Project finance is the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure, in which project debt and equity used to finance the project are paid back from the cash flow generated by the project. Project financing is a loan structure that relies primarily on the project's cash flow for repayment, with the project's assets, rights and interests held as secondary security or collateral. Project finance is especially attractive to the private sector because companies can fund major projects off balance sheet.
2. UNIT – 1 A Project is a temporary, unique and progressive attempt or endeavor made to produce some
kind of a tangible or intangible result (a unique product, service, benefit, competitive advantage, etc.).
It usually includes a series of interrelated tasks that are planned for execution over a fixed period of
time and within certain requirements and limitations such as cost, quality, performance, others.
key characteristics of a project
1.A single definable purpose, end-item or result. This is usually specified in terms of cost, schedule
and performance requirements.
2.Unique Deliverable(s). Any project aims to produce some deliverable(s) which can be a product,
service, or some another result. Deliverables should address a problem or need analyzed before project
start.
3.Temporary. This key characteristic means that every project has a finite start and a finite end. The
start is the time when the project is initiated and its concept is developed. The end is reached when all
objectives of the project have been met (or unmet if it’s obvious that the project cannot be completed
– then it’s terminated)
4.Projects involve unfamiliarity. Because a project differs from what was previously done, it also
involves unfamiliarity. And oft time a project also encompasses new technology and, for the
organization/firm undertaking the project, these bring into play significant elements of uncertainty and
risk.
5.The organization usually has something at stake when undertaking a project. The unique project
“activity” may call for special scrutiny or effort because failure would jeopardize the organization/firm
or its goals.
6.Purposeful as it has a rational and measurable purchase
7.Logical as it has a certain life-cycle
8.Structured as it has interdependencies between its tasks and activities
9.Conflict as it tries to solve a problem that creates some kind of conflict
10.Limited by available resources
11.Risk as it involves an element of risk
Contents of Detailed Project Report
1. General Information
3. • Name
• Constitution & Sector
• Location
• Nature of Industry and Product
• Promoters and their contribution
• Cost of Project and means of finance
2. Promoter’s Details
3. Marketing & Selling Arrangement
4. Particulars of the Project
• Product mix and capacity
• Location & Site
• Plant & Machinery
• Raw Materials
• Utilities
5. Technical Arrangements
6. Production Process
7. Environmental Aspects
8. Schedule of Implementation
9. Cost of the Project
10. Means of Finance
11. Profitability Estimates
• Assumptions
• Projected Income Statement
• Projected Balance Sheet
• Projected Cash Flow Statement
• Appraisal based on Profitability statement
13. Economic Considerations
14. Appendices
• Estimates of cost of production
• Calculation of depreciation
• Calculation of working capital and margin money for working capital
4. • Repayment/Interest Schedule of term loan and bank finance
• Calculation of tax
• Coverage ratios
• NPV,IRR etc
• Sensitivity Analysis
Project finance
The term “project finance” is used loosely by academics, bankers and journalists tom describe a range
of financing arrangements. Often bandied about in trade journals and industry conferences as a new
financing technique, project finance is actually a centuries-old financing method that predates
corporate finance. However, with the explosive growth in privately financed infrastructure projects in
the developing world, the technique is enjoying renewed attention. In this example, the chief
characteristic of the project financing is the use of the project’s output or assets to secure financing.
When a study is conducted relating to the various components of the cost of the project, such study is
called project financing
Project finance scheme
Objective: To provide long term finance for the establishment of new industrial, infrastructure, agri-
horticulture, fishery and animal husbandry projects as well as expansion, diversification and
modernization of existing ones.
Types of Assistance: Term loan, direct subscription/underwriting of equity and debt instruments,
provide financial guarantee and participate in deferred payment guarantee.
Eligibility: Industrial concerns conforming to the definition in Section 2 (c) of the IDBI Act,
Infrastructure, Agro-horticulture, Fishery and Animal Husbandry projects.
Project Cost: Minimum assistance: NEDFi ordinarily finances projects with loan component of Rs.25
lakh and above. However smaller projects in innovative fields and in the hill states are also considered.
Maximum assistance: Normally, NEDFi can consider up to maximum exposure of 10% of paid up
capital & reserves. However, it can consider projects requiring higher investment in consortium with
other financial institutions and banks.
Nature of assistance: Rupee Term Loan
Promoters’ contribution: 30-40% of the total project cost. However, in the case of consortium
financing it will be at par with the norms of All India Financial Institutions.
5. Debt Equity Ratio: Ordinarily 1.5 : 1
Interest Rate: Based on Prime Lending Rate fixed from time to time. Actual rate within the prevailing
rate band depends upon creditworthiness of borrower and risk perception. As on date, the prevailing
interest rate is 15% per annum. There is provision for 1% rebate on interest rate for timely repayment
on due dates.
Up-front fee: 1% of the loan amount sanctioned
Security: First charge on movable and immovable fixed assets.
