pm 0012 – project finance & budgeting

5/26/2018 Pm 0012 Project Finance & Budgeting

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Master of Business Administration - MBA Semester 3

PM 0012 PROJECT FINANCE & BUDGETING(4 credits)(Book ID: B1238)

ASSIGNMENT- Set 1

Marks 60NoteAnswer all questions. Kindly note that answers for 10 marks questions

should be approximately of 400 words. Each question is followed by evaluation

scheme.

1. Evaluate the golden rules of project risk management. (10 Marks)

The benefits of risk management in projects are huge. Managing of risks in a project isan indispensable part of the project. These rules also help in delivering the project ontime with the results the project sponsor demands. Below mentioned are the rules formanaging the project.Rule 1: Make risk management part of your projectThe proper implementation of risk management helps to get the complete benefits ofthis approach. Those projects which do not have a perfect risk management approachare either ignorant, or are confident that no risks will occur in their project.Rule 2: Identify risks early in your projectThe first phase in project risk management is to identify the risks that are present inyour project. The sources which are used to identify the risks are people and paper.

People include your team members, who bring their personal experiences and expertisealong with them.Rule 3: Communicate about risksYou can give the project risks more importance in team meetings, thusshowing itsimportance to the team members that give them some time to discuss these risks andreport new ones.Rule 4: Consider both threats and opportunitiesModern risk approaches focus on positive risks and the project opportunities. They turnbeneficial to the project and organization by executing the project faster, better andmaking it more profitable.Rule 5: Clarify ownership issues

Once you have created a list of risks, the next step is to state the responsibility of therisk. A risk owner has to be present for each and every risk that is found. He has theresponsibility to optimize the risk for the project. This enables the people to act andcarry out tasks in order to decrease threats and enhance opportunities.Rule 6: Prioritize risksThe project managers must prioritize risks that help them to deliver good results. Assome risks need to be given more time, it is better to spend your time on the risks thatcause the biggest losses and gains


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Rule 7: Analyze risksIt is essential to understand the nature of risks before jumping into conclusions. This willhelp you to analyze the risks. This analysis happens at different levels. A more detailedanalysis shows the order of magnitude in categories like costs, lead time or productquality. The analysis can also be done by focusing on the events that precede a risk

occurrence and the causes of risks.Rule 8: Plan and implement risk responsesAvoiding risks means maximizing the project returns in such a way that you do notencounter a risk anymore. This could mean changing the supplier or adopting a differenttechnology, and terminating a project once you deal with a fatal risk.Rule 9: Register project risksThis rule emphasizes the concept of bookkeeping. If you maintain a risk log, it will helpyou to track the progress. This is also an excellent medium of communication thatenables you to inform and update the team members and stakeholders about theprogress.Rule 10: Track risks and associated tasks

The rule 10 states that the tracking of risks is a routine schedule which is performed bythe project managers. Most of them make the job very easy by integrating these riskstasks into their daily routine. These risk tasks are used in identifying and analyzing risks,and for generating, selecting and implementing responses.

2.Explain different types of discounted cash flows (10 Marks)

Discounted Cash Flow (DCF) is a method to estimate the project, company or assetsinvestment opportunity by means of the conception of time value for money. In DFCmethod, the projects value is the future estimated cash flows discounted at a rate thatreflect the risk of the projected cash flow. A common practice is to use the DCF method

to value companies or projects. There are three major discounted cash flow analysesfor project evaluation and selection. They are:

Internal Rate of Return (IRR)

Net Present Value (NPV)

Profitability Index (PI)

DFC is based on free cash flow which is a reliable method to cut through theunpredictability and guesstimates involved in reported earnings. The free cash flowmodels examine the money left for investors regardless of the cash outlay whethercounted as an expense or turned into an asset on the balance sheet.Net Present Value analysis (NPV):-The Net Present Value Method is a primary capital

budgeting method that uses DFC technique. The net cash flows in NPV are discountedto their present value before comparing with the capital outlay required by theinvestment. The difference between the net cash flow and the capital outlay amounts isthe NPV. The NPV analysis considers Timing of cash flowswhile comparing differentstreams of cash flows. The firm must invest on projects that possess positive NPV andavoid any negative NPV projects. The project is acceptable once the net present valueis zero or positive. Accepting positive NPV profits shareholders as:

NPV uses Cash flows


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NPV uses all the cash flows of the project

NPV discounts the cash flows properly

The NPV is a standard technique meant for the financial assessment of long-termprojects. On meeting the financial charges for a project, it determines the excess or

shortage of cash flows in present value (PV) terms. The rule for NPV is:NPV = Present value of net cash flows

