CHAPTER 4

Project Preparation (Formulation)

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.
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:
 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

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 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)
 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

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.
 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 from past data observations, Examples
include Time series analysis, Regression (correlation) analysis, moving average, exponential
smoothing etc.
A. Time series projection methods
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
a= y – b(x)

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

Year Demand/Sales Year Demand/Sales Year Demand/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 Year for analysis Actual Year Year for analysis Year Year for analysis
1995 0 2000 5 2005 10
1996 1 2001 6 2006 11
 1997 2 2002 7 2007 12
1998 3 2003 8 2008 13
1999 4 2004 9

Computation:
X Y XY X2
0 10,000 0 0
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=1,998,000 ∑X2=819
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 analysis Demand/sales forecasts

2009 14 27,440
2010 15 28,536
2011 16 29,633
2012 17 30,730
2013 18 31,826
2014 19 32,923
2015 20 34,020
c) Sales forecast diagram:

27

2009 2015

Simple Moving Average Method: When demand for a product is neither growing nor declining
rapidly, and if it does not have seasonal characteristics, a moving average can be useful in
removing the random fluctuations for forecasting. Although moving averages are frequently
centered, it is more convenient to use past data to predict the following period directly. To
illustrate, a centered five-month average of January, February, March, April and May gives an
average centered on March. However, all five months of data must already exist.

Illustration 6.2: The data in the first two columns of the following table depict the sales of a
company. The first two columns show the month and the sales.
The forecasts based on 3, 6 and 12 month moving average and shown in the next three columns
The 3 month moving average of a month is the average of sales of the preceding three months
 Past sales of generators Forecasts produced by
Month Actual 3 month moving 6 month moving 12 month moving
units sold average average average
January 450
February 440
March 460
April 410 (450+440+460)/3 =
450
May 380 (440+460+410)/3 =
437
June 400 (460+410+380)/3 =
417
July 370 397 423
August 360 383 410
September 410 377 397
October 450 380 388
November 470 407 395
December 490 443 410
January 460 470 425 424
The 6 month moving average is given by the average of the preceding 6 months
actual sales. For the month of July it is calculated as
July's forecast = (Sum of the actual sales from January to June) / 6
= (450 + 440 + 460 + 410 + 380 + 400) / 6
= 423 (rounded)
For the forecast of January by the 12 month moving average we sum up the actual sales from
January to December of the preceding year and divide it by 12.
Note:
1. A moving average can be used as a forecast as shown above but when graphing moving
averages it is important to realize, that being averages, they must be plotted at the midpoint of the
period to which they relate.

2. Twelve-monthly moving averages or moving annual totals form part of a commonly used
diagram, called the Z chart. It is called a Z chart because the completed diagram is shaped like a
Z. The top part of the Z is formed by the moving annual total, the bottom part by the individual
monthly figures and the sloping line by the cumulative monthly figures.
Illustration 6.3: Using the data given in the Illustration 1 forecast the demand for the period 1987
to 1991 using

a. 3- year moving average and

b. 5- year moving average
If we want to check the error in our forecast as Error = Actual observed value - Forecasted value
find which one gives a lower error in the forecast.

Year Demand Three year moving Average Five year Average

Forecast Error Forecast Error

1983 100 - - - -
1984 105 - - - -
1985 103 - - - -
1986 107 102.6 4.4 - -
1987 109 105.0 4.0 - -
1988 110 106.3 3.7 104.8 5.2
1989 115 108.6 6.4 106.8 8.2
1990 117 111.3 5.7 108.8 8.2
1991 114.0 - 111.6 -
Here we observe that the forecast always lags behind the actual values. The lag is greater for the
5-year moving average based forecasts.

