CHAPTER 4

PROJECT PREPARATION (FORMULATION)

Feasibility Study: Dimensions and Reporting

A project feasibility study is a key process that justifies whether to go ahead

with a certain project idea or to disregard it. As the name implies, a
feasibility study is an analysis of the viability of an idea from different
parameters. The feasibility study focuses on helping answer the essential
question of “Should we proceed with the proposed project idea?”

Feasibility studies can be used in many ways but primarily focus on

proposed business ventures. Determining early that a business idea will not
work saves time, money and heartache later.

A feasible business venture is one where the business will:

 generate adequate cash-flow and profits,

 Withstand the risks it will encounter.
 Remain viable in the long-term and meet the goals of the founders.

The venture can be a new start-up business, the purchase of an existing

business, an expansion of current business operations, or a new enterprise
for an existing business. Feasibility study is only one step in the business
assessment and development process. The feasibility study helps to “frame”
and “flesh-out” specific business scenarios so they can be studied in-depth.

During this process the number of business alternatives under

consideration is usually quickly reduced. During feasibility process you may
investigate variety of ways of organizing the business and positioning your
product in the market place. It is like an exploratory journey and you may
take several paths before you reach your destination. There is often some
confusion between a feasibility study and a business plan. A feasibility
study is not a business plan.

Project Analysis and Management By Dereje W. Page 1

The business plan outlines the actions needed to take the proposal from
“idea” to “reality.” The feasibility study outlines and analyzes several
alternatives or methods of achieving business success. So the feasibility
study helps to narrow the scope of the project to identify the best business
scenarios. The business plan deals with only one alternative or scenario.
The feasibility study helps to narrow the scope of the project to identify and
define two or three scenarios or alternatives. The consultant conducting the
feasibility study may work with the group to identify the “best” alternative
for their situation. This becomes the basis for the business plan.

The feasibility study is conducted before the business plan. A business plan
is prepared only after the business venture has been deemed to be feasible.

REASONS TO DO A FEASIBILITY STUDY

Conducting a feasibility study is a good business practice. Examination of

successful business organizations indicates that they do not go into new
business venture without first thoroughly examining all of the issues and
assessing the probability of business success.

A feasibility study will:

 Narrow business alternatives and give focus to the project

 Surface new opportunities through the investigative process
 Identify reasons not to proceed
 Enhance the probability of success by addressing and mitigating (to
lessen) factors early on that could affect the project.
 Provide quality information for decision-making.
 Help to increase investment in the company: Investment will be
enhanced by companies through wise use of resources.
 Provide documentation that the business venture was thoroughly
investigated.

Project Analysis and Management By Dereje W. Page 2

  Help in securing funding from lending institutions and other monetary
sources.

The feasibility study is a critical step in the business assessment process. If

properly conducted, it may be the best investment one ever makes.

REASONS GIVEN NOT TO DO A FEASIBILITY STUDY

Project leaders and sponsors may find themselves under pressure to skip
the “feasibility analysis” step and go directly to building a business.
Individuals from within and outside of the project may push to skip this
step. Reasons given for not doing a feasibility analysis include the following;

 We know that it is feasible as an existing business is already doing it

 Why do another feasibility study when one was done just a few years
ago: previously conducted feasibility studies will not be useful to make
an investment decision currently because as time passes several
changes are encountered in the political, economical, social, and
technological (PEST) environments. Hence recent data shall be
gathered for the project idea at hand.
 Feasibility studies are just a way for consultants to make money
 The market analysis has already been done by business that is going
to sell us the equipment: feasibility study of the equipment
manufacturer or distributor doesn’t help other next parties in the
channel through transitivity. Hence, a computer assembly is feasible
doesn’t mean a computer training center will be feasible any time.
 Why not just hire a general manager who can do the study: a general
manager is always hired after a feasible business idea has been
obtained and is in the process of being implemented or is in operation.
 Feasibility studies are a waste of time: though feasibility studies will
take time to complete, reversing a wrong decision that was
undertaken without feasibility studies will require more time and the
incurrence of other scarce resources.

Project Analysis and Management By Dereje W. Page 3

 The reasons given above should not discourage business people from
conducting a meaningful and accurate feasibility study because, once
decisions have been about proceeding with a proposed business, they are
often difficult to change. However, some aspects of the feasibility study
may even require special attention through support or functional studies.

SUPPORT (FUNCTIONAL) STUDIES)

Support or functional studies cover specific aspects of an investment

project, and are required as prerequisite for, or in support of, pre
feasibility and feasibility studies, particularly large scale investment
proposal. Support or Functional studies are also a part of project
preparation stage and are usually conducted separately, for later
incorporation in the prefeasibility or feasibility studies.

Examples of such studies are as follows:

 Market studies of the products to be manufactured, including

demand projections in the market to be served together with
anticipated market penetration.
 Raw material and supply studies, covering current and projected
availability of raw materials and inputs basic to the project, and the
current and projected price trends of such materials and inputs.
 Laboratory and pilot-plant tests, which are carried out to the extent
necessary to determine the suitability of particular raw materials
or products.

In most cases, the results of a support study, when undertaken either

before or together with a feasibility study, form an integral part of the
latter and lessen its burden and cost. The last outcome of the
feasibility study is the final appraisal and report.

PROJECT APPRAISAL (APPRAISAL REPORT)

Project Analysis and Management By Dereje W. Page 4

When a feasibility study is completed the various parties involved in the
project will carry out their own appraisal of the investment project in
accordance with their individual objectives and evaluation of expected risks,
costs and gains. A formal project appraisal report is usually required at the
end of a feasibility study. The better the quality of the project feasibility
study made, the easier will be the appraisal work to be performed. The
techniques applied to appraise a project may revolve around technical,
commercial, market, managerial, organizational, financial and economic
aspects of the project under consideration.

The findings of a feasibility study will be summarized in what is called the

executive summary.

EXECUTIVE SUMMARY

The feasibility study should begin with a brief executive summary outlining
the project data (assessed and assumed) and the conclusions and
recommendations which would then be covered in detail in the body of the
study. However, any supporting material such as statistics, results of
market surveys, detailed technical descriptions and equipment lists, plant
layouts etc should be presented in a separate annex of the study.

The executive summary should concentrate on and cover all critical aspects
of the study, such as the following:

 The degree of reliability of the data on the business

environment.
 project inputs and outputs
 the margin of error (uncertainty and risk) in forecasts of market,
supply and technological trends, and
 The project design.