Where:Ct = the net cash receipt at the end of yearIo = the initial investment outlayr = the discount rate/the required minimum rate of return on investmentn = the project/investment's duration in yearsInternal Rate of Return:-Internal Rate of Return (IRR) is the rate at which the projectNPV becomes zero. It also offers the estimated return rate of the project, assuming thatthe assured conditions are met. It summarizes the projects merits to a single number. Itis the rate that determines whether or not an investment is worth pursuing.The loan amount fails to state the market interest rate. It is the borrower who keepstrack of the received amount, the amount to be received and the due dates ofrepayments. The IRR finds out the market interest rate involved by considering thereceipt of a given amount of cash in return for a series of promised future repayments.This is also called as implicate rate of return or economic rate of return.IRR is also considered as the growth rate a project is expected to generate. The actualreturn rate of a project often disagrees from its estimated IRR rate. Hence, a projectwith considerably higher IRR value still offers a much better opportunity of stronggrowth.Based on relative risk and other factors, managements need to have an IRR equal to orhigher than the cost of capital. The interest rate is used to discount a series of cashflows to the NPV. Once the NPV and the cash flows are known the IRR is calculated byadding the two values and considering the percentage of the obtained value.The Internal Return Rate can be found out by using the formula below:

Where:Cn = Cash Flow

n = Period which is a positive integern = Total number of periodsThe profitability indexis a method of capital budgeting. It holds the link connecting theinvestment and a proposed projects payoff. It is a variation of NPV method.Profitability Index = Present value of cash inflow

Present value of cash outflow


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3.What are the decisions to be considered while making capitalinvestment? (10 Marks)Capital Investment Decision:-The most important purpose of capital investment is toefficiently allocate the firms capital funds in order to get the best possible return. Themost important phase of capital investment decision is evaluating the projects and

allocating capital depending on the requirements of the projects.The capital investment decisions involve five main decisions. They are:

Objective function

Investment decision

Financing decision

Dividend decision

ValuationObjective Function :-The first thing to be considered while making capital investmentdecisions is to exactly define the objectives of the capital investment. Traditionally, theobjective of corporate finance in decision making is to maximize the value of the firm.The other objective is to maximize stockholder wealth. The objective for firms that are

publicly traded is to maximise the stock price, when the stock is traded and markets areefficient.Investment Decision :-The second is the investment decision that looks at how abusiness must allocate resources across competing users. The discount rate, oftentermed as the project "hurdle rate", is critical in making an appropriate decision. Thehurdle rate reflects the risk in an investment that is typically measured by instability ofcash flows, and must take into account the financing mix. The hurdle rate must behigher for projects with high risks and reflect the financing mix used i.e. owners funds(equity) or borrowed money (debt). The financing mixture that maximises the hurdle rateand matches financing assets must be chosen.Financing Decision:-Appropriate financing of the investment is necessary to achieve

the goals of the firm in terms of finance. The sources of financing generally comprise acombination of debt and equity. Equity financing is less risky when compared to debtfinancing, with respect to cash flow commitment. However, it results in a dilution ofownership, control and earnings. Management must match the financing mix to theasset that is financed considering the timing and the cash flow.Dividend Decision :-The fourth investment decision is the dividend decision that

relates to how much a firm must reinvest back into operations and how much must bereturned to the owners. Dividend is defined as the payment made to stockholders fromthe firms earnings, whether the earnings were generated in the current period or inprevious periods. It is the portion of profit distributed among owners that is obtainedafter tax reduction. The distribution is in the form of cash, scrip, and property dividend or

bonus shares. The decision to issue dividends and if issued, what amount to issue iscalculated on the basis of the companys inappropriate profit and earning prospects forthe next coming year. The three thoughts on dividends are:

Dividends and dividend policy does not affect value if there are no taxdisadvantages associated with dividends and if companies can issue stock, at nocost, to raise equity whenever needed.

Dividends are bad, and increasing dividends reduces value if dividends have atax disadvantage.


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Dividends are good and increasing dividends increases value if stockholders likedividends, or dividends operate as a signal of future prospects.

