Professional Documents
Culture Documents
Project Finance Sem 4
Project Finance Sem 4
FINANCE
Sub Code: 721
Developed by
Abasaheb Chavan
On behalf of
Prin. L.N. Welingkar Institute of Management Development & Research
Advisory Board
Chairman
Prof. Dr. V.S. Prasad
Former Director (NAAC)
Former Vice-Chancellor
(Dr. B.R. Ambedkar Open University)
Board Members
1. Prof. Dr. Uday Salunkhe 2. Dr. B.P. Sabale 3. Prof. Dr. Vijay Khole 4. Prof. Anuradha Deshmukh
Group Director Chancellor, D.Y. Patil University, Former Vice-Chancellor Former Director
Welingkar Institute of Navi Mumbai (Mumbai University) (YCMOU)
Management Ex Vice-Chancellor (YCMOU)
The companies, individuals and events referred to herein are fictional. Any similarity to
actual companies, individuals, events is purely coincidental.
CONTENTS
1. THE PROJECT 3 – 25
2. PROJECT APPRAISAL 26 – 34
3. TECHNICAL APPRAISAL 35 – 57
4. ECONOMIC APPRAISAL 58 – 73
5. MARKET APPRAISAL 74 – 87
6. FINANCIAL APPRAISAL 88 – 116
7. CAPITAL STRUCTURE 117 – 135
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
1.1 Introduction
1.2 Steps on Formulating a Project
1.3 Steps on Financing the Project
1.4 Steps on Implementation of the Project
1.5 Post Implementation Work
1.6 Total Project Life Cycle
1.7 Sample Form for Undertaking New Project
1.8 Summary
1.9 Self-Assessment Questions
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1.1 INTRODUCTION
The Indian Government is considering interlinking the various rivers; Mahindra Motors is
taking over an international motor company; Reliance Retail is planning to expand their stores
throughout the country; A steel plant wants to set-up new arc furnace; Meghna, a dentist is planning
to start her own clinic; Raj is planning to buy a motorbike; All these situations involve are Projects
and involve a Capital Expenditure Decision.
Often, Capital Expenditure Decisions represent the most important decisions taken by a firm.
The consequences are Long-term, Irreversible and involve substantial outlays. Not only are they
extremely important but also pose difficulties due to measurement, uncertainty and have a temporal
spread.
As a financial manager, the investment decisions that you will make today will be critical to the
future of your firm. A wise investment decision will create wealth and make the owners or
shareholders of the company richer by exploiting an opportunity to increase the value of the firm.
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The Project
Alternatively, a poor investment decision will decrease the value of your company and destroy
shareholder wealth.
Throughout this subject, we shall assume that maximizing shareholder wealth is the goal of
the owners of the firm, the shareholders. We also assume that managers, acting in the interest of
the owners of the firm, use shareholder wealth maximization as their ultimate decision criterion.
However, in reality, there are many conflicts of interest between the shareholders and the
managers.
Projects differ from other types of work (e.g. process, task, procedure). Meanwhile, in the
broadest sense a project is defined as a specific, finite activity that produces an observable and
measurable result under certain pre-set requirements.
From the given definition, any project can be characterised by these characteristics:
⚫ Temporary: This key characteristic means that every project has a finite start and a finite
end. The start is the time when the project is initiated and its concept is developed. The
end is reached when all objectives of the project have been met (or unmet if it’s obvious
that the project cannot be completed – then it’s terminated).
⚫ Unique Deliverable(s): Any project aims to produce some deliverable(s) which can be a
product, service, or some another result. Deliverables should address a problem or need
analysed before project start.
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planning processes result in developing more effective solutions to progress and develop
projects.
⚫ Organizing a meeting
Expenditure is incurred and benefits are Expenditure is made from one-time benefit/
available on recurring basis. utility. To avail benefit second time, the
expenditure will have to be incurred again.
Expenditure generally creates a Capital Asset. Expenditure is to use and maintain the assets
so created.
Expenditure is charged to the P&L A/c in form Expenditure is charged to the P&L A/c in the
of depreciation charges spread over the useful same year in which it is incurred.
life period of the assets.
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The Project
A smart finance manager keeps controls on Revenue Expenditure to reduce the overheads of
the organization and make it more efficient. However, he deploys Project Finance to take his
organization to the next level. Let us just have a look at the revenue expenditure of M/s Predict
Projects Pvt. Ltd. (your assumed company):
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Chapter – 1
Data Collection
Documentation
Project Appraisal
Conclusion
After it is concluded that a project is feasible and doable, the promoters and finance managers
work on getting the resources to complete the project. He will look at the various sources available
to his disposal and cost of each source. He will arrive at an optimum level of debt and equity to
arrive at an optimum Weighted Average Cost of Funds and evaluate the Return on the Investment
in the project.
A project is a proposal for capital investment to develop facilities to provide goods and
services. It is implemented in order to generate cash flows. The investment proposal may be for
setting up a new unit, expansion or improvement of existing facilities. The project, however, has to
be amenable for analysis and evaluation as an independent unit.
The projects have increased in size and complexity. Projects for tomorrow are not geared to
the mass production of simpler goods but customized ones produced by flexible manufacturing
systems.
Project identification is, however, a continual process. With the opening up of the economy,
demand for sophisticated inputs is continuously rising. The quest for new combinations of factors
for optimizing output and improving productivity to strengthen the competitive position of Indian
industry in the international marketplace is an ongoing process. Further, the growing demand for
complex, sophisticated, customized goods and services in international markets has added a new
dimension to project concept.
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The Project
Good ideas are the key to success for any project. They can be generated using various
methods such as:
1. SWOT Analysis
2. Cost reduction
3. Productivity improvement
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Chapter – 1
⚫ Availability of inputs
⚫ Adequacy of market
⚫ Reasonableness of cost
The identification of project ideas is followed by a preliminary selection stage on the basis of
their technical, economic and financial soundness. The objective at this stage is to decide whether
a project idea should be studied in detail and to determine the scope of further studies. The findings
at this stage are embodied in a prefeasibility study or opportunity study. For purpose of screening
and priority fixation, project ideas are developed into prefeasibility studies. Prefeasibility studies
give output of plant of economic size, raw material requirement, sales realization, total cost of
production, capital input/output ratio, labor requirement, power and other infrastructure facilities.
The project selection exercise should also ensure that it conforms to overall economic policy of the
government.
Primary Information
Primary Information represents the information that is collected for the first time to meet the
specific purpose on hand. Following are some of the various methods to obtain Secondary
Information:
⚫ Observation
⚫ In-depth Techniques
⚫ Experiments
⚫ Market Survey
Data can be of various kinds – cost of raw materials, technical specifications of raw materials,
buyers’ market for finished products, price points to effectively enter the market, geographical
areas, excise duties on raw materials and finished products, transportation costs, competition
analysis, etc.
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The Project
Good amount of data is available through a number of sources – market dealers, CMIE, the
internet, Credit Agencies, Analysts, Trade Journals, etc. For specialized or exclusive projects,
Market Survey companies and Technical Consultants can be contacted.
Nothing can be worse than a skewed Project Report based on inaccurate, unreal data. It can
cause great repercussion on the fate of the Project.
Data
Collection
Primary Secondary
Secondary Information
Secondary Information is the information that has to be gathered in some other context and is
already available. Following are some of the various methods to obtain Secondary Information:
⚫ Census of India
⚫ Plan Reports
⚫ Economic Survey
⚫ Guidelines to Industries
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⚫ Trade Publications
(c) Documentation
All the data collected and assimilated has to be documented and presented in formats
understandable to the Project Team, and Top Decision Makers.
It can be presented in various formats – Tables, Graphically – Pie Charts, Bar Graphs, Line
Graphs, etc.
1. Technical: To assess whether that project is technically sound with respect to various
parameters such as technology, plant capacity, raw material availability, location,
manpower availability, etc.
2. Economic: To look into the economic benefits to the society and to the nation.
3. Market: To understand the potential market for the products and at the marketing
strategy. To review competence of the marketing team.
4. Financial: To assess the financial feasibility of project – cost of project, cost of capital,
revenues, cash flows and return on capital employed.
Project Appraisal is the final document in the formulation of a project proposal. Project
Appraisal is prepared either by the financial institution or consultants or experts. The cost of project
Appraisal can be debited to project cost and can be counted as part of promoter’s contribution.
The Project Appraisal should contain all technical and economic data that are essential for the
evaluation of the project. Before dealing with any specific aspect, Project Appraisal should examine
public policy w.r.t. the industry. After that, it should specify output and alternative techniques of
production in terms of process choice and ecology friendliness, choice of raw material and choice of
plant size. The Project Appraisal after listing and describing alternative locations should specify a
site after necessary investigation. The study should include a layout plan along with a list of
buildings, structures and yard facilities by size, type and cost. An essential part of the feasibility
study is the schedule of implementation and estimates of expenditure during construction. Major
and auxiliary equipment by type, size and cost along with specification of sources of supply for
equipment and process know-how has to be listed. The study has to identify supply sources and
present estimates, costs for transportation, services, water supply and power. The quality and
dependence of raw materials and their source of supply have to be investigated and presented in
the feasibility study. Before presentation of the financial data, market analysis has to be covered to
help in establishing and determining economic levels of output and plant size.
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The Project
Financial data should cover preliminary estimates of sale revenue, capital costs and operating
costs for different alternatives along with their profitability. Project Appraisal should present
estimates of working capital requirement to operate the unit at a viable level. Additional information
on financing, breakdown of cost of capital and cash flow is prepared.
(e) Conclusion
Once all the data is put on the paper, the Project Team and the Top management decision
makers are to decide the priority of the project vis-à-vis alternate proposals. They are prepared as
to the profitability or revenue decides whether the project has to be implemented or it is to be
shelved.
The decision makers will decide based on various criteria on how the particular project will
benefit the organization. A particular project may be very sound financially may get shelved as it is
less beneficial vis-à-vis alternative project. Similarly, a project may not be financially viable but may
be considered as it has many indirect benefits such as improvement of the quality or product or
improved services to its customers.
Project Finance:
Project finance is the funding (financing) of long-term infrastructure, industrial projects,
and public services using a non-recourse or limited recourse financial structure. The debt and
equity used to finance the project are paid back from the cash flow generated by the project.
Project finance helps finance new investment by structuring the financing around the project's
own operating cash flow and assets, without additional sponsor guarantees. Thus, the technique is
able to alleviate investment risk and raise finance at a relatively low cost, to the benefit of sponsor
and investor alike.
Heads such as Plant, Machinery, Equipment, Manpower, Contingencies, Power Costs, Raw
Materials, Working Capital requirements, etc.
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securities offered to public. These securities can be traded on public secondary markets like
Bombay Stock Exchange or National Stock Exchange, which are recognized stock exchanges that
facilitate trading of public securities.
Promoters usually go for Projects that creates value for the owners or shareholders of the
firm. Maximum value for shareholders is created if project generates maximum ROI and Cost of
Source of Funds is kept as low as possible. If the Cost of Source of Funds is not higher than ROI by
at least 2% or the Net Present Value (NPV) of the project is negative, it is not worthwhile doing the
project.
Private capital comes either in the form of loan given by banks, financial institutions, NBFCs,
Private Lenders in form of Term Loans, Working Capital, etc.
Public capital comes either in the form of issuing shares, preference, warrants, debentures,
bonds to public, institutions, investors, PE companies, etc.
Equity
Equity
Preference
Sources of Bonds
Finance
Term Loans
Debt
Working
Capital
Advances
Miscellaneous
Sources
Debt and preference stock entail more or less fixed payments, estimating cost of debt and
preference is relatively easy. Preference capital carries a fixed rate of dividend and is redeemable
in nature.
Cost of Equity is difficult to estimate. The difficulty stems from the fact that equity
shareholders have a residual claim on the earnings of the company. This means that they will
receive a return when all other claimants (lenders, preference shareholders) have been paid.
Generally, equity is costlier than debt as these investors expect higher rate of return
compared to debt.
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Suppose a company uses 30% equity @ 24%, 20% preference @ 12% and 40% debt @13%,
and then the Weighted average cost of capital of the company is
WACC = (Proportion of equity) × (Cost of equity) + (Proportion of preference) × (Cost of
preference) + (Proportion of debt) × (Cost of debt)
Re E Rp P Rd D
= + +
D+E+P D+E+P D+E+P
= WeR e + WpR p + WdR d
Company cost of capital is the rate of return expected by existing capital providers. It
reflects the business risk of existing assets and the capital structure currently employed.
Project cost of capital is the rate of return expected by existing capital providers for a new
project or investment the company proposed to undertake. It depends on the business risk and the
debt capacity of the new project.
WACC = 14.8%
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in that case, there may not be requirement of a consultant. But still, consultant may be required for
the basic engineering and design supervision and approval.
(g) Commissioning
After the project has been physically completed, i.e., the work on all activities such as civil
engineering work, structural fabrication, supply and installation of equipment have been completed,
the next stage comes for the commissioning of the project, so as to make the commercial utilization
of the project. Commercial utilization may be commercial production as envisaged in the approved
project.
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The Project
In some organizations, the handing over of the plant and equipment is done by executing the
handing over and taking over act. Authorities from both the departments, i.e., Project and
Organization sign this Act. This is a statement signed jointly by the authorities of project and
operation department.
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Every Project starts with an idea. Once the financiers are satisfied about its feasibility, they
finance it and they get their income from revenue streams generated from the Project.
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The Project
Generation of Ideas
Data Collection
Formulation Documentation
Project Appraisal
Conclusion
Investment in the
Project
Sources of Funds
Financing of the
Cost of Each Source
Project
Weighted Average
Cost of Capital
Return on Project
Investment
Engagement of
Consultants
Financial Closure
Contracts Finalization
Execution of
Contracts/Project
Commissioning
Performance
Guarantee Test
Handing over to
Operation
Closure of Contract
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Chapter – 1
PROJECT
Project Type/Idea
Project Name/s
Generated by Key
Department Person
Brief Summary on the
project and its benefit
to the organization
Data Collected
SWOT Analysis
Strengths 1.
2.
3.
4.
Opportunities 1.
2.
3.
4.
Weaknesses 1.
2.
3.
4.
Threats 1.
2.
3.
4.
Appraisals/Findings
Technical 1.
2.
3.
4.
Economic 1.
2.
3.
4.
Market 1.
2.
3.
4.
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The Project
Financial 1.
2.
3.
4.
Additional Revenue
Generated/Costs
Saved
Conclusions 1.
2.
3.
Potential Revenue
Potential Amounts
Saved
Investments Particulars Amount (`) Particulars Amount (`)
(a) (e)
(b) (f)
(c) (g)
(d) (h)
Total Project Cost (`)
Sources of Funds Particulars Amount (`) Cost Cost per Weighted
p.a annum (`) Average
(%) Capital Cost
(WACC) (%)
Own Contribution
Preferred Stock
Internal Accruals
Term Loan/s
Debentures/Warrants
Bonds
Other Sources
Total
Return on Project
Recommended by Name Designation Signature
(A)
Approved/Rejected by Name Designation Signature
(A)
(B)
(C)
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Government of India has launched the “MAKE IN INDIA” campaign to promote the domestic
industrial production.
1.8 SUMMARY
Essentially, a capital project represents a scheme for investing resources that can be
analyzed and appraised reasonably independently.
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Capital Expenditure decisions often represent the most important decisions taken by a firm.
Their importance stems from three interrelated reasons: long-term effects, irreversibility and
substantial outlays.
A smart financial manager will try to save running costs by reducing expenses. He will
increase expenses if more value is created by spending more.
Formulation of a Project involves various stages such as: Generation and Screening of Ideas,
Data Collection, Documentation, Project Appraisal and Conclusion.
Financing of a Project involves detailed study on various aspects such as: Investment in the
Project, Sources of Funds, Cost of Each Source, Weighted Average Cost of Funds invested and
Return on Investment from the Project.
Post Implementation Work includes Analyzing Completion Cost and Capitalization and Post
Project Evaluation and Report.
Project finance helps finance new investment by structuring the financing around the project's
own operating cash flow and assets, without additional sponsor guarantees. Thus, the technique is
able to alleviate investment risk and raise finance at a relatively low cost, to the benefit of sponsor
and investor alike.
2. Write down three major differences between Capital Expenditure v/s Revenue
Expenditure.
7. Draw the complete flowchart for entire life cycle of the Project.
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1. Expenditure which is made for one-time benefit/utility. But when it is to avail benefit
second time, and subsequently is categorised as ------------------------------
2. From the given definition of the project any project can be characterised by ------------------
----------------characteristics:
(a) Temporary
4. The Project Appraisal should contain all technical and economic data that are essential
for the evaluation of the project. Before dealing with any specific aspect, Project
Appraisal should examine --------------------
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The Project
Answers:
qqq
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter
Summary
PPT
MCQ
Video1
Video2
Chapter – 2
2 PROJECT APPRAISAL
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
2.1 Introduction to Project Appraisals
2.5 Summary
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Project Appraisal
Project appraisal is the process of assessing, in a structured way, the case for proceeding
with a project or proposal, or the project's viability. It often involves comparing various options,
using economic appraisal or some other decision analysis technique. The entire project should be
objectively appraised for the same feasibility study should be taken in its principal dimensions,
technical, economic, financial, social and so far, to establish the justification of the project or project
appraisal is the process of judging whether the project is profitable or not to client or it is a process
of detailed examination of several aspects of a given project before recommending of some
projects.
Thus, Project appraisal is the structured process of assessing the viability of a project or
proposal. It involves calculating the feasibility of a project before resources are committed. It is an
essential tool for effective action in starting a project. Project Appraisal is also a tool used to review
the projects completed by the organization.
When a project is at the conceptualization stage, the owners and managers have a rough idea
of what they are going to produce, what price they might sell it, and how many units will be sold.
Many a times, project conceptualization takes place on the basis of an idea or market gap
perceived by the Top Management or Project Manager.
Project Appraisal may be carried out by the various stakeholders or interested parties such
as:
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The Project Appraisal gives a clear and unbiased view from an outsider’s point of view. It is a
means which can give a better picture of partnerships can choose the best projects to help them
achieve what they want for the organization. It is defined as taking a second look critically and
carefully at a project by a person who is in no way involved or connected with its preparation. He is
able to take independent, dispassionate and objective view of the project in totality, along with its
various components
Any project’s success or failure depends on the pre-planning work carried out by the project’s
team and the promoters. A project’s success or failure depends 80% on thorough planning and
appraisals and 20% on execution and other parameters.
The earlier the project appraisal starts the better it is for the organization. The company is in a
better position to decide how much capital to deploy for the project to decide to scrap an unviable
project.
1. Technical Appraisal
2. Economic Appraisal
3. Market Appraisal
4. Financial Appraisal
Project appraisal is a requirement before funding of project is done. But tackling problems is
about more than getting the systems right on paper. Experience in projects emphasizes the
importance of developing an ‘appraisal culture’ which involves developing the right system for local
circumstances and ensuring that everyone involved recognizes the value of project appraisal and
has the knowledge and skills necessary to play their part in it.
⚫ Provide documentation to meet financial and audit requirements and to explain decisions
to all the stakeholders and auditors.
The terms evaluation, appraisal and assessment are used interchangeably. They are used in
analyzing the soundness of an investment project. The analysis is based on projections in terms of
cash flows. The analysis is carried out by the entrepreneurs or promoters of the project, the
merchant banker who, is going to be involved in the management and underwriting of public issue
and public financial institutions who may lend money.
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Project Appraisal
project) or on national profitability (net overall importance of the project) to the nation as a whole.
The purpose of the project appraisal is to ensure that the project is technically sound, provides
reasonable financial return and conforms to the overall economic policy of the country. In view of
the importance of the competitive status of unit, performance measures have to be applied to
assess the ability of a unit to meet competition in the modern business environment.
Appraisals are very important before dedicating resources towards a project. Some of the
important reasons for appraising a project are:
Appraisal asks fundamental questions about whether funding is required and whether a
project will create value for the organization. It can give confidence that the money is
being put to good use, and help identify other funding to support a project. Getting it right
may help an organization garner further resources to meet the project objectives.
Appraisal involves the comprehensive analysis of a wide range of data, judgments and
assumptions, all of which need adequate evidence. This helps ensure that projects
selected for funding:
⚫ Are deliverable
⚫ Are sustainable
Appraisal helps ensure that projects will be properly managed, by ensuring appropriate
financial and monitoring systems are in place, that there are contingency plans to deal
with risks and setting milestones against which progress can be judged.
The process of project development, appraisal and delivery is complex and should be
suitable to the organization. Good appraisal systems should ensure that:
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Chapter – 2
⚫ All the necessary information is gathered for appraisal, often as part of project
development in which projects will need support.
Project Appraisal is process of assessing the following types of the Appraisal Aspects. And
these Key aspects of appraisal will be evaluated before commencement of Project. Appraisal
factors are evaluated by a personal who is not involved in the preparation of the Project Proposal.
⚫ Organisational Aspects
⚫ Technical Aspects
⚫ Managerial Aspects
⚫ Economic Aspects
⚫ Financial Aspects
1. Organisational Aspects:
Organisational aspects help you to see if project is adequately staffed with the structure
of the Organization. And helps to check Resource, Recruitment, and Training aspects
2. Technical Appraisal
Technical Appraisal is the technical review to ascertain that the project is technically
sound in all respects with respect to various parameters such as technology, plant
capacity, raw material availability, location, manpower availability, etc. The technical
review is done by qualified and experienced personnel available in institutions and/or
outside experts (particularly where large and technologically sophisticated projects are
involved).
3. Managerial Aspects :
Managerial aspects help you to assess competency and business knowledge of the
promoter’s aspects.
4. Economic Appraisal
Economic appraisal is the economic review carried out by financial institutions that looks
into the economic benefits to the society and to the nation. They also look at various
parameters such as resource cost and effective rate of protection.
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Project Appraisal
Admittedly, the economic appraisal done by financial institutions is not very rigorous and
sophisticated. Also, the emphasis placed on this appraisal is rather limited. This will also
help to check the following benefits to the project.
⚫ Better output
⚫ Better services
⚫ Better employment
⚫ Better revenue
⚫ Better earnings
⚫ Better standards
⚫ Better income
⚫ Better distribution
5. Market Appraisal
Market Appraisal is carried out to understand the potential market for the products and at
the marketing strategy. A review of the market survey and competence of the marketing
team. Also, whether the unit can sell its products at the desired/estimated price points.
6. Financial Appraisal
Financial appraisal is concerned with assessing the financial feasibility of a new capital
investment proposal or expansion of existing productive facilities. This involves an
assessment of funds required to implement the project and the sources of the same. The
other aspect of financial appraisal relates to estimation of operating costs and revenues,
prospective liquidity and financial returns in the operating phase.
Financial appraisal helps to assess the cost of the project and review the project
revenues. And this type of appraisal analysis helps the company to avoid overspending
on a project resource and requirements to produce the outputs. This will also help the
organisations to check feasibility of alternatives to spend less and gain more profits.
Below are the key things we can understand by performing the Financial Analysis.
⚫ Cost: Finding out the cost to complete the project and produce the outputs
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Chapter – 2
3. Past audited accounts for three years of the company and associated entities
5. Organization Chart
11. Financial Projections, Cash flows, Fund flows, Break-even Point Analysis
14. In-principal arrangement for Working Capital Facility from Banks, etc.
2.5 SUMMARY
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Project Appraisal
Technical
Economic
Market
Financial.
3. What are the various aspects of Project Appraisal? Write a brief note on each.
4. Enlist the major documents will help a financial institution to appraise the Project.
(a) Feasibility
(b) Sustainability
2. Organizational aspects help you to see if project is ------------------- with the structure of
the Organization. And helps to check Resource, Recruitment, and Training aspects.
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Chapter – 2
3. The process of project development, appraisal and delivery is complex and should be
suitable to the organization. Good appraisal systems should ensure that ----------------------
(a) Project application, appraisal and approval functions are separate, and all the
necessary information is gathered for appraisal, often as part of project development
in which projects will need support.
(a) Technical
(b) Economic
5. Financial appraisal helps to assess the cost of the project and review the project
revenues. And this type of appraisal analysis helps the company to avoid overspending
on a project resource and requirements to produce the outputs therefore while doing the
financial appraisal important aspects such as ------------------- has to be taken in to
consideration.
(a) Cost: for Finding out the cost to complete the project and produce the outputs and
Pricing for : Setting of the Product Pricing for Profits
(b) Financing for : Increasing in investment and efficient use of the fund
(c) Investment vs Income for : Understanding the cost of production and Profits
Answers:
qqq
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REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter
Summary
PPT
MCQ
Video1
Technical Appraisal
3 TECHNICAL APPRAISAL
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
3.1 Introduction
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Chapter – 3
3.10 Summary
3.1 INTRODUCTION
Technical Appraisal is the technical review carried out by financial institutions to ascertain that
the project is technically sound with respect to various parameters such as technology, plant
capacity, raw material availability, location, manpower availability, etc.
Is the project in a position to deliver marketable products from the resources deployed? Is the
Return on Investment sufficient to service the cost of loan/equity and leave a reasonable amount for
the enterprise to carry out sustainable operations?
1. It ensures that the project is technically feasible – all the inputs required to set up the
project are available.
Usually, technical appraisal is carried out by independent agencies carrying out technical
studies or by the institution by their in-house technical experts. The financial analyst participating in
the project appraisal exercise should be able to raise basic issues relating to technical analysis
using common sense and economic logic.
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Technical Appraisal
⚫ A project will be assessed using various appraisal methods such as technical appraisal,
legal appraisal, Economical appraisal etc., in order to identify its potential for successful
completion and ROI.
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Chapter – 3
The technical review done by the financial institutions focuses mainly on the following
aspects:
⚫ Manufacturing Process/Technology
⚫ Technical Arrangements
⚫ Product Mix
⚫ Plant Capacity
⚫ Environmental Aspects
⚫ Vinyl chloride can be manufactured by using one of the following reactions: acetylene on
hydrochloric acid or ethylene on chlorine.
⚫ Paper, using bagasse as the raw material can be manufactured by the Kraft process or
the soda process or the Simon Cusi process.
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Technical Appraisal
Sinter Plant
Limestone
– Sinter
Secondary
Steelmaking
Molten
Steel
Coal
Blast Furnace –
Molten Iron Click this
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Coke Ovens – Electric Arc
Recycled Coke Furnace
Steel – Scrap
direct
reduction
furnace
Fe ore electric
arc
natural
furnace metallurgic
gas continuous
drum
casting
spongy
iron sheet
products
coal
scrap metal
coke
blast long
coke converter
furnace products
kiln
rust
cast iron
limestone
ingot iron
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Chapter – 3
Feed Bins
Coal
Mill
Raw Mill
Hot Gas
Generator
Rotary Kiln
Raw Mill
Mineral Filter
Clinker Cooler Gypsum Component Bulk Dispatch Packing Machine Bag Palletization
Cement Cement
Clinker Silo Silo
Storage
Cement Mill
cleaning and
to atmosphere
Water
Water
Chlorine
Ethylene
Air
1,2-dichloroethane
HCl
Vinyl chloride
Light
distillate
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Technical Appraisal
⚫ Availability of manpower and transport: The plant should not be located where skilled
labor for that industry is not available. For example, a footwear company that required
skilled stitching labor would not be advisable to be set up where the laborers would be
hesitant to travel/stay.
⚫ Plant Capacity: To meet a certain plant capacity requirement, only a certain production
technology may be viable.
⚫ Investment outlay and production cost: The cost of technology/process should not be
so high that the unit itself is uncompetitive and cannot sustain over a period of time.
⚫ Use by other Units: The technology adopted should be proven successful by other
units, preferably in India.
(a) Selection of the process or technology. Design, purchase, procurement and installation of
the plant and training of the manpower.
(b) Process and performance guarantees in terms of plant capacity, product quality and
consumption of raw materials and utilities.
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Chapter – 3
(d) utilities.
However, operating conditions like power or raw material or labor shortages can influence
capacity. Sometimes, seasonal availability of raw materials (such as sugarcane for sugar plants)
can hamper plant capacity. It is indeed difficult to assess capacity.
For instance, paper plant capacity varies with grammage. In a textile mill, capacity varies with
the composition of yarn of different counts. The daily production in a sugar mill depends on sugar
content of the cane; and annual production on the length of the crushing season. The extent and
degree of integration and facilities for by-product recovery also affect size of project investment and
profitability. An integrated textile mill with cotton as a starting material would require larger
investment and is more profitable than an unintegrated mill of the same capacity producing fabric
grey cloth.
Sometimes additional investment would improve the profitability enormously. In a caustic soda
plant, recovery of chlorine and hydrogen no doubt require additional investment but improve
profitability as compared to a plant producing just caustic soda.
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Technical Appraisal
Usually, location is selected such that it is close to supply of raw materials and/or to the
markets where the final products shall be consumed. Further, availability of infrastructure such as
roads, power and water availability are critical. By power, we broadly mean power supply that is
cost-effective, uninterrupted and stable. Transportation of raw materials to the plant and finished
goods to the markets is also possible in cost-effective and available easily.
Polluting units should be set up away from residential areas, in approved industrial zones and
where permission from Pollution Control Board is easily available. Usually, polluting units are set up
where the Effluent Treatment Plants (ETPs) are already available to neutralize the output waste.
Structures and civil works are the domain of the technical team, equipment suppliers,
architects, structural consultants and the administration team. Various technical design parameters
are taken into consideration such as load requirements for machinery foundation, height of
machinery/ceiling, ventilation, heat generated in the production areas, cleanrooms, administrative
staff requirements, loading/unloading areas, secure zones, handling of effluents and wastages, etc.
Polluting units should be set up away from residential areas, in approved industrial zones and
where permission from Pollution Control Board is easily available. Usually, polluting units are set up
where the Effluent Treatment Plants (ETPs) are already available to neutralize the output waste.
In technical appraisal, inputs are scrutinized for availability and quality dependability. If there
are seasonal variations, especially, in the case of agricultural inputs, variations in price have to be
checked. Similarly, power quality has to be checked in terms of variation in supply voltage and
in-line current frequency and duration of blackouts. Finally, the quality and availability of water
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Chapter – 3
which shows seasonal trends especially in case of a project requiring water as an input should be
checked.
The consumer demands are at an all-time high – choice of colors, taste, packaging, sizes and
at the desired prices. At the same time, the production being sustainable for the organization.
Today is the age of mass customization.
Flexibility is desired at the production level so that more customization is possible to suit the
wide variety of users. Flexible manufacturing system is the emerging system to manufacture what
the customer wants. These systems help in production of a large variety of products in small batch
sizes. The days of assembly line manufacturing emphasizing economies of scale are over. Even
otherwise flexibility imparts strength to the project to withstand market fluctuations and variations in
the quality of inputs.
Undependable supply of basic inputs could result in closure of the project or bankruptcy of the
organization. If coal, the main ingredient for a power plant is not available in sufficient quantity, it
can throw all project calculations in disarray. It will affect not just the organization but also millions
of consumers, production facilities and the national economy. If iron ore is not available for a steel
unit, it can disturb steel production while will have a cascading effect on important infrastructure
projects.
It is better to have as much interdependence of parameters so that shortfall in one can have
disorder in the entire project. For example, a small integrated paper plant using bagasse, paddy
husk or straw without need to recover process chemicals is considered more viable than large
integrated paper mill requiring forest based raw material, water and effluent disposal system.
Project charts and layouts are the tools to define the scope of the project and provide the
basis for detailed project engineering. These are general functional layout, material flow diagram,
production line diagram, utility layout and plan layout. The various different kinds of technical
drawings are:
1. General functional layout should facilitate smooth and economical movements of raw
materials, work-in-progress and finished goods.
2. Material flow diagram presents flow of materials, utilities, intermediate products, final
products scrap and emissions.
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3. Production line diagram establishes the progress of production from one machine to
another with description, location, space required, need for power and utilities and
distance from the next section.
4. Utility layouts show the principal consumption points of power, water and compressed
air which helps in the installation of utility supply.
5. Plant layout identifies the exact location of each piece of equipment determined by
proper utilization of space leaving scope for expansion, smooth flow of goods to minimize
production cost and safety of workers.
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Chapter – 3
48 Stack loss
61 92 60
Hot mill
Loss
1137 Loss 25
103
760 260 128
Cold mill Shear line Circling Loss
49 10
Loss 13
290 308
Loss 16
115 Slitter line Corrugator
28 28
176 10
200
Annealer Packing
176
735 MT/MO
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Fin Rolls RF Welding Fin-Cutting Cooling Sizing Straightening Cut-off Run Out Table
Hollows End-Tagging Annealign Degreasing Rinsing Picking Rinsing Phosphating Cold Water Rinsing
Stonecutting
and
Final
Inspection
Hot Water Scraping Air Drying Drawing Straightening Tag End Cutting Outing Packing
Dipping
DC
FUSE
BOX
PV ARRAY
INVERTER
WITH
BATTERY
CHARGER BATTERY DC TO AC
GENERATOR CONVERSION AC
CHARGER
(INVERTER) FUSE
BOX
AUTOMATIC TRANSFER
SWITCH
Utility Layout
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Chapter – 3
Cement Plant
Plant Layout
Estimates of production costs and projection of profitability is the concluding part of the
technical appraisal. Cost of production is worked out taking into account the build-up of capacity
utilization, consumption norms for various inputs and yields and recovery of by-products. In
estimating production, a general build-up starting with 40% and reaching a normal level of 80% in
three to four years time is provided. In practice, capacity utilization may fall short of estimated levels
on account of defective plant and machinery, inadequate operating skills, inadequacy of raw
materials, shortage of power and lack of demand. The cost of production and profitability estimates
take into account the level of production in different years and product-mix (which are dependent on
market potential, prices, marketing strategy, technical constraints relating to process and plant
facilities, and operators’ efficiency), norms of raw material consumption (including provision for
wastage), power and fuel requirement, their costs, salaries and wages, repairs and maintenance,
administrative overheads, selling expenses (including product promotion) and interest on
borrowings. Adequate provision is made for higher expenses in the initial years for, technical
troubles, higher wastages and lower yields, lower operating efficiency and higher selling costs.
Here, too, comparison with similar projects is useful. The profitability estimates should be on a,
realistic selling price. In a competitive market, penetration price for a new producer will have to be
lower than the current price of an established manufacturer.
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Output
Just delve over the technological developments over the past few years; Do we use the VCR
nowadays, Audio Players, CD Players, Fax machines, Telex, Wire Connected Landline phones?
Globalization of world economies and availability of new technologies expose any product or project
to the severe global competition. It is necessary to ensure that the project/unit is strong and can
face competition. The competitive status of a manufacturing unit is evaluated by eight performance
measures some of which form part of technical appraisal.
⚫ Work-in-process (WIP)
⚫ Throughput
⚫ Capacity
⚫ Flexibility
⚫ Performability
⚫ Quality
1. MLT: The manufacturing lead time (MLT) is the total time required to process the product
through the manufacturing plant. MLT should ideally be equal to actual machining and
assembly time. The ratio of MLT to the sum of processing time is a good indicator of the
time a part is unnecessarily lying on the factory floor. Real value is added to a product
during a product’s passage through the production system. Other times such as move
time, queue time and setup time should be reduced.
2. WIP: Work-in-process (WIP) is the quantity of semi-finished product currently lying on the
factory floor. WIP constitutes an investment and many companies incur large WIP costs.
Recent trend is to consider inventory as avoidable since required items only are
produced. WIP can be measured by multiplying the rate at which parts flow through the
factory with the length of time parts spend in the factory which is MLT. The number of
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Chapter – 3
parts currently being processed should be equal to the number of busy machines which
in turn equals the total number of machines multiplied by the utilization factor. Ideally,
there should be as many parts waiting as are being processed. WIP should be low.
3. Machine utilization: Machine utilization should not be decided with a view to amortize
the cost of machinery faster by higher utilization. Such a view turns a machine asset into
an inventory asset. Idle inventory may be perishable or may not be in demand resulting in
tying up cash in raw materials. If the choice is between idle machinery and building up
inventory, let the machine be idle. Machine should be run to manufacture exactly the
right quality of exactly right things at exactly the right time.
4. Throughput: Throughput is the hourly or daily production rate which is the reciprocal of
production time per unit of the product.
5. Capacity: Capacity is defined in terms of possible output the plant is able to produce
over some specified duration. In the case of continuous plant, the duration is 24 hours a
day, 7 days a week whereas in others it is defined over a shift period. Capacity is
measured as tons in the case of a steel mill, seat miles in the case of airlines, rooms in
the case of hotels and total available beds in the case of hospital. Available machine
hours are used to measure capacity when output is non-homogenous or the plant
produces a variety of products.
6. Flexibility: Flexibility is the ability of the system to respond effectively to change. High
degree of flexibility requires higher levels of automation and large investment. Flexibility
is fundamental to achieve competitiveness. Further it provides a strategic advantage to
handle risk associated with uncertain markets. Transfer lines which produce identical
parts do not have flexibility and cannot tolerate design modifications or part mix changes
or machine failure. On the other hand, job shops are highly flexible and are used for
manufacture of one-of-a-kind products. Their trait is large MLT and high WIP.
8. Quality: Maintenance of high quality depends on the integrity of the materials and
integrity of manufacturing process. Together, they help the supply of products that are
made right the first time. Quality is an important constituent in attaining competitiveness.
Total Quality Control (TQC) involves control of quality at source. Errors should be
corrected at the source where work is performed. This is defect prevention where
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Technical Appraisal
workers and supervisors have the primary responsibility for quality and any problems with
process are corrected immediately. Quality control at source provides fast feedback on
defects. This is unlike the sampling method employed after the lot has already been
produced. The benefits of total quality control are fewer rework labor hours and less
material waste. Good quality increases productivity. The basic requirements of total
quality control are process control, easy to see quality, insistence on compliance and
100% inspection.
Generally there are 6 steps identified to improve productivity and quality management in
organisations. These are as under in brief:
For example, measure the quality and productivity of the customer support center, measuring
the average time for solving problems and client satisfaction rate in cases of support.
If possible, implement automated tests that can be performed without human intervention,
which result in easy to interpret, modify or correct and approve or disapprove processes.
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Chapter – 3
Control production so that defects will be corrected immediately at the beginning before they
affect your final product
India ranks at a dismal low vis-à-vis Global benchmarks in terms of launch of innovative
products, productivity and safety records. There is an urgent need to improve the quality and
productivity to strengthen the competitiveness of Indian industry.
Among the methods used to Myron productivity and strengthen competitiveness are expert
systems and enterprise resource planning (ERP) which spread the use of lean techniques and lean
thinking. The adoption of these methods has to be insisted upon while making appraisal to help
improve the competitiveness of the unit.
1. Expert Systems (ES): Expert Systems (ES) are being used in manufacturing
environments to improve productivity and flexibility. They are used along with capacity
planning to ensure that parts are manufactured to meet due dates and optimise use of
production equipment. When used in conjunction with conventional methods, ES can
handle unforeseen circumstances allowing for easy extension and modifications to
revised schedules. They are also used for simulation of the scheduling system and to
assist with machine learning of scheduling procedures.
An ES is a computer program that performs a task normally done by an expert and which
in doing so, uses captured, heuristic knowledge. It can make the best expertise available
to a decision maker at the very moment the decision must be made. Its primary function
has been in diagnostics, decision making, system debugging and problem solving. Of
late, its use in the field of manufacturing has grown considerably, and now many systems
are being used in the areas of production scheduling, process planning, quality control
and inventory management.
Expert system has two components, knowledge base and an inference engine. Inference
engines are of two types, backward chaining which is goal driven and forward chaining
which is data driven. They can be used to search knowledge and find a suitable solution
to the problem one has.
For metal industry, researchers in the US have developed an ES to produce rolling mill
schedules (procedures) that yield specified values for metallurgical properties such as
grain size and internal stress. The results were used to help consolidate and downsize
the overall operations.
Expert systems are a way to convert corporate knowledge into corporate assets. An ES
enables the distribution of knowledge of experts present in one place and to accumulate
in one place; the knowledge of several widely separated experts. Usually, ES is faster
and more accurate as it uses the same logic normally used by the expert.
Resort to ES is attributable to the need to cut the lead time required to carry a product
from conception to a finished state. To remain competitive in the global context,
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manufacturing has to do better and more, using fewer resources. Lean manufacturing
uses less of each input: less labor, less machinery, less space, and less time in
designing products. In lean production, each act in the factory, as it were done on
demand.
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2. Enterprise Resource Planning (ERP): Lean techniques apply the idea of lean
production thinking to the whole company. The supply chain connects the factory to its
suppliers upstream and its customers downstream. Various parts of the company need to
share the flow of the same information. The new software program let the companies
integrate their financial data with payrolls, manufacturing and inventory records and
purchasing. Enterprise Resource Planning (ERP) is the toolkit that spreads lean thinking
throughout the company. A company using ERP can know, how efficiently its various
resources, people, money, machines are being used to satisfy its customers. The
integration of all aspects of company data into the same software helps to keep
manufacturing operations in balance and to keep work flowing smoothly through the
factory. Bottlenecks and imbalances show up quickly and can be set right.
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Chapter – 3
The implementation of the project has Cost and Time overrun implications. The scheduling of
construction, delivery and installation of machinery and other potential causes of delay form an
important part of the technical aspects of the project appraisal.
The schedule of construction depends mainly on the speed of civil construction works,
delivery period of equipment, as well as the efficiency of the management to tie up various ends in
a coordinated and speedy manner. Since an overrun in the pre-commissioning time invariably leads
to overrun in cost and consequential problems, it is important that the timing of construction is
realistically planned. For all main physical elements of the projects, from project concept, obtaining
Government approvals, tying up financial arrangements, engineering design, land acquisition,
building construction, procurement of equipment, its erection and testing to final commissioning,
there must be realistic time schedules and a coherent arrangement, which leads to the completion
of the project on most economical basis.
Use of scheduling techniques like Gantt Charts, PERT, CPM and GERT and proper
adherence to them is an essential aspect to be insisted upon in technical appraisal.
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3.10 SUMMARY
The technical appraisal is carried out by independent agencies carrying out technical studies
or by the institution by their in-house technical experts. The financial analyst participating in the
project appraisal exercise should be able to raise basic issues relating to technical analysis using
common sense and economic logic.
⚫ Technical Appraisal is the technical review to ascertain that the project is sound with
respect to various parameters such as technology, plant capacity, raw material
availability, location, manpower availability, etc.
