Project Appraisal .

105
Ifmanagementappraisal of persons who are already
to be done, a visit to such enterprise(s) thatmanaging
the
affairs ofby some
them other
is (are) managed enterprise(s)
will throw light.
Theindustrialrelations prevailing in that enterprise, morale of the employees, the prevailing supe-
rrelationship,
jor-subordinate Jabour turnover, labour unrest, productivity of
reflect the managerial capablities of the persons employees are some of
that will
factors concerned.
Theimportance of
the management appraisal is being increasingly felt now a days inview of the
growingnumber of units that have become sick due to mismanagement. Though management ap-
praisal
lis a vital aspect of project appraisal, it still remains more of asubjective exercise and it will
continueto remain s0, though refinements are possible. This is because, management appraisal is
Concermed with the appraisal
of human qualities.

SOCIAL COST BENEFIT ANALYSIS

3.7
objective of an individual, a firm or a company in investing on a project is to earn the
The main
maximum possible returns for the investment. Accordingly, the project promoters are solely inter-

estedin
wealth maximisation. Hence the project promoters tend to evaluate only the commercial
nTofitabilityofaproject.
There are some projects that may not offer attractive returns. as far as commerçial profitability is
concermed, but still such projects are undertaken since they haye social implications. Such projects
atepublicprojects like road, railway, bridge and other transport projects, imigation projects, power
projects etc., for which socio-economic considerations play a significant part rather than mere com-
meTcial profitability. Such projects are analysed for their net socio-economic benefits and the profit
hlity analysis of such projects is known as national profitability analysis, which is nothing but the
sncio-economiccost-benefit analysis done at the national level.
benefits to the nation. The
Every project imposes certain costs to the nation and produces certain
benefit derived from any
costs may be of two types viz., direct costs and indirect costs. So also, the
benefits.
project will also be of two types, viz., direct benefits and indirect
direct benefits are
For analysing the commercial profitability of projects, only the direct costs and costs and direct
direct
taken into account. Further, for assessing the commercial profitability, the
analysis, in' other words, the
benefits are reckoned at the makët prices. The national profitability
social cost-benefit analysis differs from commercial profitability analysis in two ways viz.,
considered in commercial profit
(a) As against the market prices of direct cost and direct benefits
into account the real cost' of direct costs
ability analysis, the social cost-benefit analysis takes
power charges) may
and 'real benefit' of direct benefits. For example, some of the inputs, (say,assessing commercial
relevant for
be subsidised. Only the subsidised prices of inputs is what is account the real cost of inputs
analysis takes into
o bproitability. However, the social cost-benefit
Accordingly, the required adjustments to
be,, the cost of inputs had they not been subsidised. analysis. Similarly, cost adjustments may
irect costs of inputs are made for social cost-benefit
output may be a product whose price is
also be required for the benefits. For example, the will take into account the
controlled by the Government. The Commercial profitability analysis while its actual benefit to
Government)
a.Controlled price (which is the market price fixed by the
price, which is what is relevant for social
A enation may be more or less than the controlled
cost-benefit analysis. alone considered for commercial profit
AS against the direct cost and direct benefits that are
the indirect costs and
doility analysis, socio-economic cost-benefit analysis takes into account
106 Project Management
a nation bears the indirect cost, the
indirect benefits to the nation. While costs/benefits are given
people of the
due
enjoy the indirect benefits. Hence, indirect
counted for in social cost-benefit analysis.
It is however difficult to assess exactly recognition naion
the and ac-
of indirect costs and indirect benefits
(which
example, consider a project of a pharmaceutical
has alwaysremained Ias a subject for debate!l). For
unit producing life saving drugs. quantum
it derives out of the project is nothing but the For the
pharmaceutical company, the benefit Thus,
the project earns on the investment.
the market price of the life saving drug is that returns
against this, the drug might be what the
pharmaceutical company will be concerned with. As society might be more one
that
Improves the well being of the society. It's contribution to the than
the society pays as price for the drug. Thus the social benefit might be much more thanwhatthe
benefit that accrue to the pharmaceutical company by way of returns.
Just as benefit has two different meanings to the project promoters and to the society, cost also
has two different meanings to these two categories of persons. The cost, as far as the
pharmaceutical
company is concerned is only the financial cost which is nothing but the direct-cost. Apart from this.
there are indirect costs to the society viz., the environmental polution caused by the pharmaceutical
industry, the harmful side effects of the drugs produced if any etc., Consider another example viz.
construction of a bridge over a river. It's indirect benefits may include improved communication
facilities, reduction in transportation costs, reduction in travelling time etc., while the indirect costs
may include acquisition of private land by the State, removal of industrial/commercialagricultural
