PROJECT MANAGEMENT. Ram Setu It is a bridge, built by Rama's army of monkeys across the sea, under the leadership of Hanuman and Under the engineering

PROJECT MANAGEMENTPROJECT MANAGEMENT

Ram SetuRam Setu

It is a bridge, built by Rama's army of monkeys across the sea, under the leadership of Hanuman and

Under the engineering supervision of Nal.

Nal, the engineer, was also a monkey ! He was the son of 'Visvakarma', the engineer of Gods in the heaven.

DEFINITIONSDEFINITIONS

According to Harrison, “ Project is a non According to Harrison, “ Project is a non routine, non repetitive, one-off undertaking, routine, non repetitive, one-off undertaking, with well defined time, financial and technical with well defined time, financial and technical performance goal;”performance goal;”

According to Project Management Institute According to Project Management Institute (PMI), “Project can be defined as a temporary (PMI), “Project can be defined as a temporary endeavor undertaken to accomplish a unique endeavor undertaken to accomplish a unique objective at goal.”objective at goal.”

CHARACTERISTICS OF PROJECTCHARACTERISTICS OF PROJECT

Objectivity or temporarinessObjectivity or temporariness Uniqueness (Non-routine activity)Uniqueness (Non-routine activity) Multidisciplinary (Demands team work)Multidisciplinary (Demands team work) Involve focused ResourcesInvolve focused Resources Life cycle with definite time limitLife cycle with definite time limit Risk and uncertaintyRisk and uncertainty Change (In response to environment)Change (In response to environment)

TYPES OF PROJECTSTYPES OF PROJECTS

Construction projectsConstruction projects

Research projectsResearch projects

Reengineering projectsReengineering projects

Procurement projectsProcurement projects

Business implementation projectsBusiness implementation projects

Miscellaneous typesMiscellaneous types

Project vis-à-vis Normal Business Operation

Projects have a start, a middle and an end making them Projects have a start, a middle and an end making them different from operational activities which are performed different from operational activities which are performed regularly over time regularly over time

The temporary nature of projects stands in contrast with normal business operations, which are repetitive, permanent, or semi-permanent functional activities to produce products or services.

It is typically created once, it is temporary, and it is specific.

88

Projects versus OperationsProjects versus Operations

ProjectsProjects Performed by peoplePerformed by people Constrained by limited Constrained by limited

resourcesresources Planned, executed and Planned, executed and

controlledcontrolled TemporaryTemporary UniqueUnique

OperationsOperations Performed by peoplePerformed by people Constrained by limited Constrained by limited

resourcesresources Planned, executed and Planned, executed and

controlledcontrolled OngoingOngoing RepetitiveRepetitive

Five functions of ProjectFive functions of Project There are five functions of project based There are five functions of project based

management: management: Organisation, scope, Organisation, scope, And And

Quality , Cost and Time. Quality , Cost and Time.

These are an enhanced version of the traditional These are an enhanced version of the traditional

quality, cost and time model quality, cost and time model adding the organisational context and the scope of the project..

A project also consumes resources (whether people, cash, materials, or time), and it has funding limits.

Project OrganizationsProject Organizations A project organization is a temporary thing. It will only exist from the

projects start until its end. Organization structures are Functional Organization.Functional Organization.

This is most suited whereThis is most suited where- Solution of technical problems is important.

- Integration of different functional units’ work is not necessary.

- Stable environment.

-Success depends on application of narrow technical know-how.

Project OrganizationProject Organization This is most suited whenThis is most suited when

- A small, self-sufficient and full-time team is required where the team - A small, self-sufficient and full-time team is required where the team leader is like leader is like an entrepreneur. Leader has full responsibility over the an entrepreneur. Leader has full responsibility over the project. project.

- Functional units are stable, provide support to project teams. - Functional units are stable, provide support to project teams.

Matrix OrganizationMatrix Organization This is a hybrid form that combines both characteristics of functional and This is a hybrid form that combines both characteristics of functional and

project organization forms.project organization forms.

••

What is Project Scope ?What is Project Scope ?

The project scope is the definition of what the project is supposed to accomplish and the budget (of time and money) that has been created to achieve these objectives.

It is absolutely imperative that any change to the scope of the project have a matching change in budget, either time or resources.

IDEA GENERATION IDEA GENERATION OR OR

IDENTIFICATION OF INVESTMENT OPPORTUNITIESIDENTIFICATION OF INVESTMENT OPPORTUNITIES

Idea generation is the process of grouping logical thoughts Idea generation is the process of grouping logical thoughts based on eitherbased on either

Significant technological breakthrough, Significant technological breakthrough,

OrOr

Combining existing fields of technology or offerings which Combining existing fields of technology or offerings which can cater to a presently unmet need or to serve a market where can cater to a presently unmet need or to serve a market where demand exceeds supply through better quality or lower prices.demand exceeds supply through better quality or lower prices.

IMPORTANCE IMPORTANCE OF OF

IDEA GENERATIONIDEA GENERATION

Important for continuous growth of Important for continuous growth of organization.organization.

Survival in the competitive market.Survival in the competitive market. Contribution towards development of society.Contribution towards development of society.

New Concept IdeationNew Concept Ideation 1414

Generate high impact ideas

for high-impact problems/opportunities

Convert best ideas into

high impact projects

Profitable

Growth

Ideation

Convert best projects into

high impact products

Idea Prioritization

Project Managemen

t

Identify high impact

problems/opportunities

Voice of the

Customer

Integrate with the business objectives

Ideation Journey

New Concept IdeationNew Concept Ideation 1515

Ideation

Input Ideas:• Many• Crazy• Stupid• Bad• Random

Output Ideas:• Few• New• Different• Good• Out-of-the-box

Project Management

Ideation is a formal,

structured process

Output ideas ready to startdevelopment

projects.

Transform Inputs to Outputs

Transform Inputs to Outputs

What is Ideation?

To Handle Ideation ChallengeTo Handle Ideation Challenge The Stage-Gate model enables detailed project The Stage-Gate model enables detailed project

portfolios control throughportfolios control through Gradual budget allocationGradual budget allocation

Prioritization of resourcesPrioritization of resources

Project Risk ManagementProject Risk Management

... because bad projects are hard to Eliminate!

1616

A Typical Stage-Gate concept A Typical Stage-Gate concept applied to a Developmentapplied to a Development

IDEAS MARKET

Technology Development Product Development

Idea Concept Application Stages

Gates

1717

© Cone Advisor© Cone Advisor

1818

Four Goals of an Ideation Process:

To stimulate large improvements in -

1. Quality and volume of new ideas,- (More good ideas per minute.)

2. Idea-to-project hit-rate,- (More good ideas end up in products).

3. Cross-linking of ideas to create new opportunities,- (Generate many new ideas in parallel – feed off each other.)

4. Visibility of plans, activities, results, and methods,- (Target Low hanging fruits. Visibility in

improvements is a motivator by itself)

Need systematic idea generation and

prioritization processes.

Need systematic idea generation and

prioritization processes.

Screening of Project AlternativesScreening of Project Alternatives

Preliminary Screening:Preliminary Screening: Compatibility with the PromotersCompatibility with the Promoters

It matches with the abilities of the promoterIt matches with the abilities of the promoter It is accessible to himIt is accessible to him It offers him the prospect of high returnIt offers him the prospect of high return

Consistency with Government PrioritiesConsistency with Government Priorities The project idea must be feasible given the given national The project idea must be feasible given the given national

goals and government regulatory framework.goals and government regulatory framework.

Availability of inputsAvailability of inputs Capital requirementCapital requirement and other technical and other technical material requirementsmaterial requirements

are within the manageable limits.are within the manageable limits.

Screening……Screening……

Adequacy of the MarketAdequacy of the Market The size of the present market should be adequate with The size of the present market should be adequate with

reasonablereasonable potential for growth potential for growth

Reasonableness of CostReasonableness of Cost Cost structure of the proposed project should be such asCost structure of the proposed project should be such as to to

generate acceptable profitgenerate acceptable profit with the expected price. with the expected price.

Acceptability of Risk levelAcceptability of Risk level Associated risk quotient Associated risk quotient from technological changesfrom technological changes or from or from

substitutes should be reasonable.substitutes should be reasonable.

Streamlining the process of Streamlining the process of Preliminary ScreeningPreliminary Screening

Translated into a Translated into a project rating indexproject rating index, ,

Using suitable project rating factorsUsing suitable project rating factors

Building weightage for each factors to indicate relative importanceBuilding weightage for each factors to indicate relative importance

5 point rating scale is used to rate each factors5 point rating scale is used to rate each factors

Factor scores are derived through multiplicationsFactor scores are derived through multiplications

Finally the factor scores are added to get the total score (project Finally the factor scores are added to get the total score (project rating index) for each project.rating index) for each project.

Example of a Project Rating Example of a Project Rating IndexIndex

Factor Factor weight

Ratings Total Score

5 4 3 2 1

Entrepreneur’s vision and firm’s strength

0.25 √ 1.25

Consistency with government priorities

0.10 √ 0.20

Input requirements-Capital need and Know-how access

0.15 √ 0.45

Size of the market- present and future potentials

0.20 √ 0.80

Cost structure of the product and its profit potentials

0.20 √ 0.60

Risk quotient in terms of the project’s sustainability

0.10 √ 0.20

Rating Index = 3.50

Project Management Basics

No matter what the type of project, project management typically follows the same pattern:

Defining &

Initiation Planning Execution Monitoring &

Control Closure

The Project Management ProcessThe Project Management Process

The project management process means planning the work and then The project management process means planning the work and then working the plan.working the plan. 7 steps7 steps of planning of planning

1. Clearly1. Clearly define define the project objective. the project objective.

2. 2. Divide and subdivideDivide and subdivide the project scope into major “pieces” the project scope into major “pieces”

3. Define the specific 3. Define the specific activities for each piece (WBS)activities for each piece (WBS)

4. Graphically 4. Graphically portray the activitiesportray the activities that need to be performed from that need to be performed from each work package in order to accomplish the project objective – in each work package in order to accomplish the project objective – in the form of the form of network diagram.network diagram.

5. 5. Make a time estimateMake a time estimate for how long it will take to complete each for how long it will take to complete each activityactivity

– – and the and the resources neededresources needed..