The executive summary should have the same structure as the body of the
feasibility study and cover, but not limited to, the following areas:

Project Analysis and Management By Dereje W. Page 5

 1. Summary of the project background and history:
 project background
 Name and address of project promoter
 Project objective and outline of the proposed basic project
strategy including geographic area and market share.
 Project location : orientation towards the market or towards
resources (raw materials)
 Economic and industrial policies supporting the project.
2. Summary of market analysis and marketing concept:
 Summarize results of marketing research: business
environment, target market and market segmentation, channels
of distribution, competition.
 List annual data on supply and demand
 Indicate projected marketing costs, elements of the projected
sales programs and revenues
 Describe impacts on raw materials and supplies, location, the
environment, the production program, plant capacity and
technology
3. Raw materials and supplies:
 Describe general availability of raw materials, processed
industrial materials and components, factory supplies, spare
parts, supplies for social and external needs.
 List annual supply requirements of material inputs
 summarize availability of critical inputs and possible strategies
4. Location, site and environment:
 Identify and describe location and plant site selected, including
ecological and environmental impact, socio economic policies,
infrastructural conditions and environment
 summarize critical aspects and justify choice of location and site
 Outline significant costs relating to location and site
5. Engineering and technology:

Project Analysis and Management By Dereje W. Page 6

  Outline of production program and plant capacity
 Describe and justify significant advantages and disadvantages
and disadvantages as well as life cycle and transfer of
technology, training, risk control, costs, legal aspects etc.
 Describe the layout and scope of the project
 summarize main plant items, their availability and costs
 describe required major civil engineering works
6. Organizational and Overhead costs:
 Describe the basic organizational design of the project
 Indicate management and measures required
7. Human resources:
 describe the socioeconomic and cultural environment as related
to significant project requirements as well as human resources
availability, recruitment and training needs, and reasons for the
employment of foreign experts, to the extent required for the
project
 Indicate key points (skills) required and total employment
numbers and costs
8. Project implementation Schedule:
 Indicate duration of plant erection and installations
 Indicate duration of production start up and running period
 Identify actions critical for the timely implementation of the
project
9. Financial analysis and investment appraisal:
 Summary of criteria governing investment appraisal
 Total investment costs: major investment data showing local and
foreign components for land and site preparation; structures
and civil engineering works; plant, machinery and equipment;
preproduction expenditures and costs, net working capital
requirements

Project Analysis and Management By Dereje W. Page 7

  Total costs of products sold such as operating costs,
depreciation charges, marketing costs, finance costs
 project financing: sources of finance, impact of cost of financing
and debt servicing on project proposal, and public policy on
financing
 aspects of uncertainty including critical variables, risks and
possible strategies and means of risk management
 national economic evaluation
 Conclusions concerning: major advantages of the project, major
drawbacks of the projects and chance of implementing the
project.

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.

Objective of the study:

The study of market and demand analysis, being the first in project
preparation, has the following main objectives:

 To systematically assess the market and the market

environment to generate pertinent data.
 To collect, analyze, and report data about a specific market
situation
 To obtain insight about the target market structure
 To identify customers needs and behavior in the market.
 To design the marketing mix fit in the context

Project Analysis and Management By Dereje W. Page 8

  To identify available distribution channels
 To identify competitors and their characteristics in the target
market
 To determine the socio-economic aspects relevant to the
preparation and evaluation of the project’s market strategy
 To identify the existing strengths and weaknesses in the internal
environment of the firm
 To project the level of demand expected
 To delineate marketing opportunities and threats
 To decide on subsequent aspects of a project
 To develop sales program of the firm.

IMPLICATIONS FOR PROJECT ANALYSIS:

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.

Project Analysis and Management By Dereje W. Page 9

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.

Market and Marketing Concepts:

1. A market is an institution set up by society as an important means to

allocate scarce resources in the economy.
 It is a locus of all potential customers involving in exchange of
values to satisfy their needs.
 It channels/transfers resources from one unit to another unit
(entity) in a given context.
2. Market participants may be described as :
 Producers of inputs/outputs

Project Analysis and Management By Dereje W. Page 10

  Sales agents, distributors (wholesalers and retailers), and
commission brokers.
 Transportation agents (distribution channels)
 Competitors and partners
 consumers
 regulators
3. Marketing is the process by which solicit members in the society
obtain what they need through creating and exchanging goods and
services with others for identifiable economic return. Nowadays, the
definition of marketing is broadened to include even the exchange of
ideas between social and political entities, (for example, election
campaigns).
4. The Marketing Mix, (often referred to as the 4Ps), are mixture of
controllable marketing variables that could be used by a marketer to
achieve the desired sales level in the target market. These 4 Ps are
product, price, promotion, and Place.
5. Marketing Strategy is a specific weapon, tool, or approach,
composed of basic variables in the marketing process. It is the action
plan that the company uses in order to achieve its marketing
objectives. It encompasses:
 Marketing expenditures: Amount, frequency, significance to
be obtained, ability to provide competitive advantage.
 Marketing mix: the degree of combination (proportion) of the
controllable and measurable marketing variables in order to
give the firm unique competitive posture in the market.
 Competitive strategy: such as low cost leadership, high quality
and differentiation, delivery performance (fast delivery and
reliability in delivery), and flexibility and customer service.
6. Elements of the Commercial dimension in project preparation:

Project Analysis and Management By Dereje W. Page 11

  Market Research: the first & basic task in any market and
demand analysis is to generate relevant information useful for
doing the subsequent tasks.
 Marketing Plan and Budget: A plan of action and budget
prepared on the basis of the results of the marketing research.

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 the 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

Project Analysis and Management By Dereje W. Page 12

  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:

Project Analysis and Management By Estimates

Demand Dereje W. Page 13
 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.

Project Analysis and Management By Dereje W. Page 14

 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 to past data observations, Examples include Time
series analysis, Regression (correlation) analysis, moving average,
exponential smoothing etc.
A. 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

Project Analysis and Management By Dereje W. Page 15

 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.