activities that prevailed in the land that was acquired, disturbance of ecological balance etc.
Social cost-benefit analysis can thus be regarded as a refinement over commercial appraisal.
taking the hidden factors into account. Social cost-benefit analysis is mainly used for evaluating
public investment projects.
3.7.1 (Objectives of Social Cost Benefit Analysis (SCBA)
SCBA aims to appraise the total impact that a project will have on an economy. Accordingly, SCBA
focuses on the following objectives that a project is expected to fulfill.
" Contribution of the project to the GDP (Gross-Domestic Product) of the
economy,
Contribution of the project to improve the benefits to the poorer sections of the society and to
reduce the regional imbalances in growth and development.
Justification of the use of scarce resources of the economy by the project.
Contribution of the project in protecting/improving the environmental conditione
3.7.2 Approach to Social Cost Benefit Analysis
There are two main approaches to Social Cost Benefit Analysis. viz., the UNIDO
Little-Minlees Approach. Though the UNDO approach is more popular, none of theApproach and the
be said to have universal applications. The suitability of an approach to a project approaches can
factors such us the present level of development of the country, the depends
extent and nature upon many
achieve etc. Sometimes modifications of future
development that the country strives to of the
necessary to be in tune with the ground
realities. Adetailed approach to SCB approaches are
scope of this
book. This is an interesting and at the same
more about this are
time
referred to
more
books involvedanalysis beyond and
on area
is
of study
the
readers who are interested to
renowned economists.
know
Welfare Economics by
 Project Appraisal 107
Approachto
SCB Analysis
UNIDO
economistsStephen Marglin, Amartya Sen and Partha
Dasgupta prepared a manual based on
UNIDO'
Aamous :experiencein cost-benefit analysis of projects. UNIDO published this manual in 1972
uSderthe title "Guidelines for Project Evaluation". Subsequently, UNIDO brought out another
manualtitled"Guide to Practical Project Appraisal" to simplify the cost-benefit analysis of projects
focpracticalapplication.
UNIDOapproach places emphasis on 'aggregate consumption' for the reason that it is one of
The for the measurement of the standard of living. As per
important parameters UNIDO approach,
the ofthe standard of living of people, and hence the raising of aggregate consumption is an
raising
the
importantobjective for social projects.
However, 'aggregate consumption' is a very broad term that evades clear definition. This is
because, consumption levels of people differ. Further, people consume a number of goods. Hence,
calculation of aggregate consumption involves converting a heterogeneous bundle of goods into a
homogeneous measure which is a difficult proposition. Therefore, the consumption level is
single
measured by measuring 'consumer's surplus' and 'consumer's willingness to pay'.
The UNIDOapproach to Social Cost Benefit analysis consists of the following stages:
1. Arriving the
financial profitability of the project based on market prices.
Ilsing shadow prices for the resources to arrive at the net benefit of the project at economic
prices.
2 Adiustment of the net benefit for the project's impact on savings and investment.
4 AdjustmentmTeVc
of thejnet bnefit for the project's impact on,income distribution. stiuate teonnic
n acrucure çan atlract moYe 1n yestmet and
5. Adjustment of thenet benefit for the goods produced whose social values differ from their
ecueaion instucture.
jclude . s c t e e o
economic Va proict
The measurement of finànciál profitability of the project based on market prices is Dothing but the
financial
financial appraisal (or financial evaluation) of projects discussed elsewhere in this book. The
analysis when done at market prices serves its purpose for private sector projects. For public sector
projects, the objective is the maximisation of social welfare. Financial appraisal of public sector
carried out on
projects and national level projects that are carried out with social objective is first
the social
Simlar lines as private sector projects and then the results obtained are adjusted to reflect
welfare implications. Hence, after the first stage of financial profitability analysis at market prices is
Completed, the next phase is considering the effect of shadow prices and adjustments.
Shadow Prices: As explained already, for social cost-benefit analysis, the market prices of
the
DOn inputs and outputs of a project are required to be corrected suitably if they do not representprice.
known as shadow
a pnces of inputs/outputs. Such corrected price of inputs/outputs is
hence, the shadow price takes care of the distortions in the market price by suitably adjusting the
market price.
ror example, newly set up Small Scale Industries in India are granted subsidy on electricity
ges by the Govermment, for the initial few years. The State Electricity Boards (SEB) may
produceged atelectricity at a cost of, say Rs. 2.50 per unit. A newly set up Small Scale Industry may be
a rate of say Rs. 1.50 per unit of electric power consumed in its first year of operation, Rs.
175 per unit, in its second year of operation Rs. 2.00 per unit in its third year of operation etc., In
Such asituation, the cost of electric power for the Small Scale Industry is Rs. 1.50 per unit, Rs. 1.75
*Lnit and Rs. 2.00 per unit for the first, second and third year of operation respectively. However
goods ,serices
bxpice gne presevts tae aeal econmic Valae ectmole}ect
pejec that ack a direct Snhkt gmice cJith
Cike polluton Qeclt beuefiT Socielimpact) that e t
108 Project Management

