CH 04; PROJECT IDENTIFICATION & PREPARATION.ppt

Chapter Four
ADMAS UNIVERSITY
PROJECT PREPARATION
1

4.1 Introduction
• Project preparation and analysis starts after project
ideas have been identified and selected.
• Project preparation should cover the whole range of
technical, institutional, economic, and financial
analysis necessary to attain the project’s objective.
• Project preparation involves assessment of key
aspects of a project (pre-feasibility & feasibility
studies).
2

Major dimensions of feasibility
studies
– Commercial Dimension: Market and
Demand Analysis
– Technical Dimension comprising:
• Production Program and Plant Capacity
• Input (Raw Materials & Supplies) Study
• Location & Site Studies and Environmental
Impact Assessment
• Engineering & Technology Study
3

Dimension of Feasibility con’t
– Institutional & Managerial Dimension
– Financial Cost-Benefit Analysis
– Social Cost-Benefit Analysis (Economic
Analysis)
4

4.2 Project Preparation
• Project preparation is the study of an investment opportunity
from different perspective.
• Main elements of project preparation are different according to
different scholars and international organization, although they
have some similarity on basic contents.
• Gittinger (1996) Identifies aspects of project preparation and
analysis to be the following:
– technical aspect,
– institutional-organisational-managerial aspects,
– social aspects,
– commercial aspect,
– financial aspect
– economic aspect. 5

• The UNIDO manual states the following to be
the project preparation steps
1.Market analysis
2.Technical analysis
3.Financial Analysis and
4.Economic analysis
6

4.3 Market And Demand Analysis
• Market analysis of a project is a systematic
inquiry seeking to gain information about the
whole environment .
 It is concerned not only with individuals and
organizations that are actual or potential
consumers of the product of the project also with
competitors and all kinds of technical, material,
political, legal and administrative constraints with
in which the project is expected to operated and
grow .
7

•The first step in project analysis (in particular
during preparation) is to:
 Estimate the potential size of the market for the
product proposed to be manufactured (or service
planned to be offered),
 Get an idea about the market share that is likely
to be captured.
•Market and demand analysis is concerned with
determining the expected/likely:
Aggregate demand for the product
Market share for the product
8

Situational
Analysis and
Specifications
of Objectives
Collection of
Secondary
Information
Conduct of
Market Survey
Characterization
of the Market
Demand
Forecasting
Market
Planning
Steps in Market and demand analysis
9

I. Situational analysis and specification of objectives
• In order to get a feel for the relationship between the product
and its market, the project analyst may talk to;-
• consumers, competitors, middlemen, and other in the
industry.
• at the preferences and purchasing power of consumer’s,
actions and
• strategies of competitors and practices of the
middlemen/distributors, whole sellers and retailers/.
• If such a situational analysis generates enough data to measure
the market and a reliable hand over projected demand and
revenue, a formal study may not need to be undertaken.
• But, in most cases a formal market and demand study is
warranted.
10

Cont’d
• In order to carry out such a study it is
necessary to spell out its objective clearly
and comprehensively.
• A helpful way of spelling out the objectives
would be to structure the objective in the
form of questions.
• Example: suppose a given project aims
at producing wheat in a given locality.
The project initiator and implementer
need information about where and how
to market their product.
11

II. Collection Of Secondary Information
• Secondary information is information that has
been gathered in some other context and is
already available.
• It provides the base and the starting point for
market and demand analysis.
• It indicates what is known and often provides
leads and clues for gathering primary
information required for further analysis. 12

III. Conduct of Market Survey
• Secondary information must be supplemented
with primary information through market
survey.
• Primary information represents information
that is collected for the first time to meet
the specific purpose on hand.
• The market survey can be a census or sample
survey
– Census Survey covers the entire population
– Sample Survey covers limited part of the
total population
13

Con’d
• The important types of information to be
gathered through the market survey include:-
– Total demand and rate of growth
– Demand in different segments of the
market
– Income and price elasticity of demand
– Motives for buying
– Purchasing plan & intentions
– Satisfaction with existing products
– Unsatisfied needs
– Attitudes towards various products, etc
14