Exponential Smoothing Method: In the previous methods of forecasting (simple and weighted
moving average), the major drawback is the need to continually carry a large amount of historical
data. (This is also true for regression analysis techniques, which we soon will cover) As each new
piece of data is added in these methods, the oldest observation is dropped, and the new forecast is
calculated. In many applications (perhaps in most), the most recent occurrences are more indicative
of the future than those in the more distant past. If this premise is valid - "that the importance of
data diminishes as the past becomes more distant" - then exponential smoothing may be the most
logical and easiest method to use.
The reason this is called exponential smoothing is that each increment in the past is decreased
by (1-a). If a is 0.05 for example, weights for various period would be as follows (α is defined
below):

Weighting at α = 0.05
 0
Most recent weighting = α (1- α) 0.0500
1
Data one time period older = α (1- α) 0.0475
2
Data two time periods older = α (1- α) 0.0451
3
Data three time periods older = α (1- α) 0.0429
Therefore, the exponents 0, 1, 2, 3 and so on give it its name.
The method involves the automatic weighting of past data with weights that decrease exponentially
with time, i.e. the most current values receive a decreasing weighting.
The exponential smoothing technique is a weighted moving average system and the underlying
principle is that the
New Forecast = Old Forecast + a proportion of the forecast error
The simplest formula is
New forecast = Old forecast + α (Latest Observation – Old Forecast)
where α (alpha) is the smoothing constant.
Or more mathematically,
Ft = Ft-1 + α (At-1 – Ft-1)

i.e Ft = α At-1 + (1- α) Ft-1

Where
Ft = the exponentially smoothed forecast for period t

Ft-1 = the exponentially smoothed forecast made for the prior period

At-1 = the actual demand in the prior period

α = the desired response rate, or smoothing constant

The smoothing constant
The value of α can be between 0 and 1. The higher value of α (i.e. the nearer to 1), the more
sensitive the forecast becomes to current conditions, whereas the lower the value, the more stable
the forecast will be, i.e. it will react less sensitively to current conditions. An approximate
equivalent of alpha values to the number of periods’ moving average is given below:

α value Approximate periods in equivalent Moving average

0.1 9
0.25 7
0.33 5
0.5 3
The total of the weights of observations contributing to the new forecast is 1 and the weight reduces
exponentially progressively from the alpha value for the latest observation to smaller value for the
older observations. For example, if the alpha value was 0.3 and June’s sales were being forecast,
then June’s forecast is produced from averaging past sales weighted as follows.

0.3 (May’s Sales) + 0.21 (April’s Sales) + 0.147 (March’s Sales)

+ 0.1029 (February Sales) + 0.072 (January Sales)
+ 0.050 (December Sales), etc
0 1 2
In the above calculation, the reader will observe that α (1- α) = 0.3, α (1- α) = 0.21, α (1- α) =
0.147
3
α (1- α) = 0.1029 and so on.
From this it will be noted that the weightings calculated approach a total of 1.
Exponential smoothing is the most used of all forecasting techniques. It is an integral part of
virtually all computerized forecasting programs, and it is widely used in ordering inventory in
retail firms, wholesale companies, and service agencies.
Exponential smoothing techniques have become well accepted for six major reasons:
1. Exponential models are surprisingly accurate
2. Formulating an exponential model is relatively easy
3. The user can understand how the model works
4. Little computation is required to use the model
5. Computer storage requirement are small because of the limited use of historical data
6. Tests for accuracy as to how well the model is performing are easy to compute
In the exponential smoothing method, only three pieces of data are needed to forecast the future:
the most recent forecast, the actual demand that occurred for that forecast period and a smoothing
constant alpha (α). This smoothing constant determines the level of smoothing and the speed of
reaction to differences between forecasts and actual occurrences. The value for the constant is
determined both by the nature of the product and by the manager’s sense of what constitutes a
good response rate. For example, if a firm produced a standard item with relatively stable demand,
the reaction rate to difference between actual and forecast demand would tend to be small, perhaps
just 5 or 10 percentage points. However, if the firm were experiencing growth, it would be
desirable to have a higher reaction rate, perhaps 15 to 30 percentage points, to give greater
 importance to recent growth experience. The more rapid the growth, the higher the reaction rate
should be. Sometimes users of the simple moving average switch to exponential smoothing but
like to keep the forecasts about the same as the simple moving average. In this case, α is
approximated by 2 ÷ (n+1), where n is the number of time periods.