6. Make a 6. Make a cost estimatecost estimate for each activity. for each activity.

7. 7. Calculate a project schedule and budgetCalculate a project schedule and budget to determine whether the to determine whether the project can be completed within the required time, with the allotted project can be completed within the required time, with the allotted funds, and with the available resources.funds, and with the available resources.

2525

Project ManagementProject Management

Role of Project ManagementRole of Project Management

Identifying requirementsIdentifying requirements Establishing clear and achievable objectivesEstablishing clear and achievable objectives Balancing the competing demands for quality, Balancing the competing demands for quality,

scope, time and costscope, time and cost

Work Breakdown StructureWork Breakdown Structure It is foundation of project planningIt is foundation of project planning

It defines It defines tasks that can be completed independent of other tasks,tasks that can be completed independent of other tasks, facilitating resource allocation, assignment of responsibilities and facilitating resource allocation, assignment of responsibilities and measurement and control of the projectmeasurement and control of the project

It is followed byIt is followed by

identification of dependencies and identification of dependencies and

estimation of activity durationsestimation of activity durations

It can be used to identity the tasks in the CPM and PERT It can be used to identity the tasks in the CPM and PERT 2626

darla/smbs/vitdarla/smbs/vit 2727

Project Planning Project Planning

Resource Availability and/or LimitsResource Availability and/or Limits Due date, late penalties, early completion Due date, late penalties, early completion

incentivesincentives BudgetBudget

Activity InformationActivity Information Identify all required activitiesIdentify all required activities Estimate the resources required (time) to complete Estimate the resources required (time) to complete

each activityeach activity Immediate predecessor(s) to each activity needed to Immediate predecessor(s) to each activity needed to

create interrelationshipscreate interrelationships


Project NetworkProject Network

• Network analysis is the general name given to certain specific techniques which can be used for the planning, management and control of projects


• ActivityActivity– A task or a certain amount of work required in the A task or a certain amount of work required in the

projectproject– Requires time to completeRequires time to complete– Represented by an arrowRepresented by an arrow

• Dummy ActivityDummy Activity– Indicates only precedence relationshipsIndicates only precedence relationships– Does not require any time of effortDoes not require any time of effort

2929


EventEvent Signals the beginning or ending of an activitySignals the beginning or ending of an activity Designates a point in timeDesignates a point in time Represented by a circle (node)Represented by a circle (node)

NetworkNetwork Shows the sequential relationships among Shows the sequential relationships among

activities using nodes and arrowsactivities using nodes and arrows

Project Network


Activity-on-node (AON)Activity-on-node (AON)

nodes represent activities, and arrows show nodes represent activities, and arrows show precedence relationshipsprecedence relationships

Activity-on-arrow (AOA)Activity-on-arrow (AOA)

arrows represent activities and nodes are arrows represent activities and nodes are events for points in timeevents for points in time

3131


Graph or bar chart with a bar for each project activity that shows passage of time

ProvidesProvides visual display of project schedule of project schedule

Gantt Chart


History of CPM/PERTHistory of CPM/PERT

Critical Path Method (CPM)Critical Path Method (CPM)

E I Du Pont de Nemours & Co. (1957) for E I Du Pont de Nemours & Co. (1957) for construction of new chemical plant and construction of new chemical plant and maintenance shut-downmaintenance shut-down

DeterministicDeterministic task times task times Activity-on-nodeActivity-on-node network construction network construction Repetitive nature of jobsRepetitive nature of jobs

PERT PERT

Project Evaluation and Review Technique (PERT)Project Evaluation and Review Technique (PERT)

U S Navy (1958) for the POLARIS missile programU S Navy (1958) for the POLARIS missile program

Multiple Multiple task time estimates (probabilistictask time estimates (probabilistic nature) nature)

Activity-on-arrowActivity-on-arrow network construction network construction

Non-repetitive jobs (R & D work)Non-repetitive jobs (R & D work)

3434

Arrows and Nodes in Arrows and Nodes in Project NetworkProject Network

Use of nodes and arrows (PERT)Use of nodes and arrows (PERT)

ArrowsArrows An arrow leads from tail to head An arrow leads from tail to head directionally to indicatedirectionally to indicate ACTIVITY,ACTIVITY, a time a time consuming effort that is required to perform a consuming effort that is required to perform a part of the work.part of the work.

NodesNodes A node is represented by a circle to A node is represented by a circle to indicate indicate EVENT EVENT,, a point in time where one or a point in time where one or more activities start and/or finish.more activities start and/or finish.

3535

Arrows - as Activities in PERTArrows - as Activities in PERT

ActivitiesActivities are pieces of Work that are pieces of Work that consumes time. May or may not consume consumes time. May or may not consume resources ( Waiting is an Activity which resources ( Waiting is an Activity which does not consume resources).does not consume resources).

Used in PERT as Activity on Arrow Used in PERT as Activity on Arrow

(AOA).(AOA).

3636

Nodes- as Activity in CPMNodes- as Activity in CPM

NodesNodes are used to denote Activities are used to denote Activities in CPM in CPM networkingnetworking and the Arrow is used to denote and the Arrow is used to denote the inter relationship and the the inter relationship and the approach is approach is called AON (Activity on Node).called AON (Activity on Node).

3737


AOA Project Network for HouseAOA Project Network for House

32 0

1

31 1

11 2 4 6 7

3

5

Lay foundation

Design house and obtain financing

Order and receive materials

Dummy

Finish work

Select carpet

Select paint

Build house

AON Project Network for House

13

22

43

31 5

1

61

71Start

Design house and obtain financing

Order and receive materials

Select paintSelect carpet

Lay foundations Build house

Finish work


Situations in network diagramSituations in network diagramA

B

C

A must finish before either B or C can start

A

B

Cboth A and B must finish before C can start

D

C

B

Aboth A and B must finish before either of C or D can start

A

C

B

D

Dummy

A must finish before B can start

both A and C must finish before D can start


Concurrent ActivitiesConcurrent Activities

2 3

Lay foundationLay foundation

Order materialOrder material

(a)(a) Incorrect precedence Incorrect precedence relationshiprelationship

(b)(b) Correct precedence Correct precedence relationshiprelationship

3

42

DummyDummyLay Lay foundationfoundation

Order materialOrder material

11

22 00

4141

PERT/CPM ChartPERT/CPM Chart

Task. A project has been defined to contain the following list of activities along with their required times for completion:

Activity No

Activity Expected completion time

Dependency

1. Requirements collection 5 -

2. Screen design 6 1

3. Report design 7 1

4. Database design 2 2,3

5. User documentation 6 4

6. Programming 5 4

7. Testing 3 6

8. Installation 1 5,7

a. Draw a Network chart for the activities. b. Calculate the earliest expected completion time. c. Show the critical path.

4242

PERT/CPM Chart (cont’d)PERT/CPM Chart (cont’d)

Network chart for the activities. Using information from the table, show the sequence of activities.

1

2

3

4

5

6

8

7

4343

PERT/CPM Chart (cont’d)PERT/CPM Chart (cont’d)

1

2

3

4

5

6

8

7

b. Calculate the earliest expected completion time. 1. Using information from the table, indicate expected completion time for each activity.

5

6

7

2

6

5 3

1

2. Calculate earliest expected completion time for each activity (TE) and the entire project.Hint: the earliest expected completion time for a given activity is determined by summing the expected completion time of this activity and the earliest expected completion time of the immediate predecessor. Rule: if two or more activities precede an activity, the one with the largest TE is used in calculation (e.g., for activity 4, we will use TE of activity 3 but not 2 since 12 > 11).

TE = 5

TE = 11

TE = 12

TE = 14

TE = 20

TE = 19 TE = 22

TE = 23

4444

PERT/CPM Chart (the end)PERT/CPM Chart (the end)

1

2

3

4

5

6

8

7

5

6

2

6

5 3

1

TE = 5

TE = 11

TE = 12

TE = 14

TE = 20

TE = 19 TE = 22

TE = 23

c. Show the critical path.The critical path represents the shortest time, in which a project can be completed. Any activity on the critical path that is delayed in completion, delays the entire project. Activities not on the critical path contain slack time and allow the project manager some flexibility in scheduling.


Network exampleNetwork exampleIllustration of network analysis of a minor redesign of a product and its associated packaging.

The key question is: How long will it take to complete this project ?

USE CPM TechniqueUSE CPM Technique 4646


Questions to prepare activity networkQuestions to prepare activity network Is this a Start Activity? Is this a Start Activity? Is this a Finish Activity? Is this a Finish Activity? What Activity Precedes this? What Activity Precedes this? What Activity Follows this? What Activity Follows this? What Activity is Concurrent with this?What Activity is Concurrent with this?

PERT ExamplePERT Example

4949

CPM calculationCPM calculation PathPath

A connected sequence of activities leading from the A connected sequence of activities leading from the starting event to the ending eventstarting event to the ending event

Critical PathCritical Path The longest path (time); determines the project durationThe longest path (time); determines the project duration

Critical ActivitiesCritical Activities All of the activities that make up the critical pathAll of the activities that make up the critical path


Forward PassForward Pass

Earliest Start Time (ES)Earliest Start Time (ES) earliest time an activity can start earliest time an activity can start ES = maximum EF of immediate predecessorsES = maximum EF of immediate predecessors

Earliest finish time (EF)Earliest finish time (EF) earliest time an activity can finishearliest time an activity can finish earliest start time plus activity timeearliest start time plus activity time

EF= ES + EF= ES + tt

Backward PassBackward Pass

Latest Start Time (LS)Latest Start Time (LS)

Latest time an activity can start without Latest time an activity can start without delaying critical path time delaying critical path time

LS= LF - LS= LF - tt Latest finish time (LF)Latest finish time (LF)

latest time an activity can be completed latest time an activity can be completed without delaying critical path timewithout delaying critical path time

LS = minimum LS of immediate LS = minimum LS of immediate predecessorspredecessors

5151

Resource-Constrained Planning

Market and Demand AnalysisMarket and Demand Analysis In most cases first step in project analysis is to In most cases first step in project analysis is to

find outfind out What is the likely What is the likely aggregate demandaggregate demand for the product or for the product or

service, and service, and WhatWhat share of the market share of the market will the proposed project enjoy will the proposed project enjoy

In order to get a “feel” for the relationship In order to get a “feel” for the relationship between the product and its market, between the product and its market, data based data based situational analysis is to be carried outsituational analysis is to be carried out. .