IV. Characterization of the Market
• Based on the secondary and primary data gathered, the
market for the product or service can be characterized as
follows:-
i. Effective Demand in the Past and Present
ii. Breakdown of Demand into market segments
• Nature of Product
• Consumer Groups
• Geographical Division
iii. Price
iv. Methods of Distribution and Sales Promotion
v. Consumers
vi. Supply and Competition
vii. Government Policy 15

V. Demand Forecasting
• After gathering information about various aspects of the market and
demand from primary and secondary sources, attempt may be made to
estimate future demand.
• There are different methods of forecasting demand as discussed below:
A. Qualitative Methods
B. Time Series Projection Methods
C. Casual Methods
A. Qualitative Methods
– These methods rely essentially on the judgment of experts to
translate qualitative information into quantitative estimates.
– Used to generate forecasts if historical data are not available
(e.g., introduction of new product)
– The important qualitative methods are:
I. Jury of Executive Method
II. Delphi Method
16

Qualitative
Method
Time series projection
Methods
Jury of Executive
Method
Delphi
Method
Trend
Projection
Method
Exponential
Smoothing
Method
Moving
Average
Method
Methods of Demand Forecasting
Causal
Method
Chain
Ratio
Method
Consumption
Level
Method
End use
Method
Leading
Indicator
Method
Econometric
Method
17

VI. Market Planning
• In order to reach the proposed product/service to a desired
level of customers, an appropriate marketing plan should be
formulated .
• Its principal purpose is meeting the customer needs better
than their competitors.
• It should focus on;-
– customer needs,
– nature of product or service offering,
– channel function and coverage.
– Current market situation
– Opportunity and issue analysis,
– Marketing strategy
18

4.4. Raw Materials and Supplies Study
• Different materials and other inputs required for operating the project
should be identified and their availability, supply and method of
estimating operating costs should be analysed.
• In this part of the feasibility study, the following can be included:-
i. Identification of the type of raw materials and supplies to be used
in the project.
ii. All requirements of materials and supplies should be identified and
specified in the study considering all socio, economic, commercial,
financial, and technical factors.
iii. The source of materials availability, their users and price of inputs
are to be analyzed. The interdependencies between projects,
material and input requirements and supply of these items should
be considered.
- location of the available resources, area of supply, access to
transport, transport costs and alternate usage of such materials
need to be collected.
19

Cont’d
iv. Costs of raw materials and supplies:-
– The costs of materials and other supplies have to be
analyzed in detail to determine project economies.
– Estimating annual operating costs for materials and
supplies are to be made explaining the price
mechanisms and key factors affecting prices.
– Cost estimates may be expressed either as the cost
per unit produced or in terms of a certain
production level to conduct sensitivity analysis.
20

Cont’d
• Raw materials (processed and/or semi – processed) may be classified into
different types;
(i) Agricultural products,
(ii) Mineral products,
(iii) Livestock and forest products, and
(iv) Marine products.
(v) Processed Industrial Materials and Components,
– While we are studying them, the following questions need to be
answered: With regard to the industrial materials;-
» What are their properties?
» What is the total requirement of the project?
» What quantity would be available from domestic sources?
» What quantity can be procured from foreign sources?
» How dependable are the supplies?
» What has been the past trend in prices?
» What is the likely future behavior of prices?
(vi) Auxiliary materials and Factory Supplies and (vii) Utilities 21

4.5. Location, Site and Environment Impact Assessment (EIA)
4.5.1. Location and Site
•The choice of location and site necessitates an
assessment of demand, size, and input requirement.
– Location refers to a relatively broad area like a
city, an industrial zone, or a coast, area; whereas,
– Site refers to a specific piece of land where the
project would be set up.
•Their selection should be judged aligned with defined
corporate strategies and the financial and economic
impacts.
•The selection of plant location and site does not
have to be undertaken in two stages. The two should be
integrated. 22

4.5.1.1. Choice of Location
• In a feasibility study, a good starting – point for the final
selection is raw materials and factory supplies, or for market
oriented – the location of the principal consumption centers .
• Location analysis has to identify locations suitable for the
industrial project under consideration.
• Traditional approach to industrial location focused, on the
proximity of raw materials and market place, mainly with the
intention of minimizing transport costs.
• The modern view requires consideration of not only
commercial, technical and financial factors, but also of the
social and environmental impact a project might have.
23