the cost for the SEB is Rs. 2.50 per unit which is the actual cost, though the SEB charges a
price. The priçe of electric power to be used for social cost-benefit analysis is
only Rs. lower
which is the shadow price of electric power. 250 per uni
The above example of price distortion and the correction needed to arrive at the
is atoo simple instance. There are a few important basic issues connected to shadow price
which are discussed below. shadow picing
(Numeraire: "Numeraire is the unit of account in which the values of inputs and
expressed. The numeraire used in UNID0 approach is the domestic accounting outputs The
rupee.
are
domestic accounting rupee takes in to account the shadow price relationships.)JThe definition of
the UNIDO numeraire is the net consumption in the hands of the
present people at the basic
level of consumption in the private sector in terms of constant price in domestic
rupees. accounting
Tradeablity of goods/services: A deciding factor in shadow pricing is the tradeability of
goods/services. tA tradeable good is one which would be traded between countries without any
restrictions, The shadow price for tradeable goods is the international price (also known as border
price')for such goods. This is because it is possible to substitute import for domestic production and
export for domestic consumption.
CA non-traded good is one that is not traded due to trade policies of the country. A
is appraised at its marginal economic value: the marginal economic value is the amount the
non-traded good
domestic
consumers are willing, to pay. for an additional unit. A non traded good may become a tradeable good
if the policy of the Government changes.
The domestic production cost of a good plus transportation cost to the
to substitute with an destination may be too low
imported good. In such instances, there won't be any import of goods as
imported goods will be costlier. Similarly,the domestic
cost to the destination may bë too high that export is notproduction cost of a good plus transportation
any export öf goods as the cost of goods will be
possible. In such instances, there won't be
cheapter abroad. Such goods that can neither be im
ported nor exported due to price differences are called
can become tradeable goods only if the non-tradeable goods. Non-tradeable goods
domestic cost becomes cheaper as compared international
to
price.
Shadow Pricing of Resources
(a) Tradeable inputs and tradeable
outputs: A good can be
increase in its consumption; results in a coresponding mcrease in considered fully traded when an
import or corresponding
rom the production point of view.A gooddecrease
in export. Another way of looking at it 1s
considered fully traded when an increase in 1s domesSle can be
increase in export,or a corresponding decrease in import.
production results in a corresponding
For fully traded goods, the shadow price is the
border
lated in terms of the. domestic currency at the eXChange raleprice (international price) of goods trans
of traded goods as given above implies that the prevailng in the market. The defnition
domesue cnanges in demand or supplv affect only
the level of imports of exports. For this to be true, the following conditions must y
1. Import and export are not restricted.
2. Supply of imported goods is perfectly elastic over the range of import volume.
3. The domestic industry has no surplus capacity; hence, any increase in domestic
met only through imports. demand is to be
 Project Appraisal 109
A Even if the domestic industry has surplus capacity, it cannot be put to use due to shortage of
necessary inputs.
5. The cost of go0ds imported to meet additional domestic demand inclusive of the cost of
transportation till the point of domestic consumption, is less than the marginal cost of domestic
production.
6 The cost of imported inputs is less than the
domestic marginal production cost.
For all practical purposes, all tradeable inputs and outputs are regarded as fully
outputs even if all the above mentioned conditions are not simultaneously satisfied.traded inputs and
(6) Non-traded inputs and outputs: A good that is tradeable, but to which all the
