studied. The Microsoft Excel also has the scenario manager being able to analyze instantaneously
the outputs under various possibilities. Although scenario manager may be considered as an im-
provement over sensitivity analysis, it is not without its limitations.
One of the limitations of the scenario manager is that it considers scenarios to be mutually exclu-
sive, which means that should scenario 1 happen and scenario 2 cannot happen. This may not be true
because the scenarios could be in continuum. The OPEC-controlled oil prices keep on fluctuating in
price and it is not necessary that it follows a unidirectional trend. The second limitation is that the
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424 | Chapter 10
analysis becomes complex when there are multiple parameters. For a simple n parameter project,
n(n − 1)!
there can be combinations of values.
2
Breakeven Analysis
Breakeven analysis is used to determine the point when the revenue received equals the cost associ-
ated with generating the revenues. In simple terms, determining the no-profit and no-loss point is the
break-even analysis. This analysis is used extensively in business decisions, and we have discussed
this technique in performing the commercial analysis in the Detailed Project Report (DPR). In the
present context of capital risk management, the breakeven analysis is used to calculate the margin
of safety, i.e., the revenue amount which is in excess over the breakeven point revenues. Breakeven
analysis is a supply side analysis that only analyzes the cost of sales. It does not factor in the law of
diminishing demand or the situation where excess availability of a product gives negative returns
or how demand would be affected at different price points. The customer-driven pricing model
suggests that the seller has to decide the price of the product on the basis of customer willingness
to pay a price commensurate with the value received. The margin of safety analysis shows the level
at which it is advisable to run operations. Breakeven analysis and sensitivity analysis are similar in
examining a range of values in order to garner more information. The breakeven analysis, therefore,
becomes a preliminary tool for capital risk assessment. Sensitivity analysis used complimentarily
with the breakeven analysis is usually very helpful.
Hillier Model
According to the Hillier Model, proposed by F. S. Hillier, the risk associated with the project can be
assessed through the standard deviation of the expected cash flows. This model gives weightage to
the standard deviations of the expected cash flow and thus assumes that the computation of stan-
dard deviations of several ranges of cash flows enables the computation of project risk. The NPV
and the standard deviation of NPV are determined by analytical derivations. Situations where there
is no correlation among yearly cash flows and situations where there is a perfect correlation are con-
sidered for the analysis. The formula to compute the Net Present Value and the standard deviation
under both the cases is given below:
Uncorrelated Cash Flows Correlated Cash Flows

n  C  n  C 
NPV = ∑ 

t
t
 −C
0 NPV = ∑ 

t
t
 −C
0
t =1  (1 + i )  t =1  (1 + i ) 
n σ 2 1/2 n  σ 
σ (NPV) = ∑

t 
2t 
σ (NPV) = ∑ 

t
t

t =1  (1 + i )  t =1  (1 + i ) 
where, Ct = Expected cash flow of the year ‘t’

st = Standard deviation of cash flow for the year ‘t’
i = Risk free interest rate
C0 = Initial investment
As we need to differentiate the risk factor and time value of money, the interest rate in the above cal-
culations would always be the risk free interest rate. In case we consider the risk adjusted discount
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rate, then we are actually counting the risk factor twice.
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Example 10.1
Two expansion projects are being considered with the following outlays and inflows. Which project
has less risk component? Consider the risk free interest rate as 6% and that the projects cash flows
are uncorrelated.
Project A
Probability = 0.3 Probability = 0.4 Probability = 0.3

Year Cash Flow Cash Flow Cash Flow
0 -15,000 -15,000 -15,000
1 4,000 5,000 6,000
2 6,000 6,000 9,000
3 8,000 7,000 5,000
4 9,000 8,000 12,000
5 10,000 9,000 8,000
Project B
Probability = 0.3 Probability = 0.4 Probability = 0.3
Year Cash Flow Cash Flow Cash Flow

0 -25,000 -25,000 -25,000
1 6,000 8,000 10,000
2 8,000 9,000 13,000
3 10,000 10,000 9,000
4 11,000 11,000 16,000
5 12,000 12,000 12,000
Solution:
The first objective is to compute the average yearly returns or inflows and the yearly standard
deviation, s.
The average return or ( X ) is given by:
X = π pi * Xi = 0.3 * 4,000 + 0.4 * 5,000 + 0.3 * 6,000 = 5,000 for Year 1, Project A
Similarly, the standard deviation s is given by the formula:
s = [pi * (X - X )2]½, and hence, for the year 1, project A we have.
s = [0.3 * (4,000 - 5,000)2 + 0.4 * (5,000 - 5,000)2 + 0.3 * (6,000 - 5,000)2]½ = 774.6
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426 | Chapter 10
Similarly, we calculate all the average returns and standard deviation for all the years and for proj-
ects A and B. This is summarized in the following tables.
Project A
Year Average cash flow s

0 -15,000
1 5,000 774.6
2 6,900 1,374.8
3 6,700 1,187.4
4 9,500 1,688.2
5 9,000 774.6
Project B
Year Average cash flow s
0 -25,000
1 8,000 1,549.2
2 9,900 2,071.2
3 9,700 458.3
4 12,500 2,291.3
5 12,000 0.0
5 X
NPVA = ∑ t =1
(1 + 0.06)
t
− Intial investment
5,000 6,900 6,700 9,500 9,000

= 1
+ 2
+ 3
+ 4
+ − 15,000 = 15,733.6
(1.06) (1.06) (1.06) (1.06) (1.06)5
5 X
NPVB = ∑ t =1
(1 + 0.06)
t
− Intial investment
8,000 9,900 9,700 12,500 12,000

= 1
+ 2
+ + + − 25,000 = 18,370.7
(1.06) (1.06) (1.06)3 (1.06)4 (1.06)5
 5 σt2 1 2
σA = 

∑ t =1

2t 
(1 + 0.06) 
 774.62 1,374.82 1,187.42 1,688.22 774.6 2 1 2
= + + + + 
 (1.06)2 (1.06)4 (1.06)6 (1.06)8 (1.06)10 

= 2,269
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 5 σt2 1 2
σB = 

∑ t =1

2t 
(1 + 0.06) 
12
 1,549.22 2,071.22 458.32 2,291.32 02 
=  + + + +
 (1.06)2 (1.06)4 (1.06)6 (1.06)8 (1.06)10 

= 2,996
As can be seen the risk for Project B is higher, and in spite of the better NPV, we should select
Project A.
Example 10.2
If the cash flows in the data given in example 1 are perfectly correlated, then which project would
be less risky and hence preferred?
Solution:
In case of perfectly correlated cash flows, the cash flows in each period behave similarly. Therefore,
if the cash flow in the first time period is trailing the expected value, then the cash flows in all the
time periods would be trailing the expected values. In such cases, the standard deviation would
also be trailing the expected values. The formulae for the NPV and s for perfectly correlated cash
flows are:
NPV = nπt = 1 [Ct / (1 + i)t] - C0
s (NPV) = nπt = 1 [st / (1 + i)t]
In our problem, the NPVA and NPVB remain the same as in Example 1, but the standard deviation
values would change.
774.6 1374.8 1187.4 1688.2 774.6

σ (NPVA ) = + + + + = 4,867.3
1.061 1.062 1.063 1.064 1.065
1549.2 2071.2 458.3 2291.3 0
σ (NPVB ) = 1
+ 2
+ 3
+ 4
+ = 5,504.5
1.06 1.06 1.06 1.06 1.065
Even when the objective is not to compare projects but to consider the risk impact on the project,
the expected value and standard deviation computed using the Hillier Model helps in making an
interval estimate for project returns.
Simulation Analysis
Most modelling techniques make assumptions such as linearity, normality, process is a statistical
process, random errors have a constant standard deviation, explanatory variables are observed
without errors, and so on. In practise, there is a high probability that the same may not be true. A
few omissions may not make the entire exercise infructuous, but preferences are given for methods
that work without any assumptions. Simulation is one such technique that only replicates the states
of events, and on the basis of past data, it generates 10X or 100X or 1000X data and identifies the
event or scenario that is most likely to happen. The generation of more data in simulation is by using
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428 | Chapter 10
ONE STANDARD
DEVIATION
68% of data
95% of data
99.7% of data
–3 –2 –1 1 1 2 3
Figure 10.4 Using the X , s the probability of getting returns
random numbers, which being random covers all the possibilities of states of events. The stages
involved in simulation are as follows:
1. Identify all the states of events.
2. Assign random numbers to each state of the event on the basis of a priori or prior record of
happenings.
3. Using random numbers, run the experiment for a large number of times to identify the event
that would happen most frequently.
4. Draw conclusions.
One of the limitations of the simulation technique is that it is not an optimizing technique, and
although the results tend to converge large number of data points, the answer may vary every time
the exercise is carried out. To overcome this drawback, simulations are run using excel or any other
software that can make a large number of calculations.
Let us consider a simple model where the life of the project is variable but the annual cash flows
are constant. The values of the annual cash flows are again not known and can vary, but once it is
decided, the inflows remain the same for the life of the project. Calculate the expected NPV for the
project. Initial Investment is `25,000. Discount rate to be considered is 8%.
Cash Flow (in `) Probability Life of the Project Probability

4,000 0.1 5 0.2
5,000 0.15 6 0.3
6,000 0.2 7 0.4
7,000 0.3 8 0.1
8,000 0.12
9,000 0.08
10,000 0.05
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Year 1 2 3 4 5 6 7 8
PVFA @ 8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747
We will use only 10 random numbers to explain the concept.
Cash Flow Probability Cumulative Probability Random Number

4,000 0.10 0.10 00 ~ 09
5,000 0.15 0.25 10 ~ 24
6,000 0.20 0.45 25 ~ 44
7,000 0.30 0.75 45 ~ 74
8,000 0.12 0.87 75 ~ 87
9,000 0.08 0.95 88 ~ 94
10,000 0.05 1.00 95 ~ 99
Random number allocation for cash flow
Life of the Project Probability Cumulative Probability Random Number

5 0.20 0.20 00 ~ 19
6 0.30 0.50 20 ~ 49
7 0.40 0.90 50 ~ 89
8 0.10 1.00 90 ~ 99
Random number allocation for project Life
S. No. Random No. Cash Flow Random No. Life NPV

1 56 7,000 57 7 11,444.6
2 6 4,000 38 6 -6,508.5
3 60 7,000 68 7 11,444.6
4 81 8,000 89 7 16,651.0
5 35 6,000 57 7 6,238.2
6 97 10,000 56 7 27,063.7
7 86 8,000 57 7 16,651.0
8 89 9,000 79 7 21,857.3
9 17 5,000 7 5 -5,036.4
10 28 6,000 38 6 2,737.3
Average 10,254.3
Therefore, it can be seen that the average NPV is expected to be `10,254.30.

As can be noticed, the results of this analysis could change if the problem is simulated for 20 times,
and yet another solution would come if it is simulated for 100 times. In practise, using Excel,
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430 | Chapter 10
the problem can be simulated for a very large number. A second limitation of simulation is how
to specify the probabilities of exogenous variables. The results of the simulation depend to a large
extent on the allocation of random numbers, which in turn depends on the allocation of cumulative
probabilities to each state of the event.
Decision Tree Analysis

The decision tree analysis has been dealt with extensively in Chapter 4B and basically comprises the
following steps:
1. Identify the problems and their alternatives.
2. Specify the probabilities and monetary outcome for each alternative.
3. Eliminate the decisions or alternatives one-by-one from the right to the left, choosing the best
alternative.
4. Using the monetary criteria only, reach the best alternative or decision.
Contextual Risk Analysis

It covers the analysis of the project that contributes to the risk of a firm and diversified investors. It
covers the range of overall potential adverse outcomes that may arise in a particular ‘context’ and
which could impact the broader range of risks at programmatic and institutional levels. The con-
text will usually be a country or region but could also cover the global thematic or political frame.
The trade war between USA and China or the BREXIT lead disintegration threat for the European
Union could be some of the threats that could be considered here. The organization or the project
management team has very little control in the case of contextual risk. Corporate risk analysis and
Decision Tress
Which Kind of Test?
Relationships Comparing Means

between Variables
Which Kind of Means?
A Sample Mean &

2 Sample Means
a Population Mean
Which Kind How are the

Is s known?
of Variables? Data Structured?
Both Both Interval No, Paired (Dyadic

Yes Independent
Nominal or Ratio Justs or Longitudinal)
Correlation or 1-Sample Independent- Paired-

Chi-Square Z-Test
Regression T-Test Samples T-Test Samples T-Test
Figure 10.5 Schematic diagram of a decision tree

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the market risk analysis could be the broad bifurcation in the case of contextual risks. It is much
complex and cumbersome aspect of capital budgeting that requires a proper evaluation of risk and
returns of the proposed investment project. Portfolio theory and capital budgeting with the analysis
of Capital Asset Pricing Model could be the extended discussion under this topic. As these topics are
more related to finance and less related to project management as such, we do not further discuss
this topic in our text.
Management of Risk
So far we have discussed about the capital budgeting risks to a project from the investment perspec-
tive. Let us now consider the process of risk management and also look at what can go wrong in a
project. Risk management attempts to recognize and manage potential and unforeseen trouble spots
that may occur in the implementation phase of the project life cycle. We identify the risk events ex-
haustively and consider our response strategy to such risks in case they happen. There are many ex-
amples where promotion projects have gone terribly wrong and had to face unexpected risks, which
were never even contemplated. MacDonald’s launched a promotional scheme in Japan in 2006,
doling out MP3 players loaded with ten free songs, without realizing that each of these promotional
MP3 players had a Trojan horse which affected all the users by stealing their passwords and other
details and forwarding it to hackers. Although MacDonald’s later apologized to their customers and
replaced the faulty MP3 players with new ones, the damage had been done.
Risk analysis and management is a key project management practice to ensure that the least
number of unpleasant surprises occur while the project is underway. A simple and streamlined risk
management process helps predict the uncertainties in the project and steps to minimize the occur-
rence or impact of these uncertainties. Risk management is an iterative process, and with proper
documentation, communication and allocation of responsibilities, the duplication of efforts and
randomization of solutions can be avoided.
Risk Management Process

Figure 10.6 shows a graphic model of the risk management cost, possibility of risk and the project
life cycle. As can be expected, the chances of improper cost and time estimates or the planning of the
Risk Event Graph

Risk Cost
High
Chances of Cost to Fix

Risks Occurring Risks Event
Low
Project Life Cycle
Figure 10.6 Risk and cost in project life cycle
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432 | Chapter 10
Risk
Identification
Risk RISK Risk

Response MANAGEMENT Assessment
Control PROCESS
Risk
Response
Strategy
Figure 10.7 Schematic presentation of the stages in the risk management process
project execution phases will be highest in the initial stages and reduce significantly as we progress
in the project life cycle. As a corollary, the cost to rectify or fix the anomalies will be the least in
the initial phases and will increase commensurately with the extension in project life cycle phases.
The cost of mismanaged risk control systems can be gauged by the loss of the NASA Mars Climate
Orbiter, where the earth station used metric pounds per second and the spacecraft’s computer pro-
cessed data in metric Newton. Had this error been detected early in the project then rectifying such
a simple error would have been much easy and cheap. Risk management is a proactive approach
rather than a reactive approach, and thus, it acts as a preventive mechanism. It might appear that the
sources of project risk are unlimited but not all happen at all times. In case we are better prepared,
then the chances of being able to handle the adversity are higher.
The risk management process is a four-step cyclical process with the first step being initiated as
soon as the fourth step is completed. Figure 10.7 shows the schematic diagram of the four-step risk
management process.
Step 1—Risk identification: Risks are to be identified and dealt with as early as possible in the
project, with risk identification being performed at every stage of the process and during key mile-
stones. A list of all possible risks that could affect the project is made at this stage. Brainstorming
exercises are carried out in groups to identify the potential risk, and a later assessment phase filters
are put in to reduce the list of identified risks. At this stage, the focus should be on events and not on
objectives. For example, if the objective is to complete the project in 6 months, then the risk is not
that the project may not be completed in 6 months. The risk could be that there is a possibility of a
longer monsoon period that may delay the project. Similar to a work breakdown structure (WBS),
a risk breakdown structure (RBS) should be created at times, which helps in identifying the risk for
each element.
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Impact
Trivial Minor Moderate Major Extreme
Rare Low Low Low Medium Medium
Unlikely Low Low Medium Medium Medium
Probability
Moderate Low Medium Medium Medium High

Likely Medium Medium Medium High High
Very likely Medium Medium High High High
Figure 10.8 25-box risk severity matrix
The RBS helps in first identifying the macro risks and then the related risks. A risk profile is a
set of questions that attempts to address the traditional areas of problems in a project. Similarly, a
risk repository, which is a historical data of risks identified in a completed project, is considered.
Checklist analysis and expert judgement are also considered for good measure at this stage. The in-
puts of all stake-holders besides the project team are useful at this stage. It must be emphasized here
that the responsibility of the project is not just with the project team but that of all the stakeholders
as well. A categorization of risks such as technical, external, organizational and in project manage-
ment would ensure that all the areas of risk are covered and nothing is left out.
Step 2—Risk assessment: It is the next step in the process where the assessments of all the risks
identified in the first stage are studied. Some risks may be very trivial, whereas some could be quite
serious in nature. This raises an important topic of assessing the project risk on a two-axis scale
with one axis representing the probability of an event and the other axis representing the impact of
the event. The probability of the event helps in evaluating the likelihood of an event and the impact
helps in evaluating the consequence of the event happening. Figure 10.8 highlights the comparison
on a 25-box matrix with some zones representing a major risk and some minor risk. This matrix is
also called risk severity matrix.
The red zone is a ‘no-go zone’, whereas the green zone could be a ‘go zone’. The intermediate
zone could be considered on the basis of individual assessment of the risk and impact possibility. A
scenario analysis is used sometime to identify the impact of a risk. The next step at this stage is to
perform a Failure Mode and Effect Analysis (FMEA) that extends the above analysis to include the
factor of detection of the risk at the appropriate time. Hence,
Risk Value = Impact * Probability of Occurrence * Detection Possibility

Each of these factors is rated on a five-point scale. In case of detection, a low score is given if it is
quite easy to detect the risk and a score of 5 is given if the risk is detected only at a very late stage.
The impact and probability scores are more straightforward and easy to comprehend. This broad
range of quantifiable scores allows for easy stratification of risk on a generally acceptable risk
assessment scheme.
No scheme is without any limitations, and similarly, the weighting of a score 5 in case of impact
and 5 in case of detection are considered equally important which may not be the case. A simple
exercise in number should also extend to a thoughtful discussion on the key events.
Step 3—Risk response strategy: It might seem like a little paradoxical when speaking about a risk
response strategy rather than a risk avoidance strategy. However, the fact that all the risks may not
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434 | Chapter 10
happen is the reason for developing the risk response strategy. Responses to the risk can be broadly
classified as follows:
• Mitigating risk
• Avoiding risk
• Transferring risk
• Sharing risk
• Retaining risk
Mitigating risk would either reduce the probability of the risk or the severity of the risk when it
happens. This is the preferred strategy of all the teams responsible for developing a risk response
strategy. The steps, here, could also help in identifying the root cause of the risk and thus help in
stemming it in the bud. This could result in a permanent solution to the problem too.
Avoiding risk is the option to alter the project plan to eliminate the risk or a condition. Let us say an
organization is considering expansion plans in a country which is likely to see some political upheaval
in the next few years. A decision to drop the expansion plan in this country in favour of a more stable
country could be a risk avoidance strategy. Technology adoption strategy could be another example of
avoiding risks by not using a new technology. The converse of not using a new technology may also
prove to be wrong at times. Nokia refusing to use the Android technology and the consequent results
is well documented.
Transferring risk to another party is common in project parlance. However, this transfer does
nothing to reduce the risk and the only thing that can happen is passing the parcel from one entity
to the other. In projects where construction is necessary, it often gets sub-contracted along with the
safety liability. Insurance might be another form of transferring the risk, but in most cases, it could
be impractical as the insurance firm not being able to quantify the risk might not give it the required
cover. Build Own Operate Transfer (BOOT) projects can also be an example of transferring risk.
Sharing Risk is a matter of collaboration with the project executing party and the project owners.
At times, if the sharing is not clearly defined, then there may be situations where both the parties
refuse to acknowledge their liability in case of an adverse event.
Retaining risk is the conscious decision of the project promoter or project team to accept their li-
ability and retain the risk aspect with them. This might happen when the risks are very large and it is
not feasible to consider transferring the same. Examples include some natural events like a Tsunami
which devastated the Fukushima Nuclear power plant in Japan and was considered a nuclear disas-
ter. While the risk is retained by the project, a contingency plan is drawn, and in an event of the risk
happening, this plan is quickly put into execution.
The more effort given to the risk response process at the beginning of the project, the better it is
for the project. Knowing that the response to risk event will be retained, transferred or mitigated
greatly reduces stress and ambiguity.
Step 4—Risk response planning: After the first three steps are accomplished, a ‘risk-register’ gets
developed. Risk register is a formal document that details all the identified risks including descrip-
tion, category, probability of occurrence, impact, response, contingency plans, owner of risk and
the current status of risk. This register becomes the bible for the last step that is the risk response
planning. There may not be a quick-fix solution to reduce or eliminate all the risks associated with
a project, but some risks can be managed and reduced strategically over longer time frame. In such
cases, we the following implementable action plans:
• Risk description with risk assessment
• Description of the action to reduce the risk
• Owner of the risk action
• Committed completion date of the risk action
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Establishing a change management system to deal with events that require formal changes in scope,
budget and schedule of the project is an essential element of risk control. All risk action plans should
be allotted to the person identified to carry out the action plan. All risk response plans have the
following objectives:
• Eliminating the risk
• Lowering the probability of risk occurrence
• Lowering the impact of the risk on the project objectives
As the risk response plans usually impact time and costs, it is mandatory that the time and cost for
the defined response plans are calculated precisely. At this stage, an assessment can be made whether
the response plan is more costly than the project risk itself! The risk scores before and after the risk
response strategy should be significantly lower. Table 10.1 outlines some examples of risk and a
typical risk response strategy.
Table 10.1 Examples of risks and risk response strategy
Risk Risk Response Strategy

Delay in delivery of hardware • Agree on penalties for the delay with the hardware supplier.
for the project • Evaluate the ways to crash the commissioning cycle on receiving
the hardware.
• Shorten the time for hardware testing.
• Test the hardware at the source by deputing engineers at the
vendor’s place.
Specifications not finalized • Ensure that the project specifications are accepted internally and
before the kick-off date that there are no objections.
• Inform the customer about the possible delay in project
completion due to the delay in finalizing the specifications.
• Make the customer agree that any request in specification
changes after the kick-off date will be treated as change request
and will be suitably charged.
It is imperative that for each risk, a trigger point should be documented and these triggers are the
warning signs. Project managers should monitor the risks just like they monitor the project progress.
Risk assessment and updating should be a part of every status meeting and project review meetings.
Accepting a possibility of a risk is a sensitive factor which must be considered by the management.
Admitting that there is a bug in the code developed or that the new software developed is not com-
patible with the existing systems reflects poorly on the developer and therefore goes unreported. If
the prevailing system is harsh to punish mistakes, then no one would be forthcoming with these
risks. If, however, the system encourages reporting of such risks, then the risk response strategy
would be better implemented. The tendency to suppress bad news is compounded when individual
responsibility is vague and there are extreme delivery pressures. Problems should be embraced and
not denied.
Risk efficiency measurement deals with capturing the data on risks during project closure stage
and analyzing the risk response strategies to each of these risks in hindsight. The lessons learnt are
then part of the organization’s lessons learnt database. Key issues such as the ratio of risks that
occurred to the number of risks that were identified, impact severity of the risks as estimated or
not, how many risks occurred, actual problems and risk response strategy differences if any, are
considered.
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436 | Chapter 10
At the last stage, a risk audit is undertaken by experts to enhance, if required, the effectiveness
of risk management in the organization. The risk audit team should evaluate the following factors:
• How good are we at identifying risk?
• Exhaustiveness and granularity of the identified risks
• Effectiveness of mitigation and contingency plans
• Linkages of project risks to the organization risks
The difference of the risk audit from the financial audit is that this audit is not a compliance audit.
Rather it is an audit to enhance the quality of risk identification and risk analysis capability of an
organization. A benchmark of good practices does get evolved after such risk audits. Some of the
key deliverables for the technical experts performing the risk audit are as follows:
• Customized check list to evaluate the risk of a project.
• Identify the important risks or conduct a risk taxonomy.
• Top 10 risks for the project that requires significant focus monitoring and attention.
• Risk radar or identifying the risk-prone areas for the project.
Summary
Risk management is becoming the most challenging aspect for managing software projects in par-
ticular and all other projects in general. No one can predict the future; nevertheless, the process of
risk management dwells upon a simple and streamlined process to predict project uncertainties, its
impact and suitable ways to overcome it. An efficient risk management helps in avoiding crisis situ-
ations and records efficiently the learning from the past mistakes/failures. The bottom line is that
project managers and team members need to be vigilant in monitoring the potential risks and iden-
tify new land mines that could derail a project. Risk management has to be a key point of interest
for the project management team. Although largely a subjective topic, some amount of quantitative
aspects in risk management help in taking the right decisions early. A contingency plan towards risk
mitigation helps in achieving the project objectives within the time and cost estimates. Risk manage-
ment is an iterative process that occurs throughout the life span of a project.
KEYWORDS
• Risk management process • Mitigating risk

• Risk register • Contingency planning
• Scenario analysis • Risk breakdown structure
• Decision tree analysis • Risk severity matrix
• Hillier model • Transferring risk
• Sensitivity analysis • Risk audit
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Re v i ew Q u est i o n s
1. Do you agree with the statement, ‘Project risks are futuristic and hence can never be fully
identified’? Give reasons.
2. How are financial risks and project-related risks different? What are the approaches to these
risks?
3. Explain the concept of Hillier’s Model for financial risk management in depth.
4. Are scenario analysis and simulation analysis one and the same? Discuss your reason for
agreement or disagreement.
5. What are the stages of risk management process and how is it linked with the project life
cycle?
6. Explain the meaning of risk register.
7. What is the difference between mitigating a risk and contingency planning?
8. Explain the four stages of risk management process.
9. List out the disadvantages of the simulation technique in assessing the financial risks.
10. Explain any two methods of financial risk management.
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Chapter
11 reaL OptiOns: OptiOns tO

enHanCe prOJeCt VaLue
LeARNiNG OBJeCTiveS

❍ Describe options and options payoff before the end of their time limits.
❍ Understand the basic difference between options of traded securities and real estate
options which are ill-traded.
❍ Understand the working of the Simple Binomial Model.
❍ Understand the limitations of the Black and Scholes Model in the absence of an underlying
security.
❍ Explain how we could use the Binomial and Black and Scholes Model for real value options.
We will maintain our highly disciplined approach to capital spending. Our objective
remains to maximize return on every dollar we invest—and to invest where we find the
very best growth opportunities.
—Richard C. Notebaert,
Chairman and CEO, Ameritech
Finance theory properly applied is critical to managing in an increasingly complex and

risky business climate... Option analysis provides a more flexible approach to valuing our
investments... To me, all kinds of business decisions are options.
—Judy Lewent, CFO, Merck
intrOduCtiOn
To understand the concept of real options and how real options can enhance the value of a project,
one must understand the concept of ‘options’. The simplest way to explain the meanings of these and
other related terms is to take the help of the stock markets where the terms ‘futures and options’ are
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440 | Chapter 11
frequently used. The origin of the term ‘futures and options’ can be traced to the financial markets of
the last quarter of the twentieth century and are now used to refer to many products, including pro-
jects. To bring in a little more perspective to the term used in projects, ‘real options’, (which business
managers have been making in capital investment decisions for centuries), is a term that is relatively
new and was coined by Professor Stewart Myers of the MIT Sloan School of Management in 1977.
Today, real options are one of the active fields of academic research. Many influential books and
several articles have been published by Professor Lenos Trigeorgis of the University of Cyprus on
this subject. Some other pioneering academicians in this field are Professors Eduardo Schwartz and
Michael Brennan. The Annual International Conference on Real Options organizes many academic
conferences on this interesting subject. The concept of real options was first popularized by Michael
J. Mauboussin, the chief US investment strategist for Credit Suisse First Boston. He used the term to
explain the gap between how the stock market visualizes some businesses and thereby prices the stock
vis-à-vis the intrinsic value for those businesses. Trigeorgis broadened exposure to real options, and
termed it as real options valuations or ROV through layman articles in publications such as The Wall
Street Journal. No MBA curriculum in reputed business schools is complete without a course on
ROV, which is self-explanatory of the importance of this concept.
Futures and Options