Cont’d
 As far as financial feasibility of alternative locations is
concerned, the following data-as well as related financial
risks, should be assessed.
Production costs (including environmental protection
costs)
Marketing costs
Investment costs
Revenues
Taxes, subsidies, grant and allowance
Net cash flows
24

4.5.1.2. Site Selection
• After the completion of final location
selection, a specific project site and, if
available, site alternatives should be defined in
the feasibility study.
• This will require an evaluation of the
characteristics of each site.
• The structure of site analysis is basically the
same as for location analysis.
25

4.5.2. Environment Impact Assessment (EIA)
• It is designed to develop an understanding of
the environmental consequences of newly
planned or existing projects and of any project
related activities.
• Environmental benefits or costs of a project
are usually externalities or side effects that
affect the society wholly or partially.
26

Cont’d
• Generally, externalities or side effects may
bind to create environmental conflicts that
might ultimately lead to;-
• Compensation claims,
• Substantial costs for purification and
equipment, and
• Possibly to the extent of the closure of
the plant.
• The general objective of environmental
impact assessment in project analysis is
– to ensure whether the development
projects are environmentally sound. 27

4.6. Production Program and Plant
Capacity
• It can be defined as the volume or number of units that
can be produced during a given period.
• The production program, range and volume of products
to be produced depend on the market requirements,
proposed marketing strategy and the availability of
resources.
• A production program should define the levels of output
to be achieved during specified periods related to the
sales forecast.
• Full production level may not be possible during initial
production operation owing to various technological,
production and commercial difficulties in addition to
marketing bottlenecks.
28

 With regards to plant capacity, generally two
capacity terms used in relation to level of
operation.
1. A feasible normal capacity (FNC) – refers
to the capacity achievable under normal
working conditions considering the technical
conditions of the plant, normal stoppages,
downtime for maintenance & tool changes,
holidays, shift pattern and management
system applied.
2. A nominal maximum capacity(NMC)– is the
technically feasible capacity that
corresponds to the installed capacity as
guaranteed by the supplier of the plant.
Cont’d
29

4.7. Technology Selection
• It provides the technical basis for all other aspects
of a project study, since a technically unfeasible
project cannot be promoted.
• Appropriate technology selection should be made.
• The advocates of appropriate technology urge that
the technology should be evaluated in terms of the
following questions:
 Whether the technology utilizes local raw
materials?
 Whether the technology utilizes local
manpower?
 Whether the technology protects ecological
balance?
 Whether the goods and services produced
cater to the basic needs? 30

Cont’d
 While selecting the best technologies for the proposed
project, the following factors must also be given due
attention:
 Technological impact on the environment: The
technology that we are going to select should not only
the one that minimizes pollution, but should also
preserve the natural resources and saves renewable
resources.
 Careful evaluation and assessment of hazardous
technologies and the use of toxic materials at different
stages of production should be made.
 Introduction of obsolete technologies must also be
carefully considered. Acquisition of previously discarded
and disassembled production plants should be
rechecked carefully.
 The primary goals of technology assessment are to
determine and evaluate the effect (impact) of different
technologies on the society and national economy. 31

4.8. Organizational and Human Resource
• This basically incorporates the socio-cultural patterns and
institutions or the population that the project is believed to
serve.
• A division of the Company into organizational units, in line
with the marketing, supply, production and administrative
functions is necessary for efficient management of operations
and designing a proper organizational structure in accordance
with the corporate strategies and policies.
• The recommended organization will depend on the social
environment as well as techno-economic necessities.
• The organizational set-up depends to a large extent on the
industrial, enterprise, strategies, polices and values of those in
power in the organization.
32

 A design of the organization usually includes the following
steps:
1. Goals and objectives of the business are stated
2. Then functions are identified
3. Functions are grouped or related
4. Organization's structure or framework designed
5. All key jobs are analyzed, designed, and described
6. A recruitment and training program prepared.
 The two reasons for preparing an organization:-
1. To achieve optimal coordination and control on all
project inputs.
2. To structure the investment and production costs and to
determine the costs linked with corresponding
organizational units.
Cont’d
33