Valuation:-Valuation is the final stage where all the decisions made by a firm are tracedthrough a final value. The purpose of an investment is to get back more than what was

put in. It can involve large amounts of money and a long term commitment. The projectvaluation makes use of:

Investment Appraisal Techniques

Investment Appraisal Rules

4.Explain IRR and WACC (10 Marks)

Internal Rate of Return:-Internal Rate of Return (IRR)is the average annual return gotthrough the life of an investment and is measured in several ways. Based on themethod adopted, it can either be the effective rate of interest on a deposit or loan, or thediscount rate that decreases to zero. It can also be the net present value of a stream ofcash inflows and outflows. If the IRR is greater than the expected rate of return oninvestment, then, the project is considered as feasible. However, it is also a mechanicalmethod (computed usually with a spreadsheet formula) and not a consistent principle. Itcan give wrong and misleading answers, where, two mutually-exclusive projects are tobe assessed. It is also called Dollar weighted rate of return.IRR is the discount rate which makes the NPV of the cash flow equal to zero. It isregarded as the most useful aspect of a project. It is used by almost all theorganizations including the World Bank in economic and financial analysis of theproject. It stands for the average earning power of the money used in the project in thetimeline of the project. This is also known as the yield of the investment.Here is a mathematical example,

RR is that discount rate i such that

n

Where,t=1Bn = Costs in every year of the project.Cn = Costs in every year of the project.n = Number of years in the project.i = Interest (discount) rate.

For example, if you are investing 10000 rupees into a project in the first year andreceived 1,500 rupees in return, the internal rate of return would be 50% and netpercent rate is 370 rupees. The discount rate would be 8%.

A project is advantageous or feasible for investment, when the IRR is greater than theopportunity cost of capital.The measurement of IRR for a project includes a trial and error method. Here,alternative discount rates are used to measure the cash flow streams of the project thatis being considered. This is done till the NPV of the project reaches zero. However, you


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will not always get a discount rate, which makes the NPV exactly equivalent to zerothrough this trial and error method. We may get discount rate, which makes the NPVcloser to zero or which makes it either positive or negative. Under such situation, weuse the method of interpolation to infer the actual value. Interpolation is simply findingthe intermediate value between two discount rates which are chosen.

Weighted Average Cost of Capital :-The calculation of a companys cost of capitalmeans the proportional weight of each category of capital. All kinds of capital sourcessuch as common stock, preferred stock, bonds and any other long-term debt areinvolved in the calculation of WACC. The WACC of a firm become higher as the betaand rate of return on equity become higher. When there is an increase in WACC notes,there is a decrease in valuation and risk. The WACC equation is the rate of each capitalcomponent multiplied by its proportional weight. Then you can measure the sum.

Where,Re = Cost of equityRd = Cost of debtE = Market value of the firm's equityD = Market value of the firm's debtV = E + DE/V = Percentage of financing that is equityD/V = Percentage of financing that is debtTc = Corporate tax rate

For example, if a firms market value of liability is 300 rupees and the market value of

equity is 400 rupees. The cost of liability is 8%, the corporate tax rate is 35% and thecost of equity is 18%, the WACC of the particular firm is

400*700 x 8%*(1-35%) + 400:700 x 18%

The answer is 12.5% which is the Weighted Average cost of CapitalBusinesses frequently discount cash flows at WACC to assess the NPV of a project.This is performed using the below formula:NPV is equal to the Present Value (PV) of the Cash Flows discounted at WACC.

5.What is sensitivity analysis? (10 Marks)

Sensitivity Analysis:-It is also referred to as simulation analysis in which keyquantitative assumptions and computations (underlying a decision, estimate, or project)are changed systematically. This is done to assess their effect on the final outcome andoverall risk or in recognition of critical factors and it attempts to predict alternativeoutcomes of the same course of action. In comparison, contingency analysis usesqualitative assumptions, to tint different scenarios and this is also called what -if


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analysis. Sensitivity report is a graph that plots the results of various assumptions of thefinal outcome in a sensitivity analysis exercise. This is also called tornado diagram.Application of Sensitivity AnalysisSensitivity analysis is used to determine the sensitiveness of the model to the changesin the value of the parameters and in the structure. Sensitivity is usually performed as a

chain of tests in which the modeler sets different parameter values, to see the way howa change in the parameter causes a change in the dynamic behavior of the stocks.Sensitivity analysis is a useful tool in model building and in model assessment as itshows the way in which the model responds to changes in parameter values. Thisanalysis helps to build confidence in the model. Many parameters in system dynamicmodels represent quantities that are very difficult or impossible to measure to a greatdeal of accuracy in the real world. Also, some parameter values change in the realworld.Sensitivity analysis allows us to determine the accuracy which is necessary for aparameter to make the model sufficiently useful and valid. If the tests reveal that themodel is insensitive, you can use an estimate rather than a value with greater precision.

