Financing of project

Dr Anurag Agnihotri
 Project background
• A project can be defined as ‘A scheme of things to be done
during a specified period in future for deriving expected
benefits under certain assumed conditions’.
• A project may be in the nature of setting up a new industrial
unit, modernization, expansion, diversification and promotion
of R&D.
Because of complexity and uniqueness involved, a capital project
needs to be launched by:
• Analyzing past environment
• Studying existing environment
• Forecasting future environment

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 Project background
• A project financing structure involves a number of equity
investors, known as sponsors, as well as a syndicate of banks
that provide loans to the operation.
• The purpose of term assistance is to meet a part of the capital
expenditure of a project.
• To set up a project, certain capital expenditure needs to be
incurred in acquiring assets such as L&B, P&M and other
infrastructural facilities like roads, water supply, railway sidings,
etc., in addition to the Preliminary / Pre-Operative Expenses
and margin on WC Limits.
• Where promoters of a project are unable to meet the entire
capital expenditure out of their own resources, Term Loans are
sanctioned to supplement the promoters’ contribution.

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 Project background
• To set up a project, certain capital expenditure needs to be
incurred in acquiring assets such as L&B, P&M and other
infrastructural facilities like roads, water supply, railway sidings,
etc., in addition to the Preliminary / Pre-Operative Expenses and
margin on WC Limits.
• Where promoters of a project are unable to meet the entire
capital expenditure out of their own resources, Term Loans are
sanctioned to supplement the promoters’ contribution.

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 Project background
• The Promotion Stage is a crucial stage in the entire life cycle of a
project. Promotion in relation to a project will comprise broadly
the following functions:
• Identification of a project
• Feasibility investigation
• Assembling the proposition
• Financing the proposition

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 I] Identification of a Project
• The first step in the project promotion is the identification of a
project. An industrial project originates as an idea in a
promoter when he observes the existence of a potential
market for a certain product.
• The promoter, on the basis of his experience, background and
ability, then considers the feasibility of manufacturing and
marketing the product at a remunerative price.
• There should be an unsatisfied demand.
• Promoters of an industrial project can constitute themselves
into any of the following forms of business organizations to
implement the project : Sole Proprietorship, Partnership, Co-
operative Society & Joint Stock Company.

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 II] Feasibility Investigation
• A detailed feasibility study is a costly exercise. It is, therefore,
desirable that, before it is undertaken, marketability of the
product to be manufactured is firmly established.
• There are agencies, specializing in market research, which
conduct such market studies. Promoters may take advantage of
their services.
• A market study aims at assessing the aggregate demand for a
product.
• The promoter will now undertake the detailed feasibility
investigation proper, comprising two feasibility studies:
• The Technical Feasibility Study
• The Economic Feasibility Study

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 II] Feasibility Investigation
- Technical Feasibility
• Technical Feasibility Study covers the following aspects:
• Location of the project
• Lay-out of the Plant
• Size of the Plant
• Factory construction
• Manufacturing process / Technology
• Process Design
• Product Design
• Scale of Operation
• Infrastructural facilities

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 II] Feasibility Investigation
- Economic Feasibility
• The prime objective of setting up a project is to derive a fair
return on the investment.
• Economic Feasibility Study, therefore, concerns itself with
matching of economic resources with the physical
requirements of a project and determining the viability of
investment therein.

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 III] Assembling the Proposition
•
- CoP & MoF
When a promoter is satisfied about the technical feasibility and
economic feasibility of a project, the next task is to work out the
Cost of the Project and the Means of financing it.
• The Cost of the Project means cost incurred for acquiring:
• Land & Building
• Plant & Machinery
• Other Fixed assets
• Technical Know-how, Engg. & Consultancy fees
• Preliminary and Pre-operative expenses
• Provision for contingencies
• Margin on WC Limits

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 III] Assembling the Proposition
- CoP & MoF
• The means of financing broadly includes:
• Borrowings:
• Internal Sources
• External Sources
• Public Issue:
• Shares
• Other Securities

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 III] Assembling the Proposition
- CoP & MoF
• Own Funds
• Retained Earnings
• Promoter’s Contribution
• Government Agencies
• Subsidy
• Other Assistance

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 IV] Financing the Proposition
• Setting up of a project involves acquisition of Fixed Assets which
facilitate the process of production. Fixed Assets have a
relatively longer life and are generally not meant for resale.
They are required to be retained over a period of time to exploit
their productive potential.
• Current Asset go through the operating cycle of Raw Material,
Work in progress and Finished Goods, which when sold bring in
cash. This cycle is generally completed in a short period of less
than one year.

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 IV] Financing the Proposition
• Thus, investment in current asset is realized over a short term,
while investment in Fixed Assets is long term in nature.
• It is realized through surplus generated in the form of Net
Profits, Depreciation and other non-cash write-offs.
• As it takes a long time for the Fixed Assets to pay for themselves,
the promoter should raise suitable long term funds to finance a
project.

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 IV] Financing the Proposition

LO N G TERM SO U RCES

O W N E D C A P IT A L B O R R O W E D C A P IT A L

S h a r e C a p it a l R e t a in e d E a r n in g s D eb en tures T e rm Lo a n s, D P G s P u b lic D e p o s it s

E q u it y P re fe re n c e

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 IV] Financing the Proposition
- Long Term Sources
• The aggregate amount of finance raised for financing a project is
referred to as Capital, comprising two components
• Owned Capital
• Borrowed Capital
• The other sources of long term funds are:
• Capital Subsidy applicable to projects coming up in certain
notified backward areas,
• Interest free sales tax loans offered by State Governments or
similar schemes.

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 IV] Financing the Proposition
- Financial Leverage
• After considering availability of long terms sources of finance,
the promoter will decide about a suitable financial structure for
the Company.
• It will depend upon the financial leverage envisaged in the
combination of sources of finance under the two categories, viz.,
Owned Capital and Borrowed Capital.
• Few projects can be financed entirely by equity or debt.

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 IV] Financing the Proposition
- Financial Leverage
• The divergent interests of debt and equity are brought into
alignment by the concept of Debt / Equity gearing which
determines the level of debt that can be supported by a given
quantum of equity.
• For this purpose, Debt means Funded Debt including all term
liabilities and equity will include Share Capital and retained
earnings, if available.
• No standard Debt Equity Ratio can be prescribed.

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 IV] Financing the Proposition
- Return on Investment
• The amount invested in a project can be recouped through
annual cash flows, over a period of time.
• In arriving at a financial plan for the project, a promoter will
examine the attractiveness of the project, vis-à-vis alternative
sources of investment.
• The process which assists the management in such a task is
collectively known as ‘Capital Investment Evaluation’.

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 IV] Financing the Proposition
- Return on Investment
• The most important and widely used Capital Investment
Evaluation techniques are:
• Pay-back Method
• Net Terminal Surplus Method
• Excess Present Value Method
• Internal Rate of Return Method

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 IV] Financing the Proposition
- Return on Investment
• The object of Pay-back Method is to find out the period of time
required for recovering the entire amount of investment made
in a project.
• The cash flows (Net Profit + Depreciation + Other non-cash
write-offs) are compared with the outlay on the project to
determine the pay-back period. Years to pay back would be:
Total Investment
Cash Flow per annum

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 IV] Financing the Proposition
- Return on Investment
• Net Terminal Surplus Method employs the concept of
compounding which involves re-investing the simple interest
earned each year along with the principal so that the principal
grows each year by the amount of interest earned during the
previous year and interest being calculated on the increased
principal also grows.
• Future Value = Principal x (1+i)

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 IV] Financing the Proposition
- Return on Investment
• Excess Present Value Method is based on the discounted cash
flow technique and uses the concept of discounting which is
just the opposite of compounding.
• In discounting, we arrive at the Present value of a future sum to
which the original amount (which we want to find out), invested
at a particular compound rate of interest has grown.
• PV = Future sum
(1+i)

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 IV] Financing the Proposition
- Return on Investment
• Internal Rate of Return Method – It is that rate at which the
sum of the discounted cash flows is equal to the investment
outlay. In other words, IRR is the rate which makes the Present
Value (PV) of benefits equal to the Present Value of costs or
reduces the Net Present Value (NPV) to zero. The object of this
method is to find the rate of return which a project is likely to
earn over its useful life.
• IRR = Lower Discount Rate + Diff. Between the two discount
rates x NPV at lower discount rate
Abs. diff. between the two NPVs.

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 Types of Term Assistance
The types of term assistance extended by the Bank can be broadly
classified into:
• Term Loans (Incl. Forex Loans)
• Deferred Payment Guarantees
• Bill Discounting Facilities
• Underwriting of Shares / Debentures

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 Types of Term Assistance
-Term Loan
• A Term Loan is a loan granted for a fixed term of not less than
one year, intended normally for financing fixed assets acquired /
to be acquired, carrying interest at a specified rate, and
scheduled for repayment in installments.
• Depending on the term for which the said terms loans are
granted, they could be classified into (a) Short Term Loans (b)
Medium Term Loans and (c) Long Term Loans.

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 Types of Term Assistance
-DPG
• Deferred Payment Guarantee (DPG) is a contract to pay to the
supplier the price of machinery, supplied by him on deferred
terms, in agreed installments with stipulated interest on the
respective due dates in case of default in payment thereof by
the buyer.
• A DPG is, in many respects, a substitute for a Term Loan and, as
far as the buyer of P&M is concerned, it serves the same
purposes as a Term Loan.
• Standards of appraisal are the same as TL.

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 Types of Term Assistance
- Bills Discounting
• Under a contract for sale of machinery on deferred payment
basis, the balance remaining to be paid after the initial down –
payment represents the deferred receivables of the seller.
• Thus, the funds of the seller get blocked for unduly long periods
and the seller requires finance against such deferred receivables
to replenish his Working Capital.

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 Types of Term Assistance
- Bills Discounting
• To facilitate availment of finance against the deferred
receivables, the seller usually draws a series of bills with
graded maturities to coincide with the due dates of payment
of the relative installments (including applicable interest).
• The bills drawn by the seller will be accepted by the buyer
before they are discounted by the seller’s banker.

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 Types of Term Assistance
- Underwriting of Shares
• Underwriting as a business will come under the scope of
‘Investment Banking’ as distinct from ‘Commercial Banking’.

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 Types of Term Assistance
- Underwriting of Shares
• The necessity for underwriting arrangement arises only in the
case of a Public Limited Company resorting to raise through the
capital issue market, a part of the Share Capital for part-
financing a project.
• Underwriting is a contract whereby a person agrees, in
consideration, to take up a specified number of shares or
debentures or amount of debenture stock to be offered to the
public, in the event of the public not subscribing for them.

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 Project Appraisal by bankers
• The purpose of Project Appraisal is to ascertain whether the
project will be sound – technically, economically, financially and
managerially – and ultimately viable as a commercial
proposition.
• The appraisal of a project will involve the examination of:
• Technical Feasibility : To determine the suitability of the
technology selected and the adequacy of the technical
investigation, and design.

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 Project Appraisal by bankers
• Economic Feasibility : To determine the conduciveness of
economic parameters to setting up the project and their impact
on the scale of operations.
• Financial Feasibility : To determine the accuracy of cost estimates,
suitability of the envisaged pattern of financing and general
soundness of the capital structure.
• Commercial Viability : To ascertain the extent of profitability of
the project and its sufficiency in relation to the repayment
obligations pertaining to term finance.

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 Project Appraisal by bankers
• Managerial Competency : To ascertain that competent men are
behind the project to ensure its successful implementation and
efficient management after commencement of commercial
production.
• A project should will also be examined, wherever appropriate,
from the point of view of its value to the national economy in
terms of socio-economic benefits like generation of employment
opportunities, forex earnings, the quantum of import
substitution, etc.

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 Project Appraisal by bankers
• The first step in Project Appraisal is to find out whether the
project is prima facie acceptable by examining salient features
such as:
• The background and experience of the applicants, particularly in
the proposed line of activity
• The potential demand for the product
• The availability of the required inputs, utilities and other
infrastructural facilities
• Whether the project is in keeping with the priorities, if any, laid
down by the Government.

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 Project Appraisal by bankers
• The original application may not contain all the basic data /
information. In such cases, it may be necessary by the bank to
interview the applicants and elicit all the necessary data /
information with a view to forming an overall idea about the
general feasibility of the project.
• After satisfying itself about the prima facie acceptability of the
project, the Bank will call for from the promoters, an ‘Application’,
containing the following essential data / information, such as:

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 Project Appraisal by bankers
• Particulars of the project along with a copy of the Project
Report furnishing details of the technology, manufacturing
process, availability of construction / production facilities, etc.
• Estimates of cost of the project detailing the item wise assets
acquired / to be acquired, inclusive of Preliminary / Pre-
operative Expenses and WC margin requirements.

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 Project Appraisal by bankers
• Details of the proposed means of financing indicating the extent
of promoters’ contribution, the quantum of Share Capital to be
raised by public issue, the composition of the borrowed capital
portion with particulars of Term Loans, DPGs, Foreign Currency
Loans, etc.
• WC requirements at the peak level (i.e., when the level of Gross
Current Assets is at the peak) during the first year of operations
after the commencement of commercial production and the
banking arrangements to be made for financing the WC
requirements.

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 Project Appraisal by bankers
• Project Implementation Schedule.
• Organizational set up along with a list of Board of Directors and
indicating the qualifications, experience and competence of (i)
The key personnel to be in charge of implementation of the
project during the construction period and (ii) The executives to
be in charge of the functional areas of purchase, production,
marketing and finance after commencement of commercial
production.

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 Project Appraisal by bankers
• Demand projection based on the overall market prospects
together with a copy of the market survey report.
• Estimates of sales, CoP and profitability.
• Projected P&L Account and B/S for the operating years during
the currency of the Bank’s term assistance.
• Proposed amortization schedule, i.e., repayment programme.

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 Project Appraisal by bankers
• Projected Funds Flow Statement covering both the construction
period and the subsequent operating years during the currency
of the Term Loan.
• Details of the nature and value of the securities offered.
• Consents from the Government / other authorities and any
other relevant information.

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 Project Appraisal by bankers
• In respect of existing concerns, in addition to this information,
particulars regarding the history of the concern, its past
performance, present financial position, etc., will also be called
for.
• The ‘Application’ completed in all respects and duly signed by
the authorized signatories of the Company will form the basis
for the detailed appraisal of the project.

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 Project Appraisal by bankers
• An inspection of the project site (or factory in the case of
existing units) will be done by the bankers.
• Each project will be examined in proper perspective having due
regard to its nature, size and scope.
• Although the basic techniques employed for appraising the
viability of various projects are more or less the same, there will
be no standard or uniform approach for appraising all projects.

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 Project Appraisal by bankers
• The ultimate objective of the appraisal exercise is to ascertain
the viability of a project with a view to ensuring the
repayment of the borrower’s obligations under the Bank’s
term assistance.
• Therefore, it is not so much the quantum of the proposed
term assistance as the prospects of its repayment that will
weigh with the Bank while appraising a project.

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 Project Appraisal by bankers
• In project appraisal, nothing will be assumed or taken for
granted by the bankers.
• All the data / information will be checked and, wherever
possible, counter-checked by the bankers through inter-firm
and inter-industry comparisons.

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 Working capital
• Current assets – Current liabilities
• It measures how much in liquid assets a company has available
to build its business.
• A short term loan which provides money to buy earning assets.
• Allows to avail of unexpected opportunities.
• Positive working capital is required to ensure that a firm is able
to continue its operations and that it has sufficient funds to
satisfy both maturing short-term debt and upcoming
operational expenses. The management of working capital
involves managing inventories, accounts receivable and payable
and cash.

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 Working capital management
• Decisions relating to working capital and short term
financing are referred to as working capital management.
Short term financial management concerned with
decisions regarding to CA and CL.
• Management of Working capital refers to management of
CA as well as CL.
• If current assets are less than current liabilities, an entity
has a working capital deficiency, also called a working
capital deficit.
• These involve managing the relationship between a firm's
short-term assets and its short-term liabilities.

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 Working capital management
• The goal of working capital management is to ensure that the
firm is able to continue its operations and that it has sufficient
cash flow to satisfy both maturing short-term debt and
upcoming operational expenses.
• Businesses face ever increasing pressure on costs and
financing requirements as a result of intensified competition
on globalised markets. When trying to attain greater
efficiency, it is important not to focus exclusively on income
and expense items, but to also take into account the capital
structure, whose improvement can free up valuable financial
resources

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 Working capital
• In a project, working capital requirements mainly arises from:
• Building up of inventory
• Making deposits with various authorities
• Making advance to suppliers
• Allowing credits to customers
• Granting loans and advances to employees
• Maintaining minimum cash balance

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 Constituents of working capital
• CURRENT ASSETS
• Inventory
• Sundry Debtors
• Cash and Bank Balances
• Loans and advances

• CURRENT LIABILITIES
• Sundry creditors
• Short term loans
• Provisions

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 Need For Working Capital
• Thus needs for working capital arises from cash or operating
cycle of a firm.
• Which refers to length of time required to complete the
sequence of events.
• Thus operating cycle creates the need for working capital & its
length in terms of time span required to complete the cycle is
the major determinant of the firm’s working capital needs.

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 Need for working capital
• As profits earned depend upon magnitude of sales and they
do not convert into cash instantly, thus there is a need for
working capital in the form of CA so as to deal with the
problem arising from lack of immediate realization of cash
against goods sold.
• This is referred to as “Operating or Cash Cycle” .
• It is defined as “The continuing flow from cash to suppliers, to
inventory , to accounts receivable & back into cash”.

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 Working capital estimates
• Current Assets
• Inventory: represents stock of raw material, indirect material,
work in progress, finished goods, goods in transit
• Sundry Debtors: estimated based on various factors such as
credit policy of the company, average credit period of the
company, etc
• Cash and bank balance: may be set at a reasonable level based
on the life cycle of product

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 Working capital estimates
• Current liabilities

o Creditors: estimated based on number of days credit,

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 Determining optimum capital structure
• The optimum capital structure for the project should be
determined keeping in mind:
• Relevant statutory provisions
• Norms and requirements of financial institutions
• Internal priorities of the Organization.
• The important questions, which arise in judicious financing
decision-making are:
• Whether to tap fund from specific source or multiple source
• What should be the quantum of financing from each source
• How initial losses of the project will be financed
• What is the time factor for fund availability

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 Determining optimum capital structure
• The basic factors, which guide financing decision, are:
• Risk
• Cost
• Control
• The choice is also governed by consideration such as ease and
flexibility in fund management

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 Analysis of Project Report
• A project report analysis includes the following methods:
• Sensitivity analysis
• Ratio Analysis
• Break Even Analysis

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 Sensitivity analysis
• Sensitivity analysis (SA) is the study of how the variation
(uncertainty) in the output of a mathematical model can be
apportioned, qualitatively or quantitatively, to different sources
of variation in the input of the model. Put another way, it is a
technique for systematically changing parameters in a model to
determine the effects of such changes. Sensitive analysis in
finance is the part of capital budgeting decisions. Suppose, if
our investment budget increases 20% due to unknown factors,
we see in sensitive analysis, what will be its affect on our NPV.
– Five forces model
– Value chain analysis
– SWOT

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 Sensitivity analysis
• In more general terms uncertainty and sensitivity analysis
investigate the robustness of a study when the study includes
some form of mathematical modeling. Sensitivity analysis can
be useful to computer modelers for a range of purposes,
including:
o support decision making or the development of
recommendations for decision makers (e.g. testing the
robustness of a result);
o enhancing communication from modelers to decision
makers (e.g. by making recommendations more credible,
understandable, compelling or persuasive);

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 Sensitivity analysis
• increased understanding or quantification of the system (e.g.
understanding relationships between input and output
variables); and
• model development (e.g. searching for errors in the model).

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 Ratio Analysis
• Ratio-analysis is a concept or technique which is as old as
accounting concept. Financial analysis is a scientific tool. It
has assumed important role as a tool for appraising the real
worth of an enterprise, its performance during a period of
time and its pit falls. Financial analysis is a vital apparatus for
the interpretation of financial statements. It also helps to find
out any cross-sectional and time series linkages between
various ratios.

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 Ratio Analysis
• Ratio-analysis means the process of computing, determining
and presenting the relationship of related items and groups of
items of the financial statements. They provide in a
summarized and concise form of fairly good idea about the
financial position of a unit. They are important tools for
financial analysis.

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 Ratio Analysis
• It’s a tool which enables the banker or lender to arrive at the
following factors :
• Liquidity position
• Profitability
• Solvency
• Financial Stability
• Quality of the Management
• Safety & Security of the loans & advances to be or already
been provided

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 Ratio Analysis
• The utility of ratio analysis will get further enhanced if
following comparison is possible.
1. Between the borrower and its competitor
2. Between the borrower and the best enterprise in the
industry
3. Between the borrower and the average performance in the
industry
4. Between the borrower and the global average

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 Classification of Ratios
Balance Sheet P/L Ratio Balance Sheet &
Ratio P/L Ratio
Financial Ratio Operating Ratio Composite Ratio
Current Ratio Gross Profit Ratio Fixed Asset
Quick Asset Ratio Operating Ratio Turnover Ratio,
Proprietary Ratio Expense Ratio Return on Total
Debt Equity Ratio Net profit Ratio Resources Ratio,
Stock Turnover Return on Own
Ratio Funds Ratio,
Earning per Share
Ratio, Debtors’
Turnover Ratio,

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 Break-even Analysis
• Break-even point analysis involves determination of that level
of operation/production at which a project breaks even.
• At BEP, the total sale revenue is equal to the total cost
(including both fixed and variable cost) which is incurred in
generating sales revenue.
• For calculating break-even point of a new project, the
financial revenue and cost figures of the year in which project
would achieve stability in terms of capacity utilization may be
taken.

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 Break-even Analysis
• The formula for computing BEP is as under:
• BEP(In physical terms) = Fixed Cost/ Contribution per unit
o Contribution per unit= Selling price per unit-variable cost
per unit
• BEP(In financial terms)= Fixed cost/(1-total variable cost/total
sales)
• BEP(In terms of capacity)= Level of production at BEP(in
physical terms)/Overall capacity of the project in physical
terms.

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 Break-even Chart
C Y S
O Profit
S 400 BEP Area C
T
&
R 300 Total cost line
B
E Fixed Cost
V Line
E T F
N Loss
100 area Break Even
U Volume
E
10 25 P 40
O X
ANNUAL PRODUCTION (UNITS)

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 Break-even Chart
• Where
• OX= Annual Production(in physical terms)
• OY= Cost & revenue line(in financial terms)
• OS= Sale line
• TF= Fixed cost line
• TC=Total cost line
• The above graph shows Break-even Volume (OP), BEP(P) and
Break-even Sales(BP). Any level of output lower than OP will
result in a loss. This is a break even volume which must be
guaranteed for acceptance of a project.

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 Break-even Chart
• In the above chart, it is easy to find out at a given level of output
on OX, fixed cost represented by XF, variable cost by FC, total
sales by XS and net profit by CS.
• The area above BEP, which shows profit, is the area of MARGIN
OF SAFETY for the project. So contribution above BEP represents
profit.
• MOS= (Level of production-Break even quantity )/overall
capacity in physical terms.

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 Project report-what to include
• Particulars of project
• Name, Date of incorporation, Registration No.
• Constitution of business(Private/public company, Partnership
Firm, etc.)
• Sector (Government/joint/private)
• Location of project
• Date of start of project

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 Project report-what to include
• Particulars of project
• Date of its completion
• Agencies involved
• Date of submission
• Date of approval

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 Project description
• Background
• Need, objective and relevance of project
• Long range plans of company
• Size in terms of capacity
• Implementations

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 Project description
• In case project is undertaken by an existing company:
• The relevant information such as:
o Name of sister/associated companies
o Shareholding pattern
o Particulars of key personnel
o Capital structure
o Status of facilities
o Borrowing status
o Capacity Utilization
o Such information must be disclosed in the project report

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 Particulars of Promoters
• In case of financing project from external sources particulars
of promoters such as:
• Qualification
• Experience on project management
• Financial Background
• Proposed organization structure of the project
• Interest/share in other/sister concern

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 Nature and Location of the Project
• Nature:
• New project, Diversification, Expansion, Modernization,
technological, upgradation, others.
• Location:
• Backward area or developed
• Rural Region or urban region

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Marketing and Commercial aspect
• Nature of goods and services to be supplied by the project
• Existing demands, trend as per past growth rate,
anticipated gap between demand and supply.
• Year wise demand projections
• Income and price elasticity of Demand
• Pattern of consumption behavior
• Preference of particular brand
• Estimation of selling price
• Degree and nature of risk involved
• Govt. restrictions, etc..

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 Other Notes
• The detailed format for preparing a project report may be
modified according to the requirement of any specific project
• Some of the data/information may have to be duly certified
by a Chartered Accountants/other designated persons for
specified purposes.
• A comprehensive project report would help a systematic and
timely appraisal of project by the lending agencies.
• In case of project to be undertaken by an existing concern,
once the project report is approved, the same would form
part of Capital Budget.

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