(6) mentioned above are not satisfied is not traded. For such non conditions (1) to
traded goods, the border price does
not reflect the economic value (shadow price). The
as under:
economic value of a non traded good is measured
" If the output of the project adds to the domestic supply, the
pay is taken as the economic value of good produced. domestic consumer's willingness to
" If the output of the project causes reduction in
production of less efficient units, such good is
valued at its marginal cost of production.
(c) Non-tradeable inputs and outputs: As we have seen already, a
if
good is considered non-tradeable
(a) its import price (CIF price) is greater than the domestic cost of
production
(b) its export price (FOB price) is less than the domestic cost of
compared to domestic production cost is due to the reason thatproduction. (Lower FOB price as
the international price is lower
than the domestic cost of production.)
The valuation of non tradeable goods, as per the principle of shadow
'consumers' willingness to pay as under pricing is done using the
" If the impact of the project is to reduce the availability of input to
to pay for that input represents the economic value of that good.
other users, their willingness
If the input requirements of the project are met by production of
tion cost of such additional units represents the economic value ofadditional
that good.
units, the produc
If the impact of the project is to increase the
consumption of the good in the economy, the
consumer's willingness to pay is the measure of the economic value.
If the impact of the project is to substitute the consumption of other
goods, the measure of economic value is only the savings in the cost of similar non tradeable
production between the
two goods (i.e., the good that was substituted and the good that substituted.)
Externalities: Certain effects of the project do not impose a cost or do not
the domain of the project itself. But, if these effects have a bearing on theconfer benefit within
a
achievement of the
country's objectives, they need to be taken into consideration for economic analysis.
that are external to the project domain, but have an impact on the country's Such effects
objectives are known as
'Externalities'.
Externalities may affect the country's objective either positively or negatively. The characteristics
of extemalities can be summarized as under:
" They are not created by the project sponsor deliberately, but they are the incidental outcomes of
the project.
110 Project Management
society.
" Their effect may be either beneficial or harmful to the
" Irespective of whether beneficial or harmful, the
externalities are beyond the
who are benefited/affected by them.
control of those
measure
They are sometimes difficult to identify and almost always difficult to
Some examples of beneficial effects of externalities are as under:
The construction of a dam across a river also provides a communication link between the
shores of the river. two
" The construction of approach roads to a project improves the overall transport
facility of the
surrounding area.
" A road improvement project results in reduction of accidents.
" Aroad improvement project results in better fuel efficiency of vehicles, lesser traveling tine
and lesser wear and tear of vehicles.
Some examples of harmful effects of extermalities are as under:
" Air pollution,water pollution, and noise pollution arecaused by projects.
" Small pox.eradication programme brought the side effect of affecting the fertility of human
beings.
"Improved transportation facility andreduced transportation time may induce unwarranted mi.
gration to towns causing further congestion; there is also the danger of cultivable lands in
villages being left unattended as farmers migrate to towns.
As we observe, the external effects are intangible in nature and hence it is very difficult to
value
their costs/benefits. They are valued by using indirect means wherever possible. In situations where
the effects of externalities can not be measured in monetary terms, at
least some form of qualitative
evaluation should be done and incorporated in the project analysis.
7

