CHAPTER FOUR

PROJECT PREPARATION (FORMULATION)

Feasibility Study: Dimensions and Reporting

A project feasibility study is a key process that justifies whether to go ahead with a
certain project idea or to disregard it. As the name implies, a feasibility study is an
analysis of the viability of an idea from different parameters. The feasibility study
focuses on helping answer the essential question of “Should we proceed with the
proposed project idea?”

Feasibility studies can be used in many ways but primarily focus on proposed business
ventures. Determining early that a business idea will not work saves time, money and
heartache later.

A feasible business venture is one where the business will:

 generate adequate cash-flow and profits,

 withstand the risks it will encounter.
 remain viable in the long-term and meet the goals of the founders.

The venture can be a new start-up business, the purchase of an existing business, an
expansion of current business operations, or a new enterprise for an existing business.
Feasibility study is only one step in the business assessment and development process.
The feasibility study helps to “frame” and “flesh-out” specific business scenarios so they
can be studied in-depth.

During this process the number of business alternatives under consideration is usually
quickly reduced. During feasibility process you may investigate variety of ways of
organizing the business and positioning your product in the market place. It is like an
exploratory journey and you may take several paths before you reach your destination.
There is often some confusion between a feasibility study and a business plan. A
feasibility study is not a business plan.

The business plan outlines the actions needed to take the proposal from “idea” to
“reality.” The feasibility study outlines and analyzes several alternatives or methods of
achieving business success. So the feasibility study helps to narrow the scope of the
project to identify the best business scenarios. The business plan deals with only one
alternative or scenario. The feasibility study helps to narrow the scope of the project to
identify and define two or three scenarios or alternatives. The consultant conducting the

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feasibility study may work with the group to identify the “best” alternative for their
situation. This becomes the basis for the business plan.

The feasibility study is conducted before the business plan. A business plan is prepared
only after the business venture has been deemed to be feasible.

REASONS TO DO A FEASIBILITY STUDY

Conducting a feasibility study is a good business practice. Examination of successful

business organizations indicates that they do not go into new business venture without
first thoroughly examining all of the issues and assessing the probability of business
success.

A feasibility study will:

 Narrow business alternatives and give focus to the project

 Surface new opportunities through the investigative process
 Identify reasons not to proceed
 Enhance the probability of success by addressing and mitigating (to lessen) factors
early on that could affect the project.
 Provide quality information for decision-making.
 Help to increase investment in the company: Investment will be enhanced by
companies through wise use of resources.
 Provide documentation that the business venture was thoroughly investigated.
 Help in securing funding from lending institutions and other monetary sources.

The feasibility study is a critical step in the business assessment process. If properly
conducted, it may be the best investment one ever makes.

REASONS GIVEN NOT TO DO A FEASIBILITY STUDY

Project leaders and sponsors may find themselves under pressure to skip the “feasibility
analysis” step and go directly to building a business. Individuals from within and outside
of the project may push to skip this step. Reasons given for not doing feasibility analyses
include the following;

 We know that it is feasible as an existing business is already doing it

 Why do another feasibility study when one was done just a few years ago:
previously conducted feasibility studies will not be useful to make an investment
decision currently because as time passes several changes are encountered in the

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 political, economical, social, and technological (PEST) environments. hence
recent data shall be gathered for the project idea at hand.
 Feasibility studies are just a way for consultants to make money
 The market analysis has already been done by business that is going to sell us the
equipment: feasibility study of the equipment manufacturer or distributor doesn’t
help other next parties in the channel through transitivity. Hence, a computer
assembly is feasible doesn’t mean a computer training center will be feasible any
time.
 Why not just hire a general manager who can do the study: a general manager is
always hired after a feasible business idea has been obtained and is in the process
of being implemented or is in operation.
 Feasibility studies are a waste of time: though feasibility studies will take time to
complete, reversing a wrong decision that was undertaken without feasibility
studies will require more time and the incurrence of other scarce resources.

The reasons given above should not discourage business people from conducting a
meaningful and accurate feasibility study because, once decisions have been about
proceeding with a proposed business, they are often difficult to change. However,
some aspects of the feasibility study may even require special attention through
support or functional studies.

SUPPORT (FUNCTIONAL) STUDIES

Support or functional studies cover specific aspects of an investment project, and are
required as prerequisite for, or in support of, pre feasibility and feasibility studies,
particularly large scale investment proposal. Support or Functional studies are also a
part of project preparation stage and are usually conducted separately, for later
incorporation in the prefeasibility or feasibility studies.

Examples of such studies are as follows:

 Market studies of the products to be manufactured, including demand

projections in the market to be served together with anticipated market
penetration.
 Raw material and supply studies, covering current and projected availability of
raw materials and inputs basic to the project, and the current and projected
price trends of such materials and inputs.
 Laboratory and pilot-plant tests, which are carried out to the extent necessary
to determine the suitability of particular raw materials or products.

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 In most cases, the results of a support study, when undertaken either before or
together with a feasibility study, form an integral part of the latter and lessen its
burden and cost. The last outcome of the feasibility study is the final appraisal and
report.

PROJECT APPRAISAL (APPRAISAL REPORT)

When a feasibility study is completed the various parties involved in the project will
carry out their own appraisal of the investment project in accordance with their individual
objectives and evaluation of expected risks, costs and gains. A formal project appraisal
report is usually required at the end of a feasibility study. The better the quality of the
project feasibility study made, the easier will be the appraisal work to be performed. The
techniques applied to appraise a project may revolve around technical, commercial,
market, managerial, organizational, financial and economic aspects of the project under
consideration.

The findings of a feasibility study will be summarized in what is called the executive
summary.

EXECUTIVE SUMMARY

The feasibility study should begin with a brief executive summary outlining the project
data (assessed and assumed) and the conclusions and recommendations which would then
be covered in detail in the body of the study. However, any supporting material such as
statistics, results of market surveys, detailed technical descriptions and equipment lists,
plant layouts etc should be presented in a separate annex of the study.

The executive summary should concentrate on and cover all critical aspects of the study,
such as the following:

 the degree of reliability of the data on the business environment.

 project inputs and outputs
 the margin of error (uncertainty and risk) in forecasts of market, supply and
technological trends, and
 the project design.

The executive summary should have the same structure as the body of the feasibility
study and cover, but not limited to, the following areas:

1. Summary of the project background and history:

 project background

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  Name and address of project promoter
 Project objective and outline of the proposed basic project strategy
including geographic area and market share.
 Project location : orientation towards the market or towards resources (raw
materials)
 Economic and industrial policies supporting the project.
2. Summary of market analysis and marketing concept:
 Summarize results of marketing research: business environment, target
market and market segmentation, channels of distribution, competition.
 List annual data on supply and demand
 Indicate projected marketing costs, elements of the projected sales
programs and revenues
 Describe impacts on raw materials and supplies, location, the environment,
the production program, plant capacity and technology
3. Raw materials and supplies:
 Describe general availability of raw materials, processed industrial
materials and components, factory supplies, spare parts, supplies for social
and external needs.
 List annual supply requirements of material inputs
 summarize availability of critical inputs and possible strategies
4. Location, site and environment:
 Identify and describe location and plant site selected, including ecological
and environmental impact, socio economic policies, infrastructural
conditions and environment
 summarize critical aspects and justify choice of location and site
 Outline significant costs relating to location and site
5. Engineering and technology:
 Outline of production program and plant capacity
 Describe and justify significant advantages and disadvantages and
disadvantages as well as life cycle and transfer of technology, training, risk
control, costs, legal aspects etc.
 Describe the layout and scope of the project
 summarize main plant items, their availability and costs
 describe required major civil engineering works
6. Organizational and Overhead costs:
 Describe the basic organizational design of the project
 Indicate management and measures required

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 7. Human resources:
 describe the socioeconomic and cultural environment as related to
significant project requirements as well as human resources availability,
recruitment and training needs, and reasons for the employment of foreign
experts, to the extent required for the project
 Indicate key points (skills) required and total employment numbers and
costs
8. Project implementation Schedule:
 Indicate duration of plant erection and installations
 Indicate duration of production start up and running period
 Identify actions critical for the timely implementation of the project
9. Financial analysis and investment appraisal:
 Summary of criteria governing investment appraisal
 Total investment costs: major investment data showing local and foreign
components for land and site preparation; structures and civil engineering
works; plant, machinery and equipment; preproduction expenditures and
costs, net working capital requirements
 Total costs of products sold such as operating costs, depreciation charges,
marketing costs, finance costs
 project financing: sources of finance, impact of cost of financing and debt
servicing on project proposal, and public policy on financing
 aspects of uncertainty including critical variables, risks and possible
strategies and means of risk management
 national economic evaluation
 Conclusions concerning: major advantages of the project, major drawbacks
of the projects and chance of implementing the project.

4.1 MARKET AND DEMAND ANALYSIS

Market analysis is a process of assessing the level of demand for the product or service to
be produced from the project. This in other words means determining the marketability of
the product or the service of the project under consideration. Different techniques of
demand forecasting are used in analyzing the availability of market for the products and
assessing the level of demand.

Objective of the study:

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The study of market and demand analysis, being the first in project preparation, has the
following main objectives:

 To systematically assess the market and the market environment to generate

pertinent data.
 To collect, analyze, and report data about a specific market situation
 To obtain insight about the target market structure
 To identify customers needs and behavior in the market.
 To design the marketing mix fit in the context
 To identify available distribution channels
 To identify competitors and their characteristics in the target market
 To determine the socio-economic aspects relevant to the preparation and
evaluation of the project’s market strategy
 To identify the existing strengths and weaknesses in the internal
environment of the firm
 To project the level of demand expected
 To delineate marketing opportunities and threats
 To decide on subsequent aspects of a project
 To develop sales program of the firm.

IMPLICATIONS FOR PROJECT ANALYSIS:

In most cases, the first step in project analysis is to estimate the potential size of the
market for the product proposed to be manufactured (or service planned to be offered)
and get an idea about the market share that is likely to be captured. Put differently,
market and demand analysis is concerned with determining the:

 Likely aggregate demand for the product, and

 Possible market share expected for the product.

The first stage in preparing the feasibility study comprises the estimation of size,
composition and development trends of demand for the product or products, careful
analysis of determining variables and their market environment, demand forecast and the
ultimate goal of the procedure: sales volume and revenue projections. the extensive and
careful analysis of past, present and future demand for the product to be produced,
together with market, institutional, and political forces influencing demand and sales of
the product in question, is of crucial importance to the success of the entire project.

