PROJECT EVALUATION

Introduction

A project in the economic sense directly or indirectly adds to the economy of the Nation.
However an introspection of the project performance clearly indicates that the situation is far
from satisfactory. Most of the major and critical projects in public sector that too in crucial sectors
like irrigation, agriculture, and infrastructure are plagued by tremendous time and cost overruns.
Even in the private sector the performance is not all that satisfactory as is evident from the growing
sickness in industry and rapid increase in non-performing assets (NPAS) of Banks and Financial
Institutions. The reasons for time and cost over runs are several and they can be broadly classified
under-technical, financial, procedural and managerial. Most of these problems mainly stem from
inadequate project formulation and haphazard implementation.

Project Identification

Project identification is an important step in project formulation. These are conceived with
the objective of meeting the market demand, exploiting natural resources or creating wealth. The
project ideas for developmental projects come mainly from the national planning process, where
as industrial projects usually stem from identification of commercial prospects and profit
potential.
As projects are a means to achieving certain objectives, there may be several alternative
projects that will meat these objectives. It is important to indicate all the other alternatives
considered with justification in favour of the specific project proposed for consideration.
Sectoral studies, opportunity studies, support studies, project identification essentially
focuses on screening the number of project ideas that come up based on information and data
available and based on expert opinions and to come up with a limited number of project options
which are promising.

Project Formulation

Project Formulation Concept

“Project Formulation” is the processes of presenting a project idea in a form in

which it can be subjected to comparative appraisals for the purpose of determining in
definitive terms the priority that should be attached to a project
under sever resource constraints. Project Formulation involves the followingsteps
(Figure 1).

PROJECT FORMULATION
↓
OPPORTUNITY STUDIES/Support Studies
↓
IDENTIFICATION OF PRODUCT/SERVICE
↓
PREFEASIBILITY STUDY
↓
FEASIBILITY STUDY
(TECHNO ECONOMIC FEASIBILITY)
↓
PROJECT APPRAISAL
↓
DETAILED PROJECT REPORT

Figure 1. Project Formulation –Schematic view

Opportunity Studies
An opportunity study identifies investment opportunities and is normally undertaken at
macro level by agencies involved in economic planning and development. In general opportunity
studies there are three types of study – Area Study, sectoral and Sub-sectoral Studies and Resource
Based Studies. Opportunity Studies and Support studies provide sound basis for project
identification.

Pre feasibility Studies / Opportunity Studies

A pre-feasibility study should be viewed as an intermediate stage between a project
opportunity study and a detailed feasibility study, the difference being primarily the extent of details
of the information obtained. It is the process of gathering facts and opinions pertaining to the
project. This information is then vetted for the purpose of tentatively determining whether the
project idea is worth pursuing furthering. Pre feasibility study lays stress on assessing market
potential, magnitude of investment, , technical feasibility, financial analysis, risk analysis etc. The
breadth and depth of pre feasibility depend upon the time available and the confidence of the
decision maker. Pre feasibility studies help in preparing a project profile for presentation to various
stakeholders including funding agencies to solicit their support to the project. It also throws light
on aspects of the project that are critical in nature and necessitate further investigation through
functional support studies.
 Support studies are carried out before commissioning pre feasibility or a feasibility study
of projects requiring large-scale investments. These studies also form an integral part of the
feasibility studies. They cover one or more critical aspects of project in detail. The contents of the
Support Study vary depending on the nature of the study and the project contemplated. Since it
relates to a vital aspect of the project the conclusions should be clear enough to give a direction
to the subsequent stage of project preparation.

Feasibility Study

Feasibility Study forms the backbone of Project Formulation and presents a

balanced picture incorporating all aspects of possible concern. The study investigates
practicalities, ways of achieving objectives, strategy options, methodology, and predict
likely outcome, risk and the consequences of each course of action. It becomes the
foundation on which project definition and rationale will be based so that the quality is
reflected in subsequent project activity. A well conducted study provides a sound base
for decisions, clarifications of objectives, logical planning, minimal risk, and a successful
cost effective project. Assessing feasibility of a proposal requires understanding of the
STEEP factors. These are as under Social, Technological, Ecological, Economic, and
Political.

A feasibility study is not an end in itself but only a means to arrive at an investment
decision. The preparation of a feasibility study report is often made difficulty by the number of
alternatives (regarding the choice of technology, plant capacity, location, financing etc.) and
assumptions on which the decisions are made. The project feasibility studies focus on
- Economic and Market Analysis
- Technical Analysis
- Market Analysis
- Financial Analysis
- Economic Benefits
- Project Risk and Uncertainty
- Management Aspects
Economic and Market Analysis
In the recent years the market analysis has undergone a paradigm shift. The demand
forecast and projection of demand supply gap for products / services can no longer be based on
extrapolation of past trends using statistical tools and techniques. One has to look at multiple
parameters that influence the market. Demand projections are to be made keeping in view all
possible developments. Review of the projects executed over the years suggests that many projects
have failed not because of technological and financial problems but mainly because of the fact
that the projects ignored customer requirements and market forces.

In market analysis a number of factors need to be considered covering – product

specifications, pricing, channels of distribution, trade practices, threat of substitutes, domestic
and international competition, opportunities for exports etc. It should aim at providing analysis of
future market scenario so that the decision on project investment can be taken in an objective
manner keeping in view the market risk and uncertainty.

Technical Analysis
Technical analysis is based on the description of the product and specifications and also
the requirements of quality standards. The analysis encompasses available alternative
technologies, selection of the most appropriate technology in terms of optimum combination of
project components, implications of the acquisition of technology, and contractual aspects of
licensing. Special attention is given to technical dimensions such as in project selection. The
technology chosen should also keep in view the requirements of raw materials and other inputs
in terms of quality and should ensure that the cost of production would be competitive. In brief the
technical analysis included the following aspects.
Technology - Availability
- Alternatives
- Latest / state-of-art
- Other implications
Plant capacity - Market demand
- Technological parameters
Inputs - Raw materials
- Components
- Power
- Water
- Fuel
- Others
Availability skilled man power
\Location
Logistics
Environmental consideration – pollution, etc.,
Requirement buildings/ foundation
Other relevant details

Environmental Impact Studies:

All most all projects have some impact on environment. Current concern of environmental
quality requires the environmental clearance for all projects. Therefore environ impact analysis
needs to be undertaken before commencement of feasibility study.

Objectives of Environmental Impact Studies:

• To identify and describe the environmental resources/values (ER/Vs) or the environmental
attributes (EA) which will be affected by the project (in a quantified manner as far as
possible).
• To describe, measure and assess the environmental effects that the proposed project will
have on the ER/Vs.
• To describe the alternatives to the proposed project which could accomplish the same
results but with a different set of environmental effects
The environmental impact studies would facilitate providing necessary remedial measures
in terms of the equipments and facilities to be provided in the project to comply with the
environmental regulation specifications.

Financial Analysis

The Financial Analysis, examines the viability of the project from financial or commercial
considerations and indicates the return on the investments. Some of the commonly used
techniques for financial analysis are as follows.

• Pay-back period.
• Return on Investment (ROI)
• Net Present Value (NPV)
• Profitability Index(PI)/Benefit Cost Ratio
• Internal Rate of Return (IRR)

Pay-back Period

This is the simplest of all methods and calculates the time required to recover the initial
project investment out of the subsequent cash flow. It is computed by dividing the investment
amount by the sum of the annual returns (income – expenditure) until it is equal to the capital
cost.
Example1. (Uniform annual return)
A farmer has invested about Rs. 20000/- in constructing a fish pond and gets annual net
return of Rs.5000/- (difference between annual income and expenditure). The pay back period
for the project is 4 years (20000/ 5000).
Example 2.(Varying annual return)
In a project Rs.1,00,000/- an initial investment of establishing a horticultural orchard. The annual
cash flow is as under.

Time Annual Annual Annual return Cumulative

Income Expenditure return
1 Year
st
60,000 30,000 30,000 30,000
2nd Year 70,000 30,000 40,000 70,000
3rd Year 85,000 25,000 60,000 1,30,000
Pay-back period = Two and half years

The drawback in this method is that it ignores any return received after the payback period
and assumes equal value for the income and expenditure irrespective of the time.

It is also possible that projects with high return on investments beyond the pay-back period
may not get the deserved importance i.e., two projects having same pay-back period –one
giving no return and the other providing large return after pay-back period will be treated equally,
which is logically not correct.
Return on Investment (ROI);
The ROI is the annual return as percentage of the initial investment and is computed by
dividing the annual return with investment. It is calculation is simple when the return is uniform.
For example the ROI of the fish ponds is (5000/ 10000) X 100 = 50%. When the return is not
uniform the average of annual returns over a period is used. For horticultural orchard average
return is (1,30,000/3) = 43333. ROI = (43333/100000) X 100 = 43.3 %.

Computation of ROI also suffers from similar limitation as of pay-back period. It does not
differentiate between two projects one yielding immediate return (lift irrigation project) and
another project where return is received after some gestation period say about 2-3 years
(developing new variety of crop).

Both the pay-back period and ROI are simple ones and more suited for quick analysis of
the projects and sometimes provide inadequate measures of project viability. It is desirable to
use these methods in conjunction with other discounted cash flow methods such as Net Present
Value (NPV), Internal Rate of Return (IRR) and Benefit-Cost ratio.

Discounted Cash Flow Analysis:

The principle of discounting is the reverse of compounding and takes the value of money
over time. To understand his let us take an example of compounding first. Assuming return of 10
%, Rs 100 would grow to Rs110/- in the first year and Rs 121 in the second year. In a reverse
statement, at a discount rate of 10% the return of Rs.110 in the next year is equivalent to
Rs100 at present. In other words the present worth of next years return at a discount rate 10 %
is only Rs.90.91 i.e., (100/110) Similarly Rs121 in the second year worth Rs 100/- at present or
the present value of a return after two years is Rs. 82.64 (100/121). These values Rs.90.91 and
rs.82.64 are known as present value of of future annual return of Rs.100 in first and second year
respectively. Mathematically, the formula for computing present value (PV) of a cash flow “C n” in
“nth” year at a discount rate of “d” is as follows;
PV= Cn / (1+d)n
The computed discount factor tables are also available for ready reference. In the financial
analysis the present value is computed for both investment and returns. The results are presented
in three different measures ie. NPV, B-C Ratio, and IRR.
Net Present Value (NPV)

Net Present Value is considered as one of the important measure for deciding the financial
viability of a project. The sum of discounted values of the stream of investments in different years
of project implementation gives present value of the cost (say C). Similarly sum of discounted
returns yields the present value of benefits (say B). The net present value (NPV) of the project is
the difference between these two values (B- C). Higher the value of NPV is always desirable for a
project.

Benefit-Cost Ratio (B-C Ratio) or Profitability Index (PI);

The B-C Ratio also referred as Profitability Index (PI), reflect the profitability of a project
and computed as the ratio of total present value of the returns to the total present value of the
investments (B/C). Higher the ratio better is the return.

Internal Rate of Return (IRR):

Internal Rate of Return (IRR) indicates the limit or the rate of discount at which the project
total present value of return (B) equals to total present value of investments ( C ) i.e. B-C
= Zero. In other words it is the discount rate at which the NPV of the project is zero. The IRR is
computed by iteration i.e. Computing NPV at different discount rate till the value is nearly zero.
It is desirable to have projects with higher IRR.

Risk and Uncertainty

Risk and Uncertainty are associated with every project. Risk is related to occurrence of
adverse consequences and is quantifiable. It is analysed through probability of occurrences. Where
as uncertainty refers to inherently unpredictable dimensions and is assessed through sensitivity
analysis. It is therefore necessary to analyse these dimensions during formulation and appraisal
phase of the programme. Factors attributing to risk and uncertainties of a project are grouped
under the following;
• Technical –relates to project scope, change in technology, quality and quantity of inputs,
activity times, estimation errors etc.
• Economical- pertains to market, cost, competitive environment, change in policy,
exchange rate etc.
 • Socio-political- includes dimensions such as labour, stakeholders etc.
• Environmental – factors could be level of pollution, environmental degradation etc.

Economic Benefits:

Apart from the financial benefits (in terms of Return on Investment) the economic
benefits of the project are also analyzed in the feasibility study. The economic benefits include
employment generation, economic development of the area where the project is located, foreign
exchange savings in case of import substitutes or earning of foreign exchange in case of export
oriented projects and others.

Management Aspects:

Management aspects are becoming very important in project feasibility studies. The
management aspects cover the background of promoters, management philosophy, the
organization set up and staffing for project implementation phase as well as operational phase, the
aspects of decentralization and delegation, systems and procedures, the method of execution and
finally the accountability.

Time Frame for Project Implementation:

The feasibility study also presents a broad time frame for project implementation. The time
frame influences preoperative expenses and cost escalations which will impact the profitability and
viability of the project.

Feasibility Report:

Based on the feasibility studies the Techno economic feasibility report or the project report
is prepared to facilitate project evaluation and appraisal and investment decisions.

Project Appraisal

The project appraisal is the process of critical examination and analysis of the proposal in
totality. The appraisal goes beyond the analysis presented in the feasibility report. At this stage,
if required compilation of additional information and further analysis of project dimensions are
undertaken. At the end of the process an appraisal note is prepared for facilitating
decision onthe project implementation.
The appraisal process generally concentrates on the following aspects.
• Market Appraisal: Focusing on demand projections, adequacy of
marketinginfrastructure and competence of the key marketing
personnel.
• Technical Appraisal: Covering product mix, Capacity, Process of manufacture
engineering know-how and technical collaboration, Raw materials and
consumables, Location and site, Building, Plant and equipments, Manpower
requirements and Break- even point.
• Environmental Appraisal: Impact on land use and micro-environment,
commitment of natural resources, and Government policy.
• Financial Appraisal: Capital, rate of return, specifications,
contingencies, costprojection, capacity utilization, and financing pattern.
• Economic Appraisal: Considered as a supportive appraisal it reviews economic
rate of return, effective rate of protection and domestic resource cost.
• Managerial Appraisal: Focuses on promoters, organization structure,
managerial personnel, and HR management.
• Social Cost Benefit Analysis (SCBA): Social Cost Benefit Analysis is a
methodology for evaluating projects from the social point of view and focuses on
social cost and benefits of a project. There often tend to differ from the costs
incurred in monetary terms and benefits earned in monetary terms by the project
SCBA may be based on UNIDO method or the Little-Mirriles (L-M) approach. Under
UNIDO method the net benefits of the project are considered in terms of economic
(efficiency) prices also referred to as shadow prices. As per the L-M approach the
outputs and inputs of a project are classified into (1) traded goods and services (2)
Non traded goods and services; and (3) Labor. All over the world including
India currently the focus ison Economic Rate of Return (ERR) based on SCBA
assume importance in projectformulation and investment decisions.
Detailed Project Report (DPR)

Once the projects are appraised and the investment decisions are made a
DetailedProject Report (DPR) is prepared. It provides all the relevant details including design
drawings, specifications, detailed cost estimates etc. and this would act as a blue print for
project implementation.