⚫ Satisfactory arrangements have to be made to obtain the technical know-how needed for
the proposed manufacturing process
⚫ Material Inputs and Utilities forms is an important aspect of technical analysis. Materials
may be classified into four broad categories: (i) raw materials, (ii) processed industrial
materials and components, (iii) auxiliary mated and factory supplies, and (iv) utilities.
⚫ Appropriate technology refers to those methods of production which are suitable local
economic, social, and cultural conditions.
⚫ Several factors have a bearing on the plant capacity decision: power, raw material
availability, technology requirements, etc.
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Chapter – 3
⚫ The important Project charts and layout drawings are: (1) general functional layout,
(ii) material flow diagrams, (iii) production line diagram, (iv) transport layout, (v) utility
consumption layout, (vi) communication layout, (vii) organizational layout, and (viii) plant
layout.
⚫ Estimates of the Cost of Production takes into account the costs such as raw materials,
power and fuel, product R&D, administrative overheads, interest on borrowings, etc.
⚫ Competitive Status of a project is assessed to ensure that the project is strong and can
face competition.
⚫ Quality and Productivity can be improved by implementing Expert Systems (ES) and
Enterprise Resource Planning (ERP).
2. What are the different aspects of Technical Appraisal? Explain each in brief.
3. Explain the different types of charts and layouts. What are the differences between each?
1. Technical Appraisal is the technical review carried out by ---------------to ascertain that the
project is technically sound with respect to various parameters such as technology, plant
capacity, raw material availability, location, manpower availability, etc.
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Technical Appraisal
(b) Process and performance guarantees in terms of plant capacity, product quality and
consumption of raw materials and utilities.
(c) Periodic Royalty fees or one-time licensing fees and Period of collaboration
agreement.
3. The structure like site preparation and development, buildings and structures , outdoor
works etc. is covered under ------------------------
4. The total time required to process the product through the manufacturing plant is called
as ---------------------------
Answers:
qqq
Copyright © Welingkar 57
REFERENCE MATERIAL
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Chapter – 4
4 ECONOMIC APPRAISAL
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
4.1 Introduction
4.7 Summary
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Economic Appraisal
4.1 INTRODUCTION
⚫ Cost–benefit analysis
⚫ Cost-effectiveness analysis
The principles of appraisal are applicable to all decisions, even though concerned with small
expenditures. However, the scope of appraisal can also be very wide. Good economic appraisal
leads to better decisions and VFM. It facilitates good project management and project evaluation.
Appraisal is an essential part of good financial management, and it is vital to decision-making and
accountability.
Let us study the names of some of the financial institutions that fund projects:
We see that these institutions are formed for some specialized purpose. One’s objective is to
promote Industrial Development, someone if for small industries, someone else for promoting
tourism. The goal is not simply to earn profit.
This indicates that these institutions are formed for a greater purpose rather than just earning
profit. Earning money is important for creating sustainable institutions, but while earning profit, they
also do a good to the society and the vast majority of population.
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Chapter – 4
5. deciding.
The problem is always the starting point of an appraisal and must be defined clearly. This
point may seem obvious, but it is often in the case that the reason why appraisals are carried out is
that, there is a solution available for a problem. That solution is then wrongly seen as the starting
point. For example, appraising the cost-effectiveness of a new drug should be reformulated as an
appraisal of what is the most cost-effective way to deal with the problem that the new drug is
licensed for.
This may have an impact on the second stage, defining alternatives, which means different
ways of dealing with the problem. The most relevant alternative should be chosen, whatever it is,
for example, another drug, another type of therapy, routine care without specific therapy or do
nothing.
⚫ itemising costs and benefits, which means drawing up a descriptive list of the costs and
benefits that are to be included in the appraisal.
⚫ measurement, which means obtaining data that describe the levels of costs and benefits
for the different alternatives; and
⚫ valuation which means converting these data into values. For example, resource use
data should be converted into costs by applying to those data the value of the resources.
Summarising the results means combining the data on costs and benefits into the results that
will be presented to whoever will decide on the problem that has been appraised. Exactly, what
form this will take, depends on the type of appraisal that is carried out
The last stage is when a decision is taken based on the appraisal by someone who has the
responsibility to make it, which should not be the appraiser. Appraisers often do recommend a
decision based on their own appraisal, or imply such a recommendation, which is legitimate if
decision rules are known. For example, suppose that there is an accepted decision rule that if the
monetary benefits of a health intervention exceed its monetary cost, then it should be provided to
the population. A finding, for a particular intervention, that its benefits are estimated to be greater
than its costs would justify a recommendation that it should be provided.
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Economic Appraisal
An important aspect of the relationship between appraisal and decision is that the scope of
the appraisal should be a clear, include whose viewpoint is to be taken. Different actors in the
health system, for example patients, health professionals and government, may have different
interests and concerns, so that what is efficient from one actor’s point of view may not be so from
another.
This determines key elements of an appraisal, such as which type of appraisal is to be used,
what constitutes a benefit and a cost and how these are to be valued. Most appraisals will take the
viewpoint of the health service, since that embodies most of those actors who are legitimate
decision makers concerning which health care is to be provided. However, appraisals may also
take the viewpoint of society as a whole, since that includes both the recipients of health care and
also the funder of it. Whatever viewpoint is adopted, those reporting an appraisal should be explicit
about which it is.
Economic Appraisal of a project deals with the impact of the project on economic aggregates.
The study of the potential impact of the project to the nation and the society. We may classify these
under two broad categories:
They are:
The economic appraisal looks at the project from the larger point of view. Economic Appraisal
analyzes if the benefits will justify the project cost/investment done.
⚫ Increased output
⚫ Enhanced services
⚫ Increased employment
⚫ Higher earnings
The economic appraisal done by financial institutions is not very meticulous and precise. Also,
the emphasis placed on this appraisal is rather limited.
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Chapter – 4
Direct employment refers to the new employment opportunities created within the project and
first round of indirect employment concerns job opportunities created in projects related on both
input and output sides of the project under appraisal.
The analysis of net foreign exchange effect may be done for the entire life of the project or on
the basis of a normal year. If two or more projects are compared on the basis of their net foreign
exchange effect, the annual figure should be discounted to their present value.
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There are some differences in the aims and methods of different economic appraisals, such
that they have been classified according to distinct types. However, there are different principles by
which they could be classified, which leads to occasional disputes about how results of a particular
type of appraisal should be interpreted or used. Three different classification principles are:
⚫ Which costs and benefits are measured and how this is done.
We will discuss all three types here, but the most widespread and popular classification in
health economics is given by Drummond et al (2015), which uses both the measurement and
decision type principles.
We concentrate here on the types of appraisals most likely to be encountered in health care.
We refer to what is being appraised as ‘alternatives’, to emphasise that we are interested in the use
of economic appraisal in health care to aid decision making about different ways of using health
care resources. This includes many kinds of decisions, including alternative ways of delivering
health care, different types of health care and different treatment options.
However, in health economics CBA is usually restricted, following Drummond et al, to a study
in which all costs and benefits are given money values. The rationale for this is that, it is only
possible to weigh up all the costs and benefits if they are measured in the same unit. In principle,
any common unit could be used, but in practice money is an obvious and natural choice, because it
is the measure of economic value most used in modern economies. Such a CBA would allow us to
calculate the net benefit of each alternative, the difference between benefits and costs, which could
of course be negative. Decision making could then be based on which of the alternatives has the
greatest net benefit.
Formally, the main decision rule for CBA is that an activity should be undertaken if the sum of
the benefits that result is greater than the sum of the costs of undertaking it or, identically, if its net
benefit is positive. If only one activity with a positive net benefit can be undertaken (because, for
example, there are limited funds), the activity with the highest net benefit should be chosen.
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Chapter – 4
CBA has a theoretical basis in economics. If costs and benefits are measured in the correct
way, for example, all costs measure their true opportunity costs, an alternative that has a net
benefit is an opportunity for a Pareto improvement. Drummond et al interpret this to mean that CBA
is therefore appropriate for answering questions about whether or not a health care programme
should be implemented or a treatment should be used, rather than which of a number of alternative
programmes or interventions is the most efficient.
Social Cost Benefit Analysis (SCBA) is a methodology for evaluating investment projects from
the social point of view. Social Cost Benefit Analysis is concerned with the examination of a project
from the view point of maximisation of net social benefit. SCBA has received a lot of emphasis in
the last few decades as it is believed that not just government, but also private projects carry some
responsibility in imparting social benefits to the nation.
In SCBA, the focus is on the social costs and benefits of the project. These often tend to differ
from monetary costs and benefits of the project. The principal sources of discrepancy are:
(b) Externalities
Perfect market competition conditions are very rare. Market imperfections create
inaccurate prices of products and services. When imperfections exist, market prices do
not reflect social values.
(i) rationing,
Consumers pay less for a commodity under rationing than they would in a competitive
market. When minimum wages are prescribed by law, laborers are paid more than what
they would be paid in perfect market conditions. Similarly, foreign exchange rates in a
regulated developing economy are less than what would prevail in absence of exchange
regulations.
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Economic Appraisal
(b) Externalities
A project may have beneficial external effects. A road created for its new project may
benefit neighboring areas. These benefits are considered in SCBA although they do not
receive any monetary compensation from the external beneficiaries.
Similarly, a project may have harmful external effect like environmental pollution. In
SCBA, the cost of environmental pollution is relevant although the project sponsors do
not incur monetary costs.
Taxes are definitely monetary costs and subsidies are monetary gains. For SCBA, they
are irrelevant as they are just considered as transfer payments.
For SCBA, the division of benefits between consumption and savings is relevant
especially in developing countries. However, for project sponsors this may be irrelevant.
A private company is not bothered as to how project benefits are distributed amongst
different groups in society. The society however, is concerned about the distribution of
benefits across different groups.
There are differences of goals amongst the marketplace and the policymakers. For
example, a blood donation camp or balanced nutrition program for school going children
is not sought by consumers in the marketplace. However, from SCBA point of view, it is
very relevant.
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Chapter – 4
While financial institutions approach project proposals primarily from finance point of view,
they also evaluate projects from larger social point of view. Though there a minor variations
amongst various institutions, they essentially follow a similar approach which is a simplified version
of the Little-Mirrlees approach.
Various financial institutions in India carry out Economic Appraisals considering the following
three aspects:
There is a wide range of techniques, but the most common forms are:
It is important that with all costings that the data are up-to-date and that each piece of cost
information relates to the same time period. Cost information should also be comparable between
sampling units. Costs of disease and other health conditions include direct costs (treatment
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programmes and services) and indirect costs of the loss of productivity in all aspects of an
individual's life (and can also include patient expenses and informal care). Time horizon costs can
occur and there is uncertainty in cost estimates (can use confidence intervals). Cost data (i.e., total
cost per patient resource use) should show mean, variability (standard deviation) and precision of
estimate (confidence intervals).
Economic analysis is concerned with the pursuit of efficiency and equity. This involves the
allocating of resources among competing uses in public health. There is almost always a trade-off
between efficiency and equity in allocating resources. Priority needs to be given to those treatments
which provide the greatest benefit per unit of cost.
There is a cost-consequences analysis (cost analysis) which differs from the others in that the
range of costs and consequences are reported without attempting to aggregate the costs or the
health benefits into a single measure. It is somewhat similar to cost effectiveness, but it is applied to
evaluate interventions with more than one multidimensional outcome.
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Chapter – 4
CEA asks "is an intervention worth the time, trouble and incurred costs relative to other
alternatives?"
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Economic Appraisal
and it combines more than one aspect of health. However, like CEA, CUA can be applied in
circumstances were the available budget is fixed and maximum benefits are sought or when the
objective is fixed and the minimum cost method of achieving the objective is sought. Cost utility
analysis is also used in the measurement of immediate intervention outcomes such as patient
satisfaction.
Efficiency can be displayed in a league table which ranks interventions according to the extra
cost per extra QALY. Activities that generate more gains for every pound of resources take priority
over those that generate less. Independent interventions can be compared e.g., hip replacements
versus breast screening. Incremental cost-effectiveness ratios (ICERs) can be computed for
adjacent interventions. These specify how much it costs for each additional infection/condition
adverted by the more effective intervention relative to the less effective. ICER is calculated by
dividing (cost of treatment A minus cost of treatment B) by (effects of treatment A minus effects of
treatment B). Do note that when combining studies, costs may differ in the base year. Convert all
costs to a common base year for comparison. Purchasing power parities (PPP) are often used to
overcome the difficulties of using exchange rates to compare countries. PPP relate to the prices of
the same basket of goods in different countries. Ideally, a league table should include marginal
incremental cost-effectiveness data by having separate entries for different sub-groups. Besides
this clinical margin, an intensity margin may also be identified, i.e. interventions may be offered at
different levels of intensity to the same patient groups, e.g., annual or biannual breast screening.
ICERs should be calculated along the intensity margin, e.g., comparisons of screening every 3
years to no screening, 2 years to 3 years screening and 1 year to 2-year screening. Size of
population affected should also be considered and costs and QALYs may need to be
disaggregated for a better comparison.
Disadvantage
It is not helpful in assessing a single programme.
CUA asks "what is the difference in costs and effects of intervention A compared to B and so
on?"
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Economic Appraisal
additional cost of additional output). People also talk about tangible costs (can we invoice for this?)
and intangible (pain, suffering etc).
4.7 SUMMARY
⚫ Cost–benefit analysis
⚫ Cost-effectiveness analysis
5. deciding.
The problem is always the starting point of an appraisal and must be defined clearly. This
point may seem obvious, but it is often the case that the reason why appraisals are carried out is
that there is a solution available for a problem.
There are some differences in the aims and methods of different economic appraisals, such
that they have been classified according to distinct types. However, there are different principles by
which they could be classified, which leads to occasional disputes about how results of a particular
type of appraisal should be interpreted or used.
Social Cost Benefit Analysis (SCBA) is a methodology for evaluating investment projects from
the social point of view. Social Cost Benefit Analysis is concerned with the examination of a project
from the view point of maximisation of net social benefit. SCBA has received a lot of emphasis in
the last few decades as it is believed that not just government, but also private projects carry some
responsibility in imparting social benefits to the nation.
There is a wide range of techniques, but the most common forms are:
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Chapter – 4
It is important that with all costings that the data are up-to-date and that each piece of cost
information relates to the same time period. Cost information should also be comparable between
sampling units. Costs of disease and other health conditions include direct costs (treatment
programmes and services) and indirect costs of the loss of productity in all aspects of an
individual's life (and can also include patient expenses and informal care). Time horizon costs can
occur and there is uncertainty in cost estimates (can use confidence intervals). Cost data (i.e. total
cost per patient resource use) should show mean, variability (standard deviation) and precision of
estimate (confidence intervals).
Economic analysis is concerned with the pursuit of efficiency and equity. This involves the
allocating of resources among competing uses in public health. There is almost always a trade-off
between efficiency and equity in allocating resources. Priority needs to be given to those treatments
which provide the greatest benefit per unit of cost.
4. Is distribution of project’s benefits irrelevant in Project Appraisal? Give your views on the
same.
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2. The process of combining the data on costs and benefits into the results that will be
presented to whoever will decide on the problem that has been appraised is called as
-----------------------------
(a) Valuation
(b) Costing
(c) Summarising
Answers:
qqq
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Chapter – 5
5 MARKET APPRAISAL
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
5.1 Introduction
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Market Appraisal
5.14 Summary
5.15 Self–Assessment Questions
5.16 Multiple Choice Questions
5.1 INTRODUCTION
Market Appraisal is the review carried out to ascertain that the products manufactured by the
project can be sold and its value realized. At the birth of the project lies fundamental questions –
what the cost price of the product is, at what price can it be sold and the number of units that can
be sold annually.
Market appraisals are carried out before putting a property on the market to give the vendor
an idea of what is possible in terms of selling price. These valuations are used to satisfy a lender
that the loan requested against a property is in line with its value, ensuring they do not lend beyond
its value
It ascertains whether the company has competent sales force and distribution network to sell
the products manufactured. It is also necessary to establish how the project is going to capture its
share of the feasible market. Whether the unit can sell its products at the desired price points?
It ascertains the size of the potential market and whether the organization has a suitable
marketing strategy.
Is the project in a position to deliver marketable products from the resources deployed? Is the
Return on Investment sufficient to service the cost of loan/equity and leave a reasonable amount for
the enterprise to carry out sustainable operations?
Now since that the market appraisal should be carefully taken into account as it would play a
significant role in pricing in the market, here are a few factors that you must take into consideration
before going for market appraisal.
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Chapter – 5
1. The first thing that should be taken into consideration is that whether there are
fundamental sales forces as well as the distribution network in the unit itself so that the
products that are manufactured can be sold out.
2. The second factor that should be taken into consideration is how the unit can capture the
shares of the available market.
3. The next thing is that if the desired price point is set for every individual product, then will
the units be able to sell those products.
4. Another factor that should be considered is that to analyse the market of whether it is a
sizable potential market or not and what are the various marketing strategies that would
be the most suitable and that are set by the unit itself.
5. The next factors that should be taken into consideration are whether the products that
are to be marketed, be delivered by the units from those sources from where it is
deployed.
6. And the last factors that should be taken into consideration are that after selling, the
value of the return on investments obtained, will it be able to cover up for the cost of the
loan or the equity. And on top of it after covering up for the loans, will it still be able to a
fair amount of share so that the further sustainable operations will be carried out.
These few factors that are needed to be taken into account in case of the market appraisal.
The market appraisal holds quite an importance in the marketing field. Some of it is as
follows-
1. The market appraisal makes sure of the fact that that the project which is in focus has a
sales force which is competent enough. Also, it helps in analyzing the distribution
network so that the products that are being manufactured could be sold effectively.
2. The other importance of the market appraisal is that with the help of it, the products can
be easily sold at such price points such that it can in a future cover up for the loans that
have been taken. And it also checks whether after the loans have been settled down, do
still have enough money after the loan has been serviced, the units even have enough of
the surplus, so that the further sustainable operations can be carried out effectively.
3. Also, market appraisals ensure a potential market that can be met by the unit’s total
capacity of the production.
4. One more importance of the market appraisal is that it provides with a particular strategy
which is well thought of so that the sales and the marketing can be carried out efficiently
for a longer duration of the time.
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Market Appraisal
Thus, a market appraisal consists of generally those recommendations that are made by the
agents which prove to be quite effective when facing a competitive market.
1. It ensures that the project has the competent sales force and distribution network to sell
the products manufactured.
2. It can sell the products at the price points such that it can service the interest on loans
taken. Even after servicing the loan, there is sufficient surplus for the unit to carry out
sustainable operations.
3. It ensures that there is a potential market which can be met by the production capacity of
the unit.
While launching a new product/model, a promoter or CEO or Project In-charge will delve on
the following questions:
How many units can be sold in first year, its expected selling price, its cost? Also, sales in
further few years down the line. Then he will estimate the costs and profits generated. An example
is depicted in the chart as shown:
Next, he will ask what the indirect costs such as the Cost of Capital, interest costs, sales
costs, salaries, etc. associated with the project. The other costs will have to be lower than the profit
generated per year. Else, he will have to go to scratch and work out the numbers again.
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Chapter – 5
The Market Appraisal done by the financial institutions focuses mainly on the following
aspects:
⚫ Demand Analysis
⚫ Market Analysis
The first step in project analysis is to estimate the potential size of the market for the product
proposed to be manufactured (or service planned to be offered) and get an idea about the market
share that is likely to be captured. Two broad issues are covered by Market and Demand Analysis:
These are very important, yet difficult questions in project analysis. Intelligent and meaningful
answers to them call for an in-depth study and assessment of various factors like patterns of
consumption growth, income and price elasticity of demand, composition of market, nature of
competition, availability of substitutes, reach of distribution channels, so on and so forth.
It is not only essential to estimate the demand for the product but also define the target
customer to position the business in order to garner the unit’s share of sales. Further, it is
necessary to establish how the unit is going to capture its share of the feasible market.
Suppose a company wants to launch a new brand of high-quality kitchenware in the domestic
market. Important questions that should be asked to get a correct Market and Demand Analysis will
be:
⚫ How is the demand distributed temporarily (pattern of sales over the year geographically?
⚫ What price will the customers be willing to pay for the improved range of kitchenware?
⚫ How can potential customers be convinced about the superiority of the new kitchenware?
⚫ What channels of distribution are most suited for the kitchenware? What trade margins
will induce distributors to carry it?
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Market Appraisal
Demand Analysis for the product proposed to be manufactured requires collection of data and
preparation of estimates. Market appraisal requires description of the product, applications, market
scope, market competition from similar products/substitutes, areas of competitive advantage,
pricing, etc. In a highly competitive environment, customized products with short lifespan are vital.
Customer needs are foremost to be kept in the manufacturer’s mind. Functionality, costs, delivery,
service, physical appearance, etc. are some of the key parameters to be attended to. Physical
distribution and manufacturing are a part of the supply chain. Reasonable estimates have to be
made regarding existing and future demand of the product.
After gathering the information, the existing position has to be assessed to ascertain whether
unsatisfied demand exists. Since cash flow projections are to be made, possible future changes in
the volume and pattern of supply and demand have to be estimated. This would help in assessing
the long-term prospects of the unit.
A wide range of forecasting methods are available to the market analyst. It can be classified
into three broad categories as under: Trend, Regression and End-use Method.
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Chapter – 5
An expected production level of the various end-user industries is made and based on that the
product use forecasts are made. Provisions have to be made for competition from substitute
products and changes due to technological changes. Hence, the end-use method should be used
judiciously.
The end-use approach enable preparation of industry-wise customer demand forecasts and it
is easy to evaluate any discrepancy in the forecasts with the actual value.
The End-use Method has limitations as it may be difficult to estimate the projected output
levels of consuming industries. More important, the consumption coefficients may vary from one
period to another in the wake of technological changes and improvements in the methods of
manufacturing.
Market analysis deals with the study of the segmented market, product positioning, product
promotion and distribution strategies and analysis of the competition. Market analysis defines the
target customer, the resultant market in terms of size, structure, growth prospects, trends and sales
potential.
Various private companies also carry out market surveys for a fee. Further, good information
relating to the market is available from various manufacturer/trade associations, trade journals and
related Government Organizations.
Market Segmentation narrows the total market which is segmented by factors such as
geographic (where they live), demographic (who they are – age, sex, income), psychographic (why
they buy – lifestyle factors) and synchro graphic (when they buy).
After the target market is defined, the feasible market has to be defined by identifying the
various produce gaps. The unit’s share in the total feasible market is tied to the structure of
industry, the impact of competition, strategies for market penetration and continued growth and
advertisement budget.
Market share depends on industry growth which will increase the total number of users of the
product and conversion of users from the total feasible market during a sales cycle. A sales cycle
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Market Appraisal
has four distinct stages – early pioneer users, early majority users, late majority users and late
users.
Behavioural
Market
Psychographic Segmentation Geographic
Demographic
Market Segmentation
3 Producer Consumer
Distribution Channels
Product Positioning will help place the product as a differential identity in the eyes of the
potential buyer. The strategy used for product positioning is usually the result of an analysis of
customers and competition.
Product Pricing decision is very important because it has a direct effect on marketing and
financial success of the business. The basic rules of pricing are that they must cover costs and
should be reduced only through lower costs. Prices may be determined on a cost plus basis as
practiced by manufacturers to recover all costs, both fixed and variable and realize a desired profit
percentage. Mark-up pricing is used by all retailers which are calculated by adding desired profit to
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Chapter – 5
the cost of the product. Finally, competitive pricing as in the case of markets where there is an
established price, and the product is more or less homogeneous.
Expensive
Bacon and
Eggs
Cold Cereal
Slow Quick
Instant
Pancakes Breakfast
Hot
Cereal
Inexpensive
Product Positioning
High Premium
Dairy Milk silk
Temptation
Dairy milk
Kit Kat
Snack Indulgence
Munch Perk 5 Star
Low Price
Choice of distribution channel to move the product from the factory to the end-user depends
on channels being used by competitors and the strategic advantage it would confer. The company
may choose direct sales, OEM (original equipment manufacturer) sales, manufacturer’s
representative, wholesale distributors, brokers, retail distributors or direct mail. Apart from channels
being used by competitors, choice of distribution strategy is based on factors such as pricing
method and internal resources.
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Market Appraisal
A promotion plan consisting of controlled distribution to sell the product has to be formulated
after the distribution strategy is formulated. It encompasses every marketing tool utilized in
communication efforts. These are advertising, packaging, public relations, sales promotion and
personal sales.
Once the market has been researched and analyzed in terms of defining it, positioning the
product and pricing, distribution and promotional strategies – financial projections can be made for
three or five years.
The criteria employed to judge what constitutes a key asset or skill within an industry or
market segment may be identified from any analysis of reasons behind successful as well as
unsuccessful companies, prime customer motivators, major component costs and barriers to
mobility. Through the competitor analysis, a marketing strategy that will generate a unique asset or
skill to provide a distinct and enduring competitive advantage has to be framed. The results of
market research which have helped in defining the distinct competitive advantage have to be
communicated in a strategic form that will attract market share as well as defend it.
Competitive strategies usually fall into product, distribution, pricing, promotion and advertising.
The competitive advantage has to be clearly established. So, the appraiser of the project
understands not only how the goals will be achieved but why the company’s strategy will work.
In order to judge the managerial capability of the promoters, the following questions are
raised:
5.14 SUMMARY
⚫ Market Appraisal is the review carried out to ascertain that the products manufactured by
the project can be sold and its value realized.
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Chapter – 5
⚫ Market Appraisal is important to determine whether the unit has a competent sales force
and distribution network, the products can be sold at the estimated price points, there is a
potential market for the products and there is a comprehensive sales and marketing
strategy for long-term operations.
⚫ Demand Analysis analyzes the aggregate demand of the product/services and what will
be the potential market share of the unit.
⚫ Market Analysis studies the market segmentation, product positioning, product promotion
and distribution strategies, competition, etc.
⚫ Financial Institution carry out Managerial Appraisal of the promoters as part of its
appraisal.
The Market Appraisal done by the financial institutions focuses mainly on the following
aspects:
⚫ Demand Analysis
⚫ Market Analysis
The first step in project analysis is to estimate the potential size of the market for the product
proposed to be manufactured (or service planned to be offered) and get an idea about the market
share that is likely to be captured. Two broad issues are covered by Market and Demand Analysis:
These are very important, yet difficult questions in project analysis. Intelligent and meaningful
answers to them call for an in-depth study and assessment of various factors like patterns of
consumption growth, income and price elasticity of demand, composition of market, nature of
competition, availability of substitutes, reach of distribution channels, so on and so forth.
It is not only essential to estimate the demand for the product but also define the target
customer to position the business in order to garner the unit’s share of sales. Further, it is
necessary to establish how the unit is going to capture its share of the feasible market.
Demand Analysis for the product proposed to be manufactured requires collection of data and
preparation of estimates. Market appraisal requires description of the product, applications, market
scope, market competition from similar products/substitutes, areas of competitive advantage,
pricing, etc. In a highly competitive environment, customized products with short lifespan are vital.
Customer needs are foremost to be kept in the manufacturer’s mind. Functionality, costs, delivery,
service, physical appearance, etc. are some of the key parameters to be attended to. Physical
distribution and manufacturing are a part of the supply chain. Reasonable estimates have to be
made regarding existing and future demand of the product.
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Market Appraisal
A wide range of forecasting methods are available to the market analyst. It can be classified
into three broad categories as under: Trend, Regression and End-use Method.
Market analysis deals with the study of the segmented market, product positioning, product
promotion and distribution strategies and analysis of the competition. Market analysis defines the
target customer, the resultant market in terms of size, structure, growth prospects, trends and sales
potential.
Market Segmentation narrows the total market which is segmented by factors such as
geographic (where they live), demographic (who they are – age, sex, income), psychographic (why
they buy – lifestyle factors) and synchro graphic (when they buy).
Choice of distribution channel to move the product from the factory to the end-user depends
on channels being used by competitors and the strategic advantage it would confer.
2. What are the various aspects of Market Appraisal? Describe each in detail.
3. How do you estimate the demand for a product which you choose to manufacture?
1. Market Appraisal is the review carried out by ------------------------to ascertain that the
products manufactured by the project can be sold and its value realized.
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Chapter – 5
2. What is important factor that needs to be considered at initial stage itself for undertaking
the market appraisal?
(a) whether there are fundamental sales forces as well as the distribution network in the
unit itself
(b) how the unit can capture the shares of the available market.
(c) will the units be able to sell those products at desired price?
(a) It ensures that the project has the competent sales force and distribution network to
sell the products manufactured.
(b) It can sell the products at the price points such that it can service the interest on loans
taken. Even after servicing the loan, there is sufficient surplus for the unit to carry out
sustainable operations.
(c) It ensures that there is a potential market which can be met by the production
capacity of the unit and there is a well thought-out sales and marketing strategy
favorable for long-term operations.
4. Market share depends on --------------------which will increase the total number of users of
the product and conversion of users from the total feasible market during a sales cycle.
5. The description of the product, applications, market scope, market competition from
similar products/substitutes, areas of competitive advantage, pricing, etc. is required for
the purpose of ---------------------------
Answers:
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Market Appraisal
qqq
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PPT
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Chapter – 6
6 FINANCIAL APPRAISAL
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
6.1 Introduction
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Financial Appraisal
6.9 Estimating Cost of Capital with Capital Asset Pricing Model (CAPM)
6.13 Summary
6.1 INTRODUCTION
Financial Appraisal is the review carried out by financial institutions to ascertain whether the
project to be financed is financially viable. The project could be a new project or expansion of
existing production facilities.
Any project appraisal exercise involves asking the three basic questions: Can we produce the
goods or services? Can we sell the goods or services? Can we earn a satisfactory return on the
investment made in the project?
While first two questions are answered can be answered reasonably well through the
technical and market appraisal. The most important question of earning sufficient return is
answered through the Financial Appraisal.
One aspect of Financial Appraisal is the assessment of funds required to implement the
project and sources of the same. The other aspect relates to estimation of operating costs and
revenues, prospective liquidity and financial returns in the operating phase.
The project’s direct benefits are estimated at the prevailing market prices. Financial appraisal
is concerned with the measurement of profitability of resources without reference to their source.
1. It ensures that the project is able to get a reasonable return on the investment made to
carry on sustainable operations.
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Chapter – 6
2. It estimates the cash flows and reasonable level of profit that the unit can make from the
operations.
3. It estimates the Cost of the Project and the Sources of Finance, their respective costs
and the Cost of Capital of the unit to complete the project.
5. It determines the Break-even Point to find the exact level of sales and production when
the unit can break-even.
For existing units, the banker and other stakeholders need to understand of the past
performance of the company. Although the financial projections may project a very rosy picture
about the future, they would like to assess what has been your performance in the past. The
company’s last three audited balance sheets and profit and loss statements as well as the latest
unaudited provisional accounts certified by the management/CA have to be analyzed.
The latest balance sheet and profit and loss account may be analyzed with a view to
ascertain, whether the concern is under/overcapitalized, whether the borrowings raised are not out
of proportion to its paid-up capital and reserves, how the current liabilities stand in relation to
current assets, whether the gross block has been properly depreciated and has not been shown at
an inflated value, whether there is any interlocking of funds with associate companies and whether
the concern has been ploughing back profits into the business and building up reserves.
They also assess the changes in balance sheets of the company over a period of time with
respect to sales, profitability, fixed assets, etc.
The capital cost of the project whether it refers to expansion or a new project should be shown
under:
(ii) Buildings,
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Financial Appraisal
It has to be ascertained that all these items are covered in the cost and the expenditure under
each item is reasonable. It will help to compare the cost of the project with the cost of a similar
project or by the information about cost that may be gathered in respect of other units in the same
industry with comparable installed capacity and other common technical features.
Electrification Technical
Computers Other
12,00,180 Know-how Sources,
14,17,175 Fees
2% 2% 5,00,143,
46,50,000
1%
Furniture & 7%
Land &
Fixtures Equity
Building
5,18,563 Capital,
1% 2,08,15,350
31% 2,50,00,000,
37%
Term Loan,
Plant & 3,70,00,000,
Machinery 56%
3,78,99,875
57% Preferred
Stock,
40,00,000,
COST OF PROJECT MEANS OF FINANCE 6%
⚫ Share capital
⚫ Term loans
⚫ Debenture capital
⚫ Deferred payments
⚫ Miscellaneous sources
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Chapter – 6
How should a promoter or project manager plan out the Project Capital Structure? He will
rationalize the capital structure with the current legal and banking norms.
(a) Share capital: Share Capital is the long-term contribution to the project by the
promoters. Any financial institution/banker would expect the promoter to contribute
around 20-30% of the total project. This promoter contribution increases with the
increase in the size of the project. For large projects, bankers expect promoters to
contribute almost 50% of the total project cost. The promoter contribution will be in the
form of unsecured loans which the financial institution will insist to convert to Paid-up
Equity Capital. Thus, the promoter contribution becomes locked in the project.
Some portion of the Share Capital can also be in the form of Preference Capital by the
preference shareholders who get generally paid a fixed dividend but who are not allowed
to withdraw the sum invested.
Modern finance in the form of Private Equity is available for startups and other
companies that provide such companies with much needed equity capital to develop but
comes at a higher cost are available nowadays.
(b) Term loans: 70-80% of the Project Cost is usually funded by the institution. It goes down
to 50% for very large projects. Depending on the project repaying capacity, the balance
amount shall be funded by the financial institution for the usual tenure as per their norms.
This is in form is a reducing balance Term Loan, where there is a principal repayment
and interest on the outstanding loan balance. As the promoter repays and the
outstanding loan balance is reduced, the interest repayment also reduces.
There are some concessions by the government for technical entrepreneurs and female
entrepreneurs. Usually, technical entrepreneurs have flexibility of lower promoter
contribution and female entrepreneurs get some discount in the rate of lending.
Terms loans are available in variety of forms such as Rupee Term Loans, Foreign
Currency Term Loans, Working Capital Term Loans, etc.
(c) Debenture capital: Debentures are debt instruments to raise capital from the public.
Maturity period is of 5 to 9 years. There are convertible debentures and non-convertible
debentures. Non-convertible debentures are straight debt instruments. Convertible
debentures are convertible partially or wholly into equity shares – conversion period,
price are determined in advance.
(d) Deferred payments: Suppliers of capital goods offer a deferred credit facility under
which the payments can be made over a period of time.
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Financial Appraisal
(e) Miscellaneous sources: A small portion of the project finance can come from
miscellaneous sources like public deposits, unsecured loans, hire purchase and lease
facilities, etc.
(f) Unsecured loans from promoters: Promoters also do provide unsecured loans to
bridge the gap between the promoter’s contribution and the equity capital required.
(g) Internal accruals in the case of an existing unit: Internal accruals from existing
operations can fund marginally gap between the capital needs for the project.
It is important that no gap is left in financing patterns. Otherwise, it will result in cost overruns
and time overruns in the implementation of the project. Financial institutions stipulate a condition
that any kind of cost overrun, or time overrun shall be funded by the promoters.
While the emphasis of financial institution is on the viability of the project, they generally
stipulate by way of security, a first legal charge on fixed assets of the company ranking pari passu
with the charge if any, in favor of other financing institutions.
Projected Profit and Loss Statements, Balance Sheets and Cash Flow Statements over a long
period – say 5 to 10 years will give us the realistic picture of the finances of the project. What is the
profit generated over a period of time? What are the interest costs? What is the Return on Capital
Employed? etc.
These projected financial statements are interrelated and are prepared on the basis of various
assumptions regarding capacity utilization, availability of inputs, their price trends and their selling
prices, various indirect costs, statutory taxes, etc. These assumptions should be scrutinized
carefully before making estimates. A proforma is annexed hereto.
New units should not go for any sharp build-up of capacity within a year or two especially if
the product is new. The quantum of raw materials and utilities estimated to be consumed to obtain
a particular quality/quantum of end product is the core of cost of manufacture estimates and should
tally with the performance guarantees furnished by the collaborators/machinery suppliers. In case
of multiproduct companies, the product mix is decided on the basis of contribution of each product,
utilization of plant capacity as well as market. There should also be reasonable annual increases in
indirect costs such as wages and salaries, electricity, etc.
Financial Appraisal’s main goal is to ascertain the profitability of the project. The promoter
might present a very rosy picture to the financial institution due to his own conviction on the project,
but it is the task of analyst to verify the estimates. It is to be ensured that the profits projected are
realistic and achievable.
Depreciation of fixed assets should be provided as per Income Tax Rules. The selling price
should be fixed keeping in view the present domestic price of the product. Repairs and
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maintenance will have to be provided keeping in view the type of industry and the number of shifts
to be worked. The profitability projections are closely linked to the schedule of implementation. On
the basis of profitability projections, cash flow and projected balance sheets are prepared for a
period of five to ten years.
(` lakhs)
Particulars Year
0 1 2 3 4 5 … 10
I. Cost of Project
1. Land and Building
2. Plant and Machinery
3. Working Capital
Total Outlay
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Financial Appraisal
There are various methods and two discounted cash flow techniques for financial appraisal to
evaluate the cash flows and profitability of investment. The methods should have three properties to
lead to consistently correct decisions.
1. It should consider all cash flows over the entire life of a project;
3. It should help to choose a project from among mutually exclusive projects which
maximize the value of the companies’ stock.
2. Payback Period.
They employ annual data at their nominal value. They do not take into account the life span of
the project but rely on one year.
The two Discounted Cash Flow techniques for Financial Appraisal are the:
They take into consideration the project’s entire life and the time factor by discounting the
future inflows and outflows to their present value.
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Chapter – 6
The simple rate of return helps in making a quick assessment of profitability, particularly
projects with short life. Its shortcoming is that it leaves out the magnitude and timing of cash flows
for the rest of the years of a project’s life. For evaluation, accurate data is required. In its absence
simple rate of return may be incorrect. Simple rate of return method is suitable for financial analysis
of existing units. It is not suitable for optimizing investment.
The Payback period shows that the project’s initial investment is recovered in ten years. Even
if cash flows are not uniform, the payback period can be calculated easily by adding together cash
flows until the investment is recovered. The payback method is calculated simple and lays
importance to recovering the original investment as fast as possible. The shorter the payback
period, the quicker is the recovery of initial investment. But it leaves out the time pattern of the cash
flows within the payback period and the cash flows after the payback period. Actually, it is biased
against projects which yield higher returns in later years. The payback period method is not suitable
for evaluation of alternatives and to make systematic comparison.
When appraising capital projects, basic techniques such as ROCE and Payback could be
used. Alternatively, companies could use discounted cash flow techniques discussed on this page,
such as Net Present Value (NPV) and Internal Rate of Return (IRR).
Money received today is worth more than the same sum received in the future, i.e., it has a
time value.
2. impact of inflation
3. effect of risk.
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Financial Appraisal
Compounding
A sum invested today will earn interest. Compounding calculates the future or terminal value
of a given sum invested today for a number of years. To compound a sum, the figure is increased
by the amount of interest it would earn over the period.
Example of compounding:
An investment of ` 1,00,000/- is to be made today. What is the value of the investment after
two years if the interest rate is 10%?
Solution:
The ` 1,00,000 will be worth ` 1,21,000/- in two years at an interest rate of 10%.
To speed up the compounding calculation, we can use a formula to calculate the future value
of a sum invested now. The formula is:
F = P(1 + r)n
N = Number of periods.
Discounting
In a potential investment project, cash flows will arise at many different points in time. To
make a useful comparison of the different flows, they must all be converted to a common point in
time, usually the present day, i.e., the cash flows are discounted.
Years 0 1 2 3 4
Discounting
PV FV
The present value (PV) is the cash equivalent now of money receivable/payable at some
future date.
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Chapter – 6
Example of discounting:
Solution:
F 1,15,000
P= n = 9
= 68,068
(1 + r) (1 + 0.06)
In discounted cash flow techniques, the rate of interest is required. There are a number of
alternative terms used to refer to the rate of interest:
⚫ cost of capital
⚫ discount rate
⚫ required return.
Discounted cash flow (DCF) techniques take account of this time value of money when
appraising project investments. The Discounted Cash Flow (DCF) methods are more objective than
earlier methods. They take into account both the magnitude and timing of expected cash flows in
each period of a project’s life. They take into account time value of money – a rupee today is has
more value than a rupee at a later date. The two methods are the:
If we treat outflows of the project as negative and inflows as positive, the NPV of the project is
the sum of the PVs of all flows that arise as a result of doing the project.
Decision rule:
The NPV represents the surplus funds (after funding the investment) earned on the project,
therefore:
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Financial Appraisal
⚫ if the company has two or more mutually exclusive projects under consideration, it should
choose the one with the highest NPV.
The following assumptions are made about cash flows when calculating the net present value:
Also interest payments are never included within an NPV calculation as these are taken
account of by the cost of capital.
Solution:
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Chapter – 6
The PV of cash inflows exceeds the PV of cash outflows by ` 29,760, which means that the
project will earn a DCF return in excess of 9%, i.e., it will earn a surplus of ` 29,760 after paying the
cost of financing. It should, therefore, be undertaken.
Advantages
Theoretically, the NPV method of investment appraisal is superior to all others. This is
because:
Disadvantages
⚫ It is relatively complex.
1. Calculate two NPVs for the project at two different costs of capital
NL
IRR = L + (H − L)
NL − NH
where,
NPV
H
L Discount rate %
True IRR
NH
Decision rule:
⚫ Projects should be accepted if their IRR is greater than the cost of capital.
A potential project’s predicted cash flows give a Novo ` 50,000 at a discount rate of 10% and
an NPV of ` 10,000 at a rate of 15%. Calculate the IRR.
Solution:
50,000 (15% − 10%)
IRR = 10% + = 14.17%
50,000 − ( −10,000)
Advantages
⚫ It means a firm selecting projects where the IRR exceeds the cost of capital should
increase shareholders’ wealth.
Disadvantages
⚫ Interpolation only provides an estimate, and an accurate estimate requires the use of a
spreadsheet programme.
⚫ Non-conventional cash flows may give rise to multiple IRRs which means the
interpolation method can’t be used.
Interpolation only provides an estimate (and an accurate estimate requires the use of a
spreadsheet program). The cost of capital calculation itself is also only an estimate and if the
margin between required return and the IRR is small, this lack of accuracy could actually mean the
wrong decision is taken.
Another drawback of IRR is that non-conventional cash flows may give rise to no IRR or
multiple IRRs. For example, a project with an outflow at T0 and T2 but income at T1 could,
depending on the size of the cash flows, have a number of different profiles on a graph (see below).
