MBA OP 03 : PROJECT MANAGEMENT

Unit 3
Process of Project Appraisal
By :
Dr. Ashok Kumar
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Project Appraisal
INTRODUCTION : The exercise of Project
appraisal simply means the assessment of a
project in terms of its economic, social, and
financial viability.
Project appraisal can be defined as the
promoter taking a second look critically and
carefully at the project to take an independent
and objective view of the project in its totality
and also in respect of its various components.
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Project Appraisal
Technical
Financial
Commercial
Economic
Managerial
Legal
Social
Ecological
Organisational
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Project Appraisal
Project
Appraisal
Technical Financial Commercial Economic Managerial Legal Social Ecological Organisational
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Scope of Project Appraisal
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The appraisal of a project is undertaken by the
financial institutions with the twin objectives
of determining the market potential of a
project and selecting an optimal strategy.
Technical Appraisal
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Selection of process knowhow
Fixation of the capacity of the plant as a whole
Selection of plant and equipment
Process description and plant layout
Evaluation of the existing transport and other
service facilities
General layout and material flow chart
Construction schedule
Commercial Appraisal
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The commercial aspects of a project include the
arrangements for marketing the output produced by
the project and the arrangement for the supply of
inputs needed to build and operate the project. On
the output side, careful analysis of the proposed
market for the project's production is essential to
ensure that there will be an effective demand at a
remunerative price. It needs to be ensured that
adequate input supplies are available for the efficient
operation of the project.
Commercial Appraisal
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A proposal should be commercially sound. Thus, before
a proposal is recommended following aspects are
examined to test the commercial viability to the
proposal.
Demand and availability of the product
Site selection
Requirement and sources of raw materials
Banking facilities, etc.
Of the above, examination of demand and availability
of the products to be produced by the project under
consideration is very important. Continuity of the
demand should also be examined.
Economic Appraisal
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A proposal has to be viable form the national
point of view also. The economy of the country
should improve on the execution of the proposal.
If a proposal is for substitution of the existing
imports of an essential product of national
consumption or defence materials and oils, the
proposal may be viewed more favourable form
national economic considerations. Sometimes
such proposal may not yield any financial gain on
tangible basis.
Economic Appraisal
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Economic Aspects :
Increased Output
Increased Employment
Enhanced Services
Larger Revenue to Government
Higher Earnings, Standard of Living
Increased National Income

Economic Appraisal
Economic rate of return
Social cost benefit analysis
Employment generation
Projects contribution to the development of
sector / economy
Industrial development of the region
Improvement in the socio-economic status of
the people of the region
Financial Appraisal
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Financial Aspects :
Financial Soundness
Efficient Operation
Cost of Production
ROI
Profitability
Budgeting
Pricing

Financial Appraisal
Estimation of capital cost
Whether proper quotations are obtained from potential
supplier?
Whether contingencies are provided?
Whether inflation factor is considered?
Estimation of working results
Whether price computation of input and output is proper?
Whether cost projections and distinction between fixed
and variable cost is proper?
Managerial Appraisal
Sound understanding and commitment of
promoters towards the project
Prior experience of the promoters
Organization structure and staffing plan
Remuneration structure of key technical and
managerial personnel

Project evaluation under risk and
uncertainty
There may be following risk and uncertainties to the
project:
Time over-run due to various reasons beyond the
control of project authorities
Cost over-run due to many reasons beyond the
control of project authorities
Change in the demand of product/service proposed
to be produced/generated from the project
Increase in the cost of production
Change in the selling prices due to downward
demand of product on account of arising of
slackness in the market

