2.Project Planning And Capital Budgeting Flashcards
Theory questions
Distinguish between Net Present-value and Internal Rate of Return.
NPV and IRR: NPV and IRR methods differ in the sense that the results regarding the choice
of an asset under certain circumstances are mutually contradictory under two methods. IN
case of mutually exclusive investment projects, in certain situations, they may give
contradictory results such that if the NPV method finds one proposal acceptable, IRR favours
another. The different rankings given by the NPV and IRR methods could be due to size
disparity problem, time disparity problem and unequal expected lives.
The net present value is expressed in financial values whereas internal rate of return (IRR) is
expressed in percentage terms.
In net present value cash flows are assumed to be re-invested at cost of capital rate. In IRR
re-investment is assumed to be made at IRR rates.
Write short note on Certainty Equivalent Approach.
Certainty Equivalent Approach (CE): This approach recognizes risk in capital budgeting
analysis by adjusting estimated cash flows and employs risk free rate to discount the adjusted
cash-flows. Under this method, the expected cash flows of the project are converted to
equivalent riskless amounts. The greater the risk of an expected cash flow, the smaller the
certainty equivalent values for receipts and longer the CE value for payment. This approach is
superior to the risk adjusted discounted approach as it can measure risk more accurately.
This is yet another approach for dealing with risk in capital budgeting to reduce the forecasts
of cash flows to some conservative levels. In certainty Equivalent approach we incorporate
risk to adjust the cash flows of a proposal so as to reflect the risk element. The certainty
Equivalent approach adjusts future cash flows rather than discount rates. This approach
explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit
and likely to be inconsistent from one investment to another.
What is the sensitivity analysis in Capital Budgeting?
Sensitivity Analysis in Capital Budgeting: Sensitivity analysis is used in Capital budgeting
for more precisely measuring the risk. It helps in assessing information as to how sensitive are
the estimated parameters of the project such as cash flows, discount rate, and the project life
to the estimation errors. Future being always uncertain and estimations are always subject to
error, sensitivity analysis takes care of estimation errors by using a number of possible
outcomes in evaluating a project. The methodology adopted in sensitivity analysis is to
evaluate a project by using a number of estimated cash flows so as to provide to the decision
maker an insight into the variability of outcome. Thus, it is a technique of risk analysis which
studies the responsiveness of a criterion of merit like NPV or IRR to variation in underlying
factors like selling price, quantity sold, returns from an investment etc.
Sensitivity analysis answers questions like,
(i) What happens to the present value (or some other criterion of merit) if flows are, say
` 50,000 than the expected ` 80,000?
(ii) What will happen to NPV if the economic life of the project is only 3 years rather than
expected 5 years?
Therefore, wherever there is an uncertainty, of whatever type, the sensitivity analysis plays a
crucial role. However, it should not be viewed as the method to remove the risk or uncertainty,
it is only a tool to analyse and measure the risk and uncertainty. In terms of capital budgeting
the possible cash flows are based on three assumptions:
(a) Cash flows may be worst (pessimistic)
(b) Cash flows may be most likely.
(c) Cash flows may be most optimistic.
Sensitivity analysis involves three steps
(1) Identification of all those variables having an influence on the project’s NPV or IRR.
(2) Definition of the underlying quantitative relationship among the variables.
(3) Analysis of the impact of the changes in each of the variables on the NPV of the project.
The decision maker, in sensitivity analysis always asks himself the question – what if?
Write short note on Social Cost Benefit analysis.
