5.

Selection of Industrial Projects

• Project Identification
• Project Appraisal
• Project Selection

1
 Process of Project Identification
Internal Objective

SWOT Brainstorming

External Project
Possibilities
Criteria Screening

Candidate Project
Proposals 2
• To achieve their objectives with the strengths
and the limitations they have under the
opportunities and threat existing, what are
the kinds of project possibilities that
companies can formulate?

3
 Searching New Ideas
To search for new ideas we have to:
• Identify our objectives – depending on
objectives of the company projects are
different
Objectives can be:
– To increase profits
– To become more competitive
– To train people in a new areas (Lean Mfg,
TQM, BPR, Kaize, BSC, JIT, …, )
4
• Brainstorm to generate alternative
solutions to achieve our objective.
• During brainstorming we have to
consider:
– The objective of the company
– SWOT analysis
• Select some criteria and screen the
ideas

5
 SWOT Analysis
SWOT analysis – the process of looking within and
the process of looking outside to choose the right
project.
Criterion that we might consider while assessing
the Strength and Weakness of Companies
Skills, knowledge and
experience of workforce Familiarity with new
Financial position technologies
Industrial contacts Ability to raise huge
Foreign collaborations investment
SCM New product development
Resource optimization Quality Management
Marketing practices etc…
6
 Opportunities
Emerging new technologies Threats/challenges
New products with new Strong competitors
markets Poor buying capacity of
New processes with better customers
features Outdated technology
Government and other New products in the
incentives market

7
 New project ideas can be originated from
the brainstorming discussion among:
• Marketing and sales
• Research and development
• Top management
• Production department
• Consumers
• Worker from lower to top
• Stakeholders

After appraisal we can determining whether the idea is

worthwhile or not.
8
During this brainstorming:
• Focus on uninhibited participation by a group
• Allow listing of ideas without suppressing
creativity at source
• Permit listing of ideas subjected to screening
and evaluation subsequently

9
 Broad Screening of Ideas
Screening helps us to find what is best
The following table shows how one can calculate a
total score to screen ridiculous ideas from non-
ridiculous ideas.
Criteria Poor (1) Fair (2) Good (3) V.Good Excellent Weight
(4)

Cost x 20%

Risk x 30%

Return x 50%

Score = 2x0.2 + 3x0.3 + 4x0.5 = 3.3 This is to

estimate how well this idea is worth 10
 Criterion in Screening Projects
• Effectiveness to achieve objective
• Risk
• Flexibility
• Cost of proposal
• Ease of implementation
• Time needed
• Payback period
• Similarity to existing business
• Environmental impact
11
 Stages of New Project Ideas

No of Project feasibility
ideas report here
Appraisal
Screening

Selection
Project chosen for
implementation

Time (Successive stages)

12
 Illustrative Example
• Objective: Reduce Vehicle Pollution in Delhi
Through Brainstorming the following project
ideas have been identified.
1. Restrict registration of new vehicles
2. Enforce strict emission regulations for vehicles
3. Ban diesel run vehicles on road
4. Introduce Mass Rapid Transport System for the city
5. Encourage Small Car Pools
6. Grow more trees/green belts in the city
7. Declaring no traffic zones in the city
8. Ban Vehicle with an age of ten or more years from playing
on the road 13
Now Do a Screening Analysis
What are the criteria we have to consider
for our quick screening?
The following criteria are selected:
a. Effectiveness to achieve objective
b. Cost of proposal
c. Ease of implementation
d. Time needed
other criterion can be added
14
 Scale of Evaluation
V. Poor poor Fair Average Good Excellent

0 1 2 3 4 5

Low Effectiveness High

High Cost Low

Difficult Ease of Implementation Easy

Max Time Min

15
 Screening of Alternative Projects
Project Effecti- Cost Ease for Time Total
No veness imple.
1 3 1 1 2 7
2 4 4 4 5 18
3 3 1 1 2 7
4 4 0 1 0 5
5 2 5 4 4 15
6 4 3 3 3 13
7 2 3 2 2 9
8 3 2 3 3 11
16
 Result of the Screening
• Project No.2: Enforce Strict Emission
regulations on Vehicles (18 points)
• Project No 5: Encourage use of Car Pools
(15pts)
• Project No 6: Grow More Trees/Green Belts in
the City (13pts)
These projects can now be appraised based on
their financial, market, technical,…, factors

