CHAPTER 6

FINANCIAL ESTIMATES AND PROJECTIONS

DR R SOUNDARA RAJAN

Cost of Project

• Means of financing

• Estimates of sales and production

• Cost of production

• Working capital requirement and its

financing

• Profitability projections

• Projected cash flow statements

• Projected balance sheets

Cost of Project

• Means of financing

• Estimates of sales and production

• Cost of production

• Working capital requirement and its

financing

• Profitability projections

• Projected cash flow statements

• Projected balance sheets

Out Line

Balance Sheet

Cash Flow Statement

Means of Finance and Time Phasing

Interest and Loan Repayment

Estimate of Working Results

Working Capital Advance (WCA)

Cost of Project and Time Phasing

Interest on WCA

Tax Factor

Depreciation

Cost of Production

Working Capital Needs

Production Plan

Projected Sales

Financial Projections

The cost of project represents the total of all items of outlay associated with a project which are supported by long-term funds. It is the sum of the outlays on the following:

The cost of project represents the total of all items of outlay associated with a project which are supported by long-term funds. It is the sum of the outlays on the following:

• Land and site development

• Buildings and civil works

• Plant and machinery

• Technical know-how and engineering fees

• Expenses on foreign technicians and training of Indian technicians abroad

• Miscellaneous fixed assets

• Preliminary and capital issue expenses

• Pre-operative expenses

• Margin money for working capital

• Initial cash losses

• Land and site development

• Buildings and civil works

• Plant and machinery

• Technical know-how and engineering fees

• Expenses on foreign technicians and training of Indian technicians abroad

• Miscellaneous fixed assets

• Preliminary and capital issue expenses

• Pre-operative expenses

• Margin money for working capital

• Initial cash losses

Cost of Project

Land and site development

1. Basic Cost + conveyance + allied charges2. Premium payable on leasehold and

conveyance3. Cost of leveling and development4. Cost of laying roads5. Cost of compound wall6. Cost of tube wells Cost of land varies from one location to

another. High in urban and low in rural

Building and civil works

Building for For plant and equipment Auxiliary services- steam, work shop, and water

supply Godowns, ware house Non factory building – canteen Garages Sewers drainage Tanks, wells etc

Cost depends on structure

Plant and Machinery

Imported- Free On Board(FOB)+ Shipping Freight, Insurance + Import duty + Clearing + Loading and unloading and transportation

Indigenous – Free on Rail (FOR)+ Sales tax + Octroi + and other taxes

Cost of stores and spares Foundation and installation

Based on latest available quote adjusted for inflation

Others

• Technical know-how and engineering fees

• Expenses on foreign technicians and training of Indian

technicians abroad

• Miscellaneous fixed assets ( furniture + office

equipments + vehicles + railway sidings + etc)

•

Others

• Preliminary and capital issue expenses ( survey, feasibility reports, incorporation expenses)

• Pre-operative expenses ( Establishment + Rent + Interest and borrowing charges+ start up expenses+ Insurance+ Miscellaneous exp)

• Margin money for working capital

• Initial cash losses

Means of Finance

To meet the cost of the project the

following means of finance are

available:

Means of Finance

To meet the cost of the project the

following means of finance are

available:

• Share capital

• Term loans

• Debenture capital

• Deferred credit

• Incentive sources

( seed capital, subsidy, deferred tax)

• Miscellaneous sources –

public deposits, leasing, unsecured loans

• Share capital

• Term loans

• Debenture capital

• Deferred credit

• Incentive sources

( seed capital, subsidy, deferred tax)

• Miscellaneous sources –

public deposits, leasing, unsecured loans

Planning financing

Norms of regulatory

bodiesKey business

considerations

Key business considerations

1.Cost- Debt is cheaper

2.Risk- financial leverage3.Control

4.Flexibility- ability to raise further money- do not

exhaust full debt capacity

In estimating sales and production, assume

that:• The capacity utilization would be at 40-50 percent of The capacity utilization would be at 40-50 percent of

the installed capacity in the first year, 50-80 percent the installed capacity in the first year, 50-80 percent in the second year, and 80-90 percent from the third in the second year, and 80-90 percent from the third year onwards.year onwards.

• Production and sales will be equal.Production and sales will be equal.

• The selling price used may be the present selling The selling price used may be the present selling price.price.