Even where the project does have one IRR, it can be seen from the graph that the decision rule
would lead to the wrong result as the project does not earn a positive NPV at any cost of capital.
NPV
Two IRRs
No IRRs
Both NPV and IRR are investment appraisal techniques which discount cash flows and are
superior to the basic techniques such as ROCE or payback. However, only NPV can be used to
distinguish between two mutually exclusive projects, as the diagram below demonstrates:
NPVA
NPVB
IRRA IRRB
The profile of Project A is such that it has a lower IRR and applying the IRR rule would prefer
Project B. However, in absolute terms, Project A has the higher NPV at the company’s cost of
capital and should, therefore, be preferred.
NPV is, therefore, the better technique for choosing between projects.
The advantage of NPV is that it tells us the absolute increase in shareholder wealth as a
result of accepting the project, at the current cost of capital. The IRR simply tells us how far the cost
of capital could increase before the project would not be worth accepting.
The modified internal rate of return (MIRR) solves many of these problems with the
conventional IRR.
In the analysis so far, the company’s cost of capital was used to discount the forecasted cash
flows of the new project. Many companies estimate the rate of return required by investors in their
securities. Towards this purpose, the company’s cost of capital is used to discount cash flows in all
new projects. This is not an accurate method since the risk of existing assets of a company may
differ from the risk of new project assets. Since investors require a higher rate of return from a very
risky company, such a company will have a higher cost of capital and will set a higher discount rate
for its new investment opportunities. The cost of capital or required rate of return on the project
would be the same as the one on company’s existing assets if the risk is the sane. The company’s
cost of capital is the correct discount rate for projects that have the same risk as the company’s
existing business. If the project risk differs from the risk on existing assets, the project has to be
evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to
which it is put.
The capital asset pricing model (CAPM) can be used for estimating the company’s cost of
capital. Each project should be evaluated at its own opportunity cost of capital. Capital asset pricing
theory tells us to invest in any project offering a return that more than compensates for the project’s
beta which measures the amount that investors expect the stock price to change for each one per
cent additional change in the market risk. The discount rate increases as project beta increases.
However, companies require different rates of return from different categories of investment. The
higher the beta risk associated with an investment, the higher the expected rate of return must be to
compensate investors for assuming risk. The CAPM provides a framework for analyzing the
relationship between risk and return. The CAPM holds that there is a minimum required rate of
return even if there are no risks, plus a premium for all non-diversifiable risks associated with
investment. Projects should be evaluated as portfolios and there is a reduction of risk when they
are so combined.
To calculate the company’s cost of capital, the beta of its assets has to be ascertained. The
beta cannot be plugged into the capital asset pricing model to find the company’s cost of capital
because the stock’s beta reflects both business and financial risk. The beta has to be adjusted to
remove the Financial Appraisal effect of financial risk since borrowing increases the beta (and
expected return) of its stock. A more reliable estimate is an average of estimated betas for a group
of companies in the same industry. While estimating project betas, fudge factors to discount rates
to offset bad outcomes of a project should be avoided. In cases where project beta cannot be
calculated directly, identification of the characteristics of high and low beta assets (for instance,
cyclical investments are high beta investment) would help to figure out effect on cash flows. Finally,
operating leverage should be assessed since high fixed production charges are like fixed financial
charges resulting in an increase in beta. The expected rate of return calculated from the capital
asset pricing model:
r = rf + B (rm – rf)
where r is discount rate, rf is interest rate on risk-free asset like treasury bill and rm expected return
can be plugged into standard discounted cash flow formula:
T T
(1 + r) [1+ r + B(r
Ct Ct
PV = =
t =1
t
t =1 f m − rf )]t
The Capital Asset Pricing Model values only the cash flow for the first period (C1). Projects,
however, yield cash flows for several years. If the risk adjusted rate r is used to discount the cash
flow, we assume that cumulative risk increases at a constant rate. The assumption will hold when
the project’s beta is constant or risk per period is constant.
An integral aspect of Financial Appraisal is Financial Analysis which takes into account the
financial features of a project, especially sources of finance. Financial Analysis helps to determine
smooth operation of the project over its entire life cycle. The two major aspects of financial analysis
are liquidity analysis and capital structure analysis. For this purpose, ratios are employed which
reveal existing strengths and weaknesses of the Project.
(a) Current ratio: The current ratio is defined as current assets [cash, bank balances,
investment in securities, accounts receivable (sundry debtors) and inventories] divided by
current liabilities [accounts payable (sundry creditors), short-term loans, short-term
creditors and advances from customers]. It is computed by,
Current Assets
Current Ratio =
Current Liabilities
The current ratio measures the assets closest to being cash over those liabilities closest
to being payable. It is an indicator of the extent to which short-term creditors are covered
by assets that are expected to be converted to cash in a period corresponding to the
maturity of claims.
(b) Acid test or Quick ratio: Since inventories among current assets are not quite liquid, the
quick ratio excludes it. The quick ratio includes only assets which can be readily
converted into cash and constitutes a better test of liquidity.
Current Assets – Inventories
Quick Ratio =
Current Liabilities
(a) Debt utilization ratio: Debt utilization ratio measures a company’s degree of
indebtedness which measures the proportion of the company’s assets financed by debt
relative to the proportion financed by equity. Debt includes current liabilities and long-
term debt. Creditors prefer low debt ratios because the lower the ratio, the greater the
cushion against creditor’s losses in the event of liquidation. The owners prefer higher
levels either to magnify earnings or to retain control total debt.
Total Debit
Debit Ratio =
Total Asset
(b) Debt-Equity Ratio: Debt-Equity Ratio is the value of the total debt divided by the book
value of equity. In calculation of debt, short-term obligations of less than one year
duration are excluded.
(c) Fixed Assets Coverage Ratio: Two other ratios relating to long-term stability used by
development finance institutions (DFIs) in appraisal of projects are fixed assets coverage
ratio and debt coverage. The fixed assets coverage ratio shows the number of times
fixed assets cover loan.
(d) Debt Coverage Ratio: The debt coverage ratio measures the degree to which fixed
payments are covered by operating profits. The ratio emphasizes the ability of the project
to generate adequate cash flow to service its financial charges (non-operating
expenses). Debt coverage ratio measures the number of times earnings cover the
payment of interest and repayment of principal. A debt coverage ratio of 2 is considered
good.
(e) Interest Coverage Ratio: The interest coverage ratio measures the number of times
interest expenses are earned or covered by profits.
(f) Market Value Ratio: Market value ratios relate to the company’s share price to its
earnings and book value per share. These ratios are a performance index of the
company and indicate the investor’s perception of the company’s performance and future
prospects.
(g) Price Earnings Ratio: P/E Ratio relates the per share earnings to price of the share.
P/E Ratios are computed for companies as well as for the market. P/E ratios are higher
for companies with high growth prospects and lower for riskier companies.
(h) Market/Book Value Ratio: The ratio of market price of the share of the company to its
book value per share gives an indication of how investors regard the company.
Generally, if the returns on assets are high, these shares sell at higher multiples of book
value than those with low return. Book value per share is the sum of net worth (paid-up
capital plus reserves) divided by number of shares outstanding.
Total Networth
Book value per share =
No. of shares outstandin g
(i) Market/Book Value Ratio (M/B ratio): If the market price per share is divided by book
value, we get the market book (M/B) ratio.
`
In
co
m
e
Break Even Profit
Point
Variable
Costs
Loss
Fixed
Costs
Units Sold
Break-even Point
It indicates the volume necessary for profitable operation of the project. With the help of
break-even analysis, the quantity required to be produced at a given sales price per unit to cover
total fixed cost and variable cost can be found. If BEP is too high, the price assumed for the output
may have to be reviewed. In summary, the viability of a project can be assessed with the help of
break-even analysis. For the purpose of break-even analysis, the conventional income statement
has to be classified into fixed and variable costs. An example of conventional income statement is
presented in Table 6.1 which is classified into fixed and variable expenses.
Materials 180,000
Labor 60,000
165,000
75,000
Profit 72,000
For deriving BEP, it is necessary to recast the income statement in Table 6.1 into fixed and
variable costs.
It may be seen from the above statement that for a sale of ` 6,00,000, the variable cost is
` 3,60,000, i.e., 60% of sales. It means that on every rupee of sales, 60 paisa (60%) is spent on
variable costs and the balance of 40 paisa (40%) is left to meet the Fixed Cost. To find the total
sales required to meet the fixed cost of ` 1,68,000, the total fixed cost is divided by 40%.
1,68,000 100
Sales required to meet fixed cost = = 4,20,000
40
The volume of ` 4,20,000 is known as the break-even sales volume which must be achieved if
loss is to be avoided. The profit status at this level is,
Sales 420,000
168,000
Profit Nil
F
BEP =
1 − (V / S)
V is variable cost
S is sales volume.
If ` 6,00,000 sales can be regarded as normal for a month (standard sales volume), capacity
utilization rate at which the project must operate in order to ‘break-even’ can be calculated. This will
be:
Break - even sales volume ` 4,20,000 100
100 = = 70%
Standard sales volume ` 6,00,000
At capacities lower than 70%, the project is bound to incur losses. On the other hand, it will
make profits at levels above the 70% capacity utilization. The ‘break-even’ capacity represents the
capacity utilization rate to be achieved to make the project viable. The normal rate for capacity
utilization is about 50%.
Intangible Benefits
⚫ Centralized database
Tangible Benefits
⚫ Lower inventory.
Strategic Issues
3. Ability to capture a greater proportion of the market for the company’s products.
6. Incremental sales resulting from the publicity gained from the company installing
advanced manufacturing technology.
Shortcomings of Traditional Financial Analysis for Advanced Manufacturing Systems like FMS
2. Capabilities and rates of new equipment are assumed to be well known and do not
change, i.e., not increase but will decrease as machine ages.
4. The pros and cons of the project can be envisaged by the manager or specialist
concerned with the project.
These assumptions are not applicable to FMS as it integrates the complete facilities of
different stages of manufacturing. CNCs would just reduce labor costs, but FMS in addition to
reducing labor costs can also help in controls and in-process inspection, work tracking,
transportation, tool control, scheduling and production control. FMS would require a smaller and
dedicated team, which is generally more motivated, loyal and sincere. It has generally been
observed in FMS that the capabilities of the system tend to increase over passage of time because
of increasing understanding of operations of the system and the accumulated experience,
upgradability of the system, both software and hardware, to speed up operations and intrinsic
flexibility of the system. FMS has the flexibility to process several part types simultaneously. In
contrast, a transfer line requires full capital expenditure before production can start. On the other
hand, changes in product type, or mix, or volume cannot be easily effected in transfer line since
such changes result in underutilization of lines. Actual costs and benefits are difficult to evaluate in
FMS. Many hidden costs like new skilled labor, training costs, costs due to adjustments or refining
cannot be accurately estimated. Hidden/non-financial savings like simple and fast engineering
change over, reduction of lead time are difficult to quantify to take into calculation in profit and loss
account. Further, FMS operations and benefits cut across various functions. A broader team is
required to evaluate FMS projects. Finally, capital costs cannot be appraised on a case-by-case
basis. They have to be evaluated by senior management of the company on a long-term plan basis
of say 5 to 10 years. Financial evaluation of FMS is feasible in the following cases:
2. All intangible benefits are evaluated and a hypothetical value attached to every
qualitative benefit.
3. Estimates of savings and costs cover 7 to 10 year period taking into consideration long-
term impact of FMS.
Before rejecting an FMS investment proposal, the following factors may be considered:
4. How can the benefits of FMS open up new markets and make the company more
competitive?
Conclusions
1. FMS should be an integral part of a well-defined strategy to meet the corporate goals.
2. While evaluating FMS, judicious designing should be done. FMS project may be unviable
but technically feasible.
3. Traditional methods of analysis may lead us astray from real justification of the FMS
project.
6.13 SUMMARY
Financial Appraisal is the review carried out by financial institutions to ascertain whether the
project to be financed is financial viable. The project could be a new project or expansion of existing
production facilities.
Financial analyses let you get a bird’s eye view of your business finances as a whole, so you
can make plans, invest smartly, and most importantly, have an accurate view on your stability and
profitability. Drafting a solid analysis isn’t a quick process, but you can make it easier if you walk
through each step carefully. What is described here is
Performing a financial analysis involves evaluating projects, budgets, and other finance-
related entities within a business or asset. It allows you to understand and examine the business's
performance and make strategic decisions about your company’s future growth and opportunities.
In short, the purpose of financial analysis is to test the profitability and financial health of the
asset. This process can include examining additional areas such as a business's Operating Profit
Margin, revenue growth, debt to EBITDA* ratio and efficiency.(*EBITDA stands for Earnings Before
Interest, Taxes, Depreciation, and Amortization.)
The income statement reports the company's financial performance over a chosen period to
highlight its profitability. It can also help predict future performance and cash flow. Businesses that
use a card reader at POS systems will need to show the associated charges on their income
statement. The same is true for any company that regularly handles credit card processing or uses
invoice software for functions like sending pro forma invoices.
The balance sheet reflects your company's total liabilities and equity by reporting all assets,
liabilities, and shareholder equity at a chosen point. The total dollar amount must zero out.
The cash flow statement reports the amount of cash generated during a specific period. It
provides information on liquidity, solvency, and future cash flows.
For small business owners, financial analysis can also help you weigh the impact that
financial decisions might have on your company. For example, if you are considering borrowing
money to launch a new product, your financial analysis can show how much you need, your
historical success with similar products, and what you can expect from the launch.
⚫ For existing units, bankers need to understand the past performance of the company. so,
they scrutinise the last three years audited financials.
⚫ Cost of the Project is the total amount of all the various components of the project.
⚫ Sources of Finance refers to the total from various sources such as equity capital, term
loans, debentures, deferred payments, miscellaneous sources, etc.
⚫ Financial Projections based on realistic assumptions will give a true picture of finances of
the company over a long period of time.
⚫ Two popular methods of Financial Appraisal are Simple Rate of Return and Payback
period.
⚫ Two popular DCF techniques are Internal Rate of Return (IRR) and Net Present Value
Method (NPV) methods of Financial Appraisal.
⚫ Financial Analysis takes into account the financial features of the project, especially
sources of finance.
⚫ Break-even Point is that level of sales at which revenues exactly equal the operating
costs.
2. What are the various parameters under Cost of Project and Sources of Funds?
3. What the various methods and DCF Methods for Financial Appraisal? Compare each.
5. Describe the IRR Method. What are its advantages and disadvantages?
1. Which document is required to be analysed with a view to ascertain, whether the concern
is under/overcapitalized, whether the borrowings raised are not out of proportion to its
paid-up capital and reserves, how the current liabilities stand in relation to current assets,
whether the gross block has been properly depreciated and has not been shown at an
inflated value, whether there is any interlocking of funds with associate companies and
whether the concern has been ploughing back profits into the business and building up
reserves?
3. Share Capital is the long-term contribution to the project by the promoters. Any financial
institution/banker would expect the promoter to contribute around ----------------of the total
project.
(a) 50%
(b) 20-30%
(c) 100%
(d) 10%
4. Which ratio helps in making a quick assessment of profitability, particularly projects with
short life?
6. It is that level of production and sales at which total revenues are exactly equal to
operating costs which is popularly called as ------------------------------
Answers:
qqq
Summary
PPT
MCQ
Video1
Video2
Capital Structure
7 CAPITAL STRUCTURE
Chapter
Objectives
After studying this chapter, you should be able to:
⚫ Provide conceptual understanding on Modigliani and Miller Proposition I and II and its
application in real-life situations.
Structure:
7.1 Introduction
7.15 Summary
7.1 INTRODUCTION
The capital structure is the particular combination of debt and equity used by a company to
finance its overall operations and growth.
Equity capital arises from ownership shares in a company and claims to its future cash flows
and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of
common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part
of the capital structure.
Project financing structure refers to the way a company finances its assets through some
combination of equity, debt, or hybrid securities. A company’s capital structure is then the
composition or ‘structure’ of its liabilities. For example, a company that sells ` 20 crores in equity
and ` 80 crores in debt is said to be 20% equity-financed and 80% debt-financed. The company’s
ratio of debt to total financing, 80% in this example is referred to as the company’s leverage. In
reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the
proportion of the capital employed of the company which come from outside of the business
finance, e.g., by taking a short-term loan etc.
This topic starts with a theory that shows capital structure is irrelevant in a world with no taxes
and no other market imperfections. It will also show that when you increase the level of debt in a
company, you increase the required rate of return on equity because increasing leverage increases
the risk of equity.
Capital Structure, as the name suggests, means arranging capital from various sources, in
order, to meet the need of long-term funds for the business. It is the combination of equities,
preference share capital, long-term loans, debentures, retained earnings along with various other
long-term sources of funds. We can say that capital structure refers to the proportion of each of
these sources of funds in the capital, which the company should raise or arrange to carry its
business effectively. Thus, capital structure is extremely important and capital structure decisions or
practices have a significant role to play in corporate financial management.
Also, capital structure decisions impact the risk and return of equity owners. Owing to such
importance, the management needs to take an informed decision of having a perfect capital mix.
The financing choices manager affect the liabilities and stockholder’s equity side of the
balance sheet. Capital budgeting decisions, on the other hand, affect the asset side of the balance
sheet.
Managers have choices of debt and equity. The key question is what mix of these securities
will maximize the value of the shareholders. Debt service requires interest payments that are tax
deductible, but equity service requires dividends, which are paid from after tax income.
However, increases in the use of debt increase the risk of default on debt service and can
lead to bankruptcy. Managers must also make choices about whether to use fixed-rate or floating-
rate debt, and how to mix long-term and short-term debt. These issues affect the cost of debt.
Financial Flexibility
All goes well for the companies when their product is received well by the consumers.
Problems come during a downturn. Even during the slowdown, the firm needs to run, and thus,
needs capital. But it becomes very difficult for a company to raise capital in bad times. Therefore,
irrespective of the booming business and economy, the business should always discount for the
bad times and do not stretch the capabilities too far.
A company with low debt in the mix would be better off in bad times. One of the most common
mistakes that companies do is raising capital through debt without analysing their ability to repay
those. As a result, they fail to service the debt in bad times, thus losing the confidence of the
investors.
Tax Exposure
Usually, debt payments are tax-deductible and result in tax benefits. This is why companies
prefer having some amount of debt in their capital structure.
There is a risk in every business. However, risk differs from company to company, industry to
industry, nature of product or service provided and so on. For instance, a company that is into the
business of utilities will have less seasonal fluctuations compared to the company in the fashion
industry. Therefore, a fashion retail company will usually be more focused on the optimal debt ratio
compared to the utility company. Lower debt asset ratio would make investors feel better about the
company’s ability to meet responsibilities even in adverse situations.
Nature of Industry
The nature of the industry plays a very important role in defining the capital structure. For
instance, in an industry where there is no barrier to the competition, the profit margin of existing
firms will be more at risk. Therefore, the firms will be hesitant to use a fixed charge bearing
securities.
Capital structure to some extent is also impacted by the fixed cost. If a company uses a very
high proportion of fixed cost in the total cost, it can amplify the variability in future earnings. If the
operating leverage is high, there are more chances of a business failure, and the company could
even go to the extent of bankruptcy. Therefore, management should take a balanced approach to
get a perfect mix of capital structure.
Management Style
The capital structure of a business also depends on whether the management is conservative
or aggressive. A management that is more aggressive would not be afraid of taking a risk, and
therefore, more debt will definitely not be an issue. On the other hand, conservative management
would prefer a lower risk even if it means comparatively lower returns.
Apart from these factors, there are various other elements that affect the capital structure
decisions of an organization. Management takes into account various ratios such as debt service
coverage ratio, interest coverage ratio and more. Cost of debt and return on investments are a few
more factors that a company considers while making capital structure decisions.
Management must evaluate the company’s needs for capital. Usually, a company needs
capital for four things – Operations, Organic growth, Acquisitions and Returning cash to
shareholders. Management must determine the minimum liquidity that it will need to finance these
four things.
Should prepare liquidity level on the basis of “what if” scenarios. For instance, preparing
capital structure if there is a 20% to 30% drop in the business activity.
Determine if the company’s credit rating is good enough to guarantee instant access to funds.
If the rating is not good, the company will then have to make adequate adjustments in the capital
structure.
Develop a clearly defined decision-making framework. This will guide the management when
dealing with different liquidity scenarios. Having a framework also means that capital structure
decisions are not just an instant reaction to a change in the condition. Instead, the decisions are
based on the carefully thought framework.
Companies raise capital for their investment projects with a mix of debt and equity
instruments. The combination of all of these instruments is known as the company’s capital
structure. For the purposes of our discussion, let us look at some key differences between debt and
equity.
1 Debt is a contractual claim to the cash Equity is a residual claim to the cash flows
flows of a company that has a fixed life of a company. Because the claim to equity
and does not depend on the company’s is residual, equity holders are entitled only
operating performance. to the operating cash flows that remain
after debt holders have been paid.
2 Debt holders do not have the right to vote Unlike debt holders, equity holders have
so cannot affect the overall management the right to vote and thus can affect the
of the company. overall management of the company.
3 Interest payments on bonds are tax Dividends paid to stockholders are not tax
deductible to the issuing corporation. deductible. This benefits lowers the
company’s cost of issuing debt, if the
company is paying taxes.
5 The company must make scheduled The company can announce dividends on
interest payments. its own will.
6 The company must repay the principal. The company does not have to buy back
the share.
It is important that a company consider its appropriate mix of debt and equity. For a given
level of sales, higher use of debt in proportion to equity makes the company more risky, because
the proportion of operating income needed to cover debt service increases with increasing debt.
Therefore, the probability rises that if sales decline due to changes in market conditions, the
company will not be able to service the debt. Clearly, debt and equity present different opportunities
to investors.
You might ask why companies use both debt and equity financing. By issuing debt, a
company’s owners can keep a greater amount of equity for themselves. Assuming a company’s
investments are profitable, the owners can finance their projects and also reap the benefit of these
investments. Some companies, however, might not be able to make the annual interest payments
on debt – or they might desire the flexibility to use their cash flow for other investments – and will
tend to issue equity instead.
Furthermore, there is a key difference between the way debt and equity holders are paid.
Companies pay interest to debt holders and dividends to equity holders. Interest expenses are tax
deductible, but dividend payments are not. As a result, companies receive a tax benefit from issuing
debt.
Most companies usually use a mix of debt and equity financing – despite the tax advantages
of debt – to suit their strategic and competitive interests.
A company’s capital structure is a mix of the various debt and equity instruments used to
finance the company. To assess the value of a company, your first need to determine the
appropriate discount rate use. Should you use the rate that is appropriate for a company financed
with 100% equity? Or should you use a company’s cost of debt as the rate at which to discount its
cash flows? Or a mix of both?
Modigliani-Miller
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the
basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical
result since it disregards many important factors in the capital structure process factors like
fluctuations and uncertain situations that may occur in the course of financing a company.
The theorem states that, in a perfect market, how a company is financed is irrelevant to its
value. This result provides the base with which to examine real-world reasons why capital structure
is relevant, that is, a company’s value is affected by the capital structure it employs. Some other
reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis
can then be extended to look at whether there is in fact an optimal capital structure: the one which
maximizes the value of the company.
In 1958, Franco Modigliani and Merton Miller (referred to as MM) published an article that
discussed whether companies could vary their capital structures to obtain better returns – that is,
whether companies could manipulate the amounts of debt and equity financing in their capital
structures to yield a higher overall return.
MM showed the conditions under which the value of a project is invariant to how it is financed.
MM also demonstrated that when a company finances a project using more debt than equity, the
residual equity becomes riskier, because it is supporting more debt claims. So even though the
debt will require a lower rate because financing with debt rather than equity is cheaper, the equity
will in turn require a higher discount rate as it takes on more risk. However, the overall rate, or the
weighted average cost of capital (WACC), will not be affected as the ratio of debt to equity in a
company’s capital structure changes.
These claims are based on specific assumptions. It was MM’s intention to define this ‘constant
value’ condition as a benchmark, much like the frictionless state or perfect vacuum in physics, or
the concept of perfect competition in economics. These conditions may not exist in the ‘real-world’,
but they provide useful anchors for thought, or benchmarks against which real conditions can be
measured. MM’s propositions offer a basis for understanding why a company’s decisions about
capital structure may, in fact, matter.
Capital structure in a perfect market: Consider a perfect capital market (no transaction or
bankruptcy costs; perfect information); companies and individuals can borrow at the same interest
rate; no taxes; and investment returns are not affected by financial uncertainty. Modigliani and
Miller made two findings under these conditions. Their first ‘proposition’ was that the value of a
company is independent of its capital structure. Their second ‘proposition’ stated that the cost of
equity for a leveraged company is equal to the cost of equity for an unleveraged company, plus an
added premium for financial risk. That is, as leverage increases, while the burden of individual risks
is shifted between different investor classes, total risk is conserved and hence no extra value
created.
Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax
system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital
decreases as the proportion of debt in the capital structure increases. The optimal structure then
would be to have virtually no equity at all, i.e., a capital structure consisting of 99.99% debt.
Capital structure in the real world: If capital structure is irrelevant in a perfect market, then
imperfections which exist in the real world must be the cause of its relevance. The theories below
try to address some of these imperfections, by relaxing assumptions made in the M&M model.
MM Proposition I
According to MM Proposition I, the total value of the securities issued by a company does not
depend on the company’s choice of capital structure. In other words, the value of the company is
determined by its real assets and growth opportunities and not by the types of securities (debt or
equity) it issues. Under particular conditions, the company’s value turns out to be constant
regardless of its capital structure.
2. Cash flows paid out to different securities are taxed at the same rate.
5. Everyone has immediate and equal access to all relevant information about the
company.
If these conditions hold, the company is said to operate in a perfect market (comparable to
perfect vacuum in physics).
MM Proposition I is based on the idea that investors can, on their own, replicate any capital
structure designed by a company. Companies cannot change value by altering the composition of
their financing. If one capital structure has a greater value than another, then investors could sell
the capital structure of greater value and buy the one of lesser value.
To understand Modigliani and Miller’s argument, consider two companies, U and L, which are
identical in all respects except for the capital structure. Both companies are expected to generate
earnings equal to ` 1,00,000 per annum in perpetuity, and the cash flows have the same risk.
MM Proposition II
The following formula states that the company’s weighted average cost of capital is a
weighted average of its cost of debt (rd) and its cost of equity (re):
D rd D re
ra = +
(D + E) (D + E)
In this formula, D and E are the market values of debt and equity, respectively, and equity,
and ra, rd, and re are the expected returns on assets, debt and equity respectively. Note that there is
no tax in the equation above, as MM’s world has no tax assumption.
We have just seen that in a perfect market, a company’s value is unaffected by its capital
structure (MM Proposition I). We also know that a company’s capital structure has no impact on the
cash flows the company is expected to generate. If the value and the future cash flows generated
by a company are not affected by its capital structure, then it must be true that the company’s
weighted average cost of capital is unaffected by a company’s capital structure.
What about the cost of equity? How does the capital structure choice impact the cost of
equity?
Rearranging the equation above, you find that the return on equity is equal to:
D
re = ra +
E(ra − rd )
If we assume that at low levels of debt rd is constant and equal to the risk-free rate, the cost of
equity increases linearly with leverage. At higher levels of debt, debt becomes risky, which means
that debt holders can no longer be certain that the company is able to meet its commitments to pay
interest and repay the principal. When debt becomes risky, r d starts to increase as leverage goes
up. In this case, more of the company’s risk is borne by the debt holders and r e still increases as
leverage increases, but at a decreasing rate.
Since leveraged equity has greater risk, it should have greater return as compensation. MM
Proposition II states that the expected return on equity is positively related to leverage.
As shown in the graph, MM Proposition II states that increasing a company’s debt ratio does
not affect the riskiness of its assets (ra is not dependent on the leverage ratio), but it does increase
the riskiness of its equity. Also note that for any company, the return on debt will always be less
than the return on equity. This is because interest payments to debt holders have higher priority
than dividend payments to equity holders, and thus debt carries less risk. However, the weighted
average sum of the return on debt and the return on equity is always constant and is equal to the
return on assets.
MM Proposition I and II point to the conclusion that companies cannot change in value simply
by repackaging their securities from equity to debt, or vice versa. As equity is replaced by debt, a
company’s overall value and its cost of capital cannot be reduced, because the riskiness of the
equity increases as the amount of debt increases. This increase in risk of the equity offsets the
reduction in risk that results from issuing debt. In other words, while the fraction of low-cost debt
increases, equity demands a return high enough to compensate for the extra risk it is bearing.
Thus, using the asset beta to calculate the cost of capital is appropriate in a world based on MM’s
assumptions where debt, but no tax, exists.
Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to
financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt
(the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further
increases in debt declines as debt increases, while the marginal cost increases, so that a company
that is optimizing its overall value will focus on this trade-off when choosing how much debt and
equity to use for financing. Empirically, this theory may explain differences in D/E ratios between
industries, but it doesn’t explain differences within the same industry.
Firm
Value PV (bankruptcy
costs)
(`)
PV (interest
tax shield)
D/E
D/E*
After a certain level of Debt, the Firm’s Value reduces instead of increasing
Pecking Order Theory tries to capture the costs of asymmetric information. It states that
companies prioritize their sources of financing (from internal financing to equity) according to the
law of least effort, or of least resistance, preferring to raise equity as a financing means “of last
resort”. Hence, internal financing is used first; when that is depleted, then debt is issued; and when
it is no longer sensible to issue any more debt, equity is issued. This theory maintains that
businesses adhere to a hierarchy of financing sources and prefer internal financing when available,
and debt is preferred over equity if external financing is required (equity would mean issuing shares
which meant ‘bringing external ownership’ into the company). Thus, the form of debt a company
chooses can act as a signal of its need for external finance. The pecking order theory is popularized
by Myers (1984) when he argues that equity is a less preferred means to raise capital because
when managers (who are assumed to know better about true condition of the company than
investors) issue new equity, investors believe that managers think that the company is overvalued
and managers are taking advantage of this overvaluation. As a result, investors will place a lower
value to the new equity issuance.
There are three types of agency costs which can help explain the relevance of capital structure.
3. Free cash flow: Unless free cash flow is given back to investors, management has an
incentive to destroy company value through empire building and perks etc. Increasing
leverage imposes financial discipline on management.
An active area of research in finance is that which tries to translate the models above as well
as others into a structured theoretical setup that is time-consistent and that has a dynamic setup
similar to one that can be observed in the real world. Managerial contracts, debt contracts, equity
contracts, investment returns, all have long lived, multi-period implications. Therefore, it is hard to
think through what the implications of the basic models above are for the real world if they are not
embedded in a dynamic structure that approximates reality. A similar type of research is performed
under the guise of credit risk research in which the modelling of the likelihood of default and its
pricing is undertaken under different assumptions about investors and about the incentives of
management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju,
Leland (1998) and Hennessy and Whited (2004).
Other
The neutral mutation hypothesis—companies fall into various habits of financing, which do not
impact on value.
⚫ In transition economies, there have been evidences reported unveiling significant impact
of capital structure on company performance, especially short-term debt such as the
case of Vietnamese emerging market economy.
⚫ Capital bearing risk includes debentures (risk is to pay interest) and preference capital
(risk to pay dividend at fixed rate).
Arbitrage
Similar questions are also the concern of a variety of speculator known as a capital structure
arbitrageur, see arbitrage.
One of the key assumptions made in the analysis above is that there are no taxes. In fact,
governments claim some of the cash flows in the form of taxes. Although tax laws differ from
country to country, in most countries, interest costs can be deducted as an expense. This
discussion assumes that the tax code allows deduction of interest costs as a business expense
before computing taxes.
Equity holders and debt holders are not the only claimants to the cash flows of a company –
the government is an additional claimant. The government exercises its claim by taxing the
company’s earnings. Payments to debt holders and equity holders are taxed differently; interest
payments to debt holders are tax-deductible, reducing a company’s taxable income by the amount
of the interest expense. Therefore, the amount of debt (and the corresponding interest payments
due) in a company’s capital structure reduces the government’s share of the company’s cash flows
and increases what is left for equity and debt holders.
In a market that is perfect, except for the existence of corporate taxes, the greatest value to a
company would result from a capital structure with 100% debt. In practice, however, companies do
not hold 100% debt, or anywhere near that percentage for the following reasons:
First, if a company goes bankrupt, it will no longer be able to utilize its tax shield from debt. As
leverage increases, the probability of financial distress increases, moderating the company’s
incentives to add more debt.
Additional Costs
There are additional costs of financial distress that also reduce a company’s incentive to
increase leverage. For example, when the company is in financial distress, it will incur various legal,
accounting and administrative expenses.
Negative Action
⚫ Creditors:More importantly, creditors will raise their required interest rate to compensate
for the higher risk of bankruptcy.
⚫ Stakeholders: Other stakeholders in the company will also become increasingly worried
as leverage increases and take actions that are likely to worsen the company’s situation.
⚫ Employees: For example, employees might start looking for other jobs because they do
not want to work for a company that might go bankrupt in the near future. Note that it is
likely that the best employees are the ones to find new jobs first.
⚫ Customers: Customers might also be worried about the survival of the company and its
commitment to supply spare parts in the future and the value of product warranties.
These customers might decide to switch to another supplier.
This discussion reflects another departure from the perfect market assumption of MM. Here,
we see that in reality, adding more debt to the capital structure of a company that is close to
financial distress will negatively impact the company’s future cash flows. Thus, in reality’ capital
structure and future cash flows are not independent (in contrast to the assumptions made by MM).
Flexibility
Another reason not to have a capital structure with 100% debt is the desire for flexibility that
comes from having cash on hand. Issuing new bonds or new shares is expensive. If a company is
financially constrained, it might be hard to obtain additional financing when a good investment
opportunity arises, thereby limiting its growth potential. This ‘opportunity cost’ must be considered
as the company takes on additional amounts of debt.
Covenants
Finally, a company might be limited in the amount of debt it can take on based on covenants
(promises) in existing debt contracts that prohibit companies from issuing debt beyond a certain
level.
The trade-off between the tax advantage of debt financing and the disadvantage of financial
distress costs results in a different optimal debt level for each company. This Optimal debt level is
often referred to as a company’s debt capacity. A company’s debt capacity reflects the owner’s
subjective willingness to bear risk; other owners may have the desire or ability to take on more
debt. In fact, according to some, this issue is the motivation behind some mergers and acquisitions.
If a company’s owners choose not to take on debt because they do not want to bear the default
risk, other potential owners or investors may see an arbitrage opportunity to buy the company and
increase its debt capacity.
The WACC method allows analysts to value a company at any capital structure – that is, at
any amount of debt and equity – to determine a blended discount rate that reflects the relative
shares of debt and equity in the company. This blended discount rate is the WACC, and it is used
to value the company’s expected future cash flows. The WACC method can be used to value a
company under either its current capital structure or under a proposed or different structure. If you
want to value a company at its current capital structure, the basic WACC method is appropriate.
However, you will often want to know if a greater valuation can be achieved by increasing the debt
ratio. In these cases, you must extend your analysis to consider WACC under changing debt
conditions.
WACC declines as the per cent of debt in the capital structure increases because of the debt
tax shield. Also note that the return on assets is defined as the required rate of return on the
company’s assets if the company is 100% equity financed.
Let us consider the components of the equation in greater detail in the section below.
re = rr + βe(rm − rf )
Note that the equity beta will, other things held constant, be higher as the debt ratio increases
because of the increased risk of holding equity. This higher equity beta will yield an increased
return on equity because of the increased proportion of debt, a concept illustrated in the graph
shown above. Also note that at high debt levels, the slope of r e as a function of the debt level is
decreasing. The reason for this is that part of the increased risk resulting from the increased debt
level is borne by debt holders.
Equity (E)
Equity (E) is the market value of the equity. This amount can easily be determined by
multiplying the number of shares issued and outstanding by the current stock price.
Debt (D)
Debt (D) is the market value of the debt. In practice, we often assume that the market value of
the debt is the same as the book value. Sometimes, we can calculate the value of long-term debt
by multiplying the number of bonds outstanding by the market price. Short-term debt is determined
by using the amount shown on the balance sheet because it is due within one year. Companies
often list the value of debt in the notes to their financial statements. Remember, a company will
generally issue debt up to its perceived debt capacity. Thus, it is assumed in this course that the
company is always operating at its current debt capacity.
Debt + Equity (D + E)
Debt + Equity (D + E) is equal to the market value of the company. Recall that D and E are
the market values of debt and equity, respectively. E is also referred to as the ‘equity value’ of the
company.
As you have learned, the WACC method can be used to value a company at its debt capacity.
WACC is a dynamic tool, however, and can also be used to value a company at any capital
structure different from its current one. Use of WACC under changing debt conditions differs from
basic WACC in that it requires you to estimate the cost of capital for a company or asset at an all-
equity capital structure and then re-estimate your calculations assuming a revised capital structure.
In practice, using WACC under changing debt conditions involves recalculating a company’s beta in
a two-step process. First, you must recalculate beta so that it reflects an all-equity capital structure.
This is known as unleveraging beta. Second, you must recalculate beta at the new capital structure,
which is known as releveraging beta.
Financial closure means that all the sources of funds required for the project have been tied
up / have been arranged. A key milestone in project implementation, financial closure may take a
long time particularly for infrastructure projects, because several things have to be sorted out to the
project structure fundable. For example, it took about three years to hammer out a in power
purchase agreement to be signed by the independent power producers with respective state
electricity boards.
⚫ The process is started early and concurrent appraisal is initiated if several lend agencies
are involved.
7.15 SUMMARY
Companies raise capital for their investment projects with a mix of debt and equity
instruments. The combination of all of these instruments is known as the company’s capital
structure
Capital Structure, as the name suggests, means arranging capital from various sources, in
order, to meet the need of long-term funds for the business. It is the combination of equities,
preference share capital, long-term loans, debentures, retained earnings along with various other
long-term sources of funds. We can say that capital structure refers to the proportion of each of
these sources of funds in the capital, which the company should raise or arrange to carry its
business effectively. Thus, capital structure is extremely important and capital structure decisions or
practices have a significant role to play in corporate financial management.
There are various factors that management must consider while making capital structure
decisions. Companies raise capital for their investment projects with a mix of debt and equity
instruments. The combination of all of these instruments is known as the company’s capital
structure.
It is important that a company consider its appropriate mix of debt and equity. For a given
level of sales, higher use of debt in proportion to equity makes the company riskier, because the
proportion of operating income needed to cover debt service increases with increasing debt.
The various other aspects that need to understand and take care are as under:
⚫ Project financing refers to the way a company finances its assets through some
combination of equity, debt or hybrid securities.
⚫ There a number of differences between Debt and Equity. Company should consider an
appropriate mix of debt and equity.
⚫ Modigliani and Miller theorem states that in a perfect market, how a company is financed
is irrelevant to its value. It ignored costs such as bankruptcy costs, agency costs, taxes
and information asymmetry.
⚫ Pecking order theory states that companies prioritize their sources of financing according
to the law of the least effort.
⚫ Structural corporate finance aims to translate models discussed above into real-world ones.
⚫ The Government is also a claimant on share of the profits generated by the company.
Debt in a capital structure reduces the government’s share and increases what is left for
equity and debt holders.
⚫ Weighted Average Cost of Capital method allows to value a company at any capital
structure.
⚫ Financial Closure means that all sources of funds required for the project have been set up.
2. Management must evaluate the company’s needs for capital. Usually, a company needs
capital for ------------------------------------
(b) Acquisitions
3. There is a key difference between the way debt and equity holders are paid. Companies
pay interest to -----------------------------
(d) Promoters
4. The Modigliani-Miller theorem, forms the basis for modern thinking on capital structure,
though it is generally viewed as a purely theoretical result since it disregards many
important factors in the capital structure process factors like ---------------------------------
(b) fluctuations and uncertain situations that may occur in the course of financing a
company
(b) Adequate underwriting arrangements are made for market-related offerings & the
resourcefulness of the promoters is well established.
(c) The process is started early and concurrent appraisal is initiated if several lend
agencies are involved
Answers:
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Summary
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MCQ
Video1
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Chapter – 8
8
PRESENTATION OF YOUR
PROJECT FOR FINANCIER
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
8.1 Introduction
8.6 Summary
8.1 INTRODUCTION
Preparation and proper presentation of your project/files is very important aspect of Project
Finance. A proper, neat file submission will greatly improve the chances of you getting the
loan/equity. A well and thoughtfully prepared file will help the bankers get their appraisals done
faster, more accurately and with minimum queries. This might improve the comfort of the bankers.
They will get the impression that they are working with professional people.
Remember that every financial institution has exhaustive appraisal procedures before lending
to you. They have many professional and technical people working with them. Many times, they
take help of professional consultants for appraisals. Further, once detailed reports are prepared and
recommendations put in, they are put before the Screening Committees. If they are not fully
satisfied with any of the appraisal reports, they refer back to the appraisal team with their
comments.
If a file is not presented completely, then there are high chances of delays/rejection. Delayed
funds or lack of funds can change the entire course of the project. Even your loan application fees,
if any can get forfeited, Professional consultants are available who help you prepare your file and
who represent your company/group to the institution in a befitting manner and get the work done.
⚫ Bankers will be more comfortable to sanction loan if almost all requirements are
submitted by the applicant.
⚫ A well-prepared file will make the project manager/promoter better prepared with the
project.
⚫ Bankers will believe that they are dealing with professional people.
5. IT/Wealth Tax assessment orders/returns/certificates for the last 3 years in the respect of
the applicant unit (if in existence) and the promoters
6. Sales Tax Returns and assessment orders for the last three years (if in existence)
12. Collaboration agreement and related details including copy approval from
RBI/Government, if required
13. Agreement with Technical consultants (if any) and related details including copy approval
from RBI/Government, if required
14. 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
15. Government order/permission converting the land into industrial land, if required
16. Location/site map of the land showing contour lines, the internal roads, power receiving
station, railway siding, tube wells, etc. and blueprints of the building plan duly approved
by the concerned government/corporation/municipality/Panchayat authorities
18. Agreement with the electricity board for sanction of requisite power load/Electricity Bill for
last three months
21. Invoices/quotations from at least three suppliers 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
22. Justification for choosing a particular supplier of plant and machinery with details of its
credentials
23. Detailed estimates for civil construction with biodata of the builder/architect
25. Please attach worksheet for calculation of cost of various inputs and break-even point
26. In-principal letter of sanction for working capital assistance to the applicant unit given by
a Bank
27. 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.
