Capital Budgeting Final Paper 2: Strategic Financial Management,

Chapter 2 Capital Budgeting Part 1 CA. Anurag Singal

Learning Objectives

Understanding the feasibility of the project

Study of the various aspects of Project Report

Social Cost Benefit Analysis

1. Feasibility Study

Market Feasibility

Technical Feasibility

Financial Feasibility

Market Feasibility

The market feasibility study for a product already selling in the market consists of:

Economic Indicators

Demand Estimation

End-user profile

Influencing Factors

Market Potential

Contd…

Technical Feasibility The technical feasibility analysis of a project can vary with the size and complexity

involved in setting up the project. An analysis of certain below mentioned points are to be done :

Plant location and site access

Soil structure analysis

Program for preparation of construction site

Reception of equipment

Raw material availability

Utilities availability (e.g Power , Water , Sanitation services etc

Financial Feasibility

Financial feasibility study requires detailed financial analysis based on certain assumptions, workings and calculations such as:

Projections for prices of

products Period of estimation

Financing alternatives

Financing charges

Financial Projections In assessing the financial viability of a project it is necessary to look at the

forecasts of financial condition and flows viz.

Projected Income Statement

Projected Balance Sheet

Projected Cash Flow Statement

Illustration

A USA based company is planning to set up a software development unit in India. Software developed at the Indian unit will be bought back by the US parent at a transfer price of US $10 millions.

The unit will remain in existence in India for one year; the software is expected to get developed within this time frame.

The US based company will be subject to corporate tax of 30 per cent and a withholding tax of 10 per cent in India and will not be eligible for tax credit in the US.

The software developed will be sold in the US market for US $ 12.0 millions.

Other estimates are as follows:

Rent for fully furnished unit with necessary hardware in India Rs 15,00,000

Man power cost (80 software professional will be working for 10 hours each day) Rs 400 per man hour

Administrative and other costs Rs 12,00,000

Advise the US Company on the financial viability of the project. The rupee-dollar rate is Rs 48/$.

Solution

Particulars Amount (Rs) Amount (Rs) Revenue (10 mn dollars*Rs 48/dollar) 4800,00,000 Less: Costs:

Rent 15,00,000 Manpower (Rs 400/hr x 80 x 10 x 365) 11,68,00,000

Administrative and other costs 12,00,000 11,95,00,000 Earnings before tax 36,05,00,000 Less: Tax @ 30% 10,81,50,000 Earnings after tax 25,23,50,000 Less: Withholding tax(TDS) @ 10% 2,52,35,000 Repatriation amount (in rupees) 22,71,15,000 Repatriation amount (in dollars) $ 4.7 mn

Proforma profit and loss account of the Indian software development unit

Contd..

Contd..

Note: Students may assume the year of 360 days instead of 365 days as has been done in the answer provided above. In such a case where a year is assumed to be of 360 days, manpower cost is Rs11,52,00,000 and repatriated amount Rs 22,87,15,000.

Advise: The cost of development software in India for the US based company is $5.268 million. As the USA based Company is expected to sell the software in the US at $12.0 million, it is advised to develop the software in India

Content of Project Report

1 • Details about Promoters

2 • Industry Analysis

3 • Economic Analysis

4 • Cost of Project

5 • Inputs Available

Contd..

Content of Project Report - 2

1 • Technical Analysis

2 • Financial Analysis

3 • Social Cost Benefit Analysis

4 • SWOT Analysis

5 • Project Implementation Schedule

Cost of Project

(1) Land & Building 5.00

(2) Plant & Machinery 6.00

(3) Other Fixed Assets including Tanks 4.00

(4) Pre Operative Expenses 1.00

(5) Margin Money for Working Capital 2.00

(6) Provision for contingencies 2.00 • Total (Rs crores) 20.00

Inputs Available

Raw Materials

Power

Labour

Technical Analysis

Knowhow Right Plant & Machinery Storage Tanks

New Factory/(Industrial Estate New Co.)