Documentation:
1. Loan Agreement.
2. Deed of hypothecation.
3. Personal guarantee from main promoters, wherever required.
4. Undertaking from the promoters for
o Meeting overrun/shortfall in the project cost/means of financing
o Non-disposal of shareholdings by the promoters
5. Undertaking from MD for non-receipt of commission, if company is in default to NEDFi.
6. Resolution under Section 293 (1)(a) and 293(1)(d) of the Company’s Act.
Advantages and Characteristics of Project Financing
• eliminate or reduce the lender’s recourse to the sponsors
• permit an off-balance sheet treatment of the debt financing
• maximize the leverage of a project
• circumvent any restrictions or covenants binding the sponsors under their respective financial
obligations
• avoid any negative impact of a project on the credit standing of the sponsors
• obtain better financial conditions when the credit risk of the project is better than the credit
standing of the sponsors
• allow the lenders to appraise the project on a segregated and stand-alone basis
• obtain a better tax treatment for the benefit of the project, the sponsors or both
• reduce political risks affecting a project
Risks
Risk involves the chance an investment’s actual return will be differ from the expected return. Risk
includes the possibility of losing some or all of the original investment. Different versions of risk are
6. usually measured by calculating the standard deviation of the historical returns or average returns of a
specific investment.
Mitigating and managing project risk
Types
Project
Risk
Financial risk
Operating risk
Political risk
Market risk
underestimation
Facilities risk
Capital shortage
Labor/material
shortage
Inflation
Design/contraction
Low productivity
Volatile product price
Engineer specification
Poor assessment
Exchange rate risk
Cash flow deficit
Tested
Technology
risk
New
Low MPT
High MPT
Product introduction
Competitive position Take/pay contract
Timing
Expropriation
Inconvertibility
Currency restriction
Higher tax
Nationalization
Identify (1)
Risk
Knowledge base,
conceptTrack&
report (4)
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Learn
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Risk statemB1(EIA
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Analyze &prioritize
(2)
Control (5)
Track& report
(4)
Plan &
schedule (3)
Master
RISK list
7. Financial risk
Any change in interest rates or cost of capital will affect the prospectus of a project. A project which
is feasible at the expected return of 12% may become infeasible if the expected return increases to
15%.the expected return directly vary with interest rates. The degree of financial risk for different
projects varies with its debt equity ratio and can be measured by the financial leverage. Financial risks
can in part be addressed by hedging against foreign exchange and interest rate, swaps, interest rate
caps, collars etc. Debt servicing can be impacted by factors such as market prices, inflation rates,
energy costs, tax rates etc.
Legal risks arise from legal and regulatory obligations, including contract risks and litigation brought
against the organization. Political environment of a country may lead to changes in legal or regulatory
changes and may cause risk due to new taxes being imposed or barriers to imports or exports being
introduced.
Political risk Shipping and offshore vessels operate globally and may be exposed to political risk,
local content requirements, risk of privacy, risk of corruption, etc.
There are many other types of risks of concern to projects. These risks can result in cost, schedule, or
performance problems and create other types of adverse consequences for the organization. For
example:
▪ Governance risk relates to board and management performance with regard to ethics, community
stewardship, and company reputation.
▪ Strategic risks result from errors in strategy, such as choosing a technology that can’t be made
to work.
▪ Operational risk includes risks from poor implementation and process problems such as
procurement, production, and distribution.
▪ Market risks include competition, foreign exchange, commodity markets, and interest rate risk,
as well as liquidity and credit risks.
▪ Risks associated with external hazards, including storms, floods, and earthquakes; vandalism,
sabotage, and terrorism; labor strikes; and civil unrest.
Refinancing risk
When the terms on which debt is available no longer match those of the underlying project, the issue
of refinancing risk arises. If only shorter term debt is available, assumptions must be made at financial
close that the project company will in the future be able to refinance its debt within certain parameters
of timing, price and other terms, and there is a risk that those assumptions will not be adhered to in
some respect.
8. Risk period
There are three main risk periods in project financing:
1) Engineering and construction
• Sponsor risk
• Pre-completion risk
2) Start-up
3) Operational
Unit-2
DEMAND FORECASTING:
Demand forecasting helps to assess future demand and to plan production accordingly. A forecast is
an estimate of a future situation. Forecast of demand is an estimation of the future level of demand. It
is necessary to take steps for the acquisition of the various factors of production like raw materials,
labor ,capital land ,building etc at the right time.
Demand forecasting may be done at macro level, industry level, and firm level .Macro level forecasting
deals with the business conditions prevailing in the entire economy. Industry level forecast is made by
various trade association and is made available to its members. Firm level forecast helps the manager
very much in his decisions. Demand forecasting necessitates an analysis of past trends and present
economic conditions. This analysis helps to make inferences about the future. An analysis of the past
trends brings to light the various factors that affected the business.
Forecasting may be done for a short period or for a long period. Short run forecasting may be for 2
months or even one year. It is concerned with the day to day working of the business. The long run
forecasting may be for a period ranging from 5 to 20 years. The period depends on the nature of the
business.
Techniques of Demand Forecasting
a) Qualitative Techniques
i. Consensus Method
1. Expert Opinion Methods
2. Delphi Methods
ii. Survey method
1. Complete enumeration Survey Method
2. Supply method
3. Sales Force Opinion
4. End Use Survey
b) Quantitative Techniques
i. Trend Projection Methods
9. ii. Barometric Method
iii. Econometric Techniques
1. Regression Method
2. Simultaneous Equation method
Feasibility Analysis
A feasibility study is performed by a company when they want to know whether a project is possible
given certain circumstances. Feasibility studies are undertaken under many circumstances to find out
whether a company has enough money for a project, to find out whether the product being created will
sell, or to see if there are enough human resources for the project. A good feasibility study will show
the strengths and deficits before the project is planned or budgeted for. By doing the research
beforehand, companies can save money and resources in the long run by avoiding projects that are not
feasible. Most investment proposals pass through the stage of checking out the feasibility. Large
project usually need a feasibility test to be carried out before a handsome amount is committed. The
strategic content in such project is high, but the availability or relevance of internal data is less.