This is often referred to as theThis is often referred to as the 3C Analysis3C Analysis which includes which includes data based data based analysis of Market Environmentanalysis of Market Environment from the interpretation of the inputs from the interpretation of the inputs received from received from Customer, Company and Competition.Customer, Company and Competition.

Market and Demand Analysis Market and Demand Analysis exampleexample

Project: Launching a new Mobile Handset Project: Launching a new Mobile Handset Who are the potential buyers of mobile?Who are the potential buyers of mobile?

What is the total market size of mobiles and the industries growth?What is the total market size of mobiles and the industries growth?

Define market segmentation of the total mobile market and where does the new one Define market segmentation of the total mobile market and where does the new one

falls?falls?

Who are the present and potential competitors?Who are the present and potential competitors?

What are the USPs of the new mobile to get the customers switching loyalty?What are the USPs of the new mobile to get the customers switching loyalty?

What are the price and warranty strategy to ensure acceptance?What are the price and warranty strategy to ensure acceptance?

What channels of distribution are most suited for the offerings?What channels of distribution are most suited for the offerings?

What are the prospects of immediate sales? What are the prospects of immediate sales?

Primary and Secondary Primary and Secondary InformationInformation

Information may be obtained from primary and secondary Information may be obtained from primary and secondary information.information.

Secondary information is information that has been gathered in Secondary information is information that has been gathered in some other contexts and is already available. some other contexts and is already available. ExamplesExamples

Census of IndiaCensus of India- provides information on population, demographic characteristics house-- provides information on population, demographic characteristics house-hold size and composition etc. –by GOIhold size and composition etc. –by GOI

Economic SurveyEconomic Survey- provides latest information on individual production, wholesale prices, - provides latest information on individual production, wholesale prices, consumer prices, inflation, exports, etc. – by Finance Ministryconsumer prices, inflation, exports, etc. – by Finance Ministry

Guidelines to IndustriesGuidelines to Industries- provides information on various industry sector – by Ministry of - provides information on various industry sector – by Ministry of IndustriesIndustries

Monthly studies of Production of selected industriesMonthly studies of Production of selected industries- provides all-India data on - provides all-India data on production, number of units installed, capacity available etc.- by Central Statistical production, number of units installed, capacity available etc.- by Central Statistical OrganizationOrganization

Monthly bulletin of Reserve Bank of IndiaMonthly bulletin of Reserve Bank of India- provides information on production indices, - provides information on production indices, inflation, balance of payments, exchange rates etc.- by RBI inflation, balance of payments, exchange rates etc.- by RBI

Secondary Information-Secondary Information-contd.contd. Industry- Specific Sources Industry- Specific Sources

Automobile- Annual Reports of Indian Automobile Manufacturers byAutomobile- Annual Reports of Indian Automobile Manufacturers by IAMAIAMA

Metallurgical- Metallurgical- Iron and Steel Control BulletinIron and Steel Control Bulletin (Quarterly by (Quarterly by

Ministry of Steel and MinesMinistry of Steel and Mines Textiles- Indian Textiles- Indian Textile BulletinTextile Bulletin by Textile Commissioner, by Textile Commissioner,

MumbaiMumbai Electrical and Electronics- Annual Report of Electrical and Electronics- Annual Report of Indian ElectricalIndian Electrical

Manufacturers AssociationManufacturers Association

- Electronics Information and - Electronics Information and

Planning (Monthly) by Information,Planning (Monthly) by Information,

Planning and Analysis Group ofPlanning and Analysis Group of

Electronics Commission, New DelhiElectronics Commission, New Delhi Cement- by Cement- by Cement Manufacturers AssociationCement Manufacturers Association, India etc., India etc.

Evaluation of Secondary InformationEvaluation of Secondary Information While secondary information is available economically and While secondary information is available economically and

readily, its reliability, accuracy and relevance for thereadily, its reliability, accuracy and relevance for the purpose purpose under consideration must be carefully examinedunder consideration must be carefully examined. The following . The following

points are important.points are important. For For what purposewhat purpose the information was collected the information was collected WhenWhen the information was the information was collectedcollected and when was it published and when was it published What was theWhat was the target population target population from which the data was from which the data was

collected for the secondary informationcollected for the secondary information HowHow representative was the sample representative was the sample How accurately was the information edited, tabulated and How accurately was the information edited, tabulated and

analysedanalysed Was the Was the statistical analysis properly appliedstatistical analysis properly applied and the data was and the data was

sufficient to be statistically sufficient sufficient to be statistically sufficient HowHow relevant the information relevant the information for the purpose it is to be usedfor the purpose it is to be used

Primary InformationPrimary Information Secondary information often does not provide a comprehensive Secondary information often does not provide a comprehensive

basis for market and demand analysis. basis for market and demand analysis. It needs to be It needs to be supplemented with primary information gathered through a supplemented with primary information gathered through a market survey,market survey, specific to the project being appraised. specific to the project being appraised.

The market survey may be a The market survey may be a census survey or a sample surveycensus survey or a sample survey..

In the census survey the entire population is covered and are In the census survey the entire population is covered and are generally used for intermediate goods and investment goods generally used for intermediate goods and investment goods when such goods are used by a small number of firms. But they when such goods are used by a small number of firms. But they become generally prohibitively expensive.become generally prohibitively expensive.

Due to this market survey in practice is typically a sample survey Due to this market survey in practice is typically a sample survey

Steps in Sample SurveySteps in Sample Survey Typically a sample survey consists of the following steps: Typically a sample survey consists of the following steps:

Define the target population– Define the target population– Target population may be divided into various segments. Mobile customers can be Target population may be divided into various segments. Mobile customers can be

segmented into various age groups and also with the various income bracket.segmented into various age groups and also with the various income bracket.

Select the Sampling Scheme and Sample Size—Select the Sampling Scheme and Sample Size— Sampling can be Simple sampling, Random sampling or could be stratified Sampling can be Simple sampling, Random sampling or could be stratified

sampling. Sample size has a bearing on the reliability of the estimates-larger the sampling. Sample size has a bearing on the reliability of the estimates-larger the sample size, greater the reliability. sample size, greater the reliability.

Develop the questionnaire–Develop the questionnaire– Industry and trade market surveys generally involve more technical and specialised Industry and trade market surveys generally involve more technical and specialised

questions than the consumer surveysquestions than the consumer surveys

Recruit and Train the Field Investigators–Recruit and Train the Field Investigators– Intimate knowledge about the objective and purpose of the survey should Intimate knowledge about the objective and purpose of the survey should be imparted.be imparted.

Steps..Steps..

Obtain information—Obtain information— Personal interviews generally ensure a high rate of response and Personal interviews generally ensure a high rate of response and

more dependable inputs.more dependable inputs.

Scrutinize the information gathered—Scrutinize the information gathered— to eliminate data which are internally inconsistent.to eliminate data which are internally inconsistent.

Analyze and Interpret the information—Analyze and Interpret the information— Results of data based on sample survey will have to be Results of data based on sample survey will have to be

extrapolated to the target population. For this purpose appropriate extrapolated to the target population. For this purpose appropriate inflationary factors based on the ratio of the size of the target inflationary factors based on the ratio of the size of the target population to the size of the sample studies, will have to be used.population to the size of the sample studies, will have to be used.

Key steps in Market Demand Analysis Key steps in Market Demand Analysis and their Inter-relationships and their Inter-relationships

Situational Analysis and specification of Objectives

Collection of Secondary Information

Conduct of Market Survey

Characterization

of the Market

Demand Forecasting

Market Planning

Objective of Market SurveyObjective of Market Survey From the Market survey, one or more of the From the Market survey, one or more of the

following information are gatheredfollowing information are gathered Total Demand and rate of growth of demand.Total Demand and rate of growth of demand.

Demand in different segments of the marketDemand in different segments of the market

Income and price elasticity of the demandIncome and price elasticity of the demand

Motives for buyingMotives for buying

Satisfaction with the existing productsSatisfaction with the existing products

Unsatisfied needsUnsatisfied needs

Customer loyalty to the brandCustomer loyalty to the brand

Attitude towards alternate productsAttitude towards alternate products

Demand ForecastingDemand ForecastingAfter gathering information about various aspects of the market and demand from Primary and Secondary sources, an attempt may be made to estimate future demand.

“Demand Forecasting is the art of predicting demand for a product or a service at some future date on the basis of certain present and past behaviour patterns of some related events.”

Characteristics of a Good Demand Characteristics of a Good Demand ForecastingForecasting

AccuracyAccuracy

SimplicitySimplicity

EconomyEconomy

TimelinessTimeliness

AvailabilityAvailability

Demand Forecasting - MethodsDemand Forecasting - Methods

Qualitative MethodsQualitative Methods– depends on the judgment of the expert.– depends on the judgment of the expert. Jury of Executive MethodJury of Executive Method Delphi MethodDelphi Method

Time Series Projection MethodTime Series Projection Method- based on the historical time series .- based on the historical time series . Trend Projection MethodTrend Projection Method Exponential smoothing methodExponential smoothing method Moving average methodMoving average method

Causal MethodsCausal Methods-seek to develop forecasts on the basis of cause-effect -seek to develop forecasts on the basis of cause-effect relationship specified in an explicit quantitative manner.relationship specified in an explicit quantitative manner.

Chain Ratio MethodChain Ratio Method Consumption level methodConsumption level method End use methodEnd use method Leading Indicator methodLeading Indicator method

Jury of Executive MethodJury of Executive Method This involves soliciting the opinions of group This involves soliciting the opinions of group

of managers on expected future sales and of managers on expected future sales and combining them into a Sales forecast.combining them into a Sales forecast.

This is a subjective estimate provided by the experts.This is a subjective estimate provided by the experts. This is an expeditious method but it’s reliability This is an expeditious method but it’s reliability

depends on the efficiency of the subjective estimates of depends on the efficiency of the subjective estimates of the experts on the variety of factors including economic, the experts on the variety of factors including economic, competitive , customer preferences and technological competitive , customer preferences and technological changes. changes.

Delphi MethodDelphi Method This method is used for eliciting the opinions of a group of This method is used for eliciting the opinions of a group of

experts. It avoids face-to-face group meetings; opinions are experts. It avoids face-to-face group meetings; opinions are sought either through mails or any other mode of impersonal sought either through mails or any other mode of impersonal communications. communications.