Ye Deman Ye Demand/ Ye Demand/

ar d/ ar Sales ar sales
Sales
19 10,000 20 18,000 20 22,000
95 00 05
19 13,000 20 19,000 20 24,000
96 01 06

Project Analysis and Management By Dereje W. Page 16

 19 14,000 20 20,000 20 24,000
97 02 07
19 17,000 20 22,000 20 25,000
98 03 08
19 18,000 20 23,000
99 04
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 for Actual Year for Ye Year for

Year analysis Year analysis ar analysis

1995 0 2000 5 20 10
05
1996 1 2001 6 20 11
06
1997 2 2002 7 20 12
07
1998 3 2003 8 20 12
08

Project Analysis and Management By Dereje W. Page 17

 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= ∑Y=269, ∑XY=1,998 ∑X2=8
91 000 ,000 19
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

Project Analysis and Management By Dereje W. Page 18

 y=12,085.74 + 1,096.7x

b) Sales forecast for the next 7 years

y=12,085.74 + 1,096.7x

Ye Year Demand/
ar for sales
analy forecasts
sis
20 14 27,440
09
20 15 28,536
10
20 16 29,633
11
20 17 30,730
12
20 18 31,826
13
20 19 32,923
14
20 20 34,020
15

c) Sales forecast diagram:

27

Project Analysis and Management By Dereje W. Page 19

 2009 2015

B. 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.

Highe Lowe
st st
Sales (Y) 220,0 50,00
00 0
Income 4,000 800
level (x)

Required: Estimate the demand function using High-Low method.

Solution:
y=a+bx

Project Analysis and Management By Dereje W. Page 20

 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

C. REGRESSION ANALYSIS: is a very popular demand forecasting

tool in practice. It involves extrapolating the past trend of demand
with identified factor affecting the demand such as income to project
the future consumption.

It measures the average amount of change in the dependent variable

associated with a unit change in one or more independent variables. There
are two types of regression analysis : simple regression (using one
independent variable) and multiple regression analysis (that uses several
independent variables). It involves

 Determining the trend of consumption by analyzing past consumption

statistics and
 Projecting future consumption by extrapolating the trend.

The results should be interpreted with diligence:

 Explanatory variable must make sense.

 The right model must be selected.
 Results should be interpreted with due care.
 Outliners, observation that is very far from the majority
observation, may be disregarded in order to avoid their effect on
the regression results.

D. EXPONENTIAL SMOOTHING METHOD: In exponential smoothing

forecasts are modified in the light of observed errors.

 If the forecast value for year t, i.e. F t, is less than the actual value for
year t, i.e. St, the forecast for the year , i.e. Ft+1, is set higher than Ft.
t+1

Project Analysis and Management By Dereje W. Page 21

  If Ft> St, Ft+1 is set lower than Ft.
In general, Ft+1 =Ft + αet
Where, Ft+1 = forecast for year t+1

α = smoothing parameter (which lies between 0 and 1)

et= error in the forecast for year t= St -- Ft

How should the first forecast (F1) and the smoothing parameter (α) be
chosen?

 A simple and reasonably satisfactory rule of thumb is to choose F 1 as

the mean of the warm-up sample (the warm-up sample consists of
several observations preceding the period for which the forecasting
exercise is began).
 For choosing α, consider several values in the range of 0 to 1 and
choose the value that minimizes the MSE (mean squared error) in the
warm-up period. the mean squared error is defined as :

1/n = ∑ (Si – Fi)2

Where Si= actual actual value of sales in period i

Fi = forecast of sales in period i

n= number of periods in the “warm-up” sample.

For simplicity of using the exponential smoothing method, in this text, it

is assumed that we know the value of Ft and α.

E.MOVING AVERAGE METHOD:

According to this method, the forecast for the next period represents a
simple arithmetic average or a weighted arithmetic average of the last few
periods.

In symbols,

Project Analysis and Management By Dereje W. Page 22

Ft+1 = St +St-1 +St-2+………St-n+1

Where, Ft+1= forecast for the next period

St = sales for the current period

n= period over which averaging is done

F. 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

Project Analysis and Management By Dereje W. Page 23

 demand for year n 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:

Project Analysis and Management By Dereje W. Page 24

 1. You are given the following demand data:

Year 19 19 19 19 20 20 20 20 20 20 20 20 20 20
96 97 98 99 00 01 02 03 04 05 06 07 08 09
Dema 10 13 14 17 18 18 19 20 22 23 22 24 24 25
nd
(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 2 28 3 34 32 33 31 31 34 35
(000 9 .5 1 .5 .7 .5 .8 .9 .3 .2
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) :

Yea 1 2 3 4 5 6 7 8 9 10 11 1
r 2
Sal 2 2 28 3 34 32 33 31 31 34 35 3
es 8 9 .5 1 .2 .7 .5 .8 .9 .3 .2 6

Project Analysis and Management By Dereje W. Page 25

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 9 14
observation 6 56
Lowest 4 7
observation 6 10

Calculate the slope coefficient, constant and the demand function.

(Use High-Low Method).

4.2 RAW MATERIALS & SUPPLIES STUDY

General

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.

Project Analysis and Management By Dereje W. Page 26

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.

UNIDO Approach in the study:

The approach followed by UNIDO in the study of raw materials and supplies
is as follows:

Step 1: Classification of raw materials:

1. Raw materials (unprocessed and semi processed.

 Agricultural products
 livestock and forests products
 marine products, and
 mineral products
2. Processed Industrial materials and components
3. Factory supplies: Auxiliary materials, utilities, and spare parts.

Step 2: Specification of requirements:

 Product characteristics and material inputs

 Requirements of raw materials and factory supplies.

Step 3: Check Availability and supply of the raw materials

Step 4: Supply marketing and supply program:

Project Analysis and Management By Dereje W. Page 27

  Supply Marketing, with the objective of :
 Cost minimization
 Risk minimization (reliable supplies sources)
 Cultivating relations with the suppliers
 supply program

Step 5: Estimate costs of raw materials and supplies

 Unit costs, annual costs, and overhead costs.

The approach followed by the UNIDO is adopted and each of the aspects
indicated in the above five steps is explained next.

Step 1 .CLASSIFICATION OF RAW MATERIALS AND SUPPLIES

1. Raw materials (Unprocessed and Semi-processed)

Agricultural products: If the basic material is an agricultural product,

first the quality of the product must be identified. Assessment of the
quantities currently and potentially available may be a cardinal and/or
functional feature in pre-investment studies involving the use of agricultural
products. In food processing industries, only the marketable surpluses of
agricultural produce should be viewed as raw materials, which are the
residue remaining after the quantities required for consumption and sowing
by producers been subtracted from the total crop production. In case of
commercial crops, the marketing surplus is the total production minus
sowing (seeds) requirements.

Livestock and Forest Products: In most cases of livestock produce and

forest resources, specific surveys are called for to establish the viability of
an industrial project. However, general data from official sources and local
authorities that is only sufficient for opportunity studies is required.