Futures and options (F and O) are two of the most commonly used derivatives and are actively
traded on most stock exchanges. Derivatives are financial instruments that derive their value from
an ‘underlying’ asset, which can be a stock (or shares) issued by a company, an exchangeable cur-
rency (like the Dollar or Euro), gold, project for extracting petroleum products or natural gases such
as the KGD-6 project of Reliance Industries. The derivative instrument does not require trading in
the underlying assets; however, the value of the derivative instrument changes according to changes
in the value of the underlying asset. This is but natural because the derivative is derived on the basis
of the value of the underlying asset. The derivative, thus, offers three primary advantages. First, the
physical ownership of the underlying asset as a mode of exchange is not required, which means
when buying a stock derivative, physical possession or ownership of stock is not necessary. Second,
the ease of trading without physical delivery or possession makes the derivative much more conven-
ient to trade and hence additional interest (and therefore, volumes providing liquidity) in such trade.
The third advantage is that the derivatives provide leverage. One can control a large holding in an
asset for a small amount of money. Since one can participate in the gain from the price movement
of the underlying asset for a fraction of the cost of the asset, it can significantly increase the rate of
return as the benefit is on a large volume of the asset without investing in the asset per se. At the
same time, the risk of an under performing asset derivative is much higher than the asset itself.
Derivatives can be of two types—exchange-traded derivatives and over the counter derivatives.
Exchange-traded derivatives, as the name signifies, are traded through organized exchanges glob-
ally. These instruments can be bought and sold through these exchanges, just like stocks are pur-
chased and sold on the stock market. Futures and options are some of the common exchange-traded
derivative instruments. Over the counter derivatives (popularly known as OTC) are not traded
through exchanges. They are not standardized and have varied features. Some of the popular OTC
instruments are forwards, swaps, swaptions, etc.
Futures
A ‘future’ is a contract to buy or sell the underlying asset for a specific price at a predetermined time.
If someone buys a futures contract, then it means that he/she promises to pay the price of the asset
at a specified time. If someone sells a@Seismicisolation
future, then he/she effectively makes a promise to transfer the
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Real Options: Options to Enhance Project Value | 441
asset to the buyer of the future at a specified price at a particular time. Every futures contract should
have the following key features:
1. Buyer
2. Seller
3. Price
4. Expiry
Some popular assets on which futures contracts are available are equity stocks, indices, commodities
and currency.
The difference between the price of the underlying asset in the spot market and the futures market
is called ‘Basis’. This is because a ‘spot market’ is a market for immediate physical delivery. The basis
is usually negative because the price of the asset in the futures market is generally more than the
price in the spot market. This is because of the interest cost, storage cost, insurance premium, etc.,
that is, if you buy the asset in the spot market, then you will be incurring all these expenses which
are not needed if you buy a futures contract. This condition of the basis being negative is called
‘Contango’.
At times, it is more profitable to hold the asset in physical form than in the form of futures. For
example, you will be eligible to receive dividends when equity shares are held in your account, but
you will not be eligible to receive dividends when you hold equity futures.
When these benefits overshadow the expenses associated with the holding of the asset, the basis
becomes positive (i.e., the price of the asset in the spot market is more than in the futures market).
This condition is called ‘backwardation’. Backwardation generally happens if the price of the asset
is expected to fall.
It is common that as the futures contract approaches maturity, the futures price and the spot price
tend to close in the gap between them, that is, the basis slowly becomes zero.
Options
Options contracts are instruments that give the holder of the instrument the right to buy or sell the
underlying asset at a predetermined price, but not an obligation to do so. This facility is available at
a price. An option can be a ‘call’ option or a ‘put’ option. A call option gives the buyer the right to
buy the asset at a given price, but not an obligation to do so. This ‘given price’ is called ‘strike price’.
It should be noted that while the holder of the call option has a right to demand the sale of an asset
from the seller, the seller has the obligation to sell but cannot demand the buyer to buy the asset.
For example, if the buyer wants to buy the asset, the seller has to sell it. The seller does not have the
right to demand a sale from the buyer. The buyer pays a premium for the option, which is foregone
if he/she does not exercise the right (and thus, the loss is limited to the premium paid). For the seller
of the option, the premium paid is the minimum assured gain. It is only fair that for the facility of
not having an obligation to buy, the buyer pays a premium and the seller who takes the obligation
to sell received the premium.
Similarly, a ‘put’ option gives the buyer a right to sell the asset at the ‘strike price’ to the buyer,
but not an obligation to do so. Here, the buyer has the right to sell and the seller has the obligation
to buy.
Therefore, in any options contract, the right to exercise the option is vested with the buyer of the
contract. The seller of the contract has only the obligation and no right. As the seller of the contract
bears the obligation, he/she is paid a price called ‘premium’. Therefore, the price that is paid for buy-
ing an option contract is called premium.
The buyer of a call option will not exercise the option (to buy) if, on expiry, the price of the asset
in the spot market is less than the strike price of the call. For example, A bought a call at a strike
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442 | Chapter 11
price of `500. On expiry, the price of the asset is `450. A will not exercise his call because he can
buy the same asset from the market at `450, rather than paying `500 to the seller of the option.
The buyer of a put option will not exercise his/her option (to sell) if, on expiry, the price of the
asset in the spot market is more than the strike price of the call. For example, suppose B bought
a put at a strike price of `600. On expiry, the price of the asset is `619. B will not exercise his put
option because he can sell the same asset in the market at `619, rather than giving it to the seller of
the put option for `600.
Real Options
Real options are a kind of options on real assets that can be defined as opportunities to respond to
various changing circumstances that a project may be exposed to. Real options offer opportunities
to changed circumstances where the organization can exercise its rights if the situation is favourable
or not and be obliged to exercise its rights should the situation be unfavourable.
Let us assume that we are setting up a low-cost small car project similar to Tata Nano. The time
taken to conceive, design, construct, execute and run a manufacturing set-up could be three years on
a minimum. Now, within these three years that the project takes to shape up, the customer prefer-
ences may change or there could be other competitors or the situations envisaged could be radically
different than those conceived at the beginning of the project. There is also a possibility that the
situation after three years would be much favourable such that a competitor or a global manufac-
turer of small cars would be keen to pick up a stake in the project or purchase the project outright.
In such circumstances lies the utility of real options, where various future opportunities are quan-
tified in today’s monetary value using the options pricing model. The possibility of identifying the
time period when these options yield optimum results is also available. Net present value (NPV) and
internal rate of return (IRR) were the discounted cash flow techniques used to evaluate the profit-
ability of the projects thus far. The over-reliance on the discount cash flow modelling often ignores
the options and the future managerial flexibility that accompany these real options. Furthermore,
due to changes possible in the future, added advantages can be derived from planning real options
in the best possible manner.
Like financial options, there are two kinds of real options, namely the real call option and the
real put option. A real call option gives the firm an option or an opportunity to start the project but
without any compulsion. It would call on the company to make a small investment (premium) in
the concerned project. These options can be utilized at the right time to avail of profits if there is an
opportunity in the future as per initially envisaged. Alternatively, these options can be postponed
for a future time to reap maximum benefits. In case of a real put option, the company can decide to
scrap the project for some salvage value, if it observes that continuing with the project is not profita-
ble. Therefore, the real options route opens an altogether different dimension in the project viability
analysis and capital budgeting mechanism. A firm may end up paying an extra premium on the real
option but stands to gain in the face of uncertainty.
American Options versus European Options

The American option is extremely flexible in that the option can be exercised (or settled) within the
maturity period. However, the European options can be settled only on the date of maturity and not
before that. Therefore, the American option offers convenience and protection from wild swings,
which might affect the profitability of the options, whereas the European option becomes risky as a
long time gap is encountered before settlement. The anytime settlement option in case of American
options also adds another dimension, which is that of optimal time period for exercising this option.
This assessment can be a tougher assessment than accepting the reality on the date of maturity, as
in the case of European option. @Seismicisolation
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Utility of Real Options

At times, a project with a negative NPV could be abandoned for obvious reasons but when the stra-
tegic NPV is considered, it might look meaningful to make investments. The strategic NPV is given
by the formula:
Strategic NPV = Conventional NPV + Real Options Value (ROV)
This means that if the real options value is sufficiently high, then it can negate a negative conven-
tional NPV, making the strategic NPV positive and hence worthy of consideration.
A company like Mahindra and Mahindra Ltd acquires REVA Electric Vehicles Ltd or Kinetic
Engineering Ltd, manufacturing scooters and motorcycles not just because the acquisition makes
a positive NPV, but because these acquisitions aid the long-term strategy of being a full-range au-
tomobile manufacturer. In such acquisitions, if the guiding parameter was conventional NPV, then
these acquisitions would never be made. It is logical to assume that the current owners would have
tried everything at hand to make their respective businesses profitable and there is nothing extra
that an acquirer (M&M in this case) could suddenly bring to the table which has hitherto not been
tried. The options pricing model helps in valuing the option the acquirer possesses (and the value it
brings) in becoming a full-range automobile manufacturer.
Key Differences between Financial Options and Real options

Some key differences between financial options and real options are enumerated here.
1. The first key difference is that the information required for valuing options and making cal-
culated decisions is readily available for financial options than real options. For example, a
holder of the call option of ONGC or L&T can look at the current stock prices, the trends in
the global market, the sentiment of the American markets, the performance of the ADR and
the GDR belonging to these companies and decide on the best course of action. However, the
value of an untested strategy related to the acquisition, as in the case of Mahindra and Ma-
hindra Ltd, cannot be read off from an NSE screen.
2. While the right to exercise a financial option is unambiguous, the holder of a real option is
unclear about the rights, the obligation and the period of validity for the right.
3. The value of a call option depends on the variability of stocks with a preference given to
stocks with higher variance or variability. In case of real options, the variability cannot be
completely defined and if there is a choice between Project A and Project B, then deciding a
better investment proposition on the basis of variability is difficult.
4. In case of call options on stocks, the payout of dividend reduces the stock price, whereby the
call option becomes less valuable as compared to the put option. Such analysis of escalation
in case of real options (premium commanded on land where the acquired company is based)
becomes difficult to compute.
How Options Work

We now understand that an option is a special contract where the option’s owner enjoys the right
to buy or sell something without any obligation to do so, for a premium and that the maximum loss
would be limited to the premium that is paid. A writer of a call option collects the option premium
from the buyer (or holder) of the option. In return, he/she is obliged to deliver the shares in case the
option holder prefers to exercise such options. If the stock price at the end of the expiration period
is less than the exercise price, then the buyer of the option will not exercise the option, and thus, the
writer of the option gains the premium. If, on the other hand, the stock price at the end of expiration
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444 | Chapter 11
period is more than the exercise price, then the buyer of the option will exercise the option, and thus,
the writer of the option loses an amount equal to the difference between the market price and the
exercise price minus the premium.
Three terms are used to describe the buyer’s status—ATM – at the money, ITM – in the money
and OTM – out of the money. The market price vis-à-vis the exercise price for the call and put op-
tion for the three terms are tabulated in Table 11.1.
Table 11.1 Terms and difference in positions for call and put options
Term Call Option Put Option

ATM Exercise price = Market price Exercise price = Market price
ITM Exercise price 6 Market price Exercise price 7 Market price
OTM Exercise price 7 Market price Exercise price 6 Market price
The value of a call (or put) option, if exercised immediately on buying, is termed as the ‘intrinsic’
value of the call (or put) option. The excess of the market price of the call option over the intrinsic
value is termed as the ‘time value’ of the call option. Suppose the market price of an L&T share is
`1,500 and the Exercise Price of the L&T call option is `1,400 and the market price of an L&T call
option is `150. Then the intrinsic value is market price – exercise price, which in this case is `100.
The time value of the option is the market price of L&T call option – intrinsic value, which is 150
- 100 = `50.
Similarly, in case of the put option, the difference of put offer market price and the intrinsic value
is termed as time value of the put option.
Figures 11.1 and 11.2 show some data on the call and put options on the American stock markets
and the Indian NSE site.
The closing price of ONGC stock on the National Stock Exchange was `263 on 30 August 2011.
Therefore, all the call options, which were purchased for lower than this amount are ITM and are
highlighted, whereas all the put options purchased above this closing price are ITM. Therefore, the
highlighted area on the put side and the highlighted area on the call side are on the opposite sides
of the closing price.
Figure 11.1 Data of Alliant Energy call and put option on the American stock market
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Figure 11.2 Data of ONGC call and put options on the National Stock Exchange
Pay-off Calculations
Pay-off a call option: The call option of the American type gives the option holder the right to buy
an asset at a fixed price during a certain period, unlike a European call option when the right to buy
can be exercised only at the end of the expiration date or on maturity. In case of projects, the real
call option would be similar to the European type call option (i.e., options exercised at the end of
the time period), as the time taken to exercise the right of buying an asset would be a substantial pe-
riod of time. Operationally, though the real call option might be American type, the substantial time
required to fructify the results of waiting to exercise the call option would give the real call option
features of a European call option. However, to explain the payoff features, we will limit our expla-
nation to a stock call option as in use in the Indian derivatives trade, which is of the American type.
Let us consider the case of ONGC call option, prior to the stock-split and bonus issue on 31
January 2011. A typical ONGC call option entitles the investor to buy 250 shares of ONGC on
or before the maturity date or expiration date at, say, a strike price of `B. It is quite possible that
in the period before maturity, the company might issue a stock split and a bonus stock. To provide
protection to the option holder, the option contract generally specifies that the exercise price and
the number of shares would be adjusted for stock splits and stock bonuses, although no adjust-
ments are made for cash dividends since the holder of the call option is not entitled to any dividend.
Annexure 1 to this chapter shows a circular issued by the National Stock Exchange in respect to
these adjustments. The ONGC stock split in the ratio 10:5 and further on the split stock 1:1 bonus
was announced, which effectively reduced the exercise price to `B/4 and the number of shares in the
call option to original number of shares multipied by 4.
The payoff of a call option C depends on the stock price, S1 (we use a subscript 1 to denote stock
price after time period 1. Accordingly, a subscript 0 denotes the stock price in period 0 or on the date
on which the call option was purchased) and the exercise option E.
C = S1 - E, when S1 7 E
or C = 0, when S1 6 E.
This means that C = Max (S1 – E, 0). It should be remembered that when the payoff is 0, it means
that the price of the call option or the premium is forfeited and there is a net loss of that amount.
Furthermore, the number of shares in every lot of call option multiplies the pay-off and also the
losses on account of premium. Consider the example of ONGC call option explained next.
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446 | Chapter 11
The ONGC call option each comprising 1000 shares was purchased when the stock price was
`250 with an option premium of `28.50, and a strike price of `300 then the total (max) loss on
account of premium paid is 28.50 * 1000 = `28,500. If, within the expiry period or on the date of
maturity, the prevalent stock price (S1) was `350, then the net gain is:
(S1 - E) * Number of shares in a lot - premium paid
= (350 - 300) * 1000 - 28,500 = `21,500
For analysis and discussion, the premium paid (and forfeited) is not considered, and hence, when-
ever S1 … E, the call is said to be OTM and is worthless. When S1 7 E, the call is said to be ITM and
the value is S1 - E.
Pay-off a put option: The pay-off of a put option just before the expiration depends on the relation-
ship between the exercise price E and the price of the underlying stock S1. If S1 Ú E, then the put is
said to be OTM and is worthless. When S1 6 E, the put is said to be ITM and the value is E - S1. Put
differently, the pay-off of the put option is Max (E - S1, 0).
FACTORS DETERMINING OPTION VALUES

Before we identify and discuss the factors determining the option values, it is important to know
the lower and the upper limits or bounds for option values. The lower bound at which the call op-
tion will ever sell (either before the expiration date or maturity date) is max (0, S0 - E), where S0 is
the price of the stock when the call option is purchased, E is the strike price. Therefore, C0 which
is the value of the call option in period 0, will never fall below zero, which addressed the situation
when S0 6 E. The value of the call option, C0 also cannot fall below S0 - E, when S0 7 E. If the second
case was not true, then everyone would have purchased the call option and sold it immediately for
profit. (Such opportunities arise at times, which is termed as arbitrage, but once again the arbitrage
opportunity is too little and very infrequent).
The upper bound or limit of the call option cannot be greater than the stock price, S0, else the
buyer would prefer to buy the stock in the cash market at a lower price. Therefore, the value of the
call option, C0, in time period 0 should be Max (S0 – C0, 0) … C0 … S0.
The exact location of the call option value, C0, would depend upon the five key factors as follows:
1. Exercise price
2. Expiration date
3. Stock price
4. Stock price variability
5. Interest rate
Let us consider the effect of all these factors on the options value.
Exercise price: The higher the exercise price, the lower would be the value of the call option. The
value of the call option would be positive if there is some possibility that the stock price would be
higher than the exercise price before the expiration date. If the exercise price is already set high, then
the chance that the stock price exceeds this Exercise price before the expiration period is less, and
hence, the value would be lower.
Expiration date: Other things remaining same, a call option with a longer expiration date would be
preferred as a longer time frame gives more flexibility for options to be squared. Hence, the value
of a call option with a longer expiration date is more than the value of a call option with a shorter
expiration date.
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Stock price: The value of the call option is based on the stock price on the day of purchase of call
option. Hence, the higher the stock price, higher would be the value of the call option.
Variability of stock price: A call option becomes interesting when the stock price within the expi-
ration period exceeds the strike price significantly. A stock with higher volumes and more fluctua-
tions (meaning higher variability) has a higher tendency to exceed the strike price significantly as
compared to a stock which has low variations, is relatively stable and fluctuates in a narrow range.
Hence, stocks with a higher volatility or variance component would be preferred (or considered of
higher value) over those stocks who have limited volatility.
Interest rate: Whenever a call option is purchased, the full price of the stock is paid only when one
decides to exercise the option at a future date. Conversely, if someone was to purchase the stock in
the cash market, then he/she would have to bear the interest burden from the starting date itself.
Therefore, in the call option, the payment, if any, is made only in the future. Therefore, the higher
rate of interest would give higher returns for funds not blocked by purchases, although there is an
option for future purchase (and to that extent the stock is blocked in your favour) with the attended
benefits of a full cash purchase. The higher the interest rate, greater would be the benefit from de-
layed payment facility of a call option and likewise lesser the interest rate, lesser would be the benefit
from delayed payment facility of a call option.
We can, thus, conclude from the above discussion that the effect of each of the key elements on
the call option value C0 is as follows:
S0 – y,
E – v, Variation – y, Expiration Date – y, Interest Rate – y
At this stage, we have only identified the influence of each of these parameters on the call option
value, but the precise relationships between these variables and the value of the call option was de-
veloped by Fisher Black and Myron Scholes in their now celebrated model known as Black–Scholes
model. (Fisher Black and Myron Scholes – ‘The pricing of Options and Corporate Liabilities’,
Journal of Political Economy, Vol–81, May–June 1973). We will refer to this model after discussing
the binomial model for options valuation.
BINOMIAL MODEL FOR OPTIONS VALUATION

While calculating the NPV in the earlier chapters, we used two steps. First, the cash inflows for the
future years have been computed and these cash inflows were discounted to the present day using
an appropriate cost of capital. Can we apply a similar procedure to find the NPV of a call option?
The answer, in this case, is an emphatic ‘No’, because the future value of the call option or the cash
inflows due to call options depends upon the stock price on the day of maturity (in case of European
call option) or changes in the entire period of validity (in case of American call option) with changes
in the underlying stock price. Furthermore, the element of the opportunity cost of capital is also
indeterminate as it changes every time the underlying stock price changes.
Does it now mean that the options cannot be valued at all? Once again, the answer is ‘No’,
because of the pioneering work was done by Fisher Black and Myron Scholes in 1973. The basic
idea underlying their model is to set up a portfolio which imitates the call option in its payoff.
This pay-off is referred to as option equivalent pay-off as it tries to imitate the returns from a
call option. The working of the Black–Scholes model is explained using a simple single period
binomial model, which would have only two states of the outcome.
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448 | Chapter 11
Options Equivalent Method

Consider Figure 11.3.
Stock Price
S1 = h S0
Period 1
Stock Price
S0
Period 0
Stock Price
S2 = l S0
Period 1
Figure 11.3 Binomial model
1. The stock currently selling for price S0 can take two possible values next year, S1 or S2, based
on whether there is an increase in the price or a decrease in the price. S1 = h S0, where h is the
percentage increase in the share price and S2 = l S0, where l is the percentage decrease in the
share price after 1 year. A 40% increase in share price is shown as h = 1.4 and a 10% decrease
in share price is shown as l = 0.9. At times the value of h and l are given in absolute form and
not in percentages. Further h S0 7 l S0.
2. An amount of B can be borrowed or lent at the risk-free interest rate r. The interest factor R
= (1 + r) is used for the sake of simplicity.
3. The value of the interest factor, R, is greater than l but lower than h. Therefore, l 6 R 6 h. This
condition ensures that the investor has to take some risk to aim for a return of h and that the
system does not provide for a risk-free arbitrage.
4. The exercise price of the call option is E.
The value of the call option, when the share price increases is Ch = Max (S1 – E, 0) = Max (h S0 –
E, 0).
Similarly, the value of the call option, when the share price decreases is Cl = Max (S2 – E, 0) = Max
(l S0 – E, 0).
Note: It is not necessary that the share price decreases below the price when the call option was pur-
chased. It can also increase but the rate of increase is lower and less than the interest factor. Hence,
even in the case of Cl, we consider = S2 – E and not E – S2.
If the call option comprises X number of shares and the amount of borrowing is `B for this invest-
ment, then the equivalent pay-off is considered identical to the pay-off of a call option at period 1.
If the stock price increases: X h S0 - R B = Ch Equation 11.1
If the stock price decreases (or increases at a very low rate):
X l S0 – R B = Cl Equation 11.2
Solving these two equations, we get the value of X and B as follows:
Ch − Cl Spread of possible option prices
X= = Equation 11.3
S0 (h − l ) Spread of possible share prices
lCh − hCl
B= Equation 11.4
(h − l )R
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X is referred to as the option delta or hedge ratio. As the portfolio consists of X shares and B debt
and has a same pay-off as that of a call option, the value of the call option is C = X S - B. This
method is termed as the option equivalent method.
Example 11.1
Consider the following data for ONGC stock. S = `265, h = 1.4, l = 0.9, E = `290, r = 10%,
R = 1.10. Find out the values of Options Delta, X and amount of debt, B that can be availed to
purchase the Options Delta, X.
Solution:
Let us first compute Ch, the value of call option before expiration, when the stock price has gone
up to h S and Cl, the value of call option before expiration, when the stock price has reduced to l S.
Ch = Max (S1 - E, 0) = Max (h S0 - E, 0). In this case,
Ch = Max (S1 - E, 0) = Max (265 * 1.4 - 290, 0)
= Max (371, 0) = `371
Similarly, Cl = Max (S2 - E, 0) = Max (l S0 - E, 0).

In this case, Cl = Max (S2 - E, 0) = Max (265 * 0.9 - 290, 0)
= Max (-51.5, 0) = `0
From Equation 11.3, we have,

X= =
X = (371 - 0)/265(1.4 - 0.9) = 2.8
From Equation 11.4, we have,
lCh − hCl 0.9 × 371 − 1.4 × 0

B= = = ` 607.09
(h − l )R (1.4 − 0.9)1.10
The portfolio should contain 2.8 shares for which the amount of money that has to be borrowed
is `607.09
The value of the call option computed by the option equivalent method is C = X S – B = 2.8 *
265 – 607.09 = `134.91
The current stock price (`265) has the effects of a pessimistic view and optimistic view factored
in, and hence, the value of the call option `134.91 today would be acceptable to both an optimist
(bull) and a pessimist (bear) in the stock market. If the value of the call option is priced more than
`134.91, then someone can sell a call option and purchase 2.8 shares of ONGC with borrowed
funds (at 10% rate of interest) and make a profit. If the value of call option is priced lower than
`134.91, then one can earn profit by selling 2.8 shares of ONGC, lending this amount at 10%
interest and buying a call option.
Risk-Neutral Method
In the solution to Example 11.1, we calculated the price of the call option without considering the
risk appetite of the investor. The price of the call option, as discussed earlier, does not depend on the
investors’ risk appetite, and hence, an alternative method called the risk-neutral method can be used
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450 | Chapter 11
to compute the value of the call option. In this method, we assume that the investors are risk-neutral
and that the expected future value of a stock call option can be converted into its present value by
using the risk-free rate. Considering Example 11.1, if the investors are risk-neutral, then the returns
from the ONGC stock would be the same as the returns from risk-free interest.
Expected return on ONGC stock
= Probability of rise * h + (1 - probability of rise) * l = 10%
If we denote the probability of rise by p, then we have,
0.4 p + (1 - p) (-0.1) = 0.1.
Solving this for p, we have p = 0.4. This is called the risk-averse or risk-neutral probability.
Therefore, when investors are risk-averse or risk-neutral, the value of the call after time period 1 is,
Probability of rise * Ch + (1 - probability of rise) * Cl
= 0.4 * Ch + (1 - 0.4) * Cl
= 0.4 * 371 + 0.6 * 0 = `148.4
This value of the call option is at the end of period 1, and hence, the present value of this call option
is `148.4/1.10 = `134.91.
As seen here, this present value of the call option is exactly similar to the one obtained by the
option equivalent method. Therefore, we can conclude that there are two methods of calculating the
option value if the world was binomial.
Black–Scholes Model
In the binomial model discussed in Section 11.4, there were two outcomes of stock prices at the
end of a certain time period, which was considered sufficient enough for calculation of interest.
This meant that the time horizon was one year (or one month/quarter/half-year, etc.). If we as-
sume that there are two possible outcomes at every mid-period or every fourth of a period, then we
get more frequent changes in the time period and a wider range of year-end or period-end prices.
Furthermore, we could also consider the situation where the prices change more or less continu-
ously which would lead to the continuum of possible prices at the end of a period (which could be
one year). Theoretically, we can also set a portfolio for this situation having a pay-off equal to that
of a call option at the end of a period in which case the variability of the stock prices would end up
playing a key role.
Fisher Black and Myron Scholes had a solution for this unwieldy situation of continuum of prices.
This model is named the Black–Scholes model. Their formula is:
E
C0 = S0 N (d1) − N (d2 ) Equation 11.5
e rt
where N (d1) and N (d2) are cumulative density function for d1 and d2 the values of which are calcu-
lated as given below:
  S0   1  

l n   + r + σ 2  t 
  E   2  
d1 = Equation 11.6
σ t
d 2 = d1 − σ t Equation 11.7
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S0 = is the price of stock at the time of issue of call option

E = Exercise price
e = Napier’s base or base of natural logarithm
r = continuously compounded risk-free annual interest rate
t = the time period to call option expiration
ln = the natural logarithm
s = standard deviation of the continuously compounded annual rate of return on the stock
In the above formula, only the standard deviation, s, needs to be calculated, whereas the other
requirements in formula are available in the problem itself. Moreover, the value of the call option is
not influenced by the risk appetite of the investor or the expected return on the stock.
Although the above Black–Scholes formula puts some sensibility in an otherwise complex scenario,
it makes a few assumptions as follows:
1. Stock pays no dividends.
2. Option can only be exercised upon expiration, which means that the options are basically
European options.
3. Market direction cannot be predicted, hence ‘random walk’.
4. No commissions are charged for transactions and there are no tax liabilities such as turnover
tax. Similarly, there are no penalties for short-selling and no restrictions on short-selling.
5. Interest rates remain constant and are known.
6. Stock returns are normally distributed, which mean volatility is constant over time and the
stock prices are continuous.
Known limitations of the Black–Scholes Model

