Course No.

ET ZC414

Project Appraisal
BITS Pilani
Hyderabad Campus

Module 2 Session 6
S. Hanumantharao Date : 1/31/2015

Total ppt :39

BITS Pilani
Hyderabad Campus

Chapter 6
Financial Estimates and Projections

Financial Estimates and

Projections
There are three basic questions to be answered in a project
appraisal exercise:
1. Can we produce the goods or services? Technical
analysis
2. Can we sell the goods or services? Market analysis
3. Can we earn a satisfactory return on the investment
made in the project?
We will now discuss the estimates and projections required
for financial appraisal.

BITS Pilani, Hyderabad Campus

Objectives
Describe the key elements of project cost.
Discuss the means of finance available for financing a
project.
Describe the major components of cost of production.
Develop profitability projections.
Develop projected cash flow statements and projected
balance sheets.

BITS Pilani, Hyderabad Campus

Cost of project
Cost of project represents the total of all items
of outlay associated with a project
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Land and site development

Buildings and civil works
Plant and machinery
Technical know-how and engineering fees
Expenses on foreign technicians and training of Indian technicians abroad
Miscellaneous fixed assets
Preliminary and capital issue expenses
Pre-operative expenses
Margin money for working capital
Initial cash losses

BITS Pilani, Hyderabad Campus

Land and Site

Development
The cost of land and site development is the sum of the
following:

Basic cost of land including conveyance and other allied charges

Premium payable on leasehold and conveyance charges
Cost of leveling and development
Cost of laying approach roads and internal roads
Cost of compound wall and gates
Cost of tube wells

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Buildings and Civil Works

Buildings for the main plant and equipment
Buildings for auxiliary services like steam supply, workshops,
laboratory, water supply, etc
Godowns, warehouses, and open yard facilities
Non-factory buildings like canteen, guest houses, time office, excise
house, etc
Quarters for essential staff
Silos, tanks, wells, chests, basins, cisterns, hoopers, bins, and other
structures necessary for installation of the plant and equipment
Garages
Sewers, drainage, etc
Other civil engineering works

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Plant and Machinery

The cost of the plant and machinery, typically the most
significant component of the project cost, consists of the
following:
Cost of imported machinery: This is the sum of (i) FOB (free
on board) value, (ii) shipping, freight, and insurance cost,
(iii) import duty, and (iv) clearing, loading, unloading, and
transportation charges.
Cost of indigenous machinery: this consists of (i) FOR (free on
rail) cost, (ii) sales tax, octroi, and other taxes, if any, and
(iii) railway freight and transport charges to the site.
Cost of stores and spares.
Foundation and installation charges.
BITS Pilani, Hyderabad Campus

Technical Know-how and

Engineering Fee
Often it is necessary to engage technical consultants or collaborators
from India and/or abroad for advice and help in various technical
matters like preparation of the project report, choice of technology,
selection of the Plant and machinery, detailed engineering, and so
on.
While the amount payable for obtaining the technical know-how and
engineering services for setting up the project is a component of the
project cost,
the royalty payable annually, which is typically a percentage of sales, is
an operating expense taken into account in the preparation of the
projected profitability statements.
Expenses on Foreign Technicians and Training of Indian Technicians
Abroad including lodging and boarding may also be included in the
project cost

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Miscellaneous Fixed
Assets
Fixed assets and machinery which are not part of the direct
manufacturing process may be referred to as
miscellaneous fixed assets.
They include items like furniture, office machinery and
equipment, tools, vehicles, railway siding, diesel
generating sets, transformers, boilers, piping systems,
laboratory equipment, workshop equipment, effluent
treatment plants, fire fighting equipment, and so on.
Expenses incurred for the procurement or use of patents,
licenses, trade marks, copyrights, etc. and deposits made
with the electricity board may also be included here.