2.8.1.Organizational Structure
• Usually the organization structure is designed primarily in line
with the different functions. Such as finance, marketing,
production and purchasing. However, there is no unique
organizational pattern.
• The organizational structure of the company can also take a
number of shapes; the most common type is the pyramid
shape, which has the following three organizational levels:
– Top management
– Middle management, and
– Supervisory management
34

2.8.2 Human Resources
• The successful implementation and operation of industrial
projects need different categories of human resources.
Example, management, supervisory staff and workers- with
sufficient skill and experience.
• The feasibility study should identify and describe such
requirements and assess the availability of human resources
as well as training needs.
 The following factors should be given due consideration
when the availability and employment of human resources
are analyzed:-
i. The general availability of relevant human resource
categories in the country and the project region.
ii. The supply and demand situation in the project region
iii. Recruitment policy and methods
iv. Training policy and program 35

NB. Difficulties in the recruitment of key personnel (such as
Managers, supervisors and skilled labor) can be dealt with,
in different ways:-
1. Recruitment is combined with intensive training of key
personnel in order to meet quality requirements.
2. Foreign expertise is recruited.
Cont’d
36

4.9. Financial and Economic Analysis
• Project financial analysis is analytical work required to
identify the critical variables which are useful to
determine the success or failure of project investment.
• Its concern is to determine, analyze and interpret all
the financial consequences of an investment that might
be relevant to and significant for the investment and
financing decisions.
• Financial analysis is the assessment, measurement and
determination of a viability of a project from the point
of implementing (participating) body, i.e., private or
public.
• It is intended to assess the financial impacts on project
participants as well as on the public sector, which will be
involved in investing and operating the project.
37

 Why Financial Analysis is Undertaken?
 It provides an adequate financing plan for the
proposed investment.
 It determines the profitability of a project.
 It assists in planning the operation and control of the
project by providing management information to both
internal and external users.
 It advises on methods of improving the financial
viability of a project entity.
 It illustrates the financial structure of the project
and its existing and potential financial viability.
Cont’d
38

 Since reliable cost estimates are fundamental to the
appraisal of an investment project, it is necessary to
check carefully all cost items that could have a significant
impact on financial feasibility.
 Cost estimates cover:-
 Initial investment cost
 Cost of production
 Marketing and distribution costs
 Plant and equipment replacement costs
 Working capital requirements and decommissioning
at the end of the project life.
Cont’d
39

 The two types of requirements are of working capital:
A.Permanent (fixed) working capital: - part of capital
which is permanently locked up in the circulation of
current assets and in keeping it moving.
B.Variable working capital: - changes with the volume of
the output of the project.
Getnet B. 37
Cont’d

• The cash flow statement shows the movement of cash into
and out of the firm and its net impact on the cash balance
within the firm.
• A statement of cash flows summarizes information about the
cash inflows (receipts) and outflows (payments) for a specific
period of time.
• The statement of cash flows reports (1) the cash effects of a
company’s operations during a period, (2) its investing
activities, (3) its financing activities, (4) the net increase or
decrease in cash during the period, and (5) the cash amount
at the end of the period.
9.3 Cash Flow Statement

• The statement of cash ﬂows reports on a company’s cash flow
activities into and out of the business from: Operating Activities,
Investing Activities and Financing Activities
• It shows how changes in the balance sheet and income statement
affect cash and cash equivalents
• It is derived from the income statement and balance sheet.
 The cash flow associated with a project may be divided into three
basic components:
1. An initial investment: - represents the relevant cash flow when the
project is set up.
2. Operating cash flows: - are the cash flows that arise from/to the
operation of the project during its economic life.
3. A terminal cash flow: - is the relevant cash flow occurring at the
end of the project life on account of liquidation of the project.
Cont’d