The first assumption that the Black–Scholes Model makes is that the risk-free rate and the volatility
of the underlying stock is fairly constant. This is not correct as risk-free rate and volatility depends
to a large extent on the market conditions and fluctuates accordingly.
Second, the Black–Scholes Model assumes that stock prices are not subject to knee-jerk reactions
and the increase or decrease in stock prices is generally gradual and continuous with a trend.
However, at times, the stock price movements are anything but continuous and large fluctuations
are (such as those seen after a merger announcement) common.
Third, the Black–Scholes Model assumes that no dividends or bonus shares are issued till the
date of expiration or in other words, the issue of bonus shares or dividends does not play a role in
valuation of the derivatives.
Fourth, the concept of stock price volatility is an estimate made by the analyst and is not based
on direct observation, as in the case for the other inputs.
Fifth, there is a tendency in the Black–Scholes Model to overvalue deep out-of-the-money calls
and undervalue deep in-the-money calls.
Sixth, it is observed that the Black–Scholes Model has a tendency to misprize options which
involve high-dividend paying stocks.
To overcome these shortcomings, ARCH or Autoregressive Conditional Heteroskedasticity
was developed as a Black–Scholes model variant. Different models such as GARCH, E-GARCH,
N-GARCH, H-GARCH, etc., were developed later. They incorporated more complex models of
volatility to get as real a picture as possible. However, due to its simplicity and ease of usage, the
classic Black–Scholes model is still very popular with options traders, despite the known limitations
explained above.
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452 | Chapter 11
Example 11.2
Using the Black–Scholes model, find the present equilibrium value of the call option, when the given
data is known,
1. Present price of stock, S0 = `100
2. Exercise price, E = `80 (Note that this call option is an European Call option, which means
the exercise price can be exercised only on the last day of the expiration period. If this call was
an American call, then the call option purchaser would have cashed it immediately.)
3. Standard deviation of continuously compounded annual returns, s = 0.35
4. Period to maturity, t = 0.4 years. (Note that if the risk-free interest rate is expressed in years,
then the period to maturity should also be in years.)
5. Risk-free interest rate = 14% per annum
Solution:
First, we calculate the value of d1 and d2 as given in Equations 11.6 and 11.7.
  S0   1  
l n   + r + σ 2  t 
  E   2  
d1 =
σ t
  100   
l n   + 0.14 + 1 0.352 × 0.4

  80   2 
 
d1 =
0.35 × SQRT (0.4)
= 1.3715
d 2 = d1 − σ t = 1.3715 − 0.35 × SQRT (0.4) = 1.150
Next, we find N (d1) and N (d2) which represent the probabilities that a random variable following
a standard normal distribution will assume values less than d1 and d2. We gather these values from
the Z table on normal distribution:
N (d1) = 0.9147 and N (d2) = 0.8531
Next, we obtain the equilibrium value of the call option at present, using the Black–Scholes formula
given in Equation 11.5.
E 80 × 0.8531
C0 = S0 N (d1) − N (d2 ) = 100 × 0.9147 − 0.14×0.4
e rt e
C0 = ` 26.94
Therefore, the present equilibrium value of the call option using the Black–Scholes formula is `26.94.
Example 11.3
Using the Black–Scholes model, find the present equilibrium value of the call option, when the below
given data is known:
1. Present price of stock, S0 = `1500
2. Exercise Price, E = `1,600
3. Standard deviation of continuously compounded annual returns, s = 0.85
4. Period to maturity, t = 0.1 years
5. Risk-free interest rate = 11% per annum
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Solution:
  S0   1  

l n   + r + σ 2  t 
  E   2  
d1 =
σ t
  1500   
l n   + 0.11 + 1 0.852 × 0.1
  1600   2  
d1 = 
0.85 × SQRT (0.1)
= −0.0647
d 2 = d1 − σ t = −0.0647 − 0.85 × SQRT (0.1) = −0.3334
a standard normal distribution will assume values less that d1 and d2. We gather these values from
the Z table on normal distribution:
N (d1) = 0.4761 and N (d2) = 0.3707

E 1600 × 0.3707
C0 = S0 N (d1) − N (d2 ) = 1500 × 0.4761 −
e rt e0.11×0.1
C0 = ` 127.52
Therefore, the present equilibrium value of the call option using the Black–Scholes formula is
`127.52.
TYPES OF REAL OPTIONS

Taking an options-based approach is not simply a matter of using a new set of valuation equations
and models. It requires a new way of framing strategic decisions. The observation here is not the
gain when moving from point A to point B, but the gain due to the various alternatives or options
that open up when transgressing the path from point A to point B. Each of the alternatives that open
up or could be explored would have some benefits and some losses associated with it and the net
gain of these alternatives is of interest.
The first step in reorienting strategic thinking, therefore, is to identify the real options that exist
in investment decisions involving some real assets. It should be remembered that uncovering real
options is much more difficult than uncovering the financial options, which are well defined. Unlike
financial options, real options are not precisely defined or beautifully packaged but do exist in almost
every business decisions. Furthermore, they tend to take a limited number of forms and by under-
standing these forms, managers can become better apt at spotting the options in their own decisions.
Some common types of real options are enumerated in the examples listed here.
Timing options: In case of traditional NPV analysis, the decision is close-ended, which means that
either we end up selecting the project when NPV is positive or we end up rejecting the project when
the NPV is negative. We do not have an option that the NPV is negative at the time of analysis and
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454 | Chapter 11
could be positive, contingent to the changes happening after two years. Therefore, a third alterna-
tive, which could exist but cannot be considered for obvious reason is the option of ‘wait and watch’
or the option of deferring the investment decision to the future.
Consider the sales of Natural Ice Creams, Mumbai-based no-preservatives manufacturer of fresh
ice-creams, which observes that the sales of ice-cream is surging. Operating at full capacity, the com-
pany is considering expansion of its plant. Launching the expansion would require a big up-front
investment, and the company’s managers cannot be sure that the sales boom will persist. They have
the option of delaying the investment until they learn more about the strength of demand. It may be
that the risk avoided by waiting to invest has a greater value than the sales that might be forfeited by
postponing expansion to their existing plant. Delaying the option of expansion or putting up a new
project is more valuable to a firm which is protected by entry barriers such as proprietary technol-
ogy, patents and licenses, as these factors diminish the threat of competition.
Growth Options: A growth option allows a firm to expand in different business avenues such as de-
bottlenecking existing operations, considering an expansion plan or contemplating newer products
to the existing line of products. The original investment is termed ‘beachhead’ by Michael Porter as
it opens up many new opportunities in the future. M&M invested in the electric car company, Reva,
and is now developing a four-door electric car. Reva Electric cars had developed and marketed only
a two-door electric car.
Amway, that sells household items through a network of independent salespeople, is deciding on
entry into the vast Chinese market. The initial investment to build a manufacturing and sales orga-
nization would be large, but it may lead to an opportunity to sell a whole range of products through
an established sales network. The investment would, thus, create growth options that have value
above and beyond the returns generated by the initial operations.
Staging Options: In this option, the entire investment is not made in one go but in incremental
stages. This ensures that the investment option does not load the finance department with a big
expense at one time. Periodic replacements of worn out machines or retrofitting/repair of existing
machines, expansion projects, etc., can be staggered in favour of costlier variable cost options of
sub-contracting, overtime production, etc.
The top management team at Godrej Appliances Ltd is reviewing a proposal from the senior vice-
president of operations to install a new manufacturing system. The proposal calls for a full, multi-
million rupee rollout at their two manufacturing factories at Mohali and Shirwal over the next two
years. However, the business benefits of the project remain uncertain. The company has the option
to invest in the new manufacturing system in phases rather than the entire investment all at once.
The conclusion of each phase will, in turn, provide further options—for continuing, for delaying or
for abandoning the effort. All these options add value to the proposed project.
Exit Options: Another characteristic of the discounted cash flow method is that when calculating the
cash flow, we presume that the project will continue till the end of its specified economic life. Most
projects may be slightly irreversible but other projects such as an expansion project may offer the
possibility of exiting the project at an early date. Bayer Crop sciences has a patent for a promising
new chemical product, but it is worried about the size of the market opportunity, especially due to
the opposition for genetically modified crops. Additionally, it is unsure whether the manufacturing
process will satisfactorily meet government regulations regarding toxic chemicals. If the company
makes an effort to commercialize the product though, then it will prefer to have the option to
abandon the project if demand does not materialize or if the environmental liability appears huge.
The exit option which could be in the form of launching the same process and product in some other
country increases the value of the project because it reduces the size of the investment at risk.
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Flexibility options: An alternate fuel vehicle allows the user of the vehicle to switch the fuel from
CNG to petrol depending upon the availability of the fuel. Similarly, a hybrid vehicle switches from
fossil fuel to electric fuel to conserve fossil fuel. A flexibility option can be considered to be similar.
If the design of the plant allows for input and output flexibilities between alternate options, then
this is termed as flexibility option.
Karbonn mobiles need to decide how to best manufacture its latest product—the Amoled cellular
device. Demand for the new product could be uncertain, although forecasts indicate that sales will
be uniform across two major metros—one in the north and another in the south. A traditional
manufacturing analysis indicates that a single plant would be much cheaper to build and operate
than two plants in two regions. However, the analysis fails to take into account the responsiveness of
option(s) that would be created by building two plants—the option to shift production from north
plant to northern markets in response to shifts in demand, customer preferences or production
costs. If the value of this ‘flexibility’ option outweighs the cost saved by building just one plant, then
Karbonn mobiles should invest in two plants and carry the excess capacity of both these plants.
Operating options: The choice to switch between outsourcing and continuing with the insourcing
option can be an example of operating options. Terasoft Inc., has contracted with other companies
to produce and package its CD-ROMs. Over the years, the sales of CD-ROMs have grown
rapidly, and hence, the company was trying to decide whether it makes sense to build its own
manufacturing plant rather than outsourcing the entire requirement to vendors. If it goes ahead
with the manufacturing plan, then it would gain a number of operating options. For example,
it would have the option to shut down the operations during times of weak demand and the
option to run additional shifts during times of high demand or to sub-contract its facilities to other
manufacturers of CD-ROMs. The value of these multiple options adds to the value of the setting
up manufacturing plant proposal.
Learning Options: After the success of the Salman Khan-starrer Bodyguard, Being Human
productions are planning to release three movies in the midst of the Christmas season. Before the
films release, the studio executives cannot predict which one will be the biggest hit, and are not sure
on how best to allocate their marketing and advertising funds. However, they have an important
learning option—They can release each movie on a limited number of screens in selected cities and
then refine their marketing plans based on what they learn. They can roll out the most popular
movie nationwide and give it a large advertising budget while putting other films into more limited
release.
APPLICATION OF BINOMIAL MODEL TO REAL OPTIONS

In this section, we will discuss two applications of the binomial model for real options—the first
being valuation of land for expansion or for real estate development and the second for valuating
an option to abandon a project.
Valuation of Land
Many large manufacturing corporates own large tracts of industrial land in the suburbs of Mumbai.
This vacant land can be used for expansion of the manufacturing facilities or can be used for com-
mercial application such as building residential colonies or commercial establishments. In addition
to these options, there are options on timing for these developments. When the economic condi-
tions are not all positive, the spread of profits (difference between the cost of the project and the
market potential) is less and when the economy is booming, the spread of profits is much higher. It,
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456 | Chapter 11
therefore, pays to wait for the right opportunity for maximum benefit. It is comparatively simple
to estimate the best use of land in the present circumstance than in future circumstances. The real
option valuation approach can be used to determine the value of a vacant land that provides the
option to choose one of the several possible uses now or in the future. The steps involved in the
process are as follows:
1. Compute the risk-neutral probabilities after doing a thorough search of market conditions
and market-driven prices. This means if a residential building complex is being proposed on
the vacant land, then the price of apartments, the appreciation in price, the rent income that
can be derived from this investment and the risk-free interest rate.
3. Calculate the expected cash flows for the next year using the risk-neutral probability out-
comes and assume that the best alternative will be chosen from within each option.
4. Compute the current value of land by discounting the expected cash flow with the risk-free
interest rate.
The solution to Example 11.4 would illustrate the steps enumerated above.
Example 11.4
M/s Jangid Builders of Mira road own a plot of land on which they can either construct a seven-
storeyed apartment block (28 flats) or a 14-storeyed apartment block (56 flats). The construction
cost of each of these two alternatives is `3 Crores (1 Crore = 10 million) and `12 Crores. The
current market price for each flat is `0.4 Crore. If the flat is not sold, then it can be put on rent for
a yearly rental (net of all expenses) of `0.025 Crore. The yearly risk-free interest rate is 12%. If the
demand for the flats pick up after one year, then the flats are expected to fetch `0.6 Crores, and in
case the demand for flats is stagnant, it can fetch a price of utmost `0.3 Crore. What is the value of
the vacant plot and does it make sense for the developer to develop this plot? The construction cost
is presumed to remain the same after one year.
Solution:
Let us first compute the profits for M/s Jangid Builders for either alternative if sales are in year 0 or
year 1. The calculations for returns in year 1 are as given in Table 11.2.
If flats sold in year 0: 7 storey: 0.4 * 28 – 3 = 8.2 cr
If flats sold in year 1: 14 storey: 0.4 * 56 – 12 = 10.4 cr
Table 11.2 Alternative options returns if sold in year 1
Alternative Buoyant Market Sluggish Market

7 storeys 0.6 * 28 - 3 = 13.8 0.3 * 28 - 3 = 5.4
14 storeys 0.6 * 56 - 12 = 21.6 0.3 * 56 - 12 = 4.8
Hence, if the builder was to build the building this year, then he/she should opt for 14 storey build-
ing, and if he was to construct the building after one year, then in case the market was buoyant, the
14 storey building is the best option. If the market is not buoyant, then a seven-storeyed building is
the best option.
Now, if there was someone offering to purchase the vacant land today, then what should be the
cut-off point below which the vacant plot should not be sold? The following analysis helps in getting
the answer to this question.
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p ` 0.625 Crores {0.6 + 0.025}
` 0.4 Crores
(1 –
p) ` 0.325 Crores {0.3 + 0.025}
Figure 11.4 Binomial tree for apartment values
With the available information, let us apply the binomial method for valuing the vacant land.
Step 1: Calculate the risk-neutral probabilities.

The binomial tree shown in Figure 11.4 tells us that an investment of `0.4 Crores in a flat in this
year yields a return of `0.625 (`0.6 Crores from increase in value and `0.025 Crores from rent re-
ceived) if the market is buoyant or `0.325 (`0.3 Crores from decrease in value and `0.025 Crores
from rent received) if the market is not buoyant.
If p is the probability of a buoyant market, which means (1 – p) is the probability of a non-
buoyant market and the risk-free interest rate is 12%, then an investor buying an apartment will
do so only if the returns of his investments is equal to the risk-free return or interest that he would
have otherwise got from his investment. (In practice, the investor would invest only when his returns
from the investment are substantially higher than the interest gains of his funds, nevertheless the
equality argument would suffice).
p × (0.625) + (1 − p) × (0.325)
Thus, = 0.4
(1.12)
Solving the above equation, we have p = 0.41 and 1 – p = 0.59
Step 2: Calculate the expected cash flow next year.

We now know that the maximum profit can be either `21.6 Crores (14-storey option is best
when the market is buoyant) or `5.5 Crores (seven-storey option is the best when the market is not
buoyant) with a probability of 0.41 and 0.59, which would yield:
0.41 * 21.6 + 0.59 * 5.5 = `12.101 Crores
Step 3: The current value of the land applying the risk-free rate of 12% is `12.101/1.12 = `10.80 Crores.
Therefore, the value of the vacant land is `10.8 Crores, and if someone is willing to purchase the
land at a price which is greater than `10.8 Crores, then the proposal should be accepted. Furthermore,
the option of constructing a 14-storey building would have given M/s Jangid Builders a maximum
profit of `10.4 Crores in year 0, which is less than the value of the land. Hence, it is advisable to
keep the land vacant in year 0 and re-explore the option of constructing buildings in year 1.
Valuation of an Abandonment Option

At times, the company is faced with a choice for purchasing equipment or machines for manufacturing.
The initial investment plan along with operational costs becomes the key deciding factor. Although
it is known that branded products come with many advantages such as superior quality, product
support, planned maintenance schedules and long-term stability assurance, the initial cost becomes
the deciding factor and cheaper Chinese make products pass muster due to low initial cost. The
attended problems with such products are known and in the long run, the conclusions are that
branded products are better than non-branded products. While there can be a debate on this issue,
another important issue which does not get considered is what if the project has to be abandoned
midway? Would the branded equipment fetch a higher resale price or does the non-branded
equipment fetch a reasonable resale price as compared to its initial investment? Such future options
linked with exit plans are known as ‘abandonment options’.
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458 | Chapter 11
Example 11.5
Welspun Textiles, a textile firm, has decided to manufacture a new type of terry towel named
‘Terrywell’. There are two alternative looms available from reputed suppliers, each costing the same
price. Supplier A’s product is a special purpose loom which has a lower operating cost but low
resale value because of the specialization. Supplier B’s product is a general-purpose product and has
a higher production-cum-operating cost. However, in case of resale, supplier B’s product fetches a
higher resale price, ostensibly because it is a general-purpose machine. The demand for ‘Terrywell’
can be high or low. The project cash flows for the two projects after 1 year (installing supplier A’s
equipment or installing supplier B’s equipment) has been worked out and the two alternatives under
different market conditions are as follows (Table 11.3).
Table 11.3 Pay-off (` million)
Market Condition Pay-off Equipment A Pay-off Equipment B

Strong demand 24 22.4
Weak demand 11.2 9.6
Equipment B has a resale value of `12.8 million at the end of year 1, whereas equipment A has a
resale value of `8 million. The price of either equipment is `14.4 million and the risk-free interest
rate is 10%. Using the Binomial model, identify the best course of action for the company.
Solution:
From the discounted cash flow analysis, it is clear that equipment A is better than equipment B, irre-
spective of the strength of the demand. However, if the option to abandon the project was ever con-
sidered, then equipment B is better than equipment A due to a higher resale price. Therefore, should
the company decide to purchase equipment B and expect to gain a maximum of `22.4 million in a
best case scenario? Let us first calculate the value of the abandonment option for equipment B. The
present value for the equipment is `14.4 million, and if the demand is strong, then the investment
will yield a return of `22.4 million (or 55.55%) and if the demand is weak, the investment will result
in a return of only `9.6 million (-33.33%).
Next, we introduce the put option. The company would want to continue with the manufactur-
ing if the demand is strong but would like to sell the equipment at the resale price if the demand is
weak. The put option in this case will have a value of `12.8 – `9.6 = `3.2 million. In case of strong
demand, the put option would not be encashed or used and the value of the put option is 0. The
diagram in Figure 11.5 shows the binomial tree for equipment B.
p `22.4 million
`14.4 million
(1 –
p) `12.8 million
Figure 11.5 Binomial tree for equipment B
As there are only two outcomes, we apply the binomial model to calculate the value of prob-
ability, p.
Expected return = p * 55.55% + (1 – p) * (-33.33%) = 10% (risk-free interest rate)
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Solving for p, we have the value of p = 48.75% (probability of strong demand) and 1 - p = 51.25%
(probability of weak demand).
The pay-off of the put option after 1 year is either 0 (in case of strong demand) or `3.2 million (in
case of weak demand). Hence, the expected pay-off of the put option is 0 * 0.4875 + 3.2 * 0.5125 =
`1.64 million. Finally, this pay-off is at the end of one year, and hence, the value of this pay-off in year
0 = `1.64/1.10 = `1.49 million. The abandonment option value for equipment B is `1.49 million.
Strategic NPV = Conventional NPV + ROV (real option valuation)
Strategic NPVB = (22.4 * 0.4875 + 9.6 * 0.5125) + 1.49 = `17.33 million
Let us calculate the value of the abandonment option for equipment A. The present value for the
equipment is `14.4 million, and if the demand is strong, then the investment will yield a return of
`24 million (or 66.66%), and if the demand is weak, then the investment will result in a return of
only `11.2 million (-22.22%).
Next, we introduce the put option. The company would want to continue with the manufactur-
ing irrespective of the demand because the resale price is lower than the return in case of weak
demand. Hence, there is no put option for equipment A. Figure 11.6 shows the binomial tree for
equipment A.
p `24 million
`14.4 million
(1 –
p) `11.2 million
Figure 11.6 Binomial tree for equipment A
As there are only two outcomes, we apply the binomial model to calculate the value of
probability, p.
Expected return = p * 66.66% + (1 - p) * (-22.22%) = 10% (risk-free interest rate)
Solving for p, we have the value of p = 36.25% (probability of strong demand) and 1 – p = 63.75%
(probability of weak demand).
Strategic NPV = Conventional NPV + ROV

Strategic NPVA = (24 * 0.3625 + 11.2 * 0.6375) + 0
= `15.84 million
The strategic NPVB 7 strategic NPVA

Hence, the company should buy the equipment of manufacturer B. This conclusion is in contrast
to our conclusion on the basis of only conventional NPV. This is the advantage of the real value
options and ROV in taking decisions.
APPLICATIONS OF BLACK–SCHOLES MODEL FOR REAL OPTIONS

The essential application and usage of the Black–Scholes model for real options is similar to the
stock options and puts. We will look at the usage of this model for two applications—valuing an
option to make a subsequent additional investment and valuing a natural resource option, where
the cost of exploring is high.
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460 | Chapter 11
Example 11.6
A leading automobile company which is not into the electric car segment wants to invest funds in
a project of an electric car company, which itself is not doing well. The chief executive of the auto-
mobile company belongs to the research and development field and knows the value of research in
developing automobiles in technology-savvy automobiles, which unfortunately is lost on the CFO,
who is a stickler for numbers. The first phase investment has a negative NPV, but the CEO is aware
of the progress on an entirely new technology product, which he believes to be investment phase
two, and is profitable. The CFO believes that the first investment itself is not paying returns, then
the question of even considering the second phase option does not arise. Should the company drop
the investment plan?
Such scenarios are experienced almost regularly in projects, and hence, it is worthwhile that the
option of subsequent investment be explored. Let us consider the financial data. The projected cash
flows of the first phase of the project are given in Table 11.4.
Table 11.4 Cash f low data (` million)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial outlay (600)
After-tax operating cash flow 80 160 200 200 160
Working capital returned 120
Net cash flow (600) 80 160 200 200 280
PV @ 15% discount – 70 121 132 114 139
PV of cash inflows = 70 + 121 + 132 + 114 + 139 = 576

Investment outlay = 600
Net present value = 576 - 600 = - 24
Phase II investment would be `1.2 billion and the present value of expected cash flow would be
`1.152 billion. (The investment and cash flow are similar in percentage terms to the initial invest-
ment in phase I). However, the prerequisite for phase II is participation in phase I. The phase II in-
vestment can be considered a call option with an exercise price of `1.2 billion. Furthermore, phase
II investment happens in the year IV.
For the Black–Scholes model (for phase II investment), we would also need the estimate of stan-
dard deviation, s, which is the most difficult part. However, a close estimate can be done by finding
the standard deviation of the stock price (if it is listed) and assuming that the stock price fluctuations
reflects the fluctuations in company’s financials or cash flows. The standard deviation is computed
to be s = 0.35.
The risk-free interest rate is assumed to be 10% per annum in this problem. The information is
tabulated for the Black–Scholes model as follows:
Present value of the asset, S0 = 1152 * e-r t = 1152 * e-.15 * 4
= `632 million
(Note that the continuous discounting method is used for finding the present value and hence
the term e-r t)
Exercise price, E = `1200 million
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Standard deviation of continuously compounded annual returns, s = 0.35. Period to maturity,

t = 4 years.
Risk-free interest rate = 12% per annum.
First, we calculate the value of d1 and d2 as given in Equations 11.6 and 11.7:
  S0   1  
l n   + r + σ 2  t 
  E   2  
d1 = 
σ t
  632   1  
l n   + 0.12 + 0.352 × 4
  1200   2  
d1 = 
0.35 × SQRT (4)
= 0.1197
d 2 = d1 − σ t = −0.1197 − 0.35 × SQRT (4) = −0.58
the Z table on normal distribution,
N (d1) = 0.5438 and N (d2) = 0.2810.
The present value of the exercise option using the continuous discounting method is found out,
which is:
E * e-r t = {1200 * e-r t} = 1200 * e-.15 * 4 = `658.57 million
Finally, we substitute all these values in the equation to obtain, C0,
E
C0 = S0 N (d1) − N (d2 ) = 632 × 0.5438 − 658.57 × 0.2810
e rt
C0 = `158.62 Million
Therefore, we can state that the call option present value of `158.62 million for the second phase
investment offsets the conventional NPV loss of `24 million. Hence, the CEO stands vindicated in
going ahead with his proposal to invest in phase I and later in phase II.
Valuing an Oil (Natural Resources) Option

We can classify oil and gas assets as ‘assets’ when there is a perception that one can make money if
an exploration well were drilled in areas with high probability of finding oil or natural gas. Cairn
Energy, which is in talks to be acquired by the Vedanta group, has many such oil exploration units in
Rajasthan. Reliance Industries has done pioneering work in the Krishna-Godavari basin and ONGC
with sister companies such as ONGC Videsh Ltd (OVL) does exploration work across the globe.
The holder of an oil asset has many options, which include drilling an exploration well as soon as
possible, or defer drilling, or sell the underlying asset. If drilling yields a developable find, then there
could be more options: the most likely ones being to develop the field immediately, or at a later point
in time, or never. Development into a producing field provides the asset with further options such as
the speed of oil recovery, production and storage capacity, movement of crude oil from the oil head
to the refining facilities, etc. Once the reserves gets depleted, the option of shutting down the facility
is imminent. The only question that remains is ‘when’ to shut down.
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462 | Chapter 11
All these options that arise in the lifetime of an oil and gas asset constitutes an opportunity to
make decisions based upon perceptions at the time whether the options are exercised or not. As the
underlying character in case of oil and gas assets changes with time, so also the infrastructure which
exists during the asset life time can change. Floating production, storage and offloading systems
were options available for extracting oil and natural gas from various points in high seas, which
were catered to only by fixed platforms. Such upgradation of technology makes consideration of all
significant options that arise during an oil and gas assets’ lifetime important. Capen (1991) empha-
sizes that decisions about oil and gas assets should be driven by values prevailing at the time of the
decisions. Option theory methods seek to implement that principle.
In case of natural asset investments (coal, iron ore, bauxite, etc.) like oil, the underlying asset is the
natural resource and the exercise price is the cost of exploration and development. If the estimated
value of the natural resource is P and the cost of development is Q, then the pay-off is P - Q, when
P 7 Q and the pay-off is 0 when P … Q. The pay-off outcome of the investment in natural resources
is similar to the pay-off outcome of a call option. To value the real option for a natural resource us-
ing the Black–Scholes model, the following has to be estimated:
1. Present value of the available reserves of the resource, S0
2. Exercise price in the form of development cost, E
3. Time to expiration of the option or period to maturity, t in years
4. Standard deviation s, for the value of the underlying asset
5. Dividend yield, y
5. Risk-free interest rate, r
As the dividend is also being considered, there would be a change in the applicable Black–Scholes
model. The revisions due to added dividend can be either short-term revisions, if the options expire
within one year or long-term revisions, when options expire after many years. In case of real options,
the expiration date of the option is over one year, and hence, the revised model incorporating
the long-term dividend is considered. The revised Black–Scholes model incorporating long-term
dividend is:
 S   1 
l n  0  + r − y + σ 2  t
 E   2 
d1 =
σ× t
d 2 = d1 − σ t
Example 11.7
Let us consider the case of ONGC Videsh Ltd (OVL), the overseas investment arm of state-run ex-
plorer ONGC. OVL has renegotiated the contract for oil acreage in Iraq that was awarded to it by
the overthrown Saddam Hussein regime. The contract for Block-8 acreage has been renegotiated
on lines of a deal that China National Petroleum Corporation signed recently for developing the
Al-Ahdad field. According to the new format, ONGC Videsh will be a service contractor and paid
18% return on $1.5 billion that it will invest to develop the field. The block is estimated to have 54
million barrels of recoverable oil and 645 million barrels of in-place reserves. The right to exploit
the basin will be enjoyed for 25 years. The marginal value per barrel of oil is presently $15, which
represents the difference between the price per barrel of oil and the marginal cost of extracting a
barrel of oil. The standard deviation, s, of oil prices is expected to be 0.2. Once the field is com-
pletely developed the net production revenue each year will be 5% of the value of the reserve. The
risk-free rate is presumed to be 10% and it takes two years to completely develop the oil field. Find
out the equilibrium value of the present call option, C0.
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Solution:
The inputs to the Black–Scholes formula are summarized as below,
S0 = Current value of the asset = Value of developed reserve discounted back for the period of
development, which in this case is 2 years = $15 * 54/(1.05)2
= $734.70 million
Exercise price, E = development cost = $1500 million
s = standard deviation of the oil price = 0.2
l = life of the option = 25 years
r = risk free rate = 18%
Net production revenue
y = Dividend yield = = 5%
Value of reserve
Step 1: Calculate d1 and d2

