the notes of subject project planning, analysis and management for the 4th semester MBA, Study notes of Project Management

Download the notes of subject project planning, analysis and management for the 4th semester MBA and more Study notes Project Management in PDF only on Docsity! M.B.A IV Semester Course FM-10 PROJECTS PLANNING, ANALYSIS & MANAGEMENT LESSONS 1 TO 14 INTERNATIONAL CENTRE FOR DISTANCE EDUCATION AND OPEN LEARNING HIMACHAL PRADESH UNIVERSITY, GYAN PATH, SUMMERHILL, SHIMLA-171005 CONTENTS SR. NO. TOPIC PAGE NO. CHAPTER – 1 INVESTMENT OPPORTUNITIES: THE PRELIMINARY STEPS 1 CHAPTER – 2 GENERATION OF PROJECT IDEA 9 CHAPTER – 3 MARKET AND DEMAND ANALYSIS 17 CHAPTER – 4 DEMAND FORECASTING 25 CHAPTER – 5 PROJECT TECHNICAL ANALYSIS 38 CHAPTER – 6 FINANCIAL ANALYSIS OF THE PROJECT 47 CHAPTER – 7 CAPITAL STRUCTURE PLANNING 60 CHAPTER – 8 PROFITABILITY ANALYSIS AND FINANCIAL PROJECTIONS 69 CHAPTER – 9 BREAK – EVEN ANALYSIS 80 CHAPTER – 10 CASH FLOW STATEMENTS 88 CHAPTER – 11 METHODS OF PROJECT APPRAISAL 97 CHAPTER – 12 PROJECT IMPLEMENTATION PRACTICES IN INDIA 116 CHAPTER – 13 SOCIAL COST-BENEFIT ANALYSIS 123 CHAPTER – 14 PROJECT DESIGN AND NETWORK ANALYSIS 133 3 4. Documents published by the Government In most developing countries where planed development has been accepted as an approach towards the removal of poverty, the plan document published by the Government provides a very useful source of project ideas. The plan document generally analyses the existing economic situation in a country and also pinpoints the investment opportunities, which fit into the overall planning effort. Considerable information can therefore, be gathered from the plan document. Departmental publications of various department of Government also provide useful information, which can help in the development of new project ideas. The project idea is a user-friendly concept of what a project should be like. It is the raw expression of the desire of the project sponsoring body to achieve something. The exact form in which the project idea is expressed is immaterial. In order to avoid unnecessary communications between the project sponsoring body and the project formulation team, the project idea should indicate broad objectives of the sponsor and limit these in time, space function and structure. In case no limitation is envisaged, the sponsoring body should state so and leave the project formulation team in no doubt about it. 1.4 CRITERIA FOR SELECTING A PARTICULAR PROJECT After gathering a large number of project profiles the entrepreneur should consider the following criteria for selecting a particular project: 1. Investment size Professional manager, who have worked in multinational companies, should think of starting medium-sized units only. Those who do not possess any prior experience should start with small ventures. 2. Location A new entrepreneur should locate his project to the extent possible in and around the state headquarters. There are many backward areas around cites. It is necessary to have such a location so to attract competent managers. This will also facilitate liaison with the state electricity Board, State Industrial development Corporation and various other agencies. Tax concession available for locating the plant at a particular place also be taken care of. 3. Technology The first project should not be a product, which requires high technology, necessitating foreign technical collaboration. It is better to go in for product with a proven technology that is indigenously available. It makes life easier to begin with. 4. Equipment The entrepreneur should select the best equipment as per advice of experienced technical consultants. He should not compromise on quality of the equipment. Many entrepreneurs enter into some sort of a deal with the equipment manufacturers for a “kick-back” and in the process sacrifice quality. 5. Marketing It is not advisable to get into a project particularly the first, which would mean survival amidst cut-throat competition involving direct selling to the ultimate consumer. One should go in for products, which have unfulfilled demand. 4 1.5 SCANNING OF BUSINESS ENVIRONMENTS AND IDENTIFYING A PROJECT Scanning of business environments is the first step in the process of identifying a project. One major aspect while choosing a project idea should be to ascertain of the marketability of the product proposed to be manufactured, its general use, industries which use it, its end- use and its buyers. You should, therefore, study the demand and supply of the product over the last few years to estimate its future demand based on the past trend. While doing so it would be necessary to take into consideration the anticipated changes in fashions, technology and level of income of the people. The study should take into account the demand and supply of the product. Although it is difficult to arrive at a prices forecast for demand and supply of a particular product, especially since reliable and up-to-date information is difficult to obtain. On the basis of the available data should be possible to decide on future prospects of the item proposed to be selected by you. Towards this, capacity utilization of the existing units could be taken as a broad indication of market for the product. Similarly, underutilization of the existing capacity could be taken as signal for little or no scope for setting up a new unit. 1.6 IMPORTANCE OF PROJECT IDENTIFICATION Project identification is often of great importance for the following reasons: 1. They become the catalytic agents of economic development. 2. They initiate the process of development in terms of employment and income generation. 3. They have beneficial consequence, which are long-term in nature. 4. Projects provide the framework of the future pattern of activities and services of the enterprises. 5. Projects usually involve substantial financial outlays. 6. They also initiate development of basic infrastructure and environment. 7. Project commitment cannot be easily reversed. 8. Project identification brings the necessary changes in society in course of time. 9. Project accelerates the process of socio-cultural development. 1.7 THE ENTERPRISES DEVELOPMENT CENTER The integrated method for facilitating the formation of new enterprises is known as the enterprises development centre. This brings together the key inputs face to face with the new generation entrepreneurs. It comprises of four principle components, viz., (1) the entrepreneurship centre; (2) the venture capital exchange; (3) the innovation centre; and (4) the incubation centre. The entrepreneurship centre conducts research and an appropriate environment to facilitate the setting up of new enterprises. The venture capital exchange provides the needed seed capital for new enterprise. The innovation centre provides technology evaluation, entrepreneurial assessment, project planning, evaluation, commercial feasibility studies, and the product development assistance to entrepreneurs. The incubation centre provides the needed impetus to new enterprises to succeed and grow. 5 1.8 PROJECT FEASIBILITY ANALYSIS A Project feasibility analysis includes market analysis, technical analysis, financial analysis and social profitability analysis. Although every feasibility analysis is different and tailored to suit the product, its goal is to identify the existing strengths and weakness of the project. The starting point of a project analysis is the establishment of objectives to be attained. The next stage is the pre-selection stage- the advisability of having an in depth study. The analysis stage consists mainly of three factors-markets, technical and financial analysis. A market analysis is a method of screening projects ideas as well as means of evaluating a project’s feasibility in terms of the market. A market analysis should cover the following areas: v A brief market description the market area, methods of transportation, existing rates of transport, channels of distribution, and general trade practices. v An analysis of past and present demand, determination of quantity value of consumption and identification of the major consumers of the product. v An analysis of past and present supply, broken down as source (whether imported of domestic), as well as information to assist in determining the competitive position of the product, such as selling prices, quality and marketing practices of competitors. The technical analysis for a project feasibility study established whether the project is technically feasible or not, and whether it offers basis for the estimation of costs. Moreover, it provides an opportunity for a consideration of the effect of various technical alternatives on employment, ecology, infrastructure demands, capital service, support of other industries, balance of payments and other factors. A technical analysis should review the techniques of processes to be applied and should incorporate: 1) A description of the product, including specification relating to its physical, mechanical and chemical properties, as well as the uses of the product. 2) A description of the selected manufacturing process, showing detailed flowcharts and presenting alternative which may have been considered and the justification for the adoption of the selected process. 3) A determination of the plant size and production schedule, which includes the expected volume for a given time period on the basis of start-up and technical factors. 4) Selection of machinery and equipment, including specifications, equipment to be purchases and its origin, quotations from suppliers, delivery dates, terms of payment, and a comparative analysis of alternatives in term of cost, reliability performance and spare parts availability. 5) Identification of plant’s location and as assessment of its desirability in terms of its distance from raw material source and markets. For a new project, this part may include a comparative study of different sites, indicating the advantages and disadvantages of each. 6) A design of the plant layout and an estimate of the cost of the erection of the proposed building and land improvements. 7) A study of the availability of raw materials and utilities including a description of physical and chemical properties, quantities needed, current and prospective costs, terms of payment, location and sources of supply, and continuity of supply. 8 1.14 TERMINAL QUESTIONS 1. Describe briefly the aspects of business environment that need to be monitored as well as the dimensions along which a firm may appraise its strengths and weakness for identifying investment opportunities. 2. Discuss the criteria for selecting a particular project. ***** 9 CHAPTER-2 GENERATION OF PROJECT IDEA STRUCTURE 2.0 Learning Objectives 2.1 Introduction 2.2 Corporate Appraisal 2.3 Scouting for Project Ideas 2.4 Preliminary Screening 2.5 Project Rating Index 2.6 Self Check Exercise 2.7 Summary 2.8 Glossary 2.9 Answers to Self Check Exercise 2.10 References/Suggested Readings 2.11 Terminal Questions 2.0 LEARNING OBJECTIVES: 1. To understand how project ideas are generated. 2. To learn about the screening of project ideas. 2.1 INTRODUCTION Proper project idea generation and screening is the utmost importance. So due attention is required while screening alternate projects, this lesson is devoted to the following aspects: Corporate Appraisal; Scouting for project ideas; Preliminary screening; and Project Rating Index 2.2 CORPORATE APPRAISAL For the purpose of identification of investment opportunities a reasonable appraisal of the strength and weakness of the company should be made. Following are the broad areas in terms of a company’s strength and weaknesses: Marketing and distribution Marketing and distribution of the products and services of the prospective project is an important aspect to be given due consideration in order to ensure the success of the project. Following dimension of this project should be specifically considered; v Market image v Product line v Distribution network v Brand loyalty 10 Production and Operation Like marketing, production and operations of the prospective project should also be properly evaluated. More impartially following aspect of this should be given due consideration; v Plant capacity and utilization thereof v Degree of vertical integration v Location of the plant v Different components of cost of production and operation Research and development Research and development is the sin qua of the success of project. Specifically the following areas should be given due attention. v Research capabilities of the firm v Track record of new product developments v Laboratories and testing facilities v Coordination between research and operation Corporate resources and personnel Corporate resources and the human resources of the enterprise should also be considered while examining a project. Specifically the following areas should b given due attention. v Corporate image v Clout with government and regulatory agencies v State of industrial relations Finance and Accounting Finance is the lifeblood of a business. Accounting and financial matters should be given due attention in this regard. Specifically the following areas should be given due attention in this respect. v Financial leverage and borrowing capacity v Cost of capital v Tax situation v Relations with shareholders and creditors v Accounting and control system v Cash flows and liquidity 2.3 SCOUTING FOR PROJECT IDEAS Good project ideas are the key to success. An effort should be made to tap wide variety of source to identify them. Following suggestions can be made in this regard. Analysis the performance of Existing Industries For having an insight into good project ideas a study of existing industries in terms of their profitability and capacity utilization is helpful. The analysis of profitability and break-even level of various industries indicates promising investment opportunities. An examination of capacity utilization of version industries provides information about the potential for further investment. 13 2.4 PRELIMINARY SCREENING By using the suggestion made in the preceding section, it is possible to develop a long list of project ideas. Some kind of preliminary screening is required to eliminate ideas, which prima facie are not promising. For this purpose, the following aspects may be looked into: v Compatibility with the promoter v Consistency with governmental priorities. v Availability of inputs v Adequacy of market v Reasonableness of cost v Acceptability of risk level Compatibility with the promoter The idea must be compatible with the interest, personality, and resources of the entrepreneur. According to Murphy, a real opportunity has three characteristics: i. It fits the personality of the entrepreneur. It squares with the abilities, training, and productivities. ii. It is accessible to him and iii. It offers him the prospect of rapid growth and high return on invested capital. Consistency with Government priorities v Is the project consistent with national goals and priorities? v Are there any environmental effects contrary to government regulations? v Can the foreign exchange requirements of the project be easily accommodated? v Will there be any difficulty in obtaining the licence for the project? Availability of Inputs The resources and inputs required for the project must be reasonably assured. To assess this, the following questions need to be answered: v Are the capital requirements of the project within manageable limits? v Is the technical know- how required for the project obtainable? v Are the raw materials required for the projects available domestically at a reasonable cost? v If raw materials have to be imported, will there be problems? v Is the power supply for the project reasonably obtainable from external sources and captive power sources? It may be noted here that Indian business has been traditionally faced with: i. Shortages of certain inputs like power, foreign exchange, and important raw materials, and ii. Fluctuating supplies of agriculture raw materials like cotton, Jute, and oil seeds. Of course, in recent times of situation has improved in some ways: I. Power generation has increased significantly. 