Sensitivity analysis can also indicate the parameter values that are reasonable to use inthe model. If the model behaves as expected from real world observations, it indicatesthe reflection of the parameter values in the real world. Sensitivity tests help themodeler to understand dynamics of a system. As the system behavior greatly changesfor a change in a parameter value we can identify a leverage point in the model. This isa parameter whose specific value can significantly influence the behavior mode of thesystem.Purpose of Sensitivity AnalysisSensitivity analysis is a technique by which we can investigate the impact of changes inproject variables on the base-case which is a most probable outcome scenario.Normally, only adverse changes are considered in sensitivity analysis. The purpose of

sensitivity analysis is: To identify the key variables which influence the project cost and benefit streams.

In Water Service Providers (WSPs), we have to use sensitivity analysis. Thisinclude water demand, investment cost, Quality and Management (O&M) cost,financial revenues, economic benefits, financial benefits, water tariffs, availabilityof raw water and discount rates.

To investigate the consequences of likely undesirable changes in those keyvariables.

To assess the effect of such changes on the project.

To identify the actions that can mitigate possible undesirable effects on theproject.

Performance of Sensitivity AnalysisSensitivity analysis should be carried out in a systematic manner and to meet the abovepurposes, we have to follow these steps:1. Identify key variables which are sensitive to the project decision

2. Calculate the effect of the variable changes on the base-case IRR or NPV.

3. Calculate a sensitivity indicator and switching value.


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4. Consider possible combinations of variables that may change at the same time in anundesirable direction.

5. Analyze the direction and level of likely changes for the key variables which areidentified, in relation with the identification of the sources of change.

Risks and AssumptionsRisks and assumptions are statements about external and uncertain factors which mayaffect each of the levels in the design summary, and which have to be taken intoaccount in the project design, through mitigating measures. Risk and assumptioninclude the assumption that other projects will achieve their objectives. If we takepositively, these statements are assumptions and if take negatively, they indicate riskareas.Example of Risks and AssumptionsIn water supply projects, assumptions can include:

Availability of land for construction of water intake on time.

The disbursement of funds on time.

A stable political situation. The completion of the dam on time.

The regular adjustment of water tariffs.

In terms of risks, these assumptions can be formulated as follows:

Non availability of land for construction.

No disbursement of fund.

Instability of Political scenario.

Dam not ready in time.

Water tariffs not regularly adjusted.

6. Analyse the parametric cost estimation

Parametric Cost Estimation:-The beginning of parametric cost estimating dates backto World War II. The war caused a demand for large number of military aircraft that farexceeded anything the aircraft industry had manufactured before. While there had beensome elementary work from time to time to develop parametric techniques for predictingcost, there was no widespread use of any cost estimating technique beyond a laboriousbuild-up of labour-hours and materials.The parametric cost estimating technique is used to measure and/or estimate the costassociated with the development, manufacture, or modification of a specified end item.The measurement is based on the technical, physical, and product or end item

characteristics.


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Sources of Data for Parametric Cost Estimation

All data needs to be accessible, reliable and convincing before an estimatingmethodology can be chosen that utilizes the base data. The two types of data are:

Primary data: Primary data is obtained directly from the original source andtherefore is of better quality and utility.

Secondary data: Secondary data is derived from primary data. It is not obtaineddirectly from the source. The secondary data which is derived is possibly alteredin the process and therefore can be of inferior value.

In the estimating process, collecting the data to produce an estimate, and evaluating thedata for reasonableness, is a very critical and time-consuming step.While collecting the data to integrate cost, schedule, and technical information for anestimate, it is important to gather cost information, and also the technical and schedule

information. The technical and schedule characteristics of programs are important indriving cost. They also give an idea about the basis for the final cost.Type of Information Required to Develop Parametric Model are-

Reliable historical cost, schedule, and technical data on a set of data points

Work Breakdown Structure (WBS), WBS dictionary and product tree

Analysis to determine significant cost drivers

Knowledge of basic statistics, modelling skills and CER development

Analysis technique


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Estimate Reliability:-In considering whether or not to use a specific estimate, we needto examine the track record of the cost estimator or the estimate provided by theorganization. If, in the past, the estimates have been close to facts, greater reliance maybe placed on the estimate. If estimates have been significantly above or below known

facts, then lower reliability should be placed on current estimates. Knowing the reliabilityof past estimates does not free the cost or price analyst from the obligation to review theestimate and the estimating methodology as they relate to proposal accuracy.Cost and price analysis should be tempered with product value. Knowledge of theproduct and its functions and use is essentially required for sound contract pricing.Value analysis is a systematic evaluation of the function of a product and its relatedcosts and its purpose is to ensure optimum value.

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