Estimates of Sales revenue, at a later stage of feasibility study, will be the basis for
evaluation of alternatives and final decisions regarding:

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  Production program
 plant capacity
 material and input choice
 Location
 Financial evaluation
 Ultimate marketing strategy.

Given the importance of market and demand analysis, it should be carried out in an
orderly and systematic manner, which, in other words, emphasizes the necessity of a
marketing research.

The key steps in such analysis/research could broadly be stated as follows:

 Situational analysis and specification of objectives

 Collection of secondary information
 Conducting market survey (primary information)
 Characterization of the market
 Demand forecasting
 Market planning.

Market and Marketing Concepts:

1. A market is an institution set up by society as an important means to allocate

scarce resources in the economy.
 It is a locus of all potential customers involving in exchange of values to
satisfy their needs.
 It channels/transfers resources from one unit to another unit (entity) in a
given context.
2. Market participants may be described as :
 Producers of inputs/outputs
 Sales agents, distributors (wholesalers and retailers), and commission
brokers.
 Transportation agents (distribution channels)
 Competitors and partners
 consumers
 regulators
3. Marketing is the process by which solicit members in the society obtain what
they need through creating and exchanging goods and services with others for
identifiable economic return. Nowadays, the definition of marketing is broadened

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 to include even the exchange of ideas between social and political entities, (for
example, election campaigns).
4. The Marketing Mix, (often referred to as the 4Ps), are mixture of controllable
marketing variables that could be used by a marketer to achieve the desired sales
level in the target market. These 4 Ps are product, price, promotion, and Place.
5. Marketing Strategy is a specific weapon, tool, or approach, composed of basic
variables in the marketing process. It is the action plan that the company uses in
order to achieve its marketing objectives. It encompasses:
 Marketing expenditures: Amount, frequency, significance to be obtained,
ability to provide competitive advantage.
 Marketing mix: the degree of combination (proportion) of the controllable
and measurable marketing variables in order to give the firm unique
competitive posture in the market.
 Competitive strategy: such as low cost leadership, high quality and
differentiation, delivery performance (fast delivery and reliability in
delivery), and flexibility and customer service.
6. Elements of the Commercial dimension in project preparation:
 Market Research: the first & basic task in any market and demand
analysis is to generate relevant information useful for doing the subsequent
tasks.
 Marketing Plan and Budget: A plan of action and budget prepared on the
basis of the results of the marketing research.

Projection of Sales Revenue

The projection of sales revenue is essentially an extension of marketing research, (i.e. it is

made in light of the outputs in the market and demand analysis). on the basis of which,
the project’s sales will be developed in terms of specific sales volume expected during
the different periods after the project goes into production.

1. Factors to be considered in Forecasting sales:

The following items affect the size of sales revenue:
 Plant capacity and production program
 marketing strategies
 Expenditure
 Mixes (4Ps)
 Competitive strategy (Cost, quality, delivery performance, and
flexibility and customer service)

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  Production technology: capital Vs labor intensive, computerized Vs manual,
etc.
 project life : estimated economic life
 market price of product(s): expected selling price
 Export/import sales by competitors
 Export/local sales by the project
2. Sales Value(Revenue):
The alternative in determining the amount of sales revenue should be identified as
follows:
 Gross sales value
 Sales tax amounts
 Sales value net of taxes.

In this regard, while estimating the level of sales revenue and/or developing the sales
program, it must be decided in advance whether to include the sales tax, which can
become a rather important cost item.

3. Marketing Costs:

In addition to sales revenue, the associated marketing costs should be estimated and
accounted for in terms of the following components:

 Variable-advertisement, promotion, salesperson salaries etc.

 Fixed

The classification of the marketing costs in to variable and fixed portions has its own
significance in analyzing the relevant costs and making sensitivity analysis for the
project.

In sum, the sequence of activities/steps in arriving at sales projection should run as

follows:

Demand Estimates
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 Supply Potential Estimates

Project’s marketing Strategy

Expected Competitors’ Strategies (if any)

Sales Projection

TECHNIQUES OF DEMAND FORECASTING:

After gathering information about various aspects of the market and the marketing
environment from primary and secondary sources, attempt may be made to estimate
future demand. A wide range of forecasting methods is available to the market
analyst. These may be classified in two categories as shown below:

I. Qualitative methods: These methods rely essentially on the judgment of

experts to translate qualitative information into quantitative estimates.
Examples in these groups are :
a) Expert opinion method: this method calls for the pooling of views of
group of experts on expected future sales and combining them into a sales
estimate. The major advantage of this method is the pooling of expertise
knowledge in the forecasting process. However, the accuracy of the
forecast will depend on the care and experience of the people providing the
inputs. The reliability of this technique is questionable.
b) Delphi method: this method involves converting the views of a group of
experts, who do not interact face-to-face, into a forecast through an iterative
process; it is used for eliciting the opinions of a group of experts with the
help of a mail survey.
The processes may include the following steps:
 A group of experts is sent a questionnaire by mail and asked to
express their view.

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  The response received from the experts are summarized without
disclosing the identity of the experts, and sent back to the experts,
along with a questionnaire meant to probe further the reasons for
extreme views expressed in the first round.
 The process may be continued for one or more rounds till a
reasonable agreement emerges in the view of the experts.

Delphi method appeals to many organizations for the following reasons:

 It is intelligible to users
 It seems to be more accurate and less expensive than the traditional
face-to-face group meetings.
 However, it may be time taking for reaching on common consensus and
hence, the final estimate.
II. Quantitative methods: uses a formal mathematical method to fit cost functions
to past data observations, Examples include Time series analysis, Regression
(correlation) analysis, moving average, exponential smoothing etc.
A. TREND PROJECTION METHOD (TIME SERIES ANALYSIS): Time
series analysis forecasts based on an analysis of how variables of interest have
moved historically over the past periods. It doesn’t make a real attempt to
analyze why the variables has changed as they did in the past, the change is only
related to time. It helps to forecast about the future based on what has happened
in the past. It is more suitable when changes have a certain pattern and the same
pattern is expected in the future too.
Time series analysis is becoming a very simple task with advancement of
computer spreadsheet technologies. When the trend projection method is used, the
most commonly employed relationship is the linear relationship,

Y=a + bx

Y= demand for the year (dependent variable)

x=time variable (independent variable)
a=intercept of the relationship
b=Slope of the relationship

b= ∑xy - nxy

∑x2 – nx2

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 a= y – b(x)

Illustration:

Consider the following sales data for product A for the past 14 years.

Yea Demand/ Year Demand/Sales Year Demand/sales

r Sales
1995 10,000 2000 18,000 2005 22,000
1996 13,000 2001 19,000 2006 24,000
1997 14,000 2002 20,000 2007 24,000
1998 17,000 2003 22,000 2008 25,000
1999 18,000 2004 23,000
Required:

a) State the sales forecast equation/demand function.

b) Forecast sales for the next 7 years.
c) Draw the sales forecast diagram.

Solution:

For purpose of time series analysis, the actual year (time) is converted into year for
analysis

Actual Year for Actual Year for Yea Year for

Year analysis Year analysis r analysis

1995 0 2000 5 2005 10

1996 1 2001 6 2006 11
1997 2 2002 7 2007 12
1998 3 2003 8 2008 12
1999 4 2004 9

Computation:

X Y XY X2
0 10,000 0 0

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1 13,000 13,000 1
2 14,000 28,000 4
3 17,000 51,000 9
4 18,000 72,000 16
5 18,000 90,000 25
6 19,000 114,000 36
7 20,000 140,000 49
8 22,000 176,000 64
9 23,000 207,000 81
10 22,000 220,000 100
11 24,000 264,000 121
12 24,000 288,000 144
13 25,000 325,000 169
∑X=91 ∑Y=269,000 ∑XY=1,998,00 ∑X2=819
0

X= ∑x/n = 91/14=6.5

Y = ∑y/n =269,000/14 = 19,214.29

b= ∑xy – nxy = 1,998,000-14(6.5)(19,214.29) = 1,096.7

∑x2 – nx2 819-14(6.5)2

a= y-bx = 19,214.29 – 1,096.7(6.5) = 12,085.74

a) Sales forecast equation : y=a+bx

y=12,085.74 + 1,096.7x

b) Sales forecast for the next 7 years

y=12,085.74 + 1,096.7x

Year Year for Demand/

analysis sales forecasts
2009 14 27,440
2010 15 28,536
2011 16 29,633
2012 17 30,730
2013 18 31,826

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 2014 19 32,923
2015 20 34,020
c) Sales forecast diagram:

27

2009 2015

B. HIGH-LOW METHOD: It uses only the highest and lowest observation values
of the dependent and independent variables. The demand function is estimated by
using these two points to calculate the slope coefficient and the constant or
intercept.
Slope coefficient (b) = difference between the highest demand and the lowest
demand in the past divided by the difference between the highest and the lowest of
the independent variable.
To compute the constant (a), we can use either the highest or the lowest
observation of the data. Both calculations yield the same answer because the
solution technique solves two linear equations with the two unknowns, the slope
coefficient and the constant because;
y=a+bx
a= y-bx
Illustration:
The following observations were extracted from 12 years data.

Highest Lowest
Sales (Y) 220,000 50,000
Income level (x) 4,000 800

Required: Estimate the demand function using High-Low method.

Solution:
y=a+bx
b=yb-yl/xb-xl = 220,000-50,000/4,000-800 = 53.125
a = y-bx = 220,000-53.125 (4,000)= 7500
y=a+bx
i.e. y=7500+53.125x

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 C. REGRESSION ANALYSIS: is a very popular demand forecasting tool in
practice. It involves extrapolating the past trend of demand with identified factor
affecting the demand such as income to project the future consumption.

It measures the average amount of change in the dependent variable associated with a
unit change in one or more independent variables. There are two types of regression
analysis : simple regression (using one independent variable) and multiple regression
analysis (that uses several independent variables). It involves

 Determining the trend of consumption by analyzing past consumption statistics

and
 Projecting future consumption by extrapolating the trend.

The results should be interpreted with diligence:

 Explanatory variable must make sense.

 The right model must be selected.
 Results should be interpreted with due care.
 Outliners, observation that is very far from the majority observation, may be
disregarded in order to avoid their effect on the regression results.

D. EXPONENTIAL SMOOTHING METHOD: In exponential smoothing forecasts

are modified in the light of observed errors.