14 II. Foreign exchange is now available more easily, and III. Supplies of certain basic industries raw materials have been augmented substantially. Adequacy of the market The size of the present market must offer the prospect of adequacy sales volume. Further, there should be a potential for growth and a reasonable return on investment. To judge the adequacy of the market the following factors have to be examined. v Total present domestic market v Competitors and their market shares v Export markets v Quality-price profile of the product vis-a-vis competitive products v Seles and distribution system v Projected increases in consumption v Barriers to the entry of new units v Economic, social, and demographic and trends favourable to increased consumption v Patent protection It may be emphasized there that barring reversionary aberrations, the demand for most of the products in India has been growing secularly. This trend would continue because of the low levels of per capita consumption in India. Fortunately, from the point of view of entrepreneurs, the Indian economy unlike most developed, western economics is not a share shift economy wherein the growth in demand for a product is likely to be at the expense of the demand for others. Reasonableness of cost The cost structure of the proposed project must enable it to realize an acceptable profit with a competitive price. The following should be examined in this regard. v Costs of material inputs v Labour costs v Factory overheads v General administration expense v Selling and distribution costs v Service costs Economies of scale Acceptability of Risk Level The desirability of a project is critically dependent on the risk characterizing it. In the assessment of risk a difficult task, indeed-the following factors should be considered: v Vulnerability to business cycles v Technological changes 15 v Competition from substitutes v Competition from imports v Governmental control over price and distribution 2.5 PROJECT RATING INDEX When a firm is evaluating a large number of project ideas regularly, it may be helpful to streamline the process of preliminary screening. For this purpose, a preliminary evaluation may be translated in to a project-rating index. The steps involved in determining the project-rating index are as follows:- 1. Identify factors relevant for project rating. 2. Assigning weights to these factors (the weights are supposed to reflect their relative importance). 3. Rate the project proposal on various factors, using a suitable rating scale. 4. For each factor multiply the factor rating with the factor weight to get the factor score. 5. Add all the factor score to get the overall project-rating index. Once the project-rating index is determined, it is compared with a pre-determined hurdle value to judge whether the project is prima facie worthwhile or not. 2.6 ELF CHECK EXERCISE 1. Marketing and ________is a key area of a company to be appraised for finding its strength and weaknesses. 2. _______is the lifeblood of a business. 3. To identify unfulfilled psychological needs of consumers ________technique is used. 2.7 SUMMARY It is imperative to give due attention to proper screening of project ideas. Effort should be made to identify those projects which appear to be prima-facie viable and promising. Once such projects have been identified, they should be subjected to rigorous screening. It is often taken for granted that there is an abundance of good and worthwhile projects, which can be identified rather easily. However, note that choosing good projects is akin to selecting under-valued securities using fundamental analysis. For this purpose the effect of various affecting the viability of the project should be studied and evaluated. 2.8 GLOSSARY Corporate Appraisal: Overall assessment of a company’s operations Brand loyalty: Positive image towards a brand and dedication to purchase it repeatedly Import substitution: Replacing foreign imports with domestic production 18 3.2 SITUATIONAL ANALYSIS AND SPECIFICATION OF OBJECTIVES OF MARKET AND DEMAND ANALYSIS In order to get a “feel” for the relationship between the product and its market, the project analyst may informally talk to customer, competitors, middleman, and others in the industry. Wherever-possible, he may look at the experience of the company to the learn about the performance and purchasing power of customers, actions, land strategies of competitors, and practices of the middleman. If such a situational analysis generates enough data to measure the market and get a reliable handle over projected demand and revenues a formal study need not be carried out, particularly when cost and time consideration so suggest. In most cases, of course, a formal study of market and demand is warranted. To carry out such a study, it is necessary to spell out its objectives clearly and comprehensively. Often this means that the intuitive and informal goals that guide situational analysis need to be expended and articulated with greater clarity. A helpful approach to spell out objectives is to structure them in the form of questions. Of course, in doing so, always bear in mind how the information generated will be relevant in forecasting the overall market demand and assessing the share of the market the project will capture. This will ensure that questions not relevant to market and demand analysis will not be asked unnecessarily: 3.3 COLLECTION OF SECONDARY INFORMATION In order to answer the questions listed while delineating the objectives of the market study, information may be obtained from secondary and/ or primary sources. Secondary information is information that has been gathered in some other context and is already available. Primary information, on the other hand, represents information that is collected for the first time to meet the specific purpose on hand. Secondary information 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. This section looks at the secondary information and the following at the information. General Sources of Secondary information The importance sources of secondary information useful for market and demand analysis in India include, Census of India, National sample survey plan Reports, Statistical abstract of the Indian Union, Industries, and Annual Reports of the Development wing. Ministry of Commerce and Industry, Annual Bulletin of statistics Exports and Imports, Techno-Economic Surveys, Industry potential Surveys, The stock exchange Directory, Monthly studies of production of selected industries, Monthly Bulletin of Reserve Bank of India and the publications of Advertising Agencies. Evaluation of Secondary Information While secondary information is available economically and readily (Provided the market analyst is able to locate it), The market analyst should seek to know: v What was the objective for collecting the information? v Who gathered the information? v When was the information gathered? v When was it published? 19 v How representative was the period for which the information was gathered? v What was the target population? v How was the sample chosen? v How representative was the sample? v How satisfactory was the process of information gathering? v What was the degree of sampling bias and non-response bias in the information gathered? v What was the degree of misrepresentation by respondents? v How accurately was the information edited, tabulated, and analyzed? v Was statistical analysis properly applied? 3.4 CONDUCT OF MARKET SURVEY Secondary information, though useful, often does not provide a comprehensive basis for market and demand analysis. It must be supplemented with primary information gathered through a market survey, specific to the project being appraised. The market survey may be a census survey or a sample survey. In a census survey the entire populations covered. Census surveys are employed principally or intermediate goods and investment goods when such goods are used by a small number of firms. In other cases, a census survey is prohibitively costly and may sample survey. In such a survey a sample of the population is connected/ observed and relevant information is gathered. On the basis of such information, inferences about the population may be drawn. The information sought in a market survey may relate to one or more of the following: v Total demand for the product and rate of growth of demand v Demand in different segment of the market v Motives for buying. v Attitudes toward various products v Socio-economic characteristics of buyers v Income and price elasticity of demand v Purchasing plans and intentions v Satisfaction with existing products v Unsatisfied needs v Distributive trade practices Steps in a sample survey A sample survey involves the following steps; 1. Definition of the target population In defining the target population the important terms should be carefully and unambiguously defined. The target population may be divided into various segments, which may have differing characteristic. For example, all television owners may be divided into three to four income brackets. 20 2. Selection of the sampling scheme and sample size There are several sampling schemes: simple random sampling, cluster sampling, sequential sampling, stratified sampling, systematic sampling, and non-probability sampling. Each scheme has its advantages and limitations The sample size, other things being equal, has a bearing on the reliability of the estimates. The larger- the sample size, the greater the reliability. 3. Development of questionnaire for collection of information The questionnaire is the principal instrument for eliciting information from the sample of the respondents. The effectiveness of the questionnaire as a device for electing the desired information depends on its length, the type of questions, and the wording of questions. Developing the questionnaire requires a thorough understanding of the product/service and its usage, imagination, insights into human behaviour, appreciation of subtle linguistic nuances, and familiarity with the tools of descriptive and inferential statistic to be used later for analysis. 4. Recruit and Train the Filed Investigators Recruiting and training of filed investigators must be planned well since can be time consuming. Great care must be taken for recruiting the right kind of investigators and imparting the proper kind of training to them. Investigators involved in industry and tread market survey need intimate knowledge of the product and technical background particularly of products bases on sophisticated technologies. 5. Collection of Information from the sample of Respondent Respondents may be interviewed personally, telephonically or by mail or obtaining information. Personal interviews ensure a high rate of response. They are, however, expensive and likely to result in biased responses because of the presence of the interviewer. Mail survey economical and evoke fairly candid responses. The response rate however, is often low. Telephonic interviews, common in western countries, have very limited applicability in India because telephone tariffs are high and telephone connections few. 6. Scrutinize the Information Gathered Information gathered should be thoroughly scrutinized to eliminate data which is internally inconsistent and which is of dubious validity. 7. Analyze and Interpret the Information Information gathered in the survey needs to be analyzed and interpreted with dew care. After tabulating it as per a plan of analysis, statistical Investigation may be conducted, wherever possible and necessary. Result of data bases on sample survey will have to be extrapolated to the target population. For this purpose, appropriate inflationary factors, bases on the ratio of the size of the target population to the size of the sample studied, will have to be used. It may be brought into notice that the results of the market survey can be vitiated by: • Non-representativeness of the sample • Imprecision and inadequacies in the questions, • Failure of the respondents to comprehend the questions, 23 (1) Demographic and sociological The consumers of a company should be categorized into the following classes on the basis of demographical and sociological considerations: 1. Age 2. Sex 3. Income 4. Profession 5. Residence 6. Social background (2) Attitudinal On the basis of attitude the consumers of a company must be classified into following categories 1. Performances 2. Intentions 3. Habits 4. Attitudes 5. Responses Supply and Competition It is necessary to know the existing sources of supply and weather they are foreign or domestic. Computation from substitutes and near-substitutes should also be specified because almost any product may be replaced by some other product as a result of relative changes in price, quality, availability, promotional effort, and so on. Government Policy The role of government in influencing the demand and market for a product may be significant. Governmental plans, polices, legislations, and orders, which have a bearing on the market and demand of the product under examination, should be spelt out. These are reflected in: production targets in national plans, import and export trade controls, import duties, export incentives, excise duties, sales tax, industrial licensing, preferential purchases, credit controls, financial regulations, and subsides/penalties of various kinds. 3.6 SELF-CHECK EXERCISE 1. Census of India is a general source of Primary information or Secondary Information? 2. Can the market survey be a sample survey or census survey? 3. ________is the principal instrument for eliciting information from the respondents. 3.7 SUMMARY Considering the important of market and demand analysis, it should be carried out in a orderly and systematic manner. The key step in such analysis are (1) situational analysis and specification of objectives. (2) Collection of secondary information. (3) Conduct of market survey, and (4) stipulation of the features of the market. The project analyst may do an informal situational analysis, which in turn may provide the basis for a formal study. For propose of market study, 24 information may be obtained from secondary and/ or primary sources. Secondary information is information that has been gathered in some other context and is already available. While secondary information is available economically, its reliability, accuracy, and relevance for the porous under consideration must be carefully examined. Secondary information, though useful, often does not provide a comprehensive basis for market and demand analysis. Therefore effort should be made to collect primary information if possible. 3.8 GLOSSARY Situation Analysis: assessment of an organization’s current and future strengths, weaknesses, opportunities and threats. Effective Demand: where demand and supply are equal 3.9 ANSWERS TO SELF-CHECK EXERCISE 1. Secondary information 2. Sample survey 3. Questionnaire 3.10 REFERENCES/SUGGESTED READINGS Ø Bryce, MC: Industrial Development, McGraw Hill (Int. Ed), New York. Chandra, Prasanna: Projects: Planning Analysis, Financing, Implementation, and Review Tata McGraw Hill, New Delhi. Ø Patel, Bhavesh M, Project Management, Vikas publishing House pvt. Ltd., New Delhi Ø Chaudhary, S.: Project Management, Tata McGraw Hill, New Delhi. 3.11 TERMINAL QUESTIONS 1. How would you evaluate secondary information? 2. Discuss the key steps in a sample survey. ***** 25 CHAPTER-4 DEMAND FORECASTING STRUCTURE 4.0 Learning Objectives 4.1 Introduction 4.2 Demand Forecasting 4.3 Objectives of Demand Forecasting 4.4 Probability of Error in Forecasting 4.5 Direct and Indirect Methods and Demand Estimation 4.5 (1) Direct Methods 4.5 (1) (a) Consumers’ Survey 4.5 (1) (b) Exports’ Opinion Survey 4.5 (1) (c) Simulated market Situation 4.5 (1) (d) Controlled market Experiment 4.5 (2) Indirect Methods 4.5 (2) (a) Trend projections 4.5 (2) (b) Regression Analysis 4.6 Demand Forecasting for New Products 4.7 Criteria or Conditions for Selecting Good Forecasting Method 4.8 Self Check Exercise 4.9 Summary 4.10 Terminal Questions 4.11 Answers to self-check exercise 4.12 Terminal Questions 4.13 Suggested Readings 4.0 LEARNING OBJECTIVES 1. To get familiar with demand forecasting. 2. To learn different methods of demand estimation. 4.1 INTRODUCTION One of the most important tasks of firms is to study the demand for their products and services. Knowing the demand for its product is significant activity for the firm. The firm must know what will be the demand for its product so that its product so that it plans proper capacity creation and avoid overproduction or underproduction. Such information will enable the firm not only to avoid overproduction or underproduction, but also to determine its price policy, promotional policy, etc. Then only it can secure optimum sales, or optimal revenue of maximum profit. Such information 28 Dangers in consumes’ survey Result of the survey should be interpreted with reasoned analysis. While relying on the responses of the consumers to questions asked, certain dangers must be taken into account. • Since the buyer is asked a hypothetical question, his answer are also hypothetical. • The buyer may feel that the interviewer wants a particular type of response. • Instead of revealing his intention, he may replay what he feels is expected by the interviewer. • He may replay to please the interviewer. • Even if the buyer reveals his true intentions, he may change his intention while making the actual purchases. Type of Consumers’ Survey There are two types of consumers’ survey: Complete Enumeration method and sample survey method. 1. Complete Enumeration Method In the complete enumeration method all potential buyers of the product are surveyed. The survey covers all the potential consumers in the market and their interviews are conducted to find out the probable demand. Once individual demands for the product are ascertained by the complete enumeration method, these are added together to find out the probable total demand for the firm’s product. Advantages of complete enumeration method: Since all potential consumers are contacted, there is a greater degree of accuracy in this method. This depends on whether the consumers have expressed their true intentions. This method is more useful when new products are to be introduced. This method is more useful when new products are to be introduced. This method may prove beneficial for products for which the number of potential consumers is small, e.g. for bulky and costly products, such as cars, big machines, refrigerators, etc. Disadvantages or Limitations of Complete Enumeration Method 1. This method is expensive, as the survey covers the entire of enumerators. 