28. In case a Company has promoted the applicant unit, please furnish 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
The promoter must prepare a Business Plan/Presentation stating the long-term and short-
term objectives of his business. It is an important tool for availing means of funding such as Private
Equity, Institutional investors, etc.
Typically, a business plan is longer than a list on a napkin (although, as you’ll see below, it is
possible – and sometimes ideal – to write your entire business plan on one page). For me in
practice, and for most real businesses, it can be as simple as a few bullet points to focus strategy,
milestones to track tasks and responsibilities, and the basic financial projections you need to plan
cash flow budget expenses.
Business plans should only become printed documents on select occasions, when needed to
share information with outsiders or team members. Otherwise, they should be dynamic documents
that you maintain on your computer. The plan goes on forever, so the printed version is like a
snapshot of what the plan was on the day that it was printed.
If you do need a formal business plan document, then that includes an executive summary, a
company overview, some information about your products and/or services, your marketing plan, a
list of major company milestones, some information about each member of the management team
and their role in the company, and details of your company’s financial plan. These are often called
the “sections” or “chapters” of the business plan, and I’ll go into much greater depth about each of
them below.
In all cases, the most important section of the business plan is the review schedule. That’s as
simple as “the third Thursday of every month” to cite one obvious example. That’s the part of the
plan that acknowledges that it is part of a planning process, in which results, and metrics will be
reviewed and revised regularly. A real business plan is always wrong — hence the regular review
and revisions — and never done — because the process of review and revise is vital.
Unfortunately, many people think of business plans only for starting a new business or
applying for business loans. But business plans are also vital for running a business, whether or not
it needs new loans or new investments. Existing businesses should have business plans that they
maintain and update as market conditions change and as new opportunities arise.
Every business has long-term and short-term goals, sales targets, and expense budgets—a
business plan encompasses all of those things and is as useful to a start-up trying to raise funds as
it is to a 10-year-old business that’s looking to grow.
If you’re serious about business, taking planning seriously is critical to your success.
Start-up Businesses
The most classic business planning scenario is for a start-up, for which the plan helps the
founders break uncertainty down into meaningful pieces, like the sales projection, expense budget,
milestones and tasks. The need becomes obvious as soon as you recognize that you don’t know
how much money you need, and when you need it, without laying out projected sales, costs,
expenses, and timing of payments. And that’s for all start-ups, whether or not they need to convince
investors, banks, or friends and family to part with their money and fund the new venture. In this
case, the business plan is focused on explaining what the new company is going to do, how it is
going to accomplish its goals, and—most importantly—why the founders are the right people to do
the job. A start-up business plan also details the amount of money needed to get the business off
the ground, and through the initial growth phases that will lead (hopefully!) to profitability.
Existing Businesses
Not all business plans are for start-ups that are launching the next big thing. Existing
businesses use business plans to manage and steer the business, not just to address changes in
their markets and to take advantage of new opportunities. They use a plan to reinforce strategy,
establish metrics, manage responsibilities and goals, track results, and manage and plan resources
including critical cash flow. And of course, they use a plan to sets the schedule for regular review
and revision.
Business plans can be a critical driver of growth for existing businesses. Did you know that
businesses that write plans and use them to manage their business grow 30% faster than
businesses that take a “seat of the pants” approach? A recent study by Professor Andrew Burke,
the founding Director of the Bettany Centre for Entrepreneurial Performance and Economics at
Cranfield School of Management, discovered exactly this.
For existing businesses, a robust business planning process can be a competitive advantage
that drives faster growth and greater innovation. Instead of a static document, business plans in
existing businesses become dynamic tools that are used to track growth and spot potential
problems before they derail the business.
Before you even start writing your business plan, you need to think about whom the audience
is and what the goals of your plan are. While there are common components that are found in
almost every business plan, such as sales forecasts and marketing strategy, business plan formats
can be very different depending on the audience and the type of business.
For example, if you’re building a plan for a biotech firm, your plan will go into details about
government approval processes. If you are writing a plan for a restaurant, details about location and
renovations might be critical factors. And the language you’d use in the biotech firm’s business plan
would be much more technical than the language you’d use in the plan for the restaurant.
Plans can also differ greatly in length, detail, and presentation. Plans that never leave the
office and are used exclusively for internal strategic planning and management might use more
casual language and might not have much visual polish. On the other end of the spectrum, a plan
that is destined for the desk of a top venture capitalist will have a high degree of polish and will
focus on the high-growth aspects of the business and the experienced team that is going to deliver
stunning results.
A one-page business plan is exactly what it sounds like: a quick summary of your business
delivered on a single page. No, this doesn’t mean a very small font size and cramming tons of
information onto a single page—it means that the business is described in very concise language
that is direct and to-the-point.
A one-page business plan can serve two purposes. First, it can be a great tool to introduce
the business to outsiders, such as potential investors. Since investors have very little time to read
detailed business plans, a simple one-page plan is often a better approach to get that first meeting.
Later, in the process, a more detailed plan will be needed, but the one-page plan is great for getting
in the door.
This simple plan format is also great for early-stage companies that just want to sketch out
their idea in broad strokes. Think of the one-page business plan as an expanded version of jotting
your idea down on a napkin. Keeping the business idea on one page makes it easy to see the
entire concept at a glance and quickly refine concepts as new ideas come up.
The internal business plan dispenses with the formalities that are needed when presenting a
plan externally and focuses almost exclusively on business strategy, milestones, metrics, budgets,
and forecasts. And of course, it also includes the review schedule for monthly review and revision.
These internal business plans skip details about company history and management team since
everyone in the company almost certainly knows this information.
Internal business plans are management tools used to guide the growth of both start-ups and
existing businesses. They help business owners think through strategic decisions and measure
progress towards goals.
External business plans, the formal business plan documents, are designed to be read by
outsiders to provide information about a business. The most common use is to convince investors
to fund a business, and the second most common is to support a loan application. Occasionally,
this type of business plan is also used to recruit or train or absorb key employees, but that is much
less common.
A formal business plan document is an extension of the internal business plan. It’s mostly a
snapshot of the internal plan as it existed at a certain time. But while the internal plan is short on
polish and formality, a formal business plan document should be very well-presented, with more
attention to detail in the language and format.
In addition, an external plan details how potential funds are going to be used. Investors don’t
just hand over cash with no strings attached—they want to understand how their funds will be used
and what the expected return on their investment is.
Finally, external plans put a strong emphasis on the team that is building the company.
Investors invest in people rather than ideas, so it’s critical to include biographies of key team
members and how their background and experience is going to help grow the company.
While we just discussed several different types of business plans, there are key elements that
appear in virtually all business plans. These include the review schedule, strategy summary,
milestones, responsibilities, metrics (numerical goals that can be tracked), and basic projections.
The projections include sales, costs, expenses, and cash flow.
These core elements grow organically as needed by the business for actual business
purpose.
And for the formal business plan document, to be read by outsiders for business purposes
such as backing a loan application or seeking investment, the following summarizes those special
case business plans. Here’s what they normally include:
Executive Summary
Just like the old adage that you never get a second chance to make a first impression, the
executive summary is your business’s calling card. It needs to be succinct and hit the key highlights
of the plan. Many potential investors will never make it beyond the executive summary, so it needs
to be compelling and intriguing.
The executive summary should provide a quick overview of the problem your business solves,
your solution to the problem, the business’s target market, key financial highlights, and a summary
of who does what on the management team.
While it’s difficult to convey everything, you might want to convey in the executive summary,
keeping it short is critical. If you hook your reader, they’ll find more detail in the body of the plan as
they continue reading. You could even consider using your one-page business plan as your
executive summary.
Company Overview
For external plans, the company overview is a brief summary of the company’s legal structure,
ownership, history, and location. It’s common to include a mission statement in the company
overview, but that’s certainly not a critical component of all business plans.
The products and services chapter of your business plan delves into the core of what you are
trying to achieve. In this section, you will detail the problem you are solving, how you are solving it,
the competitive landscape, and your business’s competitive edge.
Depending on the type of company you are starting, this section may also detail the
technologies you are using, intellectual property that you own, and other key factors about the
products that you are building now and plan on building in the future.
Target Market
As critical as it is that your company is solving a real-world problem that people or other
businesses have, it’s equally important to detail who you are selling to. Understanding your target
market is key to building marketing campaigns and sales processes that work. And, beyond
marketing, your target market will define how your company grows.
The marketing and sales plan details the strategies that you will use to reach your target
market. This portion of your business plan provides an overview of how you will position your
company in the market, how you will price your products and services, how you will promote your
offerings, and any sales processes you need to have in place.
Plans are nothing without solid implementation. The milestones and metrics chapter of your
business plan lays out concrete tasks that you plan to accomplish complete with due dates and the
names of the people to be held responsible.
This chapter should also detail the key metrics that you plan to use to track the growth of your
business. This could include the number of sales leads generated, the number of page views to
your website, or any other critical metric that helps determine the health of your business.
Management Team
The management team chapter of a business plan is critical for entrepreneurs seeking
investment but can be omitted for virtually any other type of plan.
The management team section should include relevant team bios that explain why your
management personnel are the right people for their jobs. After all, good ideas are a dime a
dozen—it’s a talented entrepreneur who can take those ideas and turn them into thriving
businesses.
Business plans should help identify not only strengths of a business, but areas that need
improvement and gaps that need to be filled. Identifying gaps in the management team shows
knowledge and foresight, not a lack of ability to build the business.
Financial Plan
The financial plan is a critical component of nearly all business plans. Running a successful
business means paying close attention to how much money you are bringing in, and how much
money you are spending. A good financial plan goes a long way to help determine when to hire
new employees or buy a new piece of equipment.
If you are a start-up and/or are seeking funding, a solid financial plan helps you figure out how
much capital your business needs to get started or to grow, so you know how much money to ask
for from the bank or from investors.
⚫ Sales Forecast
⚫ Personnel Plan
⚫ Balance Sheet
For more details on what to include in your business plan, check out our detailed business
plan outline, download a business plan template in Word format, or read through our library of
sample business plans so you can see how other businesses have structured their plans and how
they describe their business strategy.
I mentioned earlier in this article that businesses that write business plans grow 30% faster
than businesses that don’t plan. Taking the simple step forward to do any planning at all will
certainly put your business at a significant advantage over businesses that just drive forward with
no specific plans.
But just writing a business plan does not guarantee your success.
The best way to extract value from your business plan is to use it as an ongoing management
tool. To do this, your business plan must be constantly revisited and revised to reflect current
conditions and the new information that you’ve collected as you run your business.
When you’re running a business, you are learning new things every day: what your customers
like, what they don’t like, which marketing tactics work, which ones don’t. Your business plan
should be a reflection of those learnings to guide your future strategy.
This all sounds like a lot of work, but it doesn’t have to be. Here are some tips to extract the
most value from your plan in the least amount of time:
1. Use your one-page business plan to quickly outline your strategy. Use this document to
periodically review your high-level strategy. Are you still solving the same problem for
your customers? Has your target market changed?
2. Use an internal plan to document processes that work. Share this document with new
employees to give them a clear picture of your overall strategy.
3. Set milestones for what you plan to accomplish in the next 30 days. Assign these tasks to
team members, set dates, and allocate part of your budget, if necessary.
4. Keep your sales forecast and expense budget current. As you learn more about
customer buying patterns, revise your forecast.
5. Compare your planned budgets and forecasts with your actual results at least monthly.
Make adjustments to your plan based on the results.
The final, most important aspect of leveraging your business plan as a growth engine is to
schedule a monthly review. The review doesn’t have to take longer than an hour, but it needs to be
a regular recurring meeting on your calendar. In your monthly review, go over your key numbers
compared to your plan, review the milestones you planned to accomplish, set new milestones, and
do a quick review of your overall strategy.
It’s easier than it sounds and can put you in that “30% growth” club faster than you think.
A format of a business plan covering almost all points required by various stakeholders is
annexed hereto.
1. Set specific objectives for managers. Good management requires setting specific
objectives and then tracking and following up. I’m surprised how many existing
businesses manage without a plan. How do they establish what’s supposed to happen?
In truth, you’re really just taking a short-cut and planning in your head—and good for you
if you can do it, but as your business grows you want to organize and plan better and
communicate the priorities better. Be strategic. Develop a plan; don’t just wing it.
2. Share your strategy, priorities and specific action points with your spouse, partner
or significant other. Your business life goes by so quickly: a rush of answering phone
calls, putting out fires, etc. Don’t the other people in your business life need to know
what’s supposed to be happening? Don’t you want them to know?
3. Deal with displacement. Displacement is probably by far the most important practical
business concept you’ve never heard of. It goes like this: “Whatever you do is something
else you don’t do.” Displacement lives at the heart of all small business strategy. At least
most people have never heard of it.
4. Decide whether or not to rent new space. Rent is a new obligation, usually a fixed
cost. Do your growth prospects and plans justify taking on this increased fixed cost?
Shouldn’t that be in your business plan?
5. Hire new people. This is another new obligation (a fixed cost) that increases your risk.
How will new people help your business grow and prosper? What exactly are they
supposed to be doing? The rationale for hiring should be in your business plan.
6. Decide whether you need new assets, how many, and whether to buy or lease
them. Use your business plan to help decide what’s going to happen in the long term,
which should be an important input to the classic make vs. buy. How long will this
important purchase last in your plan?
7. Share and explain business objectives with your management team, employees
and new hires. Make selected portions of your business plan part of your new employee
training.
8. Develop new business alliances. Use your plan to set targets for new alliances, and
selected portions of your plan to communicate with those alliances.
9. Deal with professionals. Share selected highlights or your plans with your attorneys
and accountants, and, if this is relevant to you, consultants.
10. Sell your business. Usually, the business plan is a very important part of selling the
business. Help buyers understand what you have, what it’s worth and why they want it.
11. Valuation of the business for formal transactions related to divorce, inheritance,
estate planning and tax issues. Valuation is the term for establishing how much your
business is worth. Usually that takes a business plan, as well as a professional with
experience. The plan tells the valuation expert what your business is doing, when, why
and how much that will cost and how much it will produce.
12. Create a new business. Use a plan to establish the right steps to starting a new
business, including what you need to do, what resources will be required, and what you
expect to happen.
13. Seek investment for a business, whether it’s a start-up or not. Investors need to see
a business plan before they decide whether or not to invest. They’ll expect the plan to
cover all the main points.
14. Back up a business loan application. Like investors, lenders want to see the plan and
will expect the plan to cover the main points.
15. Grow your existing business. Establish strategy and allocate resources according to
strategic priority.
The real value of creating a business plan is not in having the finished product in hand; rather,
the value lies in the process of researching and thinking about your business in a systematic way.
The act of planning helps you to think things through thoroughly, study and research if you are not
sure of the facts and look at your ideas critically. It takes time now, but avoids costly, perhaps
disastrous, mistakes later.
This business plan is a generic model suitable for all types of businesses. However, you
should modify it to suit your particular circumstances. Before you begin, review the section titled
Refining the Plan, found at the end. It suggests emphasizing certain areas depending upon your
type of business (manufacturing, retail, service, etc.). It also has tips for fine-tuning your plan to
make an effective presentation to investors or bankers. If this is why you’re creating your plan, pay
particular attention to your writing style. You will be judged by the quality and appearance of your
work as well as by your ideas.
It typically takes several weeks to complete a good plan. Most of that time is spent in research
and rethinking your ideas and assumptions. But then, that’s the value of the process. So, make time
to do the job properly. Those who do never regret the effort. And finally, be sure to keep detailed
notes on your sources of information and on the assumptions underlying your financial data.
Business Plan
OWNERS
Street Address
Address 2
Telephone
Fax
I. Table of Contents
I. Table of Contents
V. Marketing Plan
X. Financial Plan
XI. Appendices
Explain the fundamentals of the proposed business: What will your product be? Who will your
customers be? Who are the owners? What do you think the future holds for your business and your
industry?
If applying for a loan, state clearly how much you want, precisely how you are going to use it,
and how the money will make your business more profitable, thereby ensuring repayment.
Mission Statement: Many companies have a brief mission statement, usually in 30 words or
fewer, explaining their reason for being and their guiding principles. If you want to draft a mission
statement, this is a good place to put it in the plan, followed by:
Company Goals and Objectives: Goals are destinations—where you want your business to
be. Objectives are progress markers along the way to goal achievement. For example, a goal might
be to have a healthy, successful company that is a leader in customer service and that has a loyal
customer following. Objectives might be annual sales targets and some specific measures of
customer satisfaction.
To whom will you market your products? (State it briefly here—you will do a more thorough
explanation in the Marketing Plan section).
Describe your industry. Is it a growth industry? What changes do you foresee in the industry,
short term and long term? How will your company be poised to take advantage of them?
Describe your most important company strengths and core competencies. What factors will
make the company succeed? What do you think your major competitive strengths will be? What
background experience, skills, and strengths do you personally bring to this new venture?
What factors will give you competitive advantages or disadvantages? Examples include level
of quality or unique or proprietary features.
V. Marketing Plan
Market Research – Why?
No matter how good your product and your service, the venture cannot succeed without
effective marketing. And this begins with careful, systematic research. It is very dangerous to
assume that you already know about your intended market. You need to do market research to
make sure you’re on track. Use the business planning process as your opportunity to uncover data
and to question your marketing efforts. Your time will be well spent.
Secondary research means using published information such as industry profiles, trade
journals, newspapers, magazines, census data, and demographic profiles. This type of information
is available in public libraries, industry associations, chambers of commerce, from vendors who sell
to your industry, and from government agencies.
Start with your local library. Most librarians are pleased to guide you through their business
data collection. You will be amazed at what is there. There are more online sources than you could
possibly use. Your chamber of commerce has good information on the local area. Trade
associations and trade publications often have excellent industry-specific data.
Primary research means gathering your own data. For example, you could do your own traffic
count at a proposed location, use the yellow pages to identify competitors, and do surveys or focus
group interviews to learn about consumer preferences. Professional market research can be very
costly, but there are many books that show small business owners how to do effective research
themselves.
In your marketing plan, be as specific as possible; give statistics, numbers, and sources. The
marketing plan will be the basis, later on, of the all-important sales projection.
Economics
⚫ What per cent share of the market will you have? (This is important only if you think you
will be a major factor in the market.)
⚫ What barriers to entry do you face in entering this market with your new company? Some
typical barriers are:
○ Unions
○ Shipping costs
○ Change in technology
Product
In the Products and Services section, you described your products and services as you see
them. Now describe them from your customers’ point of view.
⚫ Describe the benefits. That is, what will the product do for the customer?
Note the difference between features and benefits and think about them. For example, a
house that gives shelter and lasts a long time is made with certain materials and to a certain
design; those are its features. Its benefits include pride of ownership, financial security, providing
for the family, and inclusion in a neighborhood. You build features into your product so that you can
sell the benefits.
What after-sale services will you give? Some examples are delivery, warranty, service
contracts, support, follow-up, and refund policy.
Customers
Identify your targeted customers, their characteristics, and their geographic locations,
otherwise known as their demographics.
The description will be completely different depending on whether you plan to sell to other
businesses or directly to consumers. If you sell a consumer product, but sell it through a channel of
distributors, wholesalers, and retailers, you must carefully analyze both the end consumer and the
middleman businesses to which you sell.
You may have more than one customer group. Identify the most important groups. Then, for
each customer group, construct what is called a demographic profile:
⚫ Age
⚫ Gender
⚫ Location
⚫ Income level
⚫ Education
⚫ Location
⚫ Size of company
Competition
Will they compete with you across the board, or just for certain products, certain customers, or
in certain locations?
Will you have important indirect competitors? (For example, video rental stores compete with
theaters, although they are different types of businesses.)
Use the Competitive Analysis table below to compare your company with your two most
important competitors. In the first column are key competitive factors. Since these vary from one
industry to another, you may want to customize the list of factors.
In the column labeled Me, state how you honestly think you will stack up in customers’ minds.
Then check whether you think this factor will be a strength or a weakness for you. Sometimes, it is
hard to analyze our own weaknesses. Try to be very honest here. Better yet, get some
disinterested strangers to assess you. This can be a real eye-opener. And remember that you
cannot be all things to all people. In fact, trying to be causes many business failures because efforts
become scattered and diluted. You want an honest assessment of your company’s strong and
weak points.
Now, analyze each major competitor. In a few words, state how you think they compare.
In the final column, estimate the importance of each competitive factor to the customer. 1 =
critical; 5 = not very important.
A B to Customer
Products
Price
Quality
Selection
Service
Reliability
Stability
Expertise
Company Reputation
Location
Appearance
Sales Method
Credit Policies
Advertising
Image
Now, write a short paragraph stating your competitive advantages and disadvantages.
Niche
Now that you have systematically analyzed your industry, your product, your customers, and
the competition, you should have a clear picture of where your company fits into the world.
In one short paragraph, define your niche, your unique corner of the market.
Strategy
Promotion
Advertising
What media, why, and how often? Why this mix and not some other?
Have you identified low-cost methods to get the most out of your promotional budget?
Will you use methods other than paid advertising, such as trade shows, catalogs, dealer
incentives, word-of-mouth (how will you stimulate it?), and network of friends or professionals?
What image do you want to project? How do you want customers to see you?
In addition to advertising, what plans do you have for graphic image support? This includes
things like logo design, cards and letterhead, brochures, signage, and interior design (if customers
come to your place of business).
Should you have a system to identify repeat customers and then systematically contact them?
Promotional Budget
Pricing
Explain your method or methods of setting prices. For most small businesses, having the
lowest price is not a good policy. It robs you of needed profit margin; customers may not care as
much about price as you think; and large competitors can underprice you anyway. Usually, you will
do better to have average prices and compete on quality and service.
Does your pricing strategy fit with what was revealed in your competitive analysis?
Compare your prices with those of the competition. Are they higher, lower, the same? Why?
How important is price as a competitive factor? Do your intended customers really make their
purchase decisions mostly on price?
Proposed Location
Probably, you do not have a precise location picked out yet. This is the time to think about
what you want and need in a location. Many start-ups run successfully from home for a while.
You will describe your physical needs later, in the Operational Plan section. Here, analyze
your location criteria as they will affect your customers.
Where is the competition located? Is it better for you to be near them (like car dealers or fast-
food restaurants) or distant (like convenience food stores)?
Distribution Channels
Retail
Wholesale
Agents
Independent representatives
Bid on contracts
Sales Forecast
Now that you have described your products, services, customers, markets, and marketing
plans in detail, it’s time to attach some numbers to your plan. Use a sales forecast spreadsheet to
prepare a month-by-month projection. The forecast should be based on your historical sales, the
marketing strategies that you have just described, your market research, and industry data, if
available.
You may want to do two forecasts: (1) a “best guess”, which is what you really expect, and
(2) a “worst case” low estimate that you are confident you can reach no matter what happens.
Remember to keep notes on your research and your assumptions as you build this sales
forecast and all subsequent spreadsheets in the plan. This is critical if you are going to present it to
funding sources.
Production
⚫ Quality control
⚫ Customer service
⚫ Inventory control
⚫ Product development
Location
What qualities do you need in a location? Describe the type of location you’ll have.
Physical requirements:
⚫ Amount of space
⚫ Type of building
⚫ Zoning
Access:
What are your requirements for parking and proximity to freeway, airports, railroads, and
shipping centers?
Construction: Most new companies should not sink capital into construction, but if you are
planning to build, costs and specifications will be a big part of your plan.
Cost: Estimate your occupation expenses, including rent, but also including maintenance,
utilities, insurance, and initial remodeling costs to make the space suit your needs. These numbers
will become part of your financial plan.
Legal Environment
⚫ Permits
⚫ Insurance coverage
Personnel
⚫ Number of employees
⚫ Pay structure
⚫ Have you drafted job descriptions for employees? If not, take time to write some. They
really help internal communications with employees.
⚫ For certain functions, will you use contract workers in addition to employees?
Inventory
⚫ What kind of inventory will you keep: raw materials, supplies, finished goods?
⚫ Seasonal buildups?
Suppliers
Should you have more than one supplier for critical items (as a backup)?
Are supply costs steady or fluctuating? If fluctuating, how would you deal with changing
costs?
Credit Policies
⚫ Do you really need to sell on credit? Is it customary in your industry and expected by your
clientele?
⚫ If yes, what policies will you have about who gets credit and how much?
⚫ What terms will you offer your customers; that is, how much credit and when is payment
due?
⚫ Will you offer prompt payment discounts? (Hint: Do this only if it is usual and customary
in your industry.)
⚫ Do you know what it will cost you to extend credit? Have you built the costs into your
prices?
If you do extend credit, you should do an aging at least monthly to track how much of your
money is tied up in credit given to customers and to alert you to slow payment problems. A
receivables aging looks like the following table:
You will need a policy for dealing with slow paying customers:
You should also age your accounts payable, what you owe to your suppliers. This helps you
plan whom to pay and when. Paying too early depletes your cash but paying late can cost you
valuable discounts and can damage your credit. (Hint: If you know you will be late making a
payment, call the creditor before the due date.)
If you’ll have more than 10 employees, create an organizational chart showing the
management hierarchy and who is responsible for key functions.
Include position descriptions for key employees. If you are seeking loans or investors, include
resumes of owners and key employees.
⚫ Board of directors
⚫ Attorney
⚫ Accountant
⚫ Insurance agent
⚫ Banker
⚫ Consultant/s
Even with the best of research, however, opening a new business has a way of costing more
than you anticipate. There are two ways to make allowances for surprise expenses. The first is to
add a little “padding” to each item in the budget. The problem with that approach, however, is that it
destroys the accuracy of your carefully wrought plan. The second approach is to add a separate
line item, called contingencies, to account for the unforeseeable. This is the approach we
recommend.
Talk to others who have started similar businesses to get a good idea of how much to allow
for contingencies. If you cannot get good information, we recommend a rule of thumb that
contingencies should equal at least 20% of the total of all other start-up expenses.
Explain your research and how you arrived at your forecasts of expenses. Give sources,
amounts, and terms of proposed loans. Also explain in detail how much will be contributed by each
investor and what per cent ownership each will have.
X. Financial Plan
The financial plan consists of a 12-month profit and loss projection, a four-year profit and loss
projection (optional), a cash flow projection, a projected balance sheet, and a break-even
calculation. Together they constitute a reasonable estimate of your company’s financial future.
More important, the process of thinking through the financial plan will improve your insight into the
inner financial workings of your company.
Many business owners think of the 12-month profit and loss projection as the centerpiece of
their plan. This is where you put it all together in numbers and get an idea of what it will take to
make a profit and be successful.
Your sales projections will come from a sales forecast in which you forecast sales, cost of
goods sold, expenses, and profit month-by-month for one year.
Research Notes: Keep careful notes on your research and assumptions, so that you can
explain them later if necessary, and also so that you can go back to your sources when it’s time to
revise your plan.
The 12-month projection is the heart of your financial plan. This section is for those who want
to carry their forecasts beyond the first year.
Of course, keep notes of your key assumptions, especially about things that you expect will
change dramatically after the first year.
If the profit projection is the heart of your business plan, cash flow is the blood.
Businesses fail because they cannot pay their bills. Every part of your business plan is
important, but none of it means a thing if you run out of cash.
The point of this worksheet is to plan how much you need before start-up, for preliminary
expenses, operating expenses, and reserves. You should keep updating it and using it afterward. It
will enable you to foresee shortages in time to do something about them—perhaps cut expenses, or
perhaps negotiate a loan. But foremost, you shouldn’t be taken by surprise.
There is no great trick to preparing it: The cash flow projection is just a forward look at your
checking account.
For each item, determine when you actually expect to receive cash (for sales) or when you
will actually have to write a check (for expense items).
You should track essential operating data, which is not necessarily part of cash flow but
allows you to track items that have a heavy impact on cash flow, such as sales and inventory
purchases.
You should also track cash outlays prior to opening in a pre-start-up column. You should have
already researched those for your start-up expenses plan.
Your cash flow will show you whether your working capital is adequate. Clearly, if your
projected cash balance ever goes negative, you will need more start-up capital.
This plan will also predict just when and how much you will need to borrow.
Explain your major assumptions, especially those that make the cash flow differ from the
Profit and Loss Projection. For example, if you make a sale in month one, when do you actually
collect the cash? When you buy inventory or materials, do you pay in advance, upon delivery, or
much later? How will this affect cash flow?
Are there irregular expenses, such as quarterly tax payments, maintenance and repairs, or
seasonal inventory buildup, that should be budgeted?
Loan payments, equipment purchases, and owner's draws usually do not show on profit and
loss statements but definitely do take cash out. Be sure to include them.
And of course, depreciation does not appear in the cash flow at all because you never write a
check for it.
A balance sheet is one of the fundamental financial reports that any business needs for
reporting and financial management. A balance sheet shows what items of value are held by the
company (assets), and what its debts are (liabilities). When liabilities are subtracted from assets,
the remainder is owners’ equity.
Optional: Some people want to add a projected balance sheet showing the estimated financial
position of the company at the end of the first year. This is especially useful when selling your
proposal to investors.
Break-even Analysis
A break-even analysis predicts the sales volume, at a given price, required to recover total
costs. In other words, it’s the sales level that is the dividing line between operating at a loss and
operating at a profit.
Fixed Costs
Break-even Sales =
1- Variable Costs
(where, fixed costs are expressed in dollars, but variable costs are expressed as a per cent of
total sales.)
XI. Appendices
Include details and studies used in your business plan for example:
⚫ Industry studies
..............................................................................................................................................................
.
For Bankers
⚫ Bankers want assurance of orderly repayment. If you intend using this plan to present to
lenders, include:
○ Amount of loan
○ Requested repayment terms (number of years to repay). You will probably not have
much negotiating room on interest rate but may be able to negotiate a longer
repayment term, which will help cash flow.
For Investors
⚫ Investors have a different perspective. They are looking for dramatic growth, and they
expect to share in the rewards:
○ How the company will use the funds, and what this will accomplish for growth
Manufacturing
⚫ Anticipated levels of direct production costs and indirect (overhead) costs—how do these
compare to industry averages (if available)?
Service Businesses
⚫ Service businesses sell intangible products. They are usually more flexible than other
types of businesses, but they also have higher labor costs and generally very little in
fixed assets
⚫ Your prices
⚫ Per cent of work subcontracted to other companies. Will you make a profit on
subcontracting?
⚫ Will the company have information systems in place to manage rapidly changing prices,
costs, and markets?
⚫ Will you be on the cutting edge with your products and services?
⚫ What is the status of research and development? And what is required to:
High-tech companies sometimes have to operate for a long time without profits and
sometimes even without sales. If this fits your situation, a banker probably will not want to lend to
you. Venture capitalists may invest, but your story must be very good. You must do longer-term
financial forecasts to show when profit take-off is expected to occur. And your assumptions must be
well documented and well argued.
Retail Business
⚫ Company image
⚫ Pricing:
⚫ Inventory:
⚫ Inventory level: Find industry average numbers for annual inventory turnover rate
(available in RMA book). Multiply your initial inventory investment by the average
turnover rate. The result should be at least equal to your projected first year’s cost of
goods sold. If it is not, you may not have enough budgeted for start-up inventory.
⚫ Customer service policies: These should be competitive and in accord with company
image.
⚫ Location: Does it give the exposure that you need? Is it convenient for customers? Is it
consistent with company image?
⚫ Credit: Do you extend credit to customers? If yes, do you really need to, and do you
factor the cost into prices?
8.6 SUMMARY
Preparation and Presentation of your project/file is a very important aspect of Project Finance.
It improves the chances of you availing the loan, creates a greater comfort towards your bankers,
creates a good impression. There is an exhaustive list of documents required to scrutinize your loan
application.
Business Plan presents the long-term and short-term plan of the organization. It is an
important tool for availing funding.
The promoter must prepare a Business Plan/Presentation stating the long-term and short-
term objectives of his business. It is an important tool for availing means of funding such as Private
Equity, Institutional investors, etc.
Business plans should only become printed documents on select occasions, when needed to
share information with outsiders or team members. Otherwise, they should be dynamic documents
that you maintain on your computer. The plan goes on forever, so the printed version is like a
snapshot of what the plan was on the day that it was printed.
Every business has long-term and short-term goals, sales targets, and expense budgets—a
business plan encompasses all of those things and is as useful to a start-up trying to raise funds as
Copyright © Welingkar 169
Chapter – 8
it is to a 10-year-old business that’s looking to grow. Before you even start writing your business
plan, you need to think about whom the audience is and what the goals of your plan are.
In addition, there are various other factors / documents which are critical in nature and
required to be submitted to Financiers. Therefore the checklist of documents to be submitted with
detailed project report is require to prepare and accordingly submit / present the documents .
This should mainly consist of brief write up on existing experience i.e., background and
conceptualization of the proposal, a write up of the present proposal and justification of the
proposal. It may consists mainly following documents:
⚫ Registered office and Operating office address with telephone, fax, email-id etc
⚫ Annual Report of the Company, in case of existing (containing Audited Balance Sheet,
Profit & Loss account) for last three years.
⚫ Existing Bankers, credit sanction letter, present outstanding and latest bank loan
statement.
⚫ Annual Report of Associated Company/s (containing Audited Balance Sheet, Profit &
Loss account) of the Company for the last three years.
Depending up on type of project you can add / modify the relevant documents including
standard information on promoter/ directors with their relevant prescribed details.
The generic business plan presented above should be modified to suit your specific type of
business and the audience for which the plan is written.
(b) Bankers will be more comfortable to sanction loan if almost all requirements are
submitted by the applicant & they will believe that they are dealing with professional
people
(c) A well-prepared file will make the project manager/promoter better prepared with the
project.
(a) it can be a great tool to introduce the business to outsiders, such as potential
investors and also it often a better approach to get that first meeting
(b) Sales Forecast, Personnel Plan with Profit and Loss Statement as well as balance
sheet
5. Bankers want assurance of orderly repayment. If you intend using this plan to present to
lenders, include:
(a) Amount of loan & How the funds will be used, also a list of all existing liens against
collateral.
(b) What this will accomplish—how will it make the business stronger?
Answers:
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Summary
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MCQ
Video1
Chapter – 9
9 TERM LOANS
Chapter
Objectives
After studying this chapter, you should be able to:
⚫ Have a look at the Application Form for Term Loan from Financial institution.
Structure:
9.1 Introduction
9.8 Summary
9.1 INTRODUCTION
Development financial institutions (DFIs) or development banks provide long-term credit for
projects. The rapid industrialization of continental Europe in the 19th century has been facilitated
with the emergence of DFIs. Many of these institutions were sponsored by national governments
and international organizations. Netherlands set up an institution in 1822; and in France institutions
such as Credit Froncier and Credit Mobilizer were created dining 1848-1852. In Asia, the Industrial
Bank of Japan founded in 1902 assisted not only in the development of the domestic capital
markets, but also obtained equity for the industrial companies in Japan.
To resolve the dearth of long-term funds and the perceived socially unjustified risk aversion of
creditors specialized financial institutions were set up in India: Industrial Finance Corporation in
1948 followed by the setting up of State Finance Corporations (SFCs) at the state level under the
State Finance Corporation Act, 1951; Industrial Credit and Investment Corporation (ICICI) in 1955;
and Industrial Development Bank of India (ICICI) as the apex bank in 1964.
There are investment institutions which mobilize resources and provide medium- to long-term
investment. These are Unit Trust of India (1964) and LIC and GIC and its subsidiaries; and
specialized institutions like the Technology Development and Information Company of India Ltd.
(TDICI), Tourism Finance Corporation of India (TFCI) and Small Industries Development Bank of
India (SIDBI) to serve in their specified areas. Of the total disbursements of ` 51,885 crores in 1997-98
by the all-India financial institutions, the three major all-India financial institutions IDBI (29.2%), IFCI
(10.9%) and ICICI (30.5%) account for 70.6%. These institutions played an important role in
acquiring and disseminating skills necessary to assess investment projects and borrowers
creditworthiness.
Companies in India obtain long-term debt mainly by raising term loans or issuing debentures.
Term loans given by banks and financial institutions have been the primary source of long-term
debt for private companies and most public companies. Term loans, also referred to as term
finance, represent a source of debt finance which is generally repayable in less than 10 years. They
are self-liquidating in nature. For western and European market, issuing bonds is also a part of
raising loan term debt. However, the Indian Bond market is nascent and not very developed.
In India, term loans are typically provided by Commercial Banks, Financial Institutions like
Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), IL&FS,
IDFC, IMF/World Bank, State Financial Corporations (SFCs), Industrial Credit and Investment
Corporation of India (ICICI), Power Finance Corporation, HUDCO, Insurance Companies (LIC and
GIC), Small Industries Development Bank of India (SIDBI) and investment companies.
Term Loans typically are those having maturity between 7 to 10 years. Term loans make take
the form of an ordinary loan or a revolving credit. In an ordinary term loan, the funds are arranged
for a period of one year upto 10 years as per the loan agreement. Line of Credit, is a commitment
by the lender to lend a certain amount of money to a company for a certain specified period of time.
Usually, Term Loans are self-liquidating in nature. Lenders do ask for audited annual reports
every year till the loan is liquidated. They undertake inspections during the development stage and
at least once in a year. Valuation reports are taken prior to each disbursement. However, there is
no monthly Stock and Book Debts statements to be submitted as in case of Working Capital
facilities.
A term loan is the most traditional (and generic) type of loan for businesses and consumers.
Term loans have a specific duration, payment frequency and carry fixed interest rates.
2. Rate does not change – not at mercy of the interest rate markets.
3. Accounting entries for term loan transactions are clear and easy.
4. Helpful for improving a credit report – steady but sure wins the race.
Debt is least costly source of long-term financing. It is the least costly because:
2. Bondholders or creditors consider debt as a relatively less risky investment and require
lower return.
4. Bondholders are creditors and have no interference in business operations because they
are not entitled to vote.
1. Interest on debt is permanent burden to the company. Company has to pay the interest
to bondholders or creditors at fixed rate whether it earns profit or not. It is legally liable to
pay interest on debt.
2. Debt usually has a fixed maturity date. Therefore, the financial officer must make
provision for repayment of debt.
3. Debt is the most risky source of long-term financing. Company must pay interest and
principal at specified time. Non-payment of interest and principal on time take the
company into bankruptcy.
4. Debenture indentures may contain restrictive covenants which may limit the company’s
operating flexibility in future.
5. Only large scale, creditworthy firm, whose assets are good for collateral can raise
capitalfrom long-term debt.
7. If interest rates go down, interest expense payments are higher relative to the market
rate.
⚫ Currency
⚫ Purpose
⚫ Security
⚫ Cost
⚫ Flexibility
⚫ Guarantee/s
⚫ Protective Covenants
The procedure associated with a term loan involves the following steps:
⚫ Promoters’ background
⚫ Means of financing
⚫ Economic considerations
⚫ Government consents
9.4.9 Monitoring
Monitoring of the project is done at the implementation stage as well as at the operational
stage. During the implementation stage, the project is monitored through:
(i) Regular reports, furnished by the company, which provide information about placement
of orders, construction of buildings, procurement of plant, installation of plant and
machinery trial production, etc.,
(iii) Discussion with promoters, bankers, suppliers, creditors, and others connected with the
project,
During the operational stage, the project is monitored with the help of:
The most important aspect of monitoring, of course, is the timely recovery of due represented
by interest and principal repayment.
A syndicated loan, also known as a syndicated bank facility, is financing offered by a group of
lenders—referred to as a syndicate—who work together to provide funds for a single borrower. The
borrower can be a corporation, a large project, or a sovereign government. The loan can involve a
fixed amount of funds, a credit line, or a combination of the two.
Syndicated loans arise when a project requires too large a loan for a single lender or when a
project needs a specialized lender with expertise in a specific asset class. Syndicating the loan
allows lenders to spread risk and take part in financial opportunities that may be too large for their
individual capital base. Interest rates on this type of loan can be fixed or floating, based on a
benchmark rate such as the London Interbank Offered Rate (LIBOR).
Syndication is an arrangement wherein several banks participate in single loan. The corporate
seeking a syndicated loan chooses a lead bank to manage the same. The lead bank prepares an
information memorandum which is sent to other banks potentially interested in participating in the
syndicated loan. Based on the interest evinced by the participating banks, the lead bank works out
the sharing arrangement.
While bilateral loans are preferred for small ticket loans, syndicated loans are becoming
popular for large ticket loan. For example, IDBI Bank lead managed a ` 6,000 crore syndicated loan
for HINDALCO in 2005. The loan has a tenor of 10 years with a reset after five years. Thirty banks
participated in this loan which was priced at five-year G-Sec yield plus 65 basis points.
How is loan syndication different from consortium financing which was popular earlier?
Consortium financing involved a presentation to be given by the company to a group of bankers
and was more rule-based. Further, under a consortium arrangement, participating banks offered
other services like letter of credit, working capital credit, guarantees and so and interacted regularly
with the company.
In cases of syndicated loans, there is typically a lead bank or underwriter, known as the
arranger, the agent, or the lead lender. The lead bank may put up a proportionally bigger share of
the loan, or it may perform duties such as dispersing cash flows among the other syndicate
members and administrative tasks.
The main goal of syndicated lending is to spread the risk of a borrower default across multiple
lenders or banks, or institutional investors, such as pension funds and hedge funds. Because
syndicated loans tend to be much larger than standard bank loans, the risk of even one borrower
defaulting could cripple a single lender. Syndicated loans are also used in the leveraged buyout
community to fund large corporate takeovers with primarily debt funding.
Syndicated loans can be made on a best-efforts basis, which means that if enough investors
can't be found, the amount the borrower receives is lower than originally anticipated. These loans
can also be split into dual tranches for banks that fund standard revolving credit lines and
institutional investors that fund fixed-rate term loans.
Like a loan syndication, consortium financing occurs for transactions that might not take place
with a single lender. Several banks agree to jointly supervise a single borrower with a common
appraisal, documentation, and follow-up and own equal shares in the transaction. Unlike in a loan
syndication, there is not one lead bank that manages the financing project; all of the banks play an
equal role in managing the project.
Consortiums are not built to handle international transactions such as a syndication loan.
Instead, a consortium may arise because the size of the project at hand is simply too large or too
risky for any single lender to assume. While loan syndications typically work across borders and
may handle financing in different currencies, consortiums typically occur within the boundaries of a
given nation.