Project Analysis and Management By Dereje W. Page 28

Marine Products: The major problem in marine-based raw materials is to
assess the potential of availability, the yields, and cost of collection.
Availability of marine products may not only depend on ecological factors,
but also on national policies and bilateral or multilateral agreements.
(Fishing Quotas)

Mineral Products: For mineral products detailed information on the

proposed exploitable deposits is essential, and proven reserves are needed.
The availability of opencast or underground mining; location, size, depth,
and quality of deposits; and the impurities and the need for beneficiation
should be qualified. A detailed analysis of physical, chemical, and other
properties of the mineral is required.

2. Processed Industrial materials and Components:

Processed industrial materials and goods constitute an expanding category

of basic inputs for various industries in developing countries. Such inputs
can generally be classified under:

 Base metals
 Semi-processed materials, and
 Manufacturing parts: components for assembly type and engineering
goods industry.

3. Factory Supplies
a) Auxiliary Materials: All manufacturing projects require various
auxiliary materials and utilities summed to be factory supplies. it is
not always easy to distinguish between auxiliary materials such as
chemicals, additives, packaging materials, paints, and varnishes and
factory supplies such as Maintenance materials, oils, greases, and
cleaning materials, since these terms are used interchangeably.
b) Utilities: A detailed assessment of the utilities required (electricity,
water, steam, compressed air, fuel, and their efficient disposals) can

Project Analysis and Management By Dereje W. Page 29

 only be made after analysis and selection of location, technology and
plant capacity. However, the general assessment of these is a
necessary part of the input study. An estimate of utilities consumption
is essential for identifying the existing sources of supply, any
bottlenecks, and shortages that exist or are likely to develop, so that
appropriate measures can be taken to provide for whether internal or
external addition supplies in good time.
c) Spare Parts: All machinery and equipment will finally break down
after a certain lifetime. Various spare parts will be required to keep a
plant in operation. The importance of correctly identifying essential
spare parts, the quantities required, and available suppliers cannot be
overemphasized. Usually, the initial investment includes spare parts
for the first one or two years of plant operations under the heading of
the initial net working capital requirement (current assets). The
consumption of spare parts during plant operation is a part of the
annual production costs (which is a manufacturing overhead cost).

Step 2. DETERMINATION/SPECIFICATION OF REQUIREMENTS:

In order to estimate the requirements of materials and supplies during the

future operation of the plant, the requirement should be identified,
analyzed, and specified in feasibility study, both quantitatively and
qualitatively. A number of factors such as Socio-economic, financial, and
technical should be considered. The specification of raw materials and
factory supplies, as required for the envisaged production technologies, is
the basis for the assessment and analysis of the availability of the project
inputs.

 Project characteristics and material Inputs: For a given industry,

the envisaged plant can be capital or labor intensive, computerized or
mechanized, complex or fairly simple. The nominal and feasible plant
capacity will have to be defined on the basis of varying supply

Project Analysis and Management By Dereje W. Page 30

 condition. Any significant dependencies on raw materials and factory
supplies of the product mix and production target will be identified in
view of market potential, expected sales, transport facilities, and
production capacity.
 Requirements of Raw Materials and Factory Supplies: The
determination of requirements of raw materials and factory supplies
forms the basis for the supply program and subsequent cost
estimates. The specifications of requirements should be made in view
of (or include):
a) User Demand: Users of the produced finished goods have their
own expectations and demand that will have implications over not
only on the choice of technology, machinery, and equipment, but
also on the type and quality of materials and inputs used.
b) Quantity Required: The quantities required can be expressed in
terms of units produced (items, tones, cubic meters); section of the
production process (auxiliary materials, utilities, spare parts);
machine or labor hours (factory supplies, spare parts); and number
of employees (medicine, social costs, etc).
c) Qualitative Properties: These include Physical properties (size,
dimension, form, state, etc); Mechanical properties (formability,
elasticity, fatigue, and hardness); Chemical properties (form,
composition policy, oxidizing, etc); and Electrical and magnetic
properties (magnetization resistance).

Step 3: AVAILABILITY AND SUPPLY OF RAW MATERIALS:

A number of projects are conceived either to exploit available raw materials

or to utilize basic materials that become available from other production
process. A feasibility study must show how the materials and inputs
required will be provided. General availability, data about materials,
potential users, and supply sources and programs are aspects that should
be analyzed and described. at the initial stage of the study, the quantity of

Project Analysis and Management By Dereje W. Page 31

basic material inputs that may be required should be assessed principally
for the purpose of determining availability, sources, and long term needs.
Final input requirement will be determined only after the plant capacity,
technology, and equipment to be used are defined.

Step 4: SUPPLY MARKETING AND SUPPLY PROGRAM:

An enterprise acts as a buyer on supply markets when purchasing required

raw materials and factory supplies and a seller in the markets for finished
goods/services.

a) Supply Marketing:

The objective of supply marketing are basically cost minimization, risk

minimization (by identifying reliable suppliers), and creating better
relationships with suppliers.

 Cost Minimization: Input costs can be reduced by selecting

appropriate suppliers and by choosing a proper volume and frequency
of the orders,( Economic order quantity/size).
 Risk Minimization and reliability of suppliers: reliability with
regard to quantity, quality, deadlines (schedule), and prices is
significant for the entire manufacturing process. (Late deliveries, lack
of quality, or poor maintenance services negatively influence the
projects activities).
 Cultivating relations with suppliers: Purchases should be focused
not only on acceptable prices, but also on establishing smooth,
productive, and long-term relations with the suppliers. Purchasing
prices and conditions largely depend on the bargaining power of the
project and its management. It is essential to identify possible supply
alternative, suppliers, and the quantities to be purchased from each
should be determined in the study.

Project Analysis and Management By Dereje W. Page 32

 b) Supply Program:

Supply program is needed to show how supplies of materials and inputs will
be secured. Evidence should be presented to justify the assumptions and
suggestions. Cost estimates should be based on the supply program
presented. A supply program should deal with:

 Identification of supplying sources and suppliers

 Agreement and regulations
 Quantities and qualities
 Consignments
 Means of transport
 Storage
 Risk assessment.

In the identification of supplier, consideration should be given to geographic

location, ownership, main activities, financial strength and profitability,
production capacity, and business experience with the product. The types of
agreement, such as long term contracts and license agreements should be
presented. Letters of intent regarding supply contract and obligation; and
agreements such as period of validity, payment terms, currency conditions,
and guarantees should be outlined.

Step 5: COST OF RAW MATERIALS AND SUPPLIES:

Unit costs: Not only the availability but also the unit costs of basic
materials and factory supplies have to be analyzed in detail, as this is a
critical factor for determining project economies. In the case of domestic
materials, current prices have to be viewed in the context of past trends and
future projection of the elasticity of supply.

For imported/ material inputs: C.I.F prices (including costs, insurance,

and freight) should invariably be adopted together with clearing charges
(including loading, port charges, tariffs, local insurance, and taxes), and

Project Analysis and Management By Dereje W. Page 33

cost of internal transport to the plant. the prices of imported inputs
generally fluctuate and depend on international market situations.

Annual costs: Estimates of annual costs for materials and supplies are to
be made. the price basis for the estimates, (price level, quotations from
suppliers, world market prices, comparisons with similar inputs in other
projects, etc), should be stated in order to enable the reader to check their
reliability.

The feasibility study should also determine key factors affecting prices,
state whether a monopolistic or oligopolistic situation exist; identify
possibilities for obtaining preferential prices; and specify government or
other administrative price controls. Cost estimates are to be divided into
foreign and local currency components according to UNIDO procedures.
The currencies most likely to be used and the exchange rates applied for the
cost estimates should be identified. This will help in making sensitivity
analysis.

At whatever level, it is possible to carry out sensitivity analysis for different

levels of production and capacity utilization in the financial calculation. In
estimating costs, the following information should be presented:

 Type of material and input

 Unit of measurement (barrels, cubic meters, etc)
 Number of input units consumed/used per unit of output produced
 estimated cost per input unit
 Estimated cost per unit of output produced
 Estimated cost per unit produced divided into direct (which are
mostly variable costs) and indirect (predominately fixed and
comprised of overheads) cost components.
 Direct cost per unit of output produced divided into foreign and local
currency components.

Project Analysis and Management By Dereje W. Page 34

  Indirect costs per unit of output produced divided into foreign and
local currency components.

In order to arrive at the total operating cost by product as well as the

total costs per year, the total number of units to be produced should be
multiplied by the estimated cost per unit. Costs are projected over the
production period.

Overhead Costs of Suppliers: When estimating material and input

requirements by project components, the project planner has to plan not
only at the level of production cost centers, but also at the level of
service, administration and finance, and sales cost centers. Thus,
estimation of suppliers and their costs should be made.

4.3. Location, site, and environmental impact assessment

GENERAL:

Location and site are often used synonymously; but must be distinguished to
properly address the relevant issues requiring assessments.

Location refers to a fairly broad area like a city, an industrial zone, or a

coastal area; whereas site refers to a specific piece of land where the
project would be set up.

Objective of location and site study:

To identify a location and site suitable to the industrial project

Dimensions for Location and Site selection:

 Traditional:
Accessibility to market
Accessibility to raw material sources
Availability of infrastructure services (like transportation) and
Utilities

Project Analysis and Management By Dereje W. Page 35

  New Dimensions Added (Public policies):
Level of urbanization and implications to bring balanced
development among localities
Regionalization and Decentralization policy
Investment policy and Incentives
Population concentration and impacts on Migration
Environmental impacts and pollutions due to over concentration

I. Location and Site Selection Aspects:

In Location and site selection, the following considerations should be made:

The choice of location should be made from a fairly wide geographical

area, within which several alternative sites can be considered.
An appropriate location could extend over a considerable area, such
as along a river bank or 15 kilometer radius around an urban area in a
particular geographic district.
Within a recommended location one or more specific project sites
should be identified and assessed in detail.
For each project alternative, the environmental impact of erecting and
operating the industrial plant should be assessed.

The main criteria or key requirements for selecting proper location and
sites should always be identified at early stage of the study. Qualitative
analysis of these key requirements would then allow the assessment of a
number of potential locations and sites, and the rejection of those not
fulfilling the key requirements. The remaining alternatives are then subject
to a more in-depth qualitative analysis of technical, financial, social
environmental and economic aspects of location and site selection.

The most important or critical requirements include, among others:

Project Analysis and Management By Dereje W. Page 36

  The Natural Environment (climatic conditions and Ecological
requirements.
 Environmental Impacts
 Socio economic policies (Role of public policies and Fiscal and legal
aspects)
 Infrastructural Conditions (Infrastructure dependence, factory
supplies, Human resources, Infrastructural services, and Effluent and
waste disposal facilities)
 Final choice of location (resource or market orientation)

In site selection, the requirements and relevant factors are:

 Site requirements (cost of land, construction requirements, local

condition, Infrastructure, effluent and waste disposal, Human
resources)
 Final site selection and cost estimates.

II. 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

Project Analysis and Management By Dereje W. Page 37

  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.

As key aspects vary from industry to industry, the project analyst will have
to use their professional skills to identify those key criteria, which are
relevant for each specific project. The identification of key requirements
helps to reduce the number of potential locations and sites at an early
stage.

The Natural Environment

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.

Environmental Impact Assessment (EIA)

Project Analysis and Management By Dereje W. Page 38

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.

Objectives of Environmental Impact Assessment:

General:

 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.

In principle, environmental impacts should be assessed on the basis of legal

regulations and emission standards and guidelines established in the
country. In countries where no regulations and standards are defined, it
may be advisable to anticipate a future tightening of environmental impact
control measures. if trends are properly considered during the project
planning stage, unexpected costs for later plant adaptations, conversions,
rehabilitations, or even the shut down of operations may be avoided or
minimized.

Socio Economic policies

A. The Role of Public Policies:

Government regulations and restrictions may be critical for the location of a

project. Projects with certain characteristics (particularly industries) may
be allowed only in a certain regions. In a number of developed and

Project Analysis and Management By Dereje W. Page 39

developing countries, there is a considerable pressure for the
decentralization of industries, the main objective of industrial
decentralization being to reduce the external diseconomies of urban
industrial concentration.

Knowledge of public policies with regard to location aspects is necessary to

enable the various concessions and incentives that may be part of such
policies to be adequately considered. Among others,

 Specific geographical zones often are setup in some countries and

varying patterns of financial incentives have been determined for
them.
 In some developing countries, direct subsidies are given to industries
located in particular areas or regions (for instance, in marginalized
areas).
 Financial and other incentives are given for projects located in under
developed regions.

Therefore, the impact of these incentives on the economics of a proposed

project should be analyzed. The growth of public sector enterprises has
been significant for industrial growth in many developing countries, in
which wider policies such as regional, industrial, and disposal aspects tend
to play a part in the location decisions.

B. The fiscal and Legal Aspects:

The fiscal and legal regulations and procedures applicable for alternative
locations should be defined. The various national or local authorities to be
contacted in respect of power and water supplies, building regulation, fiscal
aspects, security needs, etc, should be listed. The corporate and individual
incomes taxes, excise duties, purchase taxes and other national or local
taxes should be ascertained for different locations, together with the
incentives and concessions available for new industries.

Project Analysis and Management By Dereje W. Page 40

Infrastructural Conditions

The availability of a developed and diversified economic and social

infrastructure is often of key importance for a project. Quantitative and
qualitative requirements for energy, utilities, labor, land, etc, may be met in
only a few locations if the project is relatively big.

i. Technical Infrastructure
ii. Transport and Communications
iii. Factory supplies
 Water
 Electricity
 Fuel
iv. Human resources
v. Effluent and water Disposal techniques

Final Choice of Location

The optimal location is where the total cost (i.e., the cost of raw material
transportation cost plus production cost plus distribution cost for final
product) is minimized.

The best choice of location would be the one where the costs of products
sold (production costs and marketing costs) are a minimum.

In a nutshell, critical to location selection are the impacts on a particular

project of factors such as:

 The availability of raw materials and inputs,

 The proximity of centers of consumption, and
 The existence of basic infrastructure facilities.

III. Site Selection

Project Analysis and Management By Dereje W. Page 41

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)

Project Analysis and Management By Dereje W. Page 42

 Socio-economic factors
 Water disposal
 Environmental factors
 Taxes and duties
 Public policies (fiscal and legal regulations)
Distance to seaport (import or export)
IV. Cost Estimates

The cost estimates at the site are:

£ Acquisition of land
£ Taxes
£ Legal expenses
£ Railway connections
£ Site preparations and development.

IV.4. PRODUCTION PROGRAM AND PLANT CAPACITY

Production Program: basis and Aspects

Sales program as a basis

Sales program shows the level of sales forecast to be realized during the
specified life of the envisaged plant (showing local sales, export sales, total
revenues over project life0.

1. Sales program is projected under market analysis

 Market requirements and market structure identified
 Marketing strategies will be defined & the implications broadly in
terms of:
 Product pricing
 Production program
 Promotional efforts
 Sales & distribution mechanisms

Project Analysis and Management By Dereje W. Page 43

  Marketing mix
 Demand forecasting
2. Provides inputs for financial analysis

After projecting sales for different stages of production, a feasibility

study should define and come up with the detailed production program.
A production program defines the level of output to be produced during
specified period and, from this viewpoint, we can say that it should be
directly related to the specific sales forecasts.

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:

Project Analysis and Management By Dereje W. Page 44

Single Product Case: Cement factory, coal factory, tea factory, Sugar
factory

Multiple Products Case: Electronics factory, machine tools, leather

products, food complex, Oil Refinery.

Case 1: Single-product-continuous process manufacturing as in cement

production

Case 2: Multiple-products-continuous process production as in an oil

refinery;

Case 3: Batch/Job orders production such as in an engineering workshop;

and

Case 4: Assembly/mass manufacturing as for the production of motor cars.

In the first case, the growth of sales may not be a great problem unless
production capacity is in excess of local demand. However, production
problems may be more critical. In the second case, both production and
sales problems may arise. In the third case, though production aspects
may present difficulties, obtaining satisfactory orders would be critical. In
the fourth case, the sales aspects in relation to price would be dominant.

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 Analysis and Management By Dereje W. Page 45

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.

The input requirements and costs have to be assessed for:

 Basic materials such as raw materials, semi-processed items, bought-

out items, etc.
 Auxiliary materials and factory supplies,
 Major utilities, and
 Direct labor requirements.

Detailed estimates in this regard should be prepared for the stages of initial
production and full production.

Project Analysis and Management By Dereje W. Page 46

Factors considered in setting the Production Program

1. Production level (capacity utilization):

 Production may not be full capacity during the initial period due
to:
 Production and technological difficulties
 Skill and productivity to be learned
 Lack of marketing experience
 Market forecast needs testing
 Plant is new for competition-time to cope up with the
competitive environment.
 A level of 40-50% of overall capacity utilization in the first year
may not be too low.
 In later years, capacity utilization might increase due to
learning and effect of experience/improvement in skill.
2. Production problems:
 Machine breakdowns and problems of line balancing in
operations; raw material shortages or materials may not be up
to the standard; utilities shortage, etc.
3. Wastage and spoilage:

Try to avoid abnormal spoilage & wastage (only anticipate normal ones).
Note that abnormal spoilages and wastages can be eliminated through
efficient operations and thus, are controllable/avoidable. However,
normal spoilages and wastages are not controllable or unavoidable.

4. Price Vs Quantity sales:

Sales might be affected by the price established. That is, higher
prices may have impacts reflected over lower sales
volume/quantity.
Which in turn affect production program

Project Analysis and Management By Dereje W. Page 47

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:
 Minimum economic size determined by the technological
factor.
 For many industrial projects, there is a certain Minimum
Economic size determined by the technological factor. For
example, a cement plant should have a capacity of at least 300
tones per day in order to use the rotary kilos method, or else it
has to employ the vertical shaft method, which is suitable for
lower capacity plants.
2. Input constraints:
 In developing countries, there may be constraints on the
availability of certain inputs, such as:
 Power supply may be limited
 Basic raw materials may be scarce

Project Analysis and Management By Dereje W. Page 48

  Foreign exchange available for imports may be
inadequate.
3. Investment costs:
 Investment cost per unit of capacity decreases as the plant
capacity increases (i.e. capacity costs increases at a decreasing
rate). That is, some capacity costs remain the same regardless
of the size of the plant (for instance, installation costs,
technicians charges, etc); and the rest often increase still at a
lesser proportion.
 Capacity Vs Investment cost: In general, as capacity increases,
the investment cost per unit of capacity decreases.
The capacity-cost relationship could be defined by the following
equation:

α
C2 = C 1 X Q2
Q1

Where,

C1 is the known cost for Q1 units of capacity

C2 is the derived cost for Q2 units of capacity

α (alpha) which is the factor reflecting capacity-cost relationship. Alpha is

usually set in between 0.2 to 0.9. If α=0, means there is no relationship
between cost and capacity; and If α =1, it means that capacity cost
increases in the same proportion with the increase in the level of capacity.

Example, Assume that C1 = Br. 1,000,000 represents the investment cost in

capacity level Q1

Q1 = 5000 units per annum at the normal capacity level, and

Project Analysis and Management By Dereje W. Page 49

α = 0.6 reflecting the capacity-cost relationship. How much will be the
investment cost in the new capacity (C 2) for a level of production (Q2) equal
to 10,000 units per annum?

Solution: Apply the formula given above and C2 = Br.1, 516,000

The implication here is that although capacity has doubled, the investment
cost in capacity has increased by a less than double cost of earlier capacity.

4. Market conditions:
 The anticipated market for the product has an important bearing on
plant capacity
 If the market for the product is likely to be very strong, a plant of
higher capacity is preferable.
 If the market is likely to be uncertain, it might be advantageous to
start with a small capacity.
 If the market starting from a small base, but is expected to grow
rapidly, the initial capacity may be higher than the initial level of
demand. Further addition to capacity may be effected with the growth
of market.
5. Resources of the firm:
 The following resources define a limit on a firm’s capacity decisions:
 Managerial infrastructure,
 Finance, and
 Availability of skilled employees to a firm.
6. Government policy:
 Minimum Economic Capacity Policy in several industries:
 Economic use of raw materials and other resources (like land,
human resources, etc)
 Economies of scale and subsequent low prices to consumers
 Optimum investment in imported machinery & equipment (to
save foreign exchange)

Project Analysis and Management By Dereje W. Page 50

  To minimize fragmented investments and encourage long-term
investments in large capacity plants.

Feasible Normal Capacity (FNC)

Once the marketing concept and the corresponding sales volume are
defined, other components have to be assessed to determine the feasible
normal plant capacity. This capacity should in fact represent the optimum
level of production as may be determined by the relative interactions of
various components of the feasibility study such as : technology, availability
of resources, investments and production costs, raw materials and supplies
(auxiliary & utilities), human resources, etc.

The FNC is achievable under normal working conditions taking into account
the following conditions:

 Installed equipment:
Level of sophistication
Standard of operation
Specific characteristics
 Technical plant conditions:
Down time (a period where by the plant is not in operation or
not running due to technical requirements).
Maintenance requirement
Total checks
 Organizational and management aspects:
Normal working hours
Holidays
Normal labor strikes
Ability to manage and coordinate diverse interactions
 Availability of inputs
 Skill of employees (i.e. employee skill should fit to the technological
requirement)

Project Analysis and Management By Dereje W. Page 51

The feasible normal capacity is the number of units produced during one
year under the above conditions and that should correspond to the sales
projections in the market and demand analysis. Therefore, both Human
Factor and System Engineering define Feasible Normal Capacity (FNC),
which is “Plant plus Human”.

Nominal Maximum Capacity (NMC)

This is the technically feasible capacity and frequently corresponds to the

installed capacity as guaranteed by the supplier of the plant. Nominal
Maximum Capacity is defined by system engineering, that is, the equipment
installed capacity, which includes reserve and stand-by capacity. To reach
the maximum output figures, overtime work may be needed as well as it
might result in excessive consumption of factory supplies, utilities, spare
parts, and wear tear parts. This results in a disproportionate production
cost increase due to diseconomies of scale. In general; the FNC is less than
the NMC under normal condition.

Determination of feasible Normal capacity (FNC)

In feasibility study, the determination of the appropriate plant capacity is

critical. Forecasts of demand and market penetration strategies for a
particular product are the starting points. The limited availability of basic
materials and inputs or resources may be constraints for certain projects,
requiring evaluation of various alternative possibilities of plant sizes and
capacity. These alternatives have to be related to various levels of
production and different levels of sales and profitability. The steps are in
short the following:

 Identify alternatives possibilities of plant size & capacity

 Determine various levels of production capacity utilization
 Examine the different level of sales & profitability expected

Project Analysis and Management By Dereje W. Page 52

Once the overall constraints on demand and market forecasts are defined,
other components of the study have to be assessed to determine the feasible
normal plant capacity. This capacity represents the optimum level of
production. One of the aspects (components) can be critical for determining
the feasible normal plant capacity of a project, but the implications of all the
above aspects should be taken into account.

Finally, prior to capacity determination, the minimum economic size,

availability of production technologies, and equipment related to various
production levels should be determined. Production capacities have tended
to increase rapidly in a number of sectors in industrialized countries to take
greater advantage of economies of scales. Increased capacities give
increased output resulting in lower unit production costs. Another
important factor is that the available process technology and equipment are
often standardized at specific capacities in different production sectors.

IV.5. TECHNOLOGY AND ENGINEERING STUDY

Engineering Study:

Objectives of the study:

 To design the functional and physical layouts in order to produce the

defined outputs.
 To determine the corresponding investment expenditures
 To determine the costs arising during the operational phase
 To accomplish necessary infrastructure investments

It is the task of engineering to design the functional and physical layouts for
the industrial plant necessary to produce the defined output and to
determine the corre4sponding investment expenditures as well as the costs
arising during the operational phase. The scope of engineering also includes
the plant site and all activities required to deliver both inputs and outputs
and to provide the necessary infrastructure investments.

Project Analysis and Management By Dereje W. Page 53

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

While the choice of technology defines the production processes to be

utilized, the effective management or technology transfer requires that the
technology and know-how are acquired on suitable terms and conditions,
and the necessary skills are available or developed. The required machinery
and equipment must be determined in relation to the technology to be
utilized, the local condition, and human capabilities. Skill development
needs to be planned through training program. The analysis must include a
survey of spare parts.

After the determination of the marketing strategy, the production program,

and capacity, a preliminary project layout has to be prepared defining the
physical features of the plant such as:

 Infrastructure
 factory and other buildings and civil works

Project Analysis and Management By Dereje W. Page 54

  Their relationships with utilities, material flows, and machinery
installations
 Other aspects of plant construction and operations.

It is necessary to identify the necessary technologies and the implications in

terms of costs, use of local raw materials, environmental impacts, and other
factors.

Technology Choice:

An important factor in determining the production program and plant

capacity is the technology and the people know-how to be utilized in the
project. Therefore, the selection of appropriate technology and know-how is
a critical element in any feasibility study.

The word “technology” or “manufacturing technique” mean a sum of

patented and unpatented knowledge, know-how, experience, and skills
needed for the transformation of raw materials into outputs. The selection
of technology should be based on a detailed consideration and evaluation of
technological alternatives and the selection of the most suitable alternative
in relation to the project or investment strategy chosen and to socio-
economic and ecological condition. The choice of technology is influenced
by a variety of considerations:

 market and marketing concepts

 Plant capacity
 Principal inputs
 Investment outlays and production cost
 Use by other units
 Product mix

Project Analysis and Management By Dereje W. Page 55

  latest developments
 Ease of absorption

Appropriate technology choice is directly related to the conditions of

applications in particular situations.

Appropriateness of Technology:

Appropriate technology refers to the methods of production, which are

suitable to heal economic, social, and cultural conditions. Technology
should be evaluated in terms of:

 Whether the technology utilizes local raw materials

 Whether the technology utilizes local manpower
 Whether the goods and services produced cater the basic needs
 whether the technology protects ecological balance
 Whether the technology is harmonious with social and cultural
conditions

The project planner, therefore, should have a good knowledge of the

present trends in technology development and local conditions to evaluate
all possible technological alternatives.

The most common mistakes at this stage of the evaluation are:

 Choice of technology which already is or is going to become obsolete

in the near future
 Choice of new versions of existing technology not sufficiently proved
and tested
 Choice of technology heavily dependent on the supplies of special
semi-products, sub-assemblies, or additives available from a monopoly
supplier (i.e. the licensor)

Project Analysis and Management By Dereje W. Page 56

  Adoption of technology incompatible with the local conditions
(climate, special raw material properties, local personnel
qualifications, etc)
 Under estimation of environmental hazards

Alternative technologies should also be evaluated with regard to their

environmental impacts. Critical elements that must be considered for the
selection of suitable technologies include:

 Economic use of raw materials,

 Low emission technologies, and
 Low-waste production processes

Assessment of Technology Required:

The technology required to produce the desired products on the basis of the
resources identified for the project may be common knowledge or the
property of owners who may be willing to transfer it under certain
conditions.

The primary goals of technology assessment are to determine and evaluate

the impacts of different technologies on the society and national economy,
impacts on the environment and socio economic feasibility assessed from
the point of view of the enterprise.

To allow the careful assessment of the suitability of the technological

alternatives required and available for the project under consideration, the
following logical sequence of steps should be followed:

Problem Definition

Technology description and Project

layout

Technology Market alternatives

Project Analysis and Management By Dereje W. Page 57

Assessment of availability

Assessment
Description
Environmental of Impact
of the
TechnologyLocal Integration
Socioeconomic
Assessment
Forecast Impact
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.

Project Analysis and Management By Dereje W. Page 58

 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
programme 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)

Project Analysis and Management By Dereje W. Page 59

 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)

Selection of Machinery and Equipment:

Objective:

 To choose an optimum group of machinery and equipment necessary

for the project, considering:
o the specific production capacity,
o Production techniques (technology), and
o Type of products to be produced

The selection of equipment and technology are interdependent. the

requirement of machinery and equipment should be defined on the basis of
the plant capacity and the selected production technology. Equipment
selection should broadly define optimum group of machinery and equipment
necessary for a specific production capacity by using a specific production
technique. The selection of machinery and equipment could be affected by
different factors that are constraints in selecting machineries and
equipments:

 Plant capacity and technological processes

 Infrastructural constraints (the availability of electric power for a
large electric furnace, the transport of heavy equipments to remote
area)
 The length of time required for training (highly sophisticated
equipment)
 Investment constraints and the availability of foreign exchange

Project Analysis and Management By Dereje W. Page 60

  Maintenance requirements and the availability of maintenance
facilities
 Government policies such as import controls (restrict the import of
certain types of equipments)

Another important issue in equipment choice is the degree of automation

that may be required.

 Computerized equipment may be required, but the capital costs of

automation tend to be high (this could be viable in developed
countries because it replaces high-cost labor)
 The competitive nature of production may require the use of
automated equipment, thus necessary skills must be developed.

Cost estimates for imported equipment should be on the basis of C.I.F and
the landed cost, as well as internal transport, insurance, and other costs up
to the plant site. Transport and other cost of domestic equipment should be
incorporated up to the plant site. the cost of erection of equipment should
be estimated, particularly when this is undertaken as an independent
operation. The lowest installation cost ranges from 1 to 2% and the highest
up to 15% depending on the equipment.

Procurement of plant and machinery could be made from different suppliers

or a turnkey contract may be given for the entire plant and machinery to a
single supplier. The factors to be considered in selecting the suppliers of
plant and machinery are:

 The desired quality of machinery

 The level of technological sophistication
 The reputation of the suppliers
 The expected delivery schedules
 The preferred payment term, and
 The required performance guarantee

Project Analysis and Management By Dereje W. Page 61

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

These define the scope of the project and provide the basis for detailed
project engineering and estimation of investment and production costs. The
plant layout is concerned with the physical layout of factory. In process
industries, the production process adopted dictates the plant layout; in
manufacturing industries, however, there is much greater flexibility in
defining the plant layout.

The important considerations in preparing the plant layout are :

 Consistency with production technology

 smooth flow of goods from one stage to another
 proper utilization of space
 scope of expansion
 Minimization of production cost
 Safety of personnel

Detailed final plant layout needs to be prepared prior to project

implementation. The detailed plant layout and basic engineering design are
required in a feasibility study to allow the preparation of cost estimates,
where detailed engineering work would usually not start before a project
enters the implementation phase.

Project Analysis and Management By Dereje W. Page 62

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:

Project Analysis and Management By Dereje W. Page 63

  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.

IV.6. Organizational and Human Resource

This basically incorporates the socio-cultural patterns and institutions or the

population that the project is believed to serve. Does the project takes into
account the cultural setup and customs of the beneficiaries? Or will it
disturb the accepted pattern? If so how should this be included as part of
the project design?

To have a chance of being carried out, a project must be related properly to

the institutional structure of the country or region where the project is to be
carried. Examples include the land tenure system, use of local institutions
such as Idir or Debbo

Similarly, managerial issues are critical for successful completion of

projects. Thus, the project analyst must examine the ability of available staff

Project Analysis and Management By Dereje W. Page 64

to identify whether they have the capacity to carry out the managerial
needs of the project.

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

Project Analysis and Management By Dereje W. Page 65

 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

Project Analysis and Management By Dereje W. Page 66

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 pat of the
implementation process of investment projects.

IV.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:

Project Analysis and Management By Dereje W. Page 67

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:

Project Analysis and Management By Dereje W. Page 68

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 equipments 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

Project Analysis and Management By Dereje W. Page 69

  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 Analysis and Management By Dereje W. Page 70

  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.

II. 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

Project Analysis and Management By Dereje W. Page 71

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.

Project Analysis and Management By Dereje W. Page 72

 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 a 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:

Project Analysis and Management By Dereje W. Page 73

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?

Project Analysis and Management By Dereje W. Page 74