2. It is time- consuming. A great deal of time is consumed, since all consumers are interviewed. 3. The method is of no use where the consumers are spread over a wide area and cannot be contacted easily. 4. In the absence of a large number of qualified and competent investigators, this method will not work effectively and hence is less reliable. 2. Sample Survey Method Due to the limitations of the complete enumerations method, simple survey method has become more popular for demand estimation. In this method, only a few consumers selected from the total potential consumers are interviewed and then the average demand is calculated on the basis of the consumers interviewed. By multiplying the total number of consumers by this average demand, the aggregate demand for the product is estimated. The sampling method of the consumer survey is based on two principles. 29 a. Principle of statistical regularity and b. Principle of inertia of large number. The first principle is based on the mathematical theory of probability and implies that a moderately large number of items chosen at random from a large group are almost sure, on the average, to possess the characteristics of the large group. The second principle of inertia of large numbers implies that other conditions being equal, large the size of the sample more accurate the inference or result is likely to be. The variation in the aggregate tends to be very small or insignificant, if the number in the sample is very large. Methods of Sample Surveys There are two type of sampling methods; (1) Random or probability sampling and (2) Non- random or non-probability sampling Random Sampling In the case of probability or random sampling method, the law of probability can be applied. In this method, each consumer or group of consumers is given an equal chance of being selected for the sample. Selection is made the help of a table of random numbers. There are five random sampling methods: (1) Simple random sampling, (2) Stratified sampling (3) Systematic Sampling, (4) Multi-stage sampling or cluster sampling and (5) multi-phase sampling. (a) Simple random sampling: In the simple random sampling each consumer gets an equal chance of being selected in the sample. There are two methods of simple random sampling. Lottery method: Where the consumers are given numbers, which are written or paper sips, and then the required number of slips is lifted blindfolded. Table of random numbers: These random number tables are available, viz.. (a) Tipett’s table of random numbers, (b) Fisher and yete’s table and (c) Kendall and Babington table. The number of consumers in the sample is selected on the bases of these numbers. (b) Stratified sampling: In the stratified sampling method, the potential buyers are divided into homogenous groups or classes called “Stratas”. Then by applying the simple random method, a sample is selected from each group. Stratified sampling ensures greater accuracy. (c) Systematic sampling: In the systematic sampling, we pick up every Kth consumer in the total number of consumers. K will be decided by divided total number of consumers by the total number in the sample. (d) Multi-stage of cluster sampling: In the multistage or cluster sampling method, the whole class of consumers is divided into further groups and again these groups are subdivided and then if necessary, there may be further subdivisions of consumers. At every stage, random sampling is applied to find out the next subdivisions. Suppose we want to take a sample survey of consumers of a particular state in India. First the state is divided into a number of villages. Again at this stage, a sample of villages is chosen at random. The total number of households in each village in the sample is counted. Then a sample of households from each village in the village sample is prepared for interview purpose. This method introduces an element of flexibility and enables the firm to cover a very big aria. 30 (e) Multi-phase Sampling: In multi-phased sampling method, we use the multi-stage sampling at various stages for the purpose of different objectives. Thus, the sample of district selected may be used to find out the incomes of the people; then in the second stage, the sample of villages for each district in the district sample may be used for some additional characteristics, such as consumers’ testes, fashion, etc., and still further, the household sample from the village sample may be used for still additional characteristics, such as the actual questions of the product the consumers would buy. Non-Random sampling Random sampling as explained above has a number of advantages. The main advantage is that it is suitable for large surveys and the principle of probability is applied to get the rustles. However, for certain purposes, non-random sampling methods are used. There are three important type of non-random or non-probability sample: (a) Judgement Sampling, (b) Quota Sampling, and (c) convenience sampling. (a) Judgement Sampling: The investigator uses his discretion or judgement in choosing sample items. He prefers those items for sample, which according to his judgement, are representative of the universe. Suppose, the firm wants to survey ten households in a locality as a sample, the expert investigator may choose ten households on the basis on his personal judgement. He will select those households, which, he think, represent the locality. Certain managerial decisions may be taken with the help of judgement sampling, where the time in short. However, this type of sampling is not scientific because there is a great degree of subjective element. If the investigator is an expert in the field, then only the judgement sampling can be truly of representative charter. (b) Quota Sampling: Where quota are allocated for the purpose of judgement sampling, it is known as quota sampling. The investigator is asked to choose the item of the sample according to quotas for different categories of items. For example, if one hundred consumers are to be chosen by the expert investigator, he may be asked to choose 50 from person above the age of 50, 25 between the age of 31 and 50; 15 between the age of 25 and 30 and 10 between the age of 15 and 24. (c) Convenience Sampling: It is also known as chunk sampling. In this type, a chunk or fraction of the universe is chosen for the investigation of survey on the basis of convenience. The sample or the chunk is selected by convenience, e. g. The sample may be readily available from a printed list, e. g. The list of telephone subscribers from a telephone directory, or from the list of members from various clubs, institutions, etc. Interviews may be conducted at the bus stops, railway stations, or on busy market roads, to find out responses for a product. Since Convenience sampling cannot be representative of the universe, its results are not satisfactory or reliable. Merits of sampling Techniques 1) Less Costly: As compared to complete enumeration method, sampling method is less costly. Only a small number of consumers are interviewed and hence total cost of the survey tends to be small. 2) Less time-consuming: Sample survey techniques are also less time-consuming. Time is saved in both collecting data and processing it. 3) More reliable: The inferences from sampling techniques are more reliable than complete enumeration method, though in the former, there are chances of errors. First, the extent of sampling error can be determined. Secondly, the possibility of inaccuracy is more in the 33 one of the markets regarding new advertising campaign or other sales promotion schemes. It first finds out buyers’ responses. If these responses are positive and satisfactory results are obtained, then it may take the risk of spending huge amounts on such campaigns on a nationwide basis. Precautions to be taken: While selecting markets for controlled experiments, areas selected should have the same characteristics such as income levels, population, social background, tastes and preferences, occupational pattern, etc. Secondly, such experiments should be conducted over an extended period of time to observe more than just initial or impact effect of price change or change in some other variable, such as advertising, packaging, quality, etc. It is quite likely that any change in sales due to changing price or other controlled variable may be a result of changes in uncontrollable factors, such as increase or decrease in income levels, changes in income distribution, changes in fashion, etc. To know whether the changes are due to uncontrollable factors, ‘controlled market experiments’ may be conducted and effects of such uncontrollable factors may be separated in order to know the net effect of controllable variables. Benefits of controlled market experiments: (1) The major benefit of controlled market experiments is that the firm knows the actual responses of the buyers to variation in controlled factors such as price of the product, sales promotion campaigns. Etc. Before taking a general decision of a price cut or price increase, the firm gets on opportunity to conduct the experiment in one or a few markets. Similarly instead of spending large amount on nationwide advertisement, it can conduct a test by introducing its new campaign in smaller areas to find out buyers’ reactions. If the results are positive and encouraging it may introduce advertising campaign on a national scale. (2) Such experiments are advantageous to large-scale firms, which supply their products throughout the country. If the experiments are conducted with great care, the firm may be saved from the dangers of under pricing, overpricing or unnecessary spending of money on wasteful advertisements. If positive and encouraging results are obtained, the firm can safely go ahead with its price-decisions or additional campaigns as planned. Limitations of controlled market experiments: For large firms, controlled market experiments provide a fund of valuable information. However, there are some major pitfalls. If such pitfalls are not anticipated and eliminated during the experiments, they may lead to unreliable results. The cost of the experiments may prove to be greater than the value of the limitations or pitfalls: 1) It may happen that changes in sales in the controlled market may not be due to change in the controlled variable. They may be the result of changes in the uncontrolled factors, such as income, income distribution, occupational patterns, tastes, fashion, etc. This is a great pitfall. Care must be taken to find out such a pitfall. Effects of uncontrollable factors should be separated to get the net effect of the controlled factors. Otherwise the results would be misleading. The firm’s decision would go wrong. It will have to pay a high cost in term of losses. 2) If the experiment is conducted over a very short period, the result obtained may not be reliable. They may be due to the initial effect of buyer’s emotional behaviour. The experiment must be conducted over a prolonged period to establish a definite relationship between the controlled factor and the sales. 34 3) Market experiments become a expletive exercise in many other way also: If the price is raised in the controlled market to test the buyer’s responses are negative, than restoring the price to earlier lower level will not bring back the original higher sales level. This is because the buyers would have taken a liking for substitutes during the experiment period and may continue with substitutes. The firm loses the market or a great deal of it permanently. 4) If the new promotion campaign fails in its experiment, it may do a long-term damage to the firm’s image and to its sales level. 5) While the firm introduces a price change or change in the promotional efforts like new advertising campaign in its market experiment, it is quite likely that the rival firms may nullify such experiment. They may introduce counterchanges in their price s or promotional campaigns and the entire efforts of the firm in conducting such an experiment may be wasted. 4.5 (2) Indirect Methods Indirect methods of demand estimation over demand forecasting for the short period cosiest of trend projections and regression analysis. Many statistical tools over techniques are now available for estimating ‘demand for the product. We first write down the demand function for the product and then with the help of regression analysis and the past data, find out coefficient of independent variable. We can also estimate demand with the method of trend projections. 4.5 (2) (a) Trend projections (Extrapolation method) In the trend projections method, past data about the dependent variable and other independent variables is used to project the sales in the coming year or years. This method is also called time series analysis method. Here we use the pairs of observations recorded over time in a particular situation. For example, we collect data about the sale of the product in the past five years. The resulting trend is then extrapolated into future periods. The result and indicated sales levels are used as the basis for the demand estimation. Moving Average Method This method is also used to find out the future sales. First the past data (say for the past five years) about the sales is collected. Then the average of the past sales is calculated. This average is taken as demand estimation for the next year, assuming that the future sales will be equal to the average of the past sales. Smoothing Techniques Smoothing techniques models of forecasting are based on the assumption that an underlying pattern can be found in the historical value of a variable for which forecasting is being prepared? Besides representing the underlying pattern, these historical observations also represent random variations. In smoothing techniques, we take some form of an average of past observations. Thereby distortions from random variation in the series are eliminated. The forecast is based on a smooth average of several past observations. 35 Smoothing techniques can be used beneficially when changes in the data series are slow from one period to the next period, and there are no frequent changes in the direction of the underlying pattern. Smoothing techniques are less expensive to store the data and chapter for developing a forecast. They are also inexpensive to operate. 4.5 (2)(b) Regression Analysis Regression analysis is one of the statistical techniques, which are widely used, in different scientific disciplines. It is a tool to measure or estimate the unknown value of one variable from the known value of another variable. In demand estimation (short period) and demand forecasting (long period), it is a very useful technique to find out the change in the quantities of the product demanded, when other independent variables, such a price, income, tastes, advertising, etc., change. Suppose, two variables X (say advertising expenditure) and Y (sales) are closely related, we can find out with the help of regression question the probable value of Y (sales) for a given value of X (advertising expenditure). When the price of the product and its quantity demanded have a functional relationship, we can find out change in the value of Y (quantity of the product demanded) for a given change in the value of X (price). The study of regression is of immense help for economists, producers and business people. Simple Regression and Multiple Regressions When we consider the relationship between two variables, one dependent variable, (e.g. sales) and another independent variable, (e.g. price), the relationship is called simple regression. Where the relationship is between the dependent variable and a number of independent variables, It is known as multiple regression. Solving regression equations and finding out of value is very complex and requires time. However, with the aid of computer programmes; simple and multiple regression can be estimated quickly and easily. First, it is necessary to specify the form of dependence of y on the x variable. This dependence may be expressed in linear form in which we show additive influence of the independent variable (X, X, X, X,...Xn) on the dependent variable Y as under. Y =a+b1 X1 +b2 X2+.....+bn Xn + e Here y (sales) is the dependent variable, b 1 ... b 2 .. bn are the coefficients of independent variables. X 1 X 2 ....Xn. ‘a’ is the intercept or the constant value of y irrespective of the influence of X variables, ‘e’ the error or residual value which will arise as the difference between the actual value of each Y observed in association with each set of X value and the estimated value of each Y that is associated with the set of X variables in the regression equation. The dependence of Y (sales) on X variable (price) may be expressed in non-liner form. The most commonly used non-linear form of regression equation shows a multiplicative influence of independent variables on the dependent variable Y. Here not only the effect of each variable on Y is considered, out the effect of changes in each independent variable on other independent variables is also considered. Y= a X 1 b 1 X 2 b 2 e A is intercept: X 1 X 2 are independent variables, b 1 .. b 2 are coefficients ‘e’ the error term. This equation can be converted into an addictive from with the help of logarithms as under: Y= log a+b 1 log X 1 + b 2 log X 2 +log e. 38 CHAPTER – 5 PROJECT TECHNICAL ANALYSIS STRUCTURE 5.0 Learning Objectives 5.1 Introduction 5.2 Material Inputs and Utilities 5.3 Manufacturing Processes/Technology 5.4 Product Mix 5.5 Plant Capacity 5.6 Location and site 5.7 Machinery and Equipments 5.8 Structure and Civil Works 5.9 Project Charts and Layouts 5.10 Work Schedule 5.11 Self Check Exercise 5.12 Summary 5.13 Glossary 5.14 Answers to Self-Check Exercise 5.15 References/Suggested Readings 5.16 Terminal Questions 5.0 LEARNING OBJECTIVES 1. To understand manufacturing process/technology. 