In Delphi method experts responses are summarized without In Delphi method experts responses are summarized without disclosing the identity of the experts and sent back to the disclosing the identity of the experts and sent back to the experts along with a questionnaire meant to probe further the experts along with a questionnaire meant to probe further the reasons for extreme views expressed in the first round.reasons for extreme views expressed in the first round.

The process continues for one or more rounds till a reasonable The process continues for one or more rounds till a reasonable agreement emerges in the views of the experts.agreement emerges in the views of the experts.

Time series Projection Time series Projection -- Trend Projection Method-- Trend Projection Method

Trend Projection Method involvesTrend Projection Method involves a) determining the trend of consumption by analyzing past consumption a) determining the trend of consumption by analyzing past consumption

statisticsstatistics b) projecting future consumption by extrapolating the trendb) projecting future consumption by extrapolating the trend

Most commonly used relationship is the linear relationshipMost commonly used relationship is the linear relationship YYtt = b + mx = b + mx ““YYtt” is the demand for year “t”” is the demand for year “t” ““t” is the time variablet” is the time variable ““b” is the intercept of the relationship andb” is the intercept of the relationship and ““m” is the slope of the relationship m” is the slope of the relationship

To estimate “m” and “b” of the linear relationship, the least To estimate “m” and “b” of the linear relationship, the least square method is used. square method is used.

Least Square MethodLeast Square Method

Linear relationshipLinear relationship

Y = b + mxY = b + mx

Least Square Method-Least Square Method-ExampleExample

Use the least square method to determine the equation of line of best fit for the data. Then plot the line.

Example…..Example…..

Moving Average MethodMoving Average Method

In the Moving Average Method of Sales Forecasting the In the Moving Average Method of Sales Forecasting the Forecast for the next period is equal to the average of the sales Forecast for the next period is equal to the average of the sales for several preceding periods.for several preceding periods.

yyt+t+yyt-1+……+ t-1+……+ yyt-n+1t-n+1

FFt+1t+1=---------------------------=---------------------------

nn

Where FWhere Ft+1 t+1 is the Forecast for the next period, is the Forecast for the next period, yyt t is the Sales is the Sales for the current period and n is the period over which the for the current period and n is the period over which the averaging is done.averaging is done.

Exponential Smoothing MethodsExponential Smoothing Methods

This method provides an exponentially This method provides an exponentially weighted moving average of all previously weighted moving average of all previously observed values.observed values.

Appropriate for data with no predictable Appropriate for data with no predictable upward or downward trend.upward or downward trend.

The aim is to estimate the current level and use The aim is to estimate the current level and use it as a forecast of future value.it as a forecast of future value.

Exponential Smoothing MethodExponential Smoothing Method In Exponential Smoothing forecasts are modified in the light of the In Exponential Smoothing forecasts are modified in the light of the

observed errors.observed errors. If the Forecast value for the year t is FIf the Forecast value for the year t is Ftt and is less than the actual and is less than the actual

value of value of yyt, t, then the Forecast for the year t+1, Fthen the Forecast for the year t+1, Ft+1t+1 will be will be = F = Ftt + + αα..ее t,t,

where where αα is the Smoothing parameters (which lies is the Smoothing parameters (which lies between 0 and 1)between 0 and 1)

and and ее tt is is the error in the forecast for the year t and is the error in the forecast for the year t and is given given

by by yyt-t-FFtt

This makes the exponential smoothing equation asThis makes the exponential smoothing equation as

FFt+1t+1 = = F Ftt + + αα.(.(yytt- F- Ftt))

or,or,

ttt FyF )1(1

Simple Exponential Smoothing MethodSimple Exponential Smoothing Method The implication of exponential smoothing can The implication of exponential smoothing can

be better seen if the previous equation is be better seen if the previous equation is expanded by replacing Fexpanded by replacing Ftt with its components as with its components as

follows:follows:

This makes the Exponential smoothing forecast as This makes the Exponential smoothing forecast as the old forecast plus an adjustment for the error that the old forecast plus an adjustment for the error that occurred in the last forecast.occurred in the last forecast.

12

1

11

1

)1()1(

])1()[1(

)1(

ttt

ttt

ttt

Fyy

Fyy

FyF

Simple Exponential Smoothing MethodSimple Exponential Smoothing Method

If this substitution process is repeated by If this substitution process is repeated by replacing Freplacing Ft-1t-1 by its components, F by its components, Ft-2t-2 by its by its

components, and so on the result is:components, and so on the result is:

Therefore, FTherefore, Ft+1t+1 is the weighted moving average is the weighted moving average

of all past observations.of all past observations.

11

33

22

11 )1()1()1()1( yyyyyF tttttt

Problem SumsProblem Sums

The demand for a product in each of the last five months is shown below.

Month 1 2 3 4 5 Demand ('00s) 13 17 19 23 24 · Use a two month moving average to generate a forecast for

demand in month 6. · Apply exponential smoothing with a smoothing constant of

0.9 to generate a forecast for demand for demand in month 6. · Which of these two forecasts do you prefer and why?

Causal MethodsCausal Methods--Chain Ratio MethodChain Ratio Method

The potential sales of a product may be estimated by applying a The potential sales of a product may be estimated by applying a series of factors to a measure of aggregate demand.series of factors to a measure of aggregate demand.

This is a simple analytical approach for demand estimation.This is a simple analytical approach for demand estimation. Demand Forecasting of Shaving Blade

Male population in country 150 million

Proportion of adult male using shaving blades 0.60

Male population using shaving blades 90 million

Number of times using per years 100

Total shaving done per year 9000 million

Proportion of shaving done with stainless steel 0.4

Average number of shaving per stainless steel blade 6

Number of stainless steel blades used per year (9000mil x0.40) / 6

= 600 mil

Proportion of market the firm can capture 0.20

Potential sales 120 mil

Consumption level method This method is used for those products that are directly

consumed. This method measures the consumption level on the basis of elasticity coefficients. The important ones are

Income Elasticity: This reflects the responsiveness of demand to variations in income. It is calculated as:

E1 = [Q2 - Q1/ I2- I1] X [I1+I2/ Q2 +Q1] Where E1 = Income elasticity of demand

Q1 = quantity demanded in the base yearQ2 = quantity demanded in the following yearI1 = income level in the base year I2 = income level in the following year

Consumption Level Method–Consumption Level Method– Price ElasticityPrice Elasticity

Price Elasticity: This reflects the responsiveness of demand to variations in price. It is calculated as:

EP = [Q2 - Q1/ P2- P1] X [P1+P2/ Q2 +Q1]

Where EP = Price elasticity of demand

Q1 = quantity demanded in the base year

Q2 = quantity demanded in the following year P1 = price level in the base year

P2 = price level in the following year

Other Causal MethodsOther Causal Methods End use method:

This method forecasts the demand of the intermediate products, based on the consumption coefficient and the projected output level of the consuming industries (e.g. Automotive sheet consumption to no. of cars produced in Maruti, Huyndai, TATA ).

Leading indicator method: This method uses the identification of the leading indicators which

change ahead of the lagging variables. Changes in the leading indicators may be used to predict the changes in the lagging variables (e.g. Urbanization to sale of AC).

Econometric method: An advanced forecasting tool, it is a mathematical expression of

economic relationships derived from economic theory.

Technical AnalysisTechnical Analysis The broad purpose of Technical analysis is The broad purpose of Technical analysis is

to ensure that the project is technically feasible in the sense that to ensure that the project is technically feasible in the sense that all the all the inputs required inputs required to set up the project are availableto set up the project are available

to facilitate the most to facilitate the most optimum formulationoptimum formulation of the project in terms of the project in terms of technology, size , location etc.of technology, size , location etc.

Technical analysis consists of ( Example-Car project)( Example-Car project) Manufacturing process/technology Material Inputs and Utilities Product mix, plant capacity, location, and site Machinery & equipment, civil works Environmental considerations Project charts and layouts

Technology and Process selectionTechnology and Process selection Appropriateness depends on the followings:-Appropriateness depends on the followings:-

Customer segments targeted decides the choice of technology. Customer segments targeted decides the choice of technology. Appropriate technology Appropriate technology here refers to those methods of production here refers to those methods of production which which are suitableare suitable to local economic , social and cultural to local economic , social and cultural conditions and conditions and are convenientare convenient to implement. to implement.

Tying up with for the Tying up with for the Technical know-howTechnical know-how needed for the process, needed for the process, which may be either through which may be either through

Technology licensing,Technology licensing, Outright purchase,Outright purchase, Joint venture arrangementJoint venture arrangement

AvailabilityAvailability and appropriateness of the and appropriateness of the input material and utilities input material and utilities, , which include power, water, fuels etc. which include power, water, fuels etc.

Choice of TechnologyChoice of Technology For manufacturing a product or services often two or more For manufacturing a product or services often two or more

alternative technologies are available. The alternative technologies are available. The choice of technologychoice of technology is influenced byis influenced by a variety of considerations:- a variety of considerations:-

Plant capacityPlant capacity :- Plant capacity requirements :- Plant capacity requirements guide the selection of appropriate guide the selection of appropriate technology. technology.

Investment outlayInvestment outlay :- Investment outlay is :- Investment outlay is guided by the technology adopted guided by the technology adopted and ultimately impacts on the cost and viability of the and ultimately impacts on the cost and viability of the

project. project. Principal inputsPrincipal inputs :- Choice of technology depends on the principal :- Choice of technology depends on the principal inputs inputs

availability availability at a cost effective manner. at a cost effective manner. Product mixProduct mix :- Technology chosen must be judged in terms of the total :- Technology chosen must be judged in terms of the total

products to be produced products to be produced including saleable by-products including saleable by-products and and effluents. effluents.

Risk of technology changeRisk of technology change :- Technology selection should consider the :- Technology selection should consider the likelihood of likelihood of obsolescence in near future obsolescence in near future..

Ease of absorptionEase of absorption :- This plays an important role in a developing country :- This plays an important role in a developing country where ease of where ease of availability of the trained people availability of the trained people for the for the

technology may not be easy. technology may not be easy.