Capital inputs: When capital inputs are made in a project, financial

creation of physical assets. The value shadow price) of physical assetsresources are used up for the
is calculated following the
principles already explained. (Let us recapitulate the principle: (a) for fully traded goods, the shadow
price is equal to the border price (b) for non traded goods, the
shadow price is measured in two
different ways, viz., the shadow price is equal to the consumers'
adds to the domestic supply and the shadow price is equal to willingness to pay, if the project
the marginal cost of production if the
output of the project causes reduction in production by less efficient units).
Apart from the shadow prices of physical assets, the
of capital. The opportunity cost of capital is the benetitother important aspect is the opportunity cost
the best alternative project. It is however difficult to foregone by sacrificing (i.e., not choosing)
estimate the opportunity cost of investment on
social projects. In principle, the possible alternative uses of the investment
best altemative should be identified. In practice, this is hard to achieve should be studied and the
since allpossible altermatives
can not be examined.
In conventional investment analysis, either the internal rate oT return is obtained or the
acenmed out of the investment are discounted at an appropnae tate Or interest and the net benefte
volue of the investment is obtained. The IRR or NPV offers a measure of the mrrent
profitability f ha
project. In the neo0-classical world of capital markets, controversy over the
never arises. There is one market rate that simultaneously represents the socialappropriate interest rate
the investment and the consumption rate of interest. Using this rate of
marginal
interest, the efficiency of
Would accrue over the years are discounted and the net present value is benefits
arrived at. Choosingthata
 Project Appraisal 111
suitable rate of discount for social projects is of crucial importance. If a too low rate is chosen,
socially inefficient projects will be undertaken. If too high an interest rate is chosen, the 'desirable'
projects will not pass acceptability criterion. The consumption rate of interest (CRI) is used in
UNIDO approach as the discount rate since this approach is based on consumption objective. If the
average level of consumption is increasing over time and if diminishing
marginal utility is accepted,
ne consumption must be discounted by a rate that reflects the growth rate of consumption and the
te of diminishing marginal utility. Further, if the Govt. considers future consumption less
than the present consumption, the discount rate must also contain an element reflecting purevaluable
time
aeference. The resulting rate is known as the consumption rate of interest (CRI). The CRI is nothing
ot the social discount rate. The rate of diminishing marginal utility and the
element reflectíng pure
ime preference are subjective parameters and hence arriving at the CRI applicable for a project
involves subjective issues. The CRI can be given by the following relationship:
[Parameter of Growth rate of [Rate of pure time
CRI = X
utility function per capita consumption] preference]
The purpose of CRI in project selection is to ensure that the Government's preferences concerning
future consumpion (growth) and curent consumption are adequately incorporated in the shadow
prices. Countries that are more committed to growth employ a low CRI. This will ensure that the
future consumption benefits from present investment are not heavily discounted.
[For a detailed account of CRI and the method of arriving at the same, interested readers are
referred to the World Bank Research Publication "Eco-nomic Analysis of Projects" by Lyn Squire
and Herman G.Van der Tak]
UNIDO approach recommends an indirect procedure for determining the CRI.. According to this
procedure, the project analyst arrives at the IRR of the social project and presents the project to the
decision makers. For social projects, normally the Government is the decision maker and deçision is
taken by a planning committee constituted by the Government If the project presented to the plan
ning committee is rejected, the project analyst can come to the conclusion that the RR arived at for
the project is above the CRI. If the project is accepted, it indicates that the IRR is either below or
equal to the CRI. By successive application of this process, the project analyst can narrow down the
range for the estimated CRI. This procedure can be useful only if the planners (decision makers)
behave rationally and consistently.
Shadow wage rate: The use of labour in one project prevents its use elsewhere. When labour is
engaged in one project, its use in its best alternative project is ruled out. The forgone output of this
labour in its best alternative use is a major component of the social cost of using that labour in the
project. Therefore, an estimate of the output foregone is needed. If the market for the labour is active
and efficient, then market wage provides a good measure of the marginal product of that labour at
market prices as well as the foregone output.
The formula suggested by UNIDO approach to arive at the SWR (Shadow Wage
Rate) is ae
under:
Labour's forgone Net social cost
Social cost of
Shadow = marginal product of increased +
reduced leisure
Wage Rate at accounting prices consumption
118 Project Management
3.8 PROJECT RISK ANALYSIS

Inprojectappraisal, risk analysis play an important part. All projects are prone to some
the other. All projects are appraised making certain assumptions. Assumptions in kind of risk
unavoidable since no two projects are unique in all respects and hence a new project appraisal
are
compared with an identical project that was executed in the past. Though there project cannot be
may be
between two different projects, exactly identical projects do not exit. There are many
project which contain assumed values. The following list of elements will give an idea ofelements of a
similarnty
the
tions on which any project appraisal is based on.
" Periodic cash inflows (the cash inflows are assumed by assumingthe selling price of
4.
assump-
product over a period of time and the plant output over the said period)
" Periodic cash outflows (the cash outflows are assumed by
assuming the purchase price of raw.
materials, the cost of power, labour etc.,)
" Life of
machinery
Salvage value of machinery
etc.,
Since a project is appraised making use of such assumptions, the appraisal is
to the risk of yielding results that may deviate from reality. very much prone