2. To know about project charts and layouts. 5.1 INTRODUCTION Analysis and technical and engineering aspects of a project is an important aspect of project management. Other types of analyses are dependent and closely intertwined with technical analysis. The important aspects of technical analysis include the followings: v Material inputs and utilities v Manufacturing process/technology v Product mix v Plant capacity v Location and site v Machineries and equipments v Structures and civil works v Project charts and layouts v Work schedule This lesion is devoted to the study of above mentioned aspects of technical analysis. 39 5.2 MATERIAL INPUTS AND UTILITIES An important aspect of technical analysis is concerned with the identification of the materials and utilities required, specifying their properties in some detail, and setting up their supply programme. There is an intimate relationship between the study of materials and utilities and other aspects of project formulation, particularly those concerned with location, technology, and equipments. Material inputs and utilities may be classified into fore board categories: (i) raw materials, (ii) processed industrial materials and components, (iii) auxiliary materials and factory supplies, and (iv) utilities. Raw Materials Raw material (processed and/or semi-processed) may be classified into four types: (i) agriculture products. (ii) Mineral products, (iii) livestock and forest products, and (iv) marine products. Agriculture products: In studying agriculture products the quality must first be examined. Then, a assessment of quantities available, currently and potentially, is require. Mineral products: In assessing mineral raw materials, information is required on the quantum of exploitable deposit and the properties of raw materials. The study should provide details of the location, size and depth of deposits and the variability of opencast or underground mining. Livestock and forest products: Secondary sources of data on livestock and forest products often do not provide a dependable basis for estimation. Hence, in general, a specific survey may be required to obtain more reliable data on the quantum of livestock produce and forest products. Marine Products: Assessing the potential availability of marine products and the cost of collection is somewhat difficult. Preliminary marine operations, essential for this purpose, have to be provided for in the feasibility study. Processed Industrial Materials and Components Processed industrial materials and components (base materials, semi-processed materials, manufactured parts, components, and sub-assemblies) represent important inputs for a number of industries. In studying them the following question need to be answered: In the case of 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 there are supplies? What has been the past trend in prices? What is the likely future behaviour of prices? Auxiliary Materials and Factory Supplies In addition to the basic raw materials and processed industrial and components, a manufacturing project requires auxiliary materials a factory supplies like chemicals, additives, packaging materials, plants, varnishes, oils, grease, cleaning materials, etc. The requirement of such auxiliary and supplies should be taken into account in the feasibility study. Utilities A broad assessment of utilities (power, water, steam, fuel, etc.) may be made at the time of input study though a detailed assessment can be made only after formulating the project with respect to location, technology, and plant capacity. 5.3 MANUFACTURING PROCESS/TECHNOLOGY For manufacturing a product/service often two or more alternative technology are available. The choice of the manufacturing technology should be made with due care. 40 Choice of Technology The choice of technology is influenced by a variety of consideration. These are discussed below: i) Plant Capacity: Often, there is a close relationship between plant capacity and production technology. To meet a given capacity requirement perhaps only a certain production technology may be viable. ii) Principal Inputs: The choice of technology depends on the principal inputs available for the project. In some cases, the new materials available influence the technology chosen. Technology based on indigenous inputs may be preferable to one based on imported inputs because of uncertainties characterizing imports. iii) Investment Outlay and Production Cost: the effect of alternative technologies on investment outlay and production cost over a period of time should be carefully assessed. iv) Use by Other Units: The technology adopted must be proven by successful use by other units, product mix. The technology chosen must be judged in terms of the total product-mix generated by it, including saleable by products. v) Latest Development: the technology adopted must be based on latest developments in order to ensure that the likelihood of technological obsolescence is eliminated. vi) Ease of Absorption: The ease with which a particular technology can be absorbed can influence the choice of technology. Sometimes a high-level technology may be beyond the absorptive capacity of a developing country, which may lack trained personnel to handle that technology. Acquiring Technology The acquiring of technology from some other enterprise may be way of (i) technology licensing, (ii) outright purchase, or (iii) joint venture arrangement. The pros and cons of these methods of acquiring technology are discussed below: Technology Licensing: A popular method of acquiring technology, the technology license givens the licenses the right to use patented technology and get related known-how on a mutually agreed basis. Often suppliers of technology tend to provide a technology package, which may consist of some elements, which are not essential. Hence the technology package should be disaggregated into its components parts like the technology proper, engineering service, supply of intermediate products, supply of equipment by the licensor, use of a trade name, etc. Effects should be made to acquire only the essential components of the technology package offered by the licensor. Purchase of Technology: This mode of acquiring technology is appropriate when (i) there is no possibility of significant improvement in technology in the foreseeable future, and (ii) there is hardly any need for technological support from the seller of technology. Joint Venture Arrangement: The supplier of technology may participate technically as well as financially in the project. Financial participation is typically in the form of equity holding. It is argued that financial participation may strengthen the motivation of technology supplier to transfer improvements promptly. Appropriateness of technology Appropriate technology refers to those methods of production, which are suitable to local economic, social, and cultural conditions. The advocates of appropriate technology urge that the technology should be evaluated in terms of the following questions: weather the technology utilizes 43 5.7 MACHINERIES AND EQUIPMENTS The requirement of machineries and equipments is dependent on production technology and plant capacity. The type of project also influences it. The choice of machineries and equipments for a manufacturing industry is somewhat wider as various machines can perform the same function with varying degrees of accuracy. To the kinds of determine machinery and equipment required for a manufacturing industry, the following procedure may be followed: (i) Estimate the likely levels of production over time. (ii)Define the various machining and other operations. (iii) Calculate the machine hours required for each type of operation. (iv) Select machineries and equipments required for each function. In addition to the machineries and equipments, a list should be prepared of spare parts and tools required. This may be divided into (i) spare parts and tools to be purchased with the original equipment, and (ii) spare parts and tools required for operational wear and tear. Constraints in Selecting Machineries and Equipments In selecting the machineries and equipments certain constraints should be borne in mind: (i) there may be a limited availability of power to set up an electricity-intensive plant like, for example, a large electric furnace; (ii) there may be difficulty in transporting a heavy equipment to a remote location; (iii) workers may not be able to operate, at least in the initial period; certain sophisticated equipments such as numerically controlled machines; (iv) the import policy of the government may preclude the import of certain machineries and equipments. Procurement of plant and Machinery For procuring plant and machinery, orders different item of plant and machinery may be placed with the different suppliers or a turnkey contract may be given for the entire plant and machinery to a single supplier. The factors to be considered in selecting the supplier/s of plant and machinery are the desired quality of machinery, the level of technological sophistication, the relative reputation of various suppliers; the expected delivery schedules, the preferred payment terms, and the required performance guarantees. If in-house technical expertise is inadequate, external consultant/s may be employed to select plant and machinery and supervise the installation of the same. 5.8 STRUCTURES AND CIVIL WORKS Structure and civil works may be divided into three categories: (i) sit preparation and development, (ii) buildings and structures, and (iii) outdoor works. Site Preparation and Development This covers the following: (i) grading and levelling of the site (ii) demolition and removal of existing structure, (iii) relocation of existing pipelines, cables, roads, power lines, etc (iv) reclamation of swamps and draining and removal standing water, (v) connections for the following utilities from the site to the public network: electric power (high tension and low tension), water of drinking and other purposes, communication (telephone, telex. Etc.), roads, railways sidings, and (vi) other site preparation and development work. Building and Structures Building and structures may be divided into: (i) factory or process buildings; (ii) ancillary building required for stores, warehouses, laboratories, utility supply centres, maintenance service and others; (iii) administrative building; (iv) staff welfare buildings, cafeteria, and medical service buildings; and (v) residential building. 44 Outdoor Works Outdoor works cover (i) supply and distribution of utilities (water, electric power, communication, steam, and gas); (ii) handling and treatment of emission, wastages, and effluent; (iii) transportation and traffic arrangements (roads, railway tracks, paths, parking areas, sheds, garages, traffic signals, etc.); (iv) outdoor lighting; (v) landscaping; and (vi) enclosure and supervision (boundary wall, fencing, barriers, gates, doors, security posts, etc.) 5.9 PROJECT CHARTS AND LAYOUTS Once data is available on the principal dimensions of the project-market size, plant capacity, production technology, machineries and equipments, buildings, and civil works, conditions obtaining at plant site, and supply of input to the project-project charts and layouts may be prepared. These define the scope of the project and provide the basis for detailed project engineering and estimation of investment and production costs. The important charts and layouts drawings are briefly described below. 1. General functional Layout This shows the general relationship between equipments; buildings, and civil works. In preparing this layout, the primary consideration is to facilitate smooth and economical movement of raw materials, work-in-process, and finished goods. This means that: (a) The layout should seek to allow traffic flow in one direction to the extent possible, with a minimum of crossing. (b Stores, workshops, and other service must be functionally situated with respect to the main factory buildings. 2. Materials Flow Diagrams This shows the flow of materials, utilities, intermediate products, final product, by-products, and emissions. Along with material flow diagram, a quantity flow diagram showing the quantities of flow may be prepared. 3. Production Line Diagrams These show how the production would progress along with the key information for main equipment. 4. Transport layout This shows the distance and means of transport outside the production line. 5. Utility Consumption Layout This shows the principal consumption points of utilities (power, water, gas, compressed air, etc.) and their required quantities and qualities. These layouts provide the basis for developing specification for utility supply installations. 6. Communication Layout This shows the various parts of the project will be connected with telephone, telex, intercom, etc. 7. Organizational Layout: This shows the organizational set-up of the project along with information on personnel required of various departments and their inter-relationship. Plan Layout- The plan layout is concerned with the physical layout of the factory. In certain industries, particularly process industries, the production process adopted dictates the plant layout. In manufacturing industries, however, there is much greater flexibility in defining the plant layout. 45 5.10 WORK SCHEDULE The work schedule, as its name suggests, reflects the plan of works concerning installation as well as initial operation. The purpose of the work schedule is: to anticipate problems likely to arise during the installation phase and suggest possible means for coping with them. To establish the phasing of investments taking into account the availability of finances. To develop a plan of operations covering the initial period. Need for Considering Alternatives The need for considering alternatives has been touched upon earlier. This point, however, needs to be emphasized. There are alternative ways of transforming an idea into a concrete project. These alternatives may differ in one or more of the following aspects: Nature of Project The project may envisage the manufacture of all the parts and components in a vertically integrated unite or it may consist of an assembly type unite, which obtains the bulk of the parts and components from outside suppliers. The project may consist of processing up to the finished stager may stop at semi-finished stage. These alternatives are available with respect to the nature of the project. Production Process There may be several alternatives with respect to the production process. The availability and characteristics of raw materials, the cost structure, and the nature of markets served as factors that have to be borne in mind while deciding about the process. Product Quality Barring a-few like clinic thermometers where a certain standard has to be maintained, the choice with respect to quality is fairly wide. This particularly true in the case of consumer products like textiles, footwear, etc. the quality and product range decisions would depend on the characteristics of the market, the elasticity of demand, consumer preferences, and the nature of competition. Scale of Operation and Time Phasing In many cases several scales of operation are feasible technically and financially. The choice of a particular scale would depend on the financial resources available, the nature of competition, the nature of demand, and the economics of scale. Further, a given capacity may be installed in one stage or in phases. The capital cost or capacity installation is usually lower when it is done in one stage. The cost of idle capacity, however, is higher when it is built in a single stage. The trade-off between these costs would determine the optimal pattern of time phasing. Location Location and size are closely interrelated. Perhaps the same demand could be satisfied by: (i) a signal plant for the entire market; or (ii) one large plant for the bulk of the market with a few smaller plants for a remaining market; (iii) several plants of similar size speared over the market areas. The choice would depend mainly on the tread-off between economies of scale in manufacturing and economies of distribution. 5.11 SELF-CHECK EXERCISE 1. In a manufacturing project, the following items like chemicals, additives, packaging materials, plants, varnishes, oils, grease, cleaning materials etc. come under which category? 