Engineering economics and Industrial Management

Unit -6 INVESTMENT EVALUATION

Investment Evaluation: Total investment costs; Projects financing; Financial evaluation.

Project cost estimation

The essential of cost control system are that:

 It should be simple and easy to understand

 It should not consume excessive resources
 It must encourage honesty and commitment amongst the team

Effective cost control depends upon the following factors:

 Realistic estimates: The estimates must be so designed that the future expenditure can
be easily monitored and controlled. In many cases these estimates will be converted
into a control document which influences the project purchases format.
 Maintain contingencies: There should always be a provision for contingencies in the
estimate to meet potential uncertainties.
 Cost forecasting: Future costs that are to be incurred are equally important in the
control of project costs. Consequent to a project progress the original forecasts
contained in the estimate will be turned actual resulting in variances from that of the
bid. All such variances must be taken into account while forecasting the future
expenditure on the incomplete project.
 Considering variances: Project cost variances fall into three categories mainly:
o Design and estimating variances, which are usually the responsibility of the
contractor and lead to profit evaporation. Feedback on corrections of the
estimating the database is essential.
o Unforeseen costs which may or may not be retrievable.
o Understanding or overspending identified out of the records maintained during
the period.
 Pricing the project: Negotiate and accept on the price and future acceptable variations
in the contract before assigning the work. This may regulate and encourage the
contractor towards efficient performance.
 Manage Inventory: Orders for inventory must be made in accordance with the project
scope and complexity so that sufficient lead-time is maintained and materials will not
run out of stock. Therefore, every operation must be expedited to prevent a supplier or
subcontractor causing a delay that affects buffer stocks.
 Effective designing : Designing needs to be compatible with inputs and building.
Estimating design input is always a difficult task, especially when the task is of
innovative nature. The Project manager must also discourage designing for perfection
beyond the specifications. It is because as the designing costs play a dominant role in
the total cost of the project. If the designs are not up to the specifications and if the
design team either excels or under-scores the project objectives and scope, there is
bound to occur cost and time overruns.
 Working Capital Management: A great many projects are affected due to lack of
sufficient fluid capital during the implementation. The cash flow and working capital
are quite sensitive to all forms of delay-prolonged use of resources, delay in
completion of the work, late submission of invoices etc.
 Monitoring and Control of Costs: Monitoring and reporting of any factor such as
output or cost by measurement of actual achievement with forecast does not in itself
constitute control. It is however an essential part of the control cycle, the basis of
reporting progress to various levels of management and providing information for
updating the plans. The monitoring system should focus on the pending work of the
project and efforts should be devoted to simultaneously update the plans.
 Information Management: Simple, relevant and speedy information management
significantly affect the total control over activities and their resulting costs. In order to
manage the information and help control the costs of future activities, the project
authorities should concentrate and keep track of the following:
o Critical activities
o Activities of long duration
o Activities that consume expensive resources
The information so required by the manager about the key activities should encompass
the details such as:
 Planned start date
 Planned finish date
 Actual start date
 Quantity of work completed to date
 New estimate of quantity of work remaining
 Predicted completion time
Estimating techniques:

Estimating Project Basic estimation data required

Technique information reqd.
Global Size/capacity  Overall costs of similar projects
Location  Inflation indices
Completion date  Market trends
 General Inflation forecasts
Factorial List of main  Established factorial estimating system
installed plant items  Recent quotations for main plant items
Location  Inflation indices
Completion date  Market trends
 General Inflation forecasts

Man hours Quantities  Hourly rates

Location  Productivities
Key dates  Overheads
Simple method  Material costs
statement  Hourly rate forecasts
Completion date  Material cost forecasts
 Plant data

Unit rate Bill of quantities  Historical unit rates for similar project items
Location  Preliminaries
Completion date  Market trends
 Inflation indices
 General inflation forecasts

Operational Material Quantities  Labour rates and productivities

Programme  Plant costs and Productivities
Key dates  Overhead costs
Method statement  Material costs
Completion date  Forecasts of Material, plant, labour, capital and
operating costs
PROJECT FINANCING

Project Financing defined : Project financing can be defined as “ the financing of a

particular economic unit in which the lender is satisfied to look initially to the cash flows and
earnings of that unit as the source of funds from which the loan will be repaid and to the
assets of the economic unit as a collateral for the loan”.