Estimates of Sales and Production

   

 

   

 

(Details may be furnished separately for each product and until the plant reaches maximum capacity utilisation)

Product

1st 2nd 3rd 4th

yr yr yr yr

Product

1st 2nd 3rd 4th

yr yr yr yr

1. Installed capacity (qty per day per annum)

2. No. of working days

3. No. of shifts

4. Estimated production per day (qty)

5. Estimated annual production(qty)

6. Estimated output as % of plant capacity

7. Sales (qty) (after adjusting stocks)

8. Value of sales (in’000 of Rs)

Product

(i)

(ii)

(iii)

Note : Production in the initial period should be assumed at a reasonable level of utilisation of capacity increasing gradually to attain full capacity in subsequent years.

Estimates of Production and Sales

Given the estimated production, the cost of

production may be worked out. The major

components of cost of production are:

• Material cost ( Next slide)

• Utilities cost ( power water and fuel)

• Labor cost ( wages – Industry norms)

• Factory overhead cost

Cost of Production

Material cost

Output

Material InputBased on

1.Theoretical consumption norms or standards2.Experience3.Performance Guarantee4.Specifications of suppliers

Production Process

Total RequirementOut put quantity

multiplied by per unit requirement of input

Step 1

Step2

ValueInput quantity

multiplied by price

Labour cost

1. B Pay2. DA3. HRA, 4. Conveyance5. Medical6. LTA7. PF, Gratuity, Bonus Consider- leaves, OT, Night shit allowance Calculated for year

Factory Over Head

Repairs and maintenance( condition of machinery, Lower initially)

Rent , Taxes , Insurance- at existing ratesFactory expenses- provisions made, in

addition contingency margin provided

In estimating the working capital requirements and

planning for its financing, bear in mind the following:

In estimating the working capital requirements and

planning for its financing, bear in mind the following:

• The working capital The working capital requirement consists of raw materials and components, work-in-process, finished goods, consumable stores, debtors, and operating expenses.

• The principal sources of working capital finance are working capital advances provided by commercial banks, trade credit, accruals and provisions, and long-term sources of financing.

• There are limits to obtaining working capital advances from commercial banks. They relate to the maximum permissible bank finance for working capital and the amounts that can be raised against each individual current asset.

Working Capital Requirement and Its Financing

Working capital

Lack of adequate working capital is often stated as one of the major reasons for sickness in industry (especially in case of SMEs).

The counter arguments from the banks have been that most firms face problems of inadequate working capital due to credit indiscipline (diversion of working capital to meet long term requirements or to acquire other assets).

In this context it would be pertinent to understand the method adopted by banks in computing the working capital requirement of the business and the quantum of bank financing to be provided by the bank.

Main factors considered in the estimation of working capital requirement

1. The nature of business and sector-wise norms Factors such as seasonality of raw materials or of demand may require a high level of inventory being maintained by the company. Similarly, industry norms of credit allowed to buyers determine the level of debtors of the company in the normal course of business.

2. The level of activity of the business Inventories and receivables are normally expressed as a multiple of a day’s production or sale. Hence, higher the level of activity, higher the quantum of inventory, receivables and thereby working capital requirement of the business. So in order to arrive at the working capital requirement of the business for the year, it is essential to determine the level of production that the business would achieve.

In case of well-established businesses, the previous year’s actual and the management projections for the year provide good indicators. The problems arise mainly in the case of determining the limit for the first time or in the initial few years of the business.

Banks often adopt industry standard norms for capacity utilization in the initial years.

Steps involved in arriving at the level of Working Capital Requirement

1. Based on the level of activity decided and the unit cost and sales price projections, the banks calculate at the annual sales and cost of production.

2. The quantum of current assets (CA) in the form of Raw Materials, Work-in-progress, Finished goods and Receivables is estimated as a multiple of the average daily turnover.

3. The multiple for each of the current assets is determined generally based on the industry norms.

4. The current liabilities (CL) in the form of credit availed by the business from its creditors or on its manufacturing expenses are deducted from the current assets (CA) to arrive at the Working Capital Requirement (WCR).

Norms of WC

Norms were fixed regarding the quantum of various current assets for different industries (as multiples of the average daily output) and the Maximum Permissible Bank Financing (MPBF) was capped at a certain percentage of the working capital requirement thus arrived at.

Example

Let us now consider the following example to illustrate the

application of all the above three methods: 

Total Current Assets (TCA) = Rs. 700 lacs

Other current liabilities (OCL) = Rs. 280 lacs (Excluding bank borrowings

Current liabilities Current Assets

Creditors 200

Raw Material 300

Other Current liability 80

Stocks 100

Bank borrowings 400

Finished Goods 150

Receivables 100

Other Current Assets 50

Total Liabilities 680

Total Assets 700

Example

Method1 : The borrower should bring in 25% of the net working capital

(current assets ‑ current liabilities excluding bank borrowing) from its owned and long term liabilities. Method II. The borrower should finance 25% of all

current assets from owned funds and long term liabilities and the balance he financed by the bank.