48 6.1 INTRODUCTION A project must be thoroughly evaluated from financial angle. To judge a project from the financial angle, we need information about the following: v Cost of project v Means of financing v Appropriate capital structure v Estimates of sales and production v Cost of production v Working capital requirement and its financing v Estimates of working results v Break-even point v Projected cash flow statements v Projected balance sheets This lesson is devoted to the study of cost of the project and the means of financing. The remaining aspects of the financial analysis would be discussed in the forthcoming lessons. 6.2 COST OF PROJECT Conceptually, the cost of project represents the total of all items of outlay associated with a project, which are supported by long-term funds. It is the sum of the outlays on the following: v Land and site development v Building and civil works. v Plant and machinery v Technical know-how and engineering fees v Expenses on foreign technicians and treating of Indian technicians abroad v Miscellaneous fixed assets v Preliminary and capital issue expenses v Pre-operative expense v Provision for contingencies v Margin money for working capital v Initial cash losses 6.2 (1) Land and site Development The cost of land and site development is the sum of the following: v Basic cost of land including conveyance and other allied changes v Cost of laying approach road and internal roads v Cost of levelling and development v Cast of gates v Cost of tube wells 49 The cost of land varies considerably from one location to another. While it is very high in urban and even semi-urban locations, it is relatively low in rural locations. The expenditure on site development, too, varies widely depending on the location and topography of the land. 6.2 (2) Building and Civil Works Building and civil works cover the following: v Building for the main plant and equipment v Buildings for auxiliary service like steam supply, workshop, and laboratory, water supply, etc. v Warehouses, and open yard facilities v Non-factory buildings like canteen, guesthouse, time office, excise house, etc. v Quarters for essential staff v Tanks, well, chests, basins, cisterns, bins, and other structures necessary for installation of plant and equipment v Garages v Sewers, drainage, etc. v Other civil engineering works. The cost of building and civil works depends on the kinds of structures required which in turn, are dictated largely by the requirements of the manufacturing process. One the kinds of structures required are specified, cost estimates are based on plinth area and rates for various types of structures. These rates, of course, vary with the location to some extent. 6.3 (3) Plant and Machinery The cost of plant and machinery, typically the most significant component of project cost, consists of the following: Cost of imported machinery: This is the sum of FOB (free on board) value, shipping, freight, and insurance cost, import duty, and clearing, loading, unloading, and transportation charges. Cost of indigenous machinery: This consists of FOR (free on rail) cost, sales, tax, and other taxes, if any, and railway freight and transport charges to site. Cost of stores and spares; this consists of input necessary for the project. Foundation and installation charges; these are the charges necessary to set up the foundations of the building. The cost of plant and machinery is based on the latest available quotation adjusted for possible escalation. Generally, the provision for escalation is equal to the following product: (latest rate of annual inflation applicable to the plant and machinery) x (length of the delivery period). 6.2 (4) Technical Know-how and Engineering fees 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 project report, choice of technology, selection of plant and machinery, detailed engineering, and so on. While the amount payable for obtaining technical know-how and engineering services for setting up the project is a component of 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. 50 6.2 (5) Expenses on Foreign technicians and Training of Indian Technicians Abroad Service of foreign technicians may be required in India for setting up the project and supervising the trial runs. Expenses on their travel, boarding, and lodging, along with their salaries and allowances must be shown here. Likewise, expenses on Indian technicians who require training abroad must also be included here. 6.2 (6) Miscellaneous Fixed Assets Fixed assets and machinery that 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 equipments, workshop equipments, effluent treatment plants, fire fighting equipments and so on. Expenses incurred for procurement or use of patents, licences, trademarks, copyrights etc. and deposits made with the electricity board may also be included here. 6.2(7) 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 associations, and incorporating commission, breakage, fees to managers and registrars, printing and postage expenses, advertising and publicity expenses listing fees, and stamp duty. 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 registers, printing and postage expenses, advertising and publicity expenses, listing fees, and stamp duty. 6.2 (8) 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 borrowing, (v) insurance charges, (vi) mortgage expenses, (vii) interest on deferred payments, (viii) start-up expenses, and (ix) miscellaneous expenses. Pre-operative expenses are directly related to the project implementation schedule. So delays in project implementation, which are fairly common, tend to push up these expenses. Appreciative of this, financial institution allow for some delay (20 to 25 per cent) in the project implementation schedule and accordingly permit a in the estimate for pre-operative expenses. Pre-operative expenses incurred up to the point of time the plant and machinery are set up may be capitalized by apportioning them to fixed-assets on some acceptable basis. Pre-operative expenses incurred from the point of time the plant and machinery are set up treated as revenue expenditure. The firm may, however, treat them as deferred revenue expenditure and write them off over a period of time. 6.2 (9) Provision of Contingencies A provision for contingencies is made to provide for certain unforeseen expenses and price increases over and above the normal inflation rate, which is already incorporated in cost estimates. To estimate the provision for contingencies the following procedure may be followed: (i) Divide the 53 Features of Equity Shares Equity shares have a number of features, which distinguish them from other securities. These features generally relate to the right and claims of equity shareholders. These are discussed below: (a) Claim for Income Equity shareholders have a claim to the residual income of company, that is, the earnings which are available after paying expenses, interest charges, taxes and preference dividends. The income of equity shareholders may be retained by the firm or paid out as dividends. Dividends are immediate cash flows to shareholders. Retained earnings are reinvested in the business and shareholders stand to gain in future in the form of the firm’s enhanced earning power and value of the business, ultimately resulting in unhands dividend and capital appreciation. It should be noted that a company is not under a legal obligation to distribute dividends out of available earnings. The dividend decision is the prerogative of the board of directors and the equity shareholders are entitled to dividend that is declared by the board of directors. (b) Claim on assets Equity shareholders also have a residual clime on the company, assets in the case of liquidation. The assets of the business are utilized first to meet the claims of creditors and preference shareholders, and whatever is left thereafter belongs to the equity shareholders. Thus, equity shares provide a cushion to absorb losses on liquidation and may even remain unpaid. (c) Right to Control Equity shareholders as owner of the company have voting write in the meeting of the shareholders on the basis of the principles ‘one share one vote’. The control of the company rests with the board of directors, who is elected by the equity shareholders. Thus, equity shareholders exercise an direct control over the working of the company. If the board fails to protect their interests, they can replace directors. However, the control by the equity shareholders is often weak and ineffective because of the apathy and indifference of most of the shareholders who rarely bother to cast their votes by post or through proxy, let alone attend the annual meetings. (d) Pre-emptive rights The pre-emptive right enables existing equity shareholders to maintain their proportional ownership. The companies Act requires companies to give existing equity shareholders the first opportunity to purchase new equity shares being issued by the company in the same proportion as their current ownership. Thus, if a shareholder owns one per cent of the company’s equity share he has pre-emptive right to by one per cent of new shares issued. Shares so offered to existing shareholders are called right shares. A shareholder may however, decline to exercise this right. (e) Limited Liability Although equity shareholders are the owners of the company, their liability is limited to the par value of shares purchased by them. If a shareholder has already fully paid the issue price of shares he cannot be asked to contribute more in the event of a financial distress as in the case of sole proprietary business or partnership firms where they have unlimited liability. They limited liability feature of equity shareholders encourages otherwise unwilling investor to invest their funds in the company. 54 6.3 (2) Preference Share Capital Preference shares are the shares which enjoy preference over equity shares in regard to, (a) payment of dividend and (b) payment of the principal amount at the time of liquidation of the company. Preference share is considered to be a hybrid security since it partake some feature of ordinary shares and some feature of debentures. It is similar to equity share in the following ways: 1. Preference dividend is payable only out of distribution profits. 2. Preference dividend is not an obligatory payment. 3. Preference dividend is not a tax-deductible payment. Preference share is similar to debenture in the following ways: Types of preference Shares Depending upon the various feathers, which can be attached to preference shares, they can be classified into the following categories: (a) Cumulative or Non-cumulative preference Shares Cumulative preference shares have a right to claim dividend on such shares also, for which dividend could not be paid due to inadequate profits. The unpaid dividend on such shares is carried forward and accumulative dividend becomes payable in the year in which the company has divisible profits. It should be noted that a company couldn’t declare’ dividend on equity shares unless preference dividends are paid with arrears. If the preference shares are non-cumulative, unpaid dividends cannot be carried forward. Dividends on such shares are payable if there are sufficient profits and the shareholders shall have no claim for the arrears of the dividend. Preference shares issued in India are generally cumulative preference shares. (b) Redeemable or non-redeemable preference Shares Redeemable preference shares have a specified maturity. These have a limited life after which these are supposed to be retired. Non-redeemable are perpetual preference shares on the other hand have no maturity period and cannot be redeemed unless the company is liquidated. The redemption of preference share capital can be carried out either out of profits by creating a capital redemption reserve or out of the proceeds of a fresh issue of equity preference capital. (c) Convertible or Non-convertible preference Shares Convertible preference shares provide the shareholders an option of converting preference shares into equity share at a certain ratio during a given period of time. For example, the preference shareholders may have the option of converting preference shares into equity shares in the ratio 1:2 after two years from the date of issue. The preference shares, which are not convertible into equity shares, are non-convertible preference shares. (d) Participating or N0n-participating Preference Shares Participating preference shares entitle preference shareholders to participate in surplus profit (that is, profit left after preference dividend and equity dividend at certain rates every year and residual assets (that is, assets left after meeting the claims of preference shareholders) in the event of liquidation according to a pre-determined criteria). For example, a preference share may carry the following participation feature: 55 (a) It is entitled to an extra dividend (b) In the event of liquidation, it is entitled to 15 per cent of the assets left after meeting all claims except the claims of equity shareholders. Non-participating preference share do not carry the additional right to share surplus profits and residual assets of the company. 6.3 (3) Debenture A debenture is an instrument in writing for raising long-term debt capital. It a promissory note issued by a company acknowledge a debt by it not its holders. It provides for the payment of the principal sum and interest thereon at regular intervals. Debentures have issue price at which they are originally issued, an interest rate and a specified maturity date. The purchasers of debentures are called debentures holders. In USA, they are more popular as Bonds. However, uncured bonds are known as debentures. In India, so such made between debentures and bonds. The public sector companies in the country have mostly issued bonds. Features of Debentures The important features of debentures are given below: (a) Interest The interest payment on debentures is a fixed obligation, irrespective of the financial situation of the issuing firm. Interest rate is called the contractual or coupon rate of interest. It indicates the percentage of the par value of the debenture that will be paid out annually, semi-annually or quarterly. Debentures interest is tax deductible for computing the company’s tax liability. (b) Maturity Debentures are issued for a specific period of time. The maturity of a debenture indicates the length of time for witch funds from debentures could be available to the company for use. If the company fails to pay for debentures issued by it on maturity the debenture holders may forced the winding up of the company as creditors. (c) Claim on assets Debenture holders have prior claim on the assets of the company being creditors of the concern. They have to be paid first before making any payment to preference or equity shareholders in the event of liquidation of the company. Further, the debenture holders may have either specific charge or floating charge against the assets of the company. However, they are not entitled to any share in the surplus assets of the company. (d) Control Since debenture holders are creditors of the company, they do not have any voting rights either to elect directors of the company or to decide other matters. Hence, they do not any control or the management of the company. (e) Call option Debenture issued sometimes carries a call option, which provides the issuing company the option to redeem debenture at a certain price before the maturity date. Often the call option is exercisable after the expiry of specified period from the date of issue. The call (buy back) price may be more then the par value of the debenture. 58 (b) Financial Lease Long-term, non-cancellable lease contracts are known as financial lease. Financial leases amortize the cost of the asset over the term of lease. These are therefore, also called full-pay out leases. Financial lease entails lower risk to the lessor. The maintenance and service costs are generally borne by the lessee. This kind of lease is commonly used for leasing land, building and large equipments etc. (c) Sale and Lease Back Under this form of lease arrangement, the firm sells an asset already owned by it to another firm and hires it back from the buyer. By such an arrangement, the firm cannot only salvage its liquidity position but also retain the services of the asset for the life of the lease. Besides, such arrangements may provide substantial tax benefits. (d) Direct Lease Under direct leasing, the lessee acquires the equipment either from the manufacturing company directly or arranges the desired equipment to be purchased by the leasing company. In the latter situation, the lessee identifies the equipment he would like to use, arranges for the leasing company to buy it from the manufacturer and sings a contract with leasing company. In the former situation, the manufacturing company itself acts as a lessor. (e) Primary and Secondary Lease The lease contract is sometimes divided into parts for the purpose of lease rentals. Primary lease provides for the recovery of the cost of the asset and profit through lease rentals during the initial years of lease contract (about 4 to 5 years) which is followed by a secondary perpetual lease on nominal lease rentals. In other words, more lease rentals are charges in the primary period and less in the secondary period of the contract. (f) Cross Border or International Lease In case of cross border lease, the lessor and the lessee are situated in two different countries. In involves relationships and tax implications more complex than the domestic lease. When the lease transaction takes place between three parties manufactures, lessor and lessee in three different countries, it is called foreign to foreign lease. (g) Closed and open Ended Lease In the close ended lease, the asset gets transferred to the lessor at the end, and the risk of obsolescence, residual, value etc. remain with the lessor being the legal owner of the asset. In the open-ended lease, the lessee has the option of purchasing the asset at the end of lease higher rate. 6.4 SELF-CHECK EXERCISE 1. Expenses borne in connection with the raising of capital from the public are referred to as ___________expenses. 