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InvestmentProject Design

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InvestmentProject Design

A Guide to Financialand Economic Analysis

with Constraints

LECH KUROWSKIDAVID SUSSMAN

John Wiley & Sons, Inc.

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Copyright C© 2011 by Lech Kurowski and David Sussman. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Kurowski, Lech.Investment project design : a guide to financial and economic analysis with constraints/

Lech Kurowski, David Sussman.p. cm. – (Wiley finance series)

Includes bibliographical references and index.ISBN 978-0-470-91389-5 (cloth)

1. Capital investments—Evaluation. 2. Investment analysis. 3. Industrial developmentprojects—Finance. 4. Infrastructure (Economics)—Finance. 5. Project management—Finance. I. Sussman, David (David Louis) II. Title.

HG4028.C4K867 2011658.15′2–dc22

2010037958

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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ToZosia Kurowska and Claire Sussman

for their lifetimes of support

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Contents

Acknowledgments xi

Symbols and Most Frequently Used Acronyms xiii

Introduction 1

CHAPTER 1Investment Environment 9

Systematic Project Analysis 10Project Environment and Strategy 11Project Development Process 33Planning Horizon and Project Life 43Project Scope 44Preinvestment Studies 46Investment Planning Infrastructure 58Appendix 1.1: Elements of Commercial and

Wider Domains 60Appendix 1.2: Outline of Business Plan for a

Manufacturing Enterprise 62Appendix 1.3: Outline of Design/Study Report 63Appendix 1.4: Information Flow Details 67Notes 69References 74

CHAPTER 2Preparing Pro-Forma Financial Statements 75

Accounting System 77Process of Financial Analysis 81Financial Costs and Benefits 84Investment Costs 87Production Cost 116Operating Cost, Factory Cost, and Cost of Product Sold 122

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viii CONTENTS

Financial Statements 127Appendix 2.1: Depreciation Methods 142Appendix 2.2: Starting Inventory Balance 148Notes 150

CHAPTER 3Financial Indicators and Criteria 155

Static Indicators 155Types of Static Indicators 156Dynamic Indicators 169Financial Criteria for Investment Decisions 188Analysis of Joint Ventures 203Project of an Ongoing Enterprise 206Appendix 3.1: Example of Cost of Capital Calculations 219Notes 225References 228

CHAPTER 4Financing the Project 231

Capital Structure 232Cost of Capital 249Notes 255References 256

CHAPTER 5The Economic Perspective 257

Private Sector 259Public Sector 259General Rationale for Economic Evaluation—Who

Needs It? 260Macroeconomic View—Impact on the

National Economy 262Price Distortions 266Applicability and Scope 272Economic Pricing Principles 278Shadow Prices of Primary Resources

(National Parameters) 292Conversion and Adjustment Factors 297Appendix 5.1: Costs and Benefits of Revenue Projects 299



Contents ix

Appendix 5.2: Global Pricing Framework—ImportableInput Forgone 301

Notes 303References 307

CHAPTER 6Economic Cost/Benefit Analysis 309

Adjustments for the Wider Domain 311Valuation at Market Prices 311Define the Accounting Unit 317Value-Added 343Notes 354References 358

CHAPTER 7Investment Decisions under Uncertainty and Risk 359

Forecasting 359Risk—Dealing with Uncertainty 364Quantitative Risk Assessment 369Qualitative Risk Assessment 380Risk Management 380Risk Immunization for Financiers 383International Investors and Risk 385Appendix 7.1: Discrete Probability Analysis—Multivariate 386Notes 387References 390

CHAPTER 8Project Appraisal 391

Macro-Micro Appraisal 392SWOT Analysis 393Stakeholder Perspectives 396Appraisal Report 399Caveats for the Appraiser 406Notes 407References 408

CHAPTER 9Implementation Planning and Budgeting 409

Implementation Planning 410Project Management 412



x CONTENTS

Conducting the Implementation Project 416Implementation Budget 437Appendix 9.1: Sample Responsibility Matrix for a

