Project Module.PDF

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CHAPTER ONE

PLAN AND PROJECTS

INTRODUCTION

In this course plan refers to the concept of development planning as discussed below. Hence wetry to see the relationship that exists between development plans and projects.

Learning Out Comes:

Dear learner after studying this chapter you are expected to know about:

• The meaning of development planning• Definition of a project• Relationship between plans and projects

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1.1 DEVELOPMENT PLANNING

Dear distance learner, in this unit you are going to study about the concept of development

planning in brief. Try to make note of the definition of development planning as pointed out by

different authorities and under stand the basic ideas laid out for the concept development planning. Also make note the different layers of development planning.

Development Planning is synonymous to economic planning. As yet, there is no unanimity ofopinion on the definition of economic planning among economists (or planners). However, thedefinition given by Todaro is widely accepted.

According to Todaro (1981) economic planning is defined as “a conscious effort by thegovernment to influence, direct, and in some cases even control changes in the principaleconomic variables of a certain country or region to achieve a predetermined set of objectivesover the long run”.

Note that the principal economic variables consist of GDP, aggregate consumption, investment,savings, etc.

Likewise, Conyers and Hills (1984) define economic planning as a continuous process whichinvolves decisions or choices about alternative ways of using available resources, with the aim ofachieving particular goals at sometime in the future.

The idea of planning acquired a tremendous support after the end of World War II whenadvanced but disrupted economies had to be rehabilitated and the underdeveloped economieswere fired with the ambition of rapid economic development. Some people did not take this ideakindly in some countries. It was perhaps due to the fact that planning came to be most activelyassociated with socialist economies. Hatred of socialism was transferred to planning too. But

such unreasoned opposition to planning has now almost vanished. On the other hand, remarkableachievements of Nazi Germany and Soviet Russia popularised the idea of economic planning.

Even in capitalist countries, where the economy is governed and directed by market incentives, planning are being practiced more or less in one or the other sector of the economy. Planning has become popular owing to the basic defects of capitalism and free enterprise and owing to therealization that, unless a free enterprise economy is regulated and controlled, it would not ensurestable growth and social welfare. That is why about 20 percent of American economy is planned,which shows to these extent current resources are controlled and disposed by the State.

Although both advanced capitalist countries and the under-developed countries have adopted planning but there is this difference between the two: in the former it is corrective planning to

ensure economic stability, in the latter it is developmental planning to ensure rapid growth.

Economic Plan: - The planning process yields an economic plan. It is a blue print of the specificset of quantitative economic targets to be reached in a given period of time. It serves as a usefultool to bring the predetermined goals into fruition.

Economic plan is broadly categorized into three parts: Comprehensive Plan, Partial plan andProject plan.

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Comprehensive Plan: sets its targets to cover all major aspects of the national economy (macro plan).

Partial Plan: Covers only a part of the national economy (e.g. Industry, Agriculture, the PublicSector, and the Private Sector Etc.).

Project (micro) plan: it is the simplest and smallest type in nature that is looking independentlyall specific micro activities. Under sectoral plan there are a number of project plans whichconstitutes the sectoral/partial/ plan.

2.2 PROJECTS

In this unit please ponder the following points:

a. What a project is?

b. Relationship of plans and projects and

c. How a project can be used as a policy instrument in undertaking development plans

1. Definition of Project

In most cases it is easier to describe rather than to define a project. In reality, the project definesitself out gradually as we talk about it and delineate its various aspects. In general, however, we

can say that a project is a complex of economic activities in which we commit scarce resourcesin expectation of benefits that exceed these resources. Both resources and benefits are usually, but not necessarily, measured in money terms. Although there are no two projects alike, some arevery similar and confusion can be avoided by describing a project accurately instead of trying todefine it elegantly.

To sketch the profile of a project comprehensively we should look at it from different viewpoints.