Con’d
• A project planner has to develop some techniques of
A project planner has to develop some techniques of
forecasting cash inflows and out flows.
forecasting cash inflows and out flows.
• Cash
Cash flow statement is a basis for showing the cash flows
flow statement is a basis for showing the cash flows
associated with operating resources, financing and
associated with operating resources, financing and
investment.
investment.
• Cash flow statements are prepared for two reasons:
Cash flow statements are prepared for two reasons:
• First, it is prepared for
First, it is prepared for financial planning purpose
financial planning purpose: to
: to
know the liquidity position of the project.
know the liquidity position of the project.
• Secondly, cash flow statement may be prepared to
Secondly, cash flow statement may be prepared to
measure the overall profitability of the project.
measure the overall profitability of the project.
• Note:
Note: Cash flow statement is the main tool of financial
Cash flow statement is the main tool of financial
planning and is sometimes referred to as the "Source and
planning and is sometimes referred to as the "Source and
application of funds statement".
application of funds statement".
43

.
STATEMENT OF CASH FLOWS (DIRECT APPROACH)

9.4 Financial Evaluation
• Ranking projects and measuring their profitability have
replaced evaluation based on inadequate planning and
subjective judgment.
• Quantitative methods were developed to use in evaluating
proposed projects.
• There are two investment evaluation methods (criteria)
I. Discounting criteria/dynamic methods – include NPV, IRR,
Benefit-Cost consideration
II. Non-discounting criteria/static methods– include payback
period and ARR
45

I. Discounting Methods (Criteria)
A. Net Present Value Method
– The NPV method is a discounted cash flow method. In
this method all net cash inflows are discounted to
present value using the required rate of return and is
then compared with the initial outlay
– If the discounted cash flow exceeds the initial outlay, it
means the project investigated is attractive since it is
expected to earn more than the required rate of return.
NPV = CF1 + CF2 + CF3---------- + CFn - ICO
(1+r)1
(1+r)2
(1+r)3
----- +(1+r)n
T
t t
t
t=1
B - C
NPV =
(1+ r)

46

Where CF= cash inflow per period (year)
r= discount rate
ICO= initial cash outlay
𝐵𝑡 𝑖𝑠 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑏𝑒𝑛𝑒𝑓𝑖𝑡
𝐶𝑡 𝑖𝑠 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 cos⁡
𝑡
∑ 𝑖𝑠 𝑡ℎ𝑒 𝑠𝑢𝑚𝑚𝑎𝑡𝑖𝑜𝑛 𝑠𝑖𝑔𝑛
Advantages
1. time value of money is considered
2. It measures the benefits directly
3. It is an objective method of selecting and evaluating
projects(By considering cash flows, NPV is not
affected by the Co.’s accounting policies, unlike net
profit).
Cont’d
47

Cont’d
Limitations
1. The NPV method does not consider the life of the
project. Hence, when mutually exclusive projects with
different lives are being considered, the NPV rule is
biased in favor of the longer-term project.
2. In practice it may be difficult to determine the discount
rate. This should relate to the cost of finance, but
calculating the costs of the different elements of
finance (share capital and loans)is difficult.
3. The NPV is an absolute figure and it does not consider
for the size of the project.
48

DECISION RULE
• Accept the project when NPV is positive
NPV > 0
• Reject the project when NPV is negative
NPV < 0
• May accept the project when NPV is zero
NPV = 0
• The NPV method can be used to select between mutually
exclusive projects; the one with the higher NPV should be
selected
49

Steps in Net Present Value Method
To determine net present value, we . . .
Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows from the
present value of the inflows.
50

B. Internal Rate of Return (IRR)
• It is another DCF method, which
represents the actual rate of return
when profit and time value of money are
taken in to account
• It is the rate that equates the present
value of cash inflow with the present
value of cash outflow of an investment.
• It is the discount rate which makes its
NPV equal to Zero.
51

Cont’d
• Hence, the question will be searching for
the discounting rate that equates the PV of
the investment and cash inflows. That is
why IRR is some times called the internally
generated rate of return. Mathematically,
IRR will be obtained when;
IO - PV (NCF) = O
o The primary decision rule with IRR is to
accept only projects with an IRR greater
than the discount rate.
52

DECISION RULE
• Accept the project when
IRR > cut off rate (cost of capital)
• Reject the project when
IRR < Cut of rate
• May accept the project when
IRR = Cut of rate.
• In case of mutually exclusive projects, the project with
highest IRR is selected, provided its IRR is more than cut
off rate
53