Portion of a Project 438Appendix 9.2: Checklist of Project Implementation Costs 438Notes 442References 443

About the Authors 445

Index 447



Acknowledgments

T he foundation for our approach to project design and appraisal consistsof ideas and concepts developed from our own work over the course of

the past 25 years, and interactions with fellow consultants and others withwhom we have collaborated, who graciously shared their knowledge andexperiences through informal discussions and communications and formalpresentations, and who have added immeasurably to the scope and depthof our effort. Their knowledge and experience in their respective areas ofexpertise has fused with that of the authors, so it is possible to identify onlyapproximately the areas of contribution of each of the following individuals,to whom we are deeply indebted (listed in alphabetical order):

Jadranko Bendekovic, the economic viewpoint, particularly the value-added approach; Janusz Lukasik, forecasting and the basic idea for theexpansion project case study; Andrzej Mlotkowski, project planning, im-plementation, and contracting; Joseph Moongananiyil who coordinated thework of the staff of the Enterprise Development Institute in Ahmedabad, In-dia, with whom the authors communicated on a wide variety of topics; KlausPertz, financial analysis; Reino Routamo, concepts of futuristic forecastingand the basic idea for the yarns case study; Maria Elena Scaffo, marketanalysis and finance; Aleksander Sulejewicz, who contributed widely to thechapter on economic analysis; Robert Youker, who greatly influenced thepresentation on project implementation and management; and Allan Young,project finance, financial planning, and risk. Jerzy Kurowski is responsiblefor much of the preparation of graphical materials. Michael Lisk, produc-tion editor at Wiley, was instrumental in integrating, organizing, and addingto the coherence of the manuscript.

Although this edition owes much of its usefulness to contributions ofthe aforementioned individuals, the authors are solely responsible for anyerrors and omissions.

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Symbols and Most FrequentlyUsed Acronyms

T he symbols described below are consistent with international usage. Theyare, however, used in different contexts and consequently might have

slightly different meanings in the main text. The exact meaning is indicatedby the subscript—for example, i(disc) and i(infl) indicate the discount rate andthe inflation rate, respectively, whereas “i” alone is used to mean interestrate.

Financial Symbols

BEP breakeven pointCOPS cost of products soldCOT coefficient of turnover (working capital)df discount factor, expressed as percentageEBITDA earnings before interest, taxes, depreciation and amortizationF fixed cost (total)f fixed cost of production, subscript denotes related resourceFC factory costsFV future valuei rate (interest, profit expectations, inflation), expressed as

percentageI investmentIN inventoryIRR internal rate of returnj used as subscript; depending on context, describes year

number, product number, input number, and so onMIRR modified internal rate of return (expressed as percentage)n number of periods, products, and so onNCF net cash flowNPV net present valueP productionp market price (product, input, etc.)PC production costsPV present value

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xiv SYMBOLS AND MOST FREQUENTLY USED ACRONYMS

Q, q quantity, unit quantity (e.g., consumption of resource per unitof production)

R project revenues (sales)ResV residual valueRoI, RoE return on investment, return on equityT tax rate (corporate, income) (expressed as percentage)V valuev unit variable costWACC weighted average cost of capital (expressed as percentage)WCap working capitalWiP work-in-progressw j weight of factor j

Economic Symbols

ADJ adjustment value (difference between adjusted value andoriginal value)

AF adjustment factor (expressed as percentage)AU accounting unitAV j values adjusted for distortions of factor jCc market cost of capitalCF conversion factor (expressed as percentage)CIF cost, insurance, and freightCRI consumption rate of interestEDR economic discount rateEIRR economic internal rate of return (expressed as percentage)FE foreign exchangeFOB free on boardFX foreign exchangeGDP (GNP) gross domestic (national) productI investment (or capital consumption when indicated)M importsMI material inputsMPS marginal propensity to saveMV market valueNFIA net factor income from abroadNNI net national incomeOER official exchange rateRP repatriated paymentsSCF standard conversion factor (in some methodologies, equal to