Material Inputs and UtilitiesMaterial Inputs and Utilities An important aspect of technical analysis is concerned with An important aspect of technical analysis is concerned with

defining the materials and inputs requireddefining the materials and inputs required, specifying their , specifying their properties in some detail, ease of availability and setting up properties in some detail, ease of availability and setting up their supply program. Material inputs and utilities may be their supply program. Material inputs and utilities may be classified into four broad categories :classified into four broad categories :

Raw material :- Raw material :- can be processed or can be the base can be processed or can be the base material material

Processed industrial materials and components :- Processed industrial materials and components :- which which are important inputs for the project. are important inputs for the project.

Auxiliary materials and factory supplies :- Auxiliary materials and factory supplies :- Which are other Which are other than basic material required for than basic material required for

processing, e.g. chemicals, processing, e.g. chemicals, additives, additives, packaging material etc. packaging material etc.

Utilities :-Utilities :- Power, water, steam etc Power, water, steam etc. . availability, which has availability, which has a bearing on selection of location, technology, a bearing on selection of location, technology, plant plant capacity etc. capacity etc.

Product Capacity. Plant Capacity, Product Capacity. Plant Capacity, Plant Location, Layout etc.Plant Location, Layout etc.

Which focuses onWhich focuses on

Choosing the optimum Choosing the optimum product mixproduct mix including variation in the size, including variation in the size, quality and broad range of customer quality and broad range of customer

Plant CapacityPlant Capacity which is technically attainable and optimum for the which is technically attainable and optimum for the market targeted.; include machinery and equipment selectionmarket targeted.; include machinery and equipment selection

Plant locationPlant location to make most cost effective and customer proximity, to make most cost effective and customer proximity, specially for Service sector projects. specially for Service sector projects.

Plant structures and Plant structures and LayoutLayout , which incorporates the basis for , which incorporates the basis for detailed project engineering and estimation of investment and detailed project engineering and estimation of investment and production costs.production costs.

Machinery, Equipment and Civil worksMachinery, Equipment and Civil works

Requirement of machineries and equipment is dependent on Requirement of machineries and equipment is dependent on production technology and plant capacity.production technology and plant capacity.

For a For a process oriented projectprocess oriented project (petrochemical etc.) machineries (petrochemical etc.) machineries and equipment at subsequent stages and equipment at subsequent stages should be balanced.should be balanced.

Apart from the base equipment Apart from the base equipment instruments, controls, internal instruments, controls, internal transportation systemstransportation systems and other support systems are also and other support systems are also provisioned.provisioned.

Spare parts, tools etc.Spare parts, tools etc. are also considered. are also considered.

In selecting the machineries and equipmentIn selecting the machineries and equipment certain constraints certain constraints should be borne in mind: should be borne in mind:

Power availabilityPower availability constraints need to be considered while selecting power intensive constraints need to be considered while selecting power intensive equipment.equipment.

Transportation and erection of the heavy equipmentTransportation and erection of the heavy equipment to remote areas are considered. to remote areas are considered. Selection of sophisticated equipment depends on theSelection of sophisticated equipment depends on the ability of the operator ability of the operator available available

etc. etc.

… … Civil WorksCivil Works Structures and civil works may be divided into three Structures and civil works may be divided into three

categories categories

Site preparation and DevelopmentSite preparation and Development :- includes (a) Removing old :- includes (a) Removing old structures, if any, (b) leveling sites © Building connections of structures, if any, (b) leveling sites © Building connections of Utilities with external networks etc.Utilities with external networks etc.

Buildings and StructuresBuildings and Structures :- includes (a) Factory or Operating :- includes (a) Factory or Operating

process workshops and buildings, (b) Ancillary workshops e.g. process workshops and buildings, (b) Ancillary workshops e.g. Stores, Transformer rooms, Warehouses, etc. Stores, Transformer rooms, Warehouses, etc.

Outdoor worksOutdoor works :- Supply and distribution of utilities, e.g. water, :- Supply and distribution of utilities, e.g. water, power, telephone etc. In certain cases transportation arrangements power, telephone etc. In certain cases transportation arrangements including laying rails or connecting roads are also taken up including laying rails or connecting roads are also taken up

Environment ConsiderationsEnvironment Considerations Environmental impacts of projects are considered to be one of Environmental impacts of projects are considered to be one of

the most adverse impacts of industrializations. This has forced the most adverse impacts of industrializations. This has forced government machineries to impose various rules and government machineries to impose various rules and regulations to control environmental impacts of the projects. regulations to control environmental impacts of the projects. Issues which are considered at the Project planning stages are Issues which are considered at the Project planning stages are

Types of effluents and emissions generated Types of effluents and emissions generated

Steps to be taken for proper treatment and disposal of effluents and emissionsSteps to be taken for proper treatment and disposal of effluents and emissions

Complying with all the statutory requirements of standards and monitori g of the Complying with all the statutory requirements of standards and monitori g of the same on a continuous basis. same on a continuous basis.

Project schedules and Project schedules and implementationsimplementations

Once data is available on the principal dimensions of the project, project Once data is available on the principal dimensions of the project, project charts and layouts may be prepared. The charts and layouts may be prepared. The important charts and layout important charts and layout drawings drawings are:are:

General functional layoutGeneral functional layout Material flow diagramMaterial flow diagram Production line diagramProduction line diagram Transportation layoutTransportation layout Utility layoutUtility layout Organizational layout etc. Organizational layout etc.

As part of technical analysis , aAs part of technical analysis , a project implementation schedule project implementation schedule is also is also prepared.prepared.

The work schedule The work schedule reflects the plan of workreflects the plan of work concerning installation as well as initial concerning installation as well as initial operation.operation.

Project Evaluation basics..Project Evaluation basics.. There are three basic questions of a Project Appraisal exercise:There are three basic questions of a Project Appraisal exercise:

Can the goods and services be Can the goods and services be producedproduced?? Can the goods and services be Can the goods and services be soldsold?? Can a satisfactory Can a satisfactory return be earnedreturn be earned from the investment made in the from the investment made in the

project?project?

To judge a To judge a project from the financial angleproject from the financial angle, we need information , we need information about the following : about the following :

Cost of projectCost of project Means of FinancingMeans of Financing Estimates of sales and productionEstimates of sales and production Cost of productionCost of production Working capital requirement and financingWorking capital requirement and financing Profitability projectionsProfitability projections Break-even pointBreak-even point Projected cash flow statementProjected cash flow statement Projected Balance-sheetProjected Balance-sheet

Cost of ProjectCost of Project The cost of project represents the sum of all items of outlay The cost of project represents the sum of all items of outlay

associated with a project which are supported by long-term funds. associated with a project which are supported by long-term funds. It is the sum of outlays on the followings:It is the sum of outlays on the followings:

Land and site developmentLand and site development

Building and civil worksBuilding and civil works

Plant and MachineryPlant and Machinery

Technical Know-how and Engineering feesTechnical Know-how and Engineering fees

Expenses on Foreign technicians and training of Indian technicians abroad, if anyExpenses on Foreign technicians and training of Indian technicians abroad, if any

Miscellaneous fixed assetsMiscellaneous fixed assets

Preliminary and Capital issue expensesPreliminary and Capital issue expenses

Pre-operative expensesPre-operative expenses

Provision for contingenciesProvision for contingencies

Margin money for working capitalMargin money for working capital

Initial cash losses Initial cash losses

Land and Site DevelopmentLand and Site Development

This includes

basic cost of land,

premium payable on lease hold,

cost of leveling and development,

cost of laying approach roads,

cost of boundary walls & gates,

cost of tube wells etc.

Building and Civil WorksBuilding 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 MachineryPlant 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 Technical Know-how and Engineering FeesEngineering 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

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 for setting up and

supervising trial runs

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 are shown here.

Similarly 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 equipment 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.

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 FinancingMeans of Financing

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

Share capitalTerm loansDebenture capitalDeferred creditIncentive sourcesMiscellaneous 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. Preference Capital at times are for

redeemable after a certain period.

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.

OthersOthersDebenture 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 announced in advance.

Deferred creditMany 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 sourcesThe government and its agencies may provide financial support as incentive to certain types of promoters or for setting up of 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 promoter’s 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.

Planning the Means of FinancePlanning the Means of Finance Guidelines and considerations:Guidelines and considerations: Norms of Regulatory bodies and Financial InstitutionsNorms of Regulatory bodies and Financial Institutions

Means of finance is generally laid down by the regulatory bodies or conform Means of finance is generally laid down by the regulatory bodies or conform certain norms laid down by Government and Financial Institutions of the country certain norms laid down by Government and Financial Institutions of the country to impart prudence to project financing decisions.to impart prudence to project financing decisions.

Key Business ConsiderationsKey Business Considerations Key Business considerations which are relevant for the project financing decision Key Business considerations which are relevant for the project financing decision

are are Cost of FundCost of Fund – Cost of – Cost of Debt fund is lowerDebt fund is lower than the cost of Equity funds. than the cost of Equity funds. Risk Risk – – Business riskBusiness risk arises from fluctuations in demand and variability of arises from fluctuations in demand and variability of prices prices

and costs.and costs.

- - Financial riskFinancial risk represents the risks arising from financial leverage represents the risks arising from financial leverage (Debt-equity ratio)(Debt-equity ratio)..

Risks borne by the Equity shareholders should not be unduly high. Firms exposed to high degree of Risks borne by the Equity shareholders should not be unduly high. Firms exposed to high degree of Business risk should have low financial risk and vice-versa.Business risk should have low financial risk and vice-versa.

ControlControl - Promoters control on the means of financing is preferred. - Promoters control on the means of financing is preferred. FlexibilityFlexibility- Firms should have reserve borrowing powers to enable it to raise debt - Firms should have reserve borrowing powers to enable it to raise debt capital in capital in

future to meet unforeseen future needs. future to meet unforeseen future needs.