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Preliminary and Capital Issue

Expenses
Expenses incurred for identifying the project, conducting the
market survey, preparing the feasibility report, drafting the
memorandum and articles of association, and
incorporating the company are referred to as preliminary
expenses.
Expenses borne in connection with the raising of capital
from the public are referred to as capital issue expenses.
The major components of capital issue expenses are:
underwriting commission, brokerage, fees to managers
and registrars, printing and postage expenses,
advertising and publicity expenses, listing fees, and
stamp duty.
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Pre-operative Expenses
Expenses of the following types incurred till the commencement of
commercial production are referred to as pre-operative expenses: (i)
establishment expenses, (ii) rent, rates, and taxes, (iii) travelling
expenses, (iv) interest and commitment charges on borrowings, (v)
insurance charges, (vi) mortgage expenses, (vii) interest on deferred
payments, (viii) start-up expenses, and (ix) miscellaneous expenses.
These are capitalized.
Pre-operative expenses are directly related to the project
implementation schedule. A 20 to 25 percent delay is common.
Expenses incurred from the point of time the plant and machinery are
set up are treated as revenue expenditure. The firm may, however,
treat them as deferred revenue expenditure and write them off over a
period of time.

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Provision for Contingencies

Firm cost items are those which have already been
acquired or for which definite arrangements have been
made.
Set the provision for contingencies at 10 to 15 percent of
the estimated cost of non-firm cost items.
Alternatively, make a provision of 10 percent for all items
(including the margin money for working capital) if the
implementation period is one year or less.
For every additional one year, make an additional provision
of 5 percent.

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Margin Money for

Working Capital
Like we provide equity to support long term assets less long term
liabilities, we also support excess of current assets over current
liabilities with working capital.
The principal support for working capital is provided by commercial
banks and trade creditors, owners also provide long term funds,
referred to as the 'margin money for working capital.
The margin money for working capital is sometimes utilized for
meeting over-runs in capital cost. This leads to a working capital
problem when the project is commissioned.
To mitigate this problem, financial institutions stipulate that a
portion of the loan amount, equal to the margin money for
working capital, be blocked initially so that it can be released
when the project is completed.

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Initial Cash losses

Most of the projects incur cash losses in the initial years.
Yet, promoters typically do not disclose the initial cash
losses because they want the project to appear attractive
to the financial institutions and the investing public.
Failure to make a provision for such cash losses in the
project cost generally affects the liquidity position and
impairs the operations.
Hence prudence calls for making a provision, overt or
covert, for the estimated initial cash losses.

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Means of finance
Share capital
Term loans
Debenture capital
Deferred credit
Incentive sources
Miscellaneous sources

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Share capital
There are two types of share capital - equity capital and
preference capital.
Equity capital represents the contribution made by the
owners of the business, the equity shareholders, who
enjoy the rewards and bear the risks of ownership.
Equity capital being risk capital carries no fixed rate of
dividend.
Preference capital represents the contribution made by
preference shareholders and the dividend paid on it is
generally fixed.

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Term Loans
Provided by financial institutions and commercial banks,
term loans represent secured borrowings which are a
very important source (and sometimes, the major
source) for financing new projects as well as for the
expansion, modernization, and renovation schemes of
existing firms.
There are two broad types of term loans available in India:
rupee term loans and foreign currency term loans.
While the former are given for financing land, building, civil works, indigenous
plant and machinery, and so on,
the latter are provided for meeting the foreign currency expenditures towards the
import of equipment and technical know-how.

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Debenture Capital
Akin to promissory notes, debentures are instruments for
raising debt capital.
There are two broad types of debentures: non-convertible
debentures and convertible debentures.
Non-convertible debentures are straight debt instruments.

Typically they carry a fixed rate of interest

and have a maturity period of 5 to 9 years.
Convertible debentures, as the name implies, are debentures which are
convertible, wholly or partly, into equity shares.

The conversion period and price are

determined in advance.

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Deferred Credit
Many a time the suppliers of the plant and machinery offer
a deferred credit facility under which payment for the
purchase of the plant and machinery can be made over
a period of time.