OER/SER)



Symbols and Most Frequently Used Acronyms xv

SER shadow exchange rateSP j shadow price (for factor j)SWR shadow wage rateVA value addedVDR value with distortions removedVEF value at efficiency pricedW wages and salariesWTP willingness to payX exports



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Intro JWBT424-Kurowski February 4, 2011 6:54 Printer: Yet to Come

Introduction

A ccumulating capital assets and applying them to provide future benefitsis a practice that dates from antiquity. Over 250,000 years ago, ances-

tors of our species Homo sapiens invested their time and energy to fashionsimple tools to improve the quality of their lives. Yet, even today, howcapital resources are applied—decisions about when, where, and how theyshould be committed—presents its challenges and does not always produceexpected results.

The central theme of this book—designing the project to be compatiblewith its operating milieu so that it is profitable and sustainable while pro-viding goods and services demanded by clients—derives in part from ourmany years as consultants to industries around the world, where we havewitnessed an inordinate quantity of idle and rusting, sometimes never used,capital facilities, almost invariably the result of poor planning. With about90,000 failures occurring annually in the relatively propitious U.S. businessenvironment alone, it’s clear that investing has always been a hazardousundertaking. Our planet is littered with remnants of investment ideas goneawry, projects that failed mainly because some critical design factor wasimproperly assessed.

Aside from the imponderable external factors that can sweep aside “thebest-laid schemes o’ mice and men,” such as political and economic up-heavals, one of the main deficiencies in project planning is that there isusually not enough of it, with decisions often made on the basis of anythingfrom intuition to inadequate analysis. The recent meltdown of the financialsector in the United States and around the world is symptomatic of world-wide economic strains that are inimical to the interests of capital investors.We believe that the approaches we provide for designing, analyzing, and ap-praising a project can increase confidence in the investment decision in theminefield of the contemporary investment environment. Preinvestment studyof appropriate breadth and depth, using these guidelines, vastly improveschances for a successful outcome.

A second motivation for the book involves potential benefits of a moreholistic view of a project’s business environment than has been the case tra-ditionally. Benefits for private and public investors are ordinarily measuredagainst corporate financial goals and objectives. As lines of demarcation

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2 INVESTMENT PROJECT DESIGN

between private and public enterprise are blurred in the global economythrough subsidies and other public support to major enterprises, and assome enterprise is either totally or partially nationalized, benefits can beadditionally measured from the perspective of society—benefits to citi-zens from public investment and conformance with public goals of privateinvestment—and at the same time enhance prospects for successful invest-ment if project outcomes complement overarching social goals as enunciatedby administrative, legislative, and judicial decision makers. We attempt toshow how the economic perspective—a much broader view of the enterpriseenvironment than is traditionally considered by investors—reduces risk andenhances prospects for a successful enterprise. This theme has been devel-oped comprehensively in Chapter 5.

Our intention is to provide guidelines for steering along the hazardousroad to success faced by private and public investors and their collaborators.While others have addressed the subject, we propose a more comprehensiveframework of analysis for any project involving capital investment—largeor small, in private and public sectors—one that clears up a number ofimportant misconceptions about financial aspects of design and appraisal,and that aligns the project more compatibly with features of its operatingenvironment than has heretofore been the norm.

Unanticipated impediments to the success of investment projects haveincluded mismatches between internal characteristics of the enterprise, itspersonnel, and other project needs, and external aspects of the operationalsetting such as market dynamics, supply constraints, or environmental im-pacts. Often there is a failure to consider alternatives that would constitutemore profitable applications of the time, energy, and other resources appliedto the contemplated project.1

Maintenance and improvement of current material standards of livingaround the world requires new investment. In fact, at both macro (economy)and micro (enterprise) levels, new investment is needed just to maintain thecurrent level of production capacity, which is diminished by technologicalobsolescence over time. Capital is also needed to accommodate advances intechnology and for improving efficiency of existing production units. Thequestion of whether a project is worthy of investment takes on ever-greatersignificance as capital accumulation for new projects is impeded by con-sumption demands of a growing population and by reticence of prospectiveinvestors and lenders in the face of increasing global uncertainties (e.g.,depletion of critical resources and political instability).