 If the forecast value for year t, i.e. F t, is less than the actual value for year t, i.e. S t,
the forecast for the year t+1, i.e. Ft+1, is set higher than Ft.
 If Ft> St, Ft+1 is set lower than Ft.
In general, Ft+1 =Ft + αet
Where, Ft+1 = forecast for year t+1
α = smoothing parameter (which lies between 0 and 1)
et= error in the forecast for year t= St -- Ft

How should the first forecast (F1) and the smoothing parameter (α) be chosen?

 A simple and reasonably satisfactory rule of thumb is to choose F 1 as the mean of

the warm-up sample ( the warm-up sample consists of several observations
preceding the period for which the forecasting exercise is began).
 For choosing α, consider several values in the range of 0 to 1 and choose the value
that minimizes the MSE (mean squared error) in the warm-up period. the mean
squared error is defined as :

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 1/n = ∑ (Si – Fi)2

Where Si= actual value of sales in period i

Fi = forecast of sales in period i

n= number of periods in the “warm-up” sample.

For simplicity of using the exponential smoothing method, in this text, it is assumed
that we know the value of Ft and α.

E.MOVING AVERAGE METHOD:

According to this method, the forecast for the next period represents a simple arithmetic
average or a weighted arithmetic average of the last few periods.

In symbols,

Ft+1 = St +St-1 +St-2+………St-n+1

Where, Ft+1= forecast for the next period

St = sales for the current period

n= period over which averaging is done

F. CONSUMPTION LEVEL METHOD:

This method estimates consumption level based on elasticity coefficients, the important
ones being the income elasticity of demand and the price elasticity of demand. It is useful
for a product that is directly consumed.

1. Income Elasticity of demand: It reflects the responsiveness of demand to variations

in income. It is measured as follow:
EI= Q2-Q1 X I1+I2
I2- I1 Q2+Q1
Where EI = income elasticity of demand
Q1 = quantity demanded in the base year
Q2= quantity demanded in the following year
I1= Income level in the base year
I2= Income level in the following year.

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 Then, demand is computed as follows:
Per capital change in demand= per capita change in income level (percentage) X EI
Projected per capita demand for year n= present per capita demand X 1+per capita
change in demand
Total demand projection for year n= projected per capita Projected population
demand for year n X level in the country for
year n

2. Price Elasticity of Demand: It measures the responsiveness of demand to variations

in price. It is computed as:

EP= Q2-Q1 X P1+P2

P2- P1 Q2+Q1
Where EP = Price elasticity of demand
Q1 = quantity demanded in the base year
Q2= quantity demanded in the following year
P1= Price per unit in the base year
P2= Price per unit in the following year.
Expected change in Expected percentage change
quantity demand due = in price per unit X EP
to a change in price

Projected demand = Current level of 1+ Expected change in quantity

quantity demand X demand due to a change in price

Assignment Questions:

Solve the following problems:

1. You are given the following demand data:

Year 199 199 199 199 200 200 200 200 200 200 200 200 200 200
6 7 8 9 0 1 2 3 4 5 6 7 8 9
Deman 10 13 14 17 18 18 19 20 22 23 22 24 24 25
d
(000
units)

Required: Develop the linear equation from the data and forecast the demand for
the year 2010 (Use Trend Projection Method)

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 2. Assume that the actual sale of a given product in period 1 is 28,000 units
while the forecasted sale is 29,000 units for the initial period. assume further
that the actual sales value for the next ten periods is the following:

Period 2 3 4 5 6 7 8 9 10 11
Sales 29 28.5 31 34.5 32.7 33.5 31. 31.9 34.3 35.2
(000 8
units)
Given α=0.2, derive the forecast of sales for the next 10 periods.

(Use Exponential Smoothing Method)

3. Consider the following time series (figure in ‘000 of units) :

Year 1 2 3 4 5 6 7 8 9 10 11 12
Sales 28 2 28.5 31 34.2 32. 33.5 31.8 31. 34.3 35.2 36
9 7 9

Assuming the forecaster has set “n” to be equal to 4, make a forecast of sales for the
periods 5 through 12. (Use Moving Average Method)

4. Consider the following observations extracted from 10 years data

X Y
Highest observation 9 1456
6
Lowest observation 4 710
6

Calculate the slope coefficient, constant and the demand function.

(Use High-Low Method)

4.2 RAW MATERIALS & SUPPLIES STUDY

General

An important aspect of technical analysis is concerned with defining the materials and
supplies required, specifying their properties in some detail, and setting up their supply
program.

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  There is close relationship between the study of raw materials and supplies
required and other project formulation stages, such as definition of plant capacity,
location, and selection of technology and equipment, as these inevitably interact
with each other.
 The main basis for selection of materials and inputs is, however, the demand
analysis, the production program and finally the plant capacity.

Therefore, issues relating to material and input requirements should be covered in the
feasibility study.

Objectives of Input Study:

 To determine
 types of raw materials and supplies required
 Availability of basic raw material suppliers
 quantity of raw materials needed for the plant
 quality of raw materials and suppliers available and needed
 To estimate the cost of raw materials and supplies needed
 To develop supply programs and devise supply marketing schemes.

UNIDO Approach in the study:

The approach followed by UNIDO in the study of raw materials and supplies is as
follows:

Step 1: Classification of raw materials:

1. Raw materials (unprocessed and semi processed).

 Agricultural products
 Livestock and forests products
 Marine products, and
 Mineral products
2. Processed Industrial materials and components
3. Factory supplies: Auxiliary materials, utilities, and spare parts.

Step 2: Specification of requirements:

 Product characteristics and material inputs

 Requirements of raw materials and factory supplies.

Step 3: Check Availability and supply of the raw materials

20
 Step 4: Supply marketing and supply program:

 Supply Marketing, with the objective of :

 Cost minimization
 Risk minimization (reliable supplies sources)
 Cultivating relations with the suppliers
 supply program

Step 5: Estimate costs of raw materials and supplies

 Unit costs, annual costs, and overhead costs.

The approach followed by the UNIDO is adopted and each of the aspects indicated in the
above five steps is explained next.

Step 1 .CLASSIFICATION OF RAW MATERIALS AND SUPPLIES

1.Raw materials (Unprocessed and Semi-processed)

Agricultural products: If the basic material is an agricultural product, first the quality of
the product must be identified. Assessment of the quantities currently and potentially
available may be a cardinal and/or functional feature in pre-investment studies involving
the use of agricultural products. In food processing industries, only the marketable
surpluses of agricultural produce should be viewed as raw materials, which are the
residue remaining after the quantities required for consumption and sowing by producers
been subtracted from the total crop production. In case of commercial crops, the
marketing surplus is the total production minus sowing (seeds) requirements.

Livestock and Forest Products: In most cases of livestock produce and forest
resources, specific surveys are called for to establish the viability of an industrial project.
However, general data from official sources and local authorities that is only sufficient
for opportunity studies is required.

Marine Products: The major problem in marine-based raw materials is to assess the
potential of availability, the yields, and cost of collection. Availability of marine products
may not only depend on ecological factors, but also on national policies and bilateral or
multilateral agreements. (Fishing Quotas)

Mineral Products: For mineral products detailed information on the proposed

exploitable deposits is essential, and proven reserves are needed. The availability of
opencast or underground mining; location, size, depth, and quality of deposits; and the

21
impurities and the need for beneficiation should be qualified. A detailed analysis of
physical, chemical, and other properties of the mineral is required.

2. Processed Industrial materials and Components:

Processed industrial materials and goods constitute an expanding category of basic inputs
for various industries in developing countries. Such inputs can generally be classified
under:

 Base metals
 Semi-processed materials, and
 Manufacturing parts: components for assembly type and engineering goods
industry.

3. Factory Supplies
a) Auxiliary Materials: All manufacturing projects require various auxiliary
materials and utilities summed to be factory supplies. it is not always easy to
distinguish between auxiliary materials such as chemicals, additives, packaging
materials, paints, and varnishes and factory supplies such as Maintenance
materials, oils, greases, and cleaning materials, since these terms are used
interchangeably.
b) Utilities: A detailed assessment of the utilities required (electricity, water, steam,
compressed air, fuel, and their efficient disposals) can only be made after analysis
and selection of location, technology and plant capacity. However, the general
assessment of these is a necessary part of the input study. An estimate of utilities
consumption is essential for identifying the existing sources of supply, any
bottlenecks, and shortages that exist or are likely to develop, so that appropriate
measures can be taken to provide for whether internal or external addition supplies
in good time.
c) Spare Parts: All machinery and equipment will finally break down after a certain
lifetime. Various spare parts will be required to keep a plant in operation. The
importance of correctly identifying essential spare parts, the quantities required,
and available suppliers cannot be overemphasized. Usually, the initial investment
includes spare parts for the first one or two years of plant operations under the
heading of the initial net working capital requirement (current assets). The
consumption of spare parts during plant operation is a part of the annual
production costs (which is a manufacturing overhead cost).

Step 2. DETERMINATION/SPECIFICATION OF REQUIREMENTS:

22
In order to estimate the requirements of materials and supplies during the future operation
of the plant, the requirement should be identified, analyzed, and specified in feasibility
study, both quantitatively and qualitatively. A number of factors such as Socio-economic,
financial, and technical should be considered. The specification of raw materials and
factory supplies, as required for the envisaged production technologies, is the basis for
the assessment and analysis of the availability of the project inputs.

 Project characteristics and material Inputs: For a given industry, the envisaged
plant can be capital or labor intensive, computerized or mechanized, complex or
fairly simple. The nominal and feasible plant capacity will have to be defined on
the basis of varying supply condition. Any significant dependencies on raw
materials and factory supplies of the product mix and production target will be
identified in view of market potential, expected sales, transport facilities, and
production capacity.
 Requirements of Raw Materials and Factory Supplies: The determination of
requirements of raw materials and factory supplies forms the basis for the supply
program and subsequent cost estimates. The specifications of requirements should
be made in view of (or include):
a) User Demand: Users of the produced finished goods have their own
expectations and demand that will have implications over not only on the
choice of technology, machinery, and equipment, but also on the type and
quality of materials and inputs used.
b) Quantity Required: The quantities required can be expressed in terms of units
produced (items, tones, cubic meters); section of the production process
(auxiliary materials, utilities, spare parts); machine or labor hours (factory
supplies, spare parts); and number of employees (medicine, social costs, etc).
c) Qualitative Properties: These include Physical properties (size, dimension,
form, state, etc); Mechanical properties (formability, elasticity, fatigue, and
hardness); Chemical properties (form, composition policy, oxidizing, etc); and
Electrical and magnetic properties (magnetization resistance).