2. Debtors are constituents of working capital requirements? True OR False 3. Retained earnings is a source of ___term finance 4. Preference share holders are the true owners of the company? True OR False 59 6.5 SUMMARY It is imperative to measure the cost of a project and evaluate its financial aspects. On the basis of the measured cost, the means of financing are explored and ascertained. An appropriate capital structure and right estimate of sales and production plays a crucial role. 6.6 GLOSSARY 1. Pre-operative expense: preliminary expenses 2. Cash losses: higher cash outflows than cash inflows during a period 6.7 ANSWERS TO SELF-CHECK EXERCISE 1. Capital issue expenses 2. True 3. Long term 4. False 6.8 REFERENCES/SUGGESTED READINGS Ø Chaudhary, S.: Project Management, Tata McGraw Hill, New Delhi. Ø I.D.B.I: Manual of Industrial Project Analysis in Developing Countries. Ø O.E.C.D: (i) Manual for Preparation of Industrial Feasibility Studies. (ii) Guide to Practical Project Appraisal. Pitale, R.L: Project Appraisal Techniques. Ø IBH. Planning Commission: Manual for Preparation of Feasibility Report. Ø Timothy, D.R. and W.R Sewell: Project Appraisal and Review, Macmillan, India. Ø Chandra, P., Project Preparation, Appraisal and Implementation. 6.9 TERMINAL QUESTIONS 1. What are the components of cost of project? 2. Describe briefly the various means of financing a project. ***** 60 CHAPTER – 7 CAPITAL STRUCTURE PLANNING STRUCTURE 7.0 Learning Objectives 7.1 Introduction 7.2 Capital Structure 7.3 Importance of Capital Structure 7.4 Determinants of Capital Structure 7.5 Financing schemes of Financial Institution 7.5 (1) Direct Financial Assistance 7.5 (2) Indirect Financial Assistance 7.6 Financing Policies and Norms 7.7 Special Financing Schemes 7.8 Self Check Exercise 7.9 Summary 7.10 Glossary 7.11 Answers to Self-Check Exercise 7.12 References/Suggested Readings 7.13 Terminal Questions 7.0 LEARNING OBJECTIVES 1. To understand the importance and determinants of capital structure. 2. To study the financial schemes of financial institutions. 7.1 INTRODUCTION We described the various means of finance that can be tapped for a project in the previous lesson. How should one go about determining the specific means of finance for a given project? It is an important question to be answered. The present lesson is devoted to various guidelines and considerations that should be borne in mind for answering this question. Various financing schemes offered by the financial institutions have also been discussed in this lesson. 7.2 CAPITAL STRUCTURE Capital structure of a firm refers to the composition or makeup of its capitalizations and it includes all long-term capital resources viz. loans, reserves, shares and bonds. It is frequently used to indicate the long-term sources of fund employed in a business enterprise. Capital structure refers to the proportion in which the firm raises its long-term funds from various sources of capital. 7.3 IMPORTANCE OF CAPITAL STRUCTURE The following reasons make capital structure decision as one of the most important decision. 1. Financial risk assumed by a firm depends upon its capital structure. 2. Capital structure affects the cost of capital of the firm. 63 during the life time of the company. Preference capital involves moderate degree of risk. It is more risky than equity capital but lesser risky than debt. From risk point of view, the issue of equity capital is preferable to the issue of debt or preference capital. 5. Ability to serve debt The ability to serve debt depends upon the Pattern and magnitude of cash flows of a firm. If a firm can generate sufficient cash to discharge are fixed interest obligations and loan repayments, it can have more debt capital structure. On the other hand, a firm with meagre cash flows from operations should not raise debt capital. Generally two ratios (i) interest coverage ratio and (ii) cash to debt service ratio are computed to assess the debt service ability of a firm. 6. Operational Characteristics Operational characteristics of a firm influence its capital structure in a significant manner. Different firm may employ different technologies to manufacture their products. Some firms employ labour intensive technologies of production whereas others may adopt capital –intensive technologies. Those firms, which employ capital-intensive technologies of productions, have large investment in fixed assets. Fixed costs constitute a major portion of total costs in such firms and thus these firms have more operating risk. Therefore, these firms should assume lesser financial risk to keep the overall risk within manageable limits. They should prefer equity capital to debt. On the other hand, firms with labour intensive technologies of production and trading firms do not have to invest much in fixed assets. Fixed costs of these firms are lower as compared to fixed costs of these firms employing capital-intensive technologies. These firms are subject to lesser operating risk and therefore they can afford to use more of debt capital. 7. Purpose of financing The purpose for which funds are to be raised has a distinct bearing on the capital structure of a firm. If the funds are needed for a productive purpose like expansion or diversification, which is expected to generate sufficient cash inflows, the firm may consider the issue of debentures for raising capital for such a purpose. On the other hand, if the funds are needed for an unproductive purpose like meeting some legal or social responsibilities, the issue of equity capital should be preferred. 8. Age and size of firm The age and size of the firm considerably affect the design of its capital structure. New and small firms have to depend upon outside equity and debt capital. As a firm grows in size, retained earnings start replacing outside debt and equity. Large and reputed companies have access to the capital market and therefore they can raise their capital through the issue of different kinds of securities. On the other hand, small firms do not have an access to the capital market and therefore, they have to depend more on owned capital. 9. Period of finance The period for which funds are needed also affect the capital structure. If the funds are needed permanently or for a long period of time, than the issue of equity capital, irredeemable debentures or preference shares should be considered. On the other hand, if the funds are needed for medium term or for relatively shorter period, than the issue of redeemable debentures or redeemable preference shares should be preferred. 64 10. Corporate tax rate Presence of corporate taxes has a significant influence on the cost of various sources of capital and hence on the capital structure of firm. As started earlier, interest on debt is tax deductible whereas dividend on preference capital or equity capital has to be paid out of post-tax profits. Consequently, cost of debt is significantly lower than the cost of equity or cost of preference capital. Therefore, it can be said the higher the tax rate, greater is the advantage of using debt capital as compared to equity capital or preference capital. 11. Floatation costs Floatation cost of raising funds from various sources of capital should be given due consideration while, designing the capital structure of a firm. Floatation costs consist of expenses of printing, promotional martial and publicity, brokerage and commission payable to intermediaries like brokers and bankers. Generally, flotation costs of debentures are lower than that of equity capital. From the floatation costs point of view debt is preference to equity shares. 12. Nature of Investors Investors can be divided into different categories on the basis of their risk return preferences. Some investors are prepared to assume higher risk to earn higher return. On the other hand, some other investors prefer playing safe. They do not want to assume higher risk and satisfied with lower return. While designing its capital structure, the firm should take care of the requirements of its investors. For those investors who do not want to take higher risk, the firm should consider issuing debentures or preference shares. For risk assuming investors the equity share should be issued. 13. Capital market conditions Conditions prevailing in the capital market not only determine the types of securities to be issued but also the rate of interest on debentures, rate of dividend on preference capital and the issue prices of various secularities. In case of favourable market conditions, the company can issue various types of securities to raise capital for its expansion and other purposes. On the other hand, if the conditions in the capital market are depressed, the firm cannot think of raising capital through the issue of equity capital and other securities. In such a situation it has to approach financial institutions for term loans to fulfil its requirement of funds. 14. Attitude of management Management of different firms differ in skills, judgement, experience, temperament and motivation. Some management are aggressive. They are prepared to assume higher risk to reduce the cost of capital and increase the market values of their firms. Such management are conservative. They do not want to assume more risk. Such management prefer equity capital as a source of funds for the firm. The conservatism on the aggressiveness of the management depends upon the age, experience, ambition and confidence of the persons constituting the management team. Therefore these factors also affect the capital structure of a firm. 15. Legal and other conditions Lastly while designing its capital structure: the firm should also take care of the relevant provision of various laws framed by the government from time to time. It should also take care of the norms set by financing institution, securities and Exchange Board of India and stock exchanges. 65 7.5 FINANCING SCHEMES OF FINANCIAL INSTITUTION Financial institutions provide both direct and indirect financial assistance. 7.5 (1) Direct Financial Assistance Financial institution provides direct financial assistance in the following ways: Rupee Term Loans: the most significant from of assistance provided by financial institution, rupee term loans are given directly to industrial concerns for setting up new projects as well as for expansion, modernisations, and renovation projects. These funds are provided for incurring expenditure for land, building plant and machinery, technical know-how, miscellaneous fixed assets, preliminary expenses, preoperative expenses, and margin money for working capital. Foreign Currency Term Loans: financial institution provide foreign currency term loan from meeting the foreign currency expenditure, towards import of plant, machinery and equipment, and also towards payment of foreign technical know-how fees. The periodical liability for interest and principal remains in the currency\currencies of the loans and is translated into rupee at the prevailing rate of exchange for making payments to the financial institutions. Subscriptions to Equity Shares and Debentures: In addition to providing term loans (in rupee as well as foreign currencies), financial institutions also subscribe to equity as well as debenture capital in a limited way. Lease Finance: A lease represents a contractual arrangement whereby the lesser (the financial institution) grants the lesson the right to use an asset in, return for periodic lease payments. Hire Purchase Finance: under a hire purchase arrangement the financial institution gives assets on hire to a user (hirer) who pays periodic hire purchase instalments. On payment of the fire purchase instalment, the ownership’ of the assets is transferred from the financial institution to the hire. Bill Discounting: financing institutions discount bills arising from the purchase of capital goods to some extent. Short Term Credit: Asset-based credit of a relatively shorter tenor is now being provided by financing institution. Seed Capital: Financial institution provides seed capital to supplement the resources of promoters of small and medium scale industrial units. Support in this form, however, is being phased out. 7.5 (2) Indirect Financial Assistance Besides providing direct financial assistance, financial institutions extend help to industrial units in obtaining finance\credit through the following ways. Deferred Payment Guarantee: Financial institutions issue guarantee on behalf of the buyers of industrial machinery to the supplier offering the facility of deferred payments. Should there be a default by the buyer in the payment of deferred instalments, financial institutions make the payment and subsequently recover the amount from assisted unit. A nominal commission is charged for providing such guarantee. 68 7.9 SUMMARY Capital structure planning is one of the strategic 0f financial management. Considerable attention is needed for designing the capital structure of the fire. Capital structure decision directly affects the cost of capital, financial risk and value of a firm. A right capital structure decision can reduce the cost of capital and increase the value of the firm. On the other hand, a wrong capital structure decision can adversely affect the value of the firm. As stated earlier, different sources of capital differ in risk return characteristics from each other. The cost of the capital and the financial risk of the firm depend upon the way the capital of the firm is raised. Thus a financial of a firm through the design of an appropriate capital of the firm is raised. Thus a financial manager can contribute to the fulfilment of value maximization objective of a firm through the design of an appropriate capital structure. Therefore due care should be exercised while selecting the financial mix. 7.10 GLOSSARY 1. Cost of capital: the minimum return investors expect for providing capital to a company. 2. Floatation cost: expenses which are associated with issuing of new securities. 7.11 ANSWERS TO SELF-CHECK EXERCISE 1. True 2. True 3. Debt 4. Interest coverage ratio, cash to debt service ratio 7.12 REFERENCES/SUGGESTED READINGS Ø Bryce, MC: Industrial Development, McGraw Hill (Int. Ed), New York. Chandra, Prasanna: Projects: Planning Analysis, Financing, Implementation, and Review Tata McGraw Hill, New Delhi. Ø Patel, Bhavesh M, Project Management, Vikas publishing House pvt. Ltd., New Delhi Ø Chaudhary, S.: Project Management, Tata McGraw Hill, New Delhi. 7.13 TERMINAL QUESTIONS 1. What are the determinants of capital structure? 2. Critically evaluate various financing schemes of financial institution known to you. ***** 69 CHAPTER-8 PROFITABILITY ANALYSIS AND FINANCIAL PROJECTIONS STRUCTURE 8.0 Learning Objectives 8.1 Introduction 8.2 Factors Affecting Profit 8.3 Estimates of Sales and Production 8.4 Estimating cost of Production 8.5 Profitability Projections 8.6 Characteristics of Profit Planning and Control 8.7 Advantages of Profit Maximization 8.8 Limitation of Profit maximization 8.9 Self Check Exercise 8.10 Summary 8.11 Glossary 8.12 Answers to Self-Check Exercise 8.13 References/Suggested Readings 8.14 Terminal Questions 8.0 LEARNING OBJECTIVES 1. To understand factors affecting Profit. 2. To understand profit maximization, its advantages and limitations. 8.1 INTRODUCTION Profitability analysis technique employed in several industrial countries is vitally important to assess the operational efficiency of a project and its profitability. It also seeks to correct the structural deficiencies and improve productivity and profits. Profit is the primary objective of an enterprises, in view of heavy investment, which is necessary for the success of most enterprises, profit in the accounting sense tends to become a long-term objective, which measures not only the success of a product but also of the development of the market for it. The word “profit” implies a comparison of the operations of business between two specific dates, which are usually separated by an interval of one year. In order to optimize these corporate resources of wealth on which national prosperity depends, the basic financial objective of companies is to maximize, within socially acceptable limits, profit from the use of the funds employed by them. The maximization of profit within a socially acceptable limit implies that a proper regard for public interest has been shown. No company can survive long without profit, for profit is the ultimate measure of its effectiveness. Also, and in a capitalist society, there is no future for a private enterprise showing repeat losses. The crucial measures of the effective performance of a business are profit, which really is a measure of how well a business performs economically. 