 Method III. The hard core current assets i.e., the current assets which are permanently required by the unit for its functioning must be exclusively financed by the borrower. The borrower should also provide 25% of the remaining current assets and only the balance will be financed by the bank

Solution

Lending under Method ITotal current assets 700Less: Other current liabilities 280Working capital gap 42025% of the above as margin from long term sources 105Maximum permissible bank finance (M.P.B.F.) 315Excess borrowings ( 400-315) 85Method IITotal current assets 700Less: 25% of above as margin from long term sources 175

525Less : Other current liabilities 280

Maximum permissible bank finance (MPBF) 245Excess borrowings (400-245)

155

Solution

Method III Total current assets 700 Less : Core current assets (assumed figure)

160Balance current assets 540Less : 25% of above

135405

Less : Other current liabilities 280Maximum Permissible Bank Finance (MPBF)

125Excess borrowings(400-125) 275 

Margin requirement

Varies with types of current assetNo fixed formula

Current Assets Margin

Raw Materials 10-25%

WIP 20-40%

Finished Goods 30-50%

Debtors 30-50%

Margin Money for working Capital

Bank Finance

Margin Money

Amount

Indigenous RM less trade credits

Imported Raw Materials

Consumable stores

Wages and salary

Cost of fuel, light, power ,taxes, insurance etc

Cost of repair and insurance

Packing and sales exp

Stock of finished goods

Stock of WIP

Outstanding Debtors

Other items of WC

Net Working Capital

Profitability Projections (or Estimates of Working Results)

Given the estimates of sales revenues and cost of production, the next step is to prepare

the profitability projections or estimates of working results (as they are referred to by

term-lending financial institutions in India). The estimates of working results may be

prepared along the following lines:

A Cost of Production

B Total administrative expenses

C Total sales expenses

D Royalty and know-how payable

E Total cost of production (A+B+C+D)

F Expected sales

G Gross profit before interest

H Total financial expenses

I Depreciation

J Operating Profit (G - H - I)

K Other income

L Preliminary expenses written off

M Profit/loss before taxation (J+K - L)

N Provision for taxation

O Profit after tax (M - N)

Less Dividend on

- Preference capital

- Equity capital

P Retained profit

Q Net cash accrual (P+I+L)

J Operating Profit (G - H - I)

K Other income

L Preliminary expenses written off

M Profit/loss before taxation (J+K - L)

N Provision for taxation

O Profit after tax (M - N)

Less Dividend on

- Preference capital

- Equity capital

P Retained profit

Q Net cash accrual (P+I+L)

Sources of Funds

1. Share issue

2. Profit before taxation with interest added back

3. Depreciation provision for the year

4. Development rebate reserve

5. Increase in secured medium and long-term borrowings for the project

6. Other medium/long-term loans

7. Increase in unsecured loans and deposits

8. Increase in bank borrowings for working capital

9. Increase in liabilities for deferred payment (including interest) to machinery suppliers

10. Sale of fixed assets

11. Sale of investments

12. Other income (indicate details)

Total (A)

Cash Flow Statement

Disposition of Funds

1. Capital expenditure for the project

2. Other normal capital expenditure

3. Increase in working capital*

4. Decrease in secured medium and long-term borrowings

- All India Institutions

- SFCs

- Banks

5. Decrease in unsecured loans and deposits

6. Decrease in bank borrowings for working capital

7. Decrease in liabilities for deferred payments (including interest) to machinery suppliers

8. Increase in investments in other companies

9. Interest on term loans

Multi-Year Projections

A new firm, ABC Limited, is being set up to manufacture alloy steel. The expected outlays and proposed financing during the construction and the first two operating years are shown in Exhibit 6.9.

The projected revenues and costs for the first two operating years are shown in Exhibit 6.10. It may be assumed that (i) the tax rate for the firm will be 60 per cent, (ii) no deductions (reliefs) are available, (iii) preliminary and pre-operative expenses will not be written off during the first two operating years, and (iv) no dividend will be paid in the first two operating years.

Based on the above information, the projected profit and loss statements, projected cash flow statements, and projected balance sheets may be prepared as shown in Exhibits 6.11, 6.12, and 6.13.

Exhibit 6.11

Projected Profit and Loss Statements of ABC Limited

Exhibit 6.12

Projected Cash Flow Statements for ABC Limited

Exhibit 6.13

Projected Balance Sheets of ABC Limited

Review

1. What is a Capital Projects ?

Essentially a capital project represents a scheme for investing resources that can

be analyzed and appraised reasonably independently

2. What are the basic characteristics of a Capital Project ?

The basic characteristic of a capital project is that it typically involves a current

outlay (or current and future outlays) of funds in the expectation of a stream of

benefits extending far into the future.