Project financing does not just confine to financing for construction and procurement of
project assets but covers the following which includes significant areas of non asset financing
:

 Pre investment of project preparation expenses

 Cost of procurement of project assets
 Construction activity of the project
 Supervision, testing and acceptance of the project
 Licensing, inspection and legal services required for start up
 Training of operating staff
 Support infrastructure like roads, electric power, water supply, sewage etc
 Start up materials and supply inventory
 Working capital

The key issue for the project managers is tapping the right source of funding agency that may
not back out mid way. A project can be financed from various sources as under :

A. Equity : Sponsors, external stakeholders including foreign investors. However, only a

portion can be raised through this route. The equity can be raised either through issue
of ordinary shares or through issuance of preference shares.
B. Bonds/Debentures : The market for these instruments in India is not matured enough to
attract
C. Internal accruals : This is applicable for existing units and not for new units
D. Unsecured loans and deposits :
E. Secured term Loans either as Rupee loans or as External Commercial borrowing in
foreign currency
F. Financing of machinery by deferred Payment guarantee issued by the banks in India.
G. Working capital finance from the banks either in Rupees or in Foreign Currency.
Working capital can be raised through Commercial Paper (CP).
Project financing by the Indian Financial Institutions and Banks : Project finance is the
financing of long term infrastructure and industrial projects based on complex financial
structure where project debt and equity are used to finance the project. Usually a project
financing scheme involves a number of equity investors known as sponsors and a syndicate of
banks who provide Long Term Loans. The loans are secured by the assets of the project or
lien is given over all the assets so that the lenders have a control in case of difficulty.
Financing a project is difficult and risky particularly during the construction or
implementation stage as the cash flows will accrue only after the project is implemented.
Longer the implementation period, more is the risk. The risk is all the more for infrastructure
projects where number of approvals are required from the Government agencies and the
estimated cash flows are also not certain. The financing of huge infra or developmental
projects is sought from the FIs/commercial banks as such huge demand cannot be fully met
from other sources. Generally a Special Purpose Vehicle(SPV) is created for each project so
as to shield the other assets of the company. Only the assets of the SPV are charged to the
lenders. The project finance is therefore more complicated than the traditional financing. This
kind of financing is mostly used in mining, power, road, airport, sea port, bridge,
telecommunication projects.

Steps in term loan assessment :

i) Submission of project report

ii) Carrying out due diligence
iii) Preparing credit report
iv) Determining rate of interest
v) Preparing and submission of Term sheet

Conducting feasibility study: Based on the project report submitted by the entrepreneur, the
assessing officer conducts the feasibility study covering the following points :

 Definition of the project

o List type and quality of the products
o General business model
o Technical process, location, inputs etc.
 Relationship to the surrounding geographical areas
o Economic and social impact on the communities
o Environmental impact on the surrounding area
 Market feasibility
o Industry description-present size and future prospects and direction
o Industry competitiveness –major competitors, identify price competitiveness
o Market potential
o Sales projection-estimate the accuracy of sales projections, identify accuracy of
underlying assumptions
o Access to market outlets-identify potential buyers, product distribution system
to be followed
 Organizational/managerial feasibility
o Business structure – legal structure, whether any joint venture with a foreign
company, availability of skilled and trained business managers, outline the
consultants and vendors for the project
o Managerial personnel – market reputation of the promoters, experience of the
promoters, qualification of the promoters, Organisation structure, succession
planning etc
 Technical feasibility
o Determine facility needs
o Suitability of production technology
o Availability and suitability of location – access to raw materials, transportation,
labour, markets, utilities
o Raw materials
o Other inputs
 Financial feasibility
o Estimate the total capital requirements
 Estimate the capital needs and how it will be met
 Estimate working capital needs
 Estimate start up capital needs until revenues are realised
 Estimate contingency capital needs on account of delay and financial
factors like inflation
o Assessment of budgeted figures, cash flows, and various ratios
 Estimate the cost and revenues
 Estimate the profit margin and expected net profit
 Estimate the sales to break even
 Estimate the returns under various production, price and sales levels.
This may be on best case, typical and worst case scenarios.

 Credit rating of the borrower which is based on

o Financial risk, managerial risk based on various ratios like DER, DSCR,
Current ratios etc
o Market condition/demand position
o Industry risk
o Rating of the facility if available
o Business consideration
o Cash flows and fund flows
o Risk analysis based on sensitivity analysis
 The credit rating of the borrower may range from lowest risk to highest risk and based
on the risk of the borrower, a decision is to be taken whether to finance the borrower
or not. Or if the rating is lower, how to strengthen the bank’s loan.
 Determining Rate of interest based on credit rating of the borrower
 Term sheet has the following details
o Details of the accounts
o Financial highlights for the preceding years if existing company
o Nature of project
o Cost of project
o Means of finance
o Nature of facility
o Purpose
o Tenure of the loan
o Margin
o Rate of interest. Rate of interest is generally floating. However, in infra projects the
rate of interest may be fixed during the project implementation to be reset every year.
After the implementation period, the rate of interest would be floating linked normally
to Bank’s Prime Lending Rate
o Primary security to be charged to the lender/s. In case no main security is available as
in the case of road projects, the cash flows are captured by the lenders through an
escrow account to ensure that the repayment is automatically ensured.
o Repayment of interest and principal terms
o Upfront fee/processing charges
o Covenants
o Collateral security wherever available is charged to the lender/s
Preparation of the proposal

Disbursement

Follow up

The appraisal of a project for project financing in a nutshell involves the following ;

i) Evaluation of the management

ii) Technical feasibility
iii) Financial feasibility
iv) Risk analysis – sensitivity analysis, credit rating of the borrower
v) Collateral securities based on the credit risk

Term loan through External Commercial Borrowing (ECB): The project can also be
financed through ECB. This financing is in foreign currency and the rate of interest is floating
bench marked to LIBOR London Inter Bank Offered Rate say 400 bps over 6 month LIBOR.
The rate of interest is reset every 6 months in that case depending upon the LIBOR on the
date of resetting date. The ECB funding is done from outside India either by Indian banks
having branches abroad or by foreign banks. ECB can also be raised by issuing of bonds in
International markets and through the suppliers of the machinery and equipment. The
maximum amount that can be raised by an Indian company is USD 3 Billion Rs 16,500 Cr
appx. The repayment of ECB varies from 3 years to 8 years and for more than 8 years
maturity, Ministry of Finance approval is required. ECBs carry comparatively lower rate of
interest depending upon the credit rating of the borrower and depending upon the global
liquidity. In tight liquidity conditions, the spread (the rate charged over LIBOR) increases and
effectively the rate of interest increases in such conditions. The rate of interest is lower than
the Rupee rate of interest but there is exchange risk as the repayment is done in Rupees(if
there are no natural hedge due to exports) and therefore the borrower will be exposed to
exchange risk. The risk can be covered only up to 1 year whereas the loan period may be
from 3 years to 8 years or more.
Financial evaluation of a project is analysis of a project for checking whether project is profitable or
not before taking project in hand. We also review the project by investigating its cost, risk and return.
If we have lots of alternatives projects, then we select best project on the basis of financial evaluation.
In simple words, we uses following tools for financial evaluating of a project.

1. Evaluate the Cost of Project

First thing which we see before take the any project from financial point of view is to evaluate the
cost of project. Whether cost of project is good according to its quality or not?

2. Time Value of Investment in Money

Time value of investment in money is the importance factor which affects the decisions of financial
evaluation of any capital investment because we check the profitability of project according to time.
Today earned one rupee from any project is better than one rupee earned after one year because we
can get interest one rupee which has earned today.

3. NPV
NPV is also good tool of financial evaluation. If we have two project and we have to choose any one
best project, then we will check NPV of each project. We will accept that project whose NPV will
higher. NPV means net present value. It is excess of present value of cash inflows over present value
of cash outflow.

4. IRR
IRR is internal rate of return. It is that rate where the total present value of cash inflow is equal to the
present value of cash outflow. So, if any project gives use this earning rate, we will accept that
project.

5. Pay back period

Pay back period is not non-discounting technique of financial evaluation. In payback period, we find
the total time in which our project will give use profit equal to our initial cost. If payback period of
one project is less that payback period of second project, then we will select first project instead of
accepting second project because less payback period will be better than longer payback period for
financial evaluating of any project.

6. Risk Evaluating
We also analyze different risks relating to financial evaluation of any project. Risk may be liquidity,
solvency or interest or any other. After this, we see whether we have ability to manage these risks, if
not, then, we leave that project for projecting our business.

The process for selecting capital projects can require much thought and analysis. Many financial
evaluation methods have been employed to determine whether to accept or reject a
project. Choosing the correct method for ranking projects can be complicated when a choice must
be made between mutually exclusive projects. (When projects are mutually exclusive, only one
project can be chosen and the others must be abandoned.) The choice in this case must be made
based on the ranking of projects in order of increasing shareholder wealth. Choices are

made based on various financial evaluation methods, one of which is to discount future net cash
flows into present value terms using the cost of capital or a discount rate. Net Present Value (NPV)
and Internal Rate of Return (IRR) are the most common methods for ranking projects in terms of the
present value of future cash flows. This article will help decision makers determine which of these
two evaluation methods—NPV or IRR—is better for evaluating mutually exclusive projects.

Net Present Value Method

The Net Present Value (NPV) Method is “a method of ranking investment proposals using the
NPV, which is equal to the present value of future net cash flows, discounted at the marginal
cost of capital.”1 The equation for NPV is as follows:

In this equation, CFt represents the expected cash flow at the Period t, k represents the cost of
capital, and n is the life of the project. When NPV is zero, the project’s cash flows are great
enough to meet the project’s required rate of return and pay back the capital invested. When
NPV is positive, there are enough cash flows to pay back the project’s debt and provide a
return to shareholders. NPV is also expressed as a dollar value, which provides a good
indicator of profitability and growth in shareholder wealth.

Internal Rate of Return Method

The Internal Rate of Return (IRR) Method is “a method of ranking investment proposals using
the rate of return on an investment, calculated by finding the discount rate that equates the
present value of future cash inflows to the project’s cost” 1. It is the rate that forces NPV to
equal 0 as shown in the following equation.

The IRR is always expressed as a percentage. For a project to be acceptable under the IRR
method, the discount rate must exceed the project’s cost of capital, otherwise known as the
hurdle rate. An IRR less than the hurdle rate represents a cost to shareholders, while an IRR
greater than the hurdle rate represents a return on investment, increasing shareholder wealth.
We must first analyze the reinvestment rate assumptions for each evaluation method. The
NPV method assumes that cash flows will be reinvested near or at the project’s current cost of
capital, while the IRR method assumes that the firm can reinvest cash flows at the project’s
IRR. The assumption that the firm will reinvest its cash flows at the current cost of capital is
more realistic than the assumption that cash flows can be reinvested at the projects IRR. This
is because the IRR may not reflect the true rate at which cash flows can be reinvested. To
correct this problem, a modified IRR (MIRR) is used that incorporates the cost of capital as
the reinvestment rate; however, the NPV method still has the advantage when compared to the
MIRR method (an example is when IRR and MIRR methods return conflicting results under
certain project conditions).

The NPV and IRR methods will return conflicting results when mutually exclusive projects
differ in size, or differences exist in the timing of cash flows. When mutually exclusive
projects exhibit these attributes, their NPV profiles will cross when plotted on a graph. This
point at which they cross is defined as the crossover rate, which happens because one
project’s NPV is more sensitive to the discount rate caused by the differences in the timing of
cash flows. In most cases, utilizing either the NPV or IRR method will lead to the same
accept-or-reject decision. An exception exists when evaluating mutually exclusive projects
with crossing NPV profiles and the cost of capital is less than the crossover rate. When these
 conditions are present, the NPV and IRR results will conflict in which project to accept or
reject. Because the NPV method uses a reinvestment rate close to its current cost of capital,
the reinvestment assumptions of the NPV method are more realistic than those associated with
the IRR method.

NPV also has an advantage over IRR when a project has non-normal cash flows. Non-normal
cash flows exist if there is a large cash outflow during or at the end of the project. The
presence of non-normal cash flows will lead to multiple IRRs. Hence, the IRR method cannot
be employed in the evaluation process. Mathematically, this problem will not occur if the
NPV method is employed. The NPV method will always lead to a singular correct accept-or-
reject decision.

In conclusion, NPV is a better method for evaluating mutually exclusive projects than the IRR
method. The NPV method employs more realistic reinvestment rate assumptions, is a better
indicator of profitability and shareholder wealth, and mathematically will return the correct
accept-or-reject decision regardless of whether the project experiences non-normal cash flows
or if differences in project size or timing of cash flows exist.

FINANCIAL EVALUATION TECHNIQUES

The financial department of a company does not deal with the daily cash flow of the business.
Instead, it deals with the long term financial planning of the company. Financial analysts use certain
techniques to determine how to plan for financial goals and how the company should structure its
budgeting in the accounting department to reach a stronger financial standing in the eyes of investors
and shareholders.

Net Worth

One of the main evaluations the financial department conducts is an assessment of the company’s net
worth, which is highlighted in the company’s annual report with the hopes of attracting potential
investors and stockholders. The net worth of a business is the total sum of the liabilities subtracted
from the owned asset values of the business. If the company has a negative worth due to outstanding
banking loans and unpaid taxes, the financial evaluation may lead analysts to create a plan to lower
the liabilities and increase the assets.

Monthly Expense Budgets

A business has a monthly operational budget that shows how much the business has in income and
how much it has in expenses. A financial evaluation of the company can include analyzing the
monthly budget to see how the business is spending money. To earn a profit, the company must spend
less than it is earning to have a monthly profit. One financial evaluation technique is to add up
everything the company is spending on a monthly basis and compare it to the income. Financial
planning and adjustment may be needed if the business has a negative income each month.
Financial Plans and Goals

Another evaluation technique is to analyze the current financial plans and its goals. A financial plan is
constructed around a set amount of financial goals that indicate what the company wants to achieve.
Business owners may set unrealistic goals, so one financial evaluation technique is to look over the
financial plan and determine whether the goals are realistic based on the income of the business and
overall spending.

Market Growth and Potential

The financial standing of a company can be improved by changing the company’s approach to the
market. Financial analysts may spend time analyzing the market in terms of its growth potential for
the particular products or services the business offers. If the company already has many direct
competitors on the market, the financial analysts may see earning potential if the company takes the
product development or services in a slightly different direction. This type of financial evaluation
technique is a pre-planning technique.