To demonstrate the method once again, assume that the long-run demand for the product under
study is relatively stable and a smoothing constant (α) of 0.05 is considered appropriate. If the
exponential method were used as a continuing policy, forecast would have been made for last
month. Assume that last month’s forecast (Ft-1) was 1,050 units. If 1,000 actually were demanded,

rather than 1,050, the forecast for this month would be

Ft =Ft-1 + a (At-1 – Ft-1)

= 1,050 + 0.05 (1,000 – 1,050)

= 1,050 + 0.05 (-50)
= 1,047.5 units
Because the smoothing coefficient is small, the reaction of the new forecast to an error of 50 units
is to decrease the next month’s forecast by only 2.5 units.
Illustration 6.4: The data are given in the first two columns and the forecasts have been prepared
using the values of α as 0.2 and 0.8.

Month Actual units sold Exponential Forecasts

α = 0.2 α = 0.8
Month
January 450 - -
February 440 450** 450**
March 460 450 + 0.2 ( 440-450) = 448 450 + 0.8(440-450) =442
April 410 448 + 0.2 ( 460-448) = 450.4 442 + 0.8(460-442) =456.4
May 380 450.4 + 0.2 (410 – 450.4) = 442.32 456.4 + 0.8(410-456.4) =419.28
June 400 429.86 387.86
July 370 423.89 397.57
August 360 413.11 375.51
September 410 402.49 363.102
October 450 403.99 400.62
November 470 413.19 440.12
December 490 424.55 464.02
January 460 437.64 484.80
** In the above example, no previous forecast was available. So January sales were used as
February’s forecast.
 The reader is advised to check the calculations for him. It is apparent that the higher α value,
0.8, produces a forecast which adjusts more readily to the most recent sales.

B. Causal methods
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
Regression Analysis Method: Regression can be defined as a functional relationship between two
or more correlated variables. It is used to predict one variable given the other. The relationship is
usually developed from observed data. The data should be plotted first to see if they appear linear
or if at least parts of the data are linear. Linear regression refers to the special class of regression
where the relationship between variables forms a straight line. The linear regression line is of the
form Y = a + bX, where Y is the value of the dependent variable that we are solving for, a is the
Y intercept, b is the slope, and X is the independent variable. (In time series analysis, X is units of
time)
Linear regression is useful for long-term forecasting of major occurrences and aggregate planning.
For example, linear regression would be very useful to forecast demands for product families.
Even though demand for individual products within a family may vary widely during a time period,
demand for the total product family is surprisingly smooth.
The major restriction in using linear regression forecasting is, as the name implies, that past data
and future projections are assumed to fall about a straight line. Although this does limit its
application, sometimes, if we use a shorter period of time, linear regression analysis can still be
used. For example, there may be short segments of the longer period that are approximately linear.
Linear regression is used both for time series forecasting and for casual relationship forecasting.
When the dependent variable (usually the vertical axis on the graph) changes as a result of time
(plotted on the horizontal axis), it is time series analysis. When the dependent variable changes
because of the change in another variable, this is a casual relationship (such as the demand of cold
drinks increasing with the temperature). We illustrate the linear trend projection with a hand fit
regression line.
Illustration 6.7: A firms sales for a product line during the 12 quarters of the past three years were
as follows.
Quarterly Sales Quarterly Sales Quarterly Sales
1 600 7 2600 13 ?
2 1550 8 2900 14 ?
3 1500 9 3800 15 ?
4 1500 10 4500 16 ?
5 2400 11 4000
6 3100 12 4900
th
Forecast the sales for the 13, 14, 15 and 16 quarters using a hand-fit regression equation.
The intercept a, where the line cuts the vertical axis, appears to be about 400. The slope b is the
"rise" divided by the "run" (the change in the height of some portion of the line divided by the
number of units in the horizontal axis). Any two points can be used, but two points some distance
apart give the best accuracy because of the errors in reading values from the graph. We use values
for the 1st and 12th quarters.
By reading from the points on the line, the Y values for quarter 1 and quarter 12 are about 750 and
4,950.
Therefore.
b = (4950 - 750) / (12- 1) =
382 the hand-fit regression equation is therefore
Y = 400 + 382X
The forecasts for quarters 13 to 16 are

Quarter Forecast
400 + 382(13) = 5366
13
400 + 382(14) = 5748
14
400 + 382(15) = 6130
14