17
Project Appraisal
• It is the process of investigating candidate
project proposals in greater detail.

• The candidate project proposals are the

inputs for project appraisal phase

18
Project appraisal is conventionally divided
into
• Market Appraisal
• Technical Appraisal
• Socio-economic appraisal
• Ecological Appraisal
• Financial Appraisal

19
 Market Appraisal/Commercial Appraisal
Market appraisal is mainly concerned with:
• What would be the total demand for the
product/service in the market?
• What would be the market share (quantity
and price-wise) of your project?
Market Aggregate Demand
Share

20
How can we determine future demand?
Existing Product
th of
w
Gro nd
a
dem
Demand

Demand Constant
history demand

Dec
dem line o
and f

Today Time 21
To estimate the future demand for existing product
we use demand history

We can use forecasting techniques to estimate

future demand (regression, exponential models,…)

22
 New Product

th of
w
Gro nd
a
dem
Demand

No demand Constant
history demand

Dec
dem line o
and f

Today Time 23
• Demand for a new product is more of
guess as there is no past data for
forecasting

• We have to consider the opinions of

experts

• Use questionnaires, discussion and

interviews to identify the future
demand of new products
24
Issues that we should consider while we
talk about Market Appraisal are:

• Past and present demand trends

• Past and present supply position
• Import and export statistics
• Nature of competition (capabilities of
other players)

25
• Elasticity of demand (what will happen to
demand as price change)

• Consumer behavior (what are the

consumers criteria to buy that product?)

• Distribution channel – helps to reach

customers

26
Technical Appraisal
Major Issues are:
Some of the issues in technical appraisal
are:
• Have good choices been made in terms of
location, size, process, machines, raw material?

27
• Availability of raw materials, power, and
other inputs available
• Optimal Scale of Operation (right decision
on the size we have chosen)
• Choice of suitable production process
• Choice of appropriate machines and
equipments
28
• Is there appropriate arrangement for the
proper treatment of effluents and waste
disposal?
• Proper layout of plant and building for
the movement of men, materials and
economical space utilization

29
Socio-Economic Appraisal
• Socio cost-benefit analysis
• How the project is going to affect the
society at large,?
• It may displace the society (social cost)
• It may provide job opportunity (Social
benefit) and may improve the life of the
society in one or another way
• Direct economic benefits and costs in terms of
Shadow prices
• If we take large land from which people
are displaced, how can it contribute to the
overall objective of the project?
30
• Impact of project on distribution of income in
society (Ruthless growth)
• Projects should reduce poverty
• Impact on fulfillment of national goals
• Self-sufficiency (eg. production of substitute
products for imports)
• Potential to generate employment
• Power of the project in in creating social
order
31
Ecological Appraisal
• Projects should not spoil the environment
• Impact of the project on the quality of air, water,
noise, vegetable, human life as a whole, …
• International norms must be met
• Major projects, such as these, cause
environmental damage: Power plants, Bulk drugs,
Chemicals, Leather processing

32
• Likely damage and the cost of
restoration (reprocessing)
• Rather than disposing the dirty
water into rivers what is the
reprocessing cost to avoid the
damage?

33
 Financial Appraisal
Most important issues are:
• Estimating the cost of the project
• Land cost, building cost, Machinery
cost, material cost, labor cost, etc
• Estimation of the likely revenues during
each period
• Cost of capital
• Calculate the loan returning capability of
the project
• Debt Service Coverage ratio
(DSCR)
• If DSCR > 2, it is worthwhile 34
• Compute project feasibility using Break Even
Point
• Scale of operation to recover cost
• Compute various financial performance
indicators of the project such as:
– Payback period (PBP);
– Net present value (NPV);
– Internal rate of return (IRR).

35
1. Payback Period
• The payback period is defined as the
number of years it will take to recover the
original investment from the future net cash
flows.
• This was the first formal method developed
for evaluating capital investment projects.