Step 3: AVAILABILITY AND SUPPLY OF RAW MATERIALS:

A number of projects are conceived either to exploit available raw materials or to utilize
basic materials that become available from other production process. A feasibility study
must show how the materials and inputs required will be provided. General availability,
data about materials, potential users, and supply sources and programs are aspects that
should be analyzed and described. at the initial stage of the study, the quantity of basic

23
material inputs that may be required should be assessed principally for the purpose of
determining availability, sources, and long term needs. Final input requirement will be
determined only after the plant capacity, technology, and equipment to be used are
defined.

Step 4: SUPPLY MARKETING AND SUPPLY PROGRAM:

An enterprise acts as a buyer on supply markets when purchasing required raw materials
and factory supplies and a seller in the markets for finished goods/services.

a) Supply Marketing:

The objective of supply marketing are basically cost minimization, risk minimization (by
identifying reliable suppliers), and creating better relationships with suppliers.

 Cost Minimization: Input costs can be reduced by selecting appropriate suppliers

and by choosing a proper volume and frequency of the orders,( Economic order
quantity/size).
 Risk Minimization and reliability of suppliers: reliability with regard to
quantity, quality, deadlines (schedule), and prices is significant for the entire
manufacturing process. (Late deliveries, lack of quality, or poor maintenance
services negatively influence the projects activities).
 Cultivating relations with suppliers: Purchases should be focused not only on
acceptable prices, but also on establishing smooth, productive, and long-term
relations with the suppliers. Purchasing prices and conditions largely depend on
the bargaining power of the project and its management. It is essential to identify
possible supply alternative, suppliers, and the quantities to be purchased from each
should be determined in the study.

b) Supply Program:

Supply program is needed to show how supplies of materials and inputs will be secured.
Evidence should be presented to justify the assumptions and suggestions. Cost estimates
should be based on the supply program presented. A supply program should deal with:

 Identification of supplying sources and suppliers

 Agreement and regulations
 Quanities and qualities
 Consignments
 Means of transport

24
  Storage
 Risk assessment.

In the identification of supplier, consideration should be given to geographic location,

ownership, main activities, financial strength and profitability, production capacity, and
business experience with the product. The types of agreement, such as long term
contracts and license agreements should be presented. Letters of intent regarding supply
contract and obligation; and agreements such as period of validity, payment terms,
currency conditions, and guarantees should be outlined.

Step 5: COST OF RAW MATERIALS AND SUPPLIES:

Unit costs: Not only the availability but also the unit costs of basic materials and factory
supplies have to be analyzed in detail, as this is a critical factor for determining project
economies. In the case of domestic materials, current prices have to be viewed in the
context of past trends and future projection of the elasticity of supply.

For imported/ material inputs: C.I.F prices (including costs, insurance, and freight)
should invariably be adopted together with clearing charges (including loading, port
charges, tariffs, local insurance, and taxes), and cost of internal transport to the plant. the
prices of imported inputs generally fluctuate and depend on international market
situations.

Annual costs: Estimates of annual costs for materials and supplies are to be made. the
price basis for the estimates, (price level, quotations from suppliers, world market prices,
comparisons with similar inputs in other projects, etc), should be stated in order to enable
the reader to check their reliability.

The feasibility study should also determine key factors affecting prices, state whether a
monopolistic or oligopolistic situation exist; identify possibilities for obtaining
preferential prices; and specify government or other administrative price controls. Cost
estimates are to be divided into foreign and local currency components according to
UNIDO procedures. The currencies most likely to be used and the exchange rates applied
for the cost estimates should be identified. This will help in making sensitivity analysis.

At whatever level, it is possible to carry out sensitivity analysis for different levels of
production and capacity utilization in the financial calculation. In estimating costs, the
following information should be presented:

 Type of material and input

25
  Unit of measurement (barrels, cubic meters, etc)
 Number of input units consumed/used per unit of output produced
 estimated cost per input unit
 Estimated cost per unit of output produced
 Estimated cost per unit produced divided into direct (which are mostly variable
costs) and indirect (predominately fixed and comprised of overheads) cost
components.
 Direct cost per unit of output produced divided into foreign and local currency
components.
 Indirect costs per unit of output produced divided into foreign and local currency
components.

In order to arrive at the total operating cost by product as well as the total costs per
year, the total number of units to be produced should be multiplied by the estimated
cost per unit. Costs are projected over the production period.

Overhead Costs of Suppliers: When estimating material and input requirements by

project components, the project planner has to plan not only at the level of production
cost centers, but also at the level of service, administration and finance, and sales cost
centers. Thus, estimation of suppliers and their costs should be made.

4.3 TECHNOLOGY AND ENGINEERING STUDY

Engineering Study:

Objectives of the study:

 To design the functional and physical layouts in order to produce the defined
outputs.
 To determine the corresponding investment expenditures
 To determine the costs arising during the operational phase
 To accomplish necessary infrastructure investments

It is the task of engineering to design the functional and physical layouts for the industrial
plant necessary to produce the defined output and to determine the corresponding
investment expenditures as well as the costs arising during the operational phase. The
scope of engineering also includes the plant site and all activities required to deliver both
inputs and outputs and to provide the necessary infrastructure investments.

Technology Study:

26
An integral part of engineering study at the feasibility stage is the selection of an
appropriate technology, planning of the acquisition and absorption of this technology,
and the corresponding know-how.

Objectives of the study:

 To select the technological alternative most suitable to the

 Socio-economic conditions in the context
 Investment strategy chosen
 Ecological condition (natural environment)
 To acquire and absorb technology and the corresponding know-how necessary

While the choice of technology defines the production processes to be utilized, the
effective management or technology transfer requires that the technology and know-how
are acquired on suitable terms and conditions, and the necessary skills are available or
developed. The required machinery and equipment must be determined in relation to the
technology to be utilized, the local condition, and human capabilities. Skill development
needs to be planned through training program. The analysis must include a survey of
spare parts.

After the determination of the marketing strategy, the production program, and capacity,
a preliminary project layout has to be prepared defining the physical features of the plant
such as:

 Infrastructure
 factory and other buildings and civil works
 Their relationships with utilities, material flows, and machinery installations
 Other aspects of plant construction and operations.

It is necessary to identify the necessary technologies and the implications in terms of

costs, use of local raw materials, environmental impacts, and other factors.

Technology Choice:

An important factor in determining the production program and plant capacity is the
technology and the people know-how to be utilized in the project. Therefore, the
selection of appropriate technology and know-how is a critical element in any feasibility
study.

The word “technology” or “manufacturing technique” mean a sum of patented and

unpatented knowledge, know-how, experience, and skills needed for the transformation

27
of raw materials into outputs. The selection of technology should be based on a detailed
consideration and evaluation of technological alternatives and the selection of the most
suitable alternative in relation to the project or investment strategy chosen and to socio-
economic and ecological condition. The choice of technology is influenced by a variety
of considerations:

 market and marketing concepts

 Plant capacity
 Principal inputs
 Investment outlays and production cost
 Use by other units
 Product mix
 latest developments
 Ease of absorption

Appropriate technology choice is directly related to the conditions of applications in

particular situations.

Appropriateness of Technology:

Appropriate technology refers to the methods of production, which are suitable to heal
economic, social, and cultural conditions. Technology should be evaluated in terms of:

 Whether the technology utilizes local raw materials

 Whether the technology utilizes local manpower
 Whether the goods and services produced cater the basic needs
 whether the technology protects ecological balance
 Whether the technology is harmonious with social and cultural conditions

The project planner, therefore, should have a good knowledge of the present trends in
technology development and local conditions to evaluate all possible technological
alternatives.

The most common mistakes at this stage of the evaluation are:

 Choice of technology which already is or is going to become obsolete in the near

future
 Choice of new versions of existing technology not sufficiently proved and tested
 Choice of technology heavily dependent on the supplies of special semi-products,
sub-assemblies, or additives available from a monopoly supplier (i.e. the licensor)

28
  Adoption of technology incompatible with the local conditions (climate, special
raw material properties, local personnel qualifications, etc)
 Under estimation of environmental hazards

Alternative technologies should also be evaluated with regard to their environmental

impacts. Critical elements that must be considered for the selection of suitable
technologies include:

 Economic use of raw materials,

 Low emission technologies, and
 Low-waste production processes

Assessment of Technology Required:

The technology required to produce the desired products on the basis of the resources
identified for the project may be common knowledge or the property of owners who may
be willing to transfer it under certain conditions.

The primary goals of technology assessment are to determine and evaluate the impacts of
different technologies on the society and national economy, impacts on the environment
and socio economic feasibility assessed from the point of view of the enterprise.

To allow the careful assessment of the suitability of the technological alternatives

required and available for the project under consideration, the following logical sequence
of steps should be followed:

29
 Problem Definition

Technology description and Project

layout

Technology Market alternatives

Assessment of availability

Technology Forecast

Assessment of Local Integration

Means of
Description Technology
of the Acquisition:
Socioeconomic Impact

Environmental Impact Assessment

When technology has to be obtained from some other enterprise, the means of acquisition
have to be determined. These can take the form of technology licensing, outright
purchase of technology or a joint venture involving participation in ownership by
technical supplier. The implications of these methods of acquisition should be analyzed.

1. Licensing: A license gives the right to use patented technology and provides for
the transfer of related know-how on mutually agreed terms. Technology licensing
has developed into a popular and effective mechanism for trade in technology. In
cases where technology licensing is considered necessary, it is desirable to have
the technology package disaggregated and to identify critical contractual elements.
2. Purchase of Technology: Outright purchase is appropriate when “one-time”
technological right or know-how are to be secured, and when there is little
likelihood of subsequent technological improvements or need for continued
technological support to the prospective licensee.
3. Participation of the license-holder in the joint venture: This refers to allowing
equity participation by a technology supplier. This type of acquisition is
sometimes found important for continuing technical assistance and supply of
inputs and services is necessary over a period of time, or access to external
markets that may otherwise be difficult to operate.