Project feasibility is a test where the prime facia viability of the investment is evaluated. Evaluation is
based on secondary but comprehensive data.
Types
1.Market feasibility
2.Technical feasibility
3.Financial feasibility
1.Market feasibility
A market feasibility study aims at assessing the sales potential of a proposed product. The approach
for conducting market feasibility study will vary depending upon the type of proposed product. If a
proposed project is new in an economy, but has been successfully marketed in some other economy,
then its market feasibility is assessed through a meaningful comparison of some broad economic and
cultural indicators in the two economies.it can also be done based on creative judgement and wishful
thinking. The need for, or importance of, a market study is quite simple. This analysis is to provide a
disinterested third party point of view for a given project based on the project’s competitive position
within a particular market, while also determining the demand for the proposed project within that
market. Conversely, the components which make-up a good market study are more complex and can
vary greatly depending upon the proposed project type.
It concentrates mainly on the 5 areas given below:
• A study of general economic factors and indicators:
The demand potential for any product is likely to have some kind of association with a few
economic indicators. A change in demand and change in one particular or some economic
10. indicators may take place simultaneously, or with lead or lag. Some of the general economic
indicators are GDP, per capita income, income disparity, population growth rate, literacy rate,
rate if urbanization, government spending and money supply.
• Demand estimation:
Projection of demand is the most important step in project feasibility study. Demand estimation
is done on the basis of mathematical/statistical models. Salient features related to demand
estimation are enumerated below:
✓ The end-user profile
✓ The study of influencing factors
✓ Regional, national and export market potential
✓ Infra structure facilities which may facilitate or constraint demand.
✓ Demand forecasting.
• Supply estimation:
Unlike demand, supply estimation is more difficult. Past trends of supply of goods can be
studied and further extrapolated. Projections so made, need to be adjusted with the help of
additional information like the project undertaken in the economy, import possibility as
governed by import policy, import tariff and international prices.
• Identification of critical success factors:
For the choice and to study the risk of a project, it is essential to identify the critical factors;
which determine the success of the project. Availability of raw material, supply and cost of
electrical power, supply of skilled manpower or other variables could be the critical success
factors. They are product and region specific.
• Estimation of demand-supply gap:
Demand and supply estimates, fine-tuned with new or changed factors, are now compared with
each other in order to find a gap. The demand-supply gap, is meaningful only for a relevant
geographical territory.it is quite likely that the forecast of demand and supply may not be a
single point forecast.
2.Technical feasibility
It means the project must be technically feasible, i.e., the requirements of the actual production process
are to be evaluated. Various factors are analyzed in checking the technical feasibility of a proposed
project. They are listed below:
• Availability of commercially exploited technology and its alternatives
• The transplantability of technology into the local environment
11. • Technological innovation rate in the product
• Production processes
• Capacity utilization rate and its justification
• Availability of raw material and other resources like power, gas, water, labour etc.
• Requirement of plant and equipment and fabrication facilities.
• A feasible product mix with possibilities for joint and by-products.
3.Financial feasibility
The financial feasibility check involves a detailed financial analysis. The financial feasibility check
involves quite a few assumptions, workings and calculations. Some are described below:
• Projections are made for prices of products, the cost of various resources required for
manufacturing goods, and capacity utilization.
• The period of estimated is determined, and the value of the project at the terminal period of
estimation period of estimation is forecast
• Financial alternatives are considered and a tentative choice of financing mix is made together
with assumptions regarding the cost of funds.
• Some financial statements are prepared in the project feasibility report. They include: Profit
Loss a/c of the company, Balance sheet of the company, Cash flow statements for the proposed
project.
• Financial indicators are calculated using data derived in various financial statements.2
parameters used are Debt service coverage ratio(DSCR) and Net present value(NPV) or
Internal rate of return(IRR)
Economic Appraisal
Economic analysis attempts to assess the overall impact of a project on improving the economic
welfare of the country. In economic analysis profitability or efficiency of a project assesses from the
point of view of a nation as a whole. It includes both direct and indirect costs and benefits in terms of
shadow price or accounting prices. Economic analysis includes all members of the society and
measures the projects positive and negative impacts in terms of willingness to pay for units of increased
consumption and to accept compensation for forgone units of consumption. In this analysis attempts
have been made to include social costs and benefits, applying shadow prices instead of market prices
to reflect true scarcity values of inputs and outputs of a project. The purpose of the economic analysis
of projects is to bring about a better allocation of resources, leading to enhanced income for investment
or consumption. All resources, inputs and outputs have an opportunity cost through which the extent
and value of project items are estimated. Project should be chosen where the resources will be used
most effectively. Economic values reflect the values that society would be willing to pay for a good or
12. a service. Financial values, in contrast, are the prices that people actually pay. In economic analysis
the main task is to convert the financial prices into economic values or to adjust the financial prices so
that they more accurately represent economic values. So an understanding of the difference between
what is actually paid and the willingness to pay value is very important.
Social Cost Benefit Analysis(SCBA)
It considers matters related to social impact. If the social benefit outweighs social cost, it results in
social impact.
Types:
i. Environmental damage
ii. Ecological imbalances
iii. Human service cost (opportunity cost)
iv. Materials used(quarrying)
v. Usage of public utility
vi. Depletion of energy & global warming
vii. Subsidies
Social benefits:
✓ Improve environment
✓ Create employment
✓ Tax benefits
✓ Improvement of resources
Factors:
✓ Market imperfection
✓ Externally (external economies)
✓ Concern for savings
✓ Merit wants
Methods of calculating SCBA:
i. UNIDO approach (United Nations International Development Organization)
ii. Little-mirrless approach
EIA (Environmental Impact Assessment)
✓ Started in 1994
✓ Comes under the Ministry of Forest &Resources
✓ EIA assessed through Environmental Action Plan(EAP)
13. o Pollution control
o Water standards
o Target small scale industries
Two schedules are categorized by ministry of forest & resources.
