UNIT-4

PROJECT FINENCING
 Project Cost estimation
• A project can only come together with all the necessary materials
and labor, and those materials and labors cost money.
• Putting together a budget that keeps costs to a minimum, while
maximizing the project’s quality and scope can be challenging. This
is why proper cost estimation is important.
• Cost estimation in project management is the process of forecasting
the financial and other resources needed to complete a project
within a defined scope.
• Cost estimation accounts for each element required for the
project—from materials to labor—and calculates a total amount
that determines a project’s budget.
• An initial cost estimate can determine whether an organization
greenlights a project, and if the project moves forward, the
estimate can be a factor in defining the project’s scope.
 Types of cost in project management

• Direct costs: Costs associated with a single

area, such as a department or the project
itself. Examples of direct costs include fixed
labor, materials, and equipment.
• Indirect costs: Costs incurred by the
organization at large, such as utilities and
quality control.
 Project cost Estimation technique

Estimation Definition Recommendations

technique

Bottom-up Assigning costs to the individual elements of the project Best for estimating projects with defined expectations and specific
estimation plan, such as tasks, milestones, or phases, and putting requirements in line with stakeholders who won’t expect major
the bucks together changes in the scope

Top-down Figuring out the project’s total price and determining the Commonly used to estimate elements on fixed price projects when
estimation scope of work that can be done the price is initially specified by the client

Analogous Relying on data from previous similar projects to forecast Recommended when there’s limited information about the project
estimation the cost

Parametric Taking specific cost variables and data points from other Usually called in for use when the previous project data you have
estimation projects to figure out the ultimate project cost is scalable

Three-point Doing the average from the best, worst, and most likely Well-advised when the risk of going over budget is high
estimation case estimations
Typical elements of cost estimation
• Labor: The cost of team members working on the
project, both in terms of wages and time
• Materials and equipment: The cost of resources
required for the project, from physical tools to
software to legal permits
• Facilities: The cost of using any working spaces not
owned by the organization.
• Vendors: The cost of hiring third-party vendors or
contractors.
• Risk: The cost of any contingency plans implemented
to reduce risk.
 Working capital requirement
• working capital requirement can be described as the
amount of money a firm would need to bridge the
gap between its accounts payable and accounts
receivable. It is essentially the amount a business
requires to keep its operations afloat.
• In the case of working capital deficit, businesses can
use their outstanding invoices and avail funds to
meet their working capital requirement. With KredX
businesses can utilise their unpaid invoices to avail
working capital within 24 -72 hours*.
 Factors That Help To Determine Required
Working Capital:
Factors Description
A significantly high sales volume
generates high revenue which means
Sales
the working capital required is not
much.
The longer it takes a business to
convert current assets into cash and
Duration of Operating Cycle
cash equivalents, the more will be the
required working capital.
Trading businesses require relatively
Type of Business high working capital when compared
to manufacturing businesses.
Businesses that extend longer terms
Terms of credit of credit to customers are often
in need of more working capital.
 Stagnant or slow turnover of
Inventory turnover extensive inventories results in a
higher working capital requirement.

Businesses that are dependent on

Seasonal variation specific seasons may need more
working capital.

Usually, labour-intensive businesses

Production technology require more capital than a business
which needs the use of machines.

A provision to meet the changes in

Contingencies
demand and products’ price.
 Compute A Company’s Working Capital
Requirement
• The formula for calculating working capital
requirement is given by -
Working Capital = Current Assets - Current Liabilities
• Here, current assets include these following -
• Cash in hand
• Cash equivalent
• Company inventory
• Accounts receivable
• Pre-paid liabilities
• Here, current liabilities include these following
• Accounts payable
• Notes payable
• Income tax owed
• Immediate debts
• Dividends
• Based on this formula, businesses can estimate their working
capital requirement easily. For instance, if the current assets
of a firm exceed its current liabilities, it indicates that the firm
has surplus working capital. Notably, items like cash
commitments, non-trade receivable and old or wasted
inventory are excluded or adjusted during the working capital
requirement calculation.
 Example of Working Capital Requirement
Calculation:

• Suppose the current assets of Mr Kumar’s

business stands at Rs. 25000, while current
liabilities amount to Rs. 45000.
Using the formula –
• Working capital = Current assets - Current
liabilities
• = Rs. (25000 - 45000)
• = - (Rs. 20000)
• Since the outcome is negative, it indicates Mr Kumar’s business has
a deficit in working capital. It means that his firm’s immediate
liquidity is not enough to optimise everyday functions.
• Some of the effective ways of reducing working capital gap include -
• Quick collection of accounts receivables
• Reducing inventory cycle
• Reducing credit terms
• Increasing sales volume
• However, to meet your working capital requirement immediately
and to keep operational activities continuous, you can opt for
alternative solutions like invoice discounting services from KredX.
 Risk & uncertainty in project
evaluation
• Risk involves situations in which the
probabilities of cash flows occurring are
known and these probabilities are objectively
or subjectively determinable.
• The main attribute of risk situation is that the
event is repetitive in nature and possesses a
frequency distribution.
• It is the inability to predict with perfect
knowledge the course of future events that
introduces risk.
• In contrast, when an event is not repetitive
and is unique in character and the finance
manager is not sure about probabilities of
cash flows themselves, uncertainty is said to
prevail.
• Uncertainty is subjective phenomenon. In
such a situation no observation can be drawn
from frequency distributions.
• .Practically no generally accepted methods
could so far be evolved to deal with situation
uncertainty while there are a number of
techniques to deal with risk.
• As such, the term risk and uncertainty will be
used interchangeably in the following
paragraphs.
 MEASUREMENT OF PROJECT RISK
• Probability Distribution
• Sensitivity Analysis
• Scenario Analysis
• Monte Carlo Simulation
• Decision Tree Analysis
 Project Financing
• Project financing is a means of obtaining funds
for industrial projects, long-term infrastructure,
and public services.
• Many businesses use this funding method to take
care of major projects using a non-recourse or
limited financial structure.
• There are several ways to secure project finance,
such as investor, loans, private finance, equity,
funds, grants, etc.
• The repayment is managed from the cash-flow
generated off the project.
• It is a secured form of lending, accepting the
project’s rights, assets, and interests as
collateral.
• Project loans are useful in more than one way.
It can help expand the manufacturing
capacity, rent a workstation, upgrade
technology, handle unexpected expenses,
experimentation for a new service or a
product, create a cash pool, etc.
• Project financing is a loan structure that relies
primarily on the project's cash flow for
repayment, with the project's assets, rights,
and interests held as secondary collateral.
• Project finance is especially attractive to the
private sector because companies can fund
major projects off-balance sheet (OBS).
 Sources of funds
1. Business Angels
Investor angels, or business angels, are people who invest their
money in the initial phase of startups, in exchange for a
participation in capital. They also usually carry out the role of a
mentor and offer their consent and experience to entrepreneurs.
Business Angels have a vast experience in the industry they operate
in. Private investors may invest in a company for a capital gain. The
investment is for a place on board or an equity stake.
2. Venture Capital
Venture capitalists invest in a project for a non-executive position on
the board. They provide capital in exchange of an equity share or a
position at a strategic level. Once the value of shares increase,
they may sell those for a profit.
3 Loan for Business
Apart from secured lending, a company can choose
unsecured business loan that comes for a fixed tenure with
a repayment plan. The cost of loan is determined by
estimating the returns from the project. The interest
payment is tax deductible in some cases. An agreement is
made between the financial institution and the borrower
for a specific loan amount and tenure.
4 Overdrafts
Overdrafts are ideal for a short-term finance. The period of
overdraft facility is for a year or less. The interest is only
charged on the amount spent from the person’s account.
Such financing can be arranged quickly like business loans.
5 Share Capital
The shareholders get profits from dividend. This share of
profit is derived from ordinary shares (owned by business
owners who can share profits of an organization from
dividends) or preference shares (does not belong to company
owners but a third-party). Capital gain is expected from selling
the shares in future. It is the company shareholders who raise
the Share Capital.
6 Debentures
Debenture loans come with a fixed or a floating rate and
provided against an organization’s assets. The debenture
holders receive payment of interest before the shareholders
receive their dividend payment. If the business fails, then
these holders are liable as preferential creditors.
• A project loan offers a great opportunity to
fund-providers and investors to be a part of
the company’s growth process and share its
profits.
• The above-mentioned sources for project
financing are crucial for new companies. Apart
from these sources, a few others to mention
are project grants and government funding.
 Capital budgeting
• Capital budgeting involves choosing projects that add value to
a company. The capital budgeting process can involve almost
anything including acquiring land or purchasing fixed assets
like a new truck or machinery.
• Corporations are typically required, or at least recommended,
to undertake those projects that will increase profitability and
thus enhance shareholders' wealth.
• However, the rate of return deemed acceptable or
unacceptable is influenced by other factors specific to the
company as well as the project.
• For example, a social or charitable project is often not
approved based on the rate of return, but more on the desire
of a business to foster goodwill and contribute back to its
community.
• Capital budgeting is the process by which investors determine
the value of a potential investment project.
• The three most common approaches to project selection are
payback period (PB), internal rate of return (IRR), and net
present value (NPV).
• The payback period determines how long it would take a
company to see enough in cash flows to recover the original
investment.
• The internal rate of return is the expected return on a
project—if the rate is higher than the cost of capital, it's a
good project.
• The net present value shows how profitable a project will be
versus alternatives and is perhaps the most effective of the
three methods.
 objectives of Capital budgting