30
 4. Disaggregation: The technology packages should be disaggregated into various
component parts, such as the technology proper, related engineering services,
phasing of domestic integration, supply of intermediate products and even the
supply of equipment by licensors. A distinction should be made between essential
and technological features and others that should be evaluated separately.
5. Technology Absorption and Adaptation: The feasibility study should indicate
the measures and actions to be taken for technological absorption and adaptation
of the acquired technology to local conditions. An essential element in staff
planning and an efficient recruitment policy has to be combined with a
comprehensive training programme for various categories of plant personnel.
Technological adaptation requires not only the adjustment of special know-how to
local factor conditions, but also the capability to modify products and processes to
suit local preferences and requirements and to initiate a process of innovative
development in a particular field.

Contract Terms and Conditions:

The contractual terms and conditions for technology acquisition and transfer need ne
highlighted in the feasibility study. The contract for technology licensing should be
carefully scrutinized with respect to:

definition (process, products, documentation)

Duration ( adaptation, upgrading, and renewal)
Warranty ( guarantee to technological features and know-how)
Access to improvement (access to improvement made by licensor)
Industrial property right (patents and usage rights)
Payments ( a lump sum, or royalties, or both)
Territorial sales right( exclusive and non-exclusive)
Training (in the plant of licensor or supply of expert)
Supply of imported input ( intermediate products or components)

Selection of Machinery and Equipment:

Objective:

 To choose an optimum group of machinery and equipment necessary for the

project, considering:
o the specific production capacity,
o Production techniques (technology), and

31
 o Type of products to be produced

The selection of equipment and technology are interdependent. the requirement of

machinery and equipment should be defined on the basis of the plant capacity and the
selected production technology. Equipment selection should broadly define optimum
group of machinery and equipment necessary for a specific production capacity by using
a specific production technique. The selection of machinery and equipment could be
affected by different factors that are constraints in selecting machineries and equipments:

 Plant capacity and technological processes

 Infrastructural constraints (the availability of electric power for a large electric
furnace, the transport of heavy equipments to remote area)
 The length of time required for training (highly sophisticated equipment)
 Investment constraints and the availability of foreign exchange
 Maintenance requirements and the availability of maintenance facilities
 Government policies such as import controls (restrict the import of certain types of
equipments)

Another important issue in equipment choice is the degree of automation that may be
required.

 Computerized equipment may be required, but the capital costs of automation tend
to be high (this could be viable in developed countries because it replaces high-
cost labor)
 The competitive nature of production may require the use of automated
equipment, thus necessary skills must be developed.

Cost estimates for imported equipment should be on the basis of C.I.F and the landed
cost, as well as internal transport, insurance, and other costs up to the plant site. Transport
and other cost of domestic equipment should be incorporated up to the plant site. the cost
of erection of equipment should be estimated, particularly when this is undertaken as an
independent operation. The lowest installation cost ranges from 1 to 2% and the highest
up to 15% depending on the equipment.

Procurement of plant and machinery could be made from different suppliers or a turnkey
contract may be given for the entire plant and machinery to a single supplier. The factors
to be considered in selecting the suppliers of plant and machinery are:

 The desired quality of machinery

 The level of technological sophistication

32
  The reputation of the suppliers
 The expected delivery schedules
 The preferred payment term, and
 The required performance guarantee

Detailed Plant Layout and Basic Engineering

Project charts and layouts may be prepared once data is available on the following
principal dimensions of the project:

 market size
 Plant capacity
 production technology
 Machineries and equipments
 Building and civil works
 Conditions in the plant site
 Supply of inputs to the project

These define the scope of the project and provide the basis for detailed project
engineering and estimation of investment and production costs. The plant layout is
concerned with the physical layout of factory. In process industries, the production
process adopted dictates the plant layout; in manufacturing industries, however, there is
much greater flexibility in defining the plant layout.

The important considerations in preparing the plant layout are :

 Consistency with production technology

 smooth flow of goods from one stage to another
 proper utilization of space
 scope of expansion
 Minimization of production cost
 Safety of personnel

Detailed final plant layout needs to be prepared prior to project implementation. The
detailed plant layout and basic engineering design are required in a feasibility study to
allow the preparation of cost estimates, where detailed engineering work would usually
not start before a project enters the implementation phase.

Civil Engineering Works

33
The feasibility study should provide plans and estimates for the civil works related to the
project. This should cover:

Site preparation and development

Factory and other buildings
Civil engineering works related to utilities, transport, emissions and effluent
discharge, internal roads, fencing and security, and other facilities and
requirements of the plant.

The plans and estimates for civil engineering works should be detailed for cost estimates
and implementation scheduling. The estimates for building and other constructions
should be based on unit costs such as building costs per square meter in the plant
surroundings.

Maintenance and Replacement requirements

An important aspect of project engineering is the determination of critical maintenance

and replacement requirements for the project. Maintenance requirements should be
assessed in terms of both the maintenance equipment that may be necessary for efficient
maintenance of the plant and facilities and the maintenance skills and capability that need
to be developed. Replacement requirements need to be determined for wear-and-tear
parts; tools and fixtures; and for spare parts, components, and materials for plant.

Overall Investment Costs

Once the production program and plant capacity are defined, a preliminary estimate can
be drawn up regarding the investment requirement, if a plant capacity is set at a fairly
standardized level and prices are available for plant and equipment:

 Cost estimates for various components of studies can be done by ratios of the total
costs of pre-feasibility and feasibility studies
 Often, estimates of machinery and equipment for a project would constitute 50%
of the total investment cost
 Buildings and civil works are to cost 10 to 15% of the total costs.
 Similarly, percentages can be set for utilities, instrumentation, piping, and other
facilities and requirements.

These figures may be useful at the project appraisal stage when analyzing the structure of
investment cost. Based on the estimates for technology, machinery and equipment, and
civil engineering works, the study should provide an overall estimate of the capital costs

34
of the project. To check the reliability of cost estimates, a detailed breakdown to the
various cost items would be necessary. A physical contingency allowance is commonly
added. The precision of cost estimates will be aided by a clear definition of the scope of
the project.

4.5 LOCATION, SITE, AND ENVIRONMENTAL IMPACT ASSESSMENT

GENERAL:

Location and site are often used synonymously; but must be distinguished to properly
address the relevant issues requiring assessments.

Location refers to a fairly broad area like a city, an industrial zone, or a coastal area;
whereas site refers to a specific piece of land where the project would be set up.

Objective of location and site study:

To identify a location and site suitable to the industrial project

Dimensions for Location and Site selection:

 Traditional:
Accessibility to market
Accessibility to raw material sources
Availability of infrastructure services (like transportation) and Utilities

 New Dimensions Added (Public policies):

Level of urbanization and implications to bring balanced development
among localities
Regionalization and Decentralization policy
Investment policy and Incentives
Population concentration and impacts on Migration
Environmental impacts and pollutions due to over concentration
I. Location and Site Selection Aspects:

In Location and site selection, the following considerations should be made:

The choice of location should be made from a fairly wide geographical area,
within which several alternative sites can be considered.

35
 An appropriate location could extend over a considerable area, such as along a
river bank or 15 kilometer radius around an urban area in a particular geographic
district.
Within a recommended location one or more specific project sites should be
identified and assessed in detail.
For each project alternative, the environmental impact of erecting and operating
the industrial plant should be assessed.

The main criteria or key requirements for selecting proper location and sites should
always be identified at early stage of the study. Qualitative analysis of these key
requirements would then allow the assessment of a number of potential locations and
sites, and the rejection of those not fulfilling the key requirements. The remaining
alternatives are then subject to a more in-depth qualitative analysis of technical, financial,
social environmental and economic aspects of location and site selection.

The most important or critical requirements include, among others:

 The Natural Environment (climatic conditions and Ecological requirements.

 Environmental Impacts
 Socio economic policies (Role of public policies and Fiscal and legal aspects)
 Infrastructural Conditions (Infrastructure dependence, factory supplies, Human
resources, Infrastructural services, and Effluent and waste disposal facilities)
 Final choice of location (resource or market orientation)

In site selection, the requirements and relevant factors are:

 Site requirements (cost of land, construction requirements, local condition,

Infrastructure, effluent and waste disposal, Human resources)
 Final site selection and cost estimates.
II. Location Analysis

Location analysis has to identify locations suitable for the industrial project under
consideration. A project can potentially be located in a number of alternative regions, and
the choice of location should be made from a fairly wide geographic area within which
several alternative sites may have to be considered.

The study should also indicate on what grounds alternative locations have been identified
and give reasons for leaving out other locations that were suitable but not selected.

The choice of suitable locations require an assessment of, among others,

36
  Market and marketing aspects
 The availability of critical project inputs, such as:
 Raw materials
 Factory supplies
 Technical projects requirements
 The type of industry
 Technology and process
 Characteristics of products or outputs
 Size of the plant
 Organizational requirements and management structure.

As key aspects vary from industry to industry, the project analyst will have to use their
professional skills to identify those key criteria, which are relevant for each specific
project. The identification of key requirements helps to reduce the number of potential
locations and sites at an early stage.

The Natural Environment

Climatic Conditions:

Climate can be an important factor for choice of location. Apart from the direct impact on
project costs of such factors as dehumidification, air conditioning, refrigeration, or
special drainage, the environmental effects may be significant. Thus, information should
be collected on temperature, rainfall, flooding, dust, fume and other factors for different
locations.

Ecological requirements:

Some projects may not have negative environmental impacts by themselves, but would
rather be sensitive to such effects. Agro industrial projects clearly depend on the use of
raw materials that have not been degraded by contaminated water and soil. Management
and labor may be reluctant to work in a factory located in a polluted area with health risk.

Environmental Impact Assessment (EIA)

EIA is an assessment which aims at ensuring that development projects are

environmentally sound (friendly).The feasibility study should include a thorough and
realistic analysis of the environmental impact of the industrial project. The impact is
often of crucial importance for the socio-economic, financial, and technical study of the
project.

37
Objectives of Environmental Impact Assessment:

General:

 To ensure the project under consideration is environmentally sound.

 To incorporate in the project design any existing regulatory requirements,
emission standards, and guidelines
 To identify measures for mitigation of adverse environmental impacts that land
for.
 To enhance the likely beneficial impacts of the project.
 To determine environmental merits of alternative projects.

In principle, environmental impacts should be assessed on the basis of legal regulations

and emission standards and guidelines established in the country. In countries where no
regulations and standards are defined, it may be advisable to anticipate a future tightening
of environmental impact control measures. if trends are properly considered during the
project planning stage, unexpected costs for later plant adaptations, conversions,
rehabilitations, or even the shut down of operations may be avoided or minimized.