Advantages of IRR
(1)Like NPV, it deals with discounted cash flows and is based
on the time value of money.
(2)The difference between the IRR and the cost of capital
indicates the additional return for risk that the project
provides.
Disadvantages of IRR
(1)If there are negative annual cash flows later than year 0,
this may lead to more than one possible IRR. In such a case,
IRR must be used with great care.
(2)If a firm has to rank mutually exclusive projects, choosing
the project with the highest IRR may result in suboptimal
outcome.
Cont’d
54

C. Benefit-Cost Ration (Profitability Index)
• The profitability index, also called benefit -
cost ratio, is the ratio of the PV of the future
net cash inflows to the initial outlay of the
project.
• It measures the desirability of the project
and evaluates the worth of an investment.
PI= PV (NCF)
PV (IO)
• In the application of PI, a project is accepted
if PI > 1, rejected if PI < 1 and we remain
indifferent if PI = 1. It should be noted that
when PI > 1, NPV is positive; PI < 1, NPV is
negative and PI=1 when NPV is zero.
Cont’d
55

DECISION RULE
The following are the acceptance rules:
– Accept the project when PI is greater than one.
PI > 1
– Reject the project when PI is less than one.
PI < 1
– May accept the project when PI is equal to one.
PI = 1
The project with positive NPV will have PI greater
than one. PI less than one means that the project’s
NPV is negative.
56

II. Non-Discounting Criteria
A. Payback Period
– It is one of the most popular and widely used
method
– It is defined as the number of years required to
recovery the original cash outlay invested in a
project
– This method measures the time needed for a
project to recover its total investment through its
net cash earnings.
– The ‘pay back’ sometimes called as pay out or pay off
period method represents the period in which the
total investment in permanent assets pays back
itself.
– It is defined as the number of years required to
recover the initial investment in full with the help of
the stream of annual cash flows generated by the
project.
57

6
Con’d
• Payback Decision Rules
– Stand-alone projects
• payback period < policy maximum  accept
• Payback period > policy maximum  reject
– Mutually Exclusive Projects
various investments are ranked according to the length
of their payback period in such a manner that the
investment within a shorter payback period is preferred
to the one which has longer pay back period.
• If PaybackA < PaybackB  choose Project A
58

Con’d
Calculation of Pay-back Period
•Pay-back period can be calculated into the following two
different situations :
I.In the case of constant annual cash inflows.
II.In the case of uneven or unequal cash inflows.
1.In the case of constant annual cash inflows : If the project
generates constant cash flow, the Pay-back period can be
computed by dividing cash outlays (original investment) by
annual cash inflows.
PBP = Total Investment
Annual Cash Flow
59

2. In the case of Uneven or Unequal Cash Inflows: In the
case of uneven or unequal cash inflows, the Pay-back period
is determined with the help of cumulative cash inflow.
•If the project cash inflow is not in “annuity form”,
cumulative cash inflow method may be used to compute
that PBP.
•It can be calculated by adding up the cash inflows until the
total is equal to the initial investment.
Cont’d
60

Strengths and weaknesses of
payback
• Strengths
– Provides an indication of a project’s risk and
liquidity.
– Easy to calculate and understand.
• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.

Cont’d
B. Accounting Rate of Return (ARR)
 This method uses accounting information, as presented
by financial statements, to measure profitability of
investment.
 It is sometimes known as Average Rate of Return and
calculated by dividing the average income after tax by
the average investment of project.
ARR= Average income x 100 or Average Income
Average investment Total Investment
62

DECISION RULE
• This method will accept all those projects whose
ARR is higher than the minimum rate established by
the management and reject those projects which
have ARR less than the minimum rate.
– Projects which have an ARR equal to or greater
than a pre-specified cutoff rate of return ─
which is usually between 15% and 30% are
─
accepted otherwise, rejected.
• This method would rank a project as number one if
it has highest ARR and lowest rank would be
assigned to the project with lowest ARR.
64

Advantages
1. It simple to calculate
2. It is based on accounting information, which
is readily available, and familiar to
businessman
3. It considers benefits over the entire life of
the project.
Limitations
1. It is based upon accounting profit, not cash
flow
2. It does not take into account the time value
of money.
Cont’d
65

CH 04; PROJECT IDENTIFICATION & PREPARATION.ppt

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CH 04; PROJECT IDENTIFICATION & PREPARATION.ppt