u 3.8.1 Risk Vs Uncertainty

'Risk' can be defined as the variability of return from an
outcomes of a given problem are known, we can concludeinvestment.
If the probabilities of possible
that the problem contains risk; in other
words the problem is risky. On the other hand, if the
problem are not known, we can conclude that the problem probabilities of possible outcomes of a given
has an element of uncertainty, i.e., the
outcome can not be predicted.
3.8.2 Kinds of Project Risks
Projects face a host of risks. Some important project risks are as
under.
Project Completion Risk: Completing the project in time and
a-major achievement. A project that is delayed will result in time within the estimated cost itself is
result in cost over-run. If the project promoters are not over-run which will consequently
meet the cost over-run, the project runs the risk of able to pump in additional funds required to
mentationmeans increase in interest commitments oncoming to a grinding halt. Also, delaved imple
the borrowed funds. When the project
ers find it difficult to meet the interest commitment during
the promot
mavnot be prepared to fund the project
66
the banker will lend his umbrellà when
implementation
additionaly to meet ne cOSt over-run. Asperiod, the lenders
the saving coes.
the whether is ine, but will get back the
it starts raining ...." Hence, once symptoms of delay in project umhrella when
implementation
additional funds becomes difficult which will add to the problem of surfaces, mobilizing
also technology failures, which may result in non-completion of project completion. There can be
projects. For projects with long
gestation period in the fields of fast developing technology, there is risk of
completed due to technological obsolescence during the course of
project project not being
Resource Risk: Raw material, power, fuel, manpower et., are the
capacity utilization and
implementusedatiobyn. a
resources
Shortage of raw material may lead to reduction in Similarly, shortage of higher cost of project.
which will make all profitability estimates wrong. power, fuel, and production,of
shortage
 Project Appraisal 119
<killed manpower will also jeopardize the project profitability calculations and the project may run
therisk of not earning the estimated returns.
Prlce risk: Price fluctuations of both inputs and outputs (.e., raw material and finished products)
affect the project. Unforeseen happenings such as Govemment's interventions in price fixation,
ability of competitors to offer their product to customers at comparatively cheaper price etc., are
effect.
ikely to have an adverse
oahnology risk: Technology risk may appear in two forms. A project that is based on unproven
technology (.e., atechnology that is proved at laboratory level but not proved at commercial level)
mayhave hidden defects which may make the project a non-starter. Rapid growth in technology may
make a project obsolete in technology due to the evolution of latest technology.
Politlcal.risk: The saying goes "Do not fight with King and God." The King (i.e., the
Government) acts as a watch dog of the country's economy and frames rules and regulations for
regulating the country's economy. The Government intervenes in many forms such as levying and
eoulating taxes, regulating monopolistic trade practices, imposing import duties, promoting exports,
prohibiting export of certain commodities, issuing import licences, controlling foreign exchange
tansactions, price controls, expropriation, nationalization etc. Political risk is a major risk since it
can not be predicted easily.
Interest rate risk: Fluctuations in interest rate may bring in an adverse effect. For example, if a
project is funded by way of long-term borrowings at a particular rate of interest, and if the interest
rate falls down subsequently, the project that availed long-term borrowing at a higher interest rate
has to service the loan only at the higher rate of interest, unless it makes alternative arrangements to
mobilize funds at the prevailing interest rate and swap the old borrOwings which is a difficult
proposition. New entrants who set up similar projects may have access to long-term loans at the
prevailing rate of interest which may be cheaper. In such a situation, projects that were implemented
with high-cost borrowings will find it difficult to compete with new entrants.
On the other hand, if the interest rate increases in future, the interest on working capital finance
(which normally carries a floating interest rate) increases which will result in lower profit margins
than estimated at the time of project appraisal. Interest rate risks can be managed to söme extent by
entering into interest rate hedging agreements like "interest cap', 'interest swap' etc.,
Exchange rate risk: Exchange rate risk (also called currency risk) is the risk arising from
currency fuctuations. Volatile exchange rates can reduce cost and productivity advantages gained
Over years of hard work. Firms exposed to international economy face this risk. When a firm has
already committed to a foreign currency denominated transaction (i.e., the firm has entered into an
agreement agreeing to make foreign currency denominated payments or agreeing to receive payments
in föreign currency), the firm is exposed to exchange rate risk. The firm will incur loss if the
exchange rate of the foreign currency has moved adversely and will earn profit if the exchange rate
has moved favourably. Many exchange rate risk hedging tools such as forward cover, leads and lags.
currency options, currency swaps etc., are available which can be efficiently made use of to manoeuvre
exchange rate risk.
3.8.3 Techniques of Risk Analysls
Though there are many mathematical techniques available for risk analysis, the following are the
Simple tools that come handy for analyzing small and medium sized proiects
120 Project Management