For example, considering projects from different angles, we can distinguish:

- projects of long and short duration, e.g. hydroelectric and annual crop projects;- projects producing goods (e.g. oil mill), research stations or information (e.g. mineral

exploration);- projects catering to regional, national or international markets;- rural and urban projects;- agricultural, industrial, transportation and other projects;- Capital, labour or energy intensive projects; and so on.

The classification could be extended considerably and cross-tabulation is, obviously, possible.

But our purpose is to show that a project has many facets and not to provide an exhaustive list of project categories. It is the analyst who will decide which characteristics of a project must beunder lined.

2. Relationship between plans and projects

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Virtually every developing country has a systematically elaborated national plan to hasteneconomic growth and further a range of social objectives. Projects provide an important means bywhich investment and other development expenditures foreseen in plans can be clarified andrealized. Sound development plans require good projects, just as good projects require sound planning. The two are interdependent.

Development strategies are packages of ways and means by which available resources are put intheir best use in achieving specified objectives. Since projects commit scarce resources, projectselection is meaningful only when it is consistently placed within a broader developmentframework. This framework is usually delineated in medium and long term development plansand policy statements issued by the government. It is within this framework that all effects of a project, e.g. its requirements and benefits, can be assessed properly. The more elaborate thedevelopment plans and policy statements, the easier becomes the work of the project planner. As

a minimum, they should outline the desired socio-economic pattern of development and shouldspecify the major objectives. A hard core of such objectives consisting of self-sustaining growth, promotion of employment, elimination of absolute poverty and improvement in incomedistribution, is of general acceptance and can serve as a guide to project selection. To these basicobjectives others are usually added, including self-reliance, independence in critical materials,etc. The analyst should constantly keep in mind the declared objectives and should always verifythat the selected project contributes to the maximum extent possible in attaining them.

Comprehensive macro-plans and elaborate sectoral programmes are of great help in identifyingdevelopment projects and in providing the framework within which they should be evaluated.However, realistic macro-and sectoral plans can not be drafted in the abstract; they should be based on a careful assessment of development potentials in various sectors of the economy. Inmost cases, this amounts to identifying and evaluating specific projects. The question whether planning should proceed “from the top down: or “from the bottom up” belongs to the past.Realistic planning is an iterative process with information, suggestions and guidance flowing inand up-and-down direction. In other words, planning the economy and planning projects should proceed in parallel reinforcing and refining each other. Consequently, we should not wait for acomprehensive macro-plan to be drafted before we embark on project planning, and vice versa.

3. The Project as a Policy Instrument

Projects have rightly been called the “cutting edge” of development. They are powerful meansto achieve the development objectives; they are crucial building blocks of a developmentstructure. Projects aim, mainly, at increasing the production of goods and services which arefundamental components of people’s welfare; after all, the main objective of any developmenteffort is to advance social well-being. However, it would be a mistake to consider projects as theonly, or always the best means to achieve every development objective; projects are not a new panacea curing all social and economic ills of a country.

Development is a complicated process that has more than economic aspects and, therefore,requires efforts and means that lie beyond the domain of economics. But even within theeconomic content of development there are multiple instruments by which objectives can be

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reached. Some of them are specially designed to achieve particular objectives while others,although capable of serving many purposes, are better in some and inferior in other cases. Sinceeconomics always aims at optimization, by maximizing results or minimizing costs, we shouldselect the most efficient means in achieving the development objectives.

In addition to projects, economic instruments that usually play an important role in the

development effort include taxation and other fiscal policies, monetary and credit policies, traderegulations and price controls, employment and wage policies etc. Many of these policyinstruments are complementary while others are substitutes. The important point is to use one ormore of them in a way that the objective is achieve in the most efficient manner. For example,the structure of a project can be designed and its inputs and outputs can be priced in such a waythat its implementation could improve the distribution of income. The question, however, israised whether the same improvement can be achieved more efficiently and faster through progressive taxation and other fiscal means. The answer to questions of this kind depends uponthe circumstances prevailing in a country at a given time.