Sometimes the participating banks form a new consortium bank that functions by leveraging
assets from each institution and disbands after the project is complete. By allowing all of the
members to pool their assets, consortiums allow smaller banks to tackle larger projects
Wherever imported machinery and equipment is necessary, the financial institutions provide
the necessary foreign exchange loan after assessing the viability of the project. The foreign
currency loans are part of various lines of credit for financing projects based on imported plant and
equipment. Some of the lines of credit are Eurodollar loans, export credit from UK, Japanese yen
loans, Deutsche Mark Revolving Funds and KFW, Germany. The loan covers CIF value of the
capital goods and the know-how fees. Interest rate depends on the rate applicable to the foreign
currency funds utilized by the financial institution. IFCI, IDBI and ICICI grant foreign currency loans.
All India financial institutions (IDBI, IFCI and ICICI) operate Exchange Rate Administration
Scheme (ERAS) to cover the risk of foreign exchange rate fluctuations. The institutions carry the
risk themselves and charge a composite rate to the borrower. The composite rate is announced
from time to time for ERAS loans to be sanctioned during the period as a band of interest rates.
Foreign Currency Term Loan (popularly known as FCTL) is the replacement for Term Loan
in INR. Foreign Currency Term Loans (FCTL) can be disbursed in four currencies viz. US$,
Sterling, Euro and Japanese Yen with a maturity period of 6 months to 7 years. It can be repaid by
bullet payment or in stipulated instalments or by conversion of rupee term loans, as per the terms of
the original sanction.
WHO CAN AVAIL THIS FACILITY: EXPORTERS, SINCE THEY HAVE A NATURAL
HEDGE.
Purpose of FCTL:
Features of FCTL
It is Financially Viable to the client(s) who are naturally hedged (ideally should have recurring /
running business for Fx Inflows).
Thus, a regular Exporter can repay through Export receivables. This FCTL $ liability creates a
natural hedge against a $ receivable asset.
Exports should be regular in nature and also part of those export receivables should be un-
hedged so that the same can be used for repayment of FCTLs
Debt Service Coverage Ratio (DSCR) essentially calculates the repayment capacity of a
borrower. DSCR less than 1 suggests inability of firm’s profits to serve its debts whereas a DSCR
greater than 1 means not only serving the debt obligations but also the ability to pay the dividends.
Debt Service Coverage Ratio (DSCR), one of the leverage/coverage ratios, is calculated in
order to know the cash profit availability to repay the debt including interest. Essentially, DSCR is
calculated when a company/firm takes loan from bank/financial institution/any other loan provider.
This ratio suggests the capability of cash profits to meet the repayment of the financial loan. DSCR
is very important from the viewpoint of the financing authority as it indicates repaying capability of
the entity taking loan.
Just a year’s analysis of DSCR does not lead to any concrete conclusion about the debt
servicing capability. DSCR is relevant only when it is seen for the entire remaining period of loan.
Sometimes, these figures are readily available but at times, they are to be determined using
the financial statements of the company/firm. Formula for DSCR is stated as follows:
⚫ Profit after tax (PAT): PAT is generally available readily on the face of the Profit and
Loss account. It is the balance of the profit and loss account which is transferred to the
reserve and surplus fund of the business. Sometimes, in absence of the profit and loss
statement, we can also find it from the balance sheet by subtracting the current year
P&L account from the previous year’s balance, which is readily available under the head
of reserve and surplus.
⚫ Interest: The amount which is paid or payable for the financial year under concern on the
loan taken.
⚫ Non-cash expenses: Non-cash expenses are those expenses which are charged to the
profit and loss account for which payment has already been done in the past years.
Following are the non cash expenses:
— Amortization of the intangible assets like goodwill, trademark, patent, copyright, etc.
⚫ Instalment amount: The amount which is paid or payable for the financial year under
review for the loan taken. It includes the payment towards principal and interest for the
financial year.
⚫ Lease Rental: The amount of lease rent paid or payable for the financial year.
Just calculating a ratio does not serve the purpose till it is not interpreted in the correct sense.
The result of a debt service coverage ratio is an absolute figure. Higher this figure better is the debt
serving capacity. If the ratio is less than 1, it is considered bad because it simply indicates that the
profits of the firm are not sufficient to service its debt obligations.
Acceptable industry norm for a debt service coverage ratio is between 1.5 to 2. The ratio is of
utmost use to lenders of money such as banks, financial institutions etc. There are two objectives of
any financial institution behind giving loan to a business, viz., earning interest and not letting the
account go bad.
Let’s take an example where the DSCR is coming to be less than 1, which directly indicate
negative views about the repayment capacity of the firm. Does this mean that the bank should not
extend loan? No, absolutely not. It is because the bank will analyze the profit generating capacity
and business idea as a whole and if the business is strong in both of them; the DSCR can be
improved by increasing the term of loan. Increasing the term of loan will reduce the denominator of
the ratio and thereby enlarge the ratio to greater than 1.
Term Loans remain a favorite avenue of raising funds for setting up new projects
9.8 SUMMARY
Term Loans typically are those having maturity between 7 to 10 years. Term loans make take
the form of an ordinary loan or a revolving credit. In an ordinary term loan, the funds are arranged
for a period of one year up to 10 years as per the loan agreement. Line of Credit is a commitment
by the lender to lend a certain amount of money to a company for a certain specified period of time.
Usually, Term Loans are self-liquidating in nature. Lenders do ask for audited annual reports
every year till the loan is liquidated. They undertake inspections during the development stage and
at least once in a year. Valuation reports are taken prior to each disbursement. However, there is
no monthly Stock and Book Debts statements to be submitted as in case of Working Capital
facilities.
There are various advantages of Term Loans such as simple repayment, rate is fixed, less
cost, interest cost is tax-deductible, relatively less risk.
There are various disadvantages of Term Loans such as being permanent burden on
company, having fixed maturity date, most risky of long-term financing, less operating flexibility,
only large creditworthy companies can avail, prepayment penalties, etc.
Term Loan has many aspects such as Currency, Interest and Principal Repayment, Period of
Repayment, Security, Guarantee, Pre-disbursement and Special Conditions, Protective Covenants,
etc.
Term Loan procedure comprises of submission of loan application file, initial processing,
appraisal, issue of letter of sanction, acceptance of terms of sanction, execution of loan agreement,
creation of security, disbursement of loans and monitoring.
Syndicated Loans are used when the requirement is larger with participation from multiple
banks. Syndicated loan, also known as a syndicated bank facility, is financing offered by a group of
lenders—referred to as a syndicate—who work together to provide funds for a single borrower. The
borrower can be a corporation, a large project, or a sovereign government. The loan can involve a
fixed amount of funds, a credit line, or a combination of the two.
Foreign Currency Loans are used when imported machinery and equipment is necessary for
the project. Foreign Currency Term Loans (FCTL) can be disbursed in four currencies viz. US$,
Sterling, Euro and Japanese Yen with a maturity period of 6 months to 7 years. It can be repaid by
bullet payment or in stipulated instalments or by conversion of rupee term loans, as per the terms of
the original sanction
Debt Service Coverage Ratio (DSCR) essentially calculates the repayment capacity of a
borrower. Essentially, DSCR is calculated when a company/firm takes loan from bank/financial
institution/any other loan provider. This ratio suggests the capability of cash profits to meet the
repayment of the financial loan. DSCR is very important from the viewpoint of the financing
authority as it indicates repaying capability of the entity taking loan.
1. Term loans make take the form of an ordinary loan or a revolving credit. In an ordinary
term loan, the funds are arranged for a period of one year up to ------------as per the loan
agreement.
(a) 10 years
(b) 7 years
(c) 5 years
(d) 3 Years
(c) Accounting entries for term loan transactions are clear and easy & helpful for
improving a credit report
3. The financing facility offered by a group of lenders who work together to provide funds for
a single borrower is called as -------------------------
(d) FCTL
4. A loan may arise because the size of the project at hand is simply too large or too risky
for any single lender to assume, therefore it is called as ------------------------------
(d) FCTL
(a) the capability of cash profits to meet the repayment of the financial loan
(c) Interest component Required to be paid during the tenor of the loan
(d) Determines the capability of the borrower to raise quantum of term loan
Answers:
Students already working on projects can copy the requirements in Word format and start filling in
the details.
Note: All the required information should be duly typed in the application form. The comments like “As per the
project report”, “As per the Annexure” will not be accepted. A soft copy should also be submitted in a
floppy along with the signed hard copy of the Application form.
APPLICATION FORM
FOR CREDIT FACILITIES
(Term Loan plus Working Capital*)
(To be submitted in duplicate)
1 DETAILS OF APPLICANT UNIT
1.1 Name of the Unit
1.2 Addresses with Telephone/Telex/Fax No.
(a) Registered Office
(b) Administrative office
(c) Factory
– Existing
– Proposed
1.3 Constitution (please strike out which are not
applicable)
1.4 Date of Incorporation
1.5 SSI Registration No.
(As given by the District Industries
Center/Directorate of Industries)
1.6 Exporters’ Code Number
1.7 Name of the business house/group to which
the unit belongs
2 PROJECT
Brief details about the existing activity, if any and proposed project
(In case of existing units, please furnish detailed information as per Annexure I)
3 MANAGEMENT
Brief particulars of the Promoters/Directors
(Furnish Bio-data and net worth statement for each person in Annexure II and III
respectively)
3.2 Shareholding
3.2.1 Please provide a list of existing and proposed equity and preference shareholders
owning or controlling 5% or more of equity shares, indicating the amount owned and
business relationship, if any, with the Company.
Total
Others
Total
4 TECHNICALLY FEASIBILITY
(Please enclose the feasibility/project report, if available/considered necessary)
4.1 Name of the Products (including by-products) and its (their) uses
4.2 Capacity (No. of Units/Quantify in Kg./Volume in Liters)
No. of working days in a month: No. of shifts in a day: No. of hours per shift:
4.3 Manufacturing process (Indicate technical details including type of process, material
flow, etc.)
4.4 Arrangement proposed for technology transfer/know-how
4.4.1 Through technical collaboration (If yes, please furnish relevant information in
Annexure V).
4.4.2 Through technical consultants (If yes, please furnish relevant information in Annexure V).
4.4.3 In-house – Yes/No. If yes, briefly explain how this will be done.
4.5 Location advantages of existing and proposed premises with reference to absence of
civic restrictions; proximity to the source of raw materials; market for the product;
availability of power, water, labor, transport; and whether backward area and benefits
available.
4.6 Type of soil and load bearing capacity (enclose test report)
4.7 Raw Materials and components (enclose copies of Proforma Invoices in respect of
each item)
Raw Material/Component
Imported/Indigenous
Quantity Required per unit of Product
Sources of Supply
Minimum Purchase Quantity/unit cost
Availability (Easy/Restricted/Seasonal, etc.)
Arrangement for transportation in case of
bulky Raw Materials/Components
4.8 Employment
Present Proposed
– Executives/Supervisors/Engineers
– Administrative/Office Staff
– Skilled Labor
– Unskilled Labor
– Others (specify)
4.9.2 Water
4.9.2.1 Indicate the requirements and suitability of water
4.9.2.2 Describe water treatment arrangements
4.9.2.3 Sources for supply of water, arrangement proposed and water charges payable
4.9.3 Steam/Compressed Air:
(a) Requirement
(b) Arrangements proposed
4.9.4 Fuel:
(a) Requirement of fuel (Type, Amount and Rate)
(b) Arrangements proposed for supply
No requirements for fuels
4.10 Effluent Treatment: Please furnish full details of the nature of atmosphere, soil, and
water pollution likely to be created by the project and the measures proposed for
control of pollution. Indicate whether necessary permission for the disposal of effluent
has been obtained from the concerned authority; if yes, a copy of the certificate should
be furnished.
4.11 Quality control
(a) Details of arrangement made for quality control
(b) Particulars of R&D activity proposed, if any
5.1.4 Extent of competition, number and names of units engaged in similar line in the area,
their capacity utilization/performance
5.1.5 How do the unit/meet propose to meet the competition (comment on the competitive
advantages enjoyed by the unit?)
5.1.6 In price and quality, how does the unit's product compare with those of its competitors?
5.2 Selling Arrangements
5.2.1 Is the unit selling directly to its customers? If so please furnish details like sales force,
showrooms, depots, etc.
5.2.2 If a selling/distribution agency has been appointed, its name, period of contract,
commission payable, period by which the bills will be paid by it etc. (enclose copies of
agreement, wherever applicable)
5.2.3 Nature and volume of orders/enquiries on hand, if any (Xerox copies to be furnished)
6 COST OF PROJECT
(Please furnish estimates of cost of project under the following heads. Indicate the
basis for arriving at the cost of project)
Project at a glance (1st stage)
6.1 Land
1. Location
2. Area (in sq. mt./sq. ft.)
3. Whether Freehold land or Leasehold
4. Purchase Price of Land, if owned
5. Name of the person(s) from whom land has been/is being purchased
(Please indicate relationship, if any with the applicant unit or the promoters/director
6. Terms of lease (such as rent, period, mortgage clause etc.)
6.2 Details of Site Development expenses
6.3 Building
1. Location
Establishment Expenses
Company Formation
Deposit with SEB
Traveling Expenses
Pre-operative Expenses
Interest During Construction
Upfront Fee
Other (Specify)
Total
6.7 Margin Money Requirements for Working Capital (As per Annexure X).
7 MEANS OF FINANCING
(Please furnish details of sources of finance for meeting the cost under the following heads)
(` lakhs)
7.1 Indicate sources from which expenditure already incurred has been financed (Please
indicate CA certificate for the same along with copies of Bills/Invoices)
7.2 Indicate the sources from which the share capital is proposed to be raised
7.3 In case internal accruals are taken as source of finance explain the basis for estimation
of internal accruals by means of a statement
7.4 Promoter's contribution to the project as % of the total cost @ 25%
7.5 Financial Assistance required:
7.5.1 Rupee Loan
7.5.2 Foreign currency Loan
7.5.3 Working Capital Term Loan
7.5.4 Other forms of assistance (e.g., LCs guarantees, etc.)
7.6 Repayment period required years and Moratorium Period (if required)
8 FUTURE PROJECTIONS
Please furnish:
8.1 Projected profitability as per Annexure VII
8.2 Project cash flow statement as per Annexure VIII
8.3 Projected Balance Sheet as per Annexure IX
8.4 Working Capital Requirements as per Annexure X
9 DETAILS OF SECURITIES OFFERED FOR THE PROPOSED ASSISTANCE
9.1 Primary:
9.2 Collateral [Give full details like nature (residential/industrial/commercial) and address of
the property, area, name of the owner, cost/market value, freehold/leasehold, whether
charged to any other bank, tenancy, etc.]
9.3 Details of guarantor(s). Please furnish Net worth Statements in the format enclosed at
Annexure III separately for each guarantor.
9.3.1 Name(s)
9.3.2 Residential Address(es)
9.3.3 Occupation(s) (If in service, name and address of his/her employer)
9.3.4 Details of any similar guarantee, if any, given to other institutions
10 OTHER DETAILS
10.1 Whether any Government enquiry, proceedings or prosecution has been instituted
against the unit or its proprietor/partners/ promoters/directors for any offences? If so,
please give details
I/We certify that all information furnished by me/us is true; that I/We have no borrowing
arrangement for the unit with any Bank except as indicated in the application; that there
is no overdues/statutory dues against me/us/promoters except as indicated in the
application; that no legal action has been/is being taken against me/us/promoters that
I/We shall furnish all other information that may be required by you in connection with
my/our application; that this may also be exchanged by you with any agency you may
deem fit; and you, your representatives, representatives of the Reserve Bank of India
or any other agency as authorized by you, may, at any time, inspect/verify my/our
assets, books of accounts, etc. in our factory/business premises as given above.
Annexure – I
No. of working days in a month: No. of shifts in a day: No. of hours per shift:
3.1 Details of Existing Fixed Assets
(a) 1. Location
2. Area (in sq. ft./sq. mt.)
3. Whether Freehold land or Leasehold
4. Purchase Price of Land, if owned
5. Rent in case of leased Land
6. Terms of Lease
(b) Building
1. Whether Owned or Leased Own Building
2. Purchase price of Building, if owned
3. Rent in Case of Leased/Rented Premises
4. Terms of lease
5. Building details
Structure Type of Area Actual Cost Date of Erection
construction (in sq.m) (in ` lakh)
Imported
(d) In case the assets have been revalued or written up at any
time during the existence of the unit, furnish full details of
such revaluation together with the reason therefore
3.2 Whether existing assets fully insured?
4 Past Performance
(` lakhs)
Particulars Last Year Last but One Year Last but Two Year
Capacity utilization (%)
Turnover – Domestic
– Exports
Net Profit
Net Worth
(Please enclose audited balance sheet for last three years)
4.1 Monthly turnover for last twelve months
5 Financial Arrangement: Sole Banking/Consortium/Multiple Banking
Sole Banking
5.1 Details of Existing Credit Facilities (Please enclose copies of sanction letters)
(` in lakhs)
Name and Nature Amt Rate of Amount Amount Security
address of of sanctioned Interest O/S as on Overdue, if (including
Bank/FI facility (date of any collateral, if
____
sanction) any)
Place:
Date: Signature
5
Sub-total
TOTAL
D. Other Assets
S. Details Amount Long term/Short term
No. (` Lakh)
TOTAL
E. Secured/Unsecured Borrowings from
S. Name of the Nature of Borrowing (long Purpose Amount Amount Nature of
No. Lender term/short term) outstanding overdue, security
(` Lakh) if any offered
(` Lakh)
Banks/Financial Institutions/Finance Companies
-
Sub-total
Associate/Sister/Group Concern
-
Sub-total
Others
-
Sub-total
TOTAL
F. Any Other Liability
S. Details Amount (` Lakh) Long term/Short term
No
-
TOTAL
G. Networth [A + B + C + D – E – F]:
I, _______________, Son of _______________, certify that the contents of this statement are
true and correct to the best of my knowledge and belief.
Place:
Date: Signature
Annexure – IV
2 Address:
3 Name(s) of Proprietor/Partners/
Promoters/Directors:
4 Past Performance (please enclose copies of audited balance sheet for last three years)
[` lakh]
Particulars Last Year Last But One Year Last But Two Year
Turnover – Domestic
– Exports
Net Profit
Net Worth
[` lakh]
Name and Nature of Amt sanctioned Rate of Amount O/S as| Amount
address of facility (date of sanction) Interest on _______ Overdue,
Bank/FI if any
Annexure – V
Please 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,
fees/royalties payable and the manner in which payable, etc.
2. Technical Consultants:
Please furnish full details of arrangement proposed to be made for obtaining technical
advice and services needed for the implementation of the project, Particulars of the
Consultants like name and address of the consultants, fees payable and the manner in
which payable, scope of work assigned to them, organizational set-up, bio data of senior
personnel, names of directors/partners, particulars of work done in the past and work on
hand.
Annexure – VI
Details of Building, Plant and Machinery and Miscellaneous Fixed Assets
Proposed in the Project
1 Particulars of building proposed to be constructed
Sr. Description Type of Built-up area (in meters) Total floor Rate of Estimated Lump sum
No. of each construc- area construction cost of each amount (in
building tion Length Breadth Height bldg case not
in sq. m. per sq. m.
(in `) (` Lakh) calcula-ted)
(` lakh)
Architect’s
fees
Others
(specify)
– Imported
– Indigenous
– Imported
Annexure – IX
PROJECTED BALANCE SHEET
[` lakh]
1st 2nd 3rd 4th 5th 6th 7th
Year Year Year Year Year Year Year
A. LIABILITIES
1 Equity Share Capital
2 Reserve and Surplus
Net Worth
3 Unsecured Loans
4 Term Loans
5 Current Liabilities
Total Liabilities
B. ASSETS
1 Net Block
2 Investment (ONCA)
3 Intangible Assets
4 Current Assets
a Inventories
b Sundry Debtors
c Cash and Bank
Balance
d Other Current Assets
Total Assets
Annexure - XI
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Summary
PPT
MCQ
Video1
Video2
Working Capital Finance
Chapter
Objectives
After studying this chapter, you should be able to:
⚫ Learn about Working Capital Techniques to find the optional level of Working Capital.
Structure:
10.1 Introduction
10.5 Working Capital Management Techniques for Finding Optimal Level of Working Capital
10.8 Summary
10.1 INTRODUCTION
Working Capital is one of the most important components of business. Businesses cannot
think of functioning without sufficient working capital to meet their day-to-day needs. Insufficient
working capital amounts to a shortage of resources. Whereas, excessive working capital results in
increased cost for the business.
Thus, it is important to have an optimum quantity of working capital to run a business. This
means working capital should neither be more nor less than the amount actually required by the
business. Furthermore, you must evaluate the return on the number of funds invested in the
business in the form of working capital. Such a return should be at least equal to the return earned
by the business in case it invested funds in other avenues.
Many times, businesses fail not because of a lack of profits but because of insufficient funds
required to run its day-to-day operations. Thus, working capital management plays an important
part. This is because it greatly impacts the liquidity and profitability of the business. So you need to
ascertain the amount of working capital needed and the sources of financing such a capital. This is
to ensure that the working capital available is sufficient to meet the short term obligations of your
business.
Working capital financing is done by various modes such as trade credit, cash credit/bank
overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of credit,
factoring, commercial paper, inter-corporate deposits, etc.
Arrangement of working capital financing forms a major part of the day-to-day activities of a
finance manager. It is a very crucial activity and requires continuous attention because working
capital is the money which keeps the day-to-day business operations smooth. Without appropriate
and sufficient working capital financing, a firm may get into troubles. Insufficient working capital may
result into non-payment of certain dues on time. Inappropriate mode of financing would result in
loss of interest which directly hits the profits of the firm.
Working capital is defined as the excess of current assets over current liabilities. It forms a
part of the aggregate capital of the business. Now, a business needs working capital to fund its
short term obligations. Typically, firms with an optimum level of working capital indicate efficiency in
managing its operations. This further enables the firm to pay for its short-term dues and day-to-day
operational expenses.
So, let’s have a look at what forms current assets and current liabilities of a business in order
to understand the above equation.
Working capital refers to Current Assets and Current liabilities. Strictly, it is not a part of
project finance which deals with financing fixed assets. But working capital has to be dealt with
under project finance for two reasons:
1. The margin money for working capital has to be financed by long-term sources.
2. The record of industrial sickness establishes that many a unit flounders on the quagmire
of inadequate working capital. Industrial sickness ties up national resources and renders
waste the project loan as well as the equity of the promoter.
Current Assets
Current Assets are the assets of the business that can be easily converted into cash within a
year or normal operating cycle of the business, whichever is greater. These assets typically include:
⚫ Inventory
⚫ Accounts Receivable
⚫ Marketable Securities
⚫ Prepaid Expenses
Current Liabilities
Current Liabilities are the obligations of the business that are due within one operating cycle
or a year, whichever is greater. Such liabilities are paid off by either using the current assets of the
business or by creating other current liabilities. Therefore, Current Liabilities include:
⚫ Accounts Payable
⚫ Notes Payable
⚫ Accrued Liabilities
⚫ Unearned Revenues
Promoters have to make sure that adequate working capital to reach break-even point and
step up capacity utilization is available. It is essential that such estimates are available, and
resources are tied up to meet the working capital requirements of the project.
Net working capital is the difference between current assets and current liabilities and is a
measure of the company’s liquidity. A survey of large companies shows that almost 50% of total net
assets of all companies are devoted to current assets; and current liabilities constitute 59.1% of
total liabilities.
⚫ In the case of smaller companies, almost 63% of total net assets were devoted to current
assets.
⚫ In the case of medium companies, 55% of total assets were devoted to current assets.
⚫ In the case of large companies, 40% of total assets were devoted to current assets, and
current liabilities constituted almost 40% of total liabilities.
The working capital need of a business depends a great deal on its nature and size. Let’s
consider various types of businesses to understand how the nature of business impacts its working
capital requirements.
When it comes to trading firms, they require less amount of money to be invested in fixed
assets. However, a huge pool of funds needs to be invested in the form of working capital. On the
other hand, retail stores must keep a large quantity of inventory to meet the diversified and
continuous needs of its customers.
Similarly, the need for working capital in manufacturing firms varies between small to a
substantial amount. This working capital amount depends upon the type of business a firm is into.
Likewise, public utility firms require less working capital but invest heavily in fixed assets. This is
because they have cash sales only and supply services over products. Hence, they have fewer
funds blocked in current assets such as debtors and inventories.
Finally, the size of the business also impacts the working capital needs of the business. Firms
with large scale operations need more working capital as compared to smaller firms.
2. Business Cycle
Business cycle too has a significant impact on the working capital needs of a business. During
the boom phase of the business cycle, businesses typically tend to expand thus requiring additional
working capital. These periods of increased business activity require additional funds to meet the
time lag between collection and sales. Further, funds are also needed to purchase additional raw
material needed to produce additional goods for increased sales.
Not only that, but the peak period also to the increased prices of raw material and increased
wages. Thus, additional funds are needed to provide for such operational expenses.
In contrast, there is lesser demand leading to both the decline of production and sale of goods
during periods of depression. Thus, less amount of working capital is required by the business to
carry out its operational activities.
3. Production Cycle
Production cycle, also known as the operating cycle, is the time difference between the
conversion of raw materials into final products. This too impacts the working capital requirements of
a business to a greater extent.
Businesses with longer production cycles need more working capital to fund its operational
activities. Therefore, firms adopt various measures to reduce their production cycle in order to
minimize their working capital requirements.
4. Seasonal Fluctuations
There are certain businesses that are seasonal in nature. This means there is a high demand
for their goods during a specific period of the year. In such cases, inventory of raw material needs
to be purchased during a specific period of time. This is done so that goods are produced and are
offered for sale when they are needed.
Thus, the need for inventory increases during this period as compared to the other periods of
the year. Therefore, businesses need additional funds to purchase inventories during the specific
time of the year. As a result, the seasonality of business impacts the working capital requirements
of the business.
5. Operational Efficiency
⚫ Short production cycles that involve less time to convert raw material into finished goods
Thus, businesses with increased operational efficiency are required to invest a lesser amount
of funds in working capital. In contrast, businesses that have lesser operational efficiency need
more funds to be invested in working capital.
would buy a letter of credit and send it to the seller. Once the seller sends the goods as per
agreement, the bank would pay the seller and collect that money from buyer.
10.4.7 Factoring
Factoring is an arrangement whereby a business sells all or selected accounts payables to a
third party at a price lower than the realizable value of those accounts. The third party here is
known as the ‘factor’ who provides factoring services to business. The factor would not only provide
financing by purchasing the accounts but also collects the amount from the debtors. Factoring is of
two types – with recourse and without recourse. The credit risk of non-payment by the debtor is
borne by the business in case of with recourse and it is borne by the factor in case of without
recourse.
Some other sources of working capital financing used are inter-corporate deposits,
commercial paper, public deposits etc.
Working capital management techniques such as intersection of carrying cost and shortage
cost, working capital financing policy, cash budgeting, EOQ and JIT are applied to manage different
components of working capital like cash, inventories, debtors, financing of working capital etc.
These effective techniques mainly manage different components of current assets.
Working capital management techniques are very effective tools in managing the working
capital efficiently and effectively. Working capital is the difference between current assets and
current liabilities of a business. Major focus is on current assets because current liabilities arise due
to current assets only. Therefore, controlling the current assets can automatically control the current
liabilities. Now, current assets include Inventories, Sundry Debtors or Receivables, Loans and
Advances, Cash and Bank Balance.
All working capital management techniques attempt to find optimum level of working capital
because both excess and shortage of working capital involves cost to the business. Excess working
capital carries the ‘carrying cost’ or ‘interest cost’ on the capital lying unutilized. Shortage of working
capital carries ‘shortage cost’ which include disturbance in production plan, loss in revenue etc.
Finding the optimum level of working capital is the main goal or winning situation for any business
manager.
There are certain techniques used for finding the optimum level of working capital or
management of different items of working capital.
Carrying Cost
Shortage Cost
Here, the levels of current assets are optimum at the point where the shortage and carrying
costs are meeting or intersecting. At this point, the total cost, as we can see, is minimum and this is
why that level of current assets is considered to be optimal.
2. Long-term financing is used for permanent and some part of temporary WC. Remaining
part of temporary WC is financed through short-term financing as and when required.
3. Long-term financing is used for permanent and short-term financing for temporary WC.
These strategies should be chosen so as to match the maturity of source of finance with the
maturity of the asset.
1. EOQ: Economic Order Quantity (EOQ) model is a famous model for managing the
inventories. It helps the inventory manager know how to find the right quantity that should
be ordered considering other factors like cost of ordering, carrying costs, purchase price
and annual sales. The formula used for finding EOQ is as follows:
C – Carrying Cost
These are some important techniques discussed here. They are very effective in managing
working capital. Managing working capital means managing current assets. Current assets like
cash can be managed using cash budgeting; inventory can be managed using inventory techniques
like EOQ and JIT. Debtors and financing of working capital can be managed using appropriate
sources of finance.
Analysis of working capital is significant for both management and short-term creditors.
Management can assess the efficiency of the working capital employed in the business. Such an
analysis helps management to detect trends and initiate corrective measures. It helps the
shareholders and creditors to determine prospects of payment of dividend and interest. The
analysis of working capital helps in determining the ability of the company to repay its current debts
promptly, assess the effectiveness of management of working capital, adequacy of working capital
and to undertake credit rating. Analysis of working capital relates to an examination of circulation,
liquidity, level and structural aspects of working capital. In the analysis of working capital, the tools
used are ratio analysis and funds flow analysis of the company.
(b) Current Ratio: Current ratio serves a similar purpose and is frequently used. It is also
called working capital ratio. It is considered as an index of solvency of a company. It
indicates the ability of the company to meet its current obligations. Changes in current
ratio can, however, be misleading. If a company raises money through commercial paper
and invests the amount in marketable securities, net working capital is unaffected but the
current ratio changes.
Current ratio is computed by dividing the total current assets by current liabilities. The
result shows the number of times the current assets pay off the current liabilities.
Current assets
Current ratio = Current liabilities
(c) Quick (or Acid test) ratio: Another ratio which measures immediate solvency is the
current ratio. It includes assets which can be quickly or immediately converted to cash.
Such assets include only cash, marketable securities and bills customers have not yet
paid (receivables). Inventories are excluded because they cannot be sold at any thing
above fire-sale prices. The liquidity arises because finished goods cannot be sold for
more than production cost. Quick ratio is computed as:
Cash + Marketable securities + Receivables Current assets – Current liabilities
QR = =
Current liabilities Current liabilities
Liquid assets
=
Current liabilities
(d) Interval Measure: Sometimes, it may be useful to compare current assets to regular
cash outgoings of a company. The interval measure is calculated by:
Cash + Marketable securities + Receivable s
Average daily expenditure from operations
The interval expressed in number of days measures the ability of the company to finance
its daily expenditure with the current assets in its position even if it receives no further
cash.
1. Turnover of raw materials: This ratio shows the number of times the raw materials were
replaced during a year. It is obtained by dividing raw materials issued to the factory by
raw materials in ending inventory.
2. Turnover of stores and spares: This ratio shows utilization of funds in stores and
spares inventory. This ratio is obtained by dividing stores and spares consumed in a
fiscal year by the value of stock and spares at the end of the fiscal year.
The stores and spares inventory may be reduced to number of months stores and spares
inventory by dividing number of months in a year by the turnover of stores and spares
inventory. A higher turnover of stores and spares inventory is an indication of
management’s efforts to reduce investment in this component. On the other hand, a
falling turnover of stores and spares inventory may be taken to mean that excessive
working funds have been deployed in this component.
4. Turnover of finished goods: This ratio is computed by dividing the net sales by finished
goods inventory. The finished goods inventory may be reduced to number of months’
finished goods inventory by dividing number of months in a year by turnover of finished
goods inventory. A higher turnover of finished goods inventory indicates that a higher
level of sales has been attained with less investment in the finished goods inventory. A
falling turnover indicates that the investment in finished goods is increasing in relation to
sales.
5. Turnover of aggregate inventory: This ratio is obtained by dividing the net sales in a
year by the value of aggregate inventory at the end of the year. The aggregate inventory
of a business enterprise may be reduced to a number of months’ inventory by dividing
the number of months in the year by ratio of turnover of aggregate inventory.
10.6.4 Work-in-process
Work-in-process represents investment by firm. It is the amount of semi-finished products
currently lying on the factory floor. In the traditional view, inventories including WIP are considered
as assets and inventory build-up is seen as value added. They are also considered as a buffer
against uncertainties arising out of delayed supplies, machine breakdowns, absenteeism and
uncertain customer orders. The desire to improve utilization of expensive equipment also
contributed to building up WIP.
In recent times, inventory is considered evil and evidence of poor design, poor forecasting,
poor coordination and poor operation of the manufacturing system. The current trend is to produce
times as required. WIP should be equal to the sum obtained by multiplying the rate at which parts
flow through the factory with the length of time parts spent in the factory.
The higher turnover of inventory quickens the flow of funds from inventory. A low turnover
ratio indicates an over-investment in inventory in relation to sales.
(a) Cash turnover ratio: This ratio shows the relationship between cash balance plus other
liquid assets and operating costs and expenses. It shows the adequacy of liquid assets
to meet current operating needs. A high turnover of cash indicates an insufficiency of
cash to provide for emergencies. A low turnover of cash shows that an excess cash
balance is lying with the enterprise.
(b) Current assets turnover ratio: This ratio measures the turnover of total current assets
used in business operations. The ratio is obtained by dividing the cost of goods sold by
total current assets. This ratio may be linked with the profitability of an enterprise. For this
purpose, two other computations are done. First, net income is divided into current
assets which gives the rate of profit on average current assets. Second, the rate of profit
of current assets is divided by the turnover of current assets which gives the rate of profit
per turnover of current assets.
The lower turnover and profitability of current assets indicate utilization of working capital
and reverse is the case with a higher turnover and profitability.
(c) Working capital turnover ratio: This ratio is obtained by dividing net sales by working
capital. This ratio indicates the efficiency with which the working capital has been used in
the company. The higher turnover of working capital represents lower investment in it
and greater profitability. But a very high turnover of working capital may also indicate the
efficient utilization of working capital in the enterprise.
(a) Sales to Total Assets: The ratio shows how hard the company’s assets are being to put
to use. The ratio is represented by:
Sales
Average total assets
This reveals how close a company is operating to capacity. A high ratio would imply that
sales cannot be stepped up without an increase in capital invested in the company.
(b) Sales to Net Working Capital: The ratio would help focus on how efficient working
capital is being used. The ratio is represented by:
Sales
Average net working capital
(c) Net Profit Margin (NPM): The ratio helps in establishing the proportion of sales that
finds its way into profits. It is computed by:
Earnings before interest and taxes (pa) – Tax
NPM =
Sales
(d) Inventory turnover: The ratio which tells about the rate at which companies turnover
their inventories is obtained by:
Cost of goods
Inventory Turnover =
Average inventory
(e) Return on Total Assets: The ratio of income (earnings before interest and after taxes)
to total assets (original cost – depreciation) is used to measure the performance of a
company.
EBIT – Tax
Return on Total Assets =
Average total assets (average of assets at the
beginning and end of the year)
(f) Payout ratio: The ratio measures the earnings paid out as dividends.
Dividend per share
Payout ratio =
Earning per share
Companies follow a low average payout ratio if earnings are not stable. Earnings not paid
out are retained in business.
(a) Price earning ratio (P/E ratio): It is a common measure of the investors’ estimate of the
company. It is obtained by:
Stock price
P/E ratio =
Earnings per share
The stock price is arrived at by assuming that dividends are at steady rate.
DIV1
Po =
r–g
Where, DIV1 measures the expected dividend next year, r is the required rate of return
and g is the expected rate of dividend growth.
To find the P/E ratio, divide current stock price formula with expected earnings per share:
Po DIV1 1
= ×
EPS1 EPS1 r – g
Normally, P/E ratios are in mid-teens. In the Indian stock market, PE ratios are quite high.
High P/E ratios normally indicate that:
⚫ The share has low risk and therefore investors accept a low prospective return (r);
⚫ The company is expected to achieve average growth while paying out a high
proportion of earnings (DIV1/EPS). But in the Indian context, high PE ratios are a
demand phenomenon. Excess demand for shares has driven up prices and high P/E
ratios have been registered.
(b) Dividend yield: Dividend yield measures dividends as a proportion of the share price.
Dividend yield per share
Dividend yield =
Share price
(c) Market to book ratio: The ratio of market price per share to book value per share
reveals the market worth of the company as compared to what past and present
shareholders have put into it. Book value per share is net worth (paid-up capital ÷ free
reserves) divided by the number of shares outstanding.
Stock price
Market to Book Ratio =
Book value per share
Market value (assets, debt and equity) to replacement cost or Tobin’s q. The ratio q is
obtained by:
Market value of assets
q=
Estimated replacemen t cost
Assets in the ratio include all assets, debt and equity; and replacement cost is current
cost estimated after adjusting historic cost for inflation. When capital equipment is worth
more than it costs to replace, q is greater than one and companies have an incentive to
invest; and when equipment is worth less than its replacement cost, q is less than one,
companies will stop investing. The merger route is preferred for acquisition of assets than
purchase new assets when q is less than 1. High market values may exist even when
existing assets are worth much more than their cost because investors believe that the
company has good opportunities.
The most important ratio tests in this regard are the amount of working capital in terms of
months’ cost of production or months’ average sales turnover. The results of these ratio tests when
compared with the norms for the industry indicates whether the size of working capital maintained
by the enterprise is excessive or adequate or inadequate to its requirements.
A comparison of working capital with other variables such as output and sales over a period of
time may also indicate the trend in the growth of working capital.
Funds flow analysis shows the sources and uses of funds of a company. This technique helps
to analyze changes in working capital components between two dates. A comparative analysis of
current assets and liabilities, as shown in the balance sheet at the beginning and the end of a year,
indicates changes in each type of current assets as well as the sources from which working capital
has been obtained. However, the technique of funds flow analysis fails to clarify the significance of
movements in the working capital structure.
Predict Projects Pvt. Ltd. has just started trading operations of an engineering product in last
year. It has applied to a Commercial Bank for Working Capital facility. A typical application for a
Working Capital Facility of ` 70 lakhs by M/s Predict Projects Pvt. Ltd. is enclosed herewith. Kindly
study it.
FORM III
Analysis of Balance Sheet
Audited Provisional Projected
Latest 1st Year 2nd Year
Current Liabilities
1 Short-term borrowings from banks (incl. bills purchased,
discounted and excess borrowings placed on repayment
basis)
10.8 SUMMARY
Working Capital is one of the most important components of business. Businesses cannot
think of functioning without sufficient working capital to meet their day-to-day needs. Insufficient
working capital amounts to a shortage of resources. Whereas excessive working capital results in
increased cost for the business.
Working Capital is the money which keeps the day-to-day business operations smooth. It
refers to Current Assets and Current Liabilities.
Working capital financing is done by various modes such as trade credit, cash credit/ bank
overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of credit,
factoring, commercial paper, inter-corporate deposits etc.
Working capital is defined as the excess of current assets over current liabilities. It forms a
part of the aggregate capital of the business. Now, a business needs working capital to fund its
short term obligations. Typically, firms with an optimum level of working capital indicate efficiency in
managing its operations. This further enables the firm to pay for its short-term dues and day-to-day
operational expenses.Therefore, working capital is a measure of business’ liquidity position,
operational efficiency, and short-term financial soundness.
Hence, working capital can be put into the equation: Working Capital = Current Assets –
Current Liabilities
The factors which determine working capital requirement can be Nature and Size of Business,
Business Cycle, production cycle, seasonal fluctuation and Operational efficiency.
The different types of working capital includes Trade credit, letter of credit, overdraft / cash
credit, bill discounting, working capital loan and factoring.
Working capital management techniques such as intersection of carrying cost and shortage
cost, working capital financing policy, cash budgeting, EOQ and JIT are applied to manage different
components of working capital like cash, inventories, debtors, financing of working capital etc.
These effective techniques mainly manage different components of current assets.
Analysis of working capital is carried out by various ratio analysis such as:
(i) Liquidity
Funds flow analysis shows the sources and uses of funds of a company.
2. What are the different kinds of Working Capital which a finance manager may tap into?
3. Discuss the various Working Capital Management Techniques for finding Optimal Level
of Working Capital.
4. Explain the various liquidity ratios of Working Capital. What is each one’s relevance?
5. Explain the various inventory turnover ratios. What is each one’s relevance?
1. The working capital management plays an important part in day to day functioning of the
company, because it greatly impacts the -------------------of the business. So you need to
ascertain the amount of working capital needed and the sources of financing such a
capital.
(a) Liquidity
(b) profitability
(d) Productivity
3. Working capital is the difference between current assets and current liabilities of a
business. Major focus is on --------------------- because current liabilities arise due to this
only and controlling of it can automatically control the current liabilities.
(a) Liquidity
(d) Profitability
4. The inventory turnover ratios show the ---------------------in different types of inventories.
5. Funds flow analysis shows the ----------------------of a company. This technique helps to
analyze changes in working capital components between two dates.
Answers:
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Summary
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Video1
Video2
Chapter – 11
11 PRIVATE EQUITY
Chapter
Objectives
After studying this chapter, you should be able to:
⚫ Get a brief overview on the Private Equity Market, its history, performance and trends.
Structure:
11.1 Introduction
11.6 Summary
11.1 INTRODUCTION
Many young companies are unable to raise capital in public equity markets because they are
not large enough to attract investor’s interests. A company having a very promising product or
service but not sufficient track record. This also holds true for companies that are in financial
distress. Such companies can get funding from Private Equity investments. Venture represents
financial investment in a risky proposition made in the hope of earning a high rate of return.
The private equity (PE) business attracts the best and brightest in corporate America,
including top performers from Fortune 500 companies and elite management consulting firms. Law
firms can also be recruiting grounds for private equity (PE) hires, as accounting and legal skills are
necessary to complete deals and transactions are highly sought after.
The fee structure for private-equity (PE) firms varies but typically consists of a management
and performance fee. A yearly management fee of 2% of assets and 20% of gross profits upon sale
of the company is common, though incentive structures can differ considerably.4
Given that a private-equity (PE) firm with $1 billion of assets under management(AUM) might
have no more than two dozen investment professionals, and that 20% of gross profits can generate
tens of millions of dollars in fees, it is easy to see why the industry attracts top talent.
The Private Equity Market is dominated by private equity companies that represent large
institutional investors. The private equity market is crucial for both start-up companies and
established publicly traded companies. For example, a public company in financial difficulty will
generally not be able to raise public equity or public debt.