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Incentive Sources
The government and its agencies may provide financial
support as an incentive to certain types of promoters or
for setting up industrial units in certain locations.
These incentives may take the form of seed capital
assistance (provided at a nominal rate of interest to
enable the promoter to meet his contribution to the
project), or capital subsidy (to attract industries to certain
locations), or tax deferment or exemption (particularly
from sales tax) for a certain period.

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Miscellaneous Sources
A small portion of the project finance may come from
miscellaneous sources like unsecured loans, public
deposits, and leasing and hire purchase finance.
Unsecured loans are typically provided by the promoters to
bridge the gap between the promoters' contribution (as
required by the financial institutions) and the equity capital
the promoters can subscribe to.
Public deposits represent unsecured borrowings from the
public at large.
Leasing and hire purchase finance represent a form of
borrowing different from the conventional term loans and
debenture capital
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Planning the Means of

Finance
Norms of Regulatory Bodies and Financial Institutions
Key Business Considerations:
Cost : cost of debt funds is lower than the cost of equity funds.
Financial risk represents the risk arising from financial leverage. It must be
emphasized that while debt capital is a cheaper source of finance it is also a
riskier source of finance because of the fixed financial burden associated with it.
Control: lenders do not have a say once repaid.
Flexibility: to raise further capital: means that the firm does not fully exhaust its
debt capacity. Put differently, it maintains reserve borrowing powers to enable it
to raise debt capital to meet largely unforeseen future needs.

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Financial Projections

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Estimates of sales and production

A reasonable assumption with respect to capacity utilization
is as follows: 40-50 per cent of the installed capacity in
the first year, 50-80 per cent in the second year, and 8090 per cent from the third year onwards.
It is not necessary to make adjustments for stocks of
finished goods. For practical purposes, it may be
assumed that production would be equal to sales.
The selling price used may be the present selling price -it is
generally assumed that changes in selling price will be
matched by proportionate changes in cost of production.

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Estimates of Production
and Sales

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Cost of production
Material cost
CIF (cost, insurance, and freight) terms
present costs, no provision for inflation

Utilities cost
Labor cost
include, besides basic pay, dearness allowance, house rent allowance,
conveyance allowance, medical reimbursement, leave travel concession,
provident fund contribution, gratuity contribution, and bonus payments. In
addition, account should be taken of vacations, overtime work, night work, work
on holidays etc
5% annual increase

Factory overhead cost + contingency margin

The expenses on repairs and maintenance, rent, taxes, insurance on factory
assets, and so on are collectively referred to as factory overheads.

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Total Administrative
Expenses
(i) administrative salaries,
(ii) remuneration to directors,
(iii) professional fees,
(iv) light, postage, telegrams, and telephones, and office
supplies (stationery, printing, etc.),
(v) insurance and taxes on office property,
and (vi) miscellaneous items.

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Total Sales Expenses

The expenses included under this head are:

(i) commission payable to dealers,

(ii) packing and forwarding charges,
(iii) salary of sales staff (which may be increased at 5 percent per annum),
(iv) sales promotion and advertising expenses,
and (v) other miscellaneous expenses.

The selling expenses depend mainly on the nature of

industry and the kind of competitive conditions that
prevail.
Typically, selling expenses vary between 5 and 10 percent
of sales. The experience of similar firms in the industry
may be used as a basic guideline.

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Working capital requirement

and its financing
Working capital requirement consists of the following: (i) raw
materials and components (indigenous as well as
imported), (ii) stocks of goods-in-process (also referred to
as work-in-process), (iii) stocks of finished goods, (iv)
debtors (receivables), (v)operating expenses, and (vi)
consumable stores.
25 percent of current assets must be supported by long-term
sources of finance.
Raw materials and receivables need less margin than WIP
and finished goods. But receivables in India often include
doubtful accounts.
Growth requires additional working capital and margins.
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The margin requirement varies with the type of current

asset. While there is no fixed formula for determining the
margin amount, the ranges within which margin
requirements for various current assets lie are as
follows:

The format given in Exhibit 6.3 may be used

to estimate the working capital requirement
the amount of likely bank finance available,
and the margin money for working capital to
be provided from long-term sources.
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BITS Pilani, Hyderabad Campus

Estimates of working results

For next 10 Years
A Cost of production
B Total administrative expenses
C Total sales expenses
D Royalty and know-how
payable
E Total cost of production (A +
B + C + D)
F Expected sales
G Gross profit before interest
(F-E)
H Total financial expenses
I Depreciation
J Operating profit (G - H - I)

K Other income
L Preliminary expenses
written of
M Profit/loss before
taxation (J + K - L)
N Provision for taxation
O Profit after tax (M - N)
Less Dividend on
- Preference capital
- Equity capital
P Retained profit
Q Net cash accrual (P +
I+ L)
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Financial Expenses
In estimating the interest on term loans, two points should
be borne in mind:
(i) Interest on term loans is based on the present rate of interest charged by the
term lending financial institutions and commercial banks.
(ii) Interest amount would decrease according to the repayment schedule of the
term loan.

The interest on working capital borrowings from banks may

be estimated as follows:
(i) determine the total requirement of the working capital,
(ii) find out the quantum of bank borrowing that would be available against the
total working capital requirement,
and (iii) calculate the interest charges on the basis of the prevailing interest rates.

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Depreciation
This is an important item, particularly for capital-intensive projects. in figuring
out the depreciation charge, the following points should be borne in mind:
1. Contingency margin and pre-operative expenses provided in estimating the
cost of project should be added to the fixed assets proportionately to
ascertain the value of fixed assets for determining the depreciation charge ..
2. Preliminary expenses in excess of 5.0 per cent of the project cost is
included under preoperative expenses which is subsequently allocated to
fixed assets proportionately to ascertain the value of fixed assets for
determining the depreciation charge.
3. The Income Tax Act specifies that the written down value method should be
used for tax purposes. It further specifies the rate of depreciation applicable
to different kinds of assets.
4. For company law (financial reporting) purposes, the method of depreciation
may be either the written down value (WDV) method or the straight line (SL)
method.

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Depreciation as per
company law
From 1988 onwards the depreciation rates under the
Companies Act have been delinked from those under the
Income Tax Act. The key depreciation rates under the
Companies Act are as follows:

PS: Depreciation rates for income tax purposes

are diferent

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Other Income
This represents income arising from transactions not part of
the normal operations of the firm.
Examples of such transactions are: sale of machinery,
disposal of scrap, etc.
Except disposal of scrap, which can be reasonably
anticipated and estimated, the effects of of other nonoperating transactions can hardly be estimated.
Of course, when non-operating transactions result in a
deficit, other income would be negative-put differently, it
will be a non-operating loss.

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Write off of Preliminary Expenses: Preliminary expenses up to 5.0

per cent of the cost of the project can be amortized in five equal
annual installments.
Profit/loss before taxation = operating profit + other income - writeoff of Preliminary Expenses
Provision for taxation: The framework for calculating the tax
payable is quite elaborate, we will work with a provision of 35
pct.
Retained profit = profit after tax less dividends paid
Net cash accrual from operations is equal to: retained profit +
depreciation + write-off of preliminary expenses + other non-cash
charges ( eg.. accounting policy changes or significant
depreciation in the market value of an asset or inventory).

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In Thousands of rupees
A

2012

2013

2014

2015

2016

Cost of Production
Administrative expenses
Administrative salaries
Remuneration to directors
Professional fees
Light, postage, telegrams, and
telephones, office supplies
Insurance and taxes on office property
Miscellaneous

Total Administrative Expenses

Total Sales Expenses

Royalty and Know-how Expenses

Total Cost of Production (A+B+C+D)

Expected Sales

Gross Profit Before Interest (F-E)

Financial expenses
Interest on term loans
Interest on borrowings for working capital

Should be prepared for 10

years