70 Profit is a signal for the allocation of resource and a yardstick for judging managerial efficiency. i t is wrong to believe that the importance given to profit planning in the literature on business finance does not reflect its genuine, importance in the financing activities of a modern business firm. In fact, it is the growth of profit, which enables a firm to pay higher dividends to its ordinary shareholders. Profit result from transactions, which should satisfy both the parties to it. The vendor should be satisfied that the prise is acceptable, and that it gives him an appropriate return for the work he has done and the risks he has taken. The purchaser should be satisfied that he has had a full value for his money. Irrespective of the way in which a company’s profitability is expressed, its profit potential depends on its product so that they provide value not only to the customer, but also to the company itself. Good pricing result in good profits. Profit is a dominant goal of a business, and profit making should be the main objective in terms of which the general effectiveness of an organization is measured have long been concerned with profit and have framed theories to explain both their meaning and distribution. According to them, profit is the reward for entrepreneurship. A source of funds, which is completely within the internal system, is that of profit making. The exact contribution, which profit make to funds, is a disputable matter. But the fact that funds are augmented by profits and reduced by losses should be beyond controversy. Goals or objectives are the ends, which a business enterprise seeks to achieve through its existence and operations. A typical business establishment seeks to achieve more than one goal and there are always restraints to the attainment of some goals. Objectives vary with the passage of time. Goals common to most contemporary establishments are; quality products and services, growth, employee satisfaction and development, service to society. 8.2 FACTORS AFFECTING PROFIT A number of factors influence profit variations. These are: 1. Mix of product changes: The effect of the mix of product changes upon profit is fairly easy to interpret and record, if a good system is in use. 2. Volume of fluctuations: The volume of sales plays a tremendous part in profit making. So long a sustained maximum volume continues at the top of capacity curve, break-even point would be far away. The profit path is wide and deep at the point. 3. Performance changes on any volume: To attain real sophistication part in profit calculation, the true profits at any given volume which should exist at a planned breakeven point are separated from the profit created by the performance at one attained volume. 4. A change in fixed costs changes the break-even point, but not the marginal profit. The marginal point is the profit picked up above the break-even point. 5. A change in variable costs and selling prices changes both the break-even point and the marginal profit. 6. The rate of marginal profit is affected by a change in variable costs, selling price and operating performance as against planned performance. 73 The cost of power here would include only the cost of bought out power and it may be estimated on the basis of power tariff structure of the concerned electricity boards. The cost of captive power would naturally be reflected in the cost of fuel, etc. The cost payable to local authorities and charge payable to some other firm to water and/or steam supply may be shown separately. Where the entire water requirement is meet out of own wells, water charges need to be shown separately. The cost of fuel (furnace oil, coal, firewood, etc.) often an important item is somewhat more difficult to estimate. Labour Labour cost is the cost of all manpower employed in the factory. Labour cost naturally is a function of the number of employees and the rate of remuneration. The requirement of workers depends on the number of operators/helpers required for operating various machines and manning various services. The number of supervisory personnel and administrative staff may be calculated on the basis of the general norms prevailing in the industry. In estimating remuneration rates, the prevailing rates in the industry/area should be taken into account. The remuneration should include, beside basic pay, dearness allowances, house rent allowance, conveyance allowance, reimbursement, leave travel concession provident fund contribution, gratuity contribution, and bonus payments, in addition, account should be taken of adding a certain percentage, on a global basis, to the basic pay. It is, however, advisable to make a detailed analysis, at least in the beginning. Labour cost estimate may be raised at the rate of 5 per cent per annum to allow for annual increment. Etc. Labour cost may be calculated for the year in which the maximum capacity utilisation is first achieved. For the earlier years, when the capacity utilisation teds to be low, somewhat lower labour cost, but not proportionately lower in relation to capacity may be assumed. Factory Overheads The expenses on repairs and maintenance, rent, taxes, insurance on factory assets, and so on are collectively referred to as factory overheads. Repairs and maintenance expenses depends on the state of the machinery. This expense tends to be lower in the initial years and higher in the later years. Rant, taxes, insurance, etc May be calculated at the existing rates. A provision should be made for meeting miscellaneous factory. In addition, a contingency margin may be provided on the items of factory overheads. 8.5 PROFITABLITY PROJECTIONS (OR ESTIMATES OF WORKING RESULTS) Given the estimate of sales revenue and cost of production, the next step is to prepare the profitability projection or estimates of working results (as they are referred to by term-leading financial institution in India). The estimates of working result may be prepared along the following lines: 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 74 G. Gross profit before interest H. Total financial expenses I. Deprecation J. Operating profit (G-H-I) K. Preliminary expenses written off L. Profit/loss before taxation (J+K-L) M. Provision for taxation N. Profit after tax (M-N) Less Dividend on - Preference Capital - Equity Capital O. Retained profit P. Net cash accrual (P+I+L) Cost of production – This represent the cost of materials, labour, utilities, and factory overheads. Total Administrative Expenses – This consists of (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 taxed on office property, and (vi) miscellaneous items. Total Sales Expenses – The expanses 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 per cent 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. The experience of similar firms in the industry may be used as a basic guideline. Royalty and know-how payable – Royalty and know-how payable annually may be shown here. The royalty rate is usually 2-5 per cent of sales. Further, royalty is payable often for a limited number of years, say 5 to 10 years. Total cost of production – this is simply the sum of cost of production; total administrative expenses, total sales expenses, and royalty and projection exercise. Expected Sales – The figures of expected sales are drawn from the estimate of sales and production prepared earlier in the financial analysis and projection exercise. Gross profit Before Interest – This represents the difference between expected sales and total cost of production. Total Financial Expenses – Financial expenses consist of interest on term loans, interest on bank borrowings, commitment charges on term loans, and commission for bank guarantees. The principal financial expenses, of course, are interest on term loans and interest on bank borrowings. In estimating the interest on term loans, two points should b borne in mind: 75 (i) Interest on term loans is based on the based on the present rate of interest charges by the leading financial institutions and commercial banks. (ii) Interest amount would decrease according to the repayment schedule of term loan. The interest on bank borrowings 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. Depreciation: This is an important item, particularly for capital-intensive projects. In figuring out the depreciation charge, the following point should be borne in mind: 1) Contingency margin and pre-operative expenses provided in estimating the cost of project should be added to fixed assets proportionately to ascertain the value of fixed assets for determining the depreciation charge. 2) Preliminary expenses in excess of 2.5 per cent of the project cost (excluding working capital margin) should be added to fixed assets proportionately to ascertain the value of fixed assets of determining the deprecation charge. 3) The income tax Act specifies that the written down value method should be used for tax purposes in 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. From 1988 onwards the depreciation rates under the Companies Act have been delinked from those under the income tax Act. 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. Expert disposal of scrap, which can be reasonably anticipated and estimated, the effect of other non-operating transactions can hardly be estimated. Of course, when non-operating transactions result in a deficit, other income would be negative-put differently there will be a non- operating loss. Write-off of Preliminary Expenses – preliminary expenses up to 2.5 per cent of the cost of project or capital employed, whichever is higher, can be amortized in ten equal annual instalments. Profit/Loss Before Taxation – This is equal to: operating profit + other income – write-off of preliminary expenses. Provision for Taxation – to figure out the tax burden, a sound understanding of the income tax Act a complicated legislation-and relevant case laws is required. While calculating the taxable income, a variety of incentives and concessions have to be taken into account. Once the taxable income, as per the income tax Act, is calculated, the tax burden can be figured out fairly easily by applying the appropriate tax rates. Profit After Taxation – This is simply profit/loss before taxation minus provision for taxation. A part of profit after tax is usually paid out as dividend-dividend on preference capital and dividend on equity capital. 78 5. In the absence of profit, business activity would remain static. A firm cannot afford to do this because: a. Price level are not stable. Profits, therefore, have to made to create additional resources. b. Investors is business would expect a positive return on their investment. Profits are essential for ensuring this return. c. It would not be possible to maintain the same level of activity because of the pressures for the expansion of business. The resources required for this purpose have to be provided through profits. 8.8 LIMITATIONS OF PROFIT MAXIMIZATION 1) Profit is essential, but it would be wrong to assume that every action initiated by the board of Directors is aimed at maximizing profits, irrespective of its social consequences. 2) One of the difficulties in looking at the comparative profitability of a number of companies lies in their different standard of valuing business assets. 8.9 SELF-CHECK EXERCISE 1. No company can survive long without _______, for _______ is the ultimate measure of its effectiveness. 2. A change in fixed costs changes the marginal profit. True OR False 3. A change in variable costs and selling prices changes both the break-even point and the ___________. 4. Factory overhead cost is a major component of cost of production? True OR False 5. Utilities consist of _______,______,_______ 8.10 SUMMARY Profit motive is the prime mover of business activity. In fact, profitability is the most useful overall measure to the health of an enterprise. In other words, the profitability of an enterprise in anyone year is the relationship between the profit made and the funds employed to earn the profit. Profitability analysis is a useful tool/technique to entrepreneurs to take right decisions in maximizing profits and to bankers and financial institutions to arrive at the viability of the enterprise and its financial needs. 8.11 GLOSSARY 1. Material cost: amount of money invested in the production of a product 2. Factory overhead cost: total cost involved in operating all production facilities of a manufacturing business that cannot be traced directly to a product 8.12 ANSWERS TO SELF-CHECK EXERCISE 1. Profit, profit 2. False 3. Marginal profit 4. True 5. Power, water, fuel 79 8.13 REFERENCES/SUGGESTED READINGS Ø Bryce, MC: Industrial Development, McGraw Hill (Int. Ed), New York. Chandra, Prasanna: Projects: Planning Analysis, Financing, Implementation, and Review Tata McGraw Hill, New Delhi. Ø IBH. Planning Commission: Manual for Preparation of Feasibility Report. Ø Timothy, D.R. and W.R Sewell: Project Appraisal and Review, Macmillan, India. Ø Chandra, P., Project Preparation, Appraisal and Implementation. 8.14 TERMINAL QUESTIONS 1. Show how various financial estimates and projections are inter-related? 2. Discuss in detail the major components of cost of production. ***** 80 CHAPTER - 9 BREAK – EVEN ANALYSIS STRUCTURE 9.0 Learning Objectives 9.1 Introduction 9.2 Break Even Point 9.3 Calculation of BEP 9.4 Utility of the Break Even Analysis 9.5 Short coming of the Break-Even Analysis 9.6 Project Planning and bank borrowing 9.7 Performance Analysis 9.8 Sensitivity Analysis 9.9 Self Check Exercise 9.10 Summary 9.11 Glossary 9.12 Answers to Self-Check Exercise 9.13 References/Suggested Readings 9.14 Terminal Questions 9.0 LEARNING OBJECTIVES 1. To study break even analysis and its utility. 2. To understand performance and sensitivity analysis. 9.1 INTRODUCTION The profitability projections or estimates of working results discussed prevision lesson are based on the assumption that the project would operate to given leaves of capacity utilization in future. In addition to knowing that the projected profits would be a certain levels of capacity utilization, it is also helpful to know that the helpful to know that the level of operation should be avoid lasses. For this purpose, the break-even point, this refers to the level of operation should be avoid losses. For this purpose, the break-even point, this refers to the level of operation at which the project neither makes profit nor incurs loss, is calculated. The determination of the break-even point of a firm is an important factor in assessing it profitability. It is a valuable control technique and a planning device in my business enterprise. It depicts the relation between total coat and total revenue at the level of a particular output. Ordinarily, the profit of an industrial unit depends upon the selling price of product (revenue), volume of business (it depends on price) and cost price of the product. 83 Break-even analysis may not prove useful to rapidly growing enterprises and to enterprises, which frequently change their product mix. It has limited utility in the case of multi product. It does not take due cognizance of factors like uncertainty and risk involved in estimates of costs, volume and profits. Irrespective of these shortcomings inherent in the usage of this technique, it is an important tool for the profitability analysis of the new project. 9.6 PROFIT PLANING AND BANK BORROWINGS; Banks providing working capital finance require proper planning of activities and funds requirements by the borrowing enterprises. To ensure this, the RBI appointed a working group to review the system of cash credit (Chairman: Shri KB Chore) in April 1979. A major recommendation of this committee accepted by the RBI was to regulate bank credit through the Quarterly Information System (QIS) statements. Quarterly Information System: Statements and their Scrutiny It is mandatory for all borrowers enjoying bank credit by way of fund based working capital limits above and inclusive of Rs. 50 lakh to submit such statements. The various forms to be furnished are as follows: Form 1: Projections for ensuring quarter (i) Production/sales, a) Whether quantity and value as a percentage of annual projection are reasonable, keeping in view orders on hand, past trends, seasonality etc. b) Capacity utilizations/BEP/margin of safety. (ii) Inventory a) Whether holding norms relevant to particular industry group are complied with and if not, reasons for higher holding. b) Whether there is a mismatch in various types of raw materials held and whether with the projected raw material holding, production as per projection can be achieved. c) Abnormality, if any, in finished goods holding. d) Whether stores and spares projected are within limits. (iii) Receivables Whether there is any abnormality in holding period, quantum, debtor velocity and over dues. (iv) Other current assets a) Whether advances to suppliers projected are as per practice. b) Whether cash and bank balance projections are reasonable. (v) Creditors a) Whether the actual credit received is truly projected – to be verified on the basis of past trends and current market practice. b) Whether materials received against letters of credit are included under this head and if such materials are included under inventory. 