Exercise 1.1

1. Identify the basic similarities put out by different authors to the concept of development planning.

2. How are development plans classified?3. What is a project?4. What do we mean by a project is a temporary endeavour?5. What is the relationship between plans and projects?6. State one project example in your locality serving to the government as its policy

instrument.

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CHAPTER TWO

STAGES OF PROJECT PLANNING – THE PROJECT CYCLE

INTRODUCTION

The various stages through which project planning proceeds from inception to implementation areoften called “the project cycle”. It is the project’s life cycle through which it advances frominfancy to maturity. The main features of this process are information gathering, analysis, anddecision making.

For analytical simplicity the project cycle in this module is divided into three phases(UNIDO approach): the pre-investment, investment and operational phases. The pre- investment phase comprises project identification, preparation and appraisal of project studies. Theinvestment phase constitutes negotiation and contracting, engineering design construction and preproduction marketing. And the operational phase includes commissioning and starts up of production, replacement and rehabilitation, and expansion and innovation.

Actually, this division is artificial but it helps to understand that project planning is a continuous process over time. Throughout the project cycle the primary preoccupation of the analyst is toconsider alternatives, evaluate them, and to make decisions on which of them should be advancedto the next stage.

With the clear understanding that project planning is an uninterrupted process, we shall discussthe investigation work to be carried out at each stage of planning starting with projectidentification. The stage of project implementation will not be covered thoroughly: we onlytouch upon it in passing. This is not because project execution is of minor importance; on thecontrary, because of its significance in transforming project expectations into realities it deservesa separate paper. The same applies to the stage of operation and post-evaluation which someauthors include in the project cycle.

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Figure 2.1. The UNIDO Project Cycle: New Industrial Projects

PreparationPre-selection

AppraisalIdentification Pre-investment

Phase

Learning Outcomes:

After studying this chapter you are expected to know about:

1. What a project cycle is in the preparation of project feasibility studies

2. The UNIDO project cycle

3. The three major phases of the UNIDO project cycle

2.1. THE PRE INVESTMENT PHASE

Dear distance learners, in this unit you will learn about the different stages of the pre-investment phase in the project cycle. Please make note of how a project matures as it passes through these different stages of the cycle. While reading this unit please think of one or more

project ideas and see how you can come about a decision of whether to invest in only one

project.

Pre-

productionmarketing

Commissioning& start-up

Negotiation &contracting

Operation

Phase

Investment

PhaseEngineeringdesign

ConstructionTraining

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The pre investment phase comprises several stages: identification of investment opportunities(opportunity studies), project preparation (pre-feasibility and feasibility studies) and projectappraisal (preparation project investment decisions report).

I Project Identification

Project identification amounts to finding projects which could contribute towards achievingspecified development objectives. In principle, especially in developing countries like Ethiopia, project identification should be an integral part of the macro-planning exercise with sectoralinformation and strategies as the main source of project ideas. In practice, however, projects arenot always derived from national and sectoral plans; they originate from multiple sources such asinvestment promotion agencies, private consultants and private investors. Irrespective of theirorigin project ideas should, in general, aim at: overcoming constraints to the development effort, be they material, human or institutional constraints; or, meeting unsatisfied needs and demand forgoods and services. Constraints, needs and demand should be interpreted broadly to include, forexample, foreign exchange constraints that might necessitate projects for import substitution orexport promotion.