Working Capital Requirement and its Working Capital Requirement and its FinancingFinancing

Working Capital Working Capital consistsconsists of of Stock (Raw Material, WIP, Finished Goods, and Maintenance spares)Stock (Raw Material, WIP, Finished Goods, and Maintenance spares) DebtorsDebtors Operating expenses in Cash/BankOperating expenses in Cash/Bank

The principal The principal sourcesource of Working Capital finances are of Working Capital finances are Working Capital advances provided by commercial banksWorking Capital advances provided by commercial banks Trade creditsTrade credits Accruals and provisionsAccruals and provisions Long term source of financingLong term source of financing

There are There are limitslimits to obtaining Working Capital advances from to obtaining Working Capital advances from commercial banks. They arecommercial banks. They are

Aggregate permissible bank finance is specified as per the norms of the lending BankAggregate permissible bank finance is specified as per the norms of the lending Bank Against each current assets a certain amount of margin money has to be provided by the Against each current assets a certain amount of margin money has to be provided by the

firm. firm.

Tandon Committee recommendation Tandon Committee recommendation Working Capital FinancingWorking Capital Financing

Tandon Committee has recommended maximum permissible Tandon Committee has recommended maximum permissible amount of bank finance for Working Capital (second out of the amount of bank finance for Working Capital (second out of the three methods being most commonly applied) as three methods being most commonly applied) as

at least 25% of Current Assets must be supported by long-term sources at least 25% of Current Assets must be supported by long-term sources of finance.of finance.

Margin requirements vary with the types of Current Assets, e.g.,Margin requirements vary with the types of Current Assets, e.g., Raw Material- 10-25%Raw Material- 10-25% WIP - 20-40%WIP - 20-40% Finished Goods- 30-50%Finished Goods- 30-50% Debtors - 30-50%Debtors - 30-50%

Estimates of Sales & ProductionEstimates of Sales & Production Sales RevenueSales Revenue Starting point for Profitability projections is the forecast of Starting point for Profitability projections is the forecast of

Sales Revenue. Considerations for this as follows:-Sales Revenue. Considerations for this as follows:- Capacity UtilizationCapacity Utilization—Capacity utilization is generally considered as 40-50% of the —Capacity utilization is generally considered as 40-50% of the

installed capacity in the first year, 50-80% in the second year and 80-90% from the installed capacity in the first year, 50-80% in the second year and 80-90% from the

third year onwardsthird year onwards

Stock-Stock- It is generally assumed that production as equal to sales and ignore any It is generally assumed that production as equal to sales and ignore any

adjustments for stock.adjustments for stock.

Selling priceSelling price is taken as net of excise. is taken as net of excise.

Selling price may be taken Selling price may be taken at present selling priceat present selling price. It is generally assumed that . It is generally assumed that

changes in selling price will be matched by proportionate changes in cost of changes in selling price will be matched by proportionate changes in cost of

production.production.

Estimates of ProductionEstimates of Production Cost of ProductionCost of Production Cost of Production are Cost of Production are

Material CostMaterial Cost- includes cost of raw material, chemicals, components and consumable - includes cost of raw material, chemicals, components and consumable

stores required for production. The present costs of various material inputs is stores required for production. The present costs of various material inputs is

considered; in other words, the factor of inflation is ignored.considered; in other words, the factor of inflation is ignored.

UtilitiesUtilities – consists of power, water and fuel. Requirements are determined on the basis – consists of power, water and fuel. Requirements are determined on the basis

of the norms specified by the collaborators, consultants etc., or the consumption of the norms specified by the collaborators, consultants etc., or the consumption

standards in the industry, whichever is higher.standards in the industry, whichever is higher.

LaborLabor- is the cost of all the manpower employed in the factory. In estimating - is the cost of all the manpower employed in the factory. In estimating

remuneration rates, the prevailing rates in the industry/area should be taken into remuneration rates, the prevailing rates in the industry/area should be taken into

account. The number of supervisory personnel and administrative staff may be account. The number of supervisory personnel and administrative staff may be

calculated on the basis of the general norms prevailing in the industry.calculated on the basis of the general norms prevailing in the industry.

Factory overheadsFactory overheads- the expenses on repairs and maintenance, rent, taxes, insurance etc. - the expenses on repairs and maintenance, rent, taxes, insurance etc.

are collectively referred to as factory overheads. are collectively referred to as factory overheads.

Profitability ProjectionsProfitability Projections The estimates of Working results may be prepared as follows:The estimates of Working results may be prepared as follows:

A A Cost of production Cost of production B Total administrative expensesB Total administrative expenses C Total sales expensesC Total sales expenses D Royalty and Know-how payableD Royalty and Know-how payable

E Total Cost of Product (A+B+C+D)E Total Cost of Product (A+B+C+D) F Expected salesF Expected sales

G Gross profit before interest (F-E)G Gross profit before interest (F-E) H Total financial expensesH Total financial expenses I DepreciationI Depreciation

J Operating profit ( G-H-I)J Operating profit ( G-H-I) K Other income K Other income L Preliminary Expenses written offL Preliminary Expenses written off

M Profit/ Loss before Taxation ( J+K-L)M Profit/ Loss before Taxation ( J+K-L) N Provision for TaxationN Provision for Taxation

O Profit after Tax (M-N)O Profit after Tax (M-N)

Less Dividend on Preference Capital/ Equity CapitalLess Dividend on Preference Capital/ Equity Capital

P Retained Profit (PAT- Dividend Pay out)P Retained Profit (PAT- Dividend Pay out)

Add Depreciation & Preliminary Expenses Written offAdd Depreciation & Preliminary Expenses Written off

Q Net Cash AccrualQ Net Cash Accrual

Projected Cash Flow StatementProjected Cash Flow Statement Source of FundsSource of Funds

Share IssueShare Issue Profit before Taxation with Interest added backProfit before Taxation with Interest added back Depreciation provision for the yearDepreciation provision for the year Development Rebate reserveDevelopment Rebate reserve Increase in secured medium and long term borrowings for the projectIncrease in secured medium and long term borrowings for the project Increase in Unsecured loans and DepositsIncrease in Unsecured loans and Deposits Increase in Bank borrowing for Working Capital etc. Increase in Bank borrowing for Working Capital etc.

TOTAL of ATOTAL of A

Disposition of FundsDisposition of Funds Capital Expenditure for the projectCapital Expenditure for the project Increase in Working Capital ( Current Assets other than cash - Current Liabilities other than Increase in Working Capital ( Current Assets other than cash - Current Liabilities other than

Bank Borrowings)Bank Borrowings) Decrease in Unsecured loans and Bank Borrowings for Working CapitalDecrease in Unsecured loans and Bank Borrowings for Working Capital TaxationTaxation Dividends (Equity & Preference Capital) Dividends (Equity & Preference Capital)

TOTAL of BTOTAL of B- Opening Balance of Cash in Hand/ BankOpening Balance of Cash in Hand/ Bank- Add, Add, Net Surplus / Deficit (A-B)Net Surplus / Deficit (A-B)- Closing Balance of Cash in Hand and at BankClosing Balance of Cash in Hand and at Bank

Cash Flow Cash Flow Problem SumsProblem Sums

Balance Sheet of X at the end of the first year is as follows:-Balance Sheet of X at the end of the first year is as follows:-

The projected Income Statement and the distribution of earnings for the 2The projected Income Statement and the distribution of earnings for the 2ndnd year is given below:-year is given below:-

SalesSales- 400 - 400 Depreciation Depreciation -20 -20 InterestInterest- 20 - 20 TaxTax – 30 – 30 DividendsDividends- 10- 10 COG soldCOG sold- 300 - 300 PBIT PBIT - 80 - 80 PBTPBT - 60 - 60 PAT PAT– 30 – 30 Retained Retained

EarningsEarnings - 20 - 20

Liabilities Rs Assets Rs

Share Capital 100 Fixed Assets 180

Reserves and Surplus 20 Investments -

Secured Loans 80 Current Assets 180

Unsecured Loans 50 Cash- 20

Current Liabilities 90 Receivables-80

Provisions 20 Inventories- 80

360 360

Problem SumsProblem Sums

During the second year the firm plans to raise a secured loan of 20, repay a During the second year the firm plans to raise a secured loan of 20, repay a previous term loan to the extent of 5 and increase unsecured loans by 10. previous term loan to the extent of 5 and increase unsecured loans by 10.

Current Liabilities and Provisions are expected to remain unchanged. Current Liabilities and Provisions are expected to remain unchanged. Firm plans to acquire fixed assets worth 30 and increase inventories by 10. Firm plans to acquire fixed assets worth 30 and increase inventories by 10. Receivables are increased by 15.Receivables are increased by 15. Other Assets would remain unchanged excepting Cash. Other Assets would remain unchanged excepting Cash. The Firm plans to pay 10 by way of Equity Dividend.The Firm plans to pay 10 by way of Equity Dividend.

Prepare the projected Cash Flow Statement:-Prepare the projected Cash Flow Statement:-

SolutionsSolutions

Source of Funds

PBIT 80

Depreciation 20

Increase in Secured Loans 15

Increase in Unsecured Loans 10

TOTAL (A) 125

Disposition of Funds

Capital Expenditure 30

Increase in Working Capital (10+15) 25

Interest 20

Taxation 30

Dividends - Equity 10

TOTAL (B) 115

Opening Balance of Cash 20

Net Surplus/ Deficit (A-B) 10

Closing Balance of Cash in Hand/Bank 30

Projected Balance SheetProjected Balance SheetAccount Category Op. Balance Changes Cl. Balance

Liabilities

Share Capital 100 - 100

Reserves and Surplus 20 +20 (Retained Earning) 40

Secured Loans 80 +20 (Addl. Term Loan)

- 5 (Repayment) 95

Unsecured Loans 50 +10 (Proposed Increase) 60

Current Liabilities 90 90

Provisions 20 20

405

Assets

Fixed Assets 180 +30 (Addl.) – 20 (Depn.) 190

Cash 20 (* Balancing Item) 30*

Inventories 80 +10 (Proposed Increase) 90

Receivables 80 + 15 (Expected Increase) 95

405

WACCWACC 'Weighted Average Cost Of Capital - WACC‘

Company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use. By taking a weighted average, we can see how much interest the company has to pay for every Re. it finances.

A firm's WACC is the overall required return on the firm as a whole and is often used internally to determine the economic feasibility of expansionary opportunities and mergers.

All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

WACC- ExampleWACC- Example WACC can calculated asWACC can calculated as

WACC= WWACC= WE xE x r rEE + W + Wpp x x r rp p + W+ WDD x x r rDD (1- (1-ttcc)) Where WWhere WE, E, WWp , p , and Wand WD D are the proportion of Equity, Preference and are the proportion of Equity, Preference and

Debt and Debt and rrE,E, rrp, p, rrD D are the component costs of Equity, Preference and are the component costs of Equity, Preference and

Debt and Debt and ttc is the corporate Tax rates.c is the corporate Tax rates.