 S   1 
l n  0  + r − y + σ 2  t
 E   2 
d1 =
σ× t
 734.70   1 
l n   + 0.18 − 0.05 + × 0.22 
 1500   2 
=
0.2 × SQRT (25)
= −0.564
d 2 = d1 − σ t = −0.564 − 0.2 × SQRT (25) = −1.564
Step 2: Find N(d1) and N(d2)

N(d1) = N(-0.564) = 0.2877
N(d2) = N(-1.564) = 0.0594
Step 3: We substitute these values in the equation to find C0,

E 1500(0.0594)
C0 = S0 N (d1) − N (d2 ) = 734.70(0.2877) −
e rt e0.18×25
= $ 210.38 Million
Therefore, the equilibrium value for the call option is $210.38 million for the OVL Iraq proposal.
Note: This discussion shows the manner in which the given data is to be analyzed. If the margin per
barrel increases or the reserves increase, then the analysis may paint a different picture.
QUALITATIVE ASSESSMENT OF OPTIONS

The project manager has to play many roles to make a project successful. He/She has to play a
key role in making well-informed and thought-out assumptions. While the Black–Scholes model
may be considered as a panacea for all problems associated with options in case of real or stock,
many assumptions of fancy proportions are required. Nevertheless, the insights provided by the
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464 | Chapter 11
Black–Scholes model can be combined with qualitative and well-informed decisions to make the op-
tion values meaningful. If one can identify and specify the circumstances under which these options
can actually work well, then an informed estimate of their values can be made. There are basically
three steps involved in the process:
Step 1: To identify the options correctly and exhaustively. Real options or projects can be broadly
grouped into two categories—incremental options and flexibility options. An incremental option
provides the firm with opportunities to make profitable future investments. A flexibility option gives
the firm options in manufacturing so that it can cope better with unexpected changes and adverse
conditions.
Step 2: To analyze uncertainty in the environment. Options are valuable when the environment is
unpredictable. The unpredictability results in opportunities, which would otherwise not be avail-
able. To give an analogy, a downgrade of the US economy brought about a world-wide dip in stocks,
which offers investors an opportunity for bottom fishing. An investor in a steady state debt instru-
ment may not get this kind of opportunity. Hedge funds typically exploit the opportunities arising
out of an uncertain environment. This is also true about real options. The flexibility offered by real
options has greater value when the environment is more uncertain.
Step 3: To use the analysis of uncertainty to value options correctly. While the Black–Scholes model
may not be readily applicable to real options because of the difficulty in quantitative assessment
of inputs, a combination of experience and judgment of the project manager helps in developing a
practical procedure for valuing options.
In conclusion, we can state that greater the uncertainty of a project, higher the value of the real
options and longer the duration of the project, higher the value of the real option. A rough estimate
of the proportional weightage to the discounted cash flows and the options under the situation of
environmental uncertainty and project duration are shown in Figure 11.7.
Long
Discounted Cash Flow: 70% Discounted Cash Flow: 60%

Project Duration
Real Options Value: 30% Discounted Cash Flow: 60%
Discounted Cash Flow: 90% Discounted Cash Flow: 75%
Discounted Cash Flow: 90% Real Options Value: 25%

Short
Environmental Uncertainty
Low High
Figure 11.7 Proportion weightage of real option and discounted cash flow
MANAGING REAL OPTIONS WITHOUT ERRORS

As can be seen from the earlier discussions, real options, in general, are much more difficult to value
than stock prices and other financial options available in the markets. The most obvious difference
between the real option and financial options is the valuation part as the value of the real option is
determined by other assets that are not actively traded. Products that are not freely traded tend to
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give a biased result as preferred by the person making the analysis. In contrast, freely traded assets
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move within a range of intrinsic valuations as there are sufficient supporters for a buy call and
sufficient supporters for a sell call. To explain this further, consider an example of a stock, which
is traded every minute, whereas factories, buildings and other real assets are bought and sold com-
paratively much infrequently. This makes it difficult to estimate how their returns are distributed
and also makes it impossible to hedge the risks associated with the real option by buying or selling
the underlying asset. Another feature of a freely traded product is the exercise price at the end of a
certain time period. In case of real options, it is difficult to estimate the exercise price at the end of
time periods. Furthermore, time periods in case of freely traded products is relatively near term (one
month), whereas the time period in case of real options is far term.
The difficulties encountered with real options valuations often result in mistakes or errors in the
valuation process. Some of the common errors are listed here.
1. Attempting to fit the given problem into the Black–Scholes model in any possible manner,
requiring many (at times, unrealistic) assumptions.
2. Making use of the price volatility of a commodity, which is the output of the natural resource
rather than the volatility of the underlying investment in valuing a natural resource invest-
ment. A change of government in an African country where the assets are based could un-
dergo serious changes in valuations, whereas the valuation of this resource is generally made
using the prevailing oil prices and oil reserves.
3. The exercise price of the real option is assumed to be fixed or constant over the entire period
of expiration. This could be difficult because the periodicity is in large units, say years, and
presuming constancy over this period may be incorrect.
4. Overestimating flexibility: Although on paper, an output can be tweaked to meet the fall in
demand, issues related to labour, commitment to local bodies, etc., may not make enforcing
the flexibility as easy as it seems to be.
5. Multiple counting risks: The forward prices used to calculate the ‘certainty-equivalent’ cash
flows may be flawed because the forward prices may inadvertently reflect the analyst’s esti-
mate of expected prices, which is incorrect.
6. There is a lack of understanding that investment choices would affect price volatility.
7. There is a possibility that the real options valuation method can be misused for justifying pet
proposals as ‘strategic investments’.
SUMMARY
Options and options strategy is an interesting development of the past few decades which helps
in maximizing the Return on Investments. Although very esoteric it is pertinent to know some key
features of the options and they are:
1. Strategic NPV = Conventional NPV + real option value (ROV)
2. The standard discounting cash flow technique has a limitation that it cannot evaluate the
value of the embedded options in any projects which can enhance the value of the project
considerably.
3. An option owner enjoys the right to buy or sell something without the obligation to do so,
for which he/she pays a premium. Similarly, an option writer has an obligation to buy or sell
something when the option owner decides to do so, for which he/she gets a premium. The op-
tion to buy is called a call option, and the option to sell is called the put option.
4. The exercise price is like a strike price at which the buy (call) option or the sell (call) option
becomes exercisable. If it is a call option and the prevalent price up to the date of expiry is
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less than the strike price, then the call option is abandoned. Similarly, if the prevalent price is
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466 | Chapter 11
less than the strike price, then the put option is abandoned. This means that for a call owner,
there is profit when the prevalent price is higher than the exercise price and for a put buyer,
the profit is realized when the prevalent price is lower than the exercise price.
5. The options can be of two types—American options and European options. In American op-
tions, the right can be exercised at any time, whereas in case of European option, the right can
be exercised only on the date of maturity.
6. Black–Scholes and binomial model are the two methods used to find the value of the option.
The only major difference in the two models is that the binomial model presumes two out-
comes at the end of a review period, whereas the Black–Scholes model presumes continuous
review period and the resultant multiple options.
7. Real options are markedly differently than stock options but the models used to value the
stock options can also be applied with some changes to the real options. In doing so, the com-
mon mistakes/errors should be avoided.
The Black and Scholes model of options valuations is widely used in the financial markets where
there is an underlying security. The application of the same in case of Real Options is difficult simply
because there is no market driven price discovery mechanism for projects. Nevertheless as has been
demonstrated in this chapter real value options can be used as long as we do not try to force fit the
Black and Scholes model. The standard discounted cash flow techniques are incapable of evaluating the
value of options embedded in the project. The case of Mahindra & Mahindra acquiring Reva Electric
and Kinetic Engineering are examples of firms employing real value options for strategic reasons.
KEYWORDS
• Discounted cash flow • Black and Scholes model

• Put options • Financial options
• Call options • ATM
• Implied volatility • OTM
• Real value options • ITM
• Binomial model
Rev i ew QU E ST I ON S
1. What are the shortcomings of the discounted cash flow technique method used in selection of
projects? How does the consideration of options help overcome these shortcomings?
2. Explain the key terms used in describing an option. How does the option owner make money
(ITM) if he/she is a call option owner? How does one make money if he/she is a put option
owner?
3. What are the differences between a European call option and an American call option?
4. What are the stages involved in finding the value of the call option using the binomial ‘option
equivalent method’?
5. How do we find the value of a call option using the risk-neutral method?
6. Explain the essential features of the Black–Scholes model.
7. Explain the key differences between the real option and the stock option.
8. What are the adjustments made in applying the Black–Scholes model to real options?
9. Discuss the common mistakes characterizing the real option valuation in practice.
10. Explain qualitative assessment@Seismicisolation
of real options.
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CH APT E R - E N D N UM E R I C A L QU E ST I ON S
1. Reliance Communications equity is currently selling at `82 per share. Within a year from now, it
can rise to `125 or fall to `70. The interest rate is 15%. The exercise price is `100. What is the
value of the call option for Reliance communications equity as per the binomial model?
2. Using the Black–Scholes model, find the present equilibrium value of the call option, when the
below given data is known,
• Present price of stock, S0 = `850
• Exercise price, E = `950
• Standard deviation of continuously compounded annual returns, s = 0.5
• Period to maturity, t = 0.5 years
• Risk-free interest rate = 12% per annum
Solution:
  S0   1  
l n   + r + σ 2  t 
  E   2  
d1 = 
σ t
  850   
l n   + 0.12 + 1 0.52 × 0.5
  950   2  
d1 = 
0.5× SQRT (0.5)
= 0.032
d 2 = d1 − σ t = 0.032 − 0.5× SQRT (0.5) = −0.322
the Z table on normal distribution,
N (d1) = 0.5120 and N (d2) = 0.3745
E 950 × 0.3745
C0 = S0 N (d1) − N (d2 ) = 850 × 0.5120 −
e rt e0.12×0.5
C0 = ` 100.14
Therefore, the present equilibrium value of the call option using the Black–Scholes formula is
`100.14.
3. Using the Black–Scholes model, find the present equilibrium value of the call option, when the
below given data is known:
• Present price of stock, S0 = `150
• Exercise price, E = `170
• Standard deviation of continuously compounded annual returns, s = 0.3
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468 | Chapter 11
• Period to maturity, t = 0.1 years

• Risk-free interest rate = 10% per annum
C0 = `1
4. Consider the following data for ITC stock. S = `205, h = 1.5, l = 0.8, E = `220, r = 12%, R = 1.12.
Find out the values of options delta, X and amount of debt, B that can be availed to purchase the
options delta, X using the options equivalent method. Use this data to compute the value of the
call option.
Solution:
Let us first compute Ch, the value of call option before expiration, when the stock price has gone
up to h S and Cl, the value of call option before expiration, when the stock price has reduced to l S.
Ch = Max (S1 - E, 0) = Max (205 * 1.5 - 220, 0)
= Max (87.5, 0) = `87/50
Likewise Cl = Max (S2 - E, 0) = Max (l S0 - E, 0). In this case, Cl = Max (S2 - E, 0)
= Max (205 * 0.8 - 220, 0)
= Max (-56, 0) = `0/-
From Equation 11.3 we have,
X= =
87.50 − 0
X= = 0.61
205(1.5 − 0.8)
From Equation 11.4 we have,

lCh − hCl 0.8 ×87.5 − 1.5× 0
B= = = `89.28
(h − l )R (1.5 − 0.8)1.12
is `89.28.
The value of the call option computed by the option equivalent method is C = X S – B = 0.61 *
205 – 89.28 = `35.77.
5. Consider the following data for Tata Steel stock. S = `490, h = 1.3, l = 0.9, E = `520, r = 12%,
R = 1.12. Find out the values of options delta, X and amount of debt, B that can be availed to
purchase the options delta, X using the options equivalent method. Use this data to compute the
value of the call option.
Solution:
is `235.05
The value of the call option computed by the option equivalent method is C = X S - B = 0.597 *
490 - 235.05 = `57.48
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6. For problem 4 above, find out the value of the call option using the risk-neutral method.
Solution:
Expected return on ITC stock is = Probability of rise * h + (1 - probability of rise) * l = 12%
(Risk-free interest rate)
0.5 p + (1 - p) (-0.2) = 0.12
Solving this for p, we have p or risk-neutral probability = 0.457. Therefore, when the investors are
risk averse or risk-neutral, the value of the call after time period 1 is,
= 0.457 * Ch + (1 - 0.457) * Cl
= 0.457 * 87.5 + 0.543 * 0 = `39.99
is `39.99/1.12 = `35.71
7. For problem 5 above, find out the value of the call option using the risk-neutral method.
Solution:
Expected return on Tata Steel stock = Probability of rise * h + (1 - probability of rise) * l = 12%
(Risk free interest rate).
0.3 p + (1 - p) (-0.1) = 0.12
Solving this for p, we have p or risk-neutral probability = 0.55.
Ch = Max (S1 - E, 0) = Max (490 * 1.3 - 520, 0)
= Max (117, 0) = `117
Cl = 0.
Therefore, when the investors are risk averse or risk-neutral, the value of the call after time period 1 is:
= 0.55 * Ch + (1 - 0.45) * Cl
= 0.55 * 117 + 0.45 * 0 = `64.35
is `64.35/1.12 = `57.45.
8. Mobil Oil Company is estimating the value of the option to extract oil from the Ras-al-Khaimah
oil basin. The following information has been gathered:
(a) Estimated oil reserve in the basin is 500 million barrels of oil.
(b) The development cost is $900 million.
(c) The right to exploit the basin will be enjoyed for 20 years.
(d) The marginal value per barrel of oil presently is $20. The marginal value is the difference
between the cost of extracting a barrel of oil and the sales revenue for a barrel of oil. The
standard deviation of oil price, s, is estimated to be 0.30.
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470 | Chapter 11
(e) On development of the oil reserve, which will take 3 years to develop, the net production
revenue will be 5% of the value of the reserve.
(f) The risk-free rate of interest is 12%.
(g) What is the value of the option to extract oil?
Solution:
The inputs to the Black–Scholes formula are summarized here.
S0 = Current value of the asset = Value of developed reserve discounted back for the period of
development, which in this case is 3 years = $20 * 500/(1.05)3 = $8638 million
Exercise price, E = development cost = $900 million
s = standard deviation of the oil price = 0.3
l = life of the option = 20 years
r = risk free rate = 12%
Net production revenue
y = Dividend yield = = 5%
Value of reserve
Step 1: Calculate d1 and d2.
 S   1 
l n  0  + r − y + σ 2  t
 E   2 
d1 =
σ× t
 8638   1 
l n   + 0.12 − 0.05 + × 0.32 
 900    2 
= = 1.77
0.3 × SQRT (20)
d 2 = d1 − σ t = 1.77 − 0.3× SQRT (20) = 0.428
Step 2: Find N(d1) and N(d2)

N(d1) = N(1.77) = 0.9616
N(d2) = N(0.428) = 0.6628
Step 3: We substitute these values in the equation to find C0,
E 900(0.6628)
C0 = S0 N (d1) − N (d2 ) = 8638(0.9616) −
e rt e0.12×20
= $8252 Million
Therefore, the equilibrium value for the call option is $8252 million for Mobil Oil company’s
Ras-al-Khaimah proposal.
CH A PT E R - E N D C A S E L E T S
A. Thales, the ancient Greek philosopher, predicted that the upcoming year’s olive harvest would
be a record-breaking bumper crop. He then offered to book the capacity of all the local olive
refiners, for a price, with a caveat that should there be a requirement (or demand) for the
refining capacity from his side, then they should offer him the same. In case there was no
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demand from his side, then the refiners were at liberty to offer their refining capacities to
other farmers. This facility is similar to a stock call option where there is a right but not an
obligation to buy the underlying asset.
His payment of the hefty fee would have been wasted had he not been able to engage the
services of the olive-pressing facility. His payment of the hefty fees would have given him
returns many times over in case there was a bumper crop, which would have seen a huge surge
in demand for olive refining, the capacity of which was committed to him.
As it turned out, Thales’ prediction proved accurate, and as the record-breaking olive crop
poured in, the demand for olive refining facilities soared. Due to high demand, the refiners
could have charged much higher fees for the use of the olive presses, but the same were already
booked by Thales. As Thales exercised his right for his option to rent out the olive presses at a
fixed price, he could make bumper profits. Therefore, by exercising his real option, Thales was
able to profit greatly from the bumper crop and bumper refining facility that he had engaged
in anticipation. He further profited by subletting the refining facility to other farmers for a very
high premium. Therefore, he not only benefitted from bumper crop but also from his options.
The Thales example, should it be true, would perhaps be the first example of successful
usage of future ‘options’.
B. Real Option Example for Real Estate: A more practical example of option is the concept of
token money paid while negotiating a real estate deal. This is a good example of a real option
that most homeowners can relate to. Let us say you are shopping for your new residence and
you stumble upon what seems to be your dream home: a spacious, new property in a good
neighbourhood that is selling at a very attractive price because the owners are moving to
another country and need to sell their home quickly.
Many others are also interested in acquiring the property which means that if you do not
move quickly enough, then you may lose out on an opportunity to own a dream house that
you covet. The issue is that the bank, which is financing this acquisition, would take time to
do the processing. If you wait for your bank to confirm the financing, then you will probably
lose the home to another buyer, thus a situation of a real predicament.
This is where the concept of a real option (in the form of token money) comes into play.
You could offer to pay the owners `10,000 to hold the property for you for two weeks. By
doing so, you buy yourself the right, but not the obligation, to purchase the home at the
offering price any time in the next two weeks once the financing comes through. If it does
not come through, or if you change your mind about the house, then you can simply let the
option expire after two weeks. Looking at it from the seller’s perspective, the sellers keep the
`10,000, and since they have numerous other buyers in the wings, they have little to lose by
accepting `10,000 to delay the sale of their home for two weeks.
The appeal of real option models is their ability to assign a positive value to uncertainty and
that this right need only be exercised if it proves profitable.
C. Drilling Rights to an Oil Field: In case of drilling rights to an oilfield, the owner of the rights
can opt to exercise them whenever oil prices rise enough to make drilling worthwhile. Given
the unpredictable nature of oil prices, considering an option that might make money is in
itself worth money. Therefore, even though oil prices may never rise sufficiently enough to
cover the costs of drilling and make profit, the opportunity to profit if prices do rise is still
worth paying for.
We can, therefore, conclude that when an oil and gas company buys the drilling rights for
a particular piece of land, it is essentially buying a real option, giving it the right (but not the
obligation) to undertake drilling when it thinks it is profitable to do so. On the contrary, if
the oil prices plummet, then@Seismicisolation
the company can choose to lapse its option and not drill for oil.
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Chapter
12 ORGANIZATION STRUCTURE FOR

BETTER PROJECT MANAGEMENT
LEARninG OBJECtivES

❍ Appreciate the human resources aspects in project management.
❍ Understand the need for project management organization structure to be different from
the functional organization management structure.
❍ Analyze the team working essentials in project management.
❍ Explain the situational factors that affect the development of teams.
❍ Examine project team pitfalls.
Coming together is a beginning, Keeping together is progress and working together is success.
– Henry Ford
INTRODUCTION
Project management is perhaps the only business which cannot be fully automated and would
require human beings to run it. The element of ‘uniqueness’ in the projects brings about the necessity
of involving people required to take decisions. With the involvement of people in the business, the
spirit of working in teams happens naturally. The Greek word synergos got converted into synergia
and then into synergy in English. It simply means ‘working together’. With working together
also comes the official line of authority and control within an organization. It should always be
remembered that although people like to work together and make excellent friends while working
together in an organization, the goal of an organization is to make profits. Relationship building
and working together should be a result of an opportunity to work for an organization and not the
other way around. While working together, one experiences a bout of positive energy and negative
energy. Most of the times, we like the positive energy part and consider managing the negative
energy as the realm of the organization. However, the job of the project organization is not to
only exercise control but to channelize the efforts of everyone towards the objective of completing
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474 | Chapter 12
Dedicated Project Team

C-Level Execs
Project Manager
Functional Functional Functional
Manager Manager Manager
Staff Staff Staff Staff Staff
Figure 12.1 Example of a project management organization
project goals. One can observe from group sports that the team which displays excellent team spirit
always wins. The duration of team sports is comparatively short and the deliverables are entirely
different. However, the level of satisfaction is the same when the winning team celebrates their
victory. Similarly, in a project organization, the satisfaction of completing a project is immense and
every team member is visibly excited.
Can we see some learnings from the success of team events? Are there some major shortcomings
in the losing team? In a project organization, are we doing the most correct things that would result
in long-term successes?
Project management structures help in developing a reporting relationship that will give good
results. Depending on the environment the organization finds itself operating in, the goals they set
for themselves, and the nature of work being done, organizations can be structured in three ways
as follows:
1. Functional organization structure
2. Projectized organization structure
3. Matrix organization structure
(a) Balanced matrix
(b) Strong matrix
(c) Weak matrix
Let us now describe each of these organization structures and list down their advantages and limi-
tations. The working style of employees of an organization depends a lot on the structure of the
organization. The organization structure dictates the role, responsibilities, working culture and just
about anything else. Generally, the functional organization would offer a static role but the other
two types of organization structure would offer a dynamic role.
FUNCTIONAL ORGANIZATION STRUCTURE

As the name suggests, the functional organization structure is a hierarchical organization structure
wherein people are grouped according to their area of specialization. Therefore, in a project organi-
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Organization Structure for better Project Management | 475
CEO
Project
Coordination
Functional Functional Functional

Staff Staff Staff
Staff Staff Staff
Staff Staff Staff
Figure 12.2 A typical functional organization
coordination group, etc. The members in these groups are supervised by a functional manager who
has higher level of expertise in the same field. This expertise helps the leader to effectively utilize the
skills of the reporting employees. This is in the interest of the organization as the final billing for
the project is done on the basis of the time sheet, which every project management professional is
required to fill on a daily basis. The objective of getting the best out of the employee is well served
when the employee’s work is supervised by someone from the same area of work.
Typically, the organization chart for such an organization would comprise the president, vice-
president, finance department, sales department, customer service, administration, operations, etc.
Each department is headed by a department head who is held accountable for the performance of
his section. Due to this structure, the quality and uniformity of performance is achieved. Each of
these departments are like a typical silo which is vertical and disconnected from the other func-
tions in the organization. The communication flow is vertical from the department heads to the
top management. As all the authority here stays with the functional manager, project management
has limited use of such a structure. A project manager will require permission from the functional
manager to fulfil his requirements, which could be frustrating, at times. If, however, the business of
the organization consists of projects like an engineering, procurement, construction (EPC) company,
then this structure may work.
Advantages of Functional Organization

Some of the benefits that accrue due to a functional organization are as follows:
1. Employees are grouped by their knowledge and skills, which help them and their department
achieve the highest degree of performance.
2. The skills of the employees get enhanced due to collaboration with fellow colleagues, all from
the same department.
3. As the work content remains similar, the advantage of economies of scale is experienced by
the team members and the department.
4. Roles are fixed for each member and this brings in better accountability.
5. The chain of command is well defined and thus an employee need not refer to many commu-
nication channels.
6. There is no overlap of work between various departments because the departments are work-
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476 | Chapter 12
7. Employees feel secure among colleagues with similar skill sets and background and this sense
of job security brings in loyalty to the organization.
8. Cooperation and communications are excellent within the department
Disadvantages of Functional Organization

Some disadvantages of a functional organization are as follows:
1. Employees may feel bored when everything is clearly spelled out. There is no opportunity to
exchange notes with other departments or check how their work is being actually used by the
next department.
2. Repetitive work can be monotonous at times and this could reduce the employee morale.
3. The performance appraisal system should be well defined so that employees do not get a feel-
ing of the organization being unfair. At times, conflicts can arise if a perceived low performing
employee gets rewarded.
4. Working in silos has the disadvantage of paying attention only to the departmental goals and
at times, ignoring similar goals of other departments. The self-centred mentality, as a result of
the functional organization, is detrimental to the organization in the long run.
5. While inter-department communication is good, intra-department communication is not
good. Lack of coordination among departments working in silos decreases flexibility and an
opportunity for innovations.
6. The functional structure is rigid which makes adaptation to any changes very difficult. In
one project management organization, only the draughting designers were allowed to use the
CAD stations, resulting in many back and forth movements between the user and the designer.
The system prevented the user from making any changes to the design, which had to be com-
pulsorily routed through the designer.
7. Functional goals take priority over organizational goals.
8. When organizations become large, the functional areas become big and difficult to manage.
Each function may operate as a separate organization and develop its own culture and issues.
PROJECTIZED ORGANIZATION STRUCTURE

The projectized organizational structure is the complete opposite of the functional organizational
structure even though the organization may still group staff according to their work functions. The
project manager who heads a vertical has the authority over that vertical with jurisdiction over the
project’s budget, schedule and the project team. Dedicated teams are put together to work on proj-
ects in a project organizational structure. The project manager has a line responsibility for the team
he heads and in turn, he reports to the project sponsors and the project board. The individuals in
the dedicated team work directly for the project manager. The clear established line of authority that
results in fast decision-making is the advantage of this method.
Advantages of Projectized Organization Structure

1. Communication becomes faster and more effective within the project teams as all the team
members work together.
2. The team members gain knowledge and experience by working on different aspects of the
business, not necessarily restricting to their areas of expertise.
3. Not limiting themselves to silos works to the advantage of team members in that they can see
the use of their part of the work and hence can enrich their designs with this added information.
4. Getting to work on different projects one after the other is always good learning for the team
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PROJECT CHIEF
COORDINATION EXECUTIVE
Project Project Project

Staff Staff Staff
Staff Staff Staff
Staff Staff Staff
(Gray boxes represent staff engaged in project activities)

Figure 12.3 Projectized organization structure
5. The entire team is focussed on the goal; therefore, there is no conflict of loyalty among team
members.
6. Resources get dedicated to the project and it is easier to schedule work. Besides, as the avail-
ability of team members is known, scheduling of work becomes convenient. When teams
work in silos, the progress of the project is slow because resources may not be available.
7. Members working in such type of organizations pick up their project management skills and
their technical leadership skills faster.
Disadvantages of Projectized Organization Structure

The disadvantages of a projected organization structure are as follows:
1.
Having a dedicated team only for one project can be a costly affair, unless when the project is
sufficiently large.
2. If the project organization continues to work for a long time on different projects, then there
may not be a cause for concern. However, if the team members have to go back to their
respective functions after the completion of the project, then they might find it difficult. Project
work is stretching, and returning to what you did before, after working in a multidisciplinary
environment on a new, challenging project is not an appealing prospect for many people.
3. If the team is working on a single project, then it is fine; but in case the team is working on
multiple projects, the team members could be under a lot of pressure.
4. Team members fear that once the job is completed and closed, there may not be another job
if the business has moved on.
5. The resources allocated will be entirely used by the team and this can be disadvantageous in
that the resource utility is restricted to only one job. Suppose two cranes are made available
for a project and the requirement on a few days is only for one crane, then the second crane
would be unused. If the resources were pooled, then the spare crane could have been used for
some other activity.
6. It has been observed that project managers in such structures often get involved in people
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478 | Chapter 12
Matrix Organization Chart Template

General Manager
Functional Functional Functional Functional

Division Manager Division Manager Division Manager Division Manager
Project
Name Name Name Name
Manager
Project
Name Name Name Name
Manager
Project
Name Name Name Name
Manager
Project
Name Name Name Name
Manager
Figure 12.4 Matrix organization structure
MATRIX ORGANIZATION STRUCTURE

A matrix organization structure is everything that a functional or projectized organization structure
is not. While the other two structures are hierarchical ‘tree structures’ and are unambiguous and
stable, the matrix organization is relatively flexible. In a matrix organization there are generally
two chains of command and employees are accountable to more than one boss. Managerial roles
are not fixed and the structure is partially impermanent. The problem areas could be balance of
power between a functional manager and project manager as the roles are not organizationally de-
fined. The reasons for the evolution of the matrix organization could be attributed to the response
to large-scale projects in contemporary organizations. These projects required rapid infusions of
technological know-how and efficient processing of large amounts of data. Older organizational
structures proved to be ill-equipped to deal with these very projects within the limited time. Matrix
organizations provided a rapid structure to respond to the interdisciplinary needs without disrupt-
ing existing functional organizational structures. Instead of disassembling the functional structure
to create a temporary project structure, the matrix structure retains the functional structure while
superimposing a temporary project structure. Team members continue to report to functional bosses
while also reporting in to the project manager for day-to-day work.
Advantages of the Matrix Organization Structure

The advantages of matrix organization structure are as follows:
1. This structure allows for rapid creation of the efficient large-scale project structures that employ
members of the organizational functional structure without disrupting the existing structure.
2. As the project structure is likely to dissolve eventually, there will not be territorial struggles to
share resources.
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3. There is clear articulation of project objectives.