Socio Economic policies

A. The Role of Public Policies:

Government regulations and restrictions may be critical for the location of a project.
Projects with certain characteristics (particularly industries) may be allowed only in a
certain regions. In a number of developed and developing countries, there is a
considerable pressure for the decentralization of industries, the main objective of
industrial decentralization being to reduce the external diseconomies of urban industrial
concentration.

Knowledge of public policies with regard to location aspects is necessary to enable the
various concessions and incentives that may be part of such policies to be adequately
considered. Among others,

 Specific geographical zones often are setup in some countries and varying patterns
of financial incentives have been determined for them.

38
  In some developing countries, direct subsidies are given to industries located in
particular areas or regions (for instance, in marginalized areas).
 Financial and other incentives are given for projects located in under developed
regions.

Therefore, the impact of these incentives on the economics of a proposed project should
be analyzed. The growth of public sector enterprises has been significant for industrial
growth in many developing countries, in which wider policies such as regional,
industrial, and disposal aspects tend to play a part in the location decisions.

B. The fiscal and Legal Aspects:

The fiscal and legal regulations and procedures applicable for alternative locations should
be defined. The various national or local authorities to be contacted in respect of power
and water supplies, building regulation, fiscal aspects, security needs, etc, should be
listed. The corporate and individual incomes taxes, excise duties, purchase taxes and
other national or local taxes should be ascertained for different locations, together with
the incentives and concessions available for new industries.

Infrastructural Conditions

The availability of a developed and diversified economic and social infrastructure is often
of key importance for a project. Quantitative and qualitative requirements for energy,
utilities, labor, land, etc, may be met in only a few locations if the project is relatively
big.

i. Technical Infrastructure
ii. Transport and Communications
iii. Factory supplies
 Water
 Electricity
 Fuel
iv. Human resources
v. Effluent and water Disposal techniques

Final Choice of Location

The optimal location is where the total cost (i.e., the cost of raw material transportation
cost plus production cost plus distribution cost for final product) is minimized.

39
The best choice of location would be the one where the costs of products sold (production
costs and marketing costs) are a minimum.

In a nutshell, critical to location selection are the impacts on a particular project of factors
such as:

 The availability of raw materials and inputs,

 The proximity of centers of consumption, and
 The existence of basic infrastructure facilities.

III. Site Selection

The study should analyze and assess alternative sites on the basis of key aspects and site-
specific requirements, and the analysis should result in a selection of a specific site.

For sites available within the selected area, the following requirements and conditions are
to be assessed:

 Ecological conditions on site (soil, site hazards, climate)

 Environmental impact (restrictions and standards)
 Socio-economic conditions (restrictions, incentives, requirements)
 Local infrastructure at site location (existing industrial infrastructure, economic
and social infrastructure, availability of critical project inputs such as labors and
factory supplies)
 Strategic aspects (extension, supply, and marketing policies)
 Cost of land
 Site preparation and development requirements and costs.

The selection of plant location and site does not have to be undertaken in two stages;
rather it should be made in an integrated manner.

Site Selection main considerations: The following factors determine the selection of the
final site:

Cost of land
Site preparation cost
Cost of utility lines extension
Environmental considerations
Size and shape of the available area
Suitability for future expansion

40
 Nature of goods (products) produced (perishables or not)
Proximity of centers of consumption (market orientation)
Infrastructure facilities (transport network, houses, power supply, etc)
Availability of labor in the area (skilled and unskilled)
Socio-economic factors
 Wate disposal
 Environmental factors
 Taxes and duties
 Public policies (fiscal and legal regulations)
Distance to seaport (import or export)
IV. Cost Estimates

The cost estimates at the site are:

£ Acquisition of land
£ Taxes
£ Legal expenses
£ Railway connections
£ Site preparations and development.

4.4 PRODUCTION PROGRAM AND PLANT CAPACITY

Production Program: basis and Aspects

Sales program as a basis

Sales program shows the level of sales forecast to be realized during the specified life of
the envisaged plant (showing local sales, export sales, total revenues over project life.

1. Sales program is projected under market analysis

 Market requirements and market structure identified
 Marketing strategies will be defined & the implications broadly in terms of:
 Product pricing
 Production program
 Promotional efforts
 Sales & distribution mechanisms
 Marketing mix
 Demand forecasting

41
 2. Provides inputs for financial analysis

After projecting sales for different stages of production, a feasibility study should
define and come up with the detailed production program. A production program
defines the level of output to be produced during specified period and, from this
viewpoint, we can say that it should be directly related to the specific sales forecasts.

Aspects in Production Program

The demand and market analysis specify the sales program, which should be
transformed into the plant production program, taking into account losses of
production within the production plant site, in storage, transportation, and by warranty
service. It indicates the level of output to be produced during specified period.

Objectives:

 To determine the type and range of products to be produced over the life of the
envisaged plant.
 To show the level of capacity utilization expected and the quantity of
production.

Considerations:

 Determine capacity utilization

 Determine the type of products or range of products
 It is related to the sales program (sales forecast)
 The determinants of a production program during the initial production
years vary considerably from project to project.
 Thus, different approaches would have to be adopted for different
industries. Below are cases illustrating this:

Single Product Case: Cement factory, coal factory, tea factory, Sugar factory

Multiple Products Case: Electronics factory, machine tools, leather products, food
complex, Oil Refinery.

Case 1: Single-product-continuous process manufacturing as in cement production

Case 2: Multiple-products-continuous process production as in an oil refinery;

Case 3: Batch/Job orders production such as in an engineering workshop; and

Case 4: Assembly/mass manufacturing as for the production of motor cars.

42
In the first case, the growth of sales may not be a great problem unless production
capacity is in excess of local demand. However, production problems may be more
critical. In the second case, both production and sales problems may arise. In the third
case, though production aspects may present difficulties, obtaining satisfactory orders
would be critical. In the fourth case, the sales aspects in relation to price would be
dominant.

The production program changes over time during the project’s life with respect to
capacity utilization. Initially, the production may not be higher than 40% to 50% of the
overall design capacity for the first one or two years of operation. This is because market
may not be ready to acquire large amount of new product or technological difficulties
may obstruct the full-capacity operation of the equipment. Full production capacity is
being reached usually towards the third or fourth year and stabilizes for about 10 to 15
years. The growth of the demand and continuous improvement in technology usually
encourages modernization of a project, which enables the production growth. After
certain period (probably 30 or more years), the project is terminated due to the low
market competitiveness, de-capitalization of the equipment or sometimes, environmental
reasons (i.e., an old plant often results in more environmental pollution).

Therefore, while planning a production program, the various production stages should be
considered in detail, both in terms of production activities and timing. Within the overall
plant capacity, there can be various levels of production activities during different stages
that are determined by various factors in different projects as discussed above. It would
be prudent to recognize that the full production may not be practicable for most projects
during the initial production operations. In general,

 Even if full production were to be achieved in the first year, marketing and sales
might prove a bottleneck.
 At the initial years, production may be programmed at well below the full
capacity in order to adjust a gradual growth of demand for a particular product.
 Growth of skills in operations can also be a limiting factor in a number of
industries and hence, production has to be tailored to the development of such
skills and productivity. Extraction rates and operating ratios should be effectively
determined and adequately planned.

The input requirements and costs have to be assessed for:

 Basic materials such as raw materials, semi-processed items, bought-out items,

etc.

43
  Auxiliary materials and factory supplies,
 Major utilities, and
 Direct labor requirements.

Detailed estimates in this regard should be prepared for the stages of initial production
and full production.

Factors considered in setting the Production Program

1. Production level (capacity utilization):

 Production may not be full capacity during the initial period due to:
 Production and technological difficulties
 Skill and productivity to be learned
 Lack of marketing experience
 Market forecast needs testing
 Plant is new for competition-time to cope up with the competitive
environment.
 A level of 40-50% of overall capacity utilization in the first year may not be
too low.
 In later years, capacity utilization might increase due to learning and effect
of experience/improvement in skill.
2. Production problems:
 Machine breakdowns and problems of line balancing in operations; raw
material shortages or materials may not be up to the standard; utilities
shortage, etc.
3. Wastage and spoilage:

Try to avoid abnormal spoilage & wastage (only anticipate normal ones). Note that
abnormal spoilages and wastages can be eliminated through efficient operations and
thus, are controllable/avoidable. However, normal spoilages and wastages are not
controllable or unavoidable.

4. Price Vs Quantity sales:

Sales might be affected by the price established. That is, higher prices may
have impacts reflected over lower sales volume/quantity.
Which in turn affect production program

Determination of Plant Capacity

44
The term “plant capacity” can generally be defined as the volume or number of units
that can be produced during a given period. This definition implies the output expectation
from the production plant.

Objectives:

 To identify factors affecting capacity decisions

 To examine alternative capacity levels in view of sales, profitability, technology,
and so on.
 To determine the feasible normal level of plant capacity
 To provide a basis for determining capacity costs (investment costs in capacity)

Factors Affecting Capacity decisions

1. Technological requirements:
 Minimum economic size determined by the technological factor.
 For many industrial projects, there is a certain Minimum Economic size
determined by the technological factor. For example, a cement plant
should have a capacity of at least 300 tones per day in order to use the
rotary kilos method, or else it has to employ the vertical shaft method,
which is suitable for lower capacity plants.
2. Input constraints:
 In developing countries, there may be constraints on the availability of
certain inputs, such as:
 Power supply may be limited
 Basic raw materials may be scarce
 Foreign exchange available for imports may be inadequate.
3. Investment costs:
 Investment cost per unit of capacity decreases as the plant capacity
increases (i.e. capacity costs increases at a decreasing rate). That is, some
capacity costs remain the same regardless of the size of the plant (for
instance, installation costs, technicians charges, etc); and the rest often
increase still at a lesser proportion.
 Capacity Vs Investment cost: In general, as capacity increases, the
investment cost per unit of capacity decreases.
The capacity-cost relationship could be defined by the following equation:

α
C2 = C1 X Q2

45
 Q1

Where,

C1 is the known cost for Q1 units of capacity

C2 is the derived cost for Q2 units of capacity

α (alpha) which is the factor reflecting capacity-cost relationship. Alpha is usually set in
between 0.2 to 0.9. If α=0, means there is no relationship between cost and capacity; and
If α =1, it means that capacity cost increases in the same proportion with the increase in
the level of capacity.