1. Selecting profitable projects

An organization comes across various profitable
projects frequently. But due to capital restrictions, an
organization needs to select the right mix of profitable
projects that will increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main
objective of capital budgeting. However, controlling
capital costs is also an important objective. Forecasting
capital expenditure requirements and budgeting for it,
and ensuring no investment opportunities are lost is
the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the
sources for procuring them is another
important objective of capital budgeting.
Finding the balance between the cost of
borrowing and returns on investment is an
important goal of Capital Budgeting.
Capital Budgeting Process
• Identifying investment opportunities
• An organization needs to first identify an
investment opportunity. An investment
opportunity can be anything from a new
business line to product expansion to
purchasing a new asset. For example, a
company finds two new products that they
can add to their product line.
• Evaluating investment proposals
• Once an investment opportunity has been recognized an
organization needs to evaluate its options for investment.
That is to say, once it is decided that new product/products
should be added to the product line, the next step would
be deciding on how to acquire these products. There might
be multiple ways of acquiring them. Some of these
products could be:
• Manufactured In-house
• Manufactured by Outsourcing manufacturing the process,
or
• Purchased from the market
• Choosing a profitable investment
• Once the investment opportunities are identified and
all proposals are evaluated an organization needs to
decide the most profitable investment and select it.
While selecting a particular project an organization
may have to use the technique of capital rationing to
rank the projects as per returns and select the best
option available. In our example, the company here has
to decide what is more profitable for them.
Manufacturing or purchasing one or both of the
products or scrapping the idea of acquiring both.
• Capital Budgeting and Apportionment
• After the project is selected an organization
needs to fund this project. To fund the project
it needs to identify the sources of funds and
allocate it accordingly. The sources of these
funds could be reserves, investments, loans or
any other available channel.
• Performance Review
• The last step in the process of capital budgeting is
reviewing the investment. Initially, the organization had
selected a particular investment for a predicted return. So
now, they will compare the investments expected
performance to the actual performance.
• In our example, when the screening for the most profitable
investment happened, an expected return would have been
worked out. Once the investment is made, the products are
released in the market, the profits earned from its sales
should be compared to the set expected returns. This will
help in the performance review.
 Capital Budgeting Techniques

• Payback period method

• In this technique, the entity calculates the time period
required to earn the initial investment of the project or
investment. The project or investment with the
shortest duration is opted for.
• Net Present value
• The net present value is calculated by taking the
difference between the present value of cash
inflows and the present value of cash outflows over a
period of time. The investment with a positive NPV will
be considered. In case there are multiple projects, the
project with a higher NPV is more likely to be selected.
• Accounting Rate of Return
• In this technique, the total net income of the
investment is divided by the initial or average
investment to derive at the most profitable
investment.
• Internal Rate of Return (IRR)
• For NPV computation a discount rate is used. IRR
is the rate at which the NPV becomes zero. The
project with higher IRR is usually selected.
• Profitability Index
• Profitability Index is the ratio of the present value
of future cash flows of the project to the initial
investment required for the project. Each
technique comes with inherent advantages and
disadvantages. An organization needs to use the
best-suited technique to assist it in budgeting. It
can also select different techniques and compare
the results to derive at the best profitable
projects
 Financial Statements
• Financial statements are necessary sources of information
about companies for a wide variety of users.
• Those who use financial statement information include
company management teams, investors, creditors,
governmental oversight agencies and the Internal Revenue
Service.
• Users of financial statement information do not necessarily
need to know everything about accounting to use the
information in basic statements.
• However, to effectively use financial statement information, it
is helpful to know a few simple concepts and to be familiar
with some of the fundamental characteristics of basic
financial statements.
 Four main accounting statements:
1. Balance Sheet
• The Balance Sheet is a statement detailing what a
company owns (assets) and claims against the company
(liabilities and owners’ equity) on a particular date.
• Some analysts take the balance sheet as similar to a
snapshot illustrating a company’s financial health.
• Keeping in mind the assets and claims, it is helpful to
remember the “left–right” accounting equation
orientation – assets on the left side, claims on the right.
Assets = Liabilities + Owner’s Equity
• In addition, there are a number of other
characteristics of the balance sheet that are
noteworthy, such as balancing, order of listing,
valuing of items, and definitions of items.
• The balance sheet must balance – that’s why
it’s called a balance sheet. In other words, the
assets must equal the claims on assets.
2. Income Statement
• The Income Statement shows a firm’s revenues and
expenses, and taxes associated with those expenses for
some financial period.
• Where the Balance Sheet may be thought of in terms of the
“left–right” orientation previously discussed, the income
statement would be thought of in “top–down” terms.
• A basic overview of income statement items shows how a
manufacturing company might present an income
statement. Income statements for other companies may
appear to be slightly different, but in general the
construction would be the same.
• An important concept in understanding the income
statement is Earnings Per Share (EPS).
• The Notes EPS for a company is net income divided
by the number of shares of common stock
outstanding. It represents the bottom line for a
company.
• Companies continually make decisions on how their
bottom line will be impacted since shareholders in
the company are concerned with how management
decisions affect individual shareholder position.
3. Cash Flow Statement
• Cash Flow Analysis is useful for short-run planning. A
historical analysis of cash flows provides insight to prepare
reliable cash flow projections for the immediate future &
make suitable arrangements.
• Cash Flow statement shows inflow – sources of cash (i.e.
positive cash flow) and outflow - uses of cash (i.e. negative
cash flows) during the period and the difference being ‘Net
Cash Flow’.
• This statement analyses changes in non-current accounts as
well as current accounts (other than cash) to determine the
flow of cash.
• Statement of changes in cash position is prepared
recording only inflows and outflows of cash,
reflecting the net change during the period.
• Cash received minus cash paid during a period is the
cash balance at the end of the period.
• If the net change in cash position has to be found out
from the profit and loss account, comparative
balance sheets, adjustments for the non-cash items
should be made.
 Types of Cash Flow
• Actual Flow of Cash
• There may be actual or direct flow of cash ‘in’ and ‘out’ of the business under the
following circumstances:
a. Actual inflow of Cash: This transaction results in the actual inflow of cash into the
business.
Similarly, there is inflow of cash when debentures are issued for cash, loans raised
in cash, sale of fixed assets for cash, dividends received in cash, etc.
Example: Issue of shares for cash:
Cash a/c Dr
To Share Capital a/c
b. Actual outflow of Cash: This transaction results in the actual outflow of cash from
the
business. Similarly, there is outflow of cash on repayment of loans, redemption of
preference shares or debentures, payment of taxes, dividend, etc. in cash.
Example: Purchase of Machinery for cash.
Machinery a/c Dr.
To Cash
• Notional Cash Flow
• The indirect movement of cash ‘in’ and ‘out’ of the business is referred to as
‘notional flow of cash’ which may take place under the following circumstances:
a. Notional inflow of cash: Notional inflow of cash takes place whenever a
transaction results in increasing current liabilities or decreasing current assets.
Example: Purchase of goods on credit.
Purchases A/c Dr.
To Creditors A/c
b. Notional outflow of cash: Notional outflow of cash takes place whenever a
transaction results in decreasing current liabilities or increasing current assets.
Example: Sale of goods on credits:
Debtors A/c Dr.
To Credit Sales A/c
4. Profit and Loss Account
• The profit and loss account shows the profit that the business
makes. This is also known as the “Trading, Profit and Loss Account”.
It is made up of the following components:
• Sales
• Direct Costs
• Gross Profit
• Indirect Costs
• Net Profit
• Taxation
• Director’s Drawings
• Investment in Business
• The profit and loss account is opened by recording
the gross profit (on credit side) or gross loss (debit
side).
• For earning net profit a businessman has to incur
many more expenses in addition to the direct
expenses.
• Those expenses are deducted from profit (or added
to gross loss), the resultant figure will be net profit or
net loss.
• The expenses which are recorded in profit and loss
account are ailed ‘indirect expenses’.
Preparation of Projected Financial
Statements
• Projected financial statements provide assumptions
about a given company’s financial situation in the
future, whether it is an annual or quarterly
projection.
• Preparing projected financial statements is a lengthy
task, as it requires analysis of the company’s
finances, reading previous budgets and income
statements, and examining the company’s current
financial situation to make assumptions about the
business’ financial potential.
• The process is the same for smaller, sole-proprietor
businesses and well-established corporations.
• When preparing the projected financial statements, there are
some common pitfalls that need to be avoided:
• Don’t prepare an over ambitious or unrealistic projection. It is
better to prepare a conservative projection and be able to
exceed your plan than it is to prepare something unrealistic
and have to explain to investors why you were unable to
achieve projected results.
• Don’t be creative in developing your presentation of the
projections. Use prescribed industry standard formats that
meet Generally Accepted Accounting Principles.
• Be sensitive to the amount of detail that is presented and
avoid the use of technical terms.
• Give the reader the proper amount of detail to make a
decision.
• Facts and extensive research should back all assumptions
used in the projections. This makes your projections more
believable.
• Fully disclose information on all issues relating to contracts,
ownership, offering price, stock options, warrants, related
party issues, risks and uncertainties. Don’t mislead the reader.
 Detailed project report
• A detailed project report is a very extensive and
elaborative outline of a project, which includes
essential information such as the resources and tasks
to be carried out in order to make the project turn
into a success.
• It can also be said that it is the final blueprint of a
project after which the implementation and
operational process can occur.
• In this comprehensive project report, the roles and
responsibilities are highlighted along with the safety
measures if any issue arises while carrying out the
plan.
 Contents of a detailed project report

• Brief information about the project

• Experience and skills of the people involved in the promotion
of the project
• Details and practical results of the industrial concerns of the
promoters of the project
• Project finance and sources of financing
• Government approvals
• Raw material requirement
• Details of the requisite securities to be given to various
financial organizations
• Other important details of the proffered project idea include
information about management teams for the project, details
about the building, plant, machinery, etc.