4. There is a workable way to integrate project objectives with functional objectives.
5. Efficient use of existing human resources is ensured.
6. Retention of expert team throughout the life of the project is possible.
7. There is rapid dispersion of team members back into the functional organization upon
completion of the project without any disruptions within organizations.
8. Cross-functional knowledge of the team members increases.
9. Matrix structures develop team spirit across the organization, which continues even after the
project is over due to familiarity of working with team members from other functions.
Disadvantages of Matrix Organization Structure

The disadvantages of matrix structure are as follows:
1. The team members have two different reporting bosses, which leads to conflict of priorities.
2. It increases organizational complexity.
3. It requires high level of cooperation between functional and project management teams.
4. Loss of accountability can lead to problems of control and could create unnecessary people
issues.
5. Slowdown in management response time for crucial decisions due to dual reporting structure
may occur.
6. It results in an increase in management overhead cost.
7. There is potential for conflicting management directives.
The matrix organization structure can further be grouped as balanced matrix, weak matrix and
strong matrix on the basis of control exercised by the project manager. For most part, the project
manager’s control is a direct function of the level at which he reports in the hierarchical organiza-
tion. If he is to be effective, the project manager must be on at least an equal level with the highest
level of functional management that he must deal with. At times, it may not be desirable to have a
balance of power between the functional head and the project manager. At times, the project may be
very important to the organization and in such cases, the project manager is given the upper hand. In
some other situations, tight control over finances might be the priority for the organizations, where
the functional department is given more control. The balance of power can be altered in any of the
following ways:
1. The administrative relationship—the levels at which the people involved and project man-
ager’s report and the support they receive from the top management.
2. The physical relationship—the distance between the various people involved in the projects.
3. The time spent on the project—the amount of time involved in the project by the respective
managers.
These three factors decide whether the matrix relation is going to be strong or weak or balanced.
The strong matrix is one in which the balance of power is on the side of the project manager. A weak
matrix as defined by the project managers as one in which the balance of power tilts decisively in the
direction of the functional manager. If the power is shared equally between the functional depart-
ment and the project management department, it is termed as a balanced matrix.
CHARACTERISTICS OF A HIGH PERFORMING TEAM

As mentioned earlier, teams with a high level of positive energy can give good project performance
and are termed high performing teams.
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480 | Chapter 12
Solid
Relationships
Common
Effective
Purpose
Processes
Accepted Excellent
Leadership Communication
Clear Roles
Figure12.5 High performing team model
The set of characteristics associated with such high-performance teams are as follows:
1. A common sense of purpose with team members being highly motivated to help each other
willingly.
2. The team identifies individual talents and builds on them. The relative inefficiencies of
individuals gets cloaked with the efficiency of others in that field.
3. Individual roles are balanced and shared to facilitate both the accomplishment of tasks and
feeling of group cohesion and morale.
4. The team in adept at solving problems rather than being weighed down by interpersonal
issues or competitive struggles.
5. Differences of opinions are encouraged and freely expressed.
6. Mistakes are treated as opportunities for learning and development rather than for pinning
down any individual.
7. Members are self-motivated in setting high-level objectives and encourage each other to realize
the objectives of the project.
8. Members identify themselves with the team and consider it an important source of both
professional and personal growth.
High-performing teams become champions, create breakthrough products, exceed customer
expectations and get projects completed with no cost or schedule variances. The team members are
bonded together with a missionary zeal to achieve project objectives. The team members trust each
other and exhibit a high level of collaborative working.
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5 Stage of Group Development

(Tuckman)
Adjourning
Performing
Norming
RETURN TO
Storming INDEPENDENCE
Forming DEPENDENCE/
INDERDEPENDENCE
Pre-group
INDEPENDENCE
Figure 12.6 Tuckman development model
THE FIVE-STAGE TEAM DEVELOPMENT MODEL

Bruce Tuckman, an educational psychologist, first developed the five-stage development process that
most high performing teams follow.
Bruce Wayne Tuckman identified a five-stage development process that most teams follow to
become high performing as early as 1965. He called them ‘Tuckman stages’ and they comprised
the following stages: forming, storming, norming, performing and adjourning. Figure 12.6 shows
the team progress through the various stages. Tuckman believed that these stages are inevitable for
a team to grow to a point where they become a performing team. Although Tuckman had initially
outlined only the first four stages, the fifth stage of ‘adjourning’ was added in 1977. When working
jointly with Mary Ann Jenson, the team realized that for projects and project management, the fifth
stage of adjourning was also important. It is quite natural for a high performing team to feel sad at
the end of a project since the team members have effectively worked as one and would now onwards
be going their separate ways.
Stage 1—Forming
As the heading suggests, this is the phase when the team meets each other for the very first time
and the members are introduced to each other. If the team members are unknown to each other,
then a formal round of ice-breaking involving sharing of backgrounds, interests and experiences are
shared. At times, it is possible that team members belonging to the same organization are familiar
with each other, although have not worked together as a team. The team learns about the project
that they are going to work on, the project level objectives and start pondering on their individual
role in the whole scheme of things. Effectively, the team members explore each other and find out
ways and means of working together.
The role of the team leader or the project manager at this stage is vital since he has to explicitly
be cognizant of the team goal and individual team member roles. A set of team working norms gets
drafted to guide all the team members in the future.
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482 | Chapter 12
Stage 2—Storming
Now that the ground rules get set on working together, there is a possibility that some team mem-
bers renege or resent the norms that have been set for working together. At times, if the team mem-
bers have some past working together experience, good or bad, it generally comes out at this stage.
The team members compete with each other for status and acceptance of their ideas, with each
member having a different opinion on what should be done. The maximum positioning and discon-
tent, if any, happens at this stage of the team development. For team members who like to remain
neutral and avoid conflicts, this is a difficult phase as they end up taking sides, much to their dislike.
The skills of the project manager get tested at this stage to ensure that team members listen to each
other and learn to respect their differences. Towards the end of this stage, the team becomes more
accepting of each other and learns how to work together in the best interests of the project. It is not
uncommon for teams to not go beyond this stage if there are too many conflicts, as the management
would not want to risk the project.
Stage 3—Norming
This is the most happening phase in the team development model simply because the team now bur-
ies their differences and shows semblance of team working. Adjustments are made to the individual
styles of working and slowly, the team takes prominence over the self. Members respect each other’s
opinions and value their differences, learn more about the team member’s strength and weaknesses,
and develop their work styles around team member’s strengths. In this stage, the team has agreed
to the team rules of working together and will share their information and resolve team conflicts, if
any, with ease. By now, the team members trust each other and actively seek each other out for as-
sistance and inputs. Rather than competing with each other, the team members believe in a common
goal and make significant progress in their work. At this stage, the project manager has a less role in
team development and can focus more on the job at hand. The team leader can then assume the role
of a team coach and be of assistance to any team member should he require any inputs.
Stage 4—Performing
The combined team output now is at a very high level with the focus on achieving the team goal as
a whole. The team members know the strengths and weaknesses of members and focus on maximiz-
ing the returns of everyone’s best points. The high performing teams work independently and the
team members are highly motivated to achieve the project objectives. In case of any disagreements,
the teams have figured out a redressal addressing mechanism which works on an automatic mode.
In this stage, the team leader or the project manager is not at all involved in decision-making as
the team members themselves make decisions quickly. The team leader continues to monitor the
progress of the teams and celebrate milestones with the team regularly. The team leader serves as a
gateway when decisions need to be taken from the higher management.
Stage 5—Adjourning
In this stage, the project comes to an end and there is not enough work for all the team members.
Some of the team members might be occupied with the finishing and documentation work but the
others may not find enough work to see them through for the full day. This stage looks at the team
from the perspective of the well-being of the team rather than from the perspective of managing the
team, as in the earlier four stages. The best practises of the team should be captured and documented
for further use. Celebrations and a warm good-bye session follow next and although there will be
sadness of separation, in the best interests of the organization, the high performing team must be
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SITUATIONAL FACTORS AFFECTING TEAM DEVELOPMENT

Research indicates that high-performance teams are likely to develop under the following working
conditions:
1. There are 10 or fewer members per team.
2. Members should have volunteered to be on the team.
3. Members are in the project from the very start.
4. Members working on projects are assigned full-time to the project and are not working on
any other assignment.
5. The organization believes in cooperation and trust.
6. The strong matrix organization is in place, wherein all the members report to the same project
manager.
7. The team is complete in that all the functional areas are well represented.
8. The team members are within a conversational distance of each other and preferably in the
same location sharing the same common facilities.
9. All the members are fully aligned with the project objectives.
10. The members recognize each other’s strengths.
11. The team members are encouraged to speak without the fear of embarrassment or rejection.
12. There is mutual respect for each team member.
It must be mentioned that the above idealistic situations would seldom be available to any project
manager but it helps to know the above the factors. At least, it will tell the project manager about
the additional burden he will have to carry in the absence of the above factors. It is also common
to allot team members to the project without involving the project manager. This happens when
the functional departments or a central planning department allots team members on the basis of
the availability of resources. Again, to optimize the resources of the organization, the allocation of
team members may be linked to the progress of the project and this is a disadvantage. Moreover, in
the initial phase of the project, the resources do not get allocated full-time. For a project manager,
to work effectively in the face of these challenges is a daunting task. It is important for the project
manager and the team members to recognize the situational constraints they are operating under
and alter their management styles accordingly.
Building High-performance Project Teams

High-performance teams (HPTs) is a concept within organization development referring to teams,
organizations, or virtual groups that are highly focused on their goals and that achieve superior
business results. High-performance teams outperform all other similar teams and they outperform
expectations given their composition.
— Katzenbach et al.: The Wisdom of Teams, Harper Business, 2003
In most organizations, a lot of emphasis is laid on building a high-performance team, but due to
operational issues and the requirements of the organization, the effort gets wasted. However, in the
interest of the students and project professionals, we list down the steps that need to be taken to
build high-performance teams. The project manager is the key person in the entire project and his
role is the most vital role in building high performance teams. The project manager is required to re-
cruit team members, conduct meetings, establish a team identity, create a common sense of purpose,
develop a shared vision, manage performance reward systems, resolve any difference of opinions or
conflicts between team members, and rejuvenate the team when the team morale is low. A seasoned
project manager would take advantage of the situational factors that contribute to the development
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of teams and change those factors that inhibit the working of teams. To do so, project managers
should possess highly involved management style that nurtures teamwork and best manages the in-
terface between the team and the organization. Some of the steps the project manager should carry
out or practise are as follows:
Gain trust early through active listening and empathy: The project manager should spend his
1.
time entirely listening to people and not trying to have a quick fix solution. In the initial few
weeks, the project manager should be patient and make copious notes before responding to a
situation. Although the organization and seniors would be happy to see the project manager
take charge from day 1 by seeing him take decisions, doing so would create barriers and blocks
in the process. The desire to act swiftly while in good faith, often communicates a lack of re-
gards for the existing structures and may tell your team that you do not think they were smart
enough to take such an obvious solution. According to some project managers, a quick fix
solution would almost always alienate the team members from the project manager. It would
make the team members defensive at the start of the process which is highly undesirable.
Create a clear purpose that will inspire people: The purpose of an organization or the project
2.
is one of the most easy and important aspects and does not require much thought. However,
more often than not, you observe that this is not the conventional wisdom. A strong purpose
excites team members to put in their best and be excited with the work in hand. For example,
the project team working on a metro project may not be motivated enough if the only objec-
tive is to finish the project on time as per the project deadlines. If the team is informed that
they are working towards alleviating the troubles of the city residents in ensuring a comfort-
able ride daily from residence to place of occupation, the sense of urgency of purpose is better
instilled. If you do not have a clear purpose, then keep asking yourself why your organization
matters until you can articulate a very high-level problem that your customers, their custom-
ers, or the world would face if you ceased to exist.
Establish a clear strategy and plan and communicate it often: The responsibility of the project
3.
manager is to ensure that the entire team is well aware about the organization purpose, the
organization strategy and how the organization plans to reach there. Every meeting or sub-
meeting of the team should enforce the strategy and plan of the organization in clear terms.
While this may sound like excessive communication, the reality is that organizations naturally
entropy as employees lose sight of the goal and direction is corrected.
Develop unambiguous and measurable indicators of success: A clear demarcation needs to be
4.
done between effort and results. A proper definition of goals helps in achieving or knowing
the under achievement of the goals. Once the goals are clearly defined, an objective way of
measuring the advances in the project can be achieved.
Ensure that every individual has clear responsibilities and performance expectations: If we
5.
consider an analogy of a pilot flying an aircraft, the pilot is not the only one responsible
for the safe operations of the flight. The maintenance crew, the ground crew and the cabin
crew have a set of objectives which they achieve, and the air traffic control–which can be
termed external to the project—also has their own objectives. Only when all these objectives
are aligned do we have a successful flight. Similarly, it is imperative for the project manager
to define the responsibilities and objectives for team members in case the project has to be
completed on time and as per the required specifications.
As can be observed, the role of the project manager is key in developing a high-performance team.
The organization role can, at best, be to support the project manager in providing adequate resourc-
es. The primary role of building high-performance teams is only enabled with the project manager
and not with the organization.
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MANAGING PROJECT CONFLICTS

Disagreements and conflicts emerge in all projects during various stages of life cycle. Bombay High
is an offshore oilfield 50 kilometres (31 miles) off the coast of Mumbai, India, in about 75 me-
tres (246 feet) of water. The oil operations are run by India’s Oil and Natural Gas Corporation
(ONGC). The designer for this project is Engineers India Limited, the project management consul-
tant is Larsen and Toubro, and the equipment is supplied by Hyundai Heavy Engineering, South
Korea. With such completely diverse organizations working towards a common goal, would there
not be any disagreements or conflicts?
As the project manager is responsible for the project and everything that can be associated with
the project, he is also responsible for resolving the conflicts that can arise in any project. A project
manager’s role is pivotal in resolving any conflict and he must exercise extreme restraint to accom-
plish the same. The project manager must remember that his job is not to make a decision or take
sides in case of a conflict but to facilitate the discussion within the group so that the team reaches a
consensus on the best possible solution. Consensus does not necessarily mean the consent of all the
team members fully, rather a consensus means that all are in agreement to the best solution under
the circumstances. For facilitating a group discussion to resolve a team level conflict the following
four major steps may be considered:
Problem identification: The project manager should be very careful in identifying the problem
1.
involving all the team members and should not be opinionated, which means he should re-
frain from saying ‘I think this is the problem’. Rather, he should identify the underlying prob-
lems like in a brainstorming session, without any evaluation. This will allow group members
to freely state their observations which could also later help in identifying solutions to the
problem. The project manager could use the gap analysis technique for identifying the prob-
lem, by stating the requirement and the diverse happening, which is the conflict. A project may
be delayed and rather than saying that the problem is the delayed project a gap analysis of
the desired outcome and the present outcome could be compared. Any problem at this stage
should not be considered as small or large, but the objective should be to eliminate it. If there
is some defensive posturing while carrying out the problem solving exercise, then it is better
postponed to the next available slot.
Generating alternatives: Once the listing of the gaps or problems are done, the next step is to
2.
generate alternate solution. Should the problem solving alternatives require creativity, brain-
storming is desirable. Piggybacking of ideas in encouraged at this stage by the project man-
ager. Many alternatives should be created at this stage. A change of location and surrounding
may also aid the process of generating alternatives.
Reaching a consensus: The next logical step is to evaluate and assess the applicability of all the
3.
objectives identified earlier. Prioritizing the objectives of conflict resolution can sometimes aid
the process of reaching an acceptable solution and a consensus for the same. Building a consen-
sus is never an easy task especially if the solution is linked to someone in particular. Wherever
the ownership of a solution is with more people, consensus building becomes relatively easy.
Minority views of dissent should also be welcomed and they should be given a fair hearing. If
these minority views are discarded, then the process of consensus building can be difficult.
Implementation of the idea: Once a solution to the conflict has been obtained, the imple-
4.
mentation of the same is equally important. In case the process of implementation is faulty,
then the best ideas to resolve any conflict can be frustrated. The project manager should be
fully open to revisit the solution or append the solution during the implementation phase. If
the chosen decision ultimately fails to resolve the conflict, the lessons learnt from the process
should not be wasted but added to the collective memory.
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At times, the conflicts are not functional conflicts but dysfunctional conflicts where a team mem-
ber has used a cuss word towards the other team member. Such behaviour may create an irreconcil-
able conflict and no amount of effort by the project manager can be useful here. To resolve such
conflicts, the organization culture and list of dos and don’ts could be better utilized. Strange it may
seem, but sometimes, the absence of a conflict could also be a problem. Often, due to time pressures,
delivery constraints, or the authoritarian attitude of the project manager, the dissent or problems
gets stifled. The potential of these stifled problems raising their ugly head at a later date is more wor-
risome. A devil’s advocate within the team can always be useful in cases where there are no conflicts.
The project manager should value and protect dissenting views within the team. Ultimately, such
timely critique of ideas leads to a successful project.
MANAGING VIRTUAL PROJECT TEAMS

Projects do not happen inside the closed doors of an office complex. The action in project manage-
ment takes place at the site where the project is being set up. Often, the project office is set up at the
site and the head office is located at a far-off place. With advances in communication, we can have
long-distance virtual communications for taking business decisions but this will put an additional
burden on the execution of the project. As this remote working is going to be a trend, the concept of
‘virtual working’ will catch up soon and the efficient team worker will be the one who is an effective
virtual team worker. Another key benefit of virtual team working is the ability to cost effectively
tap into a wide pool of talent available at various locations. Most software development companies
allow the flexibility of working from home and such issues could be mostly experienced in software
projects.
A virtual project team worker is one who fulfils the following conditions:
1. He is not expected to be physically present where the action is.
2. He is likely to work on the move from any location.
How different is it for the project manager to manage a team that is co-located and remotely lo-
cated? Are there any extra considerations or risks in managing a virtual team? These are some of
the questions with which a project manager managing virtual project teams must grapple with. A
virtual team worker is likely to feel isolated if the set-up is not right. The virtual team worker is also
required to be more self-managing and focus his efforts differently than the collocated team worker.
A project manager managing a virtual team will have to consider five primary aspects to maintain
effectiveness. They are summarized as follows:
1.
Manage goals: Although goal setting is important for any project, in case of a virtual project,
it become more pertinent, simply because the team worker cannot physically walk into the of-
fice of the project manager to ask clarifying questions or review goal statements displayed on
the walls. Explaining to the virtual team worker how his individual goals and targets matter
to the whole project is, therefore, necessary. It would be a good idea to add the project team
goal statements on the worksite or the communications medium.
Manage communications: About 80% of the project manager’s time is spent in effective com-
2.
munication and if the communication is not effective enough, the time spent will be even
more. Although there is no difference in the communication needs in case of collocation and
remote location, in case of remote location, the possibility of clarifying the communication
after it is concluded is absent. In collocated team communication, non-verbal communication
also plays a role, which is lost in case of remote location communication. The electronic com-
munication medium link between the remote location and the project office should be handled
well; otherwise, much of the information is lost in the medium. Visual communication is far
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superior than non-visual communication, because in the latter case, it is not known whether
proper attention is being paid to the exchange of ideas or not.
Keep people motivated: It is human nature to feel demotivated in case the virtual team worker
3.
feels isolated and complains of missing all the action. Out of sight could also lead to loss of
focus, and hence, the project manager must devise ways and means to engage and motivate
the remote team players effectively. Holding a virtual team lunch could also be interesting as
it brings in the fun element while communicating between remote locations.
Regularly assess the effectiveness of the remote communications: The project manager must
4.
rightly assess the comfort level of each team member with the medium of communication be-
ing used. The willingness of the virtual team member to accept the virtual setting and not feel
isolated should be periodically checked. Off-line discussions may help assuage the effective-
ness of formal communication channels.
Use virtual collaborative tools: Phones with conferencing facility, online web meetings, global
5.
time clock and mobile computers are some of the gadgets required for effective virtual com-
munications. Just like a new software is tested for compatibility, the communication systems
across location should be tested first for compatibility and the comfort of team members in
using the same.
To conclude, we can state that virtual teams are increasingly prevalent in the developed world
and the newer generation is well acquainted with the tools that aid the process. Managing a virtual
project team can be richly rewarding and requires the same competencies as required in managing a
collocated team. The added element here is the sensitivity to communication styles of the remotely
located team members. The success of the virtual team depends entirely on the communication abil-
ity and the ability to manage communications with all the team members.
PROJECT TEAM PITFALLS

High performance project teams can produce dramatic results but there are some serious pitfalls
of working in teams, which the project manager should be aware about. Some of the issues are
summarized here.
1.
Groupthink: The tendency of the group member to think critically in favour of what everyone
feels right is termed as groupthink. Not voicing dissent because you are the lone voice can lead
to groupthink. This malady can happen when pressures for conformity exist, coupled with an
illusion of invincibility to suspend critical discussions of decisions. When decisions get made
fast with no consideration to alternatives, there is a chance that such decisions can go wrong
at a later time. The sane voices of dissent or requesting deliberations are often termed the ‘bad
guys’ in the team and this muzzles their creativity. The aim of the team is agreement and not
argument is a classic example of groupthink.
Bureaucratic bypass syndrome: In order to do things quickly. the normally accepted protocols
2.
are bypassed and the command channels are labelled bureaucratic. Short-cuts are always ap-
pealing and invigorating, especially if done with a good objective. A team which works thus
might alienate other workers who are outside the team and are constrained to follow the laid
down procedures of the organization. Such outside team workers constrained by the organi-
zation norms will later on put roadblocks to the project progress.
Team spirit becomes team infatuation: One of the reasons for the stage of ‘adjourning’ a high-
3.
performance team is to ensure that the team members can also work effectively well when
working in different teams. A high-performance team is a source of tremendous satisfaction
to the team members, which will generate emotions such as excitement, joy and chaos when
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working on challenging assignments. The team members become much infatuated by the
challenges of the project and the team talent available to them. This complete preoccupation
with the project and the project team, while contributing greatly to the remarkable success of
the project, can leave a string of broken professional and personal relationships. Burnout and
disorientation can be experienced by the team members once the project is complete.
Going native: This phrase was coined by the British when they found that their British
4.
employees mingled with the locals that they tend to forget the goals of their British employers.
A similar phenomenon can be experienced when the team members are working overseas or
in case of those who closely identify themselves with the customer’s needs, disregarding the
needs of the employers. Dealing with these situations is tricky and best left to the situation at
hand. At best, the project manager should be aware of such possibilities.
SUMMARY
Project managers often work with less than adequate or ideal conditions, and hence, it is difficult to
define the organization structure or support facilities which will work in their favour. Furthermore,
the projects themselves are unique and not repetitive, which makes defining a single system that
works across various situation next to impossible. The matrix organization structure works best for
project management, which can further be classified into balanced structure, strong structure and
weak structure, depending on the clout of the project manager vis-à-vis` the functional manager.
Projects are prone to quick fix solutions which work when problems have to be solved on the spot,
but eventually come to haunt the project team at a later date. Moreover, the project manager has to
deal with issues related to people which can never be a quick fix solution. Projects are characterized
by glorious uncertainties, and hence, the tendency for innovative and off the cuff solutions. Project
managers must invariably work in teams and have to curb their own desires to set a benchmark for
the team. Required to lead by examples, the project manager ends up in situations not to his liking
but has to devote his energies to the same.
Project managers need to forge team identity and a shared vision that command the attention and
allegiance of team workers. Virtual project management is advisable when teams are located in re-
mote places and have their own problems related to improper communication. The project manager
would have the difficult task to stress the team but reward individuals in the team to encourage and
motivate them to excel further. In doing so, they have to be careful in not doing too good a job and
avoid the pitfalls of excessive group cohesion.
Finally, we can say that the project manager has to lead by example and that his success as a team
leader depends, to a large extent, on walking the talk. It would require personal conviction, disci-
pline, sensitivity to team dynamics and a constant awareness of how personal actions are perceived
by others.
KEYWORDS
• Dysfunctional conflict • Project team working

• Functional organization • Virtual project team
• Matrix organization • Project conflicts
• Projectized organization • High performance project teams
• Groupthink • Tuckman’s five-stage team development
• Project vision model
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R e v i ew Q ues t i o n s
1. What are the limitations of the functional organization?