36
Example 1
Assume that you invest Birr 100,000 in a
project. A year later you invest another Birr
50,000. From the second year onwards the
net cash you receive is Birr 45,000 per year
over a period of five years. The cash flow is as
follows:

37
Year Net Cash Flow, B irr Cu m m u la tive Cash Flow

0 -1 0 0 ,0 0 0 -1 0 0 ,0 0 0

1 -5 0 ,0 0 0 -1 5 0 ,0 0 0

2 +4 5 ,0 0 0 -1 0 5 ,0 0 0

3 +4 5 ,0 0 0 -6 0 ,0 0 0

4 +4 5 ,0 0 0 -1 5 ,0 0 0

5 +4 5 ,0 0 0 +3 0 ,0 0 0

6 +4 5 ,0 0 0 +7 5 ,0 0 0

38
• Thus pay back period = 4 + 15,000/45,000 = 4.33
years = 4 years and 4 months
• In general, investment projects with a relatively
short payback period are preferable.
• One advantage of this method is that it is easy to
calculate and apply.
• Its disadvantage is that it ignores cash flows
beyond the payback period

39
Example 2
Let us say we were offered a series of cash inflows at
the end of each of the next four years as Birr 5000,
Birr 4000, Birr 3000, and Birr 1000. Say the initial
cash outlay for this proposal is Birr 10,000. We are
faced with finding the payback period for this
hypothetical investment. Below you will find a
tabular form that shows the time period, the
corresponding cash flow, and the cumulative sum of
the cash flows.
40
Year Cash Cash inflow Cumulative
outflow cash flow
0 -10,000 -10,000

1 5000 -5000

2 4000 -1000

3 3000 2000

4 1000 3000

Pay back period = 2+(1000/3000)*12 = 2 years and

4 months

43
2. Net present value
• The net present value (NPV) method is a
useful method for evaluating investment
projects.
• The NPV is equal to the present value of
future net cash flows discounted at the cost
of capital minus the present value of the
cost of the investment.
• The advantage of this method is that it
takes into account the potential of the
business over the entire planning period of
the investment.
42
 CF1 CF2 CF3 CFn
NPV  [    ....  ]  CF0
(1  r ) (1  r ) (1  r )
1 2 3
(1  r ) n

Where,
CF1, CF2, CF3 … , future cash inflows occurring at the

end of first year, second year, etc

n = life of project in years
r = discount rate (cost of capital)
CF0 = present cash outflow.

43
Example 1
Calculate the NPV of the following project.

Investment on the project Birr 1,000,000

Life of the project 5 years
Cost of capital 15%

Year 1 2 3 4 5

Cash inflow 200,000 300,000 400,000 300,000 100,000

44
Solution
Present value of future cash inflows is given by

CF1 CF2 CF3 CF4 CF5

    
(1  r ) (1  r ) (1  r ) (1  r ) (1  r ) 5
1 2 3 4

200000 300000 400000 300000 1000000

    
(1  0.15) (1  0.15) (1  0.15) (1  0.15) (1  0.15) 5
1 2 3 4

= Birr 885,002
NPV = 885,002 – 1,000,000 = Birr-114,998

45
Example 2
Calculate the NPV of the following Project
Investment on the project Birr 1,000,000
Life of the project 5 years
Cost of capital 13%

Year 1 2 3 4 5

Cash inflow 300,000 400,000 400,000 300,000 200,000

46
Present value of future cash inflows is given by
CF1 CF2 CF3 CF4 CF5
    
(1  r ) (1  r ) (1  r ) (1  r ) (1  r ) 5
1 2 3 4

300000 400000 400000 300000 2000000

    
(1  0.13) (1  0.13) (1  0.13) (1  0.13) (1  0.13) 5
1 2 3 4

= Birr 1,148,506
NPVB = 1,148,506 – 1000,000 = Birr 148,506

Note
A project is said to be viable if its NPV
47
3. Internal Rate of Return (IRR)
• The Internal rate of return of a project is
the discount rate (cost of capital) that makes
the net present value equal to zero.
• In other words, IRR is that rate of discount
which would equate the present value of
cash outflows (investments on the project) to
the present value of cash inflows (the
benefits over the life of the project) 48
Example
For a project with a given data, calculate the IRR
Year Cash outflow Cash inflow, Birr
0 Birr 1,000,000 -
1 400,000
2 250,000
3 250,000
4 200,000
5 200,000
6 150,000

49
 Solution
Let r be the internal rate of return. The IRR is
arrived at by equating the present value of cash
out flow and the present value of cash inflows.

NPV =400000/(1+r)^1+250000/(1+r)^2
+250000/(1+r)^3+200000/(1+r)^4
+200000/(1+r)^5+150000/(1+r)^6 - 1000000

Thus, NPV = 0 when r = 14.113

50
 4. Debt Service Coverage Ratio (DSCR)

DSCR is used to determine whether the project is

generating enough income to pay its debt obligations.
In general, it is calculated by:
DSCR = Net Operating Income
Total Debt Service

A DSCR of less than 1 would mean a negative cash

flow. A DSCR of less than 1, say 0.95, would mean
that there is only enough net operating income to
cover 95% of annual debt payments.