" Break Even analysis

Sensitivity analysis
" Decision tree analysis
" Monte-carlo technique
" Game theory
Break Even Analysis: The financial viability of a project is estimated by
Sumptions like the cost of raw material, cost of consumables, cost of labour, making various as-
expected
tion, expected capacity utilization of the plant etc. The proof of pudding is in sales realisa-
implementation, the project starts earning profit or starts incurring loss depending on theeating. After
volume that it could achieve, the actual cost of inputs, the actual sales realisation actual sol
factors, the costs of inputs and the price of outputs are decided by the influence of etc. Of these
The only thing that is under the control of the project promoter is market forces.
the level of output (i.e., capacihy
utilization). Hence, it is very essential to know the level of operation below which the
incur losses. Break even point (BEP) refers to the level of project will
operation
earns profit nor incurs loss. Calculation of BEP for the given cost at which the project neither
minimum capacity utilization that the project should aim at in order to and price levels indicate the
situation. BEP also helps in identifying the level of profit/loss for a be in a no-profit, no-losS
the level of operation required to attain a specified level of operation and
specified profit/to avoid a
Break even analysis starts with dividing the costs into two specified loss etc.
variable costs. broad heads, viz., fixed costs and
Fixed costs: All projects incur certain costs that are
fixed in nature. These costs remain
inrespective of the changes in the volume of output. Following are some of the fixed costs:
constant
" Rent payable for land
" Rent payable for
factory/office premises
" Insurance prenmium on fixed assets
" Interest payable on long-term
" Administrative expenses borrowing/deposits
" Annual Maintenance
Charges payable for machinery maintenance
" Depreciation
" Property tax
etc.

Variable costs: These- are

cost is a variable cost since it those costs that vary directly with
depends on the level of output. Sometheother
level of output. Raw material
" Consumable stores variable costs are as under.
" Power, fuel, water charges
" Selling expenses
etc.

Referring to Fig. 3.3.,

At the Break even point,
Sales realization = Fixed cOst + variable cost
 Project Appraisal 121

Sales
-Total Cost
Revenue/cost
Break even point OA - Break even volume

Fixed cost

A X
Out put
Fig. 3.3
Referring to fig 3.3,
At the break even point,
Sales realization = Fixed Cost + Variable cost
Le.. (Output) x Selling price per unit = Fixed cost + (output) × Variable cost per unit
i.e., Output x (Selling price per unit - Variable cost per unit) = Fixed cost

Fixed cost
i.e., output =
(Selling price per unit - Variable cost per unit)

ie., Break Even Point

Fixed cost
(in terms of no. of units) =
(Selling price per unit - Variable cost per unit)
Contribution: Contribution is the difference between the sales realisation and the variable cost.
Excess of selling price over variable cost is called by the term 'contribution' since it contributes
towards fixed cost and profit. For example, if the selling price per unit of a product is Rs. 12 and the
variable cost per unit is Rs. 7, the contribution per unit is Rs. 5 (12-7) ie., one unit of production
contributes Rs. 5 towards fixed cost and profit. If the fixed cost is say, Rs. 50,000, the BEP (in terms
of no. of units) is 10,000 [50,000/5]. This means that at the level of output of 10,000 units, the
contribution covers exactly the fixed cost. Hence, this is a no-profit, no-loss situation. Contribution
first goes to meet the fixed cost up to BEP and subsequent to reaching of BEP, contribution adds to
profit. Fixed cost
BEP (in terms of no. of units) =
(Selling price per unit - Variable cost per unit)
Fixed cost
Contribution per unit

Fixed cost
B.E.P. (in terms of rupees)= Contribution per unit x Selling price per unit
122 Project Management

Ilustration 3.6
The details of production costs and revenues of a project are as under:
Total cost :Rs. 65,000
Fixed cost :Rs. 25,000
Sales (8,000 units) :Rs. 80,000
Find the BEP in terms of no. of units. What should be the output if the profit desired
is Rs.
Solution:
Variable cost (for 8,000units) Total cost - Fixedcost
20,000)
:Rs. 65,000 - Rs. 25,000
:Rs 40,000
Variable cost per unit :Rs 40,000/8,000
:Rs 5
BEP (in terms of no. of units)
Fixed cost
(Selling price per unit - Variable cost per unit)
25000
10 -5
:5000 units
Output for a desired profit of Rs. 20,000
Let Xbe the no. of units required to be
produced for achieving a profit of Rs. 20,000
Profit = Sales - Total cost
= Sales - (Fixed cos +
Variable cost)
= (10X) - (25,000 + 5X)
1.e., 20,000 = 15X 25,000
15X = 45,000
X=9,000
Therefore, the output required for achieving a profit of Rs.
20,000 is 9,000 units. (Refer Fig. 3.4)
Sales
90,000
Revenue/cost Total cost
70,000 JProft
I

50,000
BEP

25,000

5,000 units 9.000 units

Output
Fig. 3.4
128 Project Management

Illustration 3.8
industrial chemica<s and :
M/s ABC Company limited is currently engaged in the manufacture of
earning a profit of Rs. 5.00 lakhs per annum after paying for materials, labour etc., The company ba.
that is most beneficial to it.
the following alternatives and wants to choose the alternative
Alternatives:
for getting the technical know-how for th
" The corpany can pay a royalty of Rs. 1.00 lakh will bring additional grose
production of a new chemical. Production of the new chemical
income of Rs. 4.00 lakhs.
identifying the formulation of the proposed new
The company can carry out research for There is a 80% probability
chemical. The research activity willcost the company Rs. 80,000/- the company will
comes out succesSful,
of açhieving success in the research. Once the research
generate additional gross income of Rs. 8.00 1akhs.
marketing programme to promote alternative
" The company can invest Rs. 75,000/- in a special
by the company. Such a venture, if
uses for the chemicals presently being manufactured 12.00 lakhs. The probability of success
successful, will generate additional gross income of Rs.
competition from existing competitors who
of such a venture is only 40% in view of the stiff
are already wellestablished in the field. resources available
the alternatives in view of the limited
The company can opt for only any one of
suited for the company using decision tree analysis.
with the company. Identify the strategy most
Solution:
decision tree (refer Fig. 3.9)
The given problem can be converted in to a
Gross/Expected Income : Rs. 4.00 Lakhs
Cost : Rs. 1.00 Lakh
E.M.V: Rs. 3.00 Lakhs
S t r a t e g y - B

No Strategy -A
D

Strategy-C Success
0.80
Gross Income :Rs. 8.00 Lakhs
Expected Income: Rs. 6.40 Lakhs

Straegy-D 0.2Fa0ilure
Gross/Expected Income: Nil

Success Gross Income :Rs. 12.00 Lakhs

3
0.40 Expected Income : Rs, 4.80 Lakhs

0.F6ai0lure
Gross/Expected Income: Nil
Flg. 3.9
 Project Appraisal 129

There are three alternative strategies available as given in the problem. Infact, there are four
strategies available, the. fourth one being not choosing any of the three given strategies.
heEMV for the four strategies are to be calculated and the strategy that has the highest EMV is
thepreferred strategy.
The calculations can be given in the fom of atable as shown below:
Alternatives Event Probability Gross Expected income Cost EMV
income
(a) (b) (c) (d) (e) () (e -)
Atemative-A
(not choosing
any strategy)
Alternative-B Success 1.00 Rs. 4.00 Rs, 4.00 Rs. 1.00 Rs. 3.00
(Payment of lakhs lakhs lakhs lakhs
royalty)
|Altemative-C Success 0.80 Rs. 8.00 Rs. 6.40 Rs. 0.80 Rs. 5.60
|(caryingout lakhs lakhs lakhs lakhs
research) Failure 0.20 0.00 0.00 (6.40 0.80)
Rs. 6.40
lakhs

Alternative-D Success 0.40 Rs. 12.00 Rs. 4.80 Rs. 0.75 Rs. 4.05
(improving lakhs lakhs lakhs lakhs
marketing) (4.80 - 0.75)

Failure 0.60 0.00 0.00

Rs. 4.80
lakhs

Observation:
Strategy-C, viz,, carrying out research for the new product is the strategy best suited for the company
since it has the maximum EMV of the available alternatives.
Illustration: 3.9
Abulk drug manufacturing company has proposed to introduce a new drug in its production line.
The production technique of the new drug has been tested in the laboratory.Commercial production
of the new drug has not yet been taken up by any of the manufacturers.
The company has the following options available before it:
(a) To set up additional manufacturing facilities and go for commercial production of the new
drug on the strength of the successful production of the drug reported at the laboratory level.
(6) To set up-a test:pilot plant for the production of the new drug and to set up additional
manufacturing facilities meant for the commercial production, on the strength of the performance
of the pilot plant: (Building a pilot plant will help the company to identify and overcome any
teething troubles in the production line.)
When the company goes for setting up new production lacilities dircctly, without going throueh
the process of pilot. plant, the.probability of getting output of the required quality is 5s% and the
probability of getting inferior quality output is 45%. ag
The pilot plant is estimated to cost Rs. 5,00,000/- and it is estinmated to have 80% probahility
giving output of the required quality and 20% probability of giving inferior quality output.