Project evaluation under risk and
uncertainty 2
Fund constraints leading to time over-run and cost
over-run
Political risks (Reliance Fresh in UP)
International risks due to problems in the countries of
foreign contractors and suppliers to the project
Design or technological obsolescence (Electronic
Typewriter, Pager)
Long gestation period (Hydropower, Infra. Projects)
Economic crisis i9nternal as well as global (USA)
Excess imports/dumping by the foreign countries.
Project evaluation under risk and
uncertainty 3
All these risks and uncertainties to the project cause
following impact on the project:
Time over-run
Cost over-run
Increase in cost of production
Decrease in selling prices and net sales realization
(NSR)
Increase in payback period
Reduction in rates of return on investment
Reduction in internal rates of return and net present
value.
Project appraisal under normal,
inflationary / deflationary conditions
Details about the project such as capital cost
estimates, profitability projection, selling prices
of its products, cost of production, etc. are
compiled assuming the currents conditions.
However, these assumptions made during the
normal conditions for the capital cost for project,
selling prices, and cost of production etc. may
change due to inflation or deflation during the
execution period and also after the execution
period of the project.
Problems arising due to
rate of discount
Discounting techniques take into account the time-value of
money. Discounting is essentially a technique by which one
can "reduce" the future benefit and cost streams to their
present worth.
For financial analysis, the discount or cut-off rate is usually the
marginal cost of money to the farm or firm for which the
analysis is being done. This often will be the rate at which the
enterprise is able to borrow money.
NPV of a project will decrease with an increase in discount
rate.
Tax burden and appraisal of project
Tax burden may be in the form of excise duty, customs duty,
sales-tax, entry tax, works contract tax and income-tax. Tax
burden may be affected by the following factors:
1. Place/State where project is being set up. There may be
various concessions besides the differential rates in various
States.
2. Certain projects carry concessional duties and taxes such as
infrastructural projects, hundred per cent export oriented
projects, projects being set up in hill areas, backward areas.
3. Tax impact due to financing mix of the project i.e. more
equity or more debt. It project is financed more by debt ,
interest impact would be more and tax impact would be less.
Similarly, when financing is done more by equity capital,
there will be less interest impact and hence higher impact of
income-tax
Legal Appraisal
Project Managers are strongly advised to take legal
advice from specialists in contract law and where
applicable international laws.
The relationship between the contracting parties must
be confirmed in a legally binding contract which
complies with the laws.
The documents have to be legally acceptable.
The legal aspect of project management include:
1. Project Contract
2. Risk Management
3. Restrictions on the suppliers liability
Social appraisal of project
Social- Anything relating to humans and their
interactions, including economic, cultural, human
rights, health and safety concerns.

Social analysis is undertaken to examine the aspects
like employment opportunities and income
distribution. The project analyst would also examine
the effects of a project on particular groups/regions.
Social Cost-Benefit analysis (SCBA)
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Social Cost-Benefit analysis (SCBA)- Analysis of
future cost and benefit streams from a
project, including items for which the market
does not provide a satisfactory measure of
economic value
Social costs and benefits- The total costs and
benefits of a project including both the private
costs and benefits and the spillovers
(externalities) on third parties and society in
general
Social Cost-Benefit analysis (SCBA)
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Social Costs:
1. Goods and materials acquired
2. Labour and Services used
3. Environmental damages
4. Public service and facilities used
5. Economic disparity
6. Wastage of natural resources
7. Soil erosion
8. Social cost of transportation etc.

Social Cost-Benefit analysis (SCBA)
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Social Benefits:
1. Products and services Provided
2. Creation of Employment opportunities
3. Source of income for government and public
4. Economic Development
5. Earning foreign exchange
6. Decrease in poverty
7. Social welfare / Community welfare work




Social Cost-Benefit analysis (SCBA)
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Advantages:
1. To identify projects those maximise the welfare
of community
2. To assess and quantify the purposes of project in
relation to community needs
3. To examine the social factors.
4. Recognition of social costs and benefits. Such as
environmental considerations.
5. Less emphasis being placed on personal
judgment and
6. Decentralised decision making through the
opportunity for community involvement .




Social Cost-Benefit analysis (SCBA)
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Disadvantages:
1. Difficult to measure social costs and benefits
and converting them into monetary terms.
2. Over statement of the values of social
benefits.
3. Complex.
4. Conflict between social welfare and financial
justification




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Problems due to change in wagerate:
1. Increase in cost of production / increase in cost of
project with an increase in wage-rates.
2. Products will become less competitive in international
markets.
3. Manufacturers may shift to machine intensive
technology, and this will lead to unemployment.
Problems due to change in exchange rates
1. Imports will be expensive if rupee deteriorates.
2. Imported Plant / Machinery / Raw material will be
expensive.
3. Result Project cost over run.
Origins of Project Risk
Risk: the potential for
loss
Project Risk: variability
in a projects NPW
Risk Analysis: The
assignment of
probabilities to the
various outcomes of
an investment project
Types of Risks in project
1. External Risk
2. Cost Risk
3. Schedule Risk
4. Technology Risk
5. Operational Risk
6. Political Risk
Techniques of Risks analysis
1. Sensitivity analysis
2. Break even analysis
3. Decision tree analysis
4. Simulation analysis
5. Probability
Methods of Describing Project Risk
Sensitivity Analysis: a means of identifying the
project variables which, when varied, have the
greatest effect on project acceptability.
Break-Even Analysis: a means of identifying the
value of a particular project variable that causes
the project to exactly break even.
Scenario Analysis: a means of comparing a base
case to one or more additional scenarios, such as
best and worst case, to identify the extreme and
most likely project outcomes.