Private equity companies invest private money in businesses they consider attractive. Private
equity companies are usually structured as partnerships, with general partners (GP) presiding over
limited partners. The partners tend to be high net-worth individuals, public and private pension
funds, endowments, foundations and sovereign wealth funds. According to PEI Media’s 2008
ranking of the top 50 private equity companies worldwide, the top four were United States-based.
These were The Carlyle Group, Goldman Sachs Principal Investment Area, TPG Capital, and
Kohlberg Kravis Roberts.
Private-equity (PE) firms have a range of investment preferences. Some are strict financiers
or passive investors wholly dependent on management to grow the company and generate returns.
Because sellers typically see this as a commoditized approach, other private-equity (PE) firms
consider themselves active investors. That is, they provide operational support to management to
help build and grow a better company.
Active private-equity (PE) firms may have an extensive contact list and C-level relationships,
such as CEOs and CFOs within a given industry, which can help increase revenue. They might also
be experts in realising operational efficiencies and synergies. If an investor can bring in something
special to a deal that will enhance the company's value over time, they are more likely to be viewed
favorably by sellers.
Investment banks compete with private-equity (PE) firms, also known as private equity funds,
to buy good companies and to finance nascent ones. Unsurprisingly, the largest investment-
banking entities such as Goldman Sachs (GS), JPMorgan Chase (JPM), and Citigroup (C) often
facilitate the largest deals.
In the case of private-equity (PE) firms, the funds they offer are only accessible to accredited
investors and may only allow a limited number of investors, while the fund's founders will usually
take a rather large stake in the firm as well.
11.2.1 History
From obscure beginnings as boutique investment houses, through the junk bond leveraged
buyout debacle of the 1980s, to the thousands in existence today, private equity companies have
become an important source of capital. According to the trade industry association, Private Equity
Growth Capital Council (PEGCC), in 2009, private equity companies raised close to $250 billion
and made more than 900 transactions with a total value over $76 billion.
11.2.2 Facts
Private equity companies typically manage funds on behalf of their investors. They look for
businesses with higher-than-average growth potential over the long term. They often provide senior
management direction to the companies in which they invest. This is especially true in cases of
majority control, because bigger returns mean bigger carried interest payouts for the GPs. Carried
interest is the portion of the funds that remains with the company after paying the limited partners
and other investors their paid-in capital plus a minimum rate of return, known as the hurdle rate,
and transaction expenses.
11.2.3 Strategies
In 2009, private equity companies invested mainly in five sectors: business services,
consumer products, healthcare, industrial products and services, and information technology.
The most common types of investment structures are leveraged buyouts, or LBOs; venture
capital; growth capital and turnaround capital. LBOs use both equity and borrow capital to invest in
companies, hence the term “leveraged”. Venture capital funds focus on new companies, mainly in
the technology, biotechnology and green energy sectors. Growth capital invests in mature
companies deemed to be undervalued. Turnaround capital, also known as distressed capital or
vulture funds, looks for financially troubled companies to buy inexpensively; potentially restructured,
often through layoffs and asset sales; and then sold for a healthy profit.
11.2.4 Performance
It is difficult, from the outside, to judge the performance of a private equity firm. Unlike public
companies that trade on the stock exchanges, subject to regulatory disclosure requirements,
private equity companies do not typically disclose their financial statements. Private equity
companies that trade publicly, like Kohlberg Kravis Roberts, do provide information on realized and
unrealized profits from their investments. The realized profits are significant. According to PEGCC,
through 2009, private equity companies have returned close to $400 billion in cumulative net profits
to their investors.
11.2.5 Trends
With consolidation, private equity companies are getting bigger, investing larger amounts all
over the world, and employing multiple investment strategies. After the financial crisis of 2008, the
lavish payouts and secretive nature of these companies were under the media and regulatory
spotlight. Disclosure requirements and other regulations are under consideration in the US and
Europe, with some already in place.
1. ICICI Venture
ICICI Venture Fund management, headquartered in Mumbai, has raised funds to the
tune of $3 billion over the last decade. As one of the largest funds, it is a subsidiary of
ICICI bank, the largest private sector bank in India.
2. Chrys Capital
This New Delhi-based fund, launched in 1999, has raised $1.9 billion in private equity
funds. It has made more than 45 investments since its inception, according its website.
3. Sequoia Capital
Sequoia Capital India, formerly known as WestBridge Capital Partners, mainly invests in
consumer, energy and financial services in India. Headquartered in Bangalore, it focuses
on investment in the seed, early and growth stages of industry.
India Value Fund, a Mumbai-based fund, was established in 1999 and boasts more than
$1.4 billion distributed across four funds. It was formerly known as GW Capital.
This company stands as one of the early investors in Indian private equity, launched in
1997. Kotak pumped $1.4 billion into the Indian market mainly in the infrastructure and
health care sectors.
Established in 1998, Gurgaon-based BPEP has over $3 billion invested mainly in the
American, Latin and Indian markets. It generally invests in manufacturing,
pharmaceutical and information technology.
7. Ascent Capital
Ascent Capital, as one of India largest private equity funds, has invested $600 million
across three funds, helping more than 40 entrepreneurs access its funds.
8. CX Partners
9. Everstone Capital
Everstone Capital, the equity subsidiary of Future Holdings, raised its first fund in 2006,
for $425 million, and set its sights on a $550-million fund in 2010, reports AltAssets.com.
Everstone invested in engineering companies, a renowned children clothing producer
and other industries.
Venture Capital is part of the private equity market. In return for the venture capital,
companies have to offer a share in their ownership. Venture capital investments can be in different
stages of business. However, it is usually made in the early stages because those investments are
more likely to yield high returns. To compensate for some likely venture failures, high returns on
some of these investments are required for venture capitalists to be willing to take on the risks
associated with these high growth businesses.
Private-equity (PE) firms are able to take significant stakes in such companies in the hopes
that the target will evolve into a powerhouse in its growing industry. Additionally, by guiding the
target’s often inexperienced management along the way, private-equity (PE) firms add value to the
firm in a less quantifiable manner as well.
Let us understand first the differences between venture capital and private equity
VC and PE firms both raise pools of capital from accredited investors known as limited
partners (LPs), and they both do so in order to invest in privately owned companies. Their goals are
the same: to increase the value of the businesses they invest in and then sell them—or their equity
stake (aka ownership) in them—for a profit.
VC vs. PE
Venture capital investment firms fund and mentor startups. These young, often tech-focused
companies are growing rapidly, and VC firms will provide funding in exchange for a minority stake
of equity—less than 50% ownership—in those businesses.
PE vs. VC
By contrast, private equity investment firms often take a majority stake—50% ownership or
more—in mature companies operating in traditional industries. PE firms usually invest in
established businesses that are deteriorating because of inefficiencies. The assumption is that once
those inefficiencies are corrected, the businesses could become profitable. This is changing a little
as PE firms increasingly buy out VC-backed tech companies.
To raise the money needed to invest in companies, VC firms open a fund and ask for
commitments from limited partners. Using this process, they're able to draw from a pool of money
that they invest into promising private companies with high growth potential. As companies grow,
they go through different stages of the venture capital ecosystem. VC firms usually focus on one or
two VC funding stages, which impacts how they invest.
If a company a VC firm has invested in is successfully acquired or goes public, the firm makes
a profit and distributes returns to the limited partners that invested in its fund. The firm could also
make a profit by selling some of its shares to another investor in what’s called the secondary
market.
Venture capitalists invest in different stages of the company’s life cycle. The various stages are:
1. Seed-money stage
2. Start-up
PE
3. First-round funding
VC
4. Second-round funding
Angel
5. Third-round funding
1. Seed-money Stage
Seed money is the initial equity capital needed to start a new business. The initial capital
money is used to develop a product or prove a concept. It is usually a small amount of financing
and does not include marketing.
2. Start-up
Financing for companies that were started within the past year. The funds usually include
marketing and product development expenditures.
3. First-round Funding
After the company has spent the start-up funds, additional capital is provided to begin sales
and manufacturing.
4. Second-round Funding
Funds provided for the working capital needs of a company whose product is selling but still
losing money.
5. Third-round Funding
Financing for a company that is at least breaking even and is considering expansion. This is
also known as mezzanine funding.
6. Fourth-round Funding
Funds provided to companies that are likely to go public within half a year. This is also called
bridge financing.
An IPO is the next stage after venture capital financing. As mentioned before, venture capital
funds are significant players in the IPOs. It is the norm that venture capitalists do not sell their
shares when one of their portfolio companies goes through an IPO. Instead, they usually sell out in
subsequent public offerings.
The maximum number of companies need seed capital. Then as they progressively move up
the pyramid, number of companies requiring funding reduces. And they move up the pyramid, the
investment size increases.
An informal survey shows that most of the companies die off in the seed financing stage itself.
Current trends indicate that only 27% of companies that are seed funded actually raise the required
angel round. 16% of the companies shut down at the Seed stage.
Venture Capitalists invest in private businesses to make profit. They attract most of their
financial resources from sophisticated institutional investors. Venture capitalists try to create value
by monitoring the companies and making sound business decisions about follow-on (staged)
investments. Venture capital financing can be thought of as a joint product of both investment
capital and consulting services. The venture capital process can be analyzed in following five steps.
Many young businesses are interested in raising capital from the limited supply of private
equity investors. These investors are interested in specific types of businesses that include
biotechnology, internet and technology. In order for any of the companies to be able to attract these
investors, their management must have a vision for converting their private company into a public
company in the future.
Once the private equity investors are interested in a particular company, they will attempt to
estimate its value. In addition to the conventional valuation methods, venture capitalists use another
method to value private companies. In this method, the future earnings of the company, i.e., when it
is expected to go public, are forecasted. With the use of price-earnings multiples for similar public
traded companies, the value of this particular company is assessed at the time of the contemplated
IPO. This value is called the exit, or terminal value because the IPO is an exit strategy for venture
capitalists.
In structuring the deal, private equity investors and the owners of the company negotiate
through the ownership proportion. Private equity investors need to determine what proportion of the
company they want in return for their investment. On the other hand, the company needs to
determine the ownership proportion that they are willing to give up in return for the capital.
After the investment, it is usual for the private equity investors to have an active role in the
investment of the company. Sometimes, they also seek out new business opportunities and try to
raise more capital for the company.
Step 5: Exit
Private equity investors and venture capitalists invest in private businesses because they are
interested in high return on their investment. There are different ways of realizing targeted returns
such as an IPO which can be an exit strategy for venture capitalists.
However, as mentioned before, these companies usually do not sell their shares at the IPO,
but after the securities have traded for some time. Alternatively, investors may exit by selling the
business to another company. Quite often, private equity investors prefer to liquidate a company, if
it is not generating sufficiently high returns.
1. Use simple and clear language. Avoid bombastic presentation and technical language
2. Focus on four basic elements, viz., people, product, market, and competition.
3. Give projections for about two to five years with emphasis on cash flows.
5. Convince them that the management team is talented, experienced, committed and
determined.
MUMBAI: Three private equity backers of India’s first voice-based search company JustDial
— Sequoia Capital, Tiger Global and SAIF Partners — will at least part sell their shares worth $600
million as the capital markets regulator-mandated lock-in period gets over this week.
Investment bankers have held talks with the PE funds for a block trade on bourses, which
would see them making one of the heftiest returns in Indian start-up investing.
The JustDial share price ended at ` 1,428 on Thursday, boosting the company’s market value
to $1.7 billion, or ` 10,000 crore. Thursday’s stock price was more than double the listing price of `
530 a year ago.
NEW DELHI: Led by the booming e-commerce sector, private equity investments in India
surged over 17% with deals worth $11.49 billion and the outlook for next year also remains positive,
says a PwC report.
According to the report by the consultancy firm, PE investments in India this year till
December 22 stood at $11,492 million (excluding real estate deals) across 459 deals.
In 2013, PE investments stood at $9,781 million by way of 469 deals.
The higher level of PE investments was largely driven by increased interest in e-commerce,
which has so far seen investments of over $2,474 million in 48 deals as against $553 million last
year (in 36 deals).
Inclusive of e-commerce, the information technology and IT-enabled Services (IT/ITeS) sector
attracted $4,827 million in PE investments, more than double the value it had attracted in 2013.
A sector-wise analysis shows that financial service was another sector which saw a spate of
deals, attracting $1,775 million of PE investments. It was followed by energy (mostly renewables).
Engineering and construction together witnessed $1531 million of PE investments.
Manufacturing and healthcare put in disappointing performances and saw decline of 62% and
33% respectively at $459 million and $868 million respectively, the report said.
Going forward, “the outlook for PE in 2015 is positive. In part, this could be attributed to the
anticipated higher levels of growth owing to the economic reforms on the anvil, it is in part also
attributed to the exit activity from the funds of 2006-08 vintage”, PwC said.
Anticipated higher growth rates and a lower interest rate regime are likely to create
investment opportunities in the consumer sector, it added.
Healthcare and Life Sciences are expected to continue to receive significant PE attention.
Financial Services is also expected to continue to see significant interest on both book-based and
fee-based businesses.
E-commerce is expected to continue to generate interest, as would the IT sector; high growth
levels in large developed markets like the US will help this trend, it said.
“Private equity investors are also going to be watching the impact of key reforms such as the
introduction of the Goods and Services Tax regime that said, there are some concerns about the
ability of the Government to speed up reforms, and this would be key to the activity levels in 2015,”
the PwC report said.
Example:
Copyright © Welingkar 245
Chapter – 11
Let us explore a scenario where you need to raise capital for your business.
You run a biotechnology start-up Predict Projects Pvt. Ltd. You are looking for venture capital
funding. Let us perform the steps in the venture capital process to raise capital for your business. At
every step, you need to make critical decisions that will determine whether you move to the next
step.
The companies, individuals and events referred to herein are fictional. Any similarity to actual
companies, individuals and events is purely coincidental.
The first step is getting the attention of the private equity investors. Your management team
has narrowed down private equity investors, Vertical Ventures to present your company’s strategy.
Vertical Ventures is a top venture capitalist in the biotechnology space.
1. Convey your vision of converting Predict Projects Pvt. Ltd. into a public limited company
in 3 years.
3. Emphasize Predict Projects Pvt. Ltd.’s improved performance since it was formed two
years ago.
4. Explain in detail how Predict Projects Pvt. Ltd. plans to spend the expected venture
capital.
Predict Projects Pvt. Ltd. into a public company in 3 years? You are right. To attract investors,
the management team must have a vision of converting their private company into a public
company in the future. This focus will get Ventura interested in your company.
Vertical Ventures is convinced about Predict Projects Pvt. Ltd.’s plans to go public in 3 years.
Now, Vertical venture needs to estimate the value of the company. Predict Projects Pvt. Ltd.’s net
income in three years is expected to be US$ 6 million. The price to earnings ratio of similarly
publicly traded companies is 20. The exit value is equal to price to earnings ratio multiplied by Net
Income. This is equal to 120 and is calculated as 20 multiplied by 6. The exit value is estimated as
US$ 120 million three years from now. This value is discounted back to the present at a rate called
target rate of return.
Given the risk that the venture capitalists are exposed to and assuming a return of 25%, what
is the discounted exit value estimated by Vertical Ventures?
Hint: The discounted exit value is computed as the estimated exit value divided by the
summation of 1 and the target rate of return to the power of number of periods.
1. US$ 80000
2. US$ 32 million
Having reviewed the options, did you think the correct answer is option 3, US$ 61.44 million.
That is correct. Vertical Ventures needs to calculate the target rate of return, which is set at a much
higher level than the cost of equity for the company. Assuming a 25% return, the discounted exit
value is US$ 61.44 million.
The third step is structuring the deal. Vertical Ventures has agreed to invest US$ 15 million.
The ownership proportion of Vertical Ventures is estimated as 24.4% of the firm.
Which one component needs to be considered while determining the ownership proportion?
1. The ownership proportion depends on the capital invested and the estimated value of the
company.
3. Ownership proportion depends only upon the capital invested by the company.
4. Ownership proportion depends upon the discretion of the company looking for funds.
Did you identify the correct answer as option 1. The ownership proportion depends on the
capital invested and the estimated value of the company? You are right again. Ownership
proportion depends on the capital invested and the estimated value of the company. The ownership
proportion is equal to capital invested by estimated value. The ownership proportion is equal to
capital invested by estimate value. The ownership proportion of Vertical Ventures is equal to 15
divided by 61.44, which is equal to 24.4% of Predict Projects Pvt. Ltd.
The fourth step is the post-deal management. Vertical Ventures places two people on the
board to monitor the operations of Predict Projects Pvt. Ltd.
Sample Term Sheets are enclosed herewith for your reference. Kindly study them. Find out
the terms which are good and flexible and ones that can create difficulties in future.
THE TERMS SET FORTH BELOW ARE SOLELY FOR THE PURPOSE OF OUTLINING
THOSE TERMS PURSUANT TO WHICH A DEFINITIVE AGREEMENT MAY BE ENTERED INTO
AND DO NOT AT THIS TIME CONSTITUTE A BINDING CONTRACT, EXCEPT THAT BY
ACCEPTING THESE TERMS THE COMPANY AGREES THAT FOR A PERIOD OF 30 DAYS
FOLLOWING THE DATE OF SIGNATURE, PROVIDED THAT THE PARTIES CONTINUE TO
NEGOTIATE TO CONCLUDE AN INVESTMENT, THEY WILL NOT NEGOTIATE OR ENTER
INTO DISCUSSION WITH ANY OTHER INVESTORS OR GROUP OF INVESTORS REGARDING
THIS “SERIES X” ROUND OF INVESTMENT. AN INVESTMENT IN THE COMPANY IS
CONTINGENT UPON, AMONG OTHER THINGS, COMPLETION OF DUE DILIGENCE AND THE
NEGOTIATION AND EXECUTION OF A SATISFACTORY STOCK PURCHASE AGREEMENT.
II. Investor: Venture Capital Partners, LLC or its affiliates (“VC”) and other investors
acceptable to the Company and VC (collectively the “Investors”)
VI. Post Investment Ownership: The company would be capitalized such that post
investment ownership at closing would be as follows:
VC [ ]%
Option Pool [ ]%
VII. Closing Date: Closing for the investment would be on or before __________, provided
that all requirements for the closing have been met or expressly waived in writing by the investors.
VIII. Board Representation: The Board of Directors will include a total of five (5) people.
Holders of Series X Convertible Preferred Stock are entitled to two (2) representatives on the
Company’s Board of Directors. Common Shareholders will have three (3) designees to the board,
one of which must be the CEO of the Company. Board of Directors meetings would be scheduled
on a monthly basis until such time as the Board of Directors votes to schedule them less frequently.
VC’s representative would be appointed to all Board Committees (including the compensation
committee), each of which would consist of three (3) members. The Company would reimburse each
Director’s reasonable expenses incurred in attending the board meetings or any other activities (e.g.,
meetings, trade shows) which are required and/or requested and that involve expenses.
IX. Proprietary Information and Inventions Agreement: Each officer, director, and
employee of the Company shall have entered into a proprietary information and inventions
agreement in a form reasonably acceptable to the Company and the Investors. Each Founder and
other key technical employee shall have executed an assignment of inventions acceptable to the
Company and Investors.
X. Dividends: An [ ]% annual dividend would accrue as of the closing date to holders of the
Series X Convertible Preferred. Accrued dividends would be payable:
(c) upon redemption of the Series X Preferred. Upon an automatic conversion, accrued but
unpaid dividends would be forfeited.
No dividends may be declared and/or paid on the Common Stock until all dividends have
been paid in full on the Convertible Preferred Stock. The Convertible Preferred Stock would also
participate pari passu in any dividends declared on Common Stock. Dividends will cease to accrue
in the event that the investor converts its holdings to Common Stock.
XI. Liquidation Preference: In the event of any liquidation or winding up of the Company, the
Series X Preferred will be entitled to receive in preference to the holders of Common Stock an
amount per share equal to their Original Purchase Price plus all accrued but unpaid dividends
(if any).
The Series X Preferred will be participating so that after payments of the Original Purchase
Price and all accrued dividends to the Preferred, the remaining assets shall be distributed pro-rata
to all shareholders on a common equivalent basis.
A merger, acquisition or sale of substantially all of the assets of the Company in which the
shareholders of the Company do not own a majority of the outstanding shares of the surviving
corporation shall be deemed a liquidation of the Company.
XII. Conversion: The Preferred will have the right to convert Preferred shares at the option of
the holder, at any time, into shares of Common Stock at an initial conversion rate of 1-to-1. The
conversion rate shall be subject from time to time to anti-dilution adjustments as described below.
XIII. Automatic Conversion: The Series X Preferred would be automatically converted into
Common Stock, at the then applicable conversion price, upon the sale of the Company’s Common
Stock in an initial public offering (“Public Offering”) at a price equal to or exceeding [ ] times the
Series X Preferred original purchase price in an offering which, after deduction for underwriter
commissions and expenses related to the gross proceeds, is not less than [ ].
XIV. Antidilution Provisions: Proportional anti-dilution protection for stock splits, stock
dividends, combinations, recapitalization, etc. The conversion price of the Preferred shall be subject
to adjustment to prevent dilution, on a “weighted average” basis, in the event that the Company
issues additional shares of Common or Common equivalents (other than reserved employee
shares) at a purchase price less than the applicable conversion price.
XV. Voting Rights: The Preferred will have a right to that number of votes equal to the
number of shares of Common Stock issuable upon conversion of the Preferred.
XVI. Restrictions and Limitations: Consent of the Series X Preferred, voting as a separate
class would be required for any actions which:
(i) alter or change the rights, preferences or privileges of the Series X Preferred.
(iii) increase the authorized number of shares of any other class of Preferred Stock;
(iv) create any new class or series of stock, which has preference over or is on parity with the
Series X Preferred.
(vi) involve a repurchase or other acquisition of shares of the Company’s stock other than
pursuant to redemption provisions described below under “Redemption”; or
XVII. Redemption: After five (5) years and at the request of the holders of the Series X
Preferred, all or part of the Series X Preferred shares may be redeemed at 110% of the Series X
purchase price plus all accrued but unpaid dividends.
(iii) If not already in place, the Company would obtain employment agreements with key
employees, which would include satisfactory (to Investor) non-compete and non-
disclosure language.
1. If, at any time after the Issuer’s initial public offering (but not within 6 months of the
effective date of a registration), Investors holding at least 51% of the Common issued or
issuable upon conversion of the Preferred request that the Issuer file a Registration
Statement covering at least 20% of the Common issued or issuable upon conversion of
the Preferred (or any lesser percentage if the anticipated aggregate offering price would
exceed $[ ]), the Issuer will be obligated to cause such share to be registered. The Issuer
will not be obligated to effect more than two registrations (other than on Form S-3 under
these demand right provisions.
5. Transfer of Rights: The registration rights may be transferred provided that the
Company is given written notice thereof and provided that the transfer (a) is in connection
with a transfer of at least 20% of the securities of the transferor, (b) involves a transfer of
at least 100,000 shares, or (c) is to constituent partners of shareholders who agree to act
through a single representative.
6. Other Provisions: Other provisions shall be contained in the Investor Rights Agreement
with respect to registration rights as are reasonable, including cross-indemnification, the
period of time in which the Registration Statement shall be kept effective, standard
standoff provisions, underwriting arrangements and the ability of the Company to delay
demand registrations for up to 90 days (S-3 Registrations for up to 60 days).
XX. Right of First Offer: The Preferred shall have the right in the event the Company
proposes an equity offering of any amount to any person or entity (other than for a strategic
corporate partner, employee stock grant, equipment financing, acquisition of another company,
shares offered to the public pursuant to an underwritten public offering, or other conventional
exclusion) to purchase up to [ ]% of such shares.
The Company has an obligation to notify the Preferred of any proposed equity offering of any
amount.
If the Preferred does not respond within 15 days of being notified of such an offering, or
decline to purchase all of such securities, then that portion which is not purchased may be offered
to other parties on terms no less favourable to the Company for a period of 120 days. Such right of
first offer will terminate upon an underwritten public offering of shares of the Company.
In addition, the Company will grant the Preferred any rights of first refusal or registration rights
granted to subsequent purchasers of the Company’s equity securities to the extent that such
subsequent rights are superior, in good faith judgment of the Board, to those granted in connection
with this transaction.
XXI. Right of Co-Sale: The Company, the Preferred and the Founders will enter into a
co-sale agreement pursuant to which any Founder who proposes to sell all or a portion of his
shares to a third party, will offer the Preferred the right to participate in such sale on a pro rata basis
or to exercise a right of first refusal on the same basis (subject to customary exclusions for up to
15% of the stock, gifts, pledges, etc.). The agreement will terminate on the earlier of an IPO or
fifteen (15) years from the close of this financing.
XXII. Use of Proceeds: The proceeds from the sale of the Preferred will be used solely for
general corporate purposes.
XXIII. Reporting Covenants: The Company would furnish to the Investor the following:
(i) Monthly Reports: Within 20 days following the end of each month, an income
statement, cash flow and balance sheet for the prior monthly period. Statements would
include year-to-date figures compared to budgets, with variances delineated.
(ii) Annual Financial Statements: Within 90 days following the end of the fiscal year, an
unqualified audit, together with a copy of the auditor’s letter to management, from a Big
Five accounting company or equivalent, which company would be approved by the
Investor.
(iii) Audit: In the event, the Company fails to provide monthly reports and/or financial
statements in accordance with the foregoing, Investor would have the authority, at the
Company’s expense, to request an audit by an accounting company of its choice, such
that statements are produced to the satisfaction of the Investor.
(iv) Annual Budget: At least 30 days before the end of each fiscal year, a budget, including
projected income statement, cash flow and balance sheet, on a monthly basis for the
ensuing fiscal year, together with underlying assumptions and a brief qualitative
description of the company’s plan by the Chief Executive Officer in support of that
budget.
(v) Non-compliance: Within 10 days after the discovery of any default in the terms of the
stock purchase agreement, or of any other material adverse event, a statement outlining
such default or event, and management’s proposed response.
XXIV. Purchase Agreement: The purchase of the Company’s Series X Preferred Stock
would be made pursuant to a Series X Convertible Preferred Stock Purchase Agreement drafted by
counsel to the Investor, which would be mutually agreeable to the Company, and the Investor. This
agreement would contain, among other things, appropriate representations and warranties of the
Company, covenants of the Company reflecting the provisions set forth herein and other typical
covenants, and appropriate conditions of closing, including among other things, qualification of the
shares under applicable Blue-Sky laws, the filing of a certificate of amendment to the Company’s
charter to authorize the Series X Preferred, and an opinion of counsel. Until the Purchase
Agreement is signed, there would not exist any binding obligation on the part of either party to
consummate the transaction. This Summary of Terms does not constitute a contractual
commitment of the Company or the Investor or an obligation of either party to negotiate with the
other.
XXV. Other: The Company would pay legal expenses incurred by the Investor at closing from
the proceeds of the investment. The investor would make all reasonable efforts to see that this
expense does not exceed $30,000. Once this term sheet is signed, the Company would accept
responsibility for legal fees incurred by the Investor if the transaction does not close up to the
amount set forth above.
XXVI. Exclusivity:
(i) Upon the acceptance hereof, the Company, its officers and shareholders agree not to
discuss the sale of assets or any equity or equity type securities, provide any information
to or close any such transaction with any other investor or prospective investor, except to
named entities mutually acceptable to Management and Investor.
(ii) The undersigned agree to proceed in good faith to execute and deliver definitive
agreements incorporating the terms outlined above and such additional terms as are
customary for transactions of the type described herein. This letter expresses the intent
of the parties and is not legally binding on any of them unless and until such mutually
satisfactory definitive agreements are executed and delivered by the undersigned. This
letter of intent may be signed by the parties in counterparts.
If this Summary of Terms is not signed and returned to VC by midnight (EST) [ ], it shall expire
without any further action on the part of VC and shall be of no further force or effect.
Date _______________
By:_________________________________________
The intent of this document is to describe, for negotiation purposes only, some key terms of
the proposed agreement between Venture Fund Investment Advisors Limited or one of its affiliates
(“Venture Fund”) (referred as “Series A Preferred Investors” or “Investors”) and XYZ Company, (the
“Company”). By signing this agreement, the Company agrees, undertakes and shall procure that
henceforth (a) no directors, officers, employees, agents and representatives of it or of any of its
direct or indirect subsidiaries or affiliates will initiate or participate in any discussion or negotiations
with any person other than investors mutually agreed upon relating to the sale, issuance or grant of
any equity interests in the Company (including any form of options, derivatives or arrangement
relating thereto) (“Company Equity Interests”) and (b) no issuance, sale, or offer to sell will be made
to any person other than investors mutually agreed upon in respect of any Company Equity.
This term sheet shall remain valid until __________. If this term sheet remains unsigned after
that time, Venture Fund at its option may immediately terminate discussions with the Company or
change any or all pricing, terms and conditions contained herein.
Confidentiality
The terms and conditions described in this Term Sheet including its existence shall be
confidential information and shall not be disclosed to any third party. If either party determines that
it is required by law to disclose information regarding this Term Sheet or to file this Term Sheet with
the Securities and Exchange Board of India (SEBI) or any equivalent regulatory body, it shall, a
reasonable time before making any such disclosure or filing, consult with the other party regarding
such disclosure or filing and seek confidential treatment for such portions of the disclosure or filing
as may be requested by the other party.
Purchase Price An amount per share (the “Purchase Price”) such that the
Purchase Price multiplied by the number of shares outstanding
on a fully diluted basis (taking into account, without limitations,
all options, warrants, stock option plans or any other
arrangements relating to the Company’s equity) prior to this
Series A Preferred financing is equal to the pre-money
valuation as explained above.
Fully diluted means the total of all classes and series of shares
outstanding combined with all options (including both issued
and unissued), warrants (including both issued and unissued)
and convertible securities of all kinds and the effect of any anti-
dilution protection regarding previous financings, all on an “as if
converted” basis and in addition, taking into account a ___ per
cent (___%) pool for issuance of employee options/equity.
Conversion Rights The holders of the Series A Preferred would have the right to
convert the Series A Preferred into shares of Common Stock, in
part or full, at any time. The Conversion rate for the Series A
Preferred would be based on the valuation described above.
Drag Along Rights: The company will provide an exit through a Qualified
IPO/Strategic sale before _____. In the event of the company
not providing an exit route, Series A Preferred investors have
the right to sell, merge or liquidate the Company at its own
option and the founders shall be obliged to offer their shares in
part or in full to facilitate an exit for Series A Preferred.
Approval of Business Plan Detailed business plan shall be presented to the board of
directors 30 days prior to the commencement of the new
financial year. The business plan including financial statements
will be made out on a monthly basis for the remainder of the
first fiscal year following investment and on a quarterly basis
thereafter. Such plan to be approved by the board of directors.
Any business plan that has less than 10% growth on any of the
“Key financial parameters” has to be specifically approved by
the Series A Preferred.
Key financial parameters are defined as: (a) Consolidated
revenue from operations, (b) Consolidated net income from
operations and (c) Net cash flow from operations.
Appointment of Senior The senior management of the company will include (a) CEO,
Management (b) CTO, (c) Head of India operations, (d) Head of SBU, and
(e) Head of sales and marketing. Any recruitment or change to
the senior management will be done in consultation with the
Series A Preferred.
The investor has the option to change any individual in the
senior management if there is significant non-performance by
Founders Earn Back Founders have the option to earn back up to 15% of the
company based on achievement of the following for CY Dec __:
1. Consolidated net income of _____ and above and operating
cash flow of _____ and above for CY Dec ____,
IN WITNESS whereof the parties hereto executed this Term Sheet the day and year first
above written.
Venture Fund
----------------------------------------------
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XYZ Company
Real estate developers use Private Equity for selected projects where the area above a
certain threshold as per Indian Government Norms.
11.6 SUMMARY
The private equity (PE) business attracts the best and brightest in corporate America,
including top performers from Fortune 500 companies and elite management consulting firms. Law
firms can also be recruiting grounds for private equity (PE) hires, as accounting and legal skills are
necessary to complete deals and transactions are highly sought after.
The fee structure for private-equity (PE) firms varies but typically consists of a management
and performance fee. A yearly management fee of 2% of assets and 20% of gross profits upon sale
of the company is common, though incentive structures can differ considerably.4
Given that a private-equity (PE) firm with $1 billion of assets under management(AUM) might
have no more than two dozen investment professionals, and that 20% of gross profits can generate
tens of millions of dollars in fees, it is easy to see why the industry attracts top talent.
Private equity investments are not traded on exchanges and are generally available to
companies that do not have access to public funding.
Private-equity (PE) firms have a range of investment preferences. Some are strict financiers
or passive investors wholly dependent on management to grow the company and generate returns.
Because sellers typically see this as a commoditized approach, other private-equity (PE) firms
consider themselves active investors. That is, they provide operational support to management to
help build and grow a better company.
Active private-equity (PE) firms may have an extensive contact list and C-level relationships,
such as CEOs and CFOs within a given industry, which can help increase revenue. They might also
be experts in realizing operational efficiencies and synergies. If an investor can bring in something
special to a deal that will enhance the company's value over time, they are more likely to be viewed
favorably by sellers.
Venture capital is part of the Private Equity market and can be defined as the capital provided
to young and relatively risky businesses seeking rapid growth, in return for a share in the
company’s ownership.
Venture Capitalists invest in the different stages of the life cycle of private companies, the
seed money stage, the start-up stage and additional rounds of funding until the IPO.
To raise the money needed to invest in companies, VC firms open a fund and ask for
commitments from limited partners. Using this process, they're able to draw from a pool of money
that they invest into promising private companies with high growth potential. As companies grow,
they go through different stages of the venture capital ecosystem. VC firms usually focus on one or
two VC funding stages, which impacts how they invest.
If a company a VC firm has invested in is successfully acquired or goes public, the firm makes
a profit and distributes returns to the limited partners that invested in its fund. The firm could also
make a profit by selling some of its shares to another investor in what’s called the secondary
market.
The venture capital process starts when a private company approaches a venture capitalist
who will estimate the value of the company. The owners of the company and the venture capitalists
state their interests and negotiate the terms of the deal. After the deal is structured, the venture
capitalists continue to support the company, often becoming actively involved in the management
and business development of the company.
The final step in a venture capital process is to implement the exit strategy. It can be an IPO,
the selling off of the business or the liquidation of the company.
3. What are the various stages of Venture Capital Financing? Describe each in brief.
(c) NBFCs
2. Active private-equity (PE) firms may have an extensive contact list and C-level
relationships, such as CEOs and CFOs within a given industry, which can help to-----------
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4. Venture Capitalists invest in the different stages of the life cycle of private companies,
5. After the deal is structured, the venture capitalists continue to support the company, often
becoming actively involved in the ---------------------------of the company.
Answers:
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Summary
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Video1
Public Listing of Securities
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
12.1 Introduction
12.6 Summary
12.7 Self-Assessment Questions
12.1 INTRODUCTION
At some point, a successful company may expand to that point that it is no longer feasible for
a single investor or even a small group of investors, to provide all the capital that the company
needs to keep growing. When that occurs, the company may choose to convert from private to
public ownership. When a company makes the transition from private to public ownership, it may
decide to list its stock on a recognized stock exchange. Popular Stock Exchanges in India are NSE
and BSE.
The general rules and guidelines for listing of securities in India states that;
(i) The public offer should in no case be less than 33 per cent of the issued capital of the
company.
(ii) The share of the Indian promoters should not be more than 40 per cent of the issued
capital of the company.
To list on an exchange, a company must comply with all listing requirements established by
the exchange and a host of laws and regulations enforced by SEBI and ROC.
To list its stock on an international exchange, a company must comply with any listing
requirements established by the exchange (such as minimum profit requirements) and a host of
laws and regulations enforced by the government body that administers the company law and
regulates equity markets. For example, in the US, this body is the Securities and Exchange
Commission (SEC); in Australia, the Australian Securities and Investments Commission (ASIC);
and in Malaysia, the Malaysian Securities Commission.
Benefits Costs
There are a variety of types of stocks a company can offer in the form of equity. These are:
1. Common Stock
2. Preferred Stock
3. Rights
4. Debentures
5. Warrants
6. Convertibles
7. Sweat Equity
8. ESOPs
The most familiar form of equity is the common or ordinary stock. Holders of common stock
are entitled to a proportionate share in any cash that is distributed to the company’s investors. They
also enjoy the right to vote (typically one vote per share) at the company’s annual meeting.
Collectively, a company’s shareholders elect the board of directors that oversees the actions of
senior management, and they also vote on important matters such as mergers and acquisitions or
changes to the corporate charter, the legal document that outlines how the company will be
governed. In some countries, companies are allowed to issue more than one class of common
stock. Often these dual-class companies issue a second class of stock with special voting rights
(such as 10 votes per share rather than 1 or the exclusive right to elect a majority of the board of
directors). Usually, senior managers or members of the founding family hold the second class of
stock; this offers insiders a mechanism to exercise control of a majority of the company’s votes
without having to invest a majority of the capital needed to finance the firm.
meaning that preferred shareholders must receive their dividends before dividends may be paid to
common stockholders. Some preferred shares pay cumulative dividends, meaning if a financially
troubled company misses a preferred payment, the payment must be made before any dividends
can be paid on common stock.
However, preferred stock has several features that more closely resemble traditional equity
securities than debt. For example, when a company pays dividends to preferred shareholders, it
cannot deduct them from taxes as it can on interest payment to bondholders. Likewise, when a
company fails to make the promised payments on its preferred stock, the preferred shareholders
have no legal right to force the company to make these payments.
Preferred stock is equity is just like common stock, its shares represent an ownership stake in
a company. However, preferred stock normally has a fixed dividend payout as well. ... Preferred
shares are issued with a set dividend that must be paid before the company's board considers any
dividend for common shareholders.
Bondholders can force the company into bankruptcy or liquidation if it does not make principal
and interest payments on time. Therefore, preferred stock is a hybrid security offering neither a
pure fixed claim like debt nor a residual claim like equity. Because it is somewhat riskier than debt,
but not as risky as common equity, preferred stock generally offers investors a return that is a little
higher than bonds, but somewhat lower than common stock.
12.2.3 Rights
A rights issue involves selling securities in the primary market by issuing rights to the existing
shareholders. When a company issues additional equity capital, it has to be offered; in the first
instance to the existing shareholders on a pro rata basis. This is required under Section 81 of the
Companies Act, 1956. The shareholders, however, may by a special resolution forfeit this right,
partially or fully, to enable a company to issue additional capital to the public.
Thus, a rights offering (rights issue) is a group of rights offered to existing shareholders to
purchase additional stock shares, known as subscription warrants, in proportion to their existing
holdings. These are considered to be a type of option since it gives a company's stockholders the
right, but not the obligation, to purchase additional shares in the company.
In a rights offering, the subscription price at which each share may be purchased is generally
discounted relative to the current market price. Rights are often transferable, allowing the holder to
sell them in the open market.
A company making a rights issue sends a letter of offer along with a composite application
form consisting of four forms (A, B, C and D) to the shareholders. Form A is meant for the
acceptance of the rights and application of additional shares. This form also shows the number of
rights shares the shareholder is entitled to. It also has a column through which a request for
additional shares may be made. Form B is to be used if the shareholder wants to renounce the
rights in favour of someone else. Form C is meant for application by the renounced in whose favour
the rights have been renounced, by the original allottee, through Form B. Form D is to be used to
make a request for split forms. The composite application form must be mailed to the company
within a specific period, which is usually 30 days.
A rights issue offers several advantages over a public issue. The flotation costs of a rights
issue are significantly lower than those of a public issue.
Theoretically, the subscription price of a rights issue is irrelevant because the wealth of a
shareholder who subscribes to the rights issue or sells the rights remains unchanged, irrespective
of what the subscription price is. Hence, the problem of transfer of wealth from existing
shareholders to new shareholders does not arise in a rights issue.
12.2.4 Debentures
Debenture is a debt instrument. A debenture is a written instrument signed by a company
acknowledging its debt due to its holders. The instrument promises to pay its holders a specific
amount of money at a fixed date in future together with periodic payment of interest. It is an
unsecured instrument. If the company gets liquidated, its debenture holders will become general
creditors. Debentures secured by specific asset of the company are termed as “Secured
Debentures”.
(b) Debenture holders have claim to income of the company. They have priority over
stockholders.
(c) Debenture holders have priority in respect of claim on the assets of the company. They
have priority over stockholders.
(d) Debenture holders do not have voting or controlling right on the company.
12.2.5 Warrants
A warrant is an option to buy a stated number of shares of stock at a specified price. It gives
the holder the right to buy common stock for cash. When the holder exercises the option, he
surrenders the right.
Warrants are a means for long-term financing. They have maturity dates of 5 years or more in
the future.
12.2.6 Convertibles
Convertible represent a bond or a share of preferred stock with embedded options issued by
organizations. The holder has a right to exchange convertible bond for equity in the issuing
company at certain times in the future. Convertible preference shares are preference shares with
the right to convert to ordinary shares.
The issue of sweat equity shares should be authorized by a special resolution passed by the
company in a general meeting The resolution should specify the number of shares, current market
price, consideration, if any, and the section of directors/employees to whom they are to be issued
As on the date of issue, a year should have elapsed since the company was entitled to commence
business.
The sweat equity shares of a company whose equity shares are listed on a recognized stock
exchange should be issued in accordance with the regulations made by the Securities and
Exchange Board of India (SEBI).
In the case of a company whose equity shares are not listed on any recognized stock
exchange, sweat equity shares can be issued in accordance with such guidelines as may be
prescribed.
In the case of unlisted companies, sweat equity shares cannot be issued before one year of
commencement of operations. Moreover, there is a cap of 15% on the number of sweat equity
shares that can be issued without a specific central government approval.
Sweat equity shares are no different from employee stock options with a one year vesting
period. It is essential when a company is formed, to assure the financial investors that the know-
how providers will stay on, or for a start-up with limited resources to attract highly qualified
professionals to join the team as long-term stakeholders.
These shares are given to a company’s employees on favourable terms, in recognition of their
work. Sweat equity usually takes the form of giving options to employees to buy shares of the
company, so they become part owners and participate in the profits, apart from earning salary.
Section 79A of the Companies Act lays down conditions for the issue of sweat equity shares.
For listed companies, there are regulations made by the SEBI. The SEBI also prescribes the
accounting treatment of sweat equity shares. Thus, sweat equity is expensed, unless issued in
consideration of a depreciable asset, in which case it is carried to the balance sheet.