1. Opportunity studies:

Where does Projects Originate? The variety of projects makes it impossible to prepare anexhaustive list of sources from where project ideas emanate; much depends on the experience,and even imagination, of those entrusted with project creation. In general, we can distinguish twolevels where project ideas are born: the macro-level and the micro-level. At the macro-level, project ideas emerge from:

(i) national, sectoral,, or regional plans and strategies supplemented by special

studies, often called opportunity studies, conducted with the explicit aim oftranslating national and sectoral programmes into specific projects;

(ii) constraints in the development process due to shortages of essential infrastructurefacilities, problems in the balance of payments, etc.;

(iii) a government’s decision to correct social and regional inequalities or to satisfy basic needs of the people through development projects;

(iv) a possible external threat that necessitates projects aiming at achieving, forexample, self-sufficiency in basic materials, energy, transportation, etc.;

(v) unusual events such as droughts, floods, earth-quakes, hostilities, etc.; and

(vi) a government’s decision to create locally project implementing capacity in suchareas as construction etc.

At the macro-level, project ideas can also originate from multilateral or bilateral developmentagencies and as a result of regional or international agreements in which a country participates.

At the micro-level, the variety of sources is equally broad. Project ideas emanate from:

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(i) the identification of unsatisfied demand or needs;(ii) the existence of unused or underutilized natural or human resources and the

perception of opportunities for their efficient use;(iii) the need to remove shortages in essential materials, services or facilities that

constrain the development effort;

(iv) the initiative of private or public enterprises in response to incentives provided bythe government;

(v) the necessity to complement or expand investments previously undertaken; and(vi) the desire of local groups or organizations to enhance their economic

independence and improve their welfare.

Project proposals could also originate from foreign firms either in response to governmentinvestment incentives or, because they consider local production a better way to secure asubstantial share of the domestic market for their products.

Opportunity studies are rather sketchy in nature and rely more on aggregate estimates rather thanon detailed analysis. Cost data are usually taken from comparable existing projects and not form

quotations of sources such as suppliers. Depending on the prevailing situation, either a general opportunity study (sector approach) or a specific opportunity study (enterprise approach) or bothwill have to be undertaken.

General opportunity studies*

General opportunity study may be divided into three categories:• Area studies to identify opportunities in a given area• Industry studies to identify opportunities in a delimited industrial branch• Resource-based studies to reveal opportunities based on the utilization of natural resources

Specific project opportunity studies*

A specific project opportunity study may be defined as the transformation of a project idea into a

broad investment proposition. This study usually springs from general opportunity studies, in theform of products with the potential for domestic manufacture. The purpose of Specific projectopportunity studies is to arrive at a quick and inexpensive determination of the salient facts of aninvestment possibility. It therefore should not involve any substantial cost in it preparation

2. Preliminary Screening: Once some project ideas have been put forward, the first step is toselect one or more of them as potentially viable. This calls for a quick preliminary screening byexperienced professionals who could also modify some of the proposals. At this stage thescreening criteria are vague and rough becoming specific and refined as project planningadvances. During preliminary selection the analyst should eliminate project proposals that are

technically unsound and risky; have no market for the output; have inadequate supply of inputs;are very costly in relation to benefits; assume overambitious sales and profitability; etc.Obviously, since the criteria are nebulous much depends on the experience and impartiality of the professionals applying them. It is, however, necessary to conduct this screening, even withindistinct criteria, in order to reduce to a manageable number the project alternatives to whichmore work and time will be devoted. After all, project planning is a process of elimination, i.e.elimination of inferior alternatives.

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3. Pre-feasibility Studies: Following the preliminary screening, promising project optionsshould be investigated in a systematic manner. This requires the preparation of brief reports thatindicate in sufficient, but not painstaking detail the project versions that are still promising andsuggest which ones should be eliminated. Sophisticated analysis, of the technical, financial,economic social and institutional aspects of the project is postponed to a later stage beforeassigning larger funds for such a study, since feasibility studies are costly and time-consuming.

However, the reports should indicate which of these aspects deserve particular attention duringthe subsequent step. Reports of this type are often called pre-feasibility or pre-investment.

The objectives of the pre- feasibility are to determine whether:• All possible project alternatives have been examined• The project idea justifies a detailed analysis by a feasibility study• Any aspects of the project critical to the project that may require in depth investigation through

functional studies• Environmental situation at the planned site and the potential impact of the projected production

process are line with national standards.