An investment project becomes part of the economic, social, and eco-logical system within which it is intended to function and prosper. It affectsthe preexisting system of supply and demand and thereby alters its char-acteristics. Project success depends upon the degree of satisfaction that it



Introduction 3

provides to sponsors and collaborators, and also to the wider communitythat provides its market, its workers, and those whose lives are affected byits presence. A useful analogy for analyzing the relation between the projectand its operational setting is the strategy of a biological organism seekingto survive and grow in its habitat.2 The enterprise seeks to earn its living byforging a useful link between resources and consumers, while at the sametime fulfilling its own objectives. It has internal characteristics that interactwith components and systems in the operational setting. Its health and well-being depend upon compatibility with friendly forces and building defensesagainst those that are hostile.

As the project faces the general hazards of doing business, producinggoods and services for public consumption, one design aspect too oftenoverlooked is the fact that even in situations where the project is designedfor finite life, the investment milieu of which the project is a part has notemporal boundary. In other words, benefits in the form of capital accu-mulation resulting from the project are generally intended for reinvestment:Culmination of the project after successful operations will provide oppor-tunities to consider new projects. For this reason, even from the perspectiveof capital accumulation, the issue of sustainability is relevant. Successoropportunities in future reinvestment rounds will demand resources, so itis prudent to design the project so that it relies to the maximum extenton sustainable consumption.3 Many studies show that it is not only envi-ronmentally beneficial but also good business to investigate the benefits ofrenewable, recycled, reduced, and reused resources in both the manufactur-ing process and in goods and services produced for industry and for publicconsumption.

Capital investment has not only shaped the modern world, but undoubt-edly has contributed much to public welfare around the globe. Events of theearly twenty-first century have demonstrated that the system of capital allo-cation is far from perfect. Excesses in capital markets have caused enormousdisruptions in the global economy, which may never regain the footing thatexisted prior to the onset of massive defaults in credit markets.

Although the proximate cause of the disruption appeared to be unprece-dented wide-scale risky behavior of market participants, including excessiveleveraging, a more fundamental explanation lies in the strains that existedin the global economy. The world’s wealthiest country continued to pileup massive trade and fiscal deficits that were being financed and otherwiseaccommodated by the rest of the world, a situation that was clearly unsus-tainable. Europe was striving to integrate countries with widely disparatepolitical structures and standards of living into an economic union. Asiancountries were struggling to apply their newfound export wealth to transi-tion into well-rounded, industrialized economies. All of this in the face of




declining stocks of fossil energy, which has supported an aura of prosperityin the industrialized countries for over a century.

Aside from macroeconomic policies (or rather, the lack of them) thatled to the disaster, clearly the declining fortunes of industrial enterprisesthroughout the world were indicative of widespread miscalculations at themicro, or enterprise, level. Planners of investment projects apparently failedto take into account the macroeconomic forces that would overwhelm themanagement capacities of their organizations. Circumstances and eventsexternal to these enterprises were apparently not sufficiently investigatedand their consequences not adequately considered in their plans so thatcalamity could be averted.

This work is an attempt to provide, for sponsors of investment projectsin the public or private sector, suggestions for improving the quality of theirinvestment decisions. Analysis of socioeconomic impacts leads to better useof scarce resources and, concomitantly, more balanced economic develop-ment. For this reason, a more extensive and intensive investigation of bothinternal capacities and features of the external project environment is pro-posed, with details of how to execute the design and analysis of the projectso that the investment decision is predicated on a sound footing of informa-tion and risk assessment. Project implementation is also covered, so that thehazards of delays in start-up and the risk of cost overruns are averted.