Example:Example: The cost of Equity, Preference and Debt of BPP Ltd. are 16%, 14% The cost of Equity, Preference and Debt of BPP Ltd. are 16%, 14%

and 12% respectively and the market value proportions of these and 12% respectively and the market value proportions of these sources of finance are 0.60, 0.05 and 0.35 respectively. sources of finance are 0.60, 0.05 and 0.35 respectively.

The Tax rate is 30%. The Tax rate is 30%. Then WACC= 0.60x 16 + 0.05x 14 + 0.35x 12 (1-0.30) = 13.24%Then WACC= 0.60x 16 + 0.05x 14 + 0.35x 12 (1-0.30) = 13.24%

Weighted Marginal Cost of Weighted Marginal Cost of CapitalCapital

Weighted average cost of Capital does not remain same at Weighted average cost of Capital does not remain same at different magnitude of financing. In fact it tends to rise as the different magnitude of financing. In fact it tends to rise as the firm seeks more and more capital.firm seeks more and more capital. As the suppliers provide more capital the rate of return required by As the suppliers provide more capital the rate of return required by

them tends to increase.them tends to increase.

There is generally a Breaking point beyond which the cost of There is generally a Breaking point beyond which the cost of new capital change, given the Capital structure of the firm.new capital change, given the Capital structure of the firm.

These levels can be established using the following These levels can be established using the following relationship.relationship.

BPBPjj = TF = TFjj/W/Wjj

Where, BPWhere, BPj j is the Breaking point is the Breaking point

Cost of Equity: CAPM ApproachCost of Equity: CAPM Approach Several approaches are used to estimate the cost of Equity. The

Capital Asset Pricing Model approach perhaps the most popular in practice.

Logic of the CAPM approach Investors are risk averse. So they require a higher expected return to bear

higher risk. Total Risk can be decomposed in the following two components.

Total Risk = Unique Risk + Market Risk Unique Risk of a security represents that portion of its risk wich stems

from Firm-specific factors like the development of a new product, a labor strike or the emergence of a new competitor.

Market Risk of a security represents that portion of its risk which is attributable to economy wide factors like growth rate of GNP, the level of Government spending, Interest rate structure, and inflation rate.

CAPM suggests that investors are compensated only for bearing the systematic risk.

Beta Value for StockBeta Value for Stock When examining a particular equity, an often-used measurement of risk is what we in the finance world call

beta.

βstock is the beta coefficient for the stock, meaning it is the covariance between the stock and the market divided by the variance of the market. We will assume the beta is 1.25.

Rmarket is the return expected from the market, but related to businesses that are. α is a constant that measures excess return for given level of risk

Now we put together these three numbers using the capital asset pricing model:

RRRRRR= RFR + β= RFR + βstockstock (R (Rmarketmarket – RFR) – RFR)

RRRRRR = 4 + 1.25 (6) = 4 + 1.25 (6)RRRRRR = 11.5% = 11.5%

Where:RRRRRR = the required rate of return, or expected return

RFR = the risk free rate

βstock = beta of the stock

Rmarket = return of the market as a whole

(Rmarket – RFR) = the market risk premium, or the return above the risk-free rate to accommodate additional unsystematic risk

Capital StructureCapital Structure Capital StructureCapital Structure The Capital Structure of a firm is the mix of different sources of finance used The Capital Structure of a firm is the mix of different sources of finance used

by the firm to finance its operations.by the firm to finance its operations.

Optimal Capital StructureOptimal Capital Structure The capital structure or combination of Debt and equity at which the WACC The capital structure or combination of Debt and equity at which the WACC

is minimum and it leads to maximum value of the firm.is minimum and it leads to maximum value of the firm.

Sources of CapitalSources of Capital DebtDebt

Bank LoansBank Loans Corporate BondsCorporate Bonds DebenturesDebentures

Shareholders MoneyShareholders Money Equity SharesEquity Shares Preference SharesPreference Shares Retained Earnings Retained Earnings

Importance of Capital StructureImportance of Capital Structure Capital Structure affects the value of the firm either by Capital Structure affects the value of the firm either by

affectingaffecting Cost of the CapitalCost of the Capital Expected Earning Expected Earning Or bothOr both

Capital Structure decision is relevant to the valuation of the Capital Structure decision is relevant to the valuation of the firm. firm. In other words, a change in the financial leverage will lead to a In other words, a change in the financial leverage will lead to a

corresponding change in the overall cost of capital as well as the total corresponding change in the overall cost of capital as well as the total value of the firm.value of the firm.

If therefore the degree of financial leverage as measured by the ratio of If therefore the degree of financial leverage as measured by the ratio of debt to equity is increased, the WACC will decline, while the value of debt to equity is increased, the WACC will decline, while the value of the firm as well as the market price of share will increase and vice the firm as well as the market price of share will increase and vice versa.versa.

Planning the Capital Structure Planning the Capital Structure Important Important Considerations –Considerations –

ReturnReturn:: ability to generate maximum returns to the shareholders, i.e. ability to generate maximum returns to the shareholders, i.e.

maximize EPS and market price per share.maximize EPS and market price per share. Cost:Cost:

minimizes the cost of capital (WACC).minimizes the cost of capital (WACC). Debt is cheaper than equity Debt is cheaper than equity

due to tax shield on interest & no benefit on dividends.due to tax shield on interest & no benefit on dividends. Risk:Risk:

insolvency risk associated with high debt component.insolvency risk associated with high debt component. Control:Control:

avoid dilution of management control, (debt preferred to new avoid dilution of management control, (debt preferred to new

equity) equity) Flexible:Flexible:

altering capital structure without much costs & delays, to altering capital structure without much costs & delays, to

raise funds whenever required.raise funds whenever required. Capacity:Capacity:

ability to generate profits to pay interest and principal. ability to generate profits to pay interest and principal.

Value of a firm depends upon earnings of a firm and its Value of a firm depends upon earnings of a firm and its cost of capital (i.e. WACC).cost of capital (i.e. WACC).

Earnings are a function of investment decisions, Earnings are a function of investment decisions, operating efficiencies, & WACC is a function of its operating efficiencies, & WACC is a function of its capital structure.capital structure.

Value of firm is derived by capitalizing the earnings by Value of firm is derived by capitalizing the earnings by its cost of capital (WACC). its cost of capital (WACC). Value of Firm = Earnings / Value of Firm = Earnings / WACCWACC

Thus, value of a firm varies due to changes in the Thus, value of a firm varies due to changes in the earnings of a company or its cost of capital, or both.earnings of a company or its cost of capital, or both.

Capital structure cannot affect the total earnings of a Capital structure cannot affect the total earnings of a firm (EBIT), but it can affect the residual shareholders’ firm (EBIT), but it can affect the residual shareholders’ earnings.earnings.

Value of a Firm – directly co-related Value of a Firm – directly co-related with the maximization of with the maximization of

shareholders’ wealth.shareholders’ wealth.

Particulars Rs.Sales (A) 10,000

(-) Cost of goods sold (B) 4,000

Gross Profit (C = A - B) 6,000

(-) Operating expenses (D) 2,500

Operating Profit (EBIT) (E = C - D) 3,500

(-) Interest (F) 1,000

EBT (G = E - F) 2,500

(-) Tax @ 30% (H) 750

PAT (I = G - H) 1,750

(-) Preference Dividends (J) 750

Profit for Equity Shareholders (K = I - J) 1,000

No. of Equity Shares (L) 200

Earning per Share (EPS) (K/ L) 5

An illustration of

Income Statement

ASSUMPTIONS –ASSUMPTIONS – Firms use only two sources of Firms use only two sources of

funds – equity & debt.funds – equity & debt. No change in investment No change in investment

decisions of the firm, i.e. no decisions of the firm, i.e. no change in total assets.change in total assets.

100 % dividend payout ratio, i.e. 100 % dividend payout ratio, i.e. no retained earnings.no retained earnings.

Business risk of firm is not Business risk of firm is not affected by the financing mix.affected by the financing mix.

No corporate or personal No corporate or personal taxation.taxation.

Investors expect future Investors expect future profitability of the firm.profitability of the firm.

Capital Structure Capital Structure

TheoriesTheories

Project SelectionProject Selection

Project selection is the process of evaluating Project selection is the process of evaluating individual projects or groups of projects, and then individual projects or groups of projects, and then choosing to implement some set of them so that the choosing to implement some set of them so that the objectives of the parent organization will be achievedobjectives of the parent organization will be achieved

Managers often use Managers often use decision-aiding models decision-aiding models to extract to extract the relevant issues of a problem from the details in the relevant issues of a problem from the details in which the problem is embeddedwhich the problem is embedded

Models represent the problem’s structure and can be Models represent the problem’s structure and can be useful in selecting and evaluating projectsuseful in selecting and evaluating projects

Chapter 2-1

Criteria for Project Selection Criteria for Project Selection ModelsModels

RealismRealism - reality of manager’s decision - reality of manager’s decision

CapabilityCapability- able to simulate different scenarios and optimize the decision- able to simulate different scenarios and optimize the decision

FlexibilityFlexibility - provide valid results within the range of conditions - provide valid results within the range of conditions

Ease of UseEase of Use - reasonably convenient, easy execution, and easily - reasonably convenient, easy execution, and easily

understoodunderstood

CostCost - Data gathering and modeling costs should be low relative to the - Data gathering and modeling costs should be low relative to the

cost of the projectcost of the project

Easy ComputerizationEasy Computerization - must be easy and convenient to gather, store and - must be easy and convenient to gather, store and

manipulate data in the modelmanipulate data in the model

Chapter 2-2

Nature of Project Selection Nature of Project Selection ModelsModels

2 Basic Types of Models2 Basic Types of Models NumericNumeric NonnumericNonnumeric

Two Critical Facts:Two Critical Facts: Models do not make decisions - People do!Models do not make decisions - People do! All models, however sophisticated, are only partial All models, however sophisticated, are only partial

representations of the reality the are meant to reflectrepresentations of the reality the are meant to reflect

Chapter 2-3

Nonnumeric ModelsNonnumeric Models Sacred CowSacred Cow - - project is suggested by a senior and powerful official in project is suggested by a senior and powerful official in

the organizationthe organization

Operating NecessityOperating Necessity - - the project is required to keep the system the project is required to keep the system

runningrunning

Competitive Necessity Competitive Necessity - - project is necessary to sustain a competitive project is necessary to sustain a competitive

positionposition

Product Line ExtensionProduct Line Extension - - projects are judged on how they fit with projects are judged on how they fit with

current product line, fill a gap, strengthen a weak link, or extend the line in current product line, fill a gap, strengthen a weak link, or extend the line in a new desirable way.a new desirable way.