1.Category A-sanctioned by Central Govt.
2.Category B-sanctioned by State Govt.
Process of EIA:
1. Screening
2. Scope
3. Impact analysis
4. Mitigation
5. Reporting
6. Review
7. Decision making
8. Monitor
Economic Cost Benefit Analysis(ECBA)
Economic Cost & Benefits and Economic Rate of Return(ERR) are calculated for determining
economic impact of a project done for projects where cash flow occurs to the national economy. Some
cash flow occurs for a firm but not to the nations.
E.g.: subsidy received by the company.it is done under the preview of ERR
UNIT - 3
Cost of the project
Whether designing a building or developing software, successful projects require accurate cost estimates. Cost
estimations forecast the resources and associated costs needed to execute a project, which helps ensure you
achieve project objectives within the approved timeline and budget.
Cost estimating is the practice of forecasting the cost of completing a project with a defined scope. It is the
primary element of project cost management, a knowledge area that involves planning, monitoring, and
controlling a project’s monetary costs. (Project cost management has been practiced since the 1950s.) The
B1(EIA is
compulsory)
B2(EIA is not
compulsory)
14. approximate total project cost, called the cost estimate, is used to authorize a project’s budget and manage its
costs.
Project Management Workflow, Dan Epstein and Rich Maltzman describe the different kinds of costs
that make up the whole cost of a project. The 5 costs they cover are:
1. Direct cost
2. Indirect cost
3. Fixed cost
4. Variable cost
5. Sunk cost
Direct cost
Direct costs are those directly linked to doing the work of the project. For example, this could include
hiring specialized contractors, buying software licenses or commissioning your new building.
Indirect cost
These costs are not specifically linked to your project but are the cost of doing business overall.
Examples are heating, lighting, office space rental (unless your project gets its own offices hired
specially), stocking the communal coffee machine and so on.
Fixed cost
Fixed costs are everything that is a one-off charge. These fees are not linked to how long your project
goes on for. So if you need to pay for one-time advertising to secure a specialist software engineer, or
you are paying for a day of Agile consultancy to help you start the project up the best way, those are
fixed costs.
Variable cost
These are the opposite of fixed costs - charges that change with the length of your project. It's more
expensive to pay staff salaries over a 12 month project than a 6 month one. Machine hire over 8 weeks
is more than for 3 weeks. You get the picture.
Sunk cost
These are costs that have already been incurred. They could be made up of any of the types of cost
above but the point is that they have happened. The money has gone. These costs are often forgotten
15. in business cases, but they are essential to know about. Having said that, stop/continue decisions are
often (wrongly) based on sunk costs. If you have spent £1m, spending another £200k to deliver
something that the company doesn't want is just wasting another £200k. Epstein and Maltzman write:
"Sunk cost is a loss which should not play any part in determining the future of the project."
Unfortunately, project sponsors and other senior executives (and even project managers) often value
completion over usefulness and it does take courage to suggest to your sponsor that you stop a project
that has already seen significant investment.
Sources of finance
Classified into;
1. On the basis of period
2. On the basis of ownership
3. On the basis of sources of generation
On the basis of period
a) Long term
i. Equity share
ii. Retained earnings
iii. Preference share
iv. Debenture
v. Loan from financial institution
vi. Loan from banks
b) Medium term
i. Loan from bank
ii. Public deposit
iii. Loan from financial institution
iv. Lease financing
c) Short term
i. Trade credit
ii. Factoring
iii. Banks
iv. Commercial paper
On the basis of ownership
a) Owners fund
i. Equity share
16. ii. Retained earning
b) Borrowers fund
i. Debenture
ii. Loan from banks
iii. Loan from financial institution
iv. Public deposits
v. Lease financing
vi. Commercial papers
On the basis of sources of generation
a) Internal sources
i. Equity share capital
ii. Retained earning
b) External sourcing
i. financial institution
ii. Loan from banks
iii. Preference share
iv. Public deposits
v. Debenture
vi. Lease financing
vii. Commercial papers
viii. Trade credit
ix. Factoring
Financial Projection
in its simplest form, a financial projection is a forecast of future revenues and expenses. Typically, the
projection will account for internal or historical data and will include a prediction of external market
factors.
In general, you will need to develop both short- and mid-term financial projections. A short-term
projection accounts for the first year of your business, normally outlined month by month. A mid-term
financial projection typically accounts for the coming three years of business, outlined year by year.
Key Elements of Financial Projection
All financial projections should include three types of financial statements:
17. Income Statement: An Income Statement shows your revenues, expenses and profit for a particular
period. If you are developing these projections prior to starting your business, this is where you will
want to do the bulk of your forecasting. The key sections of an income statement are:
a) Revenue
b) Expenses
c) Total Income – Your revenue minus your expenses, before income taxes.
d) Income Taxes
e) Net Income – Your total income without income taxes.
Cash Flow Projection: A Cash Flow Projection will demonstrate to a loan officer or investor that you
are a good credit risk and can pay back a loan if it’s granted. The three sections of a Cash Flow
Projection are:
a) Cash Revenues
b) Cash Disbursements – Look through your ledger and list all of the cash expenditures that you
expect to pay that month.
c) Reconciliation of Cash Revenues to Cash Disbursements
Balance Sheet: This overview will present a picture of your business’ net worth at a particular time.