The methods described herein are relevant to the design, analysis, andappraisal of industrial, commercial, and infrastructure investment projectsin private and public sectors. They are applicable to revenue-generating andnonrevenue projects, as well as projects of virtually any scale.

This volume is structured somewhat differently from others on the sub-ject. It is intended more as a guide to project design and analysis ratherthan to provide a definitive framework for conducting an investment study.Design/study is presented as a continuous process, rather than consisting ofdiscrete stages, to conform more closely to practice. Mobility of productionfactors, particularly capital and labor, is more important than ever to takeinto account. Project design is necessarily less tidy than in the past, respond-ing to increasing complexity of doing business in most parts of the world.

Confronted with resource constraints, global competition, and an in-creasingly crowded world, investment analysis demands greater attention tothe wider domain4—the operational environment, including infrastructure,beyond the edges of the project proper and its commercial setting—which isa major theme of this work. The proposed methods of design and analysisare considered to be applicable in virtually any investment environment, inboth industrialized and developing countries.

There is a tendency to cloud distinctions between the project’s compo-nents and characteristics, its impacts and constraints, as either internal or



Introduction 5

external. It is difficult to conceive of any project feature that is purely withinone or the other category. A decision to appoint a manager cannot be totallyseparated from the availability of personnel within the population, or fromthe institutions that provided his training and experience. The terminologyemployed (e.g., internal) is a way of conforming to familiar semantics whileat the same time alluding to the unavoidable conjunction of what is internaland external to the project.

Investment, in this context, refers to projects that increase the stockof fixed capital/assets—that is, capital applied to new production or toexpansion, modernization, or other forms of rehabilitation of productionunits, and not investments in marketable securities of existing enterprises,although the methods of investment appraisal are similar.5

The order of the chapters only loosely relates to a sequential design andappraisal process. In practice, the design can commence at any point andproceed through a wide variety of sequential and iterative stages. Chap-ters are independent, but inextricably linked. In the interest of maintain-ing continuity within each chapter, ideas that are important but peripheralto the main line of thought are added as appendixes and referenced inthe text.

In addition to the main text chapters, two case studies are integralparts of the presentation. They are referenced at appropriate points in thetext, covering supplementary topics: “Cambria Yarns Project” and “Vic-toria Coke Project.” These are available on our web site, www.wiley.com/go/investmentprojectdesign. The case studies underpin discussions and ex-positions on methods of design and analysis. The Cambria Yarns Project(CYP) is a new investment undertaken to exploit export opportunities forprocessed high-quality yarns rather than currently exported raw material.The case is analyzed for its commercial viability and also its impacts uponthe national economy. Results of the financial analysis are integrated andlabeled (e.g., Income Statement—CPY) at appropriate points in the text ofChapters 2–4, and results of economic analysis are included in Chapters 5and 6.

The second case, the Victoria Coke Project (VCP), is an example of arehabilitation project that results in restoration of capacity and operatingefficiencies. It is undertaken as a joint venture between foreign and domesticpartners. A predominant feature is the special methods of incremental finan-cial analysis appropriate for this type of project. The issue of asset valuationand how it affects negotiations on share distribution is another aspect of thecase. Results are completely contained on the web site. The project name issometimes in the abbreviated form, VCP.

Chapter 1, “Investment Environment,” covers the framework for projectdesign and development: the commercial and wider domains in which the




enterprise is to be created and operated; design impacts of infrastructureand resource constraints; the rationale for strategic orientation, regardlessof project size and complexity; and methods of developing strategies.

Chapter 2, “Preparing Pro-Forma Financial Statements,” deals withmethods for generating income, cash flow, and balance projections as thebasis for estimating performance indicators. In this chapter and the next,the main elements of analysis and results for the Cambria Yarns Project (seeour web site) are interwoven into the text at appropriate points.

