COST OF PROJECT AND MEANS OF FINANCING

COST OF PROJECT AND MEANS OF FINANCING

A project is concerned finance is the basic prerequisite. Without proper financial arrangement an entrepreneur is finding difficult to go ahead with his project. Funds requirement should be optimum so as to avoid the problems of both under and over capitalisation. So the cost project should be accurately estimated. Once the estimation of cost of project is over, the next step is to find out the sources of financing. After identifying the various available sources, a finance mix should be finalised. The selected finance mix should be optimum from the point of view of cost, control and flexibility.

COST OF PROJECT The cost of project represents the total of all items of outlay associated with a project which are supported by long-term funds. The major cost elements of a project are the following: Land and site development Buildings and civil works Plant and machinery Technical know-how and engineering fees Expenses on foreign technicians and training for Indian technicians abroad. Miscellaneous fixed assets Preliminary and capital issue expenses Margin money for working capital Initial cash losses

Land and site development This includes basic cost of land, premium payable on lease hold, cost of levelling and development, cost of laying approach roads, cost of gates, cost of tube wells etc. The cost of land varies considerably from one location to another location. Similarly the expenditure on site development also varies according to topography of the land.

Buildings and civil works This includes buildings for the main plant and equipment, building for auxiliary services like work shops, laboratory etc., godowns, warehouses, quarters for staff etc. The cost of buildings and civil works depends on the kinds of structures required. Once the kinds of structures required are specified, cost estimates are based on the plinth area and rates for various types of structures.

Plant and machinery The cost of plant and machinery is the most significant component of the project cost. This includes the cost of imported machinery and its allied cost, cost of indigenous machinery, cost of stores and spares and installation and foundation charges. The cost of the plant and machinery is based on the latest available quotation adjusted for possible escalation.

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 the project report, choice of technology, selection of the plant and machinery, and so on. So the amount payable for obtaining the technical know-how and engineering services for setting up the project is an important component of the project cost.

Expenses on foreign technicians and training of Indian technicians abroad Services 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.

Miscellaneous fixed assets Fixed assets which 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 sidings, diesel generating sets, transformers, boilers, piping systems, laboratory equipments etc. Expenses incurred for the procurement or use of patents, licenses, trade marks, copyrights, etc and deposits made with electricity board may also be included here.

Preliminary and capital issue expenses Expenses incurred for identifying the project, conducting market survey, preparing feasibility report, drafting memorandum and articles of association and incorporating the company are referred to as preliminary expenses. 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 registrars, printing and postage expenses, advertising and publicity expenses, listing fees, and stamp duty.

Pre-operative expenses Some revenue expenses incurred till the commencement of commercial production are referred to as pre-operative expenses. This includes establishment expenses, rent, rates and taxes, travelling expenses, interest and commitment charges on borrowings, insurance charges, mortgage expenses, interest on deferred payments, start-up expenses, and miscellaneous expenses.

Provision for 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 the cost estimates.

Margin money for working capital The principal support for working capital is provided by commercial banks and trade creditors. However, a certain part of the working capital requirement has to come from long-term sources of finance. Referred to as the margin money for working capital, this is an important element of the project cost.

Initial cash losses Most of the projects incur cash losses in the initial years. Yet, promoters typically do not disclose the initial cash losses because they want the project to appear attractive to the

financial institutions and investing public. Failure to make a provision for such cash losses in the project cost generally affects the liquidity position and impairs the operations.

MEANS OF FINANCING To meet the cost of project the following means of finance are available:

Share capita Term loans Debenture capital Deferred credit Incentive sources Miscellaneous sources

Share capital There are two types of share capital-equity capital and preference capital. Equity capital represents the contribution made by the owners of the business, the equity shareholders, who enjoy the rewards and bear risks of ownership. Equity capital being the risk capital carries no fixed rate of dividend. Preference capital represents the contribution made by preference shareholders and the dividend paid on it is generally fixed.

Term Loans Term loans are provided by financial institutions and commercial banks represents secured borrowings which are a very important source for financing new projects as well as expansion, modernization, and renovation schemes of existing firms. There are two broad types of term loans available in India: rupee term loans and foreign currency term loans. While the former are given for financing land, building, civil works, indigenous plant and machinery, and so on, the latter are provided for meeting the foreign currency expenditures towards the import of equipment and technical know how.

Debenture capital Debentures are instruments for raising debt capital. There are two broad types of

debentures: convertible debentures and non convertible debentures. Convertible debentures as the name implies, are debentures which are convertible, wholly or partly, in to equity shares. The conversion period and price are announces in advance.

Deferred credit Many a time the suppliers of plant and machinery offer a deferred credit facility under which payment for the purchase of plant and machinery can be made over a period of time.

Incentive sources The government and its agencies may provide financial support as inventive to certain types of promoters or for setting up industrial units in certain locations. These incentives may be in the form of seed capital assistance, capital subsidy or tax exemption for a certain period.

Miscellaneous sources: A small portion of project finance may come from miscellaneous sources like unsecured loans, public deposits, and leasing and hire purchase finance. Unsecured loans are typically provided by the promoters to bridge the gap between the promoters contribution and the equity capital the promoters can subscribe to. Public deposits represent unsecured borrowings from the public at large. Leasing and hire purchase finance represent a form of borrowing different form the conventional term loans and debenture capital.

Factors affecting selection of means of finance The selection of means of finance governs the following considerations: a) Norms of regulatory bodies and financial institutions b) Key business considerations

Norms of Regulatory bodies and financial institutions In many countries, including India, the proposed means of financing for a project must be either approved by a regulatory agency or conform to certain norms laid down by the government or financial institutions in this regard. The primary purpose of such

regulation is to impart prudence to project financing decisions and provide a measure protection to investors. Key business considerations The key business considerations which are relevant for the project financing decision are: cost, risk, control and flexibility.

Cost In general the cost of debt fund is lower than the cost of equity funds. The primary reason is that the interest payable on debt capital is a tax-deductible expense whereas the dividend payable on equity capital is not.

Risk The main sources of risk for a firm are: business risk and financial risk. Business risk refers to the variability of earning before interest and taxes and arises mainly from fluctuations in demand and variability of prices and costs. Financial risk represents the risk arising from financial leverage. It must be emphasized that while debt capital is cheap it is also risky because of the fixed financial burden associated with it.

Control From the point of view of promoters of the project, the issue of control is important. They would ordinarily prefer a scheme of financing which enables them to maximise their control, current as well as potential, over the affairs of the firm, given their commitment of funds to the project.

Flexibility This refers to the ability of a firm to raise further capital from any source it wishes to tap to meet the future financing needs. In most practical situations, flexibility means that the firm does not exhaust fully its debt capacity. WORKING CAPITAL Working capital is the amount of money required by an enterprise for carrying out its day to day operations. The money invested in current assets like raw materials, finished products, debtors etc is known as working capital. The current assets in aggregate refer to gross working capital and the excess of current assets over current liabilities are called net working capital. The working capital is of two types: permanent working capital and variable working capital. Usually the permanent working capital is financed by long-term source of finance and variable working capital by short-term sources.

The short-term sources of finance primarily include the following: 1.Loans from banks 2.Public deposits 3.Trade credit 4.Pledging and factoring 5.Bank overdraft 6.Cash credit 7.Bills discounting 8.Advances from customers 9.Accruals