Example, Assume that C1 = Br. 1,000,000 represents the investment cost in capacity level
Q1

Q1 = 5000 units per annum at the normal capacity level, and

α = 0.6 reflecting the capacity-cost relationship. How much will be the investment cost in
the new capacity (C2) for a level of production (Q2) equal to 10,000 units per annum?

Solution: Apply the formula given above and C2 = Br.1, 516,000

The implication here is that although capacity has doubled, the investment cost in
capacity has increased by a less than double cost of earlier capacity.

4. Market conditions:
 The anticipated market for the product has an important bearing on plant capacity
 If the market for the product is likely to be very strong, a plant of higher capacity
is preferable.
 If the market is likely to be uncertain, it might be advantageous to start with a
small capacity.
 If the market starting from a small base, but is expected to grow rapidly, the initial
capacity may be higher than the initial level of demand. Further addition to
capacity may be effected with the growth of market.
5. Resources of the firm:
 The following resources define a limit on a firm’s capacity decisions:
 Managerial infrastructure,
 Finance, and
 Availability of skilled employees to a firm.
6. Government policy:

46
  Minimum Economic Capacity Policy in several industries:
 Economic use of raw materials and other resources (like land, human
resources, etc)
 Economies of scale and subsequent low prices to consumers
 Optimum investment in imported machinery & equipment (to save foreign
exchange)
 To minimize fragmented investments and encourage long-term investments
in large capacity plants.

Feasible Normal Capacity (FNC)

Once the marketing concept and the corresponding sales volume are defined, other
components have to be assessed to determine the feasible normal plant capacity. This
capacity should in fact represent the optimum level of production as may be determined
by the relative interactions of various components of the feasibility study such as :
technology, availability of resources, investments and production costs, raw materials and
supplies (auxiliary & utilities), human resources, etc.

The FNC is achievable under normal working conditions taking into account the
following conditions:

 Installed equipment:
Level of sophistication
Standard of operation
Specific characteristics
 Technical plant conditions:
Down time (a period where by the plant is not in operation or not running
due to technical requirements).
Maintenance requirement
Total checks
 Organizational and management aspects:
Normal working hours
Holidays
Normal labor strikes
Ability to manage and coordinate diverse interactions
 Availability of inputs
 Skill of employees (i.e. employee skill should fit to the technological requirement)

47
The feasible normal capacity is the number of units produced during one year under the
above conditions and that should correspond to the sales projections in the market and
demand analysis. Therefore, both Human Factor and System Engineering define
Feasible Normal Capacity (FNC), which is “Plant plus Human”.

Nominal Maximum Capacity (NMC)

This is the technically feasible capacity and frequently corresponds to the installed
capacity as guaranteed by the supplier of the plant. Nominal Maximum Capacity is
defined by system engineering, that is, the equipment installed capacity, which includes
reserve and stand-by capacity. To reach the maximum output figures, overtime work may
be needed as well as it might result in excessive consumption of factory supplies, utilities,
spare parts, and wear tear parts. This results in a disproportionate production cost
increase due to diseconomies of scale. In general; the FNC is less than the NMC under
normal condition.

Determination of feasible Normal capacity (FNC)

In feasibility study, the determination of the appropriate plant capacity is critical.

Forecasts of demand and market penetration strategies for a particular product are the
starting points. The limited availability of basic materials and inputs or resources may be
constraints for certain projects, requiring evaluation of various alternative possibilities of
plant sizes and capacity. These alternatives have to be related to various levels of
production and different levels of sales and profitability. The steps are in short the
following:

 Identify alternatives possibilities of plant size & capacity

 Determine various levels of production capacity utilization
 Examine the different level of sales & profitability expected

Once the overall constraints on demand and market forecasts are defined, other
components of the study have to be assessed to determine the feasible normal plant
capacity. This capacity represents the optimum level of production. One of the aspects
(components) can be critical for determining the feasible normal plant capacity of a
project, but the implications of all the above aspects should be taken into account.

Finally, prior to capacity determination, the minimum economic size, availability of

production technologies, and equipment related to various production levels should be

48
determined. Production capacities have tended to increase rapidly in a number of sectors
in industrialized countries to take greater advantage of economies of scales. Increased
capacities give increased output resulting in lower unit production costs. Another
important factor is that the available process technology and equipment are often
standardized at specific capacities in different production sectors.

4.6 Financial Analysis

Financial Cost-Benefit Analysis

The analysis of financial costs and benefits is a key step in the project preparation
process, which seeks to ascertain whether the proposed project will be financially viable
i.e. in the sense of being able to meet the burden of servicing debt and whether the
proposed project will satisfy the returns/expectations of those who provide capital and/or
the promoters.

Objectives of Financial cost-benefit analysis:

 To establish the project’s financial viability for the private investor

 Commercial profitability is the yardstick for selection among competing projects.

Components of financial analysis:

 Investment cost estimation

 Revenue estimation
 Production costs & expenses
 profitability analysis
 Cash flow estimation and analysis
 Financial ratio analysis
 Uncertainty/risk analysis
 Debt repayment schedule

Technical aspects of financial analysis:

At the technical level of financial analysis, the basic activities involved are:

 Projection of cash inflows and outflows- for each period that enables computation
of net cash flows of the project,
 Setting of the cost of capital-which is a very difficult task in countries like ours
where there is no capital markets,
 Discounting of net cash flows of the project.

49
Why evaluate cash flows rather than profits?

 Cash is what ultimately counts-profits are only a guide to cash availability: they
cannot actually be spent.
 Profit measurement is subjective-the time period in which income and expenses
are recorded, and so on, are a matter of judgment,
 Cash is used to pay dividends-dividends are the ultimate method of transferring
wealth to equity shareholders.

Determining relevant cash Flows:

Elements of cash inflows and outflows of the project under consideration can be
described as follows:

Cash inflows: project cash inflows are expected to appear from the following
sources:

 Sales of the products or services

 Sales of by products
 recovery of net working capital
 other miscellaneous sources

Cash outflows- the project will have the following major categories of cash outflows:

Initial investment costs: These are defined as the sum of fixed assets (fixed investment
costs plus pre-production expenditures) and net working capital. expenditures for fixed
assets constitute the resources required for construction and equipping an investment
project.

 Investment costs = fixed capital + Net working capital

 Fixed capital = fixed investment + pre-production capital costs,

Hence, investment costs = fixed investment + pre-production capital costs + Net

working capital

Production costs: Production costs include the following three main categories of
costs:

 Material costs (direct)

 Labor costs (direct)
 Factory overhead costs- represent indirect materials and parts, indirect labor and
other overhead costs such as depreciation of facilities and equipments etc.

50
Two approaches of determining the projected cash flows of a project:

 A cash flow forecast based on the income statement, in which the statement is
adjusted for non-cash items. The resulting figure refers to funds provided by
operations. Considering cash flows not recognized in the income statement leads
to the final funds position of the project.
 A cash receipts and disbursement statement, or the cash budget, reflecting the
initial cash balance, the receipt for the period, the expected disbursements and the
ending cash balance.

Supporting schedules for financial analysis are the following:

 Investment cost schedule

 production cost schedule
 Working capital schedule
 Loan repayment schedule

INVESTMENT PROJECT APPRAISAL METHODS:

Once the above analysis is made, the next tasks are going directly to the project appraisal
techniques. Investment project appraisal methods are classified into two basic categories.
These are non discounted cash flow methods and discounted cash flow methods.

A. NON-DISCOUNTED CASH FLOW METHODS:

I. PAYBACK PERIOD METHOD: The payback period is the number of years
required to return the original investment from the net cash flows (net operating
income after taxes plus depreciation). When deciding between two or more competing
projects the usual decision is to accept the one with the shortest payback.

The decision rules are:

 If payback < acceptable time limit, accept project

 If payback > acceptable time limit, reject project

Merits of payback as an investment appraisal technique:

 Simplicity
 Rapidly changing technology- If new plant is likely to be scrapped in a shorter
period because of obsolescence, a quick payback is essential.

51
  Improving investment conditions-when investment conditions are expected to
improve in the near future, attention is directed to those projects which will release
funds soonest, to take advantage of the improved climate.
 Payback favors projects with a quick return.

Demerits of payback as an investment appraisal technique:

 Project return may be ignored

 Timing is ignored
 Lack of objectivity
 Project profitability is ignored

Example: Assume that a firm is considering two projects: Project A and Project B, each
requires an investment of Br 100 millions. The cost of capital is 10%. Below is the
summary of expected net cash flows in millions.

Year Project A Project B

1 50 10
2 40 20
3 30 30
4 10 40
5 1 50
6 1 60

Required: Calculate the payback period and comment upon the two projects.

II. ACCOUNTING RATE OF RETURN (ARR): It uses data from the income
statement. This is computed by using the following formula:

Accounting rate of return= Average net profit

Average Annual Investment

Example: Assume the company invested in the construction of Business Machine whose
investment cost is $607,500. Useful life is 4 years. Estimated disposal value is zero, and
expected cash inflow from operations is $ 200,000.

Required: Accounting Rate of Return

Advantages of using ARR method:

52
  It is simple to calculate using accounting data
 Earnings of each year are included in calculating the profitability of the project.

Disadvantages of using ARR method:

 It is inconsistent with wealth maximization as the objective of the firm

 Since it uses the accounting data it includes the amount of accruals in calculating
the earnings “net profit”
 It is based on the familiar accrual accounting
 It ignores the time value of money

B. DISCOUNTED CASH FLOW METHODS:

I. NET PRESENT VALUE METHOD (NPV): It is the method of evaluating
projects that recognizes that the Birr received immediately is preferable to a
Birr received at some future date. It discounts the cash flows to take into
account the time value of money.
NPV = Present value of cash inflows – Present value of cash outflows
If the NPV is positive, the project will be accepted; if negative, it should be
rejected.
Problems with NPV are it is difficult to explain to non-finance people and
solution is in Birr amounts, not in percentage rates of return.
II. INTERNAL RATE OF RETURN METHOD (IRR): The IRR is the
estimated rate of return for a proposed project, given its incremental cash
flows.
OR The IRR is the discount rate that makes the present value of a project’s
cash flows equals its initial investment.
OR The IRR is the discount rate that makes the NPV equal to zero.
Note: The hurdle rate is considered the firm’s required rate of return on
investment projects of average risk. If the project’s IRR ≥ the hurdle rate,
it should be accepted, otherwise it should be rejected.