Social Cost Benefit Analysis: It is increasingly realised that commercial evaluation of
projects is not enough to justify commitment of funds to a project especially when the project
belongs to public utility and irrespective of its financial viability it needs to be implemented in
the interest of the society as a whole. Huge amount of funds are committed every year to
various public projects of all types–industrial, commercial and those providing basic
infrastructure facilities. Analysis of such projects has to be done with reference to the social
costs and benefits since they cannot be expected to yield an adequate commercial rate of
return on the funds employed at least during the short period. A social rate of return is more
important. The actual costs or revenues do not necessarily reflect the monetary measurement
of costs or benefits to the society. This is because the market price of goods and services are
often grossly distorted due to various artificial restrictions and controls from authorities, hence
a different yardstick has to be adopted for evaluating a particular project of social importance
and its costs and benefits are valued at ‘opportunity cost’ or shadow prices to judge the real
impact of their burden as costs to the society. Thus, social cost benefit analysis conducts a
monetary assessment of the total cost and revenues or benefits of a project, paying particular
attention to the social costs and benefits which do not normally feature in conventional
costing.
United Nations Industrial Development Organisation (UNIDO) and Organisation of Economic
Cooperation and Development (OECD) have done much work on Social Cost Benefit analysis.
A great deal of importance is attached to the social desirability of projects like employment
generation potential, value addition, foreign exchange benefit, living standard improvement
etc. UNIDO and OECD approaches need a serious consideration in the calculation of benefits
and costs to the society. This technique has got more relevance in the developing countries
where public capital needs precedence over private capital.
Comment briefly on the social cost benefit analysis in relation to evaluation of an Industrial
project.
Social Cost-Benefit Analysis of Industrial Projects: This refers to the moral responsibility
of both PSU and private sector enterprises to undertake socially desirable projects – that is,
the social contribution aspect needs to be kept in view.
Industrial capital investment projects are normally subjected to rigorous feasibility analysis and
cost benefit study from the point of view of the investors. Such projects, especially large ones
often have a ripple effect on other sections of society, local environment, use of scarce
national resources etc. Conventional cost-benefit analysis ignores or does not take into
account or ignores the societal effect of such projects. Social Cost Benefit (SCB) is
recommended and resorted to in such cases to bring under the scanner the social costs and
benefits.
SCB sometimes changes the very outlook of a project as it brings elements of study which are
unconventional yet very relevant. In a study of a famous transportation project in the UK from
a normal commercial angle, the project was to run an annual deficit of more than 2 million
pounds. The evaluation was adjusted for a realistic fare structure which the users placed on
the services provided which changed the picture completely and the project got justified. Large
public sector/service projects especially in under-developed countries which would get
rejected on simple commercial considerations will find justification if the social costs and
benefits are considered.
SCB is also important for private corporations who have a moral responsibility to undertake
socially desirable projects, use scarce natural resources in the best interests of society,
generate employment and revenues to the national exchequer.
Indicators of the social contribution include
(a) Employment potential criterion;
(b) Capital output ratio – that is the output per unit of capital;
(c) Value added per unit of capital;
(d) Foreign exchange benefit ratio.
Write a brief note on project appraisal under inflationary conditions.
Project Appraisal under Inflationary Conditions: Project Appraisal normally involves
feasibility evaluation from technical, commercial, economic and financial aspects. It is
generally an exercise in measurement and analysis of cash flows expected to occur over the
life of the project. The project cash outflows usually occur initially and inflows come in the
future.
During inflationary conditions, the project cost increases on all heads viz. labour, raw material,
fixed assets such as equipments, plant and machinery, building material, remuneration of
technicians and managerial personnel etc. Beside this, inflationary conditions erode
purchasing power of consumers and affect the demand pattern. Thus, not only cost of
production but also the projected statement of profitability and cash flows are affected by the
change in demand pattern. Even financial institutions and banks may revise their lending rates
resulting in escalation in financing cost during inflationary conditions. Under such
circumstances, project appraisal has to be done generally keeping in view the following
guidelines which are usually followed by government agencies, banks and financial
institutions.
(i) It is always advisable to make provisions for cost escalation on all heads of cost, keeping
in view the rate of inflation during likely period of delay in project implementation.
(ii) The various sources of finance should be carefully scruitinised with reference to probable
revision in the rate of interest by the lenders and the revision which could be effected in
the interest bearing securities to be issued. All these factors will push up the cost of
funds for the organization.
(iii) Adjustments should be made in profitability and cash flow projections to take care of the
inflationary pressures affecting future projections.
(iv) It is also advisable to examine the financial viability of the project at the revised rates and
assess the same with reference to economic justification of the project. The appropriate
measure for this aspect is the economic rate of return for the project which will equate
the present value of capital expenditures to net cash flows over the life of the projects.
The rate of return should be acceptable which also accommodates the rate of inflation
per annum.
(v) In an inflationary situation, projects having early payback periods should be preferred
because projects with long payback period are more risky.
Under conditions of inflation, the project cost estimates that are relevant for a future date will
suffer escalation. Inflationary conditions will tend to initiate the measurement of future cash
flows. Either of the following two approaches may be used while appraising projects under
such conditions:
(i) Adjust each year’s cash flows to an inflation index, recognising selling price increases
and cost increases annually; or
(ii) Adjust the ‘Acceptance Rate’ (cut-off) suitably retaining cash flow projections at current
price levels.
An example of approach (ii) above can be as follows:
Normal Acceptance Rate : 15.0%
Expected Annual Inflation : 5.0%
Adjusted Discount Rate : 15.0 × 1.05 or 15.75%
It must be noted that measurement of inflation has no standard approach nor is easy.
This makes the job of appraisal a difficult one under such conditions.
What is Capital rationing?
Capital Rationing: When there is a scarcity of funds, capital rationing is resorted to. Capital
rationing means the utilization of existing funds in most profitable manner by selecting the
acceptable projects in the descending order or ranking with limited available funds. The firm
must be able to maximize the profits by combining the most profitable proposals. Capital
rationing may arise due to (i) external factors such as high borrowing rate or non-availability of loan funds due to constraints of Debt-Equity Ratio; and (ii) Internal Constraints Imposed by
management. Project should be accepted as a whole or rejected. It cannot be accepted and
executed in piecemeal.
IRR or NPV are the best basis of evaluation even under Capital Rationing situations. The
objective is to select those projects which have maximum and positive NPV. Preference
should be given to interdependent projects. Projects are to be ranked in the order of NPV.
Where there is multi-period Capital Rationing, Linear Programming Technique should be used
to maximize NPV. In times of Capital Rationing, the investment policy of the company may not
be the optimal one.
In nutshell Capital Rationing leads to:
(i) Allocation of limited resources among ranked acceptable investments.
(ii) This function enables management to select the most profitable investment first.
(iii) It helps a company use limited resources to the best advantage by investing only in the
projects that offer the highest return.
(iv) Either the internal rate of return method or the net present value method may be used in
ranking investments.
Explain the concept ‘Zero date of a Project’ in project management.
Zero Date of a Project means a date is fixed from which implementation of the project begins.
It is a starting point of incurring cost. The project completion period is counted from the zero
date. Pre-project activities should be completed before zero date. The pre-project activities
should be completed before zero date. The pre-project activities are:
a. Identification of project/product
b. Determination of plant capacity
c. Selection of technical help/collaboration
d. Selection of site.
e. Selection of survey of soil/plot etc.
f. Manpower planning and recruiting key personnel
g. Cost and finance scheduling.
What are the steps for Simulation Analysis?
Steps for simulation analysis.
1. Modelling the project- The model shows the relationship of N.P.V. with parameters and
exogenous variables. (Parameters are input variables specified by decision maker and
held constant over all simulation runs. Exogenous variables are input variables, which
are stochastic in nature and outside the control of the decision maker).
2. Specify values of parameters and probability distributions of exogenous variables.
3. Select a value at random from probability distribution of each of the exogenous variables.
4. Determine N.P.V. corresponding to the randomly generated value of exogenous variables
and pre-specified parameter variables.
5. Repeat steps (3) & (4) a large number of times to get a large number of simulated
N.P.V.s.
6. Plot frequency distribution of N.P.V.
What is simulation analysis and how it is beneficial?
Simulation is the exact replica of the actual situation. To simulate an actual situation, a model
shall be prepared. The simulation Analysis is a technique, in which infinite calculations are
made to obtain the possible outcomes and probabilities for any given action.
Monte Carlo simulation ties together sensitivities and probability distributions. The method
came out of the work of first nuclear bomb and was so named because it was based on
mathematics of Casino gambling. Fundamental appeal of this analysis is that it provides
decision makers with a probability distribution of NPVs rather than a single point estimates of
the expected NPV.
This analysis starts with carrying out a simulation exercise to model the investment project. It
involves identifying the key factors affecting the project and their inter relationships. It involves
modeling of cash flows to reveal the key factors influencing both cash receipt and payments
and their inter relationship.
This analysis specifies a range for a probability distribution of potential outcomes for each of
model’s assumptions.
1. Modelling the project: The model shows the relationship of NPV with parameters and
exogenous variables. (Parameters are input variables specified by decision maker and
held constant over all simulation runs. Exogenous variables are input variables, which
are stochastic in nature and outside the control of the decision maker).
2. Specify values of parameters and probability distributions of exogenous variables.
3. Select a value at random from probability distribution of each of the exogenous variables.
4. Determine NPV corresponding to the randomly generated value of exogenous variables
and pre-specified parameter variables.
5. Repeat steps (3) & (4) a large number of times to get a large number of simulated NPVs.
6. Plot probability distribution of NPVs and compute a mean and Standard Deviation of
returns to gauge the project’s level of risk.
Advantages of Simulation Analysis:
(1) We can predict all type of bad market situation beforehand.
(2) Handle problems characterized by
(a) numerous exogenous variables following any kind of distribution.
(b) Complex inter-relationships among parameters, exogenous variables and
endogenous variables. Such problems defy capabilities of analytical methods.
(c) Compels decision maker to explicitly consider the inter-dependencies and
uncertainties featuring the project.
Explain in brief the contents of a Project Report.
The following aspects need to be taken into account for a Project Report -
1. Promoters: Their experience, past records of performance form the key to their selection
for the project under study.
2. Industry Analysis: The environment outside and within the country is vital for determining
the type of project one should opt for.
3. Economic Analysis: The demand and supply position of a particular type of product under
consideration, competitor’s share of the market along with their marketing strategies,
export potential of the product, consumer preferences are matters requiring proper
attention in such type of analysis.
4. Cost of Project: Cost of land, site development, buildings, plant and machinery, utilities
e.g. power, fuel, water, vehicles, technical know how together with working capital
margins, preliminary/pre-operative expenses, provision for contingencies determine the
total value of the project.
5. Inputs: Availability of raw materials within and outside the home country, reliability of
suppliers cost escalations, transportation charges, manpower requirements together with
effluent disposal mechanisms are points to be noted.
6. Technical Analysis: Technical know-how, plant layout, production process, installed and
operating capacity of plant and machinery form the core of such analysis.
7. Financial Analysis: Estimates of production costs, revenue, tax liabilities profitability and
sensitivity of profits to different elements of costs and revenue, financial position and
cash flows, working capital requirements, return on investment, promoters contribution
together with debt and equity financing are items which need to be looked into for
financial viability.
8. Social Cost Benefit Analysis: Ecological matters, value additions, technology
absorptions, level of import substitution form the basis of such analysis.
9. SWOT Analysis: Liquidity/Fund constraints in capital market, limit of resources available
with promoters, business/financial risks, micro/macro economic considerations subject to
government restrictions, role of Banks/Financial Institutions in project assistance, cost of
equity and debt capital in the financial plan for the project are factors which require
careful examinations while carrying out SWOT analysis.
10. Project Implementation Schedule: Date of commencement, duration of the project, trial
runs, cushion for cost and time over runs and date of completion of the project through
Network Analysis have all to be properly adhered to in order to make the project feasible.