Chapter 3, “Financial Indicators and Criteria,” explains the derivationof performance indicators from financial statements and criteria for stake-holders related to opportunity cost of capital and to inflation, exchangerates, and risk; methods of analysis appropriate for projects of existing en-terprises; and valuation of the enterprise in connection with joint ventureand takeover negotiations.

Chapter 4, “Financing the Project,” reviews sources of equity, debt,and other capital to cover the cost of project assets and implementation,and both conventional and innovative financing schemes, including private-public partnerships.

Chapter 5, “The Economic Perspective,” regards the project’s impactson the regional, national, or international economy as a means of assuringcompatibility with the host environment, including those directly related tooperations and those that are external (i.e., social and economic effects thatarise from the existence of the project but are unrelated to its commercialperformance). Quantitative costs and benefits are identified and valued interms of an economic accounting unit.

Chapter 6, “Economic Cost/Benefit Analysis,” is a guide for systemat-ically compiling quantitative and qualitative effects of the project. A socialdiscount rate is applied as a hurdle or challenge as part of the appraisal pro-cess; an alternative approach to economic assessment, value-added, is alsodiscussed, and correspondences between the two methods identified. Anal-ysis and results of the Cambria Yarns Project are included as appropriatein the text, including distribution impacts of savings/investment and directconsumption among social groups.

Chapter 7, “Investment Decisions under Uncertainty and Risk,” viewsthe project design as a forecast, replete with uncertainties and associatedrisks in virtually every one of its design dimensions. Methods of identify-ing areas of uncertainty and assessing qualitative and quantitative risk arepresented, as well as implications for stakeholders.

Chapter 8, “Project Appraisal,” discusses methods of arriving at aninvestment decision based upon a comparison of project performance char-acteristics that derive from design and analysis, the criteria of each type ofparticipant—investor, financier, guarantor, regulator, licensor—and special



Introduction 7

concerns of foreign investors. Issues that may be of concern to each type ofparticipant are identified, and discussion of appraisal reporting is included.

Chapter 9, “Implementation Planning and Budgeting,” explains the de-velopment of a preliminary implementation plan as prerequisite to decisionmaking and detailed planning. Activation of enterprise functions in the pre-production phase (e.g., market development and procurement) constitutepart of the implementation plan and costs. Project management and con-tractual alternatives are discussed.

“Cambria Yarns Project” describes the background and essential fea-tures of a project to convert domestically produced cotton into mainly ex-portable processed cotton yarn. Analyses of financial and economic viabilityof the project are integrated into the text at appropriate points. Externalagricultural impacts are internalized in the economic analysis (see our website).

“Victoria Coke Project” describes an example of rehabilitation of acompany suffering from deterioration of its production facilities, and fromexcessive use of production factors. Techniques of financial analysis for jointventure partners are covered (see our web site).

Note: All of the tables of the Cambria Yarns Project are included in thetext, some in abbreviated form, which illustrate the structure of analysis.Complete Excel tables from which they were extracted can be found at ourweb site. Tables for the Victoria Coke Project are found only on the website.

A comprehensive discussion of market issues is also included on ourweb site: “Market Research and Marketing.”

NOTES

1. William R. Easterly, The Elusive Quest for Growth: Adventures and Misadven-tures in the Tropics (Cambridge, MA: MIT Press, 2002). Easterly discusses whyand how much capital investment in the developing countries has been wastedas a result of the failure of international investment promotion agencies to fosterpolicies that would incentivize engagement in productive and profitable lines ofmarket activity.

2. Biological organisms acquire their strategies through the process of evolution;natural selection molds both the organism and the manner of accommodating toits environment. However, strategic development among biological organisms isnot very efficient. Essentially random mutations are tested against the prevailingenvironment and, if found wanting, are quickly obliterated. We see the vestigesonly in fossilized remains of experimental organisms that took the wrong turn.Investors do not have the luxury of trial and error in strategic development forthe enterprise, as the process would be unacceptably costly.