2. Describe the advantages of the matrix organization over projectized organization.
3. Describe the advantages of the matrix organization over functional organization.
4. Why do high performing teams function well?
5. Explain the stages identified by Tuckman in the five-stage team development model.
6. What role does a project manager play in effective team management?
7. Explain the difficulties encountered in managing virtual teams.
8. What are the further bifurcation of the matrix organization?
9. For a small project of duration six months, what type of organizational structure would you
recommend and why?
10. Why is it important to adjourn the team process when there is a highly cohesive team?
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Chapter
13 EARNED VALUE ANALYSIS
leARninG obJeCTiveS

❍ Understand the importance of Project Variance Analysis before the completion of the
project.
❍ When to and when not to perform Earned Value analysis
❍ Key advantages of the Earned Value Analysis
❍ The application of Earned Value Analysis techniques in projects.
❍ Understand how the S curve analysis leads to Earned Value Analysis.
INTRODUCTION
A project is a one-off entity that has to be completed over a period of time within the constraints of
scope and cost besides time. As a project is unique, we cannot benchmark it against some earlier proj-
ect to know whether the pace of work is sufficient to complete the project on schedule or not. The cost
associated with the project is the next concern. If a project costs `10,000 and it has to be completed
within 10 days, then an approximate expense of `1,000 per day is budgeted. If after 6 days, `6,000 has
been spent, then does it mean that the project is within cost estimates? If only expenditure is incurred
but the actual work worth only `3,000 is carried out (and the additional `3,000 spent is lying idle in
inventory) in 6 days, then this project would be delayed and also affected by cost overruns. If a proj-
ect developer wants to abandon a project midway through the development phase, then what value
should be considered for the incomplete work? Less than the actual value is a loss for the seller and a
value more than the actual value of the incomplete work is a loss for the buyer.
In both the above examples, it is clear that there has to a means to monitor the progress of the
project and then using these means as a base or a standard to address various project control
related queries such as estimate of additional cost to complete the project, the extent of delay in
project completion, the extent of cost overrun, etc. The ‘earned value’ concepts discussed later in
this chapter are effective tools to address these queries and for effective project control mechanisms.
Project control involves a periodic comparison of performance with target, a search for the causes
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of deviation and computing the effects of these deviations on the project schedule and project cost.
Earned value analysis helps in the latter objective of project control and is not designed to identify
the causes of variation.
VARIANCE ANALYSIS APPROACH

The traditional approach to project control involves a comparison of the actual cost with the bud-
geted cost to determine the variance. An example of variance analysis is given in Table 13.1.
Table 13.1 Cost and variance data for two projects
Activity A Activity B
Budgeted cost in the period `60,000 `40,000
Cumulative budget to date `220,000 `85,000
Actual cost in the period `65,000 `32,000
Cumulative actual cost to date `270,000 `90,000
Variance for the period `(5,000) `8,000
Cumulative variance to date `(50,000) `(5,000)
If the cumulative budget or budgeted cost for a period is more than the cumulative actual cost or
the actual cost for the period, respectively, then it shows a positive variance. This means that the ex-
penses incurred are less than the budgeted cost. However, it does not say whether whatever expenses
incurred have been converted into fruitful work. Furthermore, these results cannot be extrapolated
to predict the cost overrun or schedule overrun.
Therefore, the variance analysis approach is inadequate for project control for the following reasons:
1.
It is backward looking rather than forward looking. It tells us only what happened in the past
but does not answer the following questions: What will happen in future? Is the rate of work
accelerating or decelerating?
2.
It does not use the data effectively to provide integrated control. In the traditional time period
under analysis, variance analysis shows whether more or less resources were expended than
budgeted. This information cannot be linked up with the value of work done, which is vital for
purposes of control.
3.
It does not tell the exit value of the incomplete project. An exit mechanism is always required
in any project. If, for some reason, the project owner wants to abandon the work midway
and/or sell the project to someone, then the work completed till date should also be valued.
Traditional variance analysis approach does not provide for this requirement.
4.
The variances cannot be used as a benchmark. As mentioned earlier, projects being unique
cannot be benchmarked or compared with other similar projects. The variances are not linked
to the work being complete and hence cannot be used for benchmarking the rate of project
completion. We will not be able to know whether the rate of completing project work has
actually increased or decreased with time.
PERFORMANCE ANALYSIS: MODERN APPROACH

TOWARDS PROJECT MONITORING AND CONTROL
Effective control over a project requires systematic ‘performance analysis’ that calls for answering
the following questions:
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1. Whether the project is progressing as per the original planned schedule or is it ahead of the
planned schedule (in which case it is a favourable development) or is it behind the planned
schedule (in which case it is not a favourable development)?
2. Whether the project cost expenditure is progressing as per the original budgeted cost or is it
requiring lesser funds than the budgeted cost (in which case it is a favourable development)
or is it requiring more funds than the budgeted cost (in which case it is not a favourable
development)?
3. On the basis of the performance analysis, if we extend the trend for the entire project, then
what would be the revised schedule of project completion and the revised cost estimates?
4. In case of project cost overrun, what is the quantum of overrun, and similarly, in case of
delayed duration for project, what is the quantum of delay? At times, there is a penalty for
project delay and this information can help the organization in working out the cost of delay.
5. The quantum of course corrections to be initiated to mitigate the effects of project cost or
project schedule overrun can be worked out.
For small and simple projects, project managers conduct performance analysis for the project as a
whole, or for its major components. As the project becomes larger and more complex, performance
analysis needs to be done for individual segments of the projects, which are referred to as ‘cost accounts’.
Earned value management (EVM) is a technique that can be used by project managers to assess
a project’s progress over time and allow project teams to understand the consequences of varia-
tions in schedule and cost performance of their projects periodically. EVM can be a periodic review
mechanism for managements to conduct periodic audits on the project progress. With the help of
EVM techniques, the management can keep track of the value being created on the project. This
information would be handy whenever the management would want to exit from the project in fa-
vour of other owners. EVM can also be used for assessing the acceleration or deceleration changes
within periods.
EVM is, thus, an important method for integrating the three key project features, namely scope,
schedule and resources for monitoring project performance. As discussed earlier, EVM compares the
amount of work or effort that was planned with what was actually earned and spent to determine if
cost and schedule performance is as planned. By comparing the planned value (the ideal progress of
the project) to the earned value (the value of the project to date based on work or effort expended), a
project manager can detect if the project is going awry in the initial stages. If any of the performance
indices is less than 1.0, then the project is in danger of going overboard on the respective parameter.
Hence, if the cost performance index (CPI) is less than 1.0, then the project is in danger of requiring
additional funds to complete, and if the schedule performance index (SPI) is less than 1.0, then the
project is in danger of incurring penalty cost for delay in completion. By monitoring and reviewing
these metrics, a project manager can report these statistics to management so that they can determine
whether to continue with the project or to abandon it. The process may be revised for similar proj-
ects by learning from the statistics and modifying expectations.
Some important points on earned value analysis/earned value management method for measuring
project performance are summarized here.
1. It compares the amount of work that was planned with what is actually accomplished to
determine if the project is progressing as planned in respect of the budgeted cost and planned
duration.
2. As the project review is taken at the end of a specific time period, it helps us to determine how
much volume and value of work have been done on a particular day of an activity/project.
3. It is a cost performance measure that helps the project manager understand the total cost
performance. It is imperative that the project be completed within the initial cost estimates
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494 | Chapter 13
as the project viability depends on many assumptions, the fundamental assumption being the
project cost.
4. The project schedule is always a factor of time, which could be days, weeks or months.
Analyzing this data when compared with the actual performance, which is measured in cost,
becomes difficult due to the presence of different units. EVM uses cost data to monitor the
schedule performance and thus is very convenient. The schedule of execution can be repre-
sented in cost terms as planned value, which is a big advantage.
5. Comparing the benchmark of project progress, whether CPI or SPI during different time peri-
ods, gives an indication to the management whether the performance of project execution has
improved or deteriorated over time. A CPI of 0.8 in the 1st month and 0.9 in the 2nd month
tells the management that the pace of doing work on the project has improved from the 1st
month to the 2nd month.
REQUIREMENTS FOR EARNED VALUE ANALYSIS

For earned value analysis (EVA) calculations, we need the following data:
1. Budget cost for a project or activity
2. Actual cost for the project or activity
3. Budgeted project cost estimate. If the individual budget costs are given, then the sum total of
all activity budget costs is sufficient
4. Project schedule and the progress till the date of review
Earned value is the budgeted cost of the completed work till date for the project. The budgeted cost
of each completed activity is considered its value and completion of an activity is considered to
contribute equivalent of its value to the total value of the project. In other words, an activity earns
value equivalent to its budgeted cost only after it is complete.
An activity that is partially completed on a particular date is also considered to have earned value
equivalent to its percentage completion on the given date multiplied by its total budgeted cost.
If the actual expenditure incurred for completion of an activity exceeds its budgeted cost, then the
project does not earn any additional benefit since activity parameters are well-specified. Even in case
of higher actual expenditure (which is the consequence of faulty project planning), the earned value
is equal to the budgeted cost of the activity/project. The variance in this case indicates cost overrun.
The total value earned for the project on any given date is the total of earned values of all the
completed activities till date as well as the total of earned values to date for partially completed
activities.
To make the working principles of earned value concepts very clear, we need to define the follow-
ing terms.
Terms used in Earned Value Analysis

1. Budgeted Cost of Work Scheduled or Scheduled Expenditure or Planned Value
It is the budgeted cost of work that should get completed till the given date if the project were
to run on schedule. At the onset of the project, the project schedule is known. The apportion-
ing of funds to the various components of the project is known during the budgeting process,
which means the budgeted expenses relating to the schedule are known. This aspect is used to
easily calculate the scheduled expenditure up to the review date.
2.
Budgeted Cost of Work Performed or Earned Value
It is the budgeted cost for the completed work. When any of the activity is completed, it is con-
sidered to have earned value equivalent to its budgeted cost. Therefore, the total of budgeted
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cost for the work performed to date is the total earned value of the project. This is not depen-
dent on the actual expenditure incurred on doing the work, and hence, there should not be a
misconception that the actual expenditure on the project is the value of the project.
3. Actual Cost of Work Performed or Project Expenditure or Actual Cost
It is the actual cost incurred in completing the work. It covers the total cost of work done,
goods received and services used, whether these have been paid for or not.
4. Budgeted Cost for Total Work
This is simply the sum of budgeted cost of individual activities/sub-projects comprising the
entire project work.
5. Additional Cost for Completion
This represents the estimate for the additional cost required for completing the project de-
pending upon the project performance till the review date. The estimate may change after the
next review period if the project performance has improved or deteriorated.
Given the above terms, the project may be monitored along the following lines:
1. Cost variance: BCWP - ACWP
(when ACWP 7 BCWP, the cost variance is negative and this indicates cost overrun)
or
Cost variance = Difference between the estimated cost of the activity and the actual cost of the
activity.
2. Schedule variance (in Cost Terms): BCWP - BCWS
or
Schedule variance = difference between the budgeted cost of performed work (Earned Value)
and the budgeted cost of work scheduled for that period. As both these terms are mentioned
in cost terms, the schedule variance is expressed in cost terms.
If BCWP 6 BCWS, then it indicates schedule delay and in case BCWP 7 BCWS, then it tells us
that the schedule is leading and that the project would be completed before schedule.
BCWP
3. Cost Performance Index (CPI) =
ACWP
The cost variances only tell us whether the project is consuming more resources or less re-
sources then the budgeted value. The effect of these variances on the final project cost is not
known and sometimes, we are interested to know the effect on the project cost due to the
variances. CPI helps us in getting answer to this query.
Budgeted project cost

Estimated project completion cost =
CPI
The additional funds required to complete the project, additional cost of completion (ACC)
are given by,
ACC = Estimated project completion cost - Budgeted project cost
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BCWP
IV. Schedule Performance Index (SPI) =
BCWS
The schedule variances only tell us whether the project is behind schedule or ahead of schedule
when compared with the required schedule in cost terms. The effect of these variances on the
final project duration is not known and at times, we are interested to know the effect on the
project duration due to the variances. Moreover, the schedule variances in cost terms and the
project duration in time terms are not compatible. SPI helps us in getting answer to this query.
Budgeted project duration

Estimated project duration =
SPI
V. Estimated Cost Performance Index
This performance index uses the data available at the time of review to calculate the CPI for
the project when completed, presuming that the project continues to progress to completion
at the present rate of work.
Budgeted cost of total work (BCTW)
Estimated CPI =
Actual cost of work Additional cost of
+
performed (ACWP) completion (ACC)
Example 13.1
A Bangalore-based software company has obtained a fixed cost contract for the supply, installation,
testing and commissioning of 3,000 desktop computers of the same specification at a cost of `600
lakhs. The company had estimated that it could supply, install, test and commission 100 comput-
ers per day so that the entire work can be completed in 30 days. The project status was reviewed
after the completion of 20 days. It was noted at the time of review that 1,800 computers have been
installed and the cost incurred was `380 lakhs. It was estimated at the time of the review that a
sum of `260 lakhs would be required for completion of the pending work, i.e., installation of the
remaining 1,200 computers.
Find the following:
(i) Budgeted cost of work scheduled at the end of 20 days, which is the review period.
(ii) Budgeted cost of work performed till the review period.
(iii) Actual cost of work performed.
(iv) Cost variance
(v) Schedule variance in cost terms
(vi) Cost performance index
(vii) Schedule performance index
(viii) Additional cost for completing the project
(ix) Project duration and whether the project can be completed within the 30 days duration
Solution:
(i) Project: To install 3000 desktop computers in 30 days @ 100 computers per day. Project
duration is 30 days.
` 600 Lakhs
(ii) Cost per computer = = ` 20,000 / −
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(iii) Review period: After 20 days.

(iv) Budgeted cost of work schedule (BCWS) or schedule expenditure or planned value (PV)
BCWS = 20 Days * 100 computers per day * `20,000 per computer = `400 lakhs.
It is the budgeted cost of work to be completed till given date if the project runs on schedule.
(v) Budgeted cost of work performed (BCWP) or earned value (EV) = 1,800 computers * `20,000
per computer = `360 lakhs
It is the budgeted cost of the completed work. When any of the activity is completed, it is con-
sidered to have earned value equivalent to its budgeted cost. Therefore, the total of budgeted
cost of the work performed to date is the total earned value of the project. It is to be noted
that although the actual expense to complete this work might be more the value earned is
equal to the budgeted cost of completed work.
(vi) Actual cost of work performed [ACWP] [project expenditure] [actual cost] = `380 lakhs
The software company has spent this amount in order to complete a task, which should have
ideally cost `360 lakhs.
(vii) Budgeted Cost for Total Work (BCTW)
This is simply the total budgeted cost for the entire project work = `600 lakhs.
( viii) Estimate of cost for remaining work:
(3,000 - 1,800) * `20,000 per computer = `240 lakhs. This represents the estimate for the
additional cost required for completing the project.
In the problem, it is given to be `260 lakhs. It will be seen later whether the estimate of `240
lakhs or `260 lakhs is correct (or whether both of them are incorrect)
(ix) Cost Variance (CV) = BCWP - ACWP
= `360 lakhs - `380 lakhs
= (−`20 lakhs)
Note: When CV is negative, it indicates cost overrun. If CV is positive, then it means the
project is within the budget. In this case, there is a cost overrun.
(x) Schedule variance (SV) (in cost terms)
= BCWP - BCWS
= `360 lakhs - `400 lakhs
= (-`40 lakhs)
Note: When SV is negative, it indicates that the project is behind the schedule; if it is positive,
then the project is ahead of the schedule.
(xi) Cost performance index (CPI)
BCWP 360
= = = 0.9474 = 0.95
ACWP 380
This means that for every one rupee spent, we have done 95 paise worth of the work, or for
every one rupee spent, we received Re. 0.95 worth of cost performance.
A value 7 1 indicates that the work is being completed better than planned, whereas a value
6 1 indicates that work is costing more than planned.
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(xii) Schedule performance index (SPI)

BCWP 360
= = = 0.9
BCWS 400
It is a measure of schedule efficiency. The project is progressing at 75% of the rate originally
planned.
(xiii) Estimated cost at completion

Budgeted cost for total work (BCTW)
=
CPI
600 600
= = = `633.33 Lakhs
0.95 360 / 380
Cost over run = `633.33 - `600 = `33.33 lakhs
or
ACC = `33.33 lakhs.
(Earlier, we had estimated the project completion total cost to be either `620 lakhs or
`640 lakhs).
(xiv) Estimated time at completion
Project duration 30 days

= = = 33.33 ∼ 34 days
SPI 0.9
Time overrun = 34 - 30 = 4 Days.
Example 13.2
A project began on 1 April, 2006 and was expected to be completed by 31 December, 2006. The
project is being reviewed on 30 September 2006 when the following information was sourced:
Budgeted cost for work scheduled (BCWS): `60,00,000
Budgeted cost for work performed (BCWP): `55,00,000
Actual cost of work performed (ACWP): `58,00,000
Budgeted cost for total work (BCTW): `1,00,00,000
Additional cost for completion (ACC): `50,00,000
Determine the following:
(i) Cost variance
(ii) Schedule variance in cost term
(iii) Cost performance index
(iv) Schedule performance index
(v) Estimated CPI
(vi) Total cost overrun
(vii) Duration of the project
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Solution:
1. Cost variance = BCWP - ACWP
Budgeted cost of work performed = 5.5 million
Actual cost of work performed = 5.8 million
Cost variance = 5.5 - 5.8 = -0.3 million.
As the cost variance is negative, the cost incurred on the project is more than budgeted cost.
2 Schedule variance in cost terms = BCWP - BCWS
Budgeted cost of work scheduled = 6 million.
Schedule variance = 5.5 - 6 = -0.5 million.
As the schedule variance is negative, it indicates that the project is running behind schedule.
BCWS 5.5
3. Cost performance index (CPI) = =
ACWP 5.8
= 0.95
BCWP 5.5
Schedule performance index (SPI) =
4. = = 0.92
BCWS 6.0
BCTW
Total cost overrun =
5. − BCTW
CPI
10
= − 10 = 0.5263 million
0.95
6. Additional cost to complete = Estimated total cost - ACWP
= (10/0.95) - 5.8 = ` 4.73 million
Original duration 9 months
Project duration =
7. = = 9.78 months
SPI 0.92
Example 13.3
A project has a budget of `250 Crores and is scheduled to complete in a period of 80 weeks. A
review of the project at the end of 50 weeks gave the following addition details:
Budgeted cost of work performed (BCWP): `170 Crores
Actual cost of work performed (ACWP): `180 Crores
Budgeted cost of work scheduled (BCWS): `187 Crores
Find the following:
(i) Cost variance
(ii) Schedule variance in cost terms
(iii) CPI
(iv) SPI
(v) Cost of completion
(vi) Time of completion
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Solution:
Total project budget cost – `250 Crores
Scheduled completion – 80 weeks
Date of reporting – End of 50 weeks
(i) Cost variance = BCWP - ACWP
Budgeted cost of work performed = 170 Crores
Actual cost of work performed = 180 Crores
Cost variance = 170 - 180 = -10 Crores
As the cost variance is negative, the cost incurred on the project is more than budgeted cost.
(ii) Schedule variance in cost terms = BCWP - BCWS
Budgeted cost of work scheduled = 170 Crores
Schedule variance = 170 - 187 = -17 Crores
As the schedule variance is negative, it indicates that the project is running behind schedule.
BCWP 170
(iii) Cost performance index (CPI) = = = 0.944
ACWP 180
BCWP 170
(iv) Schedule performance index (SPI) = = = 0.91
BCWS 187
BCTW 250
(v) Cost of completing the project = = = ` 264.8 Crores
0.944 0.944
Scheduled duration
(vi) Time of completion = = 87.91 weeks ∼ 88 weeks
0.91
Till the date of reporting, the actual cost of work performed has exceeded the budgeted cost by `10
Crores. The cost of completion would exceed the budgeted cost of completion by `15 Crores and
the time of completion would exceed the scheduled completion period of 80 weeks by 8 weeks.
Example 13.4
A project has a budget of `5,00,000 and is scheduled to be completed in 1 year. Table 13.2 shows
the cumulative values of planned costs, earned value and actual costs at the end of each of the first
4 months.
Month Planned Cost Earned Value Actual Cost

1 `20,000 `24,000 `23,500
2 `60,000 `58,000 `62,000
3 `1,10,000 `95,000 `1,05,000
4 `2,20,000 `1,90,000 `2,05,000
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Calculate the following values:

(a) Cost performance index for each of the 4 months.
(b) Schedule performance index for each of the 4 months.
(c) Estimated cost to complete the project based on the performance at the end of the 4th month.
(d) Estimated time to complete the project based on performance at the end of the 4th month.
Solution:
The planned cost is actually budgeted cost of work scheduled. The earned value is the budgeted cost
of work performed and the actual cost is actual cost of work performed.
BCWP
( a ) Cost performance index (CPI) =
ACWP
BCWP
( b ) Schedule performance index (SPI) =
BCWS
The CPI and SPI for each month is worked out in a tabular form shown in Table 13.3.
Table 13.3 CPI and SPI for each month
BCWP BCWP
Planned Cost Earned Value Actual Cost CPI = SPI =
Month BCWS BCWP ACWP ACWP BCWS
1 `20,000 `24,000 `23,500 1.02 1.2
2 `60,000 `58,000 `62,000 0.94 0.97
3 `1,10,000 `95,000 `1,05,000 0.90 0.86
4 `2,20,000 `1,90,000 `2,05,000 0.93 0.86
(c) Estimated cost to complete the project on the basis of the

BCTW
CPI of fourth month =
CPI
where, BCTW is the budgeted cost for total work
CPI = 5,00,000/0.93 = `5,37,634
(d) Estimated time to complete the project on the basis of the SPI of 4th month
Estimated project duration 1

= = = 1.163 years
SPI 0.86
Example 13.5
The following data (Table 13.4) are known about a project when the project review was conducted:
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Table 13.4 Project data details
% Completion Cost in ` Lakhs

Activity Scheduled Actual Budgeted Actual
1 100 100 10.0 12.0
2 100 100 12.0 12.5
3 70 60 18.0 12.0
4 55 50 25.0 13.0
5 30 25 20.0 6.0
6 10 0 15.0 0
7 0 0 10.0 0
8 0 0 8.5 0
9 0 0 6.5 0
10 0 0 5.0 0
The project is expected to be completed in 35 days. Find the following:

(i) Budgeted cost for work scheduled
(ii) Budgeted cost for work performed
(iii) Cost variance
(iv) CPI
(v) SPI
(vi) Cost of completion of the project
(vii) Time of completion of the project
Solution:
BCWS (Budgeted cost of work scheduled)

= % of scheduled completion * budgeted cost for that activity.
BCWP (Budgeted cost of work performed)
= % of actual completed * budgeted cost for that activity.
The analysis is shown in Table 13.5.
Table 13.5 Analysis table
% Completion Cost in ` Lakhs

Scheduled Actual Budgeted Actual BCWS BCWP Cost Variance
Activity (A) (B) (C ) (D) (A * C) (B * C) BCWP - (D)
1 100 100 10.0 12.0 10 10 -2
2 100 100 12.0 12.5 12 12 -0.5
3 70 60 18.0 12.0 12.6 10.8 -1.2
4 55 50 25.0 13.0 13.75 12.5 -0.5
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5 30 25 20.0 6.0 6 5 -1
6 10 0 15.0 0 1.5 0 0
7 0 0 10.0 0 0 0 0
8 0 0 8.5 0 0 0 0
9 0 0 6.5 0 0 0 0
10 0 0 5.0 0 0 0 0
Total 130.0 55.5 55.85 50.3 -5.2
BCWS = `55.85 lakhs

BCWP = `50.3 lakhs
Cost variance = BCWP - ACWP = 50.3 - 55.5 = -5.20
CPI = BCWP/ACWP = 50.3/55.5 = 0.91
SPI = BCWP/BCWS = 50.3/55.85 = 0.90
Cost of completion = Budgeted cost/CPI = 130/0.91 = `142.86 lakhs
Time of completion = Scheduled duration/SPI = 35/0.90 = 38.89 ~ 39 weeks.
Hence, the project is likely to be completed in 39 weeks instead of the scheduled 35 weeks and the
project cost is likely to escalate up to `142.86 lakhs.
Example 13.6
The following information (Table 13.6) is available at the end of day 40 of a new plant erection
project. Determine if the project is under control based on earned value evaluation system, and if
not, what is the likely extent of cost and time overruns at completion.
Table 13.6 Project-related details
Total Budget Actual Cost Actual % of

Activity Predecessor(s) Duration (Days) (` ’000) till Date Completion
A – 10 300 250 100
B A 8 400 450 100
C A 12 350 380 100
D C 0 0 0 0
E B, D 18 405 400 70
F E 16 450 – 0
Solution:
We need to know the project duration to calculate the time overrun. Moreover, to calculate the
earned value, we must know how many activities have been completed and how many activities
are partially complete. Hence, construction of a network diagram, activity early start (ES) and early
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finish (EF) times and project duration must be calculated at the beginning. The network diagram is
shown in Figure 13.1. Table 13.7 gives us the ES, EF times.
4 E 18
B8
A 10 F 16
1 2 5 6
D0
C 12
3
Path 1: A ~ B ~ E ~ F, duration = 52 days.

Path 2: A ~ C ~ D ~ E ~ F, duration = 56 days.
Duration Total Budget Actual Cost Actual % of

Activity Predecessor(s) (Days) ES EF (` ’000) till Date Completion
A – 10 0 10 300 250 100
B A 8 10 18 400 450 100
C A 12 10 22 350 380 100
D C 0 22 22 0 0 0
E B, D 18 22 40 405 400 70
F E 16 40 56 450 – 0
At the end of day 40, activities A, B, C, D and E should have been completed. Activities A, B, C and
D are completed but only 70% of activity E has been completed.
Budgeted cost of work performed = 100% * budget for activity A
+ 100% * budget for activity B + 100% * budget for activity C + 100%
budget for activity D + 70% * budget for activity E = `1,333.50 (`’000)
Budgeted cost of work scheduled = 100% * budget for activity A
+ 100% * budget for activity B + 100% * budget for activity C + 100%
budget for activity D + 100% * budget for activity E = `1,455 (`’000)
Actual cost of work performed = Sum of actual cost till date = 250
+ 450 + 380 + 400 = `1,480 (`’000)
Cost variance = BCWP - ACWP = 1,333.50 - 1,480 = -146.5 (`’000)
This indicates that the project is behind schedule.
BCWP 1,333.50
CPI = = = 0.90
ACWP 1,480
BCWP 1,333.50
SPI = = = 0.92
BCWS 1,455
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Budgeted cost for project 1,905

Project cost = =
CPI 0.90
= 2.116.67 (` ’0000)
Hence, the project cost overrun is 2,116.67 - 1,905 = `211.67 (`’000).

Project time = Project duration/SPI = 56/0.92 = 60.87 ~ 61 days. Hence, project cost overrun =
61 - 56 = 5 days.
Example 13.7
The progress observed at the end of the 7th day from the beginning of a 12-day duration project is
given in Table 13.8. The actual cost incurred till date is reported to be `3,100.00.
Draw a Gantt chart for the project and find the project performance on the basis of cost
and schedule performance indices. (Assume the activity costs are incurred uniformly over its
duration).
Immediate Estimated Budgeted Cost % of Completion

Activity Predecessor Duration in Days of Activity (`) at End of 7 Days
A – 3 600 100
B – 1 200 100
C A 4 800 75
D B 4 700 100
E B 5 500 95
F D 2 200 80
G E 3 500 50
H C 4 400 0
I F 2 600 0
J G 3 300 0
MMM, VI Sem, Mumbai Univ, 2003, 2012
Solution:
We have to construct the network, find the ES and EF for all activities and estimate the duration of
the project.
Path 1: A ~ C ~ H, duration = 11 days.
Path 2: B ~ D ~ F ~ I, duration = 9 days.
Path 3: B ~ E ~ G ~ J, duration = 12 days.
Path 3 is the longest duration path and hence the critical path. The budgeted project duration
is 12 days.
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C4
2 4
H4
A3
F2 I2
1 5 7 9
B1 D4
J3
E5 G3
3 6 8
Immediate Duration Budgeted cost % of Completion

Activity Predecessor in Days ES EF of Activity (`) at End of 7 Days BCWS BCWP
A – 3 0 3 600 100 600 600
B – 1 0 1 200 100 200 200
C A 4 3 7 800 75 800 600
D B 4 1 5 700 100 700 700
E B 5 1 6 500 95 500 475
F D 2 5 7 200 80 200 160
G E 3 6 9 500 50 167 250
H C 4 7 11 400 0 – –
I F 2 7 9 600 0 – –
J G 3 9 12 300 0 – –
Total 4,800 3,167 2,985
The Gantt chart for the project is as given in Figure 13.3.

