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Introduction to Project Finance

By Prof. Anirban Dutta

Learning Objectives
Appreciate the importance and difficulties associated with capital investments Describe the broad phases of capital budgeting Discuss the important facets of project analysis Explain the three goals of a project Understand the management of risk

Capital Investments: Importance and Difficulties

Importance
Capital expenditure decisions often represent the most important decisions taken by a firm. Their importance stems from three interrelated reasons:
Long-Term Effects Irreversibility Substantial Outlays

Difficulties
While capital expenditure decisions are extremely important, they also pose difficulties which stem from three principal sources:
Measurement Problems Uncertainty Temporal Spread

Types of Capital Investments

Strategic vs. Tactical Investment


A strategic investment is one that has a significant impact on the direction of the firm
ITCs decision to invest in a agro-food project may be regarded as a strategic investment

A tactical investment is meant to implement a current strategy as efficiently or as profitably as possible


An investment made by ITC to replace an old machine to improve productivity represents a tactical investment

Expansion vs. Diversification Investment


An expansion investment is meant to increase the capacity to cater to a growing demand A diversification investment is aimed at producing new products or services or entering into new geographical areas

Phases of Capital Budgeting

Capital Budgeting Process


Capital budgeting is a complex process which may be divided into six broad phases:
Planning Analysis Selection Financing Implementation Review

Capital Budgeting Process


Planning Analysis

The solid arrows reflect the main sequence: planning precedes analysis; analysis precedes selection; and so on.
The dashed arrows indicate that the phases of capital budgeting are not related in a simple, sequential manner. Instead, there are several feedback loops reflecting the iterative nature of the process.

Selection

Financing

Implementation

Review

Planning
The planning phase of a firms capital budgeting process is concerned with the articulation of its broad investment strategy and the generation and preliminary screening of project proposals. A prelude to the full blown feasibility study, this exercise is meant to assess:
(i) whether the project is prima facie worthwhile to justify a feasibility study and (ii) what aspects of the project are critical to its viability and hence warrant an in-depth investigation

Analysis
If the preliminary screening suggests that the project is prima facie worthwhile, a detailed analysis of the marketing, technical, financial, economic, and ecological aspects is undertaken. Based on the information developed in this analysis, the stream of costs and benefits associated with the project can be defined.

Selection
Selection follows, and often overlaps, analysis. A wide range of appraisal criteria have been suggested to judge the worthwhileness of a project. They are divided into two broad categories:
Non-discounted criteria Discounted criteria

To apply the various appraisal criteria, suitable cut-off values (hurdle rate, target rate, and cost of capital) have to be specified.

Financing
Once a project is selected, suitable financing arrangements have to be made. The two broad sources of finance for a project are equity and debt. Flexibility, risk, income, control, and taxes (referred to by the acronym FRICT) are the key business considerations that influence the capital structure (debt-equity ratio) decision and the choice of specific instruments of financing.

Implementation
Stage Project and engineering designs Negotiations and contracting Concerned with Site probing and prospecting, preparation of blueprints, and plant designs, plant engineering, selection of specific machineries and equipments Negotiating and drawing up of legal contracts with respect to project financing, acquisition of technology, construction of building and civil works, provision of utilities, supply of machinery and equipments, marketing arrangements, etc. Site preparation, construction of buildings and civil works, erection and installation of machinery and equipment Training of engineers, technicians, and workers. (This can proceed simultaneously with the construction work.) Start up of the plant. (This is a brief but technically crucial stage in the project development cycle.)

Construction

Training Plant commissioning

Review
Once the project is commissioned, the review phase has to be set in motion. Performance review should be done periodically to compare actual performance with projected performance.

Levels of Decision Making

Different Levels
Operating decisions Where is the decision taken Lower level management Administrative decisions Middle level management Semi-structured Strategic decisions Top level management Unstructured

How structured is the decisions Routine What is the level of resource commitment What is the time horizon

Minor resource Moderate resource Major commitment commitment resource commitment Short-term Medium-term Long-term

Operating capital budgeting decision Administrative capital budgeting decision Strategic capital budgeting decision

: : :

Minor office equipment Balancing equipment Diversification project

Facets of Project Analysis

Market Analysis
Market Analysis is concerned primarily with two questions: What would be the aggregate demand for the proposed product / service in the future? What would be the market share of the project under appraisal?

Market Analysis
The kinds of information required are:
Consumption trends in the past and the present consumption level Past and present supply position Production possibilities and constraints Imports and exports Structure of competition Cost structure Elasticity of demand

Market Analysis
Consumer behaviour, intentions, motivations, attitudes, preferences, and requirements Distribution channels and marketing policies in use Administrative, technical, and legal constraints

Technical Analysis
Analysis of the technical and engineering aspects of a project needs to be done continually when a project is formulated. Technical analysis seeks to determine whether the prerequisites for the successful commissioning of the project have been considered and reasonably good choices have been made with respect to location, size, process, etc.

Financial Analysis
Financial analysis seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those who provide the capital.

Financial Analysis
The aspects which have to be looked into while conducting financial analysis are:
Investment outlay and cost of project Means of financing Projected profitability Break-even point Cash flows of the project

Financial Analysis
Investment worthwhileness judged in terms of various criteria of merit Projected financial position Level of risk

Economic Analysis
Economic analysis, also referred to as social cost benefit analysis, is concerned with judging a project from the larger social point of view. The questions sought to be answered in social cost benefit analysis are:
What are the direct economic benefits and costs of the project measured in terms of shadow (efficiency) prices and not in terms of market prices?

Economic Analysis
What would be the impact of the project on the distribution of income in the society? What would be the impact of the project on the level of savings and investment in the society? What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficiency, employment, and social order?

Ecological Analysis
In recent years, environmental concerns have assumed a great deal of significance. The key questions raised in ecological analysis are:
What is the likely damage caused by the project to the environment? What is the cost of restoration measures required to ensure that the damage to the environment is contained within acceptable limits?

Three Goals of a Project

What is Managed? The Three Goals of a Project


The performance of a project is measured by three criteria.
Is the project on time or early? Is the project on are under budget? Does the project meet the agreed-upon specifications to the satisfaction of the customer?

What is Managed? The Three Goals of a Project


Projects have three interrelated objectives: to
1) Meet the budget, 2) Finish on schedule, and 3) Meet specifications that satisfy the client.

Because we live in an uncertain world, as work on the project proceeds, unexpected problems are bound to arise.

Confronting Uncertainty The Management of Risk

Project Risks
The real world or business is fraught with risks. Effective project management requires an ability to deal with uncertainty. The actions of a project manager (PM) can reduce the uncertainty but, can never eliminate it.

Project Risks
In todays turbulent business environment, effective decision making is predicated on an ability to manage the ambiguity that arises while we operate in a world characterized by uncertain information.

End of Session

THANK YOU

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