84 (vi) Other current liabilities a) Whether advances received from customers and statutory liabilities are projected and are as per past trends. b) Whether repayment obligations payable within a year are included. c) Whether overall projections are comparable with the projections on the basis of which facilities were sanctioned. d) Whether bank borrowing projections are reasonable and are within the sanctioned limit, within MPEF, under method, commensurate with available fully-paid stocks and receivables. e) Whether sufficient net working capital and current ration of over 1.33 is available. Form II: Actuals for the past quarter The actuals furnished are to be compared with estimates given earlier as per form I and variations if any, under individual components are to be analysed. Checks applied for scrutiny of form I can also be used for this purpose also with slight modifications. Form III: Provisional half-yearly operational data with funds flow position (i) Whether the operations of the borrower are broadly as per projections or nearer to projection is to be scrutinized under various heads such as: (a) Sales (b) Operating profit (c) Closing stock (d) Percentage of raw material consumed (e) Percentage cost of production to sales Should the operative data indicate symptoms of slackness in the unit’s activity, the borrower should be prepared to initiate corrective action to gear up and achieve projection so as to become eligible for drawl of facilities. (ii) Funds flow statement, inter alia, should scrutinize; a. Whether short term funds are used for short term purposes or are there any diversions; b. Whether long term sources are sufficient to sustain the provision of sufficient net working capital; c. How are the sources of funds deployed and whether they are proper? With the abolition of CAS and introduction of CMA in its place, more responsibility devolves on banks to ensure the quality of credit. Therefore, banks have to be alert in checking the QIS statements, imposition of penalty to ensure compliance of submission of statement by borrowers act as a check on credit discipline. 9.7 PERFORMANCE ANALYSIS Two types of ratio are very helpful in performance analysis – the profit and loss account ratios that show the relationship of various items of profit and loss accounts with sales and the turnover ratios that show how well a company is utilizing its resources. The broadest measures of overall performance are, however, given by the ROI or return on investment. This ratio has been discussed below: 85 Return on Investment This ratio shows how much a company is earning on its capital employed. Thus if a company has Rs. 5 lakh as equity capital and Rs. 3 lakh as loan, its total capital employed would be Rs. 8 lakh. Suppose it earns Rs. 80,000 in a year before interest and taxation and ROI will be 10%. It is calculated thus: (net profit before interest and income tax/ capital employed)x100 Net Capital Employed is the amount of funds invested in business. It can be calculated from the balance sheet in one of the following two ways: a) Equity Share Capital + Preference Share Capital + Reserves and Surplus +Short Term and Long Term Liabilities – Non-operating Assets (e.g. Investments) and miscellaneous expenditure if such item appears on the assets side of the balance sheet. OR b) Fixed Assets + Current Assets- Current Liabilities. It is obvious that the amount of net capital employed would be the same whichever way it is calculated. The following point may be noted in this regard. c) It is not generally proper to include outside investments when calculating the Net Capital Employed. The profit is also the profit before interest on such investments. The idea is that the return on investment for funds employed within the business should be calculated separately from the return on investment for funds employed outside a business. However, if the ROI for the total business is to be calculated, investment should be included in the figure of Net Capital Employed, and the income from such investments should also be taken into credit when calculating Net Profit Before Interest and Tax. Intangible Assets (Assets which have no physical existence like goodwill, patent and trademark) should be included in the figure of Capital Employed, especially if they have been paid for. Only if these are totally fictitious and represent no rights or benefits to the business, should they be excluded from the figure of Net Capital Employed. ROI is a very significant measure for inter-firm comparison and for evaluating performances of various units within a firm. Actually, ROI combines in itself the net effect of all types of ratios. Ratios of the Profit and Loss Account and turnover ratios indicate the performance of a company. All these ratios are ultimately reflected in ROI. A slight fall in turnover efficiency or a rise in costs would immediately affect the ROI. It is because of this that ROI is called the broadest measure of performance. 9.8 SENSITIVITY ANALYSIS Under the sensitivity analysis, instead of using one estimate of each variable, several estimates are used under varying conditions. Applying sensitivity analysis at the project planning stage by finding the optimistic and pessimistic alternatives can reduce the element of uncertainty. For example, considering the pessimistic solutions, the project’s viability in the worst of all possible situations can be determined. If the sensitivity analysis shows that the project will be commercially viable under pessimistic conditions, the project can be considered non-risky. 88 CHAPTER – 10 CASH FLOW STATEMENTS STRUCTURE 10.0 Learning Objectives 10.1 Introduction 10.2 Management Decisions and Cash Flow 10.3 Staging Posts in the Measurement of Cash Flows 10.4 Mechanics of cash flow dynamics 10.5 Format of cash flow statement as per the requirement of financial institutions 10.6 Projected balance sheets 10.7 Limitations of cash flow statement 10.8 Interpretation of cash flow statement 10.9 Self Check Exercise 10.10 Summary 10.11 Glossary 10.12 Answers to Self-Check Exercise 10.13 References/Suggested Readings 10.14 Terminal questions 10.0 LEARNING OBJECTIVES 1. To understand the relationship between management decision and cash flow. 2. To study the mechanics of cash flow dynamics. 10.1 Introduction The cash flow statement shows the movement of cash into and out of the firm and its net impact on the cash balance with the firm. This statement serves as a tool of financial planning and control. Having regard to the importance of cash flow statements, this chapter is devoted to the study of the relationship between cash flow analysis and management decisions and the preparation of cash flow statements. 10.2 Management Decisions and Cash Flow Cash does not flow on its own; it flows as a direct consequence of the management’s action or inaction in operating the cash tank. But whose hands are on the tap? There are ten categories of management decisions which cause the cash flow. These are summarized as follows: (1) Operating Decisions. Culminating in potential cash flow from operations before tax. (2) Capital Expenditure Decisions (a) Acquisition (purchase) (b) Disposal (sale) 89 (3) Inventory Decisions (a) Increase in inventory (b) Decrease in inventory (4) Customer Credit Decisions (a) Increase or Extension of Credit (b) Reduction in Credit (5) Supplier Credit Policies (a) Increase in or extension of credit (b) Reduction in credit (6) Other accepted credit terms (7) Taxes on Profits (8) Financial Obligations (a) Interest payment (b)Dividend payment (c)Repayment of borrowed capital (9) Investment Decisions: utilization of temporary surplus cash. (a) Purchase (b) Sale (10) Financing Decisions: acquisition of new money (a) From shareholders (b) By borrowing Any useful analysis of the cash flow will highlight the impact of the above mentioned decision areas if the management is to use such analysis to guide the firm along the path of solvency. For this reason, the cash tank approach may be the most powerful method of presentation. 10.3 STAGING POSTS IN THE MEASUREMENT OF CASH FLOWS The source and application of cash or cash flow statement should not only show the sources and application in such a way as to balance nicely, at the end it should highlight which functional areas of management have contributed to the final cash position of the firm. Both borrowers and lenders should be concerned not only with cash movements, but also with the area of management, which has caused these movements. Cash flow analysis should use sub-totals to reveal the following staging posts in determining the ultimate cash flow position: CASH FLOW OUT OF INVESTING ACTIVITIES OUTFLOW: A. Acquisitions of fixed assets B. Acquisition of investments C. Loans to other companies D. Investment in joint ventures 90 DEDUCT: INFLOW: A. Sale of fixed assets B. Interest received C. Dividend received D. Sale of investments Net cash Outflow/Inflow of Investing Activities; CASH FLOW ARISING FROM FINANCING ACTIVITIES INFLOW: A. Proceeds from issue of share capital B. Proceeds from borrowing DEDUCT: OUTFLOW: A. Share issue expenses B. Redemption of debentures C. Premium paid on redemption of debentures D. Dividend paid E. Debenture issue expenses Net Cash Inflow in Course of Financing Activities. Stage 1 should show the potential cash flow operations before tax, i.e., that source of cash flow which has been generated by the operating management from normal trading, unadulterated by other cash movements or financing and tax decisions over which the operating management has little or no control. This item generally speaking, is profit before interest and tax, plus depreciation and any other non-cash charges against profit. Stage 2 reveals the internally generated cash flow, i.e., stage 1 minus the tax actually paid on corporate profits. This stage is akin to person’s take home pay and indicates the net amount generated by current operations for internal consumption. Stage 3 shows the operating cash profile, i.e., stage 2 minus the necessary investment (or plus the disinvestments) in additional fixed assets, services, inventories and customer credit that will be necessary to achieve the level of activity reflected at Stage 1. This stage indicates whether the operational activities of the firm are self-supporting, whether they require the input of additional finance or whether they are providing a surplus. Stage 4 reveals the total cash requirements (or surplus), i.e., Stage 3 further adjusted for non-operating financial obligations such as the payment of interest and dividends, significant payments under leasing contracts and necessary repayments of borrowing or preference share capital. Stage 5 shows either the financing of Stage 4 requirements, i.e., the detailed proposals for funding any requirements at stage 4 or the utilization of stage 4 surplus, i.e., the proposals for dealing with any surplus revealed at stage 4. 93 7. Increase in unsecured loans and deposits 8. Increase in bank borrowings for working capital 9. Increase in liabilities for deferred payment (including interest) to machinery suppliers 10. Sale of fixed assets 11. Sale of investments 12. Other income (indicate details) Total (A) Disposition of Cash 1. Capital expenditure for the budget 2. Other normal capital expenditure 3. Increase in working capital* 4. Decrease in secured medium and long-term borrowings - All India Institutions - SFCs - Banks 5. Decrease in unsecured loans and deposits 6. Decrease in bank borrowings for working capital 7. Decrease in liabilities for deferred payments (including interest) to machinery suppliers 8. Increase in investments in other companies 9. Interest on term loans 10. Interest on bank borrowings for working capital 11. Taxation 12. Dividends - Equity - Preference 13. Other expenditure (indicate details) Total (B) - Opening Balance of cash in hand and at bank - Net surplus/deficit (A-B) - Closing balance of cash in hand and at bank *Working capital here is defined as: (Current assets other than cash) – (Current liabilities other than bank borrowings) 10.6 PROJECTED BALANCE SHEETS The balance sheet showing the balances in various asset and liability accounts reflects the financial condition of the firm at a given point of time. The format of balance sheet prescribed by the Companies Act is given below: 94 Format of Balance Sheet Prescribed by the Companies Act Liabilities Assets Share Capital Fixed Assets Reserves and surplus Investments Secured loans Current assets, loans and advances Unsecured loans Miscellaneous expenditures and losses Current liabilities and provisions The liabilities side of the balance sheet shows the sources of finance employed by the business. A word about its components shown on the left hand side of the balance sheet is in order. Share capital consists of paid-up equity and preference capital. Reserves and surplus represent mainly the accumulated retained earnings. They are shown in different accounts like the capital reserve, the investment allowance reserve and the general reserve. Secured loans represent the borrowings of the firm against which security has been provided. The important components of secured loans are debentures, term loans from financial institutions and loans from commercial banks. Unsecured loans represent borrowings against which no specific security has been provided. The important constituents are: fixed deposits from public and unsecured loans from promoters. Current liabilities are obligations which mature in the near future, usually a year. These obligations arise mainly from activities, which enter the operating cycle: payables from acquiring materials and supplies used in production and accrual of wages, salaries and rentals. Provisions include mainly tax provision, provision for provident fund, provision for pension and gratuity and provision for proposed dividends. The assets side of the balance sheet shows how funds have been used in the business. The major asset components may be described briefly. Fixed assets are tangible long-lived resources ordinarily used for producing goods and services. They are shown at original cost less depreciation. Investments represent financial securities owned by the firm. Current assets, loans and advances consist of cash, debtors, inventories of different kinds and loans and advances made by the firm. Miscellaneous expenditures and losses represent outlays not covered by the previously described asset accounts and accumulated losses, is any. For preparing the projected balance sheet at the end of year n + 1, we need information about the following: Ø The balance sheet at the end of year n Ø The projected income statement and the distribution of earnings for the year n + 1 Ø The sources of external financing proposed to be tapped in the year n + 1 Ø The proposed repayment of debt capital (long-term, intermediate term and short term) during the year n + 1 Ø The outlays and the disposal of fixed assets during the year n + 1 Ø The changes in the level of current assets during the year n + 1 95 Ø The changes in other assets and certain outlays like preoperative and preliminary expenses (which are capitalized) during the year n + 1 Ø The cash balance at the end of year n + 1 10.7 LIMITATIONS OF CASH FLOW STATEMENT The limitations of Cash Flow Statement are: a) The cash flow statement shows the changes that have taken place between the dates of two balance sheets. It may not, however, show the detailed path of the changes. b) The inside information, like the scrapping of an asset, will not be available in the balance sheet in many cases. To that extent, the cash flow statement becomes an understatement. c) The projected cash flow statement is based on set of budget accounts. These budget accounts are themselves based on sales forecasts/estimates, which may not be accurate. The cash flow technique suffers from these limitations because of the limitations of the balance sheet and the budget accounts. However, within these limitations and given the nature of the balance sheet and budget accounts, the dynamic nature of the cash flow control as one of the tools for decision making and management control needs no emphasis. 10.8 INTERPRETATION OF CASH FLOW STATEMENT The cash flow statement answers the following questions: i. Where did the profits go? Why are they not available for the payment of dividends or the financing of an expansion programme? ii. Why is equity necessary? iii. Why cash should not be obtained from outside sources? iv. What are the additional cash generated by the enterprise? v. How much additional cash obtained from the various other sources? vi. What is the impact of cash flow on the future profitability and dividend paying capacity? vii. Is there any undue build up of any asset – fixed assets, inventory or receivables? If yes, how much? And for how much time? viii. Is the increase in the buildup of inventory/receivables commensurate with an increase in short term bank borrowings sought for? ix. Is there any diversion, i.e., are short term cash used for the buildup of fixed and non-current assets? Or used for something to acquire non-productive assets? x. Is the financing pattern acceptable on all scores? 10.9 SELF-CHECK EXERCISE 1. Acquisition of fixed assets is an example of cash outflow. True OR False 2. Decrease in fixed and non-current assets is a source of cash outflow. True OR False 3. Reserves and ________ represent the accumulated retained earnings.