Gantt Chart
J
I
H
G
Activity
F
E
D
C
B
A
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Time
Figure 13.3 Gantt chart at the end of the 7th day

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Budgeted cost for work scheduled is `3,167

Budgeted cost for work performed is `2,985
Actual cost of work performed is `3,100 (data given in the problem).
BCWP 2,985
Cost performance indices (CPI) = = = 0.96
ACWP 3,100
BCWP 2,985
Schedule performance indices (SPI) = = = 0.94
BCWS 3,167
Cost of completion = Budgeted cost/CPI = 4,800/0.96 = `5,000

Time of completion = Scheduled duration/SPI = 12/0.94 = 12.76 ~ 13 days.
Example 13.8
A project consisting of eight activities was reviewed on completing of 12 days after its start. Find the
project performance on the basis of cost and schedule performance indices. What is the estimated
duration of the project?
Table 13.10 Activity related details
Duration Budgeted Cost Actual Cost Actual % Completion

Activity (Days) (` ’000) (` ’000) at the End of Day 12
A1-2 5 60 62 100
B2-3 7 70 70 100
C2-4 5 75 73 100
D2-5 7 82 70 90
E3-6 6 69 0 0
F4-6 8 54 10 20
G5-7 6 50 0 0
H6-7 5 40 0 0
Solution:
We will have to construct the network (Figure 13.4) and identify the critical path to know the proj-
ect duration.
Path 1: A ~ B ~ E ~ H, 23 days.
Path 2: A ~ C ~ F ~ H, 23 days.
Path 3: A ~ D ~ G, 18 days.
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B7 E6
A5 C5 F8 H5
1 2 4 6 7
D7 G6
5
Figure 13.4 Network diagram for the project
The project duration is 23 days. The evaluation of the ES and EF times is as shown in Table 13.11.
Table 13.11 Project activity-related details
Duration Budgeted Actual Cost Actual % Completion

Activity in Days ES EF Cost (` ’000) (` ’000) at the End of Day 12 BCWP BCWS
A1-2 5 0 5 60 62 100 60 60
B2-3 7 5 12 70 70 100 70 70
C2-4 5 5 10 75 73 100 75 75
D2-5 7 5 12 82 70 90 73.8 82
E3-6 6 12 18 69 0 0 0 0
F4-6 8 10 18 54 10 20 10.8 13.5
G5-7 6 12 18 50 0 0 0 0
H6-7 5 18 23 40 0 0 0 0
Total 500 285 289.6 300.5
Notes:
1. BCWP is the percentage of the budgeted cost converted into actual work or the earned value.
2. BCWS is the budgeted cost of work that should be performed up to the day of review, i.e.,
12. In case of activity F, up to day 12, 2 days (out of a total 8 days) should be completed as
 54 
per schedule. Hence, BCWS for activity F is  × 2 = days = 13.5.
 8 
Budgeted cost of work performed = 289.6
Budgeted cost of work scheduled = 300.5
Actual cost of work performed = 285
BCWP 289.6
CPI = = = 1.02
ACWP 285
BCWP 289.6
SPI = = = 0.96
BCWS 300.5
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The project is delayed but is working within the cost estimates. The estimated project duration is:
Project duration 23
= = 23.96 ∼ 24 days
SPI 0.96
Example 13.9
A project with a total budgeted cost of `350 Crores is scheduled to be completed in 80 weeks. A
periodic review taken at the end of 50 weeks after commencement indicates the following:
EEarned value BCWP: `270 crores
Actual expenditure ACWP: `280 crores
Scheduled earned value BCWS: `287 crores
What do you interpret about the project progress till date with regard to time and cost on the
basis of following calculations?
(i) Cost performance index (CPI)
(ii) Schedule performance index (SPI)
(iii) Estimated cost to complete
(iv) Estimated time to complete
Solution:
(Such problems for 10 marks must be attempted without fail, as by far, this would be the easiest
question.)
BCWP 270
(i) Cost performance index or CPI = = = 96.43%
ACWP 280
BCWP 270
(ii) Schedule performance index or SPI = = = 94.07%
BCWS 287

On the basis of CPI and SPI, we can conclude that the project is suffering both cost and
schedule delays and is likely to incur additional cost for completion with duration beyond the
budgeted duration.
Budgeted cost of total work (BCTW)
(iii) Estimated cost to complete =
CPI
350
= = `362.96 ∼ `363 Crores
0.9643
Budgeted project duration

(iv) Estimated duration to complete the project =
SPI
80
= = 85.043 ∼ 86 days
0.9407
(Rounding off should be to the next higher whole number).

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510 | Chapter 13
Example 13.10
The progress observed at the end of the 7th day from the beginning of the project is as given in
Table 13.12.
Table 13.12 Activity-related details
Duration Budgeted Cost Actual Cost Actual % Completion

Activity (Days) (` Lakhs) (` Lakhs) at the End of Day 7
A1-2 3 5 4 100
B2-3 4 8 9 90
C2-4 3 4 5 95
D2-5 8 5 3 60
E3-6 5 3 0 0
F4-6 4 2 1 30
G5-7 5 10 0 0
H6-7 3 7 0 0
If the costs are incurred linearly in proportion to activity completion, then find the following:
(i) Cost variance
(ii) Cost performance index
(iii) Schedule performance index
(iv) Estimated cost of project completion
(v) Estimated duration of the project
Solution:
The first step is to construct the network (Figure 13.5) and identify the critical path to know the
budgeted project duration.
B4 E5
A3 C3 F4 H3
1 2 4 6 7
D8 G5
5
Figure 13.5 Network diagram for the project
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Path 1: A ~ B ~ E ~ H, 15 days.
Path 2: A ~ C ~ F ~ H, 13 days.
Path 3: A ~ D ~ G, 16 days.
The project duration is 16 days. The evaluation of the ES and EF times is shown in Table 13.13.
Table 13.13 Project activity related details
Duration Budgeted Actual Cost Actual % Completion

Activity (Days) ES EF Cost (` Lakhs) (` Lakhs) at the End of the Day 7 BCWP BCWS
A1-2 3 0 3 5 4 100 5 5
B2-3 4 3 7 8 9 90 7.2 8
C2-4 3 3 6 4 5 95 3.8 4
D2-5 8 3 11 5 3 60 3 2.5
E3-6 5 7 12 3 0 0 0 3
F4-6 4 6 10 2 1 30 0.6 0.5
G5-7 5 11 16 10 0 0 0 0
H6-7 3 12 15 7 0 0 0 0
Total 44 22 19.6 23
Notes:
1. BCWP is the percentage of the budgeted cost converted into actual work or the earned value.
2. BCWS is the budgeted cost of work that should be performed up to the day of review, i.e.,
7. In case of activity F, up to day 7, 1 day (out of a total 4 days) should be completed as per
2 
schedule. Hence, BCWS for activity F is  ×1 day  = 0.5.
 4 
Budgeted cost of work performed = 19.6
Budgeted cost of work scheduled = 23
Actual cost of work performed = 22
(i) Cost variance = BCWP - ACWP = 19.6 - 22 = -2.4
BCWP 19.6
(ii) CPI = = = 0.89
ACWP 22
BCWP 19.6
(iii) SPI = = = 0.85
BCWS 23
Budgeted cost of total work
(iv) Estimated cost of the project on completion =
CPI
44
= = 49.43 ∼ 50 lakhs
0.89
Project duration 16
(v) = = 18.82 ∼ 19 days
SPI 0.85
Hence, the project is likely to be delayed and completed in 19 days.
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512 | Chapter 13
Example 13.11
Consider the data given in Table 13.14 for a small project. The actual performance is measures at
the end of 5 months in terms of % actual completion and actual cost incurred. Assume all activities
will begin at the earliest, determine the following:
(a) Cost performance index and schedule performance index.
(b) Revised project duration and cost.
Table 13.14 Small project data
Activity Predecessor(s) Normal Time Normal Cost Actual Cost % Actual Completion
A – 4 6 6 100
B – 12 15 6 40
C – 4 3 3 95
D A 10 15 2 7
E C 6 10 0 0
F A 14 11 8 7
G B, D, E 8 10 0 0
Solution:
(a) Although there is no requirement to draw the network diagram for the calculations, we will
as a matter of practice still draw the network diagram as shown in Figure 13.6. The early start
(ES) and early finish (EF) besides BCWP and BCWS calculations are shown in Table 13.15.
CPI = BCWP/ACWP = 16.67/25 = 0.67
SPI = BCWP/BCWS = 16.67/19.21 = 0.87
(b) Revised project cost = Budgeted cost/CPI = 70/0.67 = 104.48
Revised project duration = Budgeted duration/SPI = 22/0.87 = 25.29 ~ 26 months
Table 13.15 BCWP and BCWS calculations
Normal Normal Actual % Actual Early Early

Activity Predecessor(s) Time Cost Cost Completion Start Finish BCWP BCWS
A – 4 6 6 100 0 4 6 6
B – 12 15 6 40 0 12 6 6.25
C – 4 3 3 95 0 4 2.85 3
D A 10 15 2 7 4 14 1.05 1.5
E C 6 10 0 0 4 10 0 1.67
F A 14 11 8 7 4 18 0.77 0.79
G B, D, E 8 10 0 0 14 22 0 0
Total 70 25 16.67 19.21
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A4 F 14
D 10
B 12 G8
1 4 5
C4
E6 Paths: A – F = 18 Months
A – D – G = 22 Months
3 B – G = 20 Months
C – E – G = 18 Months
Project Duration ➔ 22 Months
[Budgeted Duration]
Figure 13.6 Network diagram and critical path calculations
COMMON AVOIDABLE MISTAKES WHILE SOLVING

EARNED VALUE ANALYSIS PROBLEMS
Some common avoidable mistakes while solving earned value analysis problems are as follows:
1. Earned value analysis puts a lot of focus on the budgeted value for completed activities or
completed projects or proportionally to partially completed projects. Hence, for any calcu-
lation of budgeted cost of work performed (BCWP) or budgeted cost of work scheduled
(BCWS), only the budgeted cost is considered. You must not consider the actual cost for cal-
culating the BCWP or the BCWS.
2. There may not be much difference in the calculated final values of BCWP and BCWS but the
differences in computation must be clearly understood. BCWP calculates the earned value and
BCWS calculates the planned value in cost terms. For BCWS, all work planned till the date of
review must be considered and work of future date (even if done before the date of review),
is completed ignored. For BCWP, all work completed (fully or partially) till the date of review
and beyond is considered.
3. The numerator for CPI and SPI is always same, i.e., BCWP. The denominator is ACWP and
BCWS, respectively.
4. If the CPI is less than 1, then the project will be over budget, and if the SPI is less than 1, then
the project would be delayed. Fractional time period is not admissible and hence should be
rounded off to the next higher whole number.
SUMMARY
Project evaluation and control are part of every project manager’s area of concern. If the project is a
small project, then the control mechanisms and prediction of completion days/completion costs are
simple. However, as the project gets complex involving many activities, a formal control technique
is required. Control measures can help in identifying the corrections required at the later stages
and can keep the organization better prepared for excesses of cost and time delays. Moreover, the
abandonment option can also be valued using the earned value management systems. Earned value
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514 | Chapter 13
concepts are not new; although its initial use was in military contract, in recent years, the private
sector has come to depend on the system for managing multiple and large projects.
Earned value is different from planned value in that an expense being planned (or incurred) does
not necessarily convert into value (earned value) for the project. It is only after the planned work
is carried out at the planned cost that the project acquires the appropriate value. This is the basis
of earned value analysis and this factor can be extrapolated to compute the cost for completing the
remaining part of the project and the duration. The presumption here is that there is a linear rela-
tionship between cost and duration and that the speed at which the work has progressed till the date
of review would be maintained till the end of the project.
Therefore, we can conclude that the earned value analysis is a form of project variance analysis
that is more progressive and useful as compared with the traditional variance analysis that can at
the most be useful for conducting a post-mortem on project progress.
U n s o lv e d P r o b l e ms
Example 13.12
A project with a total budgeted cost of `250 Crores is scheduled to be completed in 80 weeks.
A periodic review taken at the end of 50 weeks after commencement indicates the following:
Earned value, BCWP = `170 Crores
Actual expenditure, ACWP = `180 Crores
Scheduled earned value, BCWS = `187 Crores
What do you interpret about the project progress till date with regard to time and cost on the basis
of following calculations?
1. Cost performance index
2. Schedule performance index
3. Estimated cost to complete
4. Estimated time to complete
Example 13.13
A project with a total budgeted cost of `300 Crores is scheduled to be completed in 80 weeks.
A periodic review taken at the end of 50 weeks after commencement indicate the following:
Earned value, BCWP = `220 Crores
Actual expenditure, ACWP = `230 Crores
Scheduled earned value, BCWS = `237 Crores
What do you interpret about the project progress till date with regard to time and cost on the basis
of following calculations?
1. Cost performance index
2. Schedule performance index
3. Estimated cost to complete
4. Estimated time to complete
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K E Y WO R D S
• Earned value (BCWP) • Additional cost of completion (ACC)

• Planned value (BCWS) • Cost performance index (CPI)
• Actual cost (ACWP) • Schedule performance index (SPI)
• Budgeted cost (BCTW)
1. Explain how ‘S’ curves and the concept of ‘earned value’ are useful to top management in as-
sessment, monitoring and control of project schedules and costs.
2. Write a short note on earned value management.
3. Explain the terms cost performance index and schedule performance index in relation to
earned value analysis. How is the project performance interpreted on the basis of these indi-
ces? Illustrate your answer with the help of a suitable example.
4. Write short note on earned value management.
5. Earned value analysis is a forward-looking analysis of project variance. Do you agree with the
statement? Give your reasons for the same.
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Chapter
14 FUTURE TRENDS IN PROJECT

MANAGEMENT
LeARninG oBJeCtiveS

❍ Understand the need for Agile project management techniques.
❍ Analyze the differences in project management requirements for evolutionary and scope
ill-defined projects.
❍ Examine the different types of Agile project management techniques.
❍ Comprehend the limitations of Agile project management techniques.
INTRODUCTION
‘You did not come to us, but we came to you,’ were the prophetic words of Kumar Mangalam Birla,
to the then Managing Director and CEO of Larsen and Toubro, Anil Manibhai Naik, in 2001,
when the Aditya Birla group took over the Reliance group stake in Larsen and Toubro, an engineer-
ing conglomerate. The context was that the late Aditya Birla had once tried to hire the services of
A.M. Naik, but the latter chose to continue with Larsen and Toubro.
Similarly, future trends in project management would come to project management professionals
sooner than they can imagine and in a direct manner. Although we may not be aware of the future
trends in project management, with the needs of the customers changing quickly and with the de-
velopments in the IT happening rapidly, one must always be prepared for the same. The concept
of agile project management, keeping the flexibility of the customer, is touted to be the next stage
in project management evolution. Although largely applicable in the case of software development
projects, agile project management can also be practised in engineering projects. The Metro project
in Mumbai uses the tunnel boring machine for tunnelling below the city and its heritage sights. The
software that monitors the progress of the tunnelling operation is so agile that it can detect even a
few millimetres of shift in the direction of the tunnel. This shift in direction is then quickly relayed to
project managers over ground who then suggest remedies or counter measures. These developments,
although very welcome and are the need of the hour, put an extra pressure in the performance of the
project management professional. The ‘floats’ shrink and the window for decision-making becomes
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518 | Chapter 14
PROJECT PROJECT PROJECT PROJECT PROJECT

Conception Definition Launch or Performance Project
& Initiation & Planning Execution & Control Close
1 2 3 4 5
Project Scope & Status & Post

Objectives
Charter Budget Tracking Mortem
Project Work Breakdown Quality Project

KPIs
Initiation Schdue Deliverables Punchlist
Effort & Cost

Gantt Chart Quality Reporting
Tracking
Communication Plan Forecasts Performance
Risk Management
Figure 14.1 The five stages of project management
extremely narrow. The software projects, which form the bulk of project management text and cases
always have an even bigger problems of delivery. As the new software is expected to exponentially
improve the performance of the existing systems, the design and delivery mechanism of the software
development process is also expected to improve exponentially. It is paradoxical, at times, that the
development of software project and utility of the software project be thus linked, but with chang-
ing technology and higher performance delivery targets, the same becomes inevitable.
The new millennium saw a large growth in the software projects over the engineered projects and
along with this growth, the attended problems of software projects surfaced. In case of engineering
projects, the entire project is first conceived in the design stage, then the planning stage details the
work involved, and finally, the implementation stage is all about following the plan. Any deviations
from the plan are red flagged and corrective actions are immediately taken to ensure completion of
the project with minimal deviation from the planned progress. The five stages of the project manage-
ment process are shown in Figure 14.1.
In case of software projects, frequent changes in the specification of the requirement of the project
was a big problem. This meant that established practices of project management of planning the
project took a back seat as the project scope got continuously changed and updated. How can one
follow the generally accepted project management stages in toto? In some parts, these dilemmas were
also faced by new product development teams in which the end products are not well defined and
generally evolves over time. We have a situation where a prototype design leads to newer ideas and
thus newer prototypes and the end product are a result of the development process rather than the
development process being a result of the end product in mind. Figure 14.2 identifies the five stages
of software project development which is also applicable to the process of developing new products.
The requirements of such software and other projects lead to the development of Agile project
management (Agile PM). Rather than planning the entire project at the start of the design cycle, Agile
PM relies on incremental, iterative development cycles to complete the newer generation projects.
Ken Schwaber, a software developer, product manager and industry consultant worked with Jeff
Sutherland to formulate the initial versions of the Scrum development process and presented Scrum
as a formal process at OOPSLA’95.*) Subsequently, SCRUM was extended and enhanced at many
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Future Trends in Project Management | 519
PRODUCT REQUIREMENTS DOCUMENT

Requirements
Design SOFTWARE ARCHITECTURE
Implementation SOFTWARE
Verification
Maintenance
Figure 14.2 Waterfall model of software project development
software companies and IT organizations. An Agile manifesto comprising 17 signatories proclaimed

that they value the following:
Individuals and interactions over processes and tools
1.
Working software over comprehensive documentation
2.
Customer collaboration over contract negotiation
3.
Responding to change over following a plan
4.
Schwaber and Sutherland were two of the 17 initial signatories of the Agile Manifesto.
Schwaber further explained the process of Agile PM by giving and analogy of a building being
constructed. Traditionally, buyers only purchased flats after the buildings were ready and had a little
or no say in the proceedings of building the flats. However, as per the Agile PM, the buyers have an
iterative interaction in selecting the design, layout, plumbing and fittings on a room-to-room basis.
Therefore, the final house is built according to the customer’s wishes. This is similar to the concept
of ‘mass customization’ in manufacturing wherein the flexibility and personalization of custom-
made products are combined with the low unit costs associated with mass production. To think of
it rationally, a ‘mass’-made product cannot be customized and a custom-built product cannot be
made in large numbers. However. the need of the hour and the demand from customers make this
concept of ‘mass customization’ a reality. Similarly, Agile PM, which is till now being applied to
software and product development projects could be one of the future trends in project management
for engineering projects as well.
Agile PM is excellent for exploratory projects in which requirements need to be developed and
newer technologies tested. The focus in Agile PM is the collaboration with the customer more often
than the traditional project management. This is because the traditional project manager was the
* Schwaber, Ken (1 February 2004). Agile Project Management with Scrum. Microsoft Press. ISBN 978-0-7356-1993-7.
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520 | Chapter 14
Continious Visibility
Integrate
&
Test
Clients
Integrate
&
Test
n
ent
lopm
e Releas
e Fe Developers Users
Dev e
Add ility n Re dba
ib vie ck
p ons w
Res
t2
sp Ad men
Integrate
y1
& pt
lop
ce
ilit
on d
Ac
sib
Test ve
?
De
Re
ment 1
AGILE
sibility 1
START
Project
Respon d
Initiate Project Release to

Develop
Ad
YES TEST
Market
Define
Requirements
Management
High Level No
Requirements
Figure 14.3 Typical stages in Agile project management
subject expert, whereas in the case of exploratory projects, the project manager may only know the
stages involved in the development process but not the end use. The customer, on the other hand,
may have an idea of what he actually wants but may not be efficient in articulating his requirements.
Therefore, the need of the hour is to break the entire project development process into smaller
functions so that the customer inputs can be obtained at every stage, making it closer to what the
customer finally requires. Customer collaboration comes at different stages and more frequently
than traditional project management wherein the customer collaboration is only during the scope
definition and during the project progress review stage. While the iterative development processes
have been around for some time, it is only recently that agile methodologies have received attention
in the gambit of project management lexicon.
In this chapter, we attempt to discuss the broad framework of Agile PM, its comparison with the
traditional project management techniques, its pluses and minuses, and the future scope of evolu-
tion. It must be remembered that the objective of this chapter is not to provide a comprehensive
account of all the methods associated with Agile PM, but rather to provide an indicator of the newer
developments in projects management.
Traditional versus Agile PM methods

A cursory look at the schematic comparison of the traditional and agile project management tech-
niques put up the same stages and might appear deceptively similar. However, a closer examination
tells us that the progression from one stage to the other is not unidirectional but can be circular,
reflecting the customer participation and changes in the scope of the work. Traditional project man-
agement specifically emphasizes on conducting a long and detailed upfront planning for all projects
irrespective of whether the requirements are known or not. The long upfront planning is emphasized
to ensure fixing the variable such as time, cost, scope, etc. A lot of time is spent on upfront planning
these parameters. In today’s fast changing environment, requirements keep changing, and all this up-
front planning is wasted if there is a major change in the specification at a later point of time. While
we complain about the high rate of project mortality with many project failures, the software and
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CONCEPTION
AGILE
INITIATION
CONCEPTION
ANALYSIS
INITIATION
DESIGN
ANALYSIS
CONSTRUCTION
DESIGN
TESTING
CONSTRUCTION
DEPLOYMENT
TESTING
DEPLOYMENT
MODEL
Figure 14.4 Schematic comparison between traditional and Agile PM
exploratory projects have a worse failure rate. This is because the scope change at a later date makes
the initial planning fruitless. Agile PM attempts to manage the subsequent scope changes in the proj-
ect planning process by providing sufficient options. This concept of allowing for scope changes at a
later stage can also be incorporated in the engineering projects, which were this far considered very
rigid. The ability to respond to changes at a later date is one of the big advantages of the Agile PM.
Figure 14.5 Traditional project management versus Agile project management
Traditional Project Management Agile PM

1. Concentrate firmly on thorough planning up 1. The planning is evolutionary and develops as the
front before the start of the project. project progresses.
2. The scope of the project is well defined and 2. As the scope of the project gets defined after the
there is not much opportunity to deviate from project progresses, Agile PM is suitable for ill-
the defined scope. defined projects.
3. With proper definition of the scope, the work 3. WBS and the work breakdown package are
breakdown structure (WBS) and the work not used here as the work content is not fully
package are firmly defined. understood.
4. The execution of the project relies heavily on 4. As software projects have different end users with
the WBS packages being completed as per different requirements, Agile PM is useful due to
schedule. The non-completion of the scheduled the constant interactions with the customers.
WBS packages leads to the concept of S Curve
and earned value analysis.
5. Most problems and risks associated with the 5. The problems associated with the project are
project are identified at the beginning of the process-dependent and as such cannot be
project. envisaged at the beginning. They are tackled as
and when they happen.
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522 | Chapter 14
Figure 14.5 Traditional project management versus Agile project management (Continued)
6. Project control is the process of comparing the 6. As the Agile PM is evolutionary, there is no
plan and the actual progress and if required, the well-defined project progress plan, resulting in
corrective actions to get the project on track. difficulties in monitoring the project on the basis
of variances.
7. This requires a very high degree of 7. A high degree of predictability is not required as
predictability to be effective. the project execution process is evolutionary with
solutions to problems being thought off as the
problems arise.
8. The waterfall model for software project 8. Software projects are often difficult to articulate,
management involves a series of logical and hence, the waterfall model leads to delays
steps with a key assumption that all the or cancellations. Agile PM being evolutionary
requirements of the process are well known at helps minimize these risks of delays and project
the beginning of the process. cancellations.
9. Traditional project management emphasis 9. When the technology being developed is at a
on linear processes, comprehensive nascent stage, things become very uncertain. Agile
documentation, spends high time on upfront PM is efficient in these situations.
planning; all requirements are fixed for the
lifetime of the project and works in a managed
organization.
10. Traditional project management is adverse 10. The change management system is inbuilt in
to changes and follows a formal change Agile PM process.
management system.
11. In case of traditional project management, 11. Agile PM follows self-organized style
techniques of the organization are as individuals are not managed and the
centralized. organization is de-centralized.
12. The split of work package is not possible 12. As Agile PM splits the processes in iterations/
and a shift of priority, once the project goes small amounts of work, the balance can be
into the execution stage, is not possible. This changed and prioritized later.
makes the traditional project management
technique rigid.
13. The key point to be noted is that traditional 13. The key point to be noted is that Agile PM
project management techniques were techniques are developed to work in an
developed to work in a predictable zone. unpredictable zone.
14. Projects are executed as decided earlier. 14. Projects are executed as they evolve.
15. Traditional project management techniques 15. Agile PM techniques embrace change.
avoid change.
16. They are typically characterized by 16. They are typically characterized by self-
conventional project teams. organized project teams.
SCRUM is one of the most common used forms of Agile PM. According to www.scrum.org, SCRUM
is a framework within which people can address complex adaptive problems while productively and
creatively delivering products of the highest value possible. Although often considered a part of
SCRUM, the following SCRUM values were added to the SCRUM guide. The following content is
adopted from Scrum.org for explanation purposes only.
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COURAGE
Scrum team members have courage to
do the right thing and work on tough
problems
FOCUS
Everyone focuses on the work of the
Sprint and the goals of the scrum team
COMMITMENT
People personally commit to achieving
the goals of the scrum team
RESPECT SC
Scrum team members respect each
RU ES
M VA L U
others to be capable, independent people
OPENNESS
The scrum team and its stakeholders
agree to be open about all the work and
the challenges with performing the work
Figure 14.6 Scrum values
AGILE PM
Primarily, Agile PM does not know the final project design in great detail and is continuously
developed through a series of incremental iterations over time. Iterations in Agile PM typically refer
to short-time frames which last from one week to four weeks. Much similar to a WBS package,
the iterations in an Agile PM develop a workable product that satisfy one or more of the desired
product features that can be demonstrated to the customer and other project stake holders. The
iterative processes have the following advantages:
1. Continuous improvement, verification and validation with customer inputs.
2. Frequent demonstration and monitoring of the changes in process, leading to lower chances
of the finished project being unacceptable on completion.
3. Early detection of problems and defects.
It appears from growing evidence that the Agile PM method of evolutionary development is su-
perior to traditional plan-driven project management. Finally, students should note that the Agile
PM is not one set method but rather a collage of methods designed to respond to the challenges of
unpredictable projects. Some of the popular Agile PM models are as follows:
1. Scrum
2. Rational Unified Process (RUP)
3. Extreme programming (XP)
4. Crystal clear
5. Agile modelling
6. Lean development
7. Dynamic system development model
8. Rapid product development
9. Kanban
10. Adaptive software development (ASD)
11. Agile unified process (AUP)
12. Scaled Agile framework
We mention only some of the most used Agile PM models here.
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524 | Chapter 14
Scrums
• Agile developement technology involving roles in

the process: Product owner, Scrum master, Team
• Activities include Sprint Planning, Sprint Review
and scrum meeting
• The artifacts produced are named Product
Backlog, Sprint Backlog and Burn down Chart.
• The Product backlog is a list of product features
prioritized by value delivered to the customer.
• The sprint backlog refers to the development tasks
that are needed in order to implement a feature
Figure 14.7 Process of Scrum
SCRUM
Of all the Agile PM frameworks, Scrum has enjoyed the maximum exposure and recognition. In
195, Schwaber and Sutherland presented a paper that first described Scrum. They used an early
version of the framework while working together at the Easel Corporation. Many of the ideas of
Scrum were derived from a Harvard Business review article written in 1986 by Hirotaka Takeuchi
and Ikujiro Nonaka. The paper described building a self-empowered team where everyone had a
daily global view of the product. The paper used rugby as an analogy and cited Scrum as an ex-
ample of a holistic or all-at-once team. A rugby Scrum tried to push to a destination without discrete
roles but as a self-organized group. The paper further introduced the concept of cross-functional
teams, which is described as organizational slices of sashimi. Different groups in the organization
Dynamic System Development
• Resource first methodology, it fixes time and resources first and then
adjusts the amount of functionality accordingly
Feasibility Study Business Study Functional Model

A feasibility report and Key features of the business Iteration
a development plan are and technology are Functional iterations,
produced over a few weeks assessed, leading to system each iteration involving
architecture definition and enhancements and
prototyping plan. increments
Design and Build Implementation

Iteration
System meets minimum
requirements and iterate
the system based on the
customer’s comments
Figure 14.8 Building blocks of dynamic system development

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were layered into one team. This meant that customer representatives, testers and graphic designers
would work as one team.
As Scrum was the earliest framework, many Agile teams still use the Scrum language to describe
Agile roles. This is true even when the Agile team decides not to adopt all of the Scrum processes.
Dynamic System Development

Dynamic systems development method (DSDM) is an Agile project delivery framework which was
primarily used as a software development method. The method was first used in 1994 and was
known to streamline the rapid application development (RAD) method. In the later versions, the
DSDM Agile project framework was revised and became a generic approach to project management
solutions rather than being restricted to software development. DSDM, in a nutshell, covers a wide
range of activities across the project life cycle such as fixing cost, quality and time at the outset. It
prioritizes work into musts, shoulds, coulds and won’t haves to adjust the project deliverables in
meeting the stated time constraint. In 2014, DSDM released the latest version of the method in the
‘DSDM Agile Project Framework’.
Extreme Programming (XP)