3. This begs the question: What is sustainable? In general, to be sustainable, em-ployment of a resource does not diminish the possibility of consumption in thefuture. These are only a few possibilities: products designed for easy disassem-bly for recycling and reuse; products made from recycled and renewable ma-terials; nonpolluting disposal (e.g., decomposition into environmentally harm-less substances); energy conservation in buildings, manufacture, and productconsumption; use of renewable energy sources—solar, wind, geothermal, tidal,hydro, biomass.

4. The term wider domain is used to indicate elements of the project’s externalenvironment beyond those traditionally considered as relevant to its design andanalysis. This is explained in some depth in Chapter 1.

5. Investment that adds to the stock of productive assets is more assuredly a con-tributor to economic well-being than is investment in financial markets where theprimary emphasis is on the price of assets rather than what they produce. Incre-ments of productive assets (physical and intangible) increase national wealth andare conducive to improvement in the standard of living of the society as a whole.


c01 JWBT424-Kurowski February 3, 2011 9:11 Printer: Yet to Come

CHAPTER 1Investment Environment

T he investment project creates an enterprise that functions in an envi-ronment comprising internal characteristics and external surroundings.

Design of internal characteristics is essentially within the province of projectpersonnel, but external features are variously susceptible to influence: Someare clearly independent of the existence of the project, others can be mod-erately affected, and some can be readily adjusted to serve project needs.Being aware of its features is the first step in assuring mutual compatibil-ity between the investment environment and the project, which is essentialto success.

A project is considered to be a set of coordinated activities intendedto achieve a specific outcome, with a beginning and an end. The projectstarts when the investment idea attracts serious attention, progresses throughpreinvestment phases of study, design, analysis, and appraisal; then, if ac-ceptable for investment, through commitment of resources and implemen-tation, in which the enterprise is either created or modified, and productionfacilities assembled, constructed, installed, and then commissioned for op-erations. The decision to invest in the project is predicated on results ofappraisal of the projected relationship between the investment and the ex-cess of benefits over costs to be derived during the operations phase, asdescribed in Chapters 2–4 (financial) and 5 and 6 (economic).

The enterprise commences operations as resources are consumed to pro-duce goods and/or services (hereinafter referred to as products) provided toconsumers; there follows a decommissioning phase, if applicable, or perhapsrenewal in the next investment cycle. The project conception and design, andits appraisal, are inevitably predicated on forecasts that are inherently un-certain; thus, consideration of associated risks is an indispensable dimensionof the planning process.

9




SYSTEMATIC PROJECT ANALYSIS

The investment project is most effectively studied and designed as a system,or perhaps a primary system with interacting subsystems. The enterprisein its environment is modeled as a whole rather than an assemblage ofindividual elements or parts. The description of system elements, structure,and processes, and their interactions, yields insights into their functions anddynamics, providing a basis for refining project design toward attainmentof objectives and goals. This requires specifications of system elements andplans to effectively mobilize resources necessary for their proper functioning(e.g., energy, materials, labor, information, technology, finance) and creativeconceptions about how they can be employed so that they are mutuallyreinforcing.

Design/study follows a logical, but not necessarily linear, sequence, oftenthrough several iterations, consisting of the following elements:

� Goals and objectives—what is to be accomplished, and why, by indi-viduals and organizations involved.

� Criteria of acceptability for stakeholders—investors, lenders, guaran-tors, regulators, licensors.

� Alternatives—the range of choices for design of the system and its com-ponents: product; enterprise organization and staffing; location; siteselection and layout; plant and ancillary facilities; process; machineryand equipment.

� Impacts of each alternative—resources consumed and generated andother tangible and intangible consequences.

� Quantitative and qualitative forecasts of impacts to the planninghorizon.

� Benefits and costs to be counted—elements to be included in assessingprofitability and other indicators of performance, and their individual,organizational and/or geographical range of relevance.