It is a summary of all your business’ financial data in three categories: assets, liabilities and equity.
a) Assets – These are the tangible objects of financial value owned by your company.
b) Liabilities – These are any debts your business owes to a creditor.
c) Equity – The net difference between your organization’s total liabilities minus its total assets.
Evaluation of Cash Flow & profitability
A cash flow is one of the most important parts of the financial analysis for a project or a business. It
represents a listing of the project cash inflows and outflows divided into time periods. The time periods
may be months, quarters or years, depending on the project needs. A cash flow can be created for either
the past accounting period (it is called the cash flow statement) or the future accounting period (the
cash flow budget). Apart from the cash flow projections, the cash flow budget may contain the actual
cash inflows and outflows, allowing you to monitor the accuracy of your projections.
18. Cash flow and profits are both crucial aspects of a business. Cash flow is the inflow and outflow of
money from a business. It is necessary for daily operations, taxes, purchasing inventory, and paying
employees and operating costs. Profit is the surplus after all expenses are deducted from revenue.
Profit is the overall picture of a business, and the basis on which tax is calculated. However when
determining which one is more important, it depends on the business and the circumstances.
Financial Analysis
One of the most important parts of the project planning process is the financial analysis. The goals of
this phase are to determine whether or not to take on the project, to calculate its profits and to ensure
stable finances during the project. In other words, financial analysis evaluates project liquidity and
profitability. Liquidity is assured by cash flow analysis, while the profitability is evaluated by the
following techniques:
Capital structure analysis
Capital Structure refers to the combination of mix of debt and equity which a company uses to finance
its long-term operations.
General assumption of capital Structure
• There are only two source of finance Debt & Equity, no Preference.
• No tax.
• No floatation cost.
• Assets of a firm remains constant.
• Business risk remains constant (that is EBIT remains constant).
• No retained earnings
Theories of Capital structure
Important theories of capital structure are as follows
i. Net income approach
ii. Net operation income approach
iii. The traditional approach
iv. Modigliani and miller approach
I. Net income Approach
19. According to this approach, a firm can minimize the weighted average cost of capital and increase the
value of the firm as well as the market price of equity shares by using debt financing to the maximum
possible extent.
This theory says that a company can increase its value and decrease the overall cost of capital by
increasing the portion of debt in its capital structure.
Assumptions of Net Income Approach
• The cost of debt is less than the cost of equity
• There are no taxes
• The risk perception of the investors is not changed by the use of debt
II. Net operating income approach
According to this approach, change in the capital structure of a company does not affect the market
value of the firm and the overall cost of capital remains constant irrespective of the method of
financing.
This theory says that, there is nothing optimal capital structure and every capital structure is the
optimum capital structure.
Assumptions of Net Operating Approach
• The market capitalizes the value of the firm as whole.
• The business risk remains constant at every level of debt equity mix
• There are no corporate taxes.
III. Modigliani Miller Approach (MM Approach)
M&M hypothesis is identical with the net operating income approach if taxes are ignored. However
when taxes are assumed to exist, their hypothesis is similar to the net income approach.
In the absence of taxes (theory of irrelevance)
The theory proves that the cost of capital is not affected by changes in the capital structure or says that
debt-equity mix is irrelevant in the determination of the total value of the firm.
MM Approach based on the following assumptions
• There are no corporate taxes
• There is perfect market
• Investors act rationally
• The expected earnings of all the firms have identical risk characteristics.
• The cut- off point of investment in a firm is capitalization rate.
20. • All the earnings are distributed to the share holders.
IV. Traditional Approach
Tradition approach is also known as Intermediate approach, is a compromise between the two
extremes of net income approach and net operating income approach. According to this theory the
value of the firm can be increased initially or the cost of capital can be decreased by using more debt
as the debt is cheaper source of funds than equity. Thus optimal capital structure can be reached by
using proper debt-equity mix. Beyond a particular point, the cost of equity increases because increased
debt increased the financial risk of the equity holders.
Break Even Analysis
Financial break-even occurs when the project breaks even on a financial basis, that is, when it has a
net present value of zero. To determine a project’s financial break-even point, we must first determine
the annual operating cash flow, OCF*, that gives it a zero NPV. The formula for the financial break-
even quantity is:
where FC = fixed costs; VC = variable cost per unit; P = price per unit; OCF* = annual operating cash
flow; and Q*cash = cash break-even point.
Financial Capital Structure
1.Working Capital Decisions
Working capital is money available to a company for day-to-day operations.
The formula for working capital is: Current Assets - Current Liabilities. In any organization, most of
the time finance managers are concerned with working capital management like
• Ensuring that enough cash exists to pay bills
• Ensuring that enough inventory exits to make and sell product
• Ensuring that any excess cash is invested in interest-bearing securities
• Ensuring that account receivable are at a level that maximizes earnings
• Ensuring that short-term borrowings are used efficiently and at lowest cost possible
Types of Working Capital
BASIS OF CONCEPT
a) Gross working capital
21. Gross working capital is the sum of all of a company's current assets (assets that are convertible to
cash within a year or less). Gross working capital includes assets such as cash, checking and savings
account balances, accounts receivable, short-term investments, inventory and marketable securities.
b) Net Working Capital
Net working capital is the aggregate amount of all current assets and current liabilities. It is used to
measure the short-term liquidity of a business, and can also be used to obtain a general impression of
the ability of company management to utilize assets in an efficient manner.
BASIS OF TIME
a) Permanent / Fixed WC
Permanent working capital is the minimum amount of current assets required on a continuing basis
over the entire year, and for several years., which is needed to conduct a business. This level of current
assets is called permanent or fixed working capital as this part is permanently blocked . It is the amount
of funds required to produce the goods and services, which are necessary to satisfy demand at a
particular point of time.
b) Temporary Working Capital
Temporary working capital represents a certain amount of fluctuations in the total current assets during
a short period to meet the seasonal needs of a firm, so is also called as the seasonal working capital.
2.Capital Budgeting Decision
A capital budgeting decision may be defined as the firms decision to invest its currents fund ( cash
flow) most efficiently in the long term assets in anticipation of an expected flow of benefits over a
series of years.
Investment decision includes
• Expansion
• Acquisition
• Modernization
• Replacement
• New product investment
• Obligatory & welfare investment
It also include outflow on R&D and major advertising campaign
The decision process
22. Before making capital budgeting decision, finance professionals often generate, review, analyze,
select, and implement long-term investment proposal that meet firm-specific criteria and are consistent
with the firms strategies goals.
Once projects have been identified, management then begins the financial process of determining
whether or not the project should be pursued. The three common capital budgeting decision tools are
the payback period, net present value (NPV) method and the internal rate of return (IRR) method.
1.Pay Back Period Method
The pay back sometimes called as pay off or pay out period method represents the period in which the
total investment in permanent assets pays back itself. It measures the period of time for the original
cost of a project to be recovered from the additional earnings of the project itself. Under this method,
various investments are ranked according to the length of their payback period in such a manner that
the investment with a shorter pay back period is preferred to the one which has longer pay back period.
In case of evaluation of a single project, it is adopted if it pays back for itself within a period specified
by the management and if the project does not pay back itself within the period specified by the
management then it is rejected.
2.Net present value method
The net present value method is the modern method of evaluating the investment proposals. This
method takes into consideration the time value of money. It recognizes the fact that a rupee earned
today is more worth than a same rupee earned tomorrow. The net present value of all inflows and out
flows of cash occurring during the entire life of the project is determined separately for each year by
discounting these flows by the firm’s cost of capital.
3.Internal Rate of Return method
The internal rate of return method is also known as a modern technique of capital budgeting that takes
into account the time value of money. It is also known as ‘time adjusted rate of return’ ‘discounted
cash flow’ ‘yield method ‘trial and error method’. In internal rate of return method the cash flows of a
project are discounted at a suitable rate by hit and trail method, which equates the net present value so
calculated to the amount of investments. Under this method the discounted rate is determined
internally, this method is called internal rate of return method.
UNIT – 4
SEBI Guidelines for Disclosure and Investors Protection to Debentures
(i) Issue of FCD with a conversion period of more than 36 months:
23. If the FCDs are issued having a conversion period of more than 36 months, it must be made optional
with ‘Call’ and ‘Put’ option.
(ii) Purpose of Issue:
Debenture issued by a company for financing or acquiring shareholding of other companies in the
same group or providing loan to any company belonging to the same is not permitted. However, it is
not applicable to the issue of FCD providing conversion is made within 18 months.
(iii) Credit Rating:
The company must obtain credit rating from CRISIL or any other recognised credit rating agency if
conversion of FCDs is made after 18 months or maturity period of NCDs/PCDs exceeds 18 months.
(iv) Debenture Trustees to be appointed:
The name of the Debenture trustees must be stated in the prospectus and the trust deed should be
executed within 6 months of the closure of issue. However, the same is not required if the debenture
have maturity period of 18 months or less.
(v) Predetermination of Premium on Conversion and Conversion Time:
The premium of conversion of PCDs/FCDs and time of conversion, if any, must be predetermined
which should be stated in the prospectus.
(vi) Rate of Interest:
The rate of interest on Debentures is freely determinable.
(vii) Conversion Option:
If the conversion of debentures is made at or after 18 months from the allotment date but before 36
months, the same must be made optional to the debenture-holders.
(viii) Disclosure of: Period of Maturity, Amount of Redemption and yield:
Amount of redemption, period of maturity and the yield on redemption for NCDs/PCDs must be stated
in the prospectus.
(ix) Discounting on Non-convertible portion of PCD:
If the PCDs are traded in the market the rate of discount must be disclosed in the prospectus.
(x) Creation of Debenture Redemption Reserve (DRR):
It is a must (except for debentures whose maturity period is 18 months or less).
Term loan
24. Term loan is a medium-term source financed primarily by banks and financial institutions. Such a type
of loan is generally used for financing of expansion, diversification and modernization of projects—
so this type of financing is also known as project financing. Term loans are repayable in periodic
installments.
Commercial banks were advanced to give particular importance to the following cases at the time of
stepping up of term lending.
• Deferred payment exports
• Industries where a substantial part of the output meant for export or where new potential for
export would be quickly made up.
• Industries with short gestation period (particularly in core sector)and those providing many
consumption goods.
• Agricultural sectors.
• Small scale industries which involve an investment upon rs.25000
• Capital goods industries and deferred payment arrangements for purchase of goods in the
domestic market.
Financial Institutions in India
1.Industrial Financial Corporation of India(IFCI)
IFCI was setup in 1948, it is the 1 st development bank in India.it provides medium and long- term
credit. Any limited company or cooperative society incorporated and registered in India which is
engaged itself in the manufacture, preservation, or processing of goods, shipping, mining, hotel
industry, generation and distribution of electricity or any other form of power is eligible for financial
assistance from the IFCI.The financial assistance takes the form of:
• Rupee loans
• Sub-loans in foreign currencies
• Underwriting of and/or direct subscription to the shares and debentures of public limited
companies.
2.State Financial Corporations(SFCs)
The State Financial Corporations(SFCs) are established under the State Financial Corporations
Act,1951 with a view to provide medium and long term finance to medium and small industries. There
are 18 SFCs operating in different states. The maximum amount of loan for a single concern is Rs.
60lakhs.As per the Amendment Act,1962, the SFCs are authorized to render financial assistance to
hotels and transport industries. The financial resources of SFCs consists of:
• Share capital
• Issue of bonds
• Refinance from IDBI
25. • Borrowing from RBI
• Loans from State Government
3.Industrial Development Bank of India(IDBI)
The IDBI was established on 1 st july,1964 under the Industrial Development Bank of India Act,1964
as a wholly owned subsidiary of the Reserve Bank of India.in terms of the Public Financial Institutions
Laws(Amendment)Act,1975, the ownership of IDBI has been transferred to the Central Government
with effect from February 16, 1976.IDBI is the apex institution in the area of development banking.
Capital: The entire share capital of Rs.50 crores of the IDBI was held by the RBI.The authorized
capital has been raised to Rs.1000 crores.
4.Industrial Credit and Investment Corporation of India(ICICI)
It was founded on January5,1955 as a public limited company with government support and under the
sponsorship of the World Bank and representatives of the Indian industry. It has played an important
role in setting up institutions, such as Over-the- Counter Exchange, CRISIL, Venture capital. The
organization structure of ICICI Bank is divided into 5 principal groups:
• Retail banking
• Wholesale banking
• Project finance &special assets management.
• International business
• Corporate Centre.
5.Small Industries Development Bank of India SIDBI
• The Government of India set up the SIDBI under a special Act of the Parliament in October
1989.
• SIDBI commenced its operations from April 2, 1990 with its head office in Lucknow.
• SIDBI has been setup as a wholly owned subsidiary of IDBI.
• Its authorized capital is Rs.250 cr. with an enabling provision to increase it to Rs.1000 cr.
• It is the apex institution which oversees, co-ordinates & further strengthens various
arrangements for providing financial and non- financial assistance to small-scale, tiny, and
cottage industries.
Objectives
Four basic objectives are set out in the SIDBI Charter. They are:
a) Financing
b) Promotion
c) Development
26. d) Co-ordination
for orderly growth of industry in the small-scale sector. The Charter has provided SIDBI considerable
flexibility in adopting appropriate operational strategies to meet these objectives.
Commercial Banks
A commercial bank is a financial institution which performs the functions of accepting deposits from
the general public and giving loans for investment with the aim of earning profit.In fact, commercial
banks, as their name suggests, axe profit-seeking institutions, i.e., they do banking business to earn
profit.
Functions:
Functions of commercial banks are classified in to two main categories—(A) Primary functions and
(B) Secondary functions.
A) Primary Functions:
• It accepts deposits
• It gives loans and advances
B) Secondary Functions
• Discounting bills of exchange or bundles:
• Overdraft facility
• Agency functions of the bank
UNIT - 5
Industrial sickness
It becomes clear from the definitions of industrial sickness that industrial sickness does not occur all
of a sudden in the life of an industrial unit. In fact, it is a gradual process with distinct stages taking
from 5 to 7 years to corrode the health of a unit beyond cure and making the unit sick. To put in simple
words, it starts with downturn in the industry whose continuation ultimately leads to setting in of
industrial sickness (Kortial 1997). The process of industrial sickness can be presented in different
ways.
The important signals of industrial sickness are:
(i) Decline in capacity utilization;
(ii) Shortages of liquid funds to meet short-term financial obligations;
27. (iii) Inventories in excessive quantities;
(iv) Non-submission of data to banks and financial institutions;
(v) Irregularity in maintaining bank accounts;
(vi) Frequent breakdowns in plants and equipment’s;
(vii) Decline in the quality of product manufactured or service rendered;
(viii) Delay or default in the payment of statutory dues such as provident fund, sales tax, excise duty,
employees’ state insurance, etc.;
(ix) Decline in technical deficiency; and
(x) Frequent turnover of personnel in the industry.
Some of the important symptoms which characterize industrial sickness are
(i) Persisting shortage of cash;
(ii) Deteriorating financial ratios;
(iii) Widespread use of creative accounting;
(iv) Continuous tumble in the prices of the shares;
(v) Frequent request to banks and financial institutions for loans;
(vi) Delay and default in the payment of statutory dues;
(vii) Delay in the audit of annual accounts; and
(viii) Morale degradation of employees and desperation among the top and middle management level.
Causes of Industrial Sickness in India
The causes of sickness of different types of industrial units are not always similar. Different industries
may become sick under different circumstances. The causes, therefore, differ from industry to industry
and even among units in the same industry. Numerous factors acting simultaneously push a unit in the
track of sickness. The causes can be broadly divided into two categories-(1) Internal and (2) External.
Internal causes are those which originate within the operational framework of the unit. They generally
arise due to internal disorders in the major functional areas (viz., production, finance, marketing,
28. personnel etc.) of an enterprize. These factors are within the control of the industrial unit and therefore
may be termed as controllable factors. On the contrary, external causes include those whose origins
are outside the operational framework of the unit. The causes are the outcome of the various changes
in the social, economic, political and international environment aced by the industry. The industry has
no direct control over these factors and therefore, these factors are described as uncontrollable factors
of industrial sickness. However, “it may be stated that all the causes are inter-connected and remedial
action for one cause may not bring any overall relief to sickness”
The causes of industrial sickness may be divided into two broad categories:
i. Internal
ii. External
Internal Causes of Sickness
The major internal factors responsible for the widespread sickness in Indian industries are discussed
below:
a) Lack of Financial Planning/ Control and Budgeting
b) Improper Utilization of Assets
c) Inefficient Working Capital Management
d) high Rate of Capital Gearing
e) Poor Collection of Bad and Doubtful Debts
f) Improper Selection of Site
g) Poor Maintenance of Plant and Machinery
h) Lack of Product Diversification
i) Inept Demand Forecasting
j) Selection of Inappropriate Product-Mix
k) Lack of Market Research / Survey
l) Absence of Proper Product Planning
m) High Absenteeism and Labour Turnover
n) Bad Industrial Relations
o) Inappropriate Wage and Salary Administration
p) Overstaffing
q) Poor Managerial Talent
r) Poor Reporting
s) Mismanagement
t) Improper Project Planning
29. External Causes of Sickness
The major external causes of sickness are
a) Lack of Adequate Industrial Credit
b) Delay in Disbursement of Loans
c) Unfavorable Investment Climate
d) Policy of Credit Restraints
e) Shortage of Inputs-
f) Demand recession leads to a decline in sales of the enterprize
g) Heavy Taxes
h) Wage Disparity in Identical Units
i) Inter-union Rivalry
Rehabilitation of Sick Units:
The rehabilitation of sick units or restoring them to normal health is a matter of great urgency in view
of the serious social, economic and political consequences of industrial illness.
(i) Cooperation between Term-Lending Institutions and Commercial Banks:
Since commercial banks provide working capital, they are in a position to know about the working of
industrial concern. But assistance from term-lending institutions is also essential for rescue operations.
(ii) Coordination between Various Government Agencies:
All government agencies, both regulatory and promotional, must join hands to restore sick units to
health.
(iii) Full cooperation from various suppliers,’ unsecured creditors and other stakeholders, particularly
from the employees, is also essential to take the concern out of the difficulties in which it is involved.
(iv) Willing Cooperation and Clear Understanding with the Project Promoters:
Generally, there is a lack of trust and confidence among the various interests concerned. It is found
that government agencies and dealing institutions are more worried about their money and are anxious
to recover them instead of curing of the health of the sick units.
(v) Checking Over-Valuation of Inventories:
The banks should verify on a regular basis the valuation of inventories both in terms of quantity and
price. This would prevent over-borrowing on the hypothecation of inventories.
(vi) Marketing:
30. There should be well organised and scientific marketing by the project promoters otherwise launching
of a project will be a leap in the dark. Good marketing arrangements will prevent industrial sickness.
(vii) Recovery of Outstanding:
Every effort should be made to realize outstanding advances so that the concern is able to gather funds
to avoid sickness.
(viii) Modernisation of Machinery:
If the sick unit is to be restored to health, old and obsolete machinery and outdated technology should
be discarded at the earliest.
(ix) Improving Labour Relations:
Restrictive labour and unreasonable trade unions are great obstacles. Improving labour relations will
go a long way in curing industrial sickness.
(x) Efficient Management:
If necessary inefficient management should be replaced. The key to industrial health lies in alert and
efficient management. The management should show a calm approach, patience and perseverance,
courage and ability to steer in bad weather.
(xi) Performance Incentives:
It is necessary to offer performance incentives to the executives and the workers to induce them to put
in their best efforts. This will be quite helpful in curing industrial sickness.
(xii) Sympathetic Government Attitude:
During periods of industrial illness the government agencies should adopt a sympathetic and
understanding attitude so that the problem is not aggravated but moves towards a solution instead.
RBI guidelines for rehabilitation of sick industries
• "...timely and adequate assistance to potentially viable MSE units which have already become
sick or are likely to become sick is of the utmost importance...in view of the sector's
contribution to the overall industrial production, exports and employment generation," RBI
said in a notification.
• As per the new guidelines, a MSE would be considered sick if any of the borrowal account of
the enterprise remains non-performing assets (NPA) for three months or more.
31. • Earlier, a unit was considered sick if its borrowal account remained sub-standard for more than
six months.
• the banks not to classify units as sick if they reach such a situation on account of "willful
mismanagement, willful default, unauthorized diversion of funds, disputes among partners."
• the unit need not to be in commercial production for at least two years to be declared sick, it
added.
• It asked for timely action by banks if there is a delay in commencement of commercial
production by more than six months for reasons beyond the control of promoters.
• Also, if company incurs losses for two years or cash loss for one year beyond the accepted time
frame and if capacity utilization is less than 50 per cent of the projected level in terms of value
during a year.
RBI said the revised guidelines would help the banks to take timely action in identification of sick
units for their revival.
Liquidation
Liquidation or winding up is a process by which company’s existence brought to an end. Liquidation
may be either be compulsory (creditors liquidation) or voluntary (shareholder’s liquidation).
Compulsory liquidation:
Parties who are entitled by law to petition for compulsory liquidation of a company are:
• The company itself
• Any creditor
• Contributories
• Secretary of state
• Official receiver
Having wounded up the company’s affairs, the liquidator must call a final meeting of the members
(voluntary winding up), (compulsory winding up) or both. The liquidator is then usually required to
send final accounts to the Register & to notify the court. The company is then dissolved.