Content of the Pre-feasibility Study: To enable the relevant authorities to decide on themerits of various project options, the pre-feasibility study should, although briefly, discuss:

(i) the structure and objectives of the project;(ii) the nature and size of the demand for the output or the needs that it would satisfy,

together with the foreseen beneficiary groups;(iii) the availability of the most important materials and human inputs;(iv) basic alternative technologies available and their merits and weaknesses;(v) approximate investment and operation costs as well as expected revenues and other

benefits;(vi) rough estimates of financial and economic returns;(vii) any major factor that is likely to have and important effect on the project; and(viii) What further information on the technical, financial, economic or institutional aspects

of the project should be acquired through special studies and surveys.

By the end of the identification stage we should know:(a) Whether further detailed work is justified;(b) what major issues have been identified, what project alternatives have been considered

and which of them have been rejected; and(c) A rough estimate of costs.

For projects that still look promising, a specific work plan for the next stage should also beincluded in the study.

Functional (support) studies

Functional or support studies cover specific aspects of a project and are required as prerequisitesfor, or in support of, pre-feasibility studies and feasibility studies, especially for large-scaleinvestment proposals. Examples of such studies include the following:• Market studies of products to be manufactured, including demand projections in the market and

the anticipated penetration• Raw material and factory supplies, covering current and projected availability and price trends• Laboratory and pilot-plant tests, done to the extent necessary to determine raw material

suitability

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• Environmental impact assessment• Economies of scale studies• Equipment selection studiesWhen a basic input may be a decisive factor in determining the viability of a project, the supportstudy is carried out before commissioning a pre-feasibility study. In most cases the results of afeasibility study, when undertaken prior or together with a feasibility study form an integral partof the latter and lessen its burden and cost.

II. Project Preparation – Feasibility Studies

If the pre-feasibility study indicates that the project is, prima facie, promising and further work is justified, the project enters the stage of preparation. The project, already defined in a sketchyform, is now being advanced to a level at which it can be appraised thoroughly before a decisionis taken on whether to implement it. The analysis of the project’s marketing, technical, financial,economic and institutional aspects should be comprehensive enough to allow the policy makers todecide on the future of the project with confidence. Project preparation takes the form of a

feasibility study conducted by the agency sponsoring the project or by consultants. At this pointit would be helpful to address a question often raised, i.e. What is the difference between a pre-feasibility and a feasibility study. The answer is simple: they differ only with respect to theamount of work needed to decide if a project is viable. The table of contents is the same in both;it is the details and the sophistication that vary.

How Much Preparation: At this point we can ask how far in detail should project preparationadvance before the project is ready for appraisal. This is a practical question and the answerdepends upon the magnitude and the characteristics of the project. Projects that commit relativelysmall amounts of investment funds do not deserve painstaking and expensive preparation. Afterall, the risks taken in implementing small projects are small; of course, what is small is a practical

question. Furthermore, projects that: (i) consist of a large number of small, dispersed components(e.g. hundreds of primary schools or village water supplies) or, (ii) depend heavily on community participation, need not be prepared in detail before an investment decision is made.

Often, those responsible for project planning complain that too much information is asked fromthem and that they have to spend unnecessarily long time in project preparation. In most casestheir complaints are not justified. They should realize that resources are scarce and mistakesexpensive. Furthermore, time spent on project preparation is not lost time. There is a trade-off between project preparation and implementation. The better a project is prepared the easier andfaster its implementation and the lower the probability of cost overruns.

The need for professional project preparation does not imply that this stage should include

engineering design that precedes implementation and which provides more accurate costestimates. However, it is essential that the project is prepared to a level that its characteristics areclearly presented, its objectives and beneficiaries accurately defined and its merits andshortcomings thoroughly discussed. It is only on such a sound base that apprized judgment can be formed by the authorities responsible for investment decisions. Obviously, when it is expectedthat the project will be financed entirely or partly by multilateral or bilateral aid agencies, theirspecific requirements and standards of project preparation should be taken into account.