3. Why capital Budget decisions are Important ?

Their importance stems from three inter-related reasons: • Long-term effects, • Irreversibility

Review

4. While capital expenditure decisions are extremely important, they pose difficulties – What are They ?• Measurement problems,Measurement problems,• Uncertainty and Uncertainty and • Temporal spread.Temporal spread.

5. Capital budgeting is a complex process which may be divided into six broad phases- What are they ?: • Planning, Planning, • Analysis, Analysis, • Selection, Selection, • Financing, Financing, • Implementation andImplementation and• Review.Review.

6. One can look at capital budgeting decisions at three levels – Explain the levels• operating, • administrative, • and strategic.

7. What are the important facets of project analysis ?

• Market analysis,

• Technical analysis,

• Financial analysis,

• Economic analysis, and

• Ecological analysis.

8. The common weaknesses found in capital budgeting systems in practice are:

• Poor alignment between strategy and Capital budgeting;

• Deficiencies in analytical techniques;

• No linkage between compensation and Financial measures;

• Reverse financial engineering;

• Weak integration between capital budgeting and expense budgeting;

• Inadequate post-audits.

9. To Judge a project from the financial angle What information is needed? :

a. cost of project,b. means of financing, c. estimates of sales and production, d. cost of production, e. working capital requirement and its financing,f. estimates of working results (profitability projections), g. break- even point, h. projected cash flow statements, and i. projected balance sheets.

10. The Cost of project represents the sum ofa. land and site development, b. buildings and civil works, c. plant and machinery, d. technical know-how and engineering fees, e. expenses on foreign technicians and training of Indian technicians abroad, f. miscellaneous fixed assets, g. preliminary and capital issue expenses,h. pre-operative expenses, provision for contingencies, i. margin money for working capital, and j. initial cash losses.

Review

11. To meet the cost of project, what source of finance is looked at ?a. Share capital (equity capital and preference capital), b. Term loans (rupee term loans and foreign currency term loans), c. Debenture capital (non-convertible debentures and convertible debentures), d. Deferred Credit, e. Incentive sources (seed capital assistance, capital subsidy, and tax deferment f. or exemption) and g. Miscellaneous sources (unsecured loans, public deposits and lease and hire

purchases finance)

12. To determine the specific means of finance for a given project, what are the things should be borne in mind:

(i) Norms of regulatory bodies and financial institutions, (ii) Key business considerations, namely cost, risk, control, and flexibility.

Review

Review

13. What is the starting point of profitability projections ?Forecast for sales and revenues. In estimating sales it is reasonable to assumethat capacity utilization would be somewhat low in the first year and rise thereafter gradually to reach the maximum level in the third or fourth year of operation.

14. What are the major cost of production ?The major components of cost of production are: a. Material cost,b. Utilities cost, c. Labour cost, and factory overhead cost. The material cost comprises the cost of raw materials, chemicals, components,and consumable stores required for production. The cost of utilities is the sum

ofthe cost of power, water, and fuel. The labor cost includes the cost of all manpower employed in the factory. The expenses on repairs and maintenance, rent, taxes and insurance on factory assets, and so on are collectively referred to as factory overheads.

15.What are the factors considered for working capital requirement ?

In estimating the working capital requirement and planning for its financing, the

following must be borne in mind:

The build up of current assets till the rated level of capacity utilization is reached,

The maximum permissible bank finance as per the second method of lending

recommended by the Tandon Committee, and the margin requirements against

various current assets.

16.Briefly explain profitability projection, cash flow and balance sheet projections.

The profitability projections or estimates of working results (as they are referred

to by term-lending financial institutions) are prepared along the following lines:

(i) cost of production, (ii) total administrative expenses, (iii) total sales expenses,

(iv) royalty and know-how payable, (v) total cost of production (vi) expected sales,

(vii) gross profit before interest, (viii) total financial expenses, (ix) depreciation,

(x) operating profit, (xi) other income, (xii) preliminary expenses written off, (xiii)

profit/loss before taxation, (xiv) provision for taxation, (xv) profit after tax, (xvi)

dividend,(xvii) retained profit, and (xviii) net cash accrual.

The cash flow statement shows movement of cash into and out of the firm and its net impact on

the cash balance with the firm. The balance sheet, showing the balance in various asset and

liability accounts, reflects the financial condition of the firm at a given point of time.

Case Study

Group-1 GroupII Group IIIPresent of Estimation for a software project

problems and challenges