Advantages of using IRR include the following:

 Considers all cash flows

 Considers time value of money
 Comparable with hurdle rate

Disadvantages of using IRR include the following:

53
  It does not show Birr improvement in value of firm if a project is accepted
 IRR can be affected by the scale (size) of the project, i.e., initial investment.
 There will be possibility if existence of multiple IRRs.

III. PROFITABILITY INDEX: It is sometimes called Benefit Cost Ratio or

Present value index. It is calculated by taking the present value of cash inflows
divided by the present value of cash outflows.
The decision criteria are to accept project with a profitability Index (PI)
greater than one. Using this criterion, projects will be ranked from the one
with highest PI down to one with the lowest, and then project would be
selected in the order of ranking up to the point where the budget is
exhausted.

Example: Assume that Mina PLC, a financial analyst, is doing a consulting work for
evaluating the two projects given below. The projects costs Br. 500 million each and the
required rate of return for each of the projects is 12%, the projects’ expected net cash
flows are as follows:

Year Project I Project II

0 (500) (500)
1 325 175
2 150 175
3 150 175
4 50 175
Required:

1. Calculate each of the project’s payback, net present value( NPV) and Internal
rate of return (IRR)
2. Which project or projects should be accepted if they are independent?

FINANCIAL AND EFFICIENCY RATIOS:

The figures appearing in the balance sheet, income statement, and the cash flows
statements convey a considerable amount of information in terms of their absolute values.

In financial analysis it is usual to refer to several well known ratios that facilitate the
analysis and specially the comparison of projects and alternatives. The computation of
ratios shall be accompanied by interpretation of their meaning. Analysts and decision
makers should also bear in mind that ratios may not be automatically regarded as good or

54
bad, but have to be evaluated in the light of the characteristics of the corresponding
industry, the type and scope of the project and the country of investment.

The ratios that are most frequently used in evaluating and assessing projects are:

Financial Ratios:

 Debt to Equity Ratio: indicates what proportion of equity and debt that the
company is using to finance its assets. Sometimes investors only use long term
debt instead of total liabilities for a more stringent test. It is also referred to as long
term debt to net worth ratio.
 Current Ratio: The current ratio is also known as working capital ratio and is
normally presented as a real ratio. This ratio is one of the best known measures of
financial strength.
 Long term Debt-service charge: It is defined as the ratio of cash generated to
debt service (interest plus repayment of principal).
 Debtors-Creditors Ratio: The ratio between debtors and creditors helps to
identify overtrading especially in rehabilitation projects. Overtrading is a situation
where too high level of production is maintained with insufficient cash resources.

Efficiency ratios:

The operational performance and profitability of an investment is measured by relating

the financial net benefits expressed as net cash flows to the corresponding capital
investment.

 Output-Capital ratio: Though used mostly in economic analysis, it is also an

important yardstick in assessing investment projects at early stages (opportunity
studies and pre-feasibility studies)
 Net Present Value Ratio: when the present value of the accumulated benefits of
the project is related to the present value of total capital invested, the net present
value ratio is obtained.
 Relation between personnel employed and investment
 Turnover of inventories: This ratio reveals how well inventory is being
managed. It is important because the more times inventory can be turned in a
given operating cycle, the greater profit. Inventory Turnover Ratio can be
calculated by divided net sales over Average Inventory at cost. But it may also be

55
 computed as the ratio of cost of goods sold to average inventory to eliminate the
gross profit element from sales.
 Accounts receivable Turnover ratio: this ratio indicates how well accounts
receivable are being collected. If receivables are excessively slow in being
converted to cash, liquidity could be severely impaired. Getting the Accounts
Receivable Turnover Ratio is a two step process and is calculated as follows:
Daily Credit sales = Net Credit sales per year/ 365 (days)
Accounts Receivable Turnover (in days) =
Accounts Receivable/Daily Credit Sales

PROJECT FINANCING

There are two types of project financing: equity and debt financing. When looking for
money, you must consider your company’s debt-to-equity ratio. The relation between
amounts borrowed and amounts invested to the business by the owners. The more money
owners have invested in their business, the easier it is to attract financing.

The proportion of debt to equity depends on how well the financial market is organized
and the availability of debt financing. In addition, the existence of capital markets and the
legal environment governing it will have a critical impact. However, shortage of financial
resources will be a critical constraint of implementing feasible investment projects.

Equity Financing:

Most small or growth-stage businesses use limited equity financing. As with debt
financing, additional equity often comes from non-professional investors such as friends,
relatives, employees, customers, or industry colleagues.

However, the most common source of professional equity funding comes from venture
capitalists. These are institutional risk takers and may be groups of wealthy individuals,
government-assisted sources, or major financial institutions. Most specialize in one or a
few closely related industries.Venture capitalists may scrutinize thousands of potential
investments annually, but only invest in a handful. The possibility of a public stock
offering is critical to venture capitalists. Quality management, a competitive or
innovative advantage, and industry growth are also major concerns.

Debt Financing:

There are many sources for debt financing: banks, savings and loans, commercial finance
companies, and the microfinance institutions. State and local governments have

56
developed many programs in recent years to encourage the growth of small businesses in
recognition of their positive effects on the economy.

Family members, friends, and former associates are all potential sources, especially when
capital requirements are smaller. Traditionally, banks have been the major source of
small business funding. Their principal role has been as a short-term lender offering
demand loans, seasonal lines of credit, and single-purpose loans for machinery and
equipment.

In addition to equity considerations, lenders commonly require the borrower’s personal

guarantees in case of default. This ensures that the borrower has a sufficient personal
interest at stake to give paramount attention to the business. For most borrowers this is a
burden, but also a necessity.

4.7 ECONOMIC AND SOCIAL ANALYSIS OF PROJECTS

Social Cost Benefit analysis (hereafter referred to as SCBA) called economic analysis,
is a methodology developed for evaluating investment projects from the point of view
of the society (or economy) as a whole. Used primarily for evaluating public
investments (though it can be applied to both private and public investments), SCBA
has received a lot of emphasis in the decades of 1960s and 1970s in view of the
growing importance of public investments in many countries, particularly in
developing countries, where governments have played a significant role in the
economic development. SCBA is also relevant, to a certain extent, to private
investments as these have now to be approved by various governmental and quasi-
governmental agencies which bring to bear larger national considerations in their
decisions.

Rationale for SCBA:

In SCBA the focus is on the social costs and benefits of the project. These often tend
to differ from the monetary costs and benefits of the project. The principal sources of
discrepancy are:

 Market imperfections
 Externalities
 taxes and subsidies
 concern for savings
 concern for redistribution
 merit wants

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UNIDO approach:

Towards the end of the 1960s and in the early 1970s two principal approaches for SCBA
emerged: The UNIDO approach and the Little-Mirrlees approach.

The UNIDO approach was first articulated in the Guidelines for Project Evaluation,
United Nations, 1972 which provides a comprehensive framework for SCBA in
developing countries. The rigor and length of this work created demand for a
succinct(brief and to the point) and operational guide for project evaluation in practice.
To fulfill this need, UNIDO came out with another publication, Guide to Practical
Project Appraisal in 1978.

The UNIDO method of project appraisal involves five stages:

1. Calculation of the financial profitability of the project measured at market prices.

2. Obtaining the net benefit of the project measured in terms of economic
(efficiency) prices.
3. Adjustment for the impact of the project on savings and investment.
4. Adjustment for the impact of the project on income distribution.
5. Adjustment for the impact of the project on merit goods and demerit goods whose
social values differ from their economic values.

Little-Mirrlees approach:

I.M.D. Little and J.A.Mirrlees have developed an approach (hereafter referred as the L-M
approach) to social cost benefit analysis expounded by them in the following works:
Manual of Industrial Project Analysis in developing Countries, Vol. II and Project
Appraisal and Planning for Developing Countries.

There is considerable similarity between the UNIDO approach and the L-M approach.
Both the approaches call for:

1. Calculating accounting (shadow) prices particularly form foreign exchange

savings and unskilled labor.
2. Considering the factor of equity.
3. Use of DCF analysis.

Despite considerable similarities there are certain differences between the two
approaches:

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 1. The UNIDO approach measures costs and benefits in terms of domestic currency
whereas the L-M approach measures costs and benefits in terms of international
prices, also referred to as border prices.
2. The UNIDO approach measures costs and benefits in terms of consumption
whereas the L-M approach measures costs and benefits in terms of uncommitted
social income.
3. The stage-by-stage analysis recommended by the UNIDO approach focuses on
efficiency, savings, and redistribution considerations in different stages. The L-M
approach, however, tends to view these considerations together.

Foreign Exchange effect of a project:

The UNIDO method uses domestic currency as the numeraire. So the foreign exchange
input of the project must be identified and adjusted by an appropriate premium. This
means that valuation of inputs and outputs that was measured in border currencies has to
be adjusted upward to reflect the shadow price of foreign exchange.

How is the shadow price of foreign exchange established? The Guidelines method
determines the shadow price of foreign exchange on the basis of marginal social value as
revealed by the consumer willingness to pay for the goods that are allowed to be
imported at the margin. The shadow price of a unit of foreign exchange is equal to :
n

∑ F iQ i P i
i=1

Where Fi is fraction of foreign exchange, at the margin, spent on importing commodity i.

Qi is the quantity of commodity I that can be bought with one unit foreign exchange (this
will be equal to 1 divided by the CIF value of the goods in question)

Pi is the domestic market clearing price of commodity i.

Example: Commodities 1, 2, 3 and 4 are imported at the margin. The proportion of

foreign exchange spent on them, the quantities that can be bought per unit of foreign
exchange, and the domestic market clearing prices are as follows:

F1 = 0.3, F2 =0.4, F3=0.2, F4=0.1

Q1 = 0.6, Q2 =1.5, Q3=0.25, Q4=3

P1 = 16, P2 =8, P3=40, P4=5

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The value of a unit of foreign exchange is:

(0.3)(0.6)(16) + (0.4)(1.5)(8) + (0.2)(0.25)(40) + (0.1)(3)(5) +Br. 11.180

The calculation of the shadow price of foreign exchange in terms of consumer

willingness to pay is based on the assumption that the foreign exchange requirement of a
project is met from the sacrifice of others. The use of foreign exchange by a project,
however, may also induce the production of foreign exchange through additional exports
or import substitution. In such a case, the shadow price of foreign exchange would be
based on the cost of producing foreign exchange, not consumer willingness to pay for
foreign exchange.

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