16 400 + 382(16) = 6512

These forecasts are based on the line only and do not identify or adjust for elements such as
seasonal or cyclical elements.
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.
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 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 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Demand 10 13 14 17 18 18 19 20 22 23 22 24 24 25
(000 units)
Required: Develop the linear equation from the data and forecast the demand for the year 2010
(Use Trend Projection Method)

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 31.8 31.9 34.3 35.2
(000 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 29 28.5 31 34.2 32.7 33.5 31.8 31.9 34.3 35.2 36
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 96 1456
Lowest observation 46 710
Calculate the slope coefficient, constant and the demand function.
(Use High-Low Method)

4.2 Raw Materials & Supplies Study

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.
 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.
4.3. Location, site and environmental impact assessment
 I. 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,
 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.
II. 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
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
 Water disposal
 Environmental factors
 Taxes and duties
 Public policies (fiscal and legal regulations)
Distance to seaport (import or export)

III. Environment impact assessment

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.
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.
Objectives of Environmental Impact Assessment:
 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.
4.4 Production Program and Plant Capacity
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:
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.
Factors considered in setting the Production Program
1. Production level (capacity utilization)
2. Production problems
3. Wastage and spoilage
4. Price Vs Quantity sales
Determination of Plant Capacity
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
2. Input constraints
3. Investment costs
4. Market conditions
5. Resources of the firm
6. Government policy
4.5 Technology and Engineering Study
Technology Study
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
Means of Technology Acquisition
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.
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 program 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)
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
Civil Engineering Works
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 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.

4.6 Organizational and Human Resource

Organization and Manning
A division of the company into organizational units in line with the marketing, supply, production
and administrative functions is necessary not only from the operational point of view, but also
during the planning phase, to allow the assessment and projection of overhead costs. It is also
essential for the feasibility of a project that a proper organizational structure should be determined
in accordance with the corporate strategies and policies. The organizational set-up depends to a
large extent on the size and type of the industrial enterprise and the strategies, polices and values
of the organization.

Plant organization and management

Organization is the means by which the operational functions and activities of the enterprise are
structured and assigned to organizational units, represented by managerial staff, supervisors and
workforce, with the objective of coordinating and controlling the performance of the enterprises
and the achievement of its business targets.

The organizational structure of an enterprise indicates the assignment of responsibilities and

delegation of authorities to the various functional units of the company, and is normally shown in
a diagram, often referred to as an organ gram. The organizational functions are the building blocks
of the company. They may be grouped into the following organizational units in line with the
specific requirements of the individual company:
 General Management
 Finance, financial control and accounting
 Personnel administration
 Marketing, sales and distribution
 Supplies, transport, storage
 Production:
o Main plant
o Service plants
o Quality assurance
o Maintenance and repair
The organizational structure of the company can also take a number of shapes, the most common
being the pyramid shape, which has the following three organizational levels:

 Top management
 Middle management, and
 Supervisory management

Human Resources
The successful implementation of any operation of an industrial project needs different categories
of human resources- management, staff and workers-with sufficient skills and experiences. The
feasibility study should identify and describe such requirements and assess the availability of
human resources as well as training needs. On the basis of the qualitative and quantitative human
resources requirement of the project, the availability of personnel and training needs, the cost
estimates of wages, salaries, other personnel-related expenses and training are prepared for the
financial analysis of the project. In case an economic evaluation is intended, the costs of unskilled
labor should be shown separately.

Human resources as required for the implementation and operation of industrial projects need to
be defined by categories, such as management and supervision personnel and skilled and unskilled
workers, and by functions, such as general management, production management and supervision,
administration, production control, machine operation and transport. The numbers, skills, and
experience required depend on the type of industry, the technology used, plant size, the cultural
and socio-economic environment of the project location, as well as the proposed organization of
the enterprise.

Since the lack of experienced and skilled personnel can constitute a significant bottleneck for
project implementation and operation, extensive training programs should be designed and carried
out as part of the implementation process of investment projects.

4.7 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.
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 equipment’s etc.
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.
 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.

III. 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:
 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:
 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 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?