In 1996, Kent Beck developed extreme programming (XP), when he was hired to work on the
Chrysler automotive comprehensive compensation system nicknamed C3. Chrysler wanted to con-
vert C3 into an object-oriented software. Three years later, Kent Beck authored a book on the best
practices that he used on this project. As XP was more prescriptive than SCRUM, it garnered a large
number of followers. XP gave more freedom than the waterfall approach to project management.
Furthermore, the software projects in the early 21st century were getting larger and the prescriptive
method really helped. The XP was more inclined to develop software programmes, and hence, for
other evolutionary programmes such as new product development, the XP had little use. Just like
Scrum, XP had the first mover advantage, which resulted in a lot of contemporaries being heavily
Extreme Programming (XP)

Life Cycle of XP consists of five phases
Exploration Planning Iteration

Customers provide Project team works with Each iteration takes one
requirements, project team customer to prioritize to four weeks and for
becomes familiar with work for first iteration, each functional tests are
technology, Effort required estimation, performed.
tools and practices. Schedule release
Productionizing Maintenance
Team performs additional Team produces new
performance testing iterations of the product
ensuring release meets to implement changes and
customer's needs. New new feature requests raised
changes may be introduced in the previous phase
Figure 14.9 Building blocks of extreme programming

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526 | Chapter 14
Adaptive Software Development

The adaptive software development life cycle focuses on results, not
tasks, and the results are identified as application features.
Speculate
Learn Collaborate
Figure 14.10 Paradigm of adaptive software development
influenced by it. Extreme programming uses practices such as test driven development (TDD), based
on the idea that a developer should know exactly the use of the software that he is developing.
Therefore, in case of the TDD approach, you actually develop a test to rate the functionality of the
outcome before developing the functionality. The second advantage is that the test is written by the
same developer who is developing the functionality of the product which is welcome. Normally, the
testing is done by a dedicated testing team which can lead to different aspects being tested after the
code has been developed. Dedicated testers are, therefore, less effective than specialist testers who
work with the code developers to develop the tests.
While developers love to develop software without any hindrance, the TDD helps overcome any
problems that may crop up. At times, when developers quit the project midway, the codes written
become difficult to understand. Under the TDD framework, as the test gets created first, even when
the developer quits midway, to understand the coding work done this far becomes comparatively
easy.
Adaptive Software Development

Adaptive software development (ASD) is a software development process that grew out of the
work by Jim Highsmith and Sam Bayer on rapid application development. According to ASD, the
continuous adaptation of the process to the work at hand is the normal state of affairs in a software
development project. Instead of the waterfall cycle, the ASD has repeating cycles of speculate,
collaborate and learn. This dynamic cycle provides for continuous learning and adaptation to the
emergent state of the project. The main characteristic of the ASD life cycle is that it is mission
focussed, feature-based, iterative, time-boxed, risk-driven and amenable to change. We can consider
ASD as an antecedent to Agile software development.
‘Speculate’ refers to project initiation and understanding the customer’s mission statement.
Knowing the project requirements in terms of timing of delivery and other basic requirements is
carried out at this stage. Collaboration refers to the effort of balancing the work based on predict-
able parts of the environment and adapting to the uncertain surrounding mix of changes caused by
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Lean Software Development
• Lean manufacturing principles applied to the software development

domain
• Toyota way of 4Ps: Philosophy, Process, People/Partnes and
Problem Solving
• Use of ‘Kanban’
• Kanban goals of higher quality, increased transparency, improved
lead time predictability, process optimization, etc.
Figure 14.11 Process of lean software development
different factors. The learning cycles are short iterations with design building and testing as the main
phases. Small mistakes on the basis of false assumptions provide an opportunity to correct bigger
mistakes at a later date and a mastery in the problem domain.
Lean Software Development

Lean software development is a natural adaptation of Toyota’s lean manufacturing processes and
practices. It is not always necessary that the systems used in manufacturing or repetitive processes
cannot be used in a unique or one-off processes like project management. Although all the systems
may not be followed, the broad concepts of reducing buffer, improving efficiencies and reducing
wasteful activities can still be practiced. The lean software development process has emerged from a
pro-lean subculture within the Agile community. Lean offers a solid conceptual framework, values
and principles as well as good practices derived from the Agile experience. Mary Poppendieck and
Tom Poppendieck authored a book in 2003, Lean software development: An Agile Toolkit, through
which the concept of lean software development originated. The book restates the traditional lean
principles as well as a set of 22 tools and compares the tools with corresponding agile practices.
Due to the popularity of the authors Poppendiecks, their concepts were more widely accepted
within the Agile community. Some of the lean principles that were used by the Poppendiecks’
include the following:
1. Eliminate waste
2. Amplify learning
3. Decide as late as possible
4. Deliver as fast as possible
5. Empower the team
6. Build integrity
7. See the whole picture
It is generally observed that only when all the lean principles are implemented together with a com-
bined focus on ‘common sense’, the software development process becomes a success.
Kanban Agile Project Management

Kanban is a lean method to manage and improve the work systems where human beings are in-
volved. Project management is a field where the presence of human beings is inevitable. The Kanban
approach aims to manage work by balancing demands with available capacity and by improving
the handling of systems level bottlenecks. Work systems are visualized to give participants a view
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528 | Chapter 14
Pool of Feature Feature User story User story User story Feature Deploy-
Delivered
ideas preparation selected identified preparation Development Acceptance ment
3 - 10 2-5 15 15 8
Epic In 30 In Ready In 5
In Epic
431 Progress Ready Progress Ready Progress (Done) Progress Ready
294
Epic Epic Story Story Story Epic Epic Epic
Epic 444 662 Epic 602-02 602-05 602-05
401 609 694
478 602 Story Story
Epic
Story
602-03 602-04 602-01 396
Epic Epic Epic
Epic
Epic 468 577 276
562 Story Story Story Story Story Story Epic
589 Epic 302-03 302-01 302-07 302-09 303-05 302-04
419
302 Epic Epic
Epic Story Story Story
302-02 302-05 302-08 362 339 Epic
439
Epic 388
651 Story Story Story Story Story
Epic
Epic Epic 335-09 335-10 335-04 335-05 335-05
329 335 521 Epic

Story Story Story Story
335-08 335-01 335-03 335-02
Story
335-07 287
Epic
Epic
582 Epic
287 Story Story Story Story
Epic 512-04 512-07 512-02 512-01
274
Discarded 512 Story Story
Epic 512-05 512-06
Story
512-03
606 Epic Epic
511 213
Epic
221
Policy
Policy Policy Policy
Business case showing Selection at
Policy Policy
Small, well-
value, cost of delay, Replenishment As per Risk assessed
understood,
size estimate and meeting chaired by ‘‘Definition of per continuous
testable, agreed
design outline. Product director. Done’’ (see...) deployment policy
with PD & Team
(see...
Figure 14.12 Kanban Board, by Andy Carmichael — Own work, CC BY-SA 4.0.
of the progress of the process from start to finish, using a kanban board. Work is pulled as capacity
permits rather than being pushed into the process when requested. The concept of visual process
management is best for knowledge-related work or software development. Kanban has a principle
emphasis on visual systems that work automatically without anyone’s authorization once designed.
In 2010, David Anderson authored a book Kanban – Successful Evolutionary Change for your
Technology Business, which described the method’s evolution from a 2004 project at Microsoft that
used the theory of constraints and drum-buffer-rope analogy.
Kanban board is not necessarily used in Kanban Agile PM; it helps to visualize the flow of work.
A typical Kanban board is shown in Figure 14.12. Typically, a Kanban board shows how work
progresses from left to right, with each column representing an important stream in the value map.
At times, a work in progress limit is set for each column, which restricts the amount of work each
column can receive. This helps in making the systems constraints visible and thus focus on the limi-
tations.
Scaled Agile Framework (SAFe)

In 2011, Dean Leffingwell created the initial version of the Scaled Agile Framework (SAFe),
which was actually the implementation of the various ideas he floated in his book, Agile Software
Requirements. The basic idea behind SAFe is that larger organizations should take a Scrum model
and upsize it to managers of big projects. These organizational players can then use the same Scrum
style processes for big picture strategy and budgeting. SAFe is a combination of lean, Agile and sys-
tems level thinking, which gives it a considerable advantage. The existing systems get infused with
newer lean and Agile ideas. SAFe divides a project into three levels—a team level, a program level
and a portfolio level. At the program level, the managers use Agile Release Train (ART), which is
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Kanban
Enterprise PORTFOLIO
Epic Epic
Enabler
Epic Enterprise NFRs
Owners Architect Backlog
Strategic Lean Budgets

Themes KPIs
Lean
Metrics Portfolio Management Value Streams
Coordination
WSJF Solution Solution LARGE SOLUTION
Demo Demo
Shared Economic
Kanban
I&A I&A
Services Solution Framework
Pre
Solution
Pre
Enabler
Post
Post
Arch/Eng Management NFRs Capability Customer
Compliance Backlog
Variable
CoF Solution
Fixed MBSE SOLUTION
STE
Set-Based TRAIN Supplier
SOLUTION INTENT
Milestones Solution Context
Continuous Delivery Pipeline PROGRAM

Roadmap
AGILE RELEASE TRAIN
Business
Owners Development and Operations
Vision System Product Continuous Continuous Release Culture
Continuous
Arch/Eng Management Intergration Deployment on Demand Automation
WSJF Exploration
PI Objectives Lean Flow
Kanban
Measurement
RTE System Demos Recovery
System I&A
NFRs
Team Feature Feature Enabler Architectural
Backlog
PI Planning
Feature
Program Increment PI Planning

Program Increment PI Planning
Enabler Feature Runway
Lean UX XP Iterations
Plan Goals TEAM
Execute
Program Increment
Product Review P P
Development Team Owner NFRs
Scrum Retro Story Enabler Story
3
SW Scrum P P
FW Master Built-In Quality
HW NFRs
Kanban Backlog Develop on Cadence 4.5
Agile Teams Leffingwell,et al. © 2008–2017 Scaled Agile, Inc.
Lean-Agile Core Lean-Agile SAFe Implementation
SPC
Leaders Values Mindset Principles Roadmap
Figure 14.13 Building blocks of SAFe

Source: SAFe for Lean Enterprises, SAFe 4.6, www.scaledagileframework.com © 2010–2019 Scaled Agile, Inc.
very similar to a Kanban board. It is designed to be a pull system that represents the constraints of
the team. Each train has a set capacity and the program level managers negotiate which stories go
into each car on the train.
Many of the creators of SAFe came from IBM’s Rational Unified Process (RUP), which placed a
great deal of emphasis on requirement gathering and portfolio management. Most large organizations
approach project management in a similar manner and for such organizatons, SAFe is the best suited.
LIMITATIONS AND CONCERNS OF AGILE PM

Agile methods in the software industry grew at the grassroots level. Most project management
professionals found traditional project management methods stifling their creativity and having
far too much emphasis on processes and documentation. The rebellion against established project
management techniques led to the initial Agile movement and the key leaders established an Agile
manifesto. The manifesto affirmed a different set of values than those that were being hitherto
followed in project management. Stories abound of how project managers, frustrated with repeated
delays and failure to meet deadlines, secretly used Agile methods with much success to complete
their projects.
The Project Management Body of Knowledge (PMBOK) incorporated the Agile PM in 2011
and offered a certificate programme in Agile PM, along with traditional Project Management
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530 | Chapter 14
Professional (PMP) certification. The disconnect in the implementation of Agile PM stems from the
fact that the top management need for budget estimates of time and cost are not met unlike the tra-
ditional project management techniques where all these control mechanisms were in place. Second,
customers got what they wanted but without any initial estimate of the cost or knowing the full
cost. Neither would the customer know the duration of the project. While ballpark figures of cost
and time estimates are always available, the uncertainty of the Agile PM method, which is its basic
tenet, renders the whole exercise of estimation redundant.
The essential facet of management is that learnings should be duplicated. Being unstructured, the
learnings of Agile PM cannot be easily duplicated and the benefits derived from these learnings often
get lost. The management and customers would be happy with a higher level of certainty and this is
not possible in Agile PM. To overcome the uncertainty, sometimes, an upper limit or ceiling is set for
a project, but that is not the correct way of working. When it comes to a professional organization,
the concept of accurate estimation is very important to the project. Another drawback of Agile PM
is that it takes its own time to seep into an organization and cannot be simply embedded overnight.
Many Agile principles such as self-organizing and intense collaboration are incompatible with cor-
porate cultures. In India, involving the customer in every aspect of running the business or making
decisions is frowned upon as it is considered disadvantageous to the business. Frequent customer
interactions are viewed as infractions and adversely affect the progress of the project. Another as-
pect of Agile PM is self-organizing teams which can look to be incomprehensible in India. In self-
organizing teams, members decide ‘who does what’ regardless of the rank or title or command and
control structure. Occasionally, a project team has individuals who like to work alone but lose out
in the collaborative working methods of Agile PM.
The size of the project which can take on Agile PM techniques successfully is also important. It
has been observed that projects which are small in size work well with Agile PM but projects which
are larger in size may not work equally well. The scaling challenges for large scale projects in using
Agile PM can be an impediment in its usage. This further leads to using hybrid systems where we
use bits of the traditional project management techniques and some bits of Agile PM. This hybrid
system may work in a few cases and not in others. One can never institutionalize such hybrid meth-
ods. Finally, we can conclude by saying that Agile PM works well for software projects and for the
initial exploratory work of the engineering projects.
SUMMARY
Agile project management has been developed in response to the requirements of fast changing cus-
tomer demands and the heightened pace of obsolescence of older technologies. This is especially true
in the case of software development projects which can be termed as evolutionary. Agile PM is very
useful when the scope of the project is not very well defined and has a higher degree of uncertainty.
Again, these aspects are very much prevalent in case of software development projects. The entire
project is broken down into development cycles and the development teams, in consultation with
the end user, create feature-driven working products in each cycle. Active customer engagement is
the hallmark of Agile PM unlike in the traditional method where the customers were only involved
in the contract signing stage. Simply put, in supply chain management terms, the traditional project
management relied on a ‘transactional’ relationship, whereas the Agile PM relies on ‘alliance’ rela-
tionship, which is the highest level of relationship with the end user. Some of the key advantages of
the Agile PM are as follows:
1. Work is divided into smaller cycles/package which can be more easily controlled and
monitored.
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2. As customers are involved in every small cycle design, the possibility of the end product being
much different than the customer expectation is minimized.
3. The stages of Agile PM demand that the features be tested and functional when completed.
As expected, the process of Agile PM is continuously developing and there is much learning in the ap-
plication of Agile PM. The initial application of Agile PM has been in software development projects
but the benefits of the process would eventually lead to the application of Agile PM techniques in the
traditional engineered projects. The ‘unpredictability’ element in projects is well addressed by Agile
PM, and hence, whichever project could face the bane of unpredictability, Agile PM is the solution.
K E Y WO R D S
• Agile PM • SCRUM
• Iterative incremental development • Scrum master
• Evolutionary project • Lean project management
• Self-organizing teams • Kanban project management
Review Questions
1. What are the limitations of traditional project management techniques?

2. What are the problems associated with a project that is evolutionary and has an ill-defined
scope?
3. List down the advantages of Agile PM and explain why it is more suitable for software devel-
opment projects and not for traditionally engineered projects.
4. What are the disadvantages of Agile PM?
5. Do you agree with the statement ‘A Scrum Master is better than a project manager’. Give
reasons for your answer.
6. What are the key differences between a self-organizing team and a conventional project team?
7. Would the excessive role of the customer in project management be a good development or
not?
8. Why is it difficult to apply Agile PM to large-scale projects?
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Glossary
Chapter 1: Introduction to Project Management
Project Scope Management: Project deliverables and expectations.

Project Time Management: Project completion time.
Project Cost Management: Project budget.
Work Breakdown Structure: Tree structure of work contents.
‘S’ Curve: Cumulative cost curve plotted over project life phases.
Project Organization: Organization that delivers projects.
Project Life Cycle: Start to completion cycle of the project.
Detailed Project Report: A summary of all project feasibility evaluations.
Project Management Professional (PMP): Internationally recognized professional designation of-
fered by the Project Management Institute.
Project Management Institute (PMI): Global nonprofit organization for project management.
EPC Company: An organization whose primary business is managing projects.
Chapter 2: Project Network Analysis–I
CPM: Critical Path method, which identifies the path which has the longest completion times.
PERT: Program Evaluation and Review Technique, a network analysis method used for probabilistic
projects.
AOA Convention: Network construction techniques where the activities are represented by arrows.
AON Convention: Network construction techniques where the activities are represented by nodes.
Float: Surplus duration available on the activity.
Slack: Surplus duration available on the node.
Crashing: Process of reducing the project duration for gaining economic advantages or for complet-
ing the project early.
Dummy Activity: A fictitious activity which does not require any resources or time.
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534 | Glossary
Chapter 3: Project Network Analysis–II
Total Float: Surplus available on the activity or the permissible delay in the start or completion
times on an activity.
Free Float: The component of total float which when consumed does not affect the float of subse-
quent activity.
Interfering Float: The component of total float which when consumed affects the float of subse-
quent activity.
Independent Float: The component of free float which when consumed does not affect the float of
previous activity.
Resources Smoothing: Process of allocation of resources where project delay is not permissible.
Resources Levelling: Process of allocation of resources where project delay is permissible.
Chapter 4A: Demand Forecasting for Commercial Viability of Projects
Forecasting: Predicting the future with reference of past data.

Simple Moving Averages: Forecasting technique which considers rolling data.
Weighted Moving Averages: Forecasting technique which considers rolling data with weightages.
Exponential Smoothing: Forecasting technique that rectifies the effect of past error.
Regression Analysis: Forecasting technique that uses the relationship between two or more variables,
and predicts the behavior of dependent variable on the basis of the independent variable.
Tracking Signal: Forecasting error measurement technique that can measure the correctness of
individual methods.
Chapter 4B: Decision Tree Analysis
Decision Node: Node where the decision maker has to make a choice.
Outcome Node: Node where the choice is beyond the control of decision maker.
Decision Tree Diagram: Pictorial diagram representing all possible decisions and outcomes of
decisions.
Expected Value of Outcome: Expected results when there are probabilistic options.
Chapter 5: Project Selection & Screening
Project Selection: Steps in selecting the appropriate project.

Project Screening: Steps involved in shortlisting appropriate project.
Project Appraisal: Process of evaluating projects.
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Glossary | 535
UNIDO: United Nations Industrial Development Organization, is a specialized agency of the United
Nations.
Break Even Analysis: Technique used to find a no profit no loss point.
Margin of Safety: Difference between actual sales and breakeven sales.
Sensitivity Analysis: Effect of uncertainty elements in inputs and outputs.
Chain Ratio Method: A method to calculate total demand for a project.
Chapter 6: Project Financial Appraisal
Capital Budgeting: Evaluation of potentially large expenses and revenues.

Time Value of Money: Concept that money at present time is worth more than money in future time.
Present Value Factor: Factor that considers rate of interest and time periods for future cash flows.
Present Value Factor of annuity: Factor that considers rate of interest and time periods for identical
future cash flows.
Payback Period: Period over which invested money is recovered.
Net Present Value: Is the difference between present value of cash inflows and outflows.
Profitability Index: A ratio of present value of cash inflows over outflows.
Benefit Cost Ratio: A ratio of present value of cash inflows over present value of cash outflows.
Net Benefit Cost Ratio: Benefit cost ratio – 1.
Internal Rate of Return: Rate of return when NPV = 0.
Common Time Horizon: Elaborate method to evaluate projects with different life spans.
Equivalent Annuity Method: Shortcut method to evaluate projects with different life spans.
Debt Service Coverage Ratio: Is the ratio of cash available to debt servicing primarily for payment
of interest and debt of a project.
Interest Coverage Ratio: Measure of a company’s ability to pay interest.
Chapter 7: Detailed Project Report
Technical Appraisal: Considers the technology feasibility for the project.

Commercial Appraisal: Considers the break-even and other issues important for the success of the
project.
Financial Appraisal: Considers the profitability or otherwise of the project.
Environmental Appraisal: Consider the environment impact of the project.
Financial Ratios: Indicators of a firm’s performance and financial situation.
Dimensional Analysis: Analysis of tangible and intangible parameters.
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536 | Glossary
Chapter 8: International Project Appraisal
Navratna Organisation: Classification of Government of India for public sector enterprises in India.
Language Barriers: Linguistic barriers in communication.
Cultural Divide: It is the virtual barrier caused by cultural differences.
PESTEL Analysis: External threats to any business venture, with P – Political, E – Economic,
S – Social, T – Technological, E – Environmental and L - Legal.
Solar Energy: Energy harnessed from the radiant light and heat of sun.
Chapter 9: Project Finance and Cash Flows
WACC: Weighted average cost of capital.

IRR: Internal rate of return.
XIRR: Extended internal rate of return.
MIRR: Modified internal rate of return.
Separation Principle: A firm’s investment decisions are separate from financing decisions.
Incremental Principle: Total profit compared with total cost.
Post-tax Principle: After tax calculations are considered.
Consistency Principle: Accounts to be consistent from one-time period to other.
Cash Flows from Equity Perspective: From shareholders perspective.
Cash Flow from Long Term Funds Perspective: When holding period is more than 1 year.
Cash Flows from Total Funds Perspective: All stakeholders’ perspective.
Financial Institutions: Company engaged in the business of dealing with financial and monetary
transactions.
Operating Cash Flows: Cash flows during the tenure of the project.
Terminal Cash Flows: Cash flows due to closure of the project.
Depreciation: A reduction of the value of the asset over time.
Chapter 10: Project Risk Analysis and Management
Risk Management Process: Process of identifying, monitoring and managing potential risks.
Risk Register: Tool for documenting risk and developing strategies to avert risk.
Scenario Analysis: Process of analyzing possible future events and evolving strategies to face them.
Decision Tree Analysis: Sequential analysis of all decision options.
Hillier Model: Model which suggests that the standard deviation is a measure of risk.
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Sensitivity Analysis: Analysis of robustness of the solution for any changes in input parameters.

Glossary | 537
Mitigating Risk: Risk reduction strategies.

Contingency Planning: Planning for unexpected events.
Risk Breakdown Structure: A hierarchically organized depiction of the identified project risks ar-
ranged by category.
Risk Severity Matrix: Risk assessment tool to define level of risk.
Transferring Risk: Passing on the consequences of risk to other party.
Risk Audit: Is the examination and documentation of the effectiveness of risk responses in dealing
with identified risk and their root causes, as well as the effectiveness of the risk management process.
Chapter 11: Real Options: Options to Enhance Project Value
Discounted Cash Flow: Method of measuring returns on investments with accounting for accumu-
lation of interest.
Put Options: An option to sell assets at an agreed price on or before an agreed time period.
Call Options: An option to buy assets at an agreed price on or before an agreed time period.
Implied Volatility: Is the estimated gyrations or volatility of the security price.
Real Value Options: A real option is a choice made available to the managers of a company with
respect to business investment opportunities. It is referred to as “real” because it typically references
projects involving a tangible asset instead of a financial instrument.
Binomial Model: A model with only two discrete options.
Black and Scholes Model: A pricing model used to calculate the fair value of a call or a put option.
Financial Options: Is a derivative instrument whose value depends on the volatility of the underly-
ing financial product.
ATM: At the money when the strike price is same as the current market price.
OTM: Out of the money, if the price of derivative is not favourable when compared with the present
market price.
ITM: In the money, if the price of derivative is favourable when compared with the present market
price.
Chapter 12: Organization Structure for better Project Management
Dysfunctional Conflict: Conflict which leads to a decline in communication within a group.

Functional Organization: Organization based on the principles of specialization.
Matrix Organization: Organization structure where the reporting relationships are like a grid.
Projectized Organization: Where the project manager has the full right over the organizational
resources.
Groupthink: It is a psychological phenomenon that occurs within a group of people in which the
desire for harmony or conformity@Seismicisolation
in the group results in an irrational or dysfunctional decision-
making outcome.
@Seismicisolation

538 | Glossary
Project Vision: A reason for contributing to the project.

Project Team Working: Result of team building.
Virtual Project Team: A team of geographically diversely located people working on a common project.
Project Conflicts: Human differences of opinion while working on a project.
High Performance Project Teams: A team of project professionals focused on winning.
Tuckman’s Five-Stage Team Development Model: Developed by Bruce Tuckman in 1965 comprises
forming, storming, norming, performing and adjourning stages of team working.
Chapter 13: Earned Value Analysis
Earned Value (BCWP): It refers to the worthiness of a project on a particular day of review. This
term calculates the sum of all the budgeted cost of completed (or partially completed) activities.
Planned Value (BCWS): If the project was to proceed as per the plan, then the project would have
earned value equal to the planned value. This term calculates the sum of all the budgeted cost of
activities scheduled up to the day of review.
Actual Cost (ACWP): This term sums up all the costs incurred till date, irrespective of the whether
these costs were converted into useful work or value or are in excess of the budgeted cost.
Budgeted Cost (BCTW): This term sums up the budgeted cost for all the activities and is the cost
assigned for the entire project if executed as per plan.
Additional Cost of Completion (ACC): This term calculates the additional funds required or the
additional cost that will be incurred to complete the project because it is incurring more expenses
then budgeted.
Cost Performance Index (CPI): It is an indicator of how the project is progressing, within budget
or over budget.
Schedule Performance Index (SPI): It is an indicator of how the project is progressing on time scale.
Chapter 14: Future Trends in Project Management
Agile PM: Is a software project management technique, which evolves continuously as the project
progresses.
Iterative Incremental Development: Is a combination of iterative and incremental development
model.
Evolutionary Project: Combination of smaller waterfall model of project development.
Self-organizing Teams: Group of extremely efficient team members working towards project suc-
cess without a leader.
SCRUM: Self organizing teams with a goal to achieve complete products with limited iterations.
Scrum Master: Facilitator of an agile development team.
Lean Project Management: Application of lean concepts in project management.
Kanban Project Management: A process of managing the flow of tasks towards achieving shared
@Seismicisolation
objectives.
@Seismicisolation

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PROJECT

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Published by Pearson India Education Services Pvt Ltd,

No part of this eBook may be used or reproduced in any manner whatsoever

Website: in.pearson.com, Email: companysecretary.india@pearson.com

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Chapter 1 Introduction to Project Management 1

Chapter 2 Project Network Analysis–I 31

Chapter 3 Project Network Analysis–II 143

Chapter 4A Demand Forecasting for Commercial Appraisal

Chapter 4B Decision Tree Analysis 215

Chapter 5 Project Selection and Screening 235

Chapter 6 Project Financial Appraisal 269

Chapter 7 Detailed Project Report 319

Chapter 8 International Project Appraisal 391

Chapter 9 Project Finance and Cash Flows 401

Chapter 10 Project Risk Analysis and Management 419

Chapter 11 Real Options: Options to Enhance Project

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Chapter 12 Organization Structure for better Project

Chapter 13 Earned Value Analysis 491

Chapter 14 Future Trends in Project Management 517

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Dr Rajan Saxena, Vice-Chancellor of the SVKM’s NMIMS

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After studying this chapter, you should be able to:

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Figure 1.1 Progress report/status of Bengaluru-based ‘Namma Metro’ as on August 1, 2009

DEFINITION OF PROJECT MANAGEMENT

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Project Life Cycle

Inception Elaboration Construction Transition

PROJECT LIFE CYCLE

THE ‘S’ CURVE

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• Indentify need • Develop: • Set up organization • Training operators

There are various ‘S’ curves, which are as follows:

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Initiation Planning Execution Closure

Figure 1.4 Sample project cost ‘S’ curve

TRAITS OF A PROJECT MANAGER

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Figure 1.5 Situations a project manager has to prevent

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PARAMETERS FOR THE SUCCESS OF A PROJECT

WORK-BREAKDOWN STRUCTURE (WBS)

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Receiver Fire control Communication Equipment Services Depot Level 3

Figure 1.6 Defence material item categories from MIL-STD-881C

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Level 1 (Deliverables) = 100%

1. Internal 2. Foundation 3. External

Chapter 4A Demand Forecasting for Commercial Appraisal

Chapter 11 Real Options: Options to Enhance Project

Chapter 12 Organization Structure for better Project

Figure 1.1 Progress report/status of Bengaluru-based ‘Namma Metro’ as on August 1, 2009