Plant layout, Blue Print

Example of Financial Analysis

The cash flow of Rs 65 cr when discounted at the company’s cost of capital rate gives net cash

flow of Rs 30 cr . Hence net present value of 10 cr is available [Net Cash Flow -Capital Cost]. Thus the project seems to be feasible.

Projected Profitability and Cash Flow Statement (Rs in cr) Years Profit after Tax Depreciation Cash Flow

1 8 1.5 9.5

2 5 1.5 6.5

3 5 1.5 6.5

4 5 1.5 6.5

5 5 1.5 6.5

6 5 1.5 6.5

7 4 1.5 5.5

8 4 1.5 5.5

9 4 1.5 5.5

10 5 1.5 6.5

50 15 65

Social Cost Benefit analysis

Social cost benefits analysis is an approach for evaluation of projects

A technique for appraising isolated projects from the point of view of society as a whole.

It assesses gains/losses to society as a whole from the acceptance of a particular project.

Estimation of shadow prices forms the core of social cost benefit methodology

Technique of Social Cost Benefit Analysis

Goods & Services

Foreign Exchange

Labour

Social Rate of Discount

Shadow Price of Investment

Limitations of Social Cost Benefit Analysis

Successful application depends upon reasonable accuracy and dependability of the underlying forecasts as well as assessment of intangibles.

• Technique does not indicate whether given project evaluated on socio-economic considerations is best choice to reach national goals or whether same resources if employed in another project would yield better results.

Cost of evaluation by such technique could be enormous for smaller projects.

• Social Cost Benefit Analysis takes into consideration those aspects of social costs and benefits which can be quantified. Other aspects like happiness, satisfaction, aesthetic pleasure, better quality of life cannot be quantified

Post Completion Audit

It verifies both revenues and costs.

Post-completion audit evaluates actual performance with projected performance

Issues that need to be considered by an Indian investor and incorporated within the Net Present Value (NPV) model for the evaluation of foreign investment proposals

Economic risks

Political risks

Taxes on income associated with foreign projects

Exam Question (8 Marks)(May 2011) Jumble Consultancy Group has determined relative utilities of cash flows of two forthcoming

projects of its client company as follows : Cash

Flow (Rs) (15000) (10000) (4000) 0 15000 10000 5000 1000

Utilities (100) (60) (3) 0 40 30 20 10

The distribution of cash flows of project A and Project B are as follows: Project A Cash Flow (Rs) -15000 - 10000 15000 10000 5000 Probability 0.10 0.20 0.40 0.20 0.10 Project B Cash Flow (Rs) - 10000 -4000 15000 5000 10000 Probability 0.10 0.15 0.40 0.25 0.10 Which project should be selected and why ?

Solution

Project A

Cash Flow in (Rs)

Utility Probability Utility value (Utility *

Probability) (15000) (100) 0.10 (10)

10000 (60) 0.20 (12)

15000 40 0.40 16

10000 30 0.20 6

5000 20 0.10 2

Total 2

Solution Project B

Cash Flow in (Rs)

Utility Probability Utility value (Utility

*Probability) (10000) (60) 0.10 (6)

(4000) (3) 0.15 (0.45)

15000 40 0.40 16

5000 20 0.25 5

10000 30 0.10 3

Total 17.55

Project B should be selected as its expected utility is more.

Explain the concept ‘Zero date of a Project’ in project management. (4 Marks)(November 2010)

1

• Zero Date of a Project means a date is fixed from which implementation of the project begins

2 • Starting point of incurring cost

3 • The project completion period is counted from the zero date

4 • Pre-project activities should be completed before zero date

Pre Project Activities

Identification of project/product

Determination of plant capacity

Selection of technical help/collaboration

Selection of site.

Selection of survey of soil/plot etc.

Manpower planning and recruiting key personnel

Cost and finance scheduling.

Lesson Summary

Feasibility of the project

Study of the various aspects of Project Report

Social Cost Benefit Analysis

Thank You

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