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Before proceeding to the stage of project appraisal we should mention that pre-feasibility andfeasibility studies become much easier to conduct when precise and comprehensive terms ofreference are prepared for these studies. Issued to a working group of local experts or to outsideconsultants, the terms of reference should make clear that the project should be researchedcarefully and all its aspects illuminated. Those responsible for planning the project should beasked to provide, as a minimum, in their report the information mentioned in these Guidelines

and to follow the methodology adopted here.

III Appraisal and Investment Decision

Up to the completion of preparation, the project has been nursed by the sponsoring agency; now itchanges hands. The project proposal in the form of a feasibility study is submitted to theinvestment decision makers for a broad and impartial appraisal. Appraisal is the comprehensiveand systematic assessment of all aspects of the proposed project. After appraising the projectcarefully, appraisers will decide whether it will be implemented or not, with or without minor

modifications.

Criteria and Questions: At the early stages of the project cycle we might say that the evaluationcriteria are mainly, but not exclusively, technical and micro-economic in character. It is at thisstage, and before an investment commitment is made, that the project should be reviewed again toconfirm that it accords with the broad development objectives, or criteria set by donors, or bankers or other parties who have a stake in the project. The framework within which the projectis appraised is broad and multi-faceted.

An investment decision should be based on based on careful consideration of macro-developmentand project perspectives to ensure that the project represents a high-priority use of the investors’resources. During appraisal, it should be verified that the project, in combination with other

policies, contributes the maximum possible towards achieving certain development objectives.To this end the following questions could be answered to the viability of a project:

(i) does the project belong to a sector where the country needs additional investment:(ii) does the project meet urgent needs of the sector, that is, does it reflect sound sub-

sector allocations;(iii) does the project represent the least-cost alternative in achieving sector and sub-sector

objectives;(iv) is the project of optimum size, too big or too small;(v) is the timing of the project right or the proposed investment is premature;(vi) is the project well designed with reasonably accurate cost and benefit estimates or are

there still many loose ends; and

(vii) if the proposed project is not implemented, what other opportunities exist to use thesame resources (physical, human, and financial).

How smoothly the appraisal will proceed depends on how well the project has been prepared.Even this indicative list of questions shows that a meaningful appraisal is possible only if the project has been carefully and professionally researched and planned.

Appraisal Perspectives: Considered always within the broad development framework, the project, during appraisal, is viewed from different perspectives.

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1. Technical: On the technical side, we must be sure that alternatives have beendiligently considered and that the selected one provides sound solutions.

2. Commercial: Appraisal of the commercial aspect amounts to verifying that themarkets for the output and the inputs of the project have been thoroughlyinvestigated, including the channels of distribution and supply.

3. Financial: From the financial viewpoint, appraisal aims at ensuring that the necessary

funds to implement and operate the project will be Available timely. And whetherthe project is financially viable.

4. Economic: The economic appraisal of the project relates closely to its technicalaspect. Of course, during project preparation cost-benefit analysis should ensure thatthe technological solutions adopted are those that best fit the conditions prevailing inthe country and are not simply the most advanced ones. However, the appraisal stageis where the final review and evaluation of these matters are made.

5. Managerial: From the managerial angle we should check whether the proposed topmanagement and key staff are adequate for the prompt implementation and smoothoperation of the project. Finally, the organizational structure of the project isreviewed to ensure that it provides for: sufficient degree of autonomy; functionalallocation of responsibilities and decision making; and a general administrative

mechanism conducive to the efficient operation of the project.

To the appraisal of these aspects of the project we can add the review of, and a judgment about itsnon-economic dimensions, e.g. dependency for key inputs and outputs on unreliable foreignmarkets. The nature and range of the non-economic aspects vary from project to project andrelate to the stated objectives of the development strategy and the conditions in the country.

