Master of Business Administration - MBA Semester 3 PM 0012 PROJECT FINANCE & BUDGETING (4 credits) (Book ID: B1238) ASSIGNMENT-

- Set 1 Marks 60 Note Answer all questions. Kindly note that answers for 10 marks questions should be approximately of 400 words. Each question is followed by evaluation scheme. 1. Evaluate the golden rules of project risk management. (10 Marks)
The benefits of risk management in projects are huge. Managing of risks in a project is an indispensable part of the project. These rules also help in delivering the project on time with the results the project sponsor demands. Below mentioned are the rules for managing the project. Rule 1: Make risk management part of your project The proper implementation of risk management helps to get the complete benefits of this approach. Those projects which do not have a perfect risk management approach are either ignorant, or are confident that no risks will occur in their project. Rule 2: Identify risks early in your project The first phase in project risk management is to identify the risks that are present in your project. The sources which are used to identify the risks are people and paper. People include your team members, who bring their personal experiences and expertise along with them. Rule 3: Communicate about risks You can give the project risks more importance in team meetings, thus showing its importance to the team members that give them some time to discuss these risks and report new ones. Rule 4: Consider both threats and opportunities Modern risk approaches focus on positive risks and the project opportunities. They turn beneficial to the project and organization by executing the project faster, better and making it more profitable. Rule 5: Clarify ownership issues Once you have created a list of risks, the next step is to state the responsibility of the risk. A risk owner has to be present for each and every risk that is found. He has the responsibility to optimize the risk for the project. This enables the people to act and carry out tasks in order to decrease threats and enhance opportunities. Rule 6: Prioritize risks The project managers must prioritize risks that help them to deliver good results. As some risks need to be given more time, it is better to spend your time on the risks that cause the biggest losses and gains

Rule 7: Analyze risks It is essential to understand the nature of risks before jumping into conclusions. This will help you to analyze the risks. This analysis happens at different levels. A more detailed analysis shows the order of magnitude in categories like costs, lead time or product quality. The analysis can also be done by focusing on the events that precede a risk occurrence and the causes of risks. Rule 8: Plan and implement risk responses Avoiding risks means maximizing the project returns in such a way that you do not encounter a risk anymore. This could mean changing the supplier or adopting a different technology, and terminating a project once you deal with a fatal risk. Rule 9: Register project risks This rule emphasizes the concept of bookkeeping. If you maintain a risk log, it will help you to track the progress. This is also an excellent medium of communication that enables you to inform and update the team members and stakeholders about the progress. Rule 10: Track risks and associated tasks The rule 10 states that the tracking of risks is a routine schedule which is performed by the project managers. Most of them make the job very easy by integrating these risks tasks into their daily routine. These risk tasks are used in identifying and analyzing risks, and for generating, selecting and implementing responses.

2. Explain different types of discounted cash flows

(10 Marks)

Discounted Cash Flow (DCF) is a method to estimate the project, company or assets investment opportunity by means of the conception of time value for money. In DFC method, the projects value is the future estimated cash flows discounted at a rate that reflect the risk of the projected cash flow. A common practice is to use the DCF method to value companies or projects. There are three major discounted cash flow analyses for project evaluation and selection. They are: Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI) DFC is based on free cash flow which is a reliable method to cut through the unpredictability and guesstimates involved in reported earnings. The free cash flow models examine the money left for investors regardless of the cash outlay whether counted as an expense or turned into an asset on the balance sheet. Net Present Value analysis (NPV):-The Net Present Value Method is a primary capital budgeting method that uses DFC technique. The net cash flows in NPV are discounted to their present value before comparing with the capital outlay required by the investment. The difference between the net cash flow and the capital outlay amounts is the NPV. The NPV analysis considers Timing of cash flowswhile comparing different streams of cash flows. The firm must invest on projects that possess positive NPV and avoid any negative NPV projects. The project is acceptable once the net present value is zero or positive. Accepting positive NPV profits shareholders as: NPV uses Cash flows

NPV uses all the cash flows of the project NPV discounts the cash flows properly

The NPV is a standard technique meant for the financial assessment of long-term projects. On meeting the financial charges for a project, it determines the excess or shortage of cash flows in present value (PV) terms. The rule for NPV is: NPV = Present value of net cash flows

Where: Ct = the net cash receipt at the end of year Io = the initial investment outlay r = the discount rate/the required minimum rate of return on investment n = the project/investment's duration in years Internal Rate of Return:-Internal Rate of Return (IRR) is the rate at which the project NPV becomes zero. It also offers the estimated return rate of the project, assuming that the assured conditions are met. It summarizes the projects merits to a single number. It is the rate that determines whether or not an investment is worth pursuing. The loan amount fails to state the market interest rate. It is the borrower who keeps track of the received amount, the amount to be received and the due dates of repayments. The IRR finds out the market interest rate involved by considering the receipt of a given amount of cash in return for a series of promised future repayments. This is also called as implicate rate of return or economic rate of return. IRR is also considered as the growth rate a project is expected to generate. The actual return rate of a project often disagrees from its estimated IRR rate. Hence, a project with considerably higher IRR value still offers a much better opportunity of strong growth. Based on relative risk and other factors, managements need to have an IRR equal to or higher than the cost of capital. The interest rate is used to discount a series of cash flows to the NPV. Once the NPV and the cash flows are known the IRR is calculated by adding the two values and considering the percentage of the obtained value. The Internal Return Rate can be found out by using the formula below:

Where: Cn = Cash Flow n = Period which is a positive integer n = Total number of periods The profitability index is a method of capital budgeting. It holds the link connecting the investment and a proposed projects payoff. It is a variation of NPV method. Profitability Index = Present value of cash inflow Present value of cash outflow

3. What are the decisions to be considered while making capital investment? (10 Marks)
Capital Investment Decision:-The most important purpose of capital investment is to efficiently allocate the firms capital funds in order to get the best possible return. The most important phase of capital investment decision is evaluating the projects and allocating capital depending on the requirements of the projects. The capital investment decisions involve five main decisions. They are: Objective function Investment decision Financing decision Dividend decision Valuation Objective Function :-The first thing to be considered while making capital investment decisions is to exactly define the objectives of the capital investment. Traditionally, the objective of corporate finance in decision making is to maximize the value of the firm. The other objective is to maximize stockholder wealth. The objective for firms that are publicly traded is to maximise the stock price, when the stock is traded and markets are efficient. Investment Decision :-The second is the investment decision that looks at how a business must allocate resources across competing users. The discount rate, often termed as the project "hurdle rate", is critical in making an appropriate decision. The hurdle rate reflects the risk in an investment that is typically measured by instability of cash flows, and must take into account the financing mix. The hurdle rate must be higher for projects with high risks and reflect the financing mix used i.e. owners funds (equity) or borrowed money (debt). The financing mixture that maximises the hurdle rate and matches financing assets must be chosen. Financing Decision:-Appropriate financing of the investment is necessary to achieve the goals of the firm in terms of finance. The sources of financing generally comprise a combination of debt and equity. Equity financing is less risky when compared to debt financing, with respect to cash flow commitment. However, it results in a dilution of ownership, control and earnings. Management must match the financing mix to the asset that is financed considering the timing and the cash flow. Dividend Decision :-The fourth investment decision is the dividend decision that relates to how much a firm must reinvest back into operations and how much must be returned to the owners. Dividend is defined as the payment made to stockholders from the firms earnings, whether the earnings were generated in the current period or in previous periods. It is the portion of profit distributed among owners that is obtained after tax reduction. The distribution is in the form of cash, scrip, and property dividend or bonus shares. The decision to issue dividends and if issued, what amount to issue is calculated on the basis of the companys inappropriate profit and earning prospects for the next coming year. The three thoughts on dividends are: Dividends and dividend policy does not affect value if there are no tax disadvantages associated with dividends and if companies can issue stock, at no cost, to raise equity whenever needed. Dividends are bad, and increasing dividends reduces value if dividends have a tax disadvantage.

Dividends are good and increasing dividends increases value if stockholders like dividends, or dividends operate as a signal of future prospects.

Valuation:-Valuation is the final stage where all the decisions made by a firm are traced through a final value. The purpose of an investment is to get back more than what was put in. It can involve large amounts of money and a long term commitment. The project valuation makes use of: Investment Appraisal Techniques Investment Appraisal Rules

4. Explain IRR and WACC

(10 Marks)

Internal Rate of Return:-Internal Rate of Return (IRR) is the average annual return got through the life of an investment and is measured in several ways. Based on the method adopted, it can either be the effective rate of interest on a deposit or loan, or the discount rate that decreases to zero. It can also be the net present value of a stream of cash inflows and outflows. If the IRR is greater than the expected rate of return on investment, then, the project is considered as feasible. However, it is also a mechanical method (computed usually with a spreadsheet formula) and not a consistent principle. It can give wrong and misleading answers, where, two mutually-exclusive projects are to be assessed. It is also called Dollar weighted rate of return. IRR is the discount rate which makes the NPV of the cash flow equal to zero. It is regarded as the most useful aspect of a project. It is used by almost all the organizations including the World Bank in economic and financial analysis of the project. It stands for the average earning power of the money used in the project in the timeline of the project. This is also known as the yield of the investment. Here is a mathematical example, RR is that discount rate i such that n Where, t=1 Bn = Costs in every year of the project. Cn = Costs in every year of the project. n = Number of years in the project. i = Interest (discount) rate. For example, if you are investing 10000 rupees into a project in the first year and received 1,500 rupees in return, the internal rate of return would be 50% and net percent rate is 370 rupees. The discount rate would be 8%. A project is advantageous or feasible for investment, when the IRR is greater than the opportunity cost of capital. The measurement of IRR for a project includes a trial and error method. Here, alternative discount rates are used to measure the cash flow streams of the project that is being considered. This is done till the NPV of the project reaches zero. However, you

will not always get a discount rate, which makes the NPV exactly equivalent to zero through this trial and error method. We may get discount rate, which makes the NPV closer to zero or which makes it either positive or negative. Under such situation, we use the method of interpolation to infer the actual value. Interpolation is simply finding the intermediate value between two discount rates which are chosen. Weighted Average Cost of Capital :-The calculation of a companys cost of capital means the proportional weight of each category of capital. All kinds of capital sources such as common stock, preferred stock, bonds and any other long-term debt are involved in the calculation of WACC. The WACC of a firm become higher as the beta and rate of return on equity become higher. When there is an increase in WACC notes, there is a decrease in valuation and risk. The WACC equation is the rate of each capital component multiplied by its proportional weight. Then you can measure the sum.

Where, Re = Cost of equity Rd = Cost of debt E = Market value of the firm's equity D = Market value of the firm's debt V=E+D E/V = Percentage of financing that is equity D/V = Percentage of financing that is debt Tc = Corporate tax rate For example, if a firms market value of liability is 300 rupees and the market value of equity is 400 rupees. The cost of liability is 8%, the corporate tax rate is 35% and the cost of equity is 18%, the WACC of the particular firm is 400*700 x 8%*(1-35%) + 400:700 x 18% The answer is 12.5% which is the Weighted Average cost of Capital Businesses frequently discount cash flows at WACC to assess the NPV of a project. This is performed using the below formula: NPV is equal to the Present Value (PV) of the Cash Flows discounted at WACC.

5. What is sensitivity analysis?

(10 Marks)

Sensitivity Analysis:- It is also referred to as simulation analysis in which key quantitative assumptions and computations (underlying a decision, estimate, or project) are changed systematically. This is done to assess their effect on the final outcome and overall risk or in recognition of critical factors and it attempts to predict alternative outcomes of the same course of action. In comparison, contingency analysis uses qualitative assumptions, to tint different scenarios and this is also called what -if

analysis. Sensitivity report is a graph that plots the results of various assumptions of the final outcome in a sensitivity analysis exercise. This is also called tornado diagram. Application of Sensitivity Analysis Sensitivity analysis is used to determine the sensitiveness of the model to the changes in the value of the parameters and in the structure. Sensitivity is usually performed as a chain of tests in which the modeler sets different parameter values, to see the way how a change in the parameter causes a change in the dynamic behavior of the stocks. Sensitivity analysis is a useful tool in model building and in model assessment as it shows the way in which the model responds to changes in parameter values. This analysis helps to build confidence in the model. Many parameters in system dynamic models represent quantities that are very difficult or impossible to measure to a great deal of accuracy in the real world. Also, some parameter values change in the real world. Sensitivity analysis allows us to determine the accuracy which is necessary for a parameter to make the model sufficiently useful and valid. If the tests reveal that the model is insensitive, you can use an estimate rather than a value with greater precision. Sensitivity analysis can also indicate the parameter values that are reasonable to use in the model. If the model behaves as expected from real world observations, it indicates the reflection of the parameter values in the real world. Sensitivity tests help the modeler to understand dynamics of a system. As the system behavior greatly changes for a change in a parameter value we can identify a leverage point in the model. This is a parameter whose specific value can significantly influence the behavior mode of the system. Purpose of Sensitivity Analysis Sensitivity analysis is a technique by which we can investigate the impact of changes in project variables on the base-case which is a most probable outcome scenario. Normally, only adverse changes are considered in sensitivity analysis. The purpose of sensitivity analysis is: To identify the key variables which influence the project cost and benefit streams. In Water Service Providers (WSPs), we have to use sensitivity analysis. This include water demand, investment cost, Quality and Management (O&M) cost, financial revenues, economic benefits, financial benefits, water tariffs, availability of raw water and discount rates. To investigate the consequences of likely undesirable changes in those key variables. To assess the effect of such changes on the project. To identify the actions that can mitigate possible undesirable effects on the project. Performance of Sensitivity Analysis Sensitivity analysis should be carried out in a systematic manner and to meet the above purposes, we have to follow these steps: 1. Identify key variables which are sensitive to the project decision 2. Calculate the effect of the variable changes on the base-case IRR or NPV. 3. Calculate a sensitivity indicator and switching value.

4. Consider possible combinations of variables that may change at the same time in an undesirable direction. 5. Analyze the direction and level of likely changes for the key variables which are identified, in relation with the identification of the sources of change. Risks and Assumptions Risks and assumptions are statements about external and uncertain factors which may affect each of the levels in the design summary, and which have to be taken into account in the project design, through mitigating measures. Risk and assumption include the assumption that other projects will achieve their objectives. If we take positively, these statements are assumptions and if take negatively, they indicate risk areas. Example of Risks and Assumptions In water supply projects, assumptions can include: Availability of land for construction of water intake on time. The disbursement of funds on time. A stable political situation. The completion of the dam on time. The regular adjustment of water tariffs. In terms of risks, these assumptions can be formulated as follows: Non availability of land for construction. No disbursement of fund. Instability of Political scenario. Dam not ready in time. Water tariffs not regularly adjusted.

6. Analyse the parametric cost estimation

Parametric Cost Estimation:-The beginning of parametric cost estimating dates back to World War II. The war caused a demand for large number of military aircraft that far exceeded anything the aircraft industry had manufactured before. While there had been some elementary work from time to time to develop parametric techniques for predicting cost, there was no widespread use of any cost estimating technique beyond a laborious build-up of labour-hours and materials. The parametric cost estimating technique is used to measure and/or estimate the cost associated with the development, manufacture, or modification of a specified end item. The measurement is based on the technical, physical, and product or end item characteristics.

Sources of Data for Parametric Cost Estimation All data needs to be accessible, reliable and convincing before an estimating methodology can be chosen that utilizes the base data. The two types of data are: Primary data: Primary data is obtained directly from the original source and therefore is of better quality and utility. Secondary data: Secondary data is derived from primary data. It is not obtained directly from the source. The secondary data which is derived is possibly altered in the process and therefore can be of inferior value. In the estimating process, collecting the data to produce an estimate, and evaluating the data for reasonableness, is a very critical and time-consuming step. While collecting the data to integrate cost, schedule, and technical information for an estimate, it is important to gather cost information, and also the technical and schedule information. The technical and schedule characteristics of programs are important in driving cost. They also give an idea about the basis for the final cost. Type of Information Required to Develop Parametric Model are Reliable historical cost, schedule, and technical data on a set of data points Work Breakdown Structure (WBS), WBS dictionary and product tree Analysis to determine significant cost drivers Knowledge of basic statistics, modelling skills and CER development Analysis technique

Estimate Reliability:-In considering whether or not to use a specific estimate, we need to examine the track record of the cost estimator or the estimate provided b y the organization. If, in the past, the estimates have been close to facts, greater reliance may be placed on the estimate. If estimates have been significantly above or below known facts, then lower reliability should be placed on current estimates. Knowing the reliability of past estimates does not free the cost or price analyst from the obligation to review the estimate and the estimating methodology as they relate to proposal accuracy. Cost and price analysis should be tempered with product value. Knowledge of the product and its functions and use is essentially required for sound contract pricing. Value analysis is a systematic evaluation of the function of a product and its related costs and its purpose is to ensure optimum value.