51
Here is a basic example of how a commercial
mortgage lender calculates the DSCR for a
commercial loan request. The lender holdbacks are
highlighted in blue, remember these are not actual
expenses, but they are deducted from the property's
gross income.

52
Gross Rents $1,000,000
Other Income 0
Total Annual Gross Income $1,000,000
Less 5% Vacancy & Collection Loss $50,000

Effective Gross Income: $950,000

Real Estate Taxes $15,000
Property Insurance $5,000
Repairs & Maintenance $5,000
Pest Control $5,000
Janitorial $5,000
Utilities $5,000
5% Off Site Management Reserve $50,000
Replacement Reserves $0.15 per
$15,000
unit
Total Operating Expenses: $105,000
53
Net Operating Income (NOI) $845,000
Now that we have calculated the NOI, we must calculate the
total debt service for the property, or simply determine the
commercial mortgage loan payment consisting of only the
principal and interest. We do not include the taxes and
insurance as they are accounted for in the expenses of the
property.
To calculate the debt service coverage ratio, simply divide the
net operating income (NOI) by the commercial mortgage loan
payment.

54
Commercial Loan Size: $10,000,000
First Mortgage
Interest Rate: 6.5%
Term: 30 Years
Annual Payments (Debt Service) = $765,774
Note

Where A = periodic payment (annual payment, i.e.,

debt service in this case)
Pu = present worth of uniformly series payment
i = interest rate, n = payment period
55
Now we can calculate the DSCR:

DSCR = Net Operating Income (NOI) = $845,000

Total Debt Service $ 765,774

DSCR = 1.10

56
• Net operating income (NOI) is the earnings
before interest, tax and debt amortization
• This is one of the most important ratios that a
lender uses to determine the repayment capacity
of a borrower.

57
• What this example tells us is that the cash flow
generated by the project will cover the new
commercial loan payment by 1.10x.
• This is generally lower than most commercial
mortgage lenders require.
• Most lenders will require a minimum DSCR of
1.20x.
If a DSCR is 1.0x, this is called breakeven, and a
DSCR below 1.0x would signal a net operating loss
based on the proposed debt structure. 58
5. Break Even Point (BEP)
• The break-even point is the point at which
revenue is exactly equal to costs.
• The break-even units indicate the level of
sales that are required to cover costs.
• Sales above that number result in profit
and sales below that number result in a
loss.

59
• Break even occurs where profit is zero:
• For this to happen the money coming into
a business (Total Revenue) must
be the same as the money leaving the
business (Total Cost)
• As such, the break even point occurs when:

Total Revenue = Total Costs

60
Total Revenue (TR)
• This is the total amount of money a firm receives from
selling goods or services
• It is calculated using the following formula:

Total Revenue (TR) = Price per unit x Number of

For example, if a firm sells 10 shirts each for Birr 150 , it’s
total revenue will be (10 x 150 = Birr1500

61
 Total Cost (TC)
This is the total amount of money a firm spends on
making goods or services
It is calculated using the following formula:
Total Cost (TC) = Total Fixed Costs (FC) + Total Variable Costs (VC)

Where:
• Total Fixed Costs = All fixed costs added together
• Total Variable Costs =variable cost per unit multi
plied by the number of units

62
Example: A local livestock producer utilizes compost waste to
develop an organic fertilizer product. The retail sales price is $5.00
per bag. The average variable cost per bag is $2.80 and average
annual fixed costs are $60,000. These three pieces of information
are:

Average Per Unit Sales Price = $5.00 per bag

Average Per Unit Variable Cost = $2.80 per bag
Average Annual Fixed Costs = $60,000.00
Let Q be the no of units at BEP
Total revenue = 5Q
Total Cost = FC + VC = 60000 + 2.8Q
At BEP, 5Q = 60000 + 2.8Q
Q = 60000/(5-2.8) = 27,273

Therefore, no profits are made from the sale of this product until
more than 27,273 bags are sold
63
 5Q
e=
2.8Q
+

nu
000
Cost =6

ve
TC

Re
in
Ga
BEP

60000
ss
Lo

27,273 Quantity produced

64