Comparative Benefit ModelComparative Benefit Model - - several projects are considered and several projects are considered and

the one with the most benefit to the firm is selectedthe one with the most benefit to the firm is selected

Chapter 2-4

Numeric Models: Numeric Models: Profit/ProfitabilityProfit/Profitability

Payback periodPayback period - - initial fixed investment/estimated annual cash initial fixed investment/estimated annual cash

inflows from the projectinflows from the project

Average Rate of Return Average Rate of Return - - average annual average annual profit/average profit/average

investment investment

Discounted Cash Flow -Discounted Cash Flow - Present Value Method Present Value Method

Internal Rate of Return -Internal Rate of Return - Finds rate of return that equates Finds rate of return that equates

present value of inflows and outflowspresent value of inflows and outflows

Profitability IndexProfitability Index - - NPV of all future expected cash flows/initial NPV of all future expected cash flows/initial

cash investmentcash investment

Chapter 2-5

137137

What is The Time Value of What is The Time Value of Money?Money?

A Re. received today is worth more than a Re. A Re. received today is worth more than a Re. received tomorrowreceived tomorrow This is because a dollar received today can be This is because a dollar received today can be

invested to earn interestinvested to earn interest The amount of interest earned depends on the rate The amount of interest earned depends on the rate

of return that can be earned on the investmentof return that can be earned on the investment Time value of money quantifies the value of a Time value of money quantifies the value of a

Re. through timeRe. through time

138138

Uses of Time Value of MoneyUses of Time Value of Money

Time Value of Money, or TVM, is a concept that is Time Value of Money, or TVM, is a concept that is used in all aspects of finance including:used in all aspects of finance including:

Project Evaluation to accept/reject decisions for project Project Evaluation to accept/reject decisions for project managementmanagement

Financial analysis of firmsFinancial analysis of firms And many others!And many others!

139139

FormulasFormulas

Common formulas that are used in TVM calculations:Common formulas that are used in TVM calculations:**

Present value of a lump sum: Present value of a lump sum:

PV = CFPV = CFtt / (1+r) / (1+r)tt OROR PV = FV PV = FVt t / (1+r)/ (1+r)tt

Future value of a lump sum:Future value of a lump sum:

FVFVtt = CF = CF00 * (1+r) * (1+r)tt OROR FV FVtt = PV * (1+r) = PV * (1+r)tt

Present value of a cash flow stream: Present value of a cash flow stream: nn

PV = PV = [CF[CFtt / (1+r) / (1+r)tt]] t=0t=0

140140

Formulas (continued)Formulas (continued)

Future value of a cash flow stream:Future value of a cash flow stream: nn

FV = FV = [CF[CFtt * (1+r) * (1+r)n-tn-t]] t=0t=0

Present value of an annuity:Present value of an annuity:PVA = PMT * {[1-(1+r)PVA = PMT * {[1-(1+r)-t-t]/r}]/r}

Future value of an annuity:Future value of an annuity:

FVAFVAtt = PMT * {[(1+r) = PMT * {[(1+r)tt –1]/r} –1]/r}

Numeric Models: ScoringNumeric Models: Scoring

Unweighted 0-1 Factor ModelUnweighted 0-1 Factor Model

Unweighted Factor Scoring ModelUnweighted Factor Scoring Model

Weighted Factor Scoring ModelWeighted Factor Scoring Model

Constrained Weighted Factor Scoring ModelConstrained Weighted Factor Scoring Model

Goal Programming with Multiple ObjectivesGoal Programming with Multiple Objectives

Chapter 2-6

Risk Versus UncertaintyRisk Versus Uncertainty

Analysis Under Uncertainty - The Management of Analysis Under Uncertainty - The Management of RiskRisk The difference between risk and uncertaintyThe difference between risk and uncertainty

RiskRisk - when the decision maker knows the probability - when the decision maker knows the probability of each and every state of nature and thus each and of each and every state of nature and thus each and every outcome. An expected value of each alternative every outcome. An expected value of each alternative action can be determinedaction can be determined

UncertaintyUncertainty - when a decision maker has information - when a decision maker has information that is not complete and therefore cannot determine the that is not complete and therefore cannot determine the expected value of each alternativeexpected value of each alternative

Chapter 2-7

Risk AnalysisRisk Analysis

Principal contribution of risk analysis is to Principal contribution of risk analysis is to focus the attention on understanding the focus the attention on understanding the nature and extent of the uncertainty associated nature and extent of the uncertainty associated with some variables used in a decision making with some variables used in a decision making processprocess

Usually understood to use financial measures Usually understood to use financial measures in determining the desirability of an in determining the desirability of an investment projectinvestment project

Chapter 2-8


Probability distributions are determined or Probability distributions are determined or subjectively estimated for each of the “uncertain” subjectively estimated for each of the “uncertain” variablesvariables

The probability distribution for the rate of return (or The probability distribution for the rate of return (or net present value) is then found by simulationnet present value) is then found by simulation

Both the expectation and its variability are important Both the expectation and its variability are important criteria in the evaluation of a projectcriteria in the evaluation of a project

Chapter 2-9


Chapter 2-10

Information Base for SelectionsInformation Base for Selections

Accounting DataAccounting Data MeasurementsMeasurements

Subjective vs. ObjectiveSubjective vs. Objective Quantitative vs. QualitativeQuantitative vs. Qualitative Reliable vs. UnreliableReliable vs. Unreliable Valid vs. InvalidValid vs. Invalid

Technological ShockTechnological Shock

Chapter 2-11

Decision Tree AnalysisDecision Tree Analysis A graphical tool for describing A graphical tool for describing (1) the actions available to the (1) the actions available to the

decision-maker, decision-maker, (2) the events that can occur, (2) the events that can occur,

and and (3) the relationship between the (3) the relationship between the

actions and events.actions and events.(4)(4) Each decision tree has two Each decision tree has two types of nodes;types of nodes;

Decision nodes are Decision nodes are represented as Squares and represented as Squares and Probability nodes are Probability nodes are represented as Circlesrepresented as Circles

The The branchesbranches leaving each round node leaving each round node represent the different states of nature represent the different states of nature while the branches leaving each square while the branches leaving each square node represent the different decision node represent the different decision alternatives.alternatives.

At the end of each limb of a tree are the At the end of each limb of a tree are the payoffs attained from the series of payoffs attained from the series of branches making up that limb. branches making up that limb.

Decision Tree Branches

Constructing a Constructing a Decision TreeDecision Tree

A Company is considering marketing a new A Company is considering marketing a new product. Once the product is introduced, product. Once the product is introduced, there is a 70% chance of encountering a there is a 70% chance of encountering a competitive product. Two options are competitive product. Two options are available each situation.available each situation.

Option 1 (with competitive product): Option 1 (with competitive product): Raise your price and see how your Raise your price and see how your competitor responds. If the competitor competitor responds. If the competitor raises price, your profit will be $60. If raises price, your profit will be $60. If they lower the price, you will lose $20. they lower the price, you will lose $20. Option 2 (without competitive product): Option 2 (without competitive product): You still two options: raise your price or You still two options: raise your price or lower your price. lower your price.

The conditional profits associated with each The conditional profits associated with each event along with the likelihood of each event event along with the likelihood of each event is shown in the decision tree. is shown in the decision tree.

Contemporary Engineering Economics, 5th edition, Contemporary Engineering Economics, 5th edition, © 2010© 2010

ConditionalProfit

Decision Points

Events

( ) Probability

Do not market

MarketCompetitiveProduct (0.7)

No CompetitiveProduct (0.3)

High

Low

High

Low

High

Low

High

Low

$60

-$20

$40

$10

$100

$30

(0.5)

(0.5)

(0.2)

(0.8)

$0

Our Price

Competitor’s price

First Decision Point Second Decision Point

ConditionalProfit

Decision Points

Events

( ) Probability

Do not market



High

Low

High

Low

High

Low

High

Low

$60

-$20

$40

$10

$100

$30

(0.5)

(0.5)

(0.2)

(0.8)

$0

Our Price

Competitor’s price

First Decision Point Second Decision Point

Rollback ProcedureRollback Procedure To analyze a decision tree, we begin at the end To analyze a decision tree, we begin at the end

of the tree and work backward.of the tree and work backward. For each chance node, we calculate the For each chance node, we calculate the

expected monetary value expected monetary value (EMV), and place it in (EMV), and place it in the node to indicate that it is the expected value the node to indicate that it is the expected value calculated over all branches emanating from calculated over all branches emanating from that node.that node.

For each decision node, we select the one with For each decision node, we select the one with the highest EMV (or minimum cost). Then the highest EMV (or minimum cost). Then those decision alternatives not selected are those decision alternatives not selected are eliminated from further consideration.eliminated from further consideration.


Making Sequential Investment Making Sequential Investment DecisionsDecisions


Do not market



Set High Price

Low

Set High Price

Low

High

Low

High

Low

$60

-$20

$40

$10

$100

$30

(0.5)

(0.5)

(0.2)

(0.8)

$0

$20

$16

$100

$20

$44

$44

Do not market



Set High Price

Low

Set High Price

Low

High

Low

High

Low

$60

-$20

$40

$10

$100

$30

(0.5)

(0.5)

(0.2)

(0.8)

$0

$20

$16

$100

$20

$44

$44

Decision RulesDecision Rules

Market the new product.Market the new product. Whether or not you encounter a competitive Whether or not you encounter a competitive

product, raise your price.product, raise your price.

The expected monetary value associated The expected monetary value associated with marketing the new product is $44.with marketing the new product is $44.


Documents

PROJECT MANAGEMENT. Ram Setu It is a bridge, built by Rama's army of monkeys across the sea, under the leadership of Hanuman and Under the engineering