Sensitivity Analysis
(Treatment of Uncertainty)
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Several times when the project is under execution, certain things
go wrong with the project with the result that the desired
benefits cannot be achieved within the stipulated time frame. For
example, the actual execution of the project is delayed or the cost
exceeds the original estimated cost (cost over-run). In such cases,
the results get fairly changed. Many times, the IRR and NPV thus
get reduced or the BCR becomes negative from positive.
In order to take care of this problem, while the projects are under
preparation or under examination, certain assumptions are
applied for testing the viability of the project. For example, it is at
times assumed that there will be a cost over-run by, say, 25% or a
reduction in revenues, say, by 10% or a delay in getting the
benefits, say, by three years and so on. Keeping one or two or all
such assumptions in view, the streams of costs and benefits are
re-drawn and the figures of c NPV, BCR and IRR are re-worked
out.
Sensitivity Analysis
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This gives a fairly good picture as to what will be the fate of
the projects if such mishaps occur. For the sensitivity analysis,
it is very essential to carry out such an exercise in projects
where high financial stakes are involved. Sensitivity and risk
analyses are particularly concerned with factors, and
combinations of factors, that may lead to unfavorable
consequences.
These factors would normally have been identified in the
project (logical) framework as project risks or project
assumptions. Sensitivity analysis tries to estimate the effect
on achieving project objectives if certain assumptions do not,
or only partly, materialize. Risk analysis assesses the actual
risk that certain assumptions do not, or only partly, occur.
Sensitivity Analysis
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Sensitivity and risk analyses are particularly
concerned with factors, and combinations of
factors, that may lead to unfavorable
consequences.
These factors would normally have been
identified in the project (logical) framework as
project risks or project assumptions.
Sensitivity analysis tries to estimate the effect on
achieving project objectives if certain
assumptions do not, or only partly, materialize.
Risk analysis assesses the actual risk that certain
assumptions do not, or only partly, occur.
Sensitivity Analysis
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The Purpose of Sensitivity Analysis
Sensitivity analysis is a technique for
investigating the impact of changes in project
variables on the base-case (most probable
outcome scenario). Typically, only adverse
changes are considered in sensitivity analysis.
Sensitivity Analysis
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The Purpose of Sensitivity Analysis
1. To help identify the key variables which
influence the project cost and benefit
streams.
2. To investigate the consequences of likely
adverse changes in these key variables;
3. To assess whether project decisions are likely
to be affected by such changes; and,
4. To identify actions that could mitigate
possible adverse effects on the project.
(c) 2001 Contemporary Engineering
Economics
37
Decision Tree Analysis
A graphical tool for
describing
(1) the actions available
to the decision-maker,
(2) the events that can
occur, and
(3) the relationship
between the actions and
events.
Decision Tree Analysis
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Decision tree approach is a graphical technique
that can be used for analysing the pros and cons
of alternative decisions and choose the best
possible course of action.
Ex. Whether to produce goods indigenously or to
import.
A decision tree is a diagrammatic representation
of the logical relationship between the different
parts of a complex situation and the possible
outcomes in different decisions.
Decision Tree Analysis
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Steps in decision tree analysis
1. Identify the problem and Alternatives
2. Specify the probabilities and monetary values
for outcomes
3. Evaluating the alternatives
Advantages of decision tree analysis:
Decision tree analysis allows a decision
maker to visualise assumptions and
alternatives in graphical form which is much
easier to understand
A company has the following estimates of the PV of
future cash flows after tax of an investment proposal,
concerned with expanding the plant capacity. The plant
expansion will cost Rs. 3,00,000. Use decision tree
approach to get a clear picture of the possible
outcomes of this investment proposal.
With Expansion Without Expansion Probability
3,00,000 2,00,000 0.2
5,00,000 2,00,000 0.4
9,00,000 3,50,000 0.4
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With Expansion expected Net cash flow
= (300000x0.2 + 500000x0.4 + 900000x0.4) 300000
= 320000
Without Expansion expected Net cash flow
= (200000x0.2 + 200000x0.4 + 350000x0.4) 0
= 260000
41
Outflow
Break-Even Analysis Chart
0 300 600 900 1200 1500 1800 2100 2400
$350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
-50,000
-100,000
Profit
Loss
Break-even Volume
X
b

=

1
4
3
0

Annual Sales Units (X)
P
W

(
1
5
%
)

42
Scenario Analysis
Variable
Considered
Worst-
Case
Scenario
Most-Likely-
Case
Scenario
Best-
Case
Scenario
Unit demand 1,600 2,000 2,400
Unit price ($) 48 50 53
Variable cost ($) 17 15 12
Fixed Cost ($) 11,000 10,000 8,000
Salvage value ($) 30,000 40,000 50,000
PW (15%) -$5,856 $40,169 $104,295
Appraisal of environmental
management and control
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Appraisal of environmental management and
control would be to know the level of arising
of pollution due to proposed project and
needs to manage and control the same as well
as measures taken, facilities provided in the
project under consideration for controlling the
pollution.