Sweat equity is a device that companies use to retain their best talent. Usually, it is given as
part of a remuneration package. However, start-ups sometimes use sweat equity to retain talent. If
the company fails, its employees may end up with worthless paper in the form of sweat equity
shares.
Unlisted companies cannot issue more than 15% of the paid-up capital in a year or shares
with a value of more than ` 5 crores – whichever is higher – except with the prior approval of the
central government. If the sweat equity is being issued for consideration other than cash, an
independent valuer has to carry out an assessment and submit a valuation report.
The company should also give ‘justification for the issue of sweat equity shares for
consideration other than cash, which should form a part of the notice sent for the general meeting’.
The board of directors’ decision to issue sweat equity has to be approved by passing a special
resolution at a shareholders’ meeting later in the year. The special resolution must be passed by
75% of the members attending voting for it.
Definition: An employee stock ownership plan (ESOP) is a type of employee benefit plan
which is intended to encourage employees to acquire stocks or ownership in the company.
Description: Under these plans, the employer gives certain stocks of the company to the
employee for negligible or less costs which remain in the ESOP trust fund, until the options vests
and the employee exercises them or the employee leaves/retires from the company or institution.
These plans are aimed at improving the performance of the company and increasing the
value of the shares by involving stock holders, who are also the employees, in the working of the
company. The ESOPs help in minimizing problems related to incentives.
Listing means the formal admission of securities of a company to the trading platform of the
Exchange. It is a significant occasion for a company in the journey of its growth and development. It
enables a company to raise capital while strengthening its structure and reputation.
Converting from a private company to a public company is a complex and highly regulated
process. Companies usually enlist the help of investment bankers or merchant bankers. Working in
concert with the company’s management, investment bankers prepare a prospectus. The
prospectus contains:
In return for these and other services that it provides, the investment bank charges the
company a fee, usually about 7% of the total amount of money that the company raises
in the offering.
2. When the investment bank is confident that the demand for shares will be more than
sufficient to supply the company with the capital it needs, the bank will write the company
a cheque in exchange for shares of stock.
The bank than resells these shares to investors who want to buy them, a process known
as underwriting.
3. When a company issues shares directly to investors (with help of an investment banker),
it is selling shares on the primary market.
4. Once securities are listed on the Stock Exchange, investors may trade these securities in
the secondary market.
1. One of the biggest is that listed companies must comply with an array of securities
regulations and disclosure requirements.
2. Listed companies must file quarterly and annual shareholding patterns, results and
secretarial audits.
3. Executives who work for these companies face insider trading regulations limiting the
circumstances in which they may buy or sell shares in the company.
4. If the company or its executives fail to comply with any of these regulations, they may
face action from the Stock Exchange or the regulator.
SEBI was created by the Government to enforce legislation passed in the Securities Act. SEBI
is primarily charged with prevention of fraud in securities market. Consequently, SEBI devotes a
substantial fraction of its resources to establish and enforce various disclosure requirements.
Stock Exchanges, on the other hand, exist mainly to provide liquidity to investors. Exchanges
act as intermediaries between buyers and sellers of securities of securities, lowering the costs of
trading.
⚫ A listed company can raise capital from a much wider pool of investors than can a
company that does not list its shares.
⚫ Once the company’s shares are publicly traded, the share price can serve as a useful
barometer of how the business is performing. The market’s perception of the value of a
listed company’s equity is reflected every day – indeed at every moment.
⚫ The company may use shares or stock options as part of the compensation package that
it offers to recruit and retain talented employees. Companies also use stock and stock
options as incentive devices. By including stock options in employee compensation
packages, companies tie employee’s financial rewards directly to the overall financial
success of the company. The financial linkage between employee success and overall
company success reduces the need for constant monitoring.
⚫ Listing the company’s stock on the public market allows the original entrepreneurs and
other investors with large stakes to sell a portion of their investment and diversify their
portfolios if they choose.
⚫ Listing shares on any exchange may also provide companies with marketing benefits.
The publicly and news coverage associated with listing securities may attract new
customers as well as new investors.
Disadvantages
⚫ There are substantial costs of going public. Firstly, there are direct costs of an Initial
Public Offering (IPO) such as underwriting fees.
⚫ Public companies are also required to provide quarterly and annual reports, and are
subject to greater public scrutiny.
⚫ Publicly listed companies have to provide more information to their shareholders than
private companies. This information will also be available to their competitors and might
put the company at a competitive disadvantage.
There are different ways in which a company may raise finances in the primary market public
offering, rights issue, and private placement.
Decision to Go Public
The decision to go public (or more precisely the decision to make an IPO so that the
securities of the company are listed on the stock market and are publicly traded) is a very important
issue. It is a complex decision, which calls for carefully weighing the benefits against costs.
An Indian company, excluding certain banks and infrastructure companies, can make an IPO
if it satisfies the following conditions:
⚫ The company has a certain track record of profitability and a certain minimum net worth.
⚫ The securities are compulsorily listed on a recognized stock exchange, which means that
a certain minimum per cent of each class of securities is offered to the public.
⚫ The promoter group (promoters, friends, relatives, associates, etc.) is required to make a
certain minimum contribution to the post-issue capital.
The IPO Process: From the perspective of merchant banking, the IPO process consists of
four major phases:
The company wishing to go public has to hire the merchant bankers to manage its offering.
The selection of a merchant banker is usually referred to as a ‘beauty contest’. Typically, it involves
meeting different merchant bankers, discussing the plans for going public, and getting a valuation
estimate. Understandably, the choice of the merchant banker is guided mainly by the valuation
estimate offered. Often, a company going for an IPO selects two or more merchant bankers to
manage the issue. The primary manager is called the “lead manager” and the other managers are
called “co-managers”.
Once the managers are selected, due diligence and prospectus preparation begin. The
merchant bankers understand the company’s business and plans, examine various documents and
records, prepare the draft prospectus, file the same with the regulatory authorities, and arrange for
its printing. Merchant bankers, lawyers, accountants, and company managers have to toil for
countless hours to complete the legal formalities that finally culminate in the printing of the
prospectus. Since book building is commonly used, the issue price is not fixed in advance, but a
price band is given.
The next phase of an IPO is the marketing phase. After all the regulatory approvals are in
place, the company embarks on a road show to promote the issue. A road show involves
presentation by the management of the company to potential investors (mostly institutional) in
different locations. Concurrently, the issue is advertised in various media primarily targeted at retail
investors.
The final phase of the IPO involves receiving subscription and allotment of shares. The
subscription is normally kept open for five to ten days. During this period, investors can submit their
bid-cum-application forms. After the subscription is closed, the merchant bankers fix the final issue
price, determine the pattern of allotment, complete the allotment of shares, and secure the listing on
one or more recognized stock exchanges.
Seasoned Equity Offering: For most companies, their IPO is seldom their last public issue.
As companies need more finances, they are likely to make further trips to the capital with seasoned
equity offerings, also called secondary offerings.
While the process of a seasoned equity offering is similar to that of an IPO, it is much
complicated. The company may employ the merchant bankers who handled the IPO. Further, with
the availability of secondary market prices, there is no need for elaborate valuation. Finally,
prospectus preparation and road shows can be completed with lesser effort and time than that
required for the IPO.
Bond Offering: The bond offering process is similar to the IPO process. There are, however,
some differences:
⚫ The prospectus for a bond offering typically emphasizes a company’s stable flows,
whereas the prospectus for an equity offering highlights the company’s growth prospects.
⚫ Pure debt securities are typically offered at a predetermined yield because the book
building route is not considered appropriate for them.
⚫ Debt securities are generally secured against the assets of the issuing company and that
security should be created within six months of the close of the issue of debentures.
⚫ A debt issue cannot be made unless credit rating from a credit rating agency is obtained
and disclosed in the offer document.
Private Placement
Private Placement of Bonds: From 1995 onwards, private placement of debentures thrived,
minimal regulation. Corporates, financial institutions, infrastructure companies, depended
considerably on privately placed debentures which were subscribed to mutual funds, banks,
insurance organizations, and provident funds.
Information and disclosures to be included in the Private Placement Memorandum were not
defined, credit rating was not mandatory, listing was not compulsory, and banks and institutions
could subscribe to these issues without too many constraints.
The regulatory framework changed significantly in late 2003 when SEBI and RBI tightened
their regulations over the issuance of privately placed debentures and the subscription of the same
by banks and financial institutions. The key features of the new regulatory dispensation are:
⚫ The disclosure requirements for privately placed debentures are similar to those of
publicly offered debentures.
⚫ Debt securities shall carry a credit rating of not less than investment grade from a rating
agency registered with SEBI.
⚫ The trading in privately placed debt shall take place between QIBs and HNIs (High Net
Worth individuals) in standard denomination of ` 10 lakh.
⚫ Banks should not invest in non-SLR securities of original maturity of less than one other
than commercial paper and certificates of deposits which are covered under guidelines.
12.6 SUMMARY
At some point in time, a company may expand to a point when it is no longer feasible for a
group of investors to provide all the capital it needs. When that occurs, it may decide to convert
from private to public ownership.
To list on an exchange, a company must comply with all the listing requirements by the
exchange and the securities regulator.
Various types of equity are issued such as common stock, preferred stock, rights, debentures,
warrants, convertibles, Sweat Equity and ESOPs.
Converting from a private company to a public company is a complex and highly regulated
process. Companies usually enlist the help of investment bankers or merchant bankers. Working in
concert with the company’s management, investment bankers prepare a prospectus. The
prospectus contains:
There are various advantages of listing a company – can raise more capital from a wider pool
of investors, share prices reflect its performance, company can use ESOPs to retain talented
employees, Original entrepreneurs can sell a portion of their investment and diversify their portfolios
and marketing benefits.
There are disadvantages of listing a company – direct costs of an IPO, companies have to
provide results quarterly and annually, disclosed information can be misused by the competitors.
There are local popular stock exchanges – NSE, BSE for companies. New BSESME
exchange for SMEs.
4. What are the various kinds of equity stocks that can be listed? Describe each in brief.
1. The most familiar form of equity is the----------------------- and holders of this stock are
entitled to a proportionate share in any cash that is distributed to the company’s
investors.
2. The process of selling securities in the primary market by issuing company to the existing
shareholders is called as -------------------------------security.
(b) ESOP
3. The issue of securities to a select group of persons not exceeding 49 (number increased
in the new Companies Act, 2013) is called as -------------------------------
(a) There are substantial costs of going public. Firstly, there are direct costs of an Initial
Public Offering (IPO) such as underwriting fees.
(b) Public companies are also required to provide quarterly and annual reports and are
subject to greater public scrutiny.
(c) Publicly listed companies have to provide more information to their shareholders than
private companies. This information will also be available to their competitors and
might put the company at a competitive disadvantage.
Answers:
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Summary
PPT
MCQ
Video1
International Capital
13 INTERNATIONAL CAPITAL
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
13.1 Introduction
13.4 Summary
13.1 INTRODUCTION
International capital flows are the financial imports a good or service, the buyer (the importer)
gives the seller (the exporter) a monetary payment, just as in domestic transactions. This net
financial flow is called its capital account balance.
International capital flows are the financial side of international trade. When someone
imports a good or service, the buyer (the importer) gives the seller (the exporter) a monetary
payment, just as in domestic transactions. If total exports were equal to total imports, these
monetary transactions would balance at net zero: people in the country would receive as much in
financial flows as they paid out in financial flows. But generally the trade balance is not zero. The
most general description of a country’s balance of trade, covering its trade in goods and services,
income receipts, and transfers, is called its current account balance. If the country has a surplus or
deficit on its current account, there is an offsetting net financial flow consisting of currency,
securities, or other real property ownership claims. This net financial flow is called its capital
account balance.
When a country’s imports exceed its exports, it has a current account deficit. Its foreign
trading partners who hold net monetary claims can continue to hold their claims as monetary
deposits or currency, or they can use the money to buy other financial assets, real property, or
equities (stocks) in the trade-deficit country. Net capital flows comprise the sum of these monetary,
financial, real property, and equity claims. Capital flows move in the opposite direction to the goods
and services trade claims that give rise to them. Thus, a country with a current account deficit
necessarily has a capital account surplus. In balance-of-payments accounting terms, the current-
account balance, which is the total balance of internationally traded goods and services, is just
offset by the capital-account balance, which is the total balance of claims that domestic investors
and foreign investors have acquired in newly invested financial, real property, and equity assets in
each other’s’ countries. While all the above statements are true by definition of the accounting
terms, the data on international trade and financial flows are generally riddled with errors, generally
because of undercounting. Therefore, the international capital and trade data contain a balancing
error term called “net errors and omissions.”
Because the capital account is the mirror image of the current account, one might expect total
recorded world trade—exports plus imports summed over all countries—to equal financial flows—
payments plus receipts.
Capital investment is the amount invested in a company to enhance its business objectives.
Also, the individual/entity can earn an income or recover the invested capital from earnings
generated by the company over the years.
1. A capital investment can be made by the executives of the company in their business by
purchasing long-term securities/assets of the company. In such cases, the capital can be
physical assets which could improve the business performance by a significant margin.
Capital investment can come from various sources, such as financial institutions, angel
investors, and venture capitalists, among others. Generally, start-ups and new companies are the
ones who seek capital investments.
However, after having received investments, the invested amount must be utilised to develop
and push the business ahead. In the same line, if a company announces to go public, the large
amount of funds pooled in from the investors is also considered as a form of capital investment.
Capital investment has its own disadvantages. While capital investment is made to improve a
company's cash flow in operations, it may sometimes be insufficient to cover the expected costs. In
such cases, the company could be forced to borrow funds from an external financier to cover for the
miscalculations.
The company expects capital investment to help build its future in the long-run. However,
capital investment results in the earnings of stakeholders being subdued in the short-term. In the
same line, stockholders also keep track of the company's debts which is why capital investments
are not favourable to many stakeholders.
Thanks to the globalization of capital markets, Indian companies can raise capital from
Euromarkets or from the domestic markets of various countries or from Export Credit Agencies.
India has been a capital-deficient country since independence and raising funds either by
means of equity or debt has always been problematic for industry. The question that comes up
when a business is planning a round of fundraising, is whether debt or equity is a better choice, and
whether funds should be raised domestically or through foreign channels.
Local markets have been sluggish in terms of fundraising, so the focus of this article is on
international fundraising. When an Indian company considers raising funds there are traditional and
non-traditional channels available. Some of the options are as follows.
⚫ Equity based. Foreign direct investment policy is very liberal and balanced, and
international investors can invest in nearly all sectors. Save in a few sensitive sectors
such as retail and insurance, 100% foreign equity participation is available. In this liberal
environment, it is easy to find equity participation.
Investment funds, which may be pure financial funds, sovereign funds, social Impact funds or
related institutions have at least two attractions. Their purpose is to invest in the industry or sector
of the target business customers, and they have an appetite to invest in India. Partnering with
foreign companies in joint ventures (JV) works best where partners are from countries that are
technology and capital rich. To have a foreign shareholder and partner in a JV allows access to the
capital markets of the foreign partner for additional equity and lower cost debt. In one particular
European country, the government offers an incentive scheme to double the equity invested by the
foreign partner in the Indian company bringing substantial benefits for both the Indian and the
foreign partner company. European economies have the foresight to invest in developing markets
to overcome the saturation in their own sectors.
⚫ Debt based. Major banks and financial institutions are the first choice when raising debt
funds from outside the country. Many commercial banks in countries such as the US,
Canada, the UK, Switzerland, Japan, China and Taiwan provide funds to Indian
businesses to finance their business needs. Debts from banks and large financial
institutions are mostly large tickets and suited for projects of significant economic
importance. Institutions such as the World Bank, the International Monetary Fund, the US
International Development Finance Corporation and the Asian Development Bank also
fall into the category of lenders that fund Indian projects of importance.
Smaller banks and debt funds are more accessible to the MSME sector. These providers are
also willing to fund smaller banks and large nonbanking financial companies. Interest rates on loans
and funds are higher than those from larger institutions, but still lower than those from domestic
funders. JV partners provide channels of funding through their own banking relationships. By
leveraging a low-cost debt, themselves, JV partners can in turn bring in a low-cost debt as a back-
to-back lender to its own business under the current external commercial banking policy in India.
With business development funding, certain European banks are willing to finance the international
business of their clients by providing low-cost debt in developing economies like India so long as
the foreign partner is part of the business.
Besides these financing choices, Indian businesses now have options open to them such as
trade factoring in businesses conducted with reputable importers of their products. Export finance is
a great advantage when buying capital goods from developed countries such as the USA, Canada,
Japan and China. Extremely low-cost finance options are available for the right customers in India.
I am presenting a few notes from the City of London Corporation prepared by TRUSTED
SOURCES and published in 2010. This will give students a perspective of how international
financiers view India and how Indian companies are tapping international markets for capital.
“Although Indian companies can now largely rely on their domestic capital market to fulfil even
“jumbo” equity offerings, this was not always the case. The equity issuance market for Indian
companies saw rapid growth from 2004 just as India’s economic growth rate started to accelerate.
Previously, only a handful of Indian firms had tapped overseas capital markets in any size and
usually by ADR/GDR issuances in New York and London, typically at around the US$100-200
million level. These offerings included ADRs listed on the NYSE by Wipro and Satyam in 2000 and
HDFC and Dr. Reddy’s Laboratories in 2001; Infosys listed on NASDAQ in 2003. They tended to be
carried out in conjunction with an offering on the BSE and/or the NSE, India’s two leading stock
exchanges, for the purpose of augmenting the limited amount of funds capable of being raised
domestically. The chart below shows the dramatic increase in overall equity issuance since 2004.
This upward trend was temporarily dented during the global crisis in 2008 but resumed again in
H2/09.
25000 Domestic
Foreign
20000
15000
10000
5000
0
20002001 20022003 20042005 20062007 200820092010
Public equity raised by Indian companies on domestic and foreign markets, 2000-10 year to
date (US$ million).
Most of the new issues in 2004 were in the domestic market as the government came forward
with privatization offers for energy companies Oil and Natural Gas Corporation (ONGC) (US$ 2.3
billion) and, after the election that year, National Thermal Power Corporation (NTPC) (US$ 1.1
billion), while Tata Consultancy Services managed a US$ 1.2 billion offering. Such large offerings
were made possible primarily by the recovery in global investor appetite as memories of the 2000-01
collapse of the technology bubble faded. In addition, investors were reassured when a Communist-
supported coalition led by the Congress Party came to power in May 2004 and signalled broad
policy continuity with its right-wing predecessor government; political risk was no longer seen as a
major impediment to investment.
This picture started to change in 2005 as the supply of listing candidates increased and was
met by growing overseas demand. The most popular mode for Indian firms to raise capital during
the first big equity rush of 2005/06 was GDR listings in Luxembourg, owing to the low compliance
costs and relatively fast approval process. These were typically small deals in the range of
US$ 30-100 million issued by mid-cap firms wishing to source quick, cheap capital for domestic
operations. But these smaller issues were overshadowed by “jumbo” offerings in 2005 for Infosys
(US$ 1.1 billion, listed both in Mumbai and on NASDAQ) and ICICI Bank (US $1.6 billion, listed
both in Mumbai and on the NYSE). These companies were joined in 2007 by Sterlite with a
US$ 2 billion NYSE-listed IPO as well as follow-on offerings from both ICICI and Infosys.
Meanwhile, the capacity of the local markets was expanding, and Cairn India raised US$1.9
billion from a purely domestic IPO in 2006. This was followed by more “jumbo”-sized domestic
offerings including large retail tranches for Reliance Power (US$ 2.6 billion) and the State Bank of
India (US$ 4.2 billion) in 2007-08. Subsequently, several state-owned minerals and energy firms
made “jumbo” offerings in 2009-10: National Mineral Development Corporation (NMDC) Ltd. (US$
2.1 billion), NTPC Ltd. (US$ 1.8 billion) and National Hydroelectric Power Corporation (NHPC) Ltd.
(US$ 1.2 billion); this trend towards privatization continues with imminent issuances from ONGC,
Indian Oil and Coal India among others. Of the remainder, the bulk of those in the US$ 200 million
to US$ 1 billion range came from banks/financials, infrastructure, energy/power generation and
realty. These huge offerings demonstrated that the domestic market, helped by a vibrant retail
segment, had come of age.
Capital raising efforts in large part relocated to Indian exchanges following the introduction by
the Securities and Exchange Board of India (SEBI) of a local qualified institutional placement (QIP)
programme in May 2006. This coincided with the gradual easing of the foreign institutional investor
(FII) scheme in India and subsequent growth in foreign institutional investors buying and trading
shares in the domestic market, thereby enabling Indian firms to tap into a larger pool of institutional
capital domestically.
Foreign institutional investors were first allowed access to India’s equity markets in 1991 as
part of the broader economic liberalisation process. Regulatory sector caps (on percentage of
equity owned in a company) restricted FII investment until 2002 when they were lifted in most
sectors. FIIs were also allowed into all derivative segments at this point, facilitating a much greater
volume of FII trading. This was followed in 2007 by the streamlining of the process for granting FII
licences.
By March 2010, there were 1,713 FIIs registered (with 5,378 registered sub-accounts). This
expansion helped portfolio flows into India soar from US$ 979 million in FY2003 to US$ 11.3 billion
in FY2004. Except for a dip in FY2009 caused by the global credit crisis, inflows have stayed strong
ever since, hitting a high of US$ 32.3 billion in FY2010. Flows remained strong in Q1/FY2011, at
US$ 4.6 billion.
40
30
20
10
–10
–20 FY FY FY FY FY FY FY FY
20 20 20 20 20 20 20 20
03 04 05 06 07 08 09 10
Accordingly, the volume of Indian issuances from Luxembourg dropped off sharply in 2007.
There were only four listings that year compared to 26 in 2006. A Hong Kong based hedge fund
told us, “Indian GDRs died as more investors got access to the domestic market via FII licences”.
Luxembourg has still attracted a handful of Indian firms to list each year since 2006, but these tend
to be small issues by mid-cap companies. The exceptions have been larger GDR issues (in the
US$ 100-400 million range) by Suzlon, Tata Motors and Tata Power. Tata Steel chose to make a
US$500 million GDR issue in London in July 2009 because of the need to raise its profile there
following its 2007 acquisition of UK steel company Corus. (One attraction of GDRs for firms
concerned about management control is that they can be issued in non-voting form; QIPs always
involve the issuance of local voting stock).
The majority of companies now use the QIP route in India. A total of 36 issuers raised ` 255
billion (US$ 5.5 billion) in QIPs domestically in FY2008, a figure that plummeted during the credit
crisis to just two companies raising a total of ` 2 billion (US$ 43 million) in FY2009. This route to
raising capital has, however, seen strong growth in FY2010: 62 QIP issues have raised ` 427 billion
(US$ 9.2 billion).
⚫ London has attracted metals, mining and energy companies. Back in 2003 the UK-
registered holding company of Vedanta Resources raised US$ 1 billion in its London offering. A
“jumbo” US$ 1.9 billion offering for the UK-registered holding company of Essar Energy as well as a
modest US$ 500 million GDR placement by Tata Steel took place in 2009. Great Eastern Energy,
specializing in coalbed methane, has recently been transferred from AIM to the LSE Main Market.
The pattern on AIM is a little different. More than one-third of India related listings on AIM have
come from real estate firms and funds. Other sectors have been clean energy, private equity, media
and infrastructure; the most recent listings are in these sectors. Only one Indian-domiciled firm –
the Noida Toll Bridge – is presently listed on AIM; most are either funds of companies domiciled in
UK tax havens such as the Isle of Man and Guernsey.
⚫ Singapore is targeting the Indian market. Singapore has so far not succeeded in
attracting a large number of Indian listings. However, an officer of the Singapore Stock Exchange
(SGX) announced that it was keen to win Indian business and could offer regional “clusters” in
“marine, offshore and energy, real estate investment trusts (REITs) and property trusts, resources
and commodities trading”. Recent press comment suggests that the much delayed launch of Indian
REITs by DLF and Unitech on the SGX may be back in prospect, potentially the first such
issuances since the Ascendas and Indiabulls REITs in 2007 and 2008. If the REITs were launched,
this would be a major achievement for Singapore. But, as a Hong Kong fund management source
told us:
“The Singapore listing of REITs and property companies has been a high profile disaster.
SEBI has not pushed forward a 2008 proposal to facilitate domestic REITs, leaving Singapore as
the only outlet for such a vehicle.”
Singapore does hold some attraction in the form of geographical proximity to India, cheaper
costs and lower taxes than London and New York. Indian firms in real estate, telecoms and
financial services could be attracted to a good peer group listed in Singapore. However, most
Indian firms remain focused on the advantages of a London or New York listing.
⚫ Mining and energy companies. The successful flotations of Vedanta, Sterlite and Essar
Energy may encourage other capital-hungry and acquisitive companies to come to
London and NYSE.
⚫ Banks and other financial services firms. Banks will need capital to finance their rapid
expansion in India’s underpenetrated market. ICICI Bank, HDFC Bank and Axis Bank
have already raised substantial quantities of capital internationally.
⚫ REITs. SEBI has not permitted REITs in India, which leaves a Singapore listing as the
only feasible option. Ascendas and Indiabulls listed India-focussed REITs in Singapore in
2007 and 2008. Other property firms are expected to follow suit. These include Fortis
Healthcare (with a reported planned deal size of US$ 600-700 million), DLF (US$ 1.5
billion), Unitech (US$ 500 million) and Embassy Property Developments (US$ 300-500
million).
In its current second term, the Congress-led coalition has managed to accelerate minority
stake sales in state-owned firms, targeting revenues of around US$ 8-10 billion per year from
issues in the domestic market.
The volume of these issues has the potential to saturate the domestic markets and force
some companies to go abroad in search of better valuations. In FY2010, for example, a high-
volume stream of overpriced issues by state-owned firms dampened primary market sentiment. Six
such issuances accounted for 54% of the total ` 576 billion (US$ 12.4 billion) raised on the domestic
markets. Aggressive pricing deterred retail investors from subscribing, and state-owned financial
institutions such as the Life Insurance Corporation of India and the State Bank of India were forced
to step in and support the issuances. The government also missed its revenue targets because it
was necessary to hold back further issuances.
The outlook for successful issuances is better in FY2011 because the government appears to
have decided to adopt more realistic pricing for its next privatization round to attract retail investors.
The target for the year is ` 400 billion (US$ 8.6 billion), and stakes in good quality firms in energy
and minerals are once again up for sale: Coal India, ONGC, Indian Oil, Manganese Ore India and
MMTC Ltd. If these issuances prove successful, investment bankers expect private firms to get
involved and take advantage of primary market momentum.
would have unleashed a flood of equity into the local market and possibly encouraged some firms
to issue shares abroad that would not have done so in the absence of the rule.
The government subsequently relaxed the programme following fears that the domestic
market could not handle the supply. State-owned enterprises will now have to dilute only up to 10%
of their equity until 2014. This means that whereas under the original requirement a projected
` 1,250 billion (US$ 27 billion) was to be issued by 35 state-owned firms, only 15 will now be
required to issue ` 200 billion (US$ 4.3 billion) of equity. Private companies will still be required to
dilute their equity to 25% over the next three years but they will be at liberty to decide both timing
and strategy (the original order mandated an annual 5% dilution until the threshold was reached).
The chart below highlights the dominance of international investors compared to domestic
institutions.
60
40
20
0
Equity market Free float market Public Institutional
capitalization capitalization shareholding holding
FII interest in primary markets remains strong. SEBI data show that in the year to 27 August
2010 FIIs invested a net ` 201 billion (US$ 4.3 billion) in primary markets compared with ` 390 billion
(US$ 8.4 billion) in secondary markets. According to the India Brand Equity Foundation, FIIs
invested more in primary markets than in secondary markets in the April-September 2009 period.
This is a very substantial commitment of funds to primary markets, demonstrating how foreign
investors are increasingly willing to buy equity in local primary markets rather than wait for GDR or
ADR issuances.
Higher valuations (and greater analyst coverage) in specialty stocks. The main
international investor bases for several key sectors do not invest directly into India either because
of restrictions on EM exposure or because they do not have the research bandwidth to cover local
Indian companies. As a result, many Indian firms will continue to gravitate towards their natural
investor base in order to achieve higher valuations. The main trends are:
⚫ Valuation arbitrage. Indian stock markets generally offer higher earnings multiples for
stocks than international markets. However, in some sectors, Indian valuations are lower
than global valuations, and there are opportunities to arbitrage this presumed mispricing.
For instance, India’s largest paper company, Ballarpur Industries, is planning to list its
Malaysian subsidiary Sabah Paper Industries in London or Singapore, partly because it
hopes that better valuations there will help to improve its Indian stock price.
⚫ Mining, metals and renewable energy in London. Indian mining and energy private
companies have traditionally listed in London. There is a good possibility that more
energy firms will list there, and Indian firms that acquire foreign energy or commodity
assets will likely list them separately in London. For instance, it is conceivable that the
state-owned Bharat Petroleum will list its Australian shale gas assets in London or
Singapore. An additional incentive for larger firms is to get representation in the FTSE
100 Index, which brings additional prestige and may bring better valuations from buying
by index funds. However, there is no evidence that state-owned firms in these sectors will
list in London; the recent spate of “jumbo” issuances has been exclusively domestic.
Another sector in which foreign valuations tend to be higher than in India is renewable energy,
and a foreign listing in London or elsewhere could make sense for a domestic renewables firm.
Foreign capital for global expansion. Mergers and acquisitions will be the biggest driver
favouring foreign listings by Indian companies. Indian firms invested ` 818 billion (US$ 17.5 billion)
outside India in FY2009 and ` 570 billion (US$ 12 billion) in FY2010. This is a long-term process
and is likely to gather force over time. The motivation for Indian companies expanding abroad to list
in their target markets is to raise their profile and reputation among host consumers, suppliers,
financiers and of course investors. A higher local profile can help to increase company sales if
consumers gain confidence in the firm. This will also have a positive effect on suppliers. Debt costs
will be more manageable if domestic financial institutions reward a higher local profile with better
terms. The ability to tap the pool of investors that have traditionally had confidence in the acquired
firm, such as British Steel and the Tata-acquired Corus, is useful because it also allows the Indian
firm to access foreign currency financing without exposing itself to FX risk if the debt is in the same
local currency as the acquired firm.
Our interviews revealed that the sectors considered to have the greatest potential for foreign
listings are banks and financial services, automobiles and components, metals, pharmaceuticals
and energy. London has a natural advantage when it comes to metals and energy firms, but firms
seeking a foothold in Europe will also gravitate towards a London listing. This dynamic works both
ways: Standard Chartered and Cairns have made domestic offerings in India in order to raise their
local profile and to tap into the local investor base. Stanchart’s IDR was a small percentage of its
overall equity, but the Cairns issue was significant (US$ 1.9 billion) and involved a productive Indian
asset.
London’s prestigious premium listing. A full London listing offers access to most global
investment groups. A senior banker at a London-based global investment bank told us:
“A London listing allows access to an enormous pool of capital. If you are in the FTSE Index,
tracker funds have got to own you and others will follow.”
Both Vedanta Resources and Essar Energy are members of the FTSE 100. London’s
reputation as a market with high standards of transparency and corporate governance is another
draw for Indian companies. Both Vedanta and Essar have faced criticism on corporate governance
grounds in India, and a foreign listing is seen as one way to signal to investors that the company
does maintain high standards. For example, the marketing of Essar’s London listing prominently
emphasized how doing so would highlight the company’s good corporate governance. At the same
time, firms in sectors like infrastructure, mining, energy and property that sometimes face corporate
governance issues may perceive that London’s governance regime is less onerous than that of the
US under Sarbox.
A further advantage of London may be better research coverage. The senior banker quoted
above advised,
“There is a global problem in equity research. The secondary equity market alone cannot
produce sufficient research coverage. This is a big problem for US listed firms from the emerging
markets where at US$ 3 billion you are only a mid-cap. You will be lucky to have a couple of
analysts following you.”
He pointed out that, at least for the present, companies of this size attract better coverage in
London. This research coverage should of course be particularly strong in the mining and energy
clusters described above. Finally, London’s track record as a successful and liquid home for
companies from Russia, South Africa, Eastern Europe and India offers encouragement to Indian
firms considering foreign listings.
Although the volume of business in the immediate term has been hit by the success of QIPs in
domestic Indian markets and the liberalization of FII access to them, investment bankers we spoke
to said that there is strong interest among Indian firms for a London listing and that several offerings
on LSE and AIM are in the pipeline.
Although New York remains attractive for banks and technology and outsourcing firms,
London will be a draw for Indian multinationals seeking to access European markets, as well as
energy, mining and metals companies and, not least, firms that believe that a London listing will
help them in strategic or valuation terms.
Advisory work
There is a level playing field in India for financial intermediaries like brokerages, underwriters
and merchant banks. Foreign firms are permitted to establish wholly owned subsidiaries that can
practise with a SEBI licence. Even state-owned issuances have involved both domestic and
foreign-owned firms: book runners and lead managers for Coal India’s forthcoming domestic listing
are Citi, Deutsche Bank, Morgan Stanley, Enam Financial, Kotak Mahindra and BofA Merrill Lynch.
Foreign audit firms such as PwC, Ernst & Young and KPMG are also permitted to offer financial
advisory services under the same regulatory umbrella (though their audit functions are more strictly
regulated).
Only Indian citizens licensed in India are permitted to practise Indian law. This means that any
legal work related to domestic listings must be carried out by local lawyers and partnerships. Indian
firms such as Amarchand & Mangaldas & Suresh A. Shroff & Co., AZB & Partners, Dua Associates,
Luthra & Luthra, FoxMandal Little and Trilegal will continue to be the main players in the domestic
market. However, foreign law firms are permitted to handle external work related to Indian
issuances abroad. This has created an opportunity for firms like Linklaters, Freshfields Bruckhaus
Deringer, Allen & Overy, Clifford Chance and Jones Day. In practice, foreign firms work closely with
their Indian counterparts and in many cases have developed longstanding relationships. Larger
firms like Linklaters have dozens of Indian lawyers on their staff in locations such as Hong Kong
and London.
There are less onerous restrictions on audit-related functions by accounting firms. Global
audit firms are not permitted to use their own names while practising in India, and there is a cap of
20 on the number of partners a firm can have and on the number of audits per partner. However,
there are no similar restrictions on the Big Four audit firms’ advisory functions such as underwriting
and consultancy once they have secured SEBI registration.
Conclusion
Continued rapid growth in demand for capital
The impressive growth over the past 10 years in the number of EM firms raising equity capital
and the amount of capital raised will continue. Although the 2008 crisis sharply interrupted this
trend, we have already witnessed a strong resumption in domestic and international capital raising
activities by companies from the larger markets of India and Brazil, including several “jumbo”
offerings (NHPC Ltd. [India] – 2009, Essar Energy [India] ─ 2010, VisaNet [Brazil] – 2009, Banco
Santander Brasil – 2009). Capital market activity in Russia (which was the most severely affected
by the crisis) and South Africa remains subdued. With the exception of two IPOs this year, Mexico’s
new issue market remains sluggish as it comes out of a deep recession – although, it must be
noted, the demand for equity capital by Mexican firms has historically lagged that of other EMs.
Robust economic growth in Brazil, India and Russia over the next few years will propel
demand for investment capital from local companies attempting to ramp up domestic operations
and expand into new markets. This demand will be intensified by other drivers, including the high
levels of investment capital needed for infrastructure development (Brazil and India), the
privatization of state-owned enterprises (Russia and India), the rapid expansion of consumer
sectors (Brazil and Russia) and foreign M&A (India).
Capital raising in South Africa and Mexico, in contrast, faces constraints on growth. In
particular, Mexico’s corporate environment, dominated by family-run companies, has a culture of
preferring debt financing over equity.
India, Brazil and South Africa: Demand will be met in large part by domestic markets,
unless there are compelling reasons to go abroad. Brazil and India’s equity markets are now
large and liquid following financial market reforms and rapid growth since 2003. They can and do
handle the majority of new offerings by local firms without the support of dual or ADR/GDR listings
in New York or London, as had been necessary in the late 1990s and early 2000s. At the top end of
the scale, the Reliance Power IPO (US$2.6 billion in 2008) highlighted the capacity of the Indian
market. The upcoming US$ 3-4 billion Coal India IPO will be a good test of post-crisis capacity.
Brazil’s Novo Mercado has shown it can handle even larger amounts, with the Banco do Brasil IPO
(US$ 5.4 billion in 2010) and the VisaNet IPO (US$ 4.2 billion in 2009) being completed without
accompanying US listings.
The super-”jumbo” Petrobras global offering, in spite of its ADR listing on the NYSE,
challenged the local market due to its sheer size. It has drained liquidity from the system and will
likely prevent many smaller offerings by mid-cap firms from taking place for several months.
The depth and liquidity of the BOVESPA and BSE/NSE in India mean that Indian and
Brazilian firms will carry out offerings domestically unless there are compelling reasons to go
abroad. The most important of these is the goal of accessing a wider pool of investors, who
increase demand and thus the pricing tension for large offerings while also providing greater
institutional support in the after-market. “Jumbo” offerings of more than US$3-5 billion in these
markets are not the only operations to benefit from twin-track issuance. Some specialty stocks
benefit from deep knowledge of their sector in certain international centres. Access for large firms to
major global indices, such as the FTSE 100 Index, has been another important driver of going
abroad, as have raising foreign capital for global expansion and building profile and reputation
among host consumers, particularly for Indian firms. Vedanta Resources, Essar Energy and Tata
Steel have all followed this path.
Nearly, all new offerings in South Africa will be carried out on the JSE, but for different
reasons than in India and Brazil. Government controls prevent all but a handful of companies from
going abroad and are unlikely to be relaxed in the near term.
13.4 SUMMARY
International capital flows are the financial side of international trade. When someone imports
a good or service, the buyer (the importer) gives the seller (the exporter) a monetary payment, just
as in domestic transactions. This net financial flow is called its capital account balance.
International capital flows are the financial side of international trade. When someone
imports a good or service, the buyer (the importer) gives the seller (the exporter) a monetary
payment, just as in domestic transactions. If total exports were equal to total imports, these
monetary transactions would balance at net zero: people in the country would receive as much in
financial flows as they paid out in financial flows. But generally, the trade balance is not zero.
1. A capital investment can be made by the executives of the company in their business by
purchasing long-term securities/assets of the company. In such cases, the capital can be
physical assets which could improve the business performance by a significant margin.
India has been a capital-deficient country since independence and raising funds either by
means of equity or debt has always been problematic for industry. The question that comes up
when a business is planning a round of fundraising, is whether debt or equity is a better choice, and
whether funds should be raised domestically or through foreign channels.
Local markets have been sluggish in terms of fundraising so the focus of this article is on
international fundraising, When an Indian company considers raising funds there are traditional and
non-traditional channels available. Some of the options are as follows.
⚫ Equity based. Foreign direct investment policy is very liberal and balanced, and
international investors can invest in nearly all sectors. Save in a few sensitive sectors
such as retail and insurance, 100% foreign equity participation is available. In this liberal
environment, it is easy to find equity participation.
⚫ Debt based. Major banks and financial institutions are the first choice when raising debt
funds from outside the country. Many commercial banks in countries such as the US,
Canada, the UK, Switzerland, Japan, China and Taiwan provide funds to Indian
businesses to finance their business needs. Debts from banks and large financial
institutions are mostly large tickets and suited for projects of significant economic
importance. Institutions such as the World Bank, the International Monetary Fund, the US
International Development Finance Corporation and the Asian Development Bank also
fall into the category of lenders that fund Indian projects of importance.
Although Indian companies largely rely on domestic capital market to fulfill jumbo equity
offerings, they do approach International Capital Markets.
2. How would you describe the current situation for capital raising in international markets
for Indian companies?
3. Which are the most desirable markets for Indian companies – sector wise?
4. Your view – Indian companies can get sufficient capital from India itself. They do not
need to tap foreign shores.
1. When someone imports a good or service, the buyer (the importer) gives the seller (the
exporter) a monetary payment, just as in domestic transactions. This net financial flow is
called its -----------------------
2. In -------------- accounting terms, the current-account balance, which is the total balance of
internationally traded goods and services, is just offset by the capital-account balance,
which is the total balance of claims that domestic investors and foreign investors have
acquired in newly invested financial, real property, and equity assets in each other’s’
countries.
(b) balance-of-payments
(a) True
(b) False
4. Foreign firms are permitted to establish -------------------------that can practise with a SEBI
licence
5. The government introduced a new rule in June 2010 that required at least ------------ of
the equity of all listed firms to be made available to the public.
(a) 51%
(b) 40%
(c) 29%
(d) 25%
Answers:
qqq
Summary
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Chapter – 14
14 CROWD FUNDING
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
14.1 Introduction to Crowd Funding
14.6 Summary
Crowd funding is solicitation of funds (small amount) from multiple investors through a web-
based platform or social networking site for a specific project, business venture or social cause.
Crowd sourced funding is a means of raising money for a creative project (for instance, music,
film, book publication), a benevolent or public interest cause (for instance, a community based
social or co-operative initiative) or a business venture, through small financial contributions from
persons who may number in the hundreds or thousands. Those contributions are sought through an
online crowd funding platform, while the offer may also be promoted through social media.
As per IOSCO Staff Working Paper – Crowdfunding: An Infant Industry Growing Fast, 2014
(‘IOSCO Paper’), Crowd funding can be divided into four categories: donation crowd funding,
reward crowd funding, peer-to-peer lending and equity crowd funding.
Donation crowd funding denotes solicitation of funds for social, artistic, philanthropic or
other purpose, and not in exchange for anything of tangible value. For example, in the
US, Kickstarter, Indiegogo etc. are some of the platforms that support donation-based
crowd funding.
Crowd Funding
Reward crowd funding refers to solicitation of funds, wherein investors receive some
existing or future tangible reward (such as an existing or future consumer product or a
membership rewards scheme) as consideration. Most of the websites which support
donation crowd funding, also enable reward crowd funding, e.g., Kicktstarter, Rockethub
etc.
3. Peer-to-peer lending
A report by the Open Data Institute in July 2013 found that between October 2010 and
May 2013, some 49,000 investors in the UK funded peer-to-peer loans worth more than
£378 million.
(a) Kickstarter
Kickstarter is a site where creative projects raise donation-based funding. These projects
can range from new creative products, like an art installation, to a cool watch, to pre-
selling a music album. It’s not for businesses, causes, charities, or personal financing
needs. Kickstarter is one of the earlier platforms and has experienced strong growth and
many break out large campaigns in the last few years.
(b) Indiegogo
While Kickstarter maintains a tighter focus and curates the creative projects approved on
its site, Indiegogo approves donation-based fundraising campaigns for most anything —
music, hobbyists, personal finance needs, charities and whatever else you could think of
(except investment). They have had international growth because of their flexibility, broad
approach and their early start in the industry.
Crowdfunder.com is the platform for raising investment (not rewards) and has a one of
the largest and fastest growing network of investors. It was recently featured on Fox
News as the new breed of crowd funding due to the story about a $ 2 billion exit of a
crowd funded company. After getting rewards-based funding on Kickstarter or Indiegogo,
companies are often giving the crowd the opportunity to invest at Crowd Funder to raise
more formal Seed and Series A rounds.
Crowd funder offers equity crowd funding currently only from individuals + angels + VCs
and was a leading participant in the JOBS Act legislation.
(d) RocketHub
Rockethub powers donation-based funding for a wide variety of creative projects. What’s
unique about RocketHub is their FuelPad and LaunchPad programs that help campaign
owners and potential promotion and marketing partners connect and collaborate for the
success of a campaign.
(e) Crowdrise
Crowdrise is a place for donation-based funding for Causes and Charity. They’ve
attracted a community of do-gooders and fund all kinds of inspiring causes and needs.
A unique Points System on Crowdrise helps track and reveal how much charitable impact
members and organisations are making.
(f) Somolend
Somolend is a site for lending for small businesses in the US, providing debt-based
investment funding to qualified businesses with existing operations and revenue.
Somolend has partnered with banks to provide loans, as well as helping small business
owners bring their friends and family into the effort.
With their Midwest roots, a strong founder who was a leading participant in the JOBS Act
legislation, and their focus and lead in the local small business market, Somolend has
begun expanding into multiple cities and markets in the US.
(g) Appbackr
If you want to build the next new mobile app and are seeking donation-based funding to
get things off the ground or growing, then check out appbackr and their niche community
for mobile app development.
(h) AngelList
If you’re a tech start-up with a shiny lead investor already signed on, or looking for
Silicon Valley momentum, then there are angels and institutions funding investments
through AngelList. For a long while AngelList didn’t say that they did crowd funding,
which makes sense as they have catered to the investment establishment of VCs in tech
start-ups, but now they’re getting into the game. The accredited investors and institutions
on AngelList have been funding a growing number of top tech start-up deals.
(i) Invested.in
You might want to create your own crowd funding community to support donation-based
fundraising for a specific group or niche in the market. Invested.in is a Venice, CA based
company that is a top name “white label” software provider, giving you the tools to get
started and grow your own.
(j) Quirky
These 10 crowd funding sites cover most campaign types or funding goals you might have.
Whether you’re looking to fundraise or not, go check out the sites here that grab your attention and
get involved in this collaborative community.
⚫ Crowd funding has revitalized the Arts at a time when public programs that support it are
steadily dying off.
⚫ Crowd funding is growing a market for impact investing in social enterprises, marrying the
worlds of entrepreneurship and philanthropy, and helping a broader base of investors to
back companies for both profits and purpose.
⚫ Crowd funding is accelerating angel investing and creating an entirely new market for
investment crowd funding for businesses.
⚫ So get involved and join a crowd funding community today. You’ll make a difference for a
project or business owner, and also help build a new and more collaborative economy.
USB Charger
Gear Tie-Down
Bottle Opener
This is an incomplete list of the most well-funded crowd funding projects, either successful or
not (23-Sep-2014).
3 Coolest Cooler Product Design Kickstarter Aug 29, 2014 $50,000 $13,285,226
8 Pono Music Digital music Kickstarter Apr 15, 2014 $800,000 $6,225,354
player
15 Project Eternity Video game Kickstarter, Oct 16, 2012 $1,100,000 $3,986,929
Independent
19 Double Fine Video game Kickstarter Mar 13, 2012 $400,000 $3,336,371
Adventure
21 Project CARS Video game World Of Nov 11, 2012 $3,108,600 $3,142,808
Mass
Development
22 Wish I Was Here Movie Kickstarter May 24, 2013 $2,000,000 $3,105,473
25 SCiO: Your Sixth Spectrometer Kickstarter Jun 15, 2014 $200,000 $2,762,571
Sense
37 Canary Home Home security Indiegogo Aug 26, 2013 $1,000,000 $1,961,464
Security
40 Scanadu Scout Health scanner Indiegogo Jul 20, 2013 $100,000 $1,664,375
43 ARKYD: A Space Space Telescope Kickstarter Jun 30, 2013 $1,000,000 $1,505,366
Telescope for
Everyone
A donation of 25,000 million (Rs 2,500 crore) has been collected for Ram Temple construction
in Ayodhya, as per banks' receipts till March 4 in crowd funding drive, Vishva Hindu Parishad (VHP)
has informed.
"Based on banks' receipts till February 4, 25,000 million has been collected during donation
drive for the construction of Ram temple in Ayodhya," VHP said.
Speaking on the matter, Champat Rai, General Secretary, Ram Janmabhoomi Teertha
Kshetra Trust, said, "Door-to-door collection has stopped. People can donate online on the Trust's
website. We are in talks to acquire land for a ground in front of the temple but nothing decided yet.
Temple to be ready in 3 years."
Prior to the crowdfunding campaign launch on January 15, the Trust had projected an
estimate of Rs 1,100 crore for the Ram temple complex construction, but it received more than Rs
1,000 crore over projection.
Shri Ram Janmabhoomi Teertha Kshetra Trust treasurer, Govind Dev Giri, has earlier told
reporters, "The funds-raising campaign has ended with generous contributions from all cross-
sections of the people, including residents of far-flung villages of India, blurring religious barriers..."
Giri had pegged the construction cost of the temple at Rs 300-400 crore, while making an
estimate of Rs 1,100 crore for building the entire complex on Ram Janambhoomi in December last
year.
Ayodhya seers have now advised the temple trust to use the surplus money for development
of Ayodhya and warned against misuse of the money donated by crores of Ram Bhaktas.
However, Anil Misra, member of the Trust said, "The budget for building the temple complex is
not final and this will be known only after the construction is complete."
Swami Paramhans Acharya, of Tapasvi Chhavni said, "The Trust should use additional funds
to set up a Sanskrit University in Ayodhya in the name of Mata Sita and establish a gaushala for
free supply of milk in the temple town."
Mahant Dhinendra Das of Nirmohi Akhara, said that "the money was donated by millions of
Indians in the name of Lord Ram and the excess money should be used for the welfare of Ayodhya
and its temples".
Hanuman Garhi temple priest, Mahant Raju Das, said the money could be used to revamp
dilapidated temples in Ayodhya.
14.6 SUMMARY
Crowdfunding has been used to fund a lot of projects in the past such as political campaign
funding, business startup funding, disaster reliefs etc. Crowdfunding is also used to raise money for
humanitarian projects such as medical relief or Non-Governmental Organizations (NGO’s). The 4
basic types of crowdfunding are:
Creative crowdsourcing involves getting different ideas and solutions for a particular project. It
allows for several people to contribute creative ideas to a task together. Microwork is also known as
Microtasking. Wisdom of the crowd involves gathering collective opinions of a large group of people
over a particular subject or issue. It is often believed that the opinions of a large group of people are
better and more useful than the opinion of a single individual.
2. Equity Crowdfunding: the backer receives shares of a company, usually in its early
stages, in exchange for the money pledged. The company's success is determined by
how successfully it can demonstrate its viability.
Application, role of crowd, crowd funding platforms etc are explained in its historical way. This
was beginning at early stages. Similarly various risks and barriers to development of crowdfunding
are also covered and explained. Crowdfunding campaigns provide producers with a number of
benefits, beyond the strict financial gains.
Crowdfunding also comes with a number of potential risks or barriers. These risks explained
in this chapter need to be properly addressed even today as they are intrinsic.
For crowdfunding of equity stock purchases, there is some research in social psychology that
indicates that, like in all investments, people don't always do their due diligence to determine if it's a
sound investment before investing, which leads to making investment decisions based on emotion
rather than financial logic.
4. Study the list of the top 50 projects funded by crowdfunding. Which are the different types
of projects funded by crowd funding?
1. Crowd funding is solicitation of funds (small amount) from multiple investors through a ----
---------------------------------for a specific project, business venture or social cause.
4. What type of crowd funding denotes solicitation of funds for social, artistic, philanthropic
or other purpose, and not in exchange for anything of tangible value?
(a) Individuals
(b) Companies
(c) Trusts
(d) NBFC
Answer:
qqq
Summary
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Chapter – 15
15
PROJECT PLANNING, RISKS
AND MANAGEMENT
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
15.1 Project Planning - Introduction
15.8 Summary
A project plan is a series of formal documents that define the execution and control stages of
a project. The plan includes considerations for risk management, resource management and
communications, while also addressing scope, cost and schedule baselines. Project planning
software is used by project managers to ensure that their plans are thorough and robust.
The key to a successful project is in the planning. The first thing to do while undertaking any
kind of project is to create a Project Plan. Many times, project planning is ignored in favour of
getting on with the work. However, many people fail to realise the value of a project plan in saving
time, money and many problems.
Your project plan is essential to the success of any project. Without one, your project may be
susceptible to common project management issues such as missed deadlines, scope creep and
cost overrun. While writing a project plan is somewhat labour intensive up front, the effort will pay
dividends throughout the project life cycle. The basic outline of any project plan can be summarised
in these five steps:
2. Identify risks and assign deliverables to your team members, who will perform the tasks
required and monitor the risks associated with them.
3. Organize your project team (customers, stakeholders, teams, ad hoc members, and so
on), and define their roles and responsibilities.
4. List the necessary project resources, such as personnel, equipment, salaries, and
materials, then estimate their cost.
6. Create a communication plan, schedule, budget and other guiding documents for the
project.
Each of the steps to write a project plan explained above correspond to the 5 project phases,
which we will outline in the next section.
Any project, whether big or small, has the potential to be very complex. It’s much easier to
break down all the necessary inclusions for a project plan by viewing your project in terms of
phases have identified the following 5 phases of a project:
1. Initiation: The start of a project, in which goals and objectives are defined through a
business case and the practicality of the project is determined by a feasibility study.
2. Planning: During this stage, the scope of the project is defined by a work breakdown
structure (WBS) and the project methodology to manage the project is decided on. Costs,
quality and resources are estimated, and a schedule with milestones and task
dependencies is identified. The main deliverable of this phase is your project plan.
3. Execution: The project deliverables are completed during this phase. Usually, this phase
begins with a kick-off meeting and is followed by regular team meetings and status
reports while the project is being worked on.
4. Monitoring & Controlling: This phase is performed in tandem with the project execution
phase. Progress and performance metrics are measured to keep progress on the project
aligned with the project plan.
5. Closure: The project is completed when the stakeholder receives the final deliverable.
Resources are released, contracts are signed off on and, ideally, there will be an
evaluation of the successes and failures.
A project is successful when the needs of the stakeholders have been met. A stakeholder is
anybody directly, or indirectly impacted by the project.
As a first step, it is important to identify the stakeholders in your project. It is not always easy
to identify the stakeholders of a project, particularly those impacted indirectly. Examples of
stakeholders are:
Once you understand who the stakeholders are, the next step is to find out their needs. The
best way to do this is by conducting stakeholder interviews. Take time during the interviews to draw
out the true needs that create real benefits. Needs that aren’t relevant and don’t deliver benefits
can be recorded and set as a low priority.
The next step, once you have conducted all the interviews, and have a comprehensive list of
needs is to prioritize them. From the prioritized list, create a set of goals that can be easily
measured. This way it will be easy to know when a goal has been achieved.
Once you have established a clear set of goals, they should be recorded in the project plan. It
can be useful to also include the needs and expectations of your stakeholders. This is the most
difficult part of the planning process completed. It’s time to move on and look at the project
deliverables.
Using the goals you have defined, create a list of things the project needs to deliver in order to
meet those goals. Specify when and how each item must be delivered.
Add the deliverables to the project plan with an estimated delivery date. More accurate
delivery dates will be established during the scheduling phase, which is next.
Create a list of tasks that need to be carried out for each deliverable identified in Step 2. For
each task, identify the following:
Once you have established the amount of effort for each task, you can workout the effort
required for each deliverable, and an accurate delivery date. Update your deliverables section with
the more accurate delivery dates.
At this point in the planning, you could choose to use a software package such as Primavera
or Microsoft Project (Gantt Charts) to create your project schedule. Alternatively, use one of the
many free templates available. Input all of the deliverables, tasks, durations and the resources who
will complete each task.
A common problem discovered at this point, is when a project has an imposed delivery
deadline from the sponsor that is not realistic based on your estimates. If you discover this is the
case, you must contact the sponsor immediately. The options you have in this situation are:
This section deals with plans you should create as part of the planning process. These can be
included directly in the plan.
Next, describe the number and type of people needed to carryout the project. For each
resource detail start dates, estimated duration and the method you will use for obtaining them.
A risk is any uncertain event or condition that might affect your project. Not all risks are
negative. Some events (like finding an easier way to do an activity) or conditions (like lower prices
for certain materials) can help your project. When this happens, we call it an opportunity; but it’s still
handled just like a risk.
There are no guarantees on any project. Even the simplest activity can turn into unexpected
problems. Anything that might occur to change the outcome of a project activity, we call that a risk.
A risk can be an event (like a snowstorm) or it can be a condition (like an important part being
unavailable). Either way, it’s something that may or may not happen …but if it does, then it will
force you to change the way you and your team work on the project.
⚫ Stakeholders input is not sought, or their needs are not properly understood.
Risks can be tracked using a simple risk log. Add each risk you have identified to your risk
log; write down what you will do in the event it occurs, and what you will do to prevent it from
occurring. Review your risk log on a regular basis, adding new risks as they occur during the life of
the project. Remember, when risks are ignored they don’t go away.
When you’re planning your project, risks are still uncertain: they haven’t happened yet. But
eventually, some of the risks that you plan for do happen, and that’s when you have to deal with
them. There are four basic ways to handle a risk.
1. Avoid: The best thing you can do with a risk is avoid it. If you can prevent it from
happening, it definitely won’t hurt your project. The easiest way to avoid this risk is to
walk away from the cliff, but that may not be an option on this project.
2. Mitigate: If you can’t avoid the risk, you can mitigate it. This means taking some sort of
action that will cause it to do as little damage to your project as possible.
3. Transfer: One effective way to deal with a risk is to pay someone else to accept it for you.
The most common way to do this is to buy insurance.
4. Accept: When you can’t avoid, mitigate, or transfer a risk, then you have to accept it. But
even when you accept a risk, at least you’ve looked at the alternatives and you know
what will happen if it occurs. If you can’t avoid the risk, and there’s nothing you can do to
reduce its impact, then accepting it is your only choice.
By the time a risk actually occurs on your project, it’s too late to do anything about it. That’s
why you need to plan for risks from the beginning and keep coming back to do more planning
throughout the project.
The risk management plan tells you how you’re going to handle risk in your project. It
documents how you’ll assess risk, who is responsible for doing it, and how often you’ll do risk
planning (since you’ll have to meet about risk planning with your team throughout the project).
Some risks are technical, like a component that might turn out to be difficult to use. Others are
external, like changes in the market or even problems with the weather.
It’s important to come up with guidelines to help you figure out how big a risk’s potential
impact could be. The impact tells you how much damage the risk would cause to your project.
Many projects classify impact on a scale from minimal to severe, or from very low to very high. Your
risk management plan should give you a scale to help figure out the probability of the risk. Some
risks are very likely; others aren’t.
Good Project Risk Management depends on supporting organisational factors, clear roles and
responsibilities, and technical analysis skills.
Project risk management in its entirety, includes the following six process groups:
2. Risk identification
Project Risk Management is the identification, assessment, and prioritization of risks followed
by coordinated and economical application of resources to minimize, monitor, and control the
probability and/or impact of unfortunate events or to maximize the realization of opportunities.
It will reap great rewards for an organization. If uncertainties in a project are taken care of or
removed, it will result in timely completion of projects in the estimated budgets. Also, all threats and
firefighting will be removed.
Managing risks on projects is a process that includes risk assessment and a mitigation
strategy for those risks. Risk assessment includes both the identification of potential risk and the
evaluation of the potential impact of the risk. A risk mitigation plan is designed to eliminate or
minimize the impact of the risk events—occurrences that have a negative impact on the project.
Identifying risk is both a creative and a disciplined process. The creative process includes
brainstorming sessions where the team is asked to create a list of everything that could go wrong.
All ideas are welcome at this stage with the evaluation of the ideas coming later.
Risk Identification
A more disciplined process involves using checklists of potential risks and evaluating the
likelihood that those events might happen on the project. Some companies and industries develop
risk checklists based on experience from past projects. These checklists can be helpful to the
project manager and project team in identifying both specific risks on the checklist and expanding
the thinking of the team. The past experience of the project team, project experience within the
company, and experts in the industry can be valuable resources for identifying potential risk on a
project.
Identifying the sources of risk by category is another method for exploring potential risk on a
project. Some examples of categories for potential risks include the following:
⚫ Technical
⚫ Cost
⚫ Schedule
⚫ Client
⚫ Contractual
⚫ Weather
⚫ Financial
⚫ Political
⚫ Environmental
⚫ People
You can use the same framework as the work breakdown structure (WBS) for developing a
risk breakdown structure (RBS). A risk breakdown structure organises the risks that have been
identified into categories using a table with increasing levels of detail to the right. The people
category can be subdivided into different types of risks associated with the people. Examples of
people risks include the risk of not finding people with the skills needed to execute the project or the
sudden unavailability of key people on the project.
Risk Evaluation
After the potential risks have been identified, the project team then evaluates each risk based
on the probability that a risk event will occur and the potential loss associated with it. Not all risks
are equal. Some risk events are more likely to happen than others, and the cost of a risk can vary
greatly. Evaluating the risk for probability of occurrence and the severity or the potential loss to the
project is the next step in the risk management process.
Having criteria to determine high-impact risks can help narrow the focus on a few critical risks
that require mitigation. For example, suppose high-impact risks are those that could increase the
project costs by 5% of the conceptual budget or 2% of the detailed budget. Only a few potential risk
events meet these criteria. These are the critical few potential risk events that the project
management team should focus on when developing a project risk mitigation or management plan.
Risk evaluation is about developing an understanding of which potential risks have the greatest
possibility of occurring and can have the greatest negative impact on the project. These become
the critical few.
Risk evaluation often occurs in a workshop setting. Building on the identification of the risks,
each risk event is analysed to determine the likelihood of occurrence and the potential cost if it did
occur. The likelihood and impact are both rated as high, medium, or low. A risk mitigation plan
addresses the items that have high ratings on both factors—likelihood and impact.
Not all project managers conduct a formal risk assessment on a project. One reason, as found
by David Parker and Alison Mobey in their phenomenological study of project managers, was a low
understanding of the tools and benefits of a structured analysis of project risks (2004). The lack of
formal risk management tools was also seen as a barrier to implementing a risk management
program. Additionally, the project manager’s personality and management style play into risk
preparation levels. Some project managers are more proactive and develop elaborate risk
management programs for their projects. Other managers are reactive and are more confident in
their ability to handle unexpected events when they occur. Yet others are risk averse, and prefer to
be optimistic and not consider risks or avoid taking risks whenever possible.
On projects with a low-complexity profile, the project manager may informally track items that
may be considered risk items. On more complex projects, the project management team may
develop a list of items perceived to be higher risk and track them during project reviews. On
projects of even greater complexity, the process for evaluating risk is more formal with a risk
assessment meeting or series of meetings during the life of the project to assess risks at different
phases of the project. On highly complex projects, an outside expert may be included in the risk
assessment process, and the risk assessment plan may take a more prominent place in the project
implementation plan.
On complex projects, statistical models are sometimes used to evaluate risk because there
are too many different possible combinations of risks to calculate them one at a time. One example
of the statistical model used on projects is the Monte Carlo simulation, which simulates a possible
range of outcomes by trying many different combinations of risks based on their likelihood. The
output from a Monte Carlo simulation provides the project team with the probability of an event
occurring within a range and for combinations of events. For example, the typical output from a
Monte Carlo simulation may indicate a 10% chance that one of the three important pieces of
equipment will be late and that the weather will also be unusually bad after the equipment arrives.
Risk Mitigation
After the risk has been identified and evaluated, the project team develops a risk mitigation
plan, which is a plan to reduce the impact of an unexpected event. The project team mitigates risks
in various ways:
⚫ Risk avoidance
⚫ Risk sharing
⚫ Risk reduction
⚫ Risk transfer
Each of these mitigation techniques can be an effective tool in reducing individual risks and
the risk profile of the project. The risk mitigation plan captures the risk mitigation approach for each
identified risk event and the actions the project management team will take to reduce or eliminate
the risk.
⚫ Risk avoidance usually involves developing an alternative strategy that has a higher
probability of success but usually at a higher cost associated with accomplishing a
project task. A common risk avoidance technique is to use proven and existing
technologies rather than adopt new techniques, even though the new techniques may
show promise of better performance or lower costs. A project team may choose a vendor
with a proven track record over a new vendor that is providing significant price incentives
to avoid the risk of working with a new vendor. The project team that requires drug
testing for team members is practicing risk avoidance by avoiding damage done by
someone under the influence of drugs.
⚫ Risk sharing involves partnering with others to share responsibility for the risky
activities. Many organisations that work on international projects will reduce political,
legal, labour, and others risk types associated with international projects by developing a
joint venture with a company located in that country. Partnering with another company to
share the risk associated with a portion of the project is advantageous when the other
company has expertise and experience the project team does not have. If a risk event
does occur, then the partnering company absorbs some or all of the negative impact of
the event. The company will also derive some of the profit or benefit gained by a
successful project.
⚫ Risk transfer is a risk reduction method that shifts the risk from the project to another
party. The purchase of insurance on certain items is a risk-transfer method. The risk is
transferred from the project to the insurance company. A construction project in the
Caribbean may purchase hurricane insurance that would cover the cost of a hurricane
damaging the construction site. The purchase of insurance is usually in areas outside the
control of the project team. Weather, political unrest, and labour strikes are examples of
events that can significantly impact the project and that are outside the control of the
project team.
Contingency Plan
The project risk plan balances the investment of the mitigation against the benefit for the
project. The project team often develops an alternative method for accomplishing a project goal
when a risk event has been identified that may frustrate the accomplishment of that goal. These
plans are called contingency plans. The risk of a truck drivers’ strike may be mitigated with a
contingency plan that uses a train to transport the needed equipment for the project. If a critical
piece of equipment is late, the impact on the schedule can be mitigated by making changes to the
schedule to accommodate a late equipment delivery.
Contingency funds are funds set aside by the project team to address unforeseen events that
cause the project costs to increase. Projects with a high-risk profile will typically have a large
contingency budget. Although the amount of contingency allocated in the project budget is a
function of the risks identified in the risk analysis process, contingency is typically managed as one
line item in the project budget.
Some project managers allocate the contingency budget to the items in the budget that have
high risk rather than developing one line item in the budget for contingencies. This approach allows
the project team to track the use of contingency against the risk plan. This approach also allocates
the responsibility to manage the risk budget to the managers responsible for those line items. The
availability of contingency funds in the line-item budget may also increase the use of contingency
funds to solve problems rather than finding alternative, less costly solutions. Most project
managers, especially on more complex projects, manage contingency funds at the project level,
with approval of the project manager required before contingency funds can be used.
Project risk is dealt with in different ways depending on the phase of the project.
⚫ Initiation: Risk is associated with things that are unknown. More things are unknown at
the beginning of a project, but risk must be considered in the initiation phase and
weighed against the potential benefit of the project’s success in order to decide, if the
project should be chosen.
⚫ Planning Phase: Once the project is approved and it moves into the planning stage,
risks are identified with each major group of activities. A risk breakdown structure (RBS)
can be used to identify increasing levels of detailed risk analysis.
Understanding where the risks occur on the project is important information for managing the
contingency budget and managing cash reserves. Most organisations develop a plan for financing
the project from existing organizational resources, including financing the project through a variety
of financial instruments. In most cases, there is a cost to the organisation to keep these funds
available to the project, including the contingency budget. As the risks decrease over the length of
the project, if the contingency is not used, then the funds set aside by the organisation can be used
for other purposes.
To determine the amount of contingency that can be released, the project team will conduct
another risk evaluation and determine the amount of risk remaining on the project. If the risk profile
is lower, the project team may release contingency funds back to the parent organisation. If
additional risks are uncovered, a new mitigation plan is developed including the possible addition of
contingency funds.
Closeout Phase
During the closeout phase, agreements for risk sharing and risk transfer need to be concluded
and the risk breakdown structure examined to be sure all the risk events have been avoided or
mitigated. The final estimate of loss due to risk can be made and recorded as part of the project
documentation. If a Monte Carlo simulation was done, the result can be compared to the predicted
result.
The Work breakdown structure (WBS) in project management is a method for completing a
complex, multi-step project. It's a way to divide and conquer large projects to get things done faster
and more efficiently. The goal of a WBS is to make a large project more manageable. Breaking it
down into smaller chunks means work can be done simultaneously by different team members,
leading to better team productivity and easier project management.
The Work Breakdown Structure, usually shortened to WBS, is a tool project managers use to
break projects down into manageable pieces. It is the start of the planning process and is often
called the ‘foundation’ of project planning. Most project professionals recognize the importance and
benefits of a WBS in outperforming projects without one.
What is a WBS?
A WBS is deliverables based; meaning the product or service the customer will get when the
project is finished. There is another tool called a Product Breakdown Structure (PBS), which comes
before the WBS and breaks a project down into outputs (products) needed to complete the project.
⚫ Provides an ideal tool for team brainstorming and for promoting team cohesion.
WBS Inputs
1. Project Scope Statement: Detailed description of the project’s deliverables and work
needed to create them.
2. Statement of Requirements: Document detailing the business need for the project and
what will be delivered in detail.
These items give you and your team all the information needed to create the WBS. You’ll also
need a WBS template.
WBS Outputs
3. Scope Baseline: The Project Scope Statement, WBS and WBS Dictionary.
A WBS is easy to create. Once the aims and objectives of the project are understood, a
meeting can be arranged where the project team breaks down the deliverables needed to complete
the project. Creation is best done as a team exercise. This helps engage your team and gives them
an emotional stake in the project. It’s a good idea to involve your stakeholders at this point.
There are two formats in which the WBS can be expressed, tabular form and graphical form.
The tabular form can be created in a spreadsheet, numbering each level and sub-level. The
graphical form can be created using drawing software, creating a tree style diagram. Either form
starts with the project name as its first level. Then all the top-level deliverables are added.
Remember, at the second level, you are looking to identify everything needed to complete the
project.
Break down each second level deliverable until you reach work packages of no less than two
weeks. As a general rule, two-week work packages are manageable. You might also consider the
8/80 rule at this point. It is up to the team how each item is broken down; there are no rules that
define this, and it will reflect the style of the team creating the WBS. It’s important to note that
activities and tasks are not included in a WBS, these are planned out from the work packages later.
Check no major areas or deliverables have been missed, and you’ve only included the work
needed to complete your project successfully. Your WBS should contain the complete project
scope, including the project management work packages. Conducting the WBS creation as a team
exercise helps make sure nothing is forgotten.
This level of decomposition makes it easy to cost each work package and arrive at an
accurate cost for the project. Similarly, people can be assigned to the work packages; however, you
may prefer to add the skills needed for the work packages and leave the people allocation until you
create your schedule, when you can see the timeline.
The next step is to transfer your WBS output into a project schedule, typically a Gantt chart.
Expand the work packages with the activities and tasks needed to complete them. The Gantt chart
is used to track progress across time of the work packages identified in your WBS.
In a perfect world, every project would be “on time and within budget.” But reality (especially
the proven statistics) tells a very different story. It is not uncommon for projects to fail. Even if the
budget and schedule are met, one must ask “did the project deliver the results and quality we
expected?” True project success must be evaluated on all three components. Otherwise, a project
could be considered a “failure.”
Have you ever seen a situation where projects begin to show signs of disorganization, appear
out of control, and have a sense of doom and failure? Have you witnessed settings where everyone
works in a silo and no one seems to know what the other team member is doing? What about team
members who live by the creed “I’ll do my part (as I see fit) and after that, it’s their problem.” Even
worse is when team members resort to finger-pointing. Situations similar to these scenarios point to
a sign that reads “danger.” And if you read the fine print under the word “danger” it reads, “your
project needs to be brought under control or else it could fail.”
When projects begin to show signs of stress and failure, everyone looks to the project
manager for answers. It may seem unfair that the burden of doom falls upon a single individual. But
this is the reason why you chose to manage projects for a living! You’ve been trained to recognize
and deal with these types of situations.
There are many reasons why projects (both simple and complex) fail; the number of reasons
can be infinite. However, if we apply the 80/20 rule, the most common reasons for failure can be
found in the following list:
2. Poorly managed
Even with the best of intentions or solid plans, project can go awry if they are not managed
properly. All too often, mishaps can occur. This is when the project manager must recognize a
warning sign and take action. If you understand the difference between symptoms and problems
and can spot warning signs of project failure, it will help you take steps to right the ship before it
keels over. Yes, it’s the project manager’s responsibility to correct the listing no one else. In
addition to applying the processes and principles taught in project management class, you can also
use your personal work skills of communication, management, leadership, conflict resolution, and
diplomacy to take corrective action.
During the course of managing a project, the project manager must monitor activities (and
distractions) from many sources and directions. Complacency can easily set in. When this happens,
the process of “monitoring” breaks down. This is why the project manager must remain in control of
a project and be aware of any activity which presents a risk of project failure.
15.8 SUMMARY
A project plan is a series of formal documents that define the execution and control stages of
a project. The plan includes considerations for risk management, resource management and
communications, while also addressing scope, cost and schedule baselines. Project planning
software is used by project managers to ensure that their plans are thorough and robust.
Project Planning in the most important step in Project and if done properly done, can save
time, money and many problems. The Plan should include Project Goals, Deliverables, Schedules
and Supporting Plans.
Any project, whether big or small, has the potential to be very complex. It’s much easier to
break down all the necessary inclusions for a project plan by viewing your project in terms of
phases have identified the following 5 phases of a project:
1. Initiation: The start of a project, in which goals and objectives are defined through a
business case and the practicality of the project is determined by a feasibility study.
2. Planning: During this stage, the scope of the project is defined by a work breakdown
structure (WBS) and the project methodology to manage the project is decided on. Costs,
quality and resources are estimated, and a schedule with milestones and task
dependencies is identified. The main deliverable of this phase is your project plan.
3. Execution: The project deliverables are completed during this phase. Usually, this phase
begins with a kick-off meeting and is followed by regular team meetings and status
reports while the project is being worked on.
4. Monitoring & Controlling: This phase is performed in tandem with the project execution
phase. Progress and performance metrics are measured to keep progress on the project
aligned with the project plan.
5. Closure: The project is completed when the stakeholder receives the final deliverable.
Resources are released, contracts are signed off on and, ideally, there will be an
evaluation of the successes and failures.
Project Risk Management involves steps such as Risk identification, Performing qualitative
risk analysis, Performing quantitative risk analysis, Planning risk responses and Monitoring and
controlling risks.
Managing risks on projects is a process that includes risk assessment and a mitigation
strategy for those risks. Risk assessment includes both the identification of potential risk and the
evaluation of the potential impact of the risk. A risk mitigation plan is designed to eliminate or
minimize the impact of the risk events—occurrences that have a negative impact on the project.
Identifying risk is both a creative and a disciplined process. The creative process includes
brainstorming sessions where the team is asked to create a list of everything that could go wrong.
All ideas are welcome at this stage with the evaluation of the ideas coming later.
The need for an emphasis on planning is what separates project management from general
management. The WBS is the first step in producing a quality project plan and setting you and your
team on the road to success. Neglecting this process in favour of getting on with the work has been
the downfall of many projects. Improve your chances of success by always producing a WBS for
your projects.
Projects fail for a variety of reasons mainly being Undefined objectives and goals, Poor
management, Lack of management commitment and Lack of a solid project plan.
1. The start of a project, in which goals and objectives are defined through a business case
and the practicality of the project is determined by a feasibility study is called as -----------
--------------
2. The Monitoring & Controlling phase is performed in tandem with the project execution
phase. -------------------------------------- are measured to keep progress on the project
aligned with the project plan.
(a) Progress
(b) Performance
(d) Implementation
3. By taking some sort of action that will cause it to do as little damage to your project as
possible is called as ---------------------------
(a) Mitigation
(b) Avoidance
(c) Transfer
(d) Acceptance
4. A method for completing a complex, multi-step project which is a way to divide and
conquer large projects to get things done faster and more efficiently is called ----------------
.
5. During the course of managing a project, the project manager must -----------------------
from many sources and directions.
Answers:
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Summary
PPT
MCQ
Video1
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Chapter – 16
16
PROJECT QUALITY
ASSURANCE AND AUDIT
Chapter
Objectives
After studying this chapter, you should be able to:
Structure:
16.1 Introduction
16.5 Summary
16.1 INTRODUCTION
Quality Assurance is an audit function that evaluates the actual project quality results against
the planned or intended results to ensure that the appropriate processes are being employed by the
project team. “Assuring” quality implies ensuring the project quality requirements are being achieve.
Quality Assurance assures the quality of the product meaning that this process ensures that
the product generated from the process is defect free and conforms to all stated customer
Quality Assurance can also be viewed upon as a proactive process, and it places importance
on planning, documentation, and guidelines finalisation that will be needed to assure the quality.
This process begins at the very start of the project to compare the product’s requirements and
expectations. Once all requirements and expectations are recognised, a plan is developed to meet
these requirements and expectations.
In, Quality Audit, a panel of external experts come and review the process and procedures. If
they discover any discrepancies, they will recommend corrective action or an enhancement in the
process. It is an excellent tool to ensure the best practice and approved procedures are being
followed.
Quality management and control tools include different diagrammatic techniques which aid in
discovering ideas, help make decisions, and priorities issues.
⚫ In quality Assurance, one checks if the plan was efficient enough to avoid any forecasted
defect. In Quality Control, one attempts to find defects and correct them while creating
the product.
⚫ Quality Assurance includes processes managing quality, and Quality Control is utilised to
validate the product quality.
⚫ Quality Audit is an example of Quality Assurance. Inspection and testing are great
examples of the Quality control process
⚫ Offer customer satisfaction, which positively affects your brand and helps individuals and
organizations grow their business.
⚫ Less rework and after-sale support is needed. This will aid one save a lot of money.
Quality Assurance and Quality Control are closely interlinked and their objective is also the
same, which is to deliver a defect-free product.
Both processes are key components of a quality management plan and augment each other.
Failing to implement either of them will lead to failure of quality management in the project.
Quality Assurance is one of the prime features in the Project Management space and one of
the most rapidly transforming areas in software creation.
Quality Assurance activities are those tasks the quality team executes to view the quality
requirements, audit the results of control measurements and analyse quality performance in order
to make sure that right quality standards and procedures are appropriately applied within the
project.
The Quality Management Plan defines the acceptable level of quality, which is typically
defined by the customer, and describes how the project will ensure this level of quality in its
deliverables and work processes. Quality management activities ensure that:
Quality Management plans apply to project deliverables and project work processes. Quality
control activities monitor and verify that project deliverables meet defined quality standards. Quality
assurance activities monitor and verify that the processes used to manage and create the
deliverables are followed and are effective.
1. Quality objectives
2. Key project deliverables and processes to be reviewed for satisfactory quality level
3. Quality standards
6. Quality tools
16.3.2 Rationale/Purpose
The purpose of developing a quality plan is to elicit the customer’s expectations in terms of
quality and prepare a proactive quality management plan to meet those expectations.
The Quality Management Plan helps the project manager determine if deliverables are being
produced to an acceptable quality level and if the project processes used to manage and create the
deliverables are effective and properly applied.
2. Project Team
3. Customer
4. Project Sponsor
A Project Audit involves comparing actual results with predicted results and explaining the
differences, if any.
1. Improvement of forecasts
2. Improvement in operations
It provides an opportunity to uncover issues, concerns and challenges encountered during the
project life cycle. Conducted midway through the project, an audit affords the project manager,
project sponsor and project team an interim view of what has gone well, as well as what needs to
be improved to successfully complete the project.
If done at the close of a project, the audit can be used to develop success criteria for future
projects by providing a forensic review. This review identifies which elements of the project were
successfully managed and which ones presented challenges. As a result, the review will help the
organization identify what it needs to do to avoid repeating the same mistakes on future projects.
2. In-depth Research.
3. Report Development.
Interview the core project sponsor and project manager to determine their “success
criteria” for the project audit and find out what they expect to gain from the audit. This
ensures that their individual and collective needs are met.
2. Questionnaire Development
Develop a questionnaire to be sent to each member of the core project team and to
selected stakeholders. Often, individuals will complete the questionnaire in advance of an
interview because it helps them to gather and focus their thoughts. The actual interview
will give the facilitator the opportunity to gain deeper insights into the team member’s
comments. The questionnaire simply serves as a catalyst for helping team members and
stakeholders reflect on the project’s successes, failures, challenges and missed
opportunities.
There are many questions that can be asked in an audit interview. It is most effective,
however, to develop open-ended questions, i.e., questions that cannot be answered with
a simple “yes” or “no.” Develop interview questions that will help identify the major project
successes; the major project issues, concerns and challenges; how the team worked
together; how vendors were managed; how reporting and meetings were handled; how
risk and change were managed, etc. Questionnaires can be used for team members
and/or other stakeholders who are unable to attend an interview.
1. Conduct individual research interviews with the project sponsor, project manager and
project team members to identify past, current and future issues, concerns, challenges
and opportunities.
3. Assess the issues, challenges and concerns in more depth to discover the root causes of
any problems.
4. Review all historical and current documentation related to the project, including team
structure, scope statement, business requirements, project plan, milestone reports,
meeting minutes, action items, risk logs, issue logs and change logs.
5. Review the project plan to determine how the vendor plan has been incorporated into the
overall project plan.
6. Interview selected stakeholders to identify and determine their initial expectations for the
project and determine to what extent their expectations have been met.
7. Review the project quality management and the product quality management to identify
issues, concerns and challenges in the overall management of the project. Identify any
opportunities that can be realized through improvements to the attention of project and
product quality.
8. Identify any lessons learned that could improve the performance of future projects within
the organization.
2. Compile the information collected from individuals who only completed the questionnaire.
4. Identify the issues, concerns and challenges presented through the review of the project
quality management and product quality management plans and isolate the opportunities
you believe may be realized.
6. Identify all of the project’s opportunities that can be realized through the report’s
recommendations.
7. Identify the lessons learned that can improve the performance of future projects within
the organization.
8. Finalize the creation of the report and recommendations based on the findings and
present the detailed report and recommendations, including a road map to get future
projects to the “next level” of performance.
16.4.1 Conclusion
The purpose of a project audit is to identify lessons learned that can help improve the
performance of a project or improve the performance of future projects by undertaking a forensic
review to uncover problems to be avoided. In this way, project audits are highly beneficial to the
organization and provide the following outcomes:
⚫ Development of lessons learned on the project that can be applied to both the
organization and its vendors.
⚫ Development of strategies which, if implemented within the organization, will increase the
likelihood of future projects being managed successfully.
⚫ Development of strategies which, if implemented within the organization, will increase the
likelihood of change initiatives being managed successfully.
⚫ Development of project success criteria which might include on-time, on-budget, meeting
customer and other stakeholder requirements, transition to next phase successfully
executed, etc.
⚫ Development of change management success criteria which might include how staff are
involved, how customers are impacted, how the organization is impacted, transition to
next level of change to be initiated, etc.
⚫ Development of criteria that will continue the improvement of relationships between the
organization and its vendors, suppliers and contractors regarding the management of
projects.
⚫ Application of the lessons learned on the project to future projects within the organization.
16.5 SUMMARY
Quality assurance is an audit function that evaluates the actual project quality results against
the planned or intended results to ensure that the appropriate processes are being employed by the
project team. “Assuring” quality implies ensuring the project quality requirements are being achieve
Quality Assurance assures the quality of the product meaning that this process ensures that
the product generated from the process is defect free and conforms to all stated customer
requirements. It is said to be a process-based approach whose primary objective is to prevent
defects in deliverables at the planning stage to avoid rework, which increases process costs.
345 Copyright © Welingkar
Chapter – 16
There are fundamentally three tools utilized in quality management – process analysis,
quality audit, and quality management and control tools. In process analysis, one analyses the
process to spot any enhancements, find the root cause of any problem that comes up, and
recognize any non-value added activities.
Project Quality Management defines the acceptable level of quality, which is typically defined
by the customer, and describes how the project will ensure this level of quality in its deliverables
and work processes.
Quality Assurance and Quality Control are closely interlinked and their objective is also the
same, which is to deliver a defect-free product.
Both processes are key components of a quality management plan and augment each other.
Failing to implement either of them will lead to failure of quality management in the project.
Quality Assurance is one of the prime features in the Project Management space and one of
the most rapidly transforming areas in software creation. Quality Assurance Activities: Planning,
Auditing and Analysing Project Quality
A Project Audit involves comparing actual results with predicted results and explaining the
differences, if any. It serves three purposes – Improvement of forecasts, Improvement in operations
and Identification of termination opportunities.
A Project Audit involves comparing actual results with predicted results and explaining the
differences, if any.
1. Improvement of forecasts
2. Improvement in operations
It provides an opportunity to uncover issues, concerns and challenges encountered during the
project life cycle. Conducted midway through the project, an audit affords the project manager,
project sponsor and project team an interim view of what has gone well, as well as what needs to
be improved to successfully complete the project.
3. What is the difference between quality control and quality assurance? Describe
(c) HR function
2. The process that assures the quality of the product meaning that this process ensures
that the product generated from the process is defect free and conforms to all stated
customer requirements is called as ---------------------
3. A Project Audit involves comparing actual results with predicted results and explaining
the differences, if any. The post-audit serves ----------------------------------- purpose.
5. The project audits are highly beneficial to the organization and provide the outcome such
as ----------------------------
(a) Development of lessons learned on the project that can be applied to both the
organization and its vendors.
(b) Development of strategies which, if implemented within the organization, will increase
the likelihood of future projects being managed successfully.
(c) Development of strategies which, if implemented within the organization, will increase
the likelihood of change initiatives being managed successfully.
Answers:
qqq
Summary
PPT
MCQ
Video1