� Unit of measurement for meaningful aggregation of impacts, and iden-tifying impacts that can only be assessed qualitatively.

� Determining quantitative performance indicators and nonquantifiablemeasures of project impact (e.g., commercial, economic, social).

� Assessing risk—decisions predicated on uncertainty in forecasts andtheir possible negative impacts on performance.

� Appraisal—comparing performance indicators and other impacts withcriteria of stakeholders, considering risk of failure to meet criteria.

� Recommending a course of action as the most favorable among alter-natives.



Investment Environment 11

For practical reasons, it is necessary to select only those aspects ofthe project with the most significant impacts for detailed analysis. Someimpacts are best estimated in aggregated form using accepted rules of thumb.However, details can be important: What appear as minor factors at theoutset can loom large when they become problematic.1

A fundamental concept for all types of projects is incremental analysis,the difference between the situation for stakeholders with the project andwithout the project. This is not the same as after versus before the project. Fora new investment the without-project situation is usually relatively straight-forward. It is concerned with the current disposition, and effects for stake-holders, of resources that will be transferred or otherwise dedicated to theproject. For a project undertaken by an existing enterprise, the without-project situation involves the operational scenario if the project is not un-dertaken. In either case, the incremental impact is the difference betweenthe with-project and without-project situations. This concept is further ex-plained in Victoria Coke Project case study, on our web site and in Chapter 3.

PROJECT ENVIRONMENT AND STRATEGY

An investment project becomes part of a system of supply and demandfor goods and services, and also an integral part of socioeconomic andecological systems within which it is to function and prosper. Its successdepends upon how well it accommodates to its operating environment, aswell as the degree of satisfaction that it provides to its clients and to thewider community that provides its market, its workers and those whoselives are affected by its presence. Whether the project is undertaken in anindustrialized or developing country or a country in transition, the analogyof a biological organism employing a strategy to survive and grow in itshabitat, or environment, described in the Introduction, is applicable.

In some environments, demonstration that the project will serve socio-economic goals and objectives and be compatible with the host ecology isrequired. Public interest is expressed through fiscal, administrative, environ-mental, and other conditions imposed by governing bodies requiring thatthe investment project employ scarce resources efficiently for local, regional,or national development. Government initiatives that encourage or compeladherence to public goals with incentives and restrictions enter into analysisand appraisal of the project.

The strategic plan might include factors involving corporate social re-sponsibility (CSR) as a means of enhancing corporate image and receptionof the project by the host community. For further discussion see our website—Corporate Social Responsibility.




Project Domains

The relationship between the project’s commercial domain and the widerdomain with which it interacts is illustrated in Figure 1.1. The commercialdomain comprises markets and suppliers, financiers, competitors, technolo-gies, and internal project characteristics designed to produce desired benefitsfor investors. The wider domain is project-specific, encompassing the polit-ical, social, economic, and environmental milieu in which the enterprise isto function. It can be delimited geographically as the community (e.g., city),the region, the country, or the international setting, and operationally asthe scope of major interactions between the project and external factors. Inreality these domains are not so clearly demarcated—they are unified by in-teractions and mutual repercussions. As one example, aesthetics and culture(a feature of the wider domain) may affect the market—what people arewilling to consume (a characteristic of the commercial domain).2 A partiallisting of elements of the commercial and wider domains for considerationis provided in Appendix 1.1.3

That project stakeholders are obliged to consider the commercialdomain is obvious, certainly for private-sector projects and often in the

PricesMarkets

Finance

Commercial

Laws,RegulationsPatents

Licenses

CompetitionProject

Natural Resources

Environmental Impacts

Socioeconomic

PhysicalEnvironmentTechnology

DistributionChannels

Culture

Politics

SocietalGoals

Economy

Commercial Domain

Wider Domain:CommunityRegionCountryInternational

Esthetics

People - Quality of Life

Flora and

Fauna

F IGURE 1.1 Commercial and Wider Domain

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