Exercise 2.1

1. What is a project cycle?2. List the phases of the UNIDO project cycle.3. Discuss about the sources of project ideas both at a macro and micro levels.

4.

How are opportunity studies, pre feasibility studies and feasibility studies different? Whatsimilarities do they have?Discuss the possible questions that could be answered by a project appraiser? Like forexample a banker

2.2 THE INVESTMENT PHASE

Now that a decision has been reached to invest in your project idea, here you learn about what

you should do while going into the implementation/realization of the project.

1.

The Project in Motion

The next stage in the project is the actual implementation of the project, followed by operation.Implementation begins immediately after the final decision on the project ends when it startsrendering the benefits envisaged. While in earlier stages of project planning there was morethinking and less action, in this stage the combination switches in favor of the latter: more actionand less thinking is needed. It is the time when the conclusions reached and the decisions made

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are put into action. Detailed designs and specifications should be drawn, tender documents haveto be prepared, bids should be invited and evaluated, orders for inputs have to be placed andcontracts to be signed, workers should be hired and put to works materials have to be moved tothe site, etc. These are complicated and interrelated activities that should be programmedcarefully and executed diligently if delays and problems are to be avoided, or at least minimized.

The phase is divided into the following stages:a) Establishing the legal, financial and organizational basis for the implementation of the

project.

b) Technology acquisition and transfer, including basic engineering.

c) Detailed engineering design and contracting, including tendering, evaluation of bids and

negotiations. Detailed engineering design will include site preparation final selection oftechnology construction planning and time scheduling as well as flow charts and scaledrawings preparation. Negotiations are concerned with legal obligations arising fromthe acquisition of technology, construction of buildings, purchase and installation ofmachinery, and financing

d) Acquisition of land construction work and installation. This involves site preparationconstruction of buildings and other civil works, together with erection and installation of

equipmente) Pre-production marketing, including the securing of supplies and setting up of the

administration of the firm. This and secures critical supplies prepares the market for thenew product

f) Recruitment and training of personnel. This stage proceeds simultaneously with theconstruction stage to ensure timely commissioning and the expected growth in productivity and efficiency in plant operations.

g) Plant commissioning and start-up. It is usually a brief but technically critical span in project implementation. It links the preceding construction phase with the operational(production) phase. The success achieved in this stage demonstrates the effectiveness ofimplementation planning and execution of the project and has a bearing on the future performance of the project.

The need to pay particular attention to project implementation can not be overemphasized. Nomatter how carefully a project has been prepared and evaluated, the expected benefits are realizedonly when it is properly implemented; it is not project reports but studiously executed projectsthat deliver the envisaged benefits. Of course, it is easier to execute a well prepared project butsound preparation is not a substitute for careful programming and close control duringimplementation. This is all the more so because most projects face problems duringimplementation and some of them can not be identified in advance; they emerge as we proceed inthe execution of the project. Some implementation problems are the result of general factors suchas changes in the economic and political situation of the country or the world market while othersare project specific.

2. The Operational Phase

This is the production phase that commences after commissioning and start-up. The resultantchallenges of this phase are viewed from the short-term perspective and long-term perspective. Inthe shot-term challenges may arise with regard to application of production techniques operation

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of equipment, inadequate labor productivity etc. The long-term view relate to the chosenstrategies and the associated production and marketing costs as well as sales revenues. Thesehave a direct relationship on the projections made during the pre-investment phase. If they provefaulty any remedial measure will not only prove difficult but may be too expensive.

2.3 REHABILITATION AND EXPANSION PROJECTS

So far you have been studying about projects which are new for implementation. Now you

make note of the tasks that should be done for existing projects which require either

rehabilitation (for example when the project is using with obsolete equipments) or expansion

(for example for projects in growth markets)

Figure 2.2: The UNIDO project cycle that incorporates rehabilitation and expansion projects

Pre-selection

Preparation

Identification

Appraisal

Pre-investment

Phase

Negotiation&Contracting

Expansion/Innovation

Operation

Phase

Engineeringdesign

Rehabilitation/Replacement

Commissioning& start-up Construction

Pre- production

marketing

InvestmentPhase

Training

NOTE: It should be noted that rehabilitation and expansion are not stages flowing fromcommissioning and start-up of the project, but rather conceptually different activities each withtheir own cycle

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Rehabilitation

Rehabilitation involves subjecting ailing factories/projects to complete technical, commercial,financial and economic reviews, in order to increase the efficiency of their operations and their profitability and to maintain them as independent entities, as well as decide on theiramalgamation with other plants or even their complete shut down. Rehabilitation proceeds in the

following carefully planned stages:a) Pre-diagnostic stage. This involves the survey of the economy and industrial sector or

branch, to identify the potential candidate enterprises and to choose the enterprises to berehabilitated

b) Diagnostic stage. The weaknesses in the chosen industries as well as the means ofrehabilitation are identified. This stage covers each aspect of the enterprise includingmanagement, energy utilization, environment, marketing, technology and equipment. Inthis context, rehabilitation feasibility studies are implemented.

A comprehensive study on rehabilitation (rehabilitation study) needs to be undertaken beforerehabilitation process can begin. This study should examine the scope and cost of the work to bedone compared with the expected benefits over the project lifetime. The results of the feasibility

study should give an indication whether to rehabilitate or abandon the idea. A team of experts isrequired to perform a rehabilitation study. Its composition depends on the complexity of the workinvolved, but basically the team should have a management and financial analyst (team leader),an industrial economist, a marketing specialist a process specialist, and eventually anenvironmental and sociology consultant. The structure of a feasibility study for a new project andthat of rehabilitation should ideally be the same, with the main objective of determining whetherthe project is viable or not. The rehabilitation study may however be more difficult to carry outdue to the various inherent constraints such as location, existing equipment and employees. Therehabilitation study analyses and makes recommendations on the following:

(i) General management(ii) Corporate objectives and strategy, business plan(iii) Marketing concept (strategic and operational aspects)

(iv)

Raw material and factory supplies(v) Location site and environmental impact assessment(vi) Engineering and technology aspects: plant capacity, production programs,

technological development and transfer, maintenance, energy audit qualitycontrol laboratory testing etc

(vii) Plant organization and overhead costs(viii) Human resources(ix) Project implementation(x) Financial evaluation

c) Short-term rehabilitation measures. During this stage short-term reorganization andrestructuring measures may be undertaken (in the areas of financial management,

inventory control, quality control etc) which do not yet require major capital investment.

d)

Appraisal of project and fund raising. Investors and financiers evaluate the viability ofthe rehabilitation project during project appraisal.

e) Rehabilitation. This stage concludes with the rehabilitation of the project proper. Thestage includes a number of activities ranging from technical and technologicaloverhauling, investment or divestment, quality control, improvement of generalmanagement, advice on sectoral strategy and planning.

Expansion

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Expansion projects are usually carried out with the following main objectives:(i) To increase the quantitative output of products and by products without changing the

product range.(ii) To change the production program by adding new products of the same line.(iii) A combination of the above two objectives.

These objectives can be achieved using the following strategies:

(i) Introduction of shift work(ii) Raising the capacity of the weakest sections of a production line in order to increase

total capacity(iii) Upgrading the technology or increasing the capacity of the entire production lines.

In order to formulate a comprehensive expansion project proposal, the data for the expansion project should be synchronized and consolidated with those of the existing plant. The financialimpact of expansion may be expressed in terms of marginal cost and benefits as well as theeconomic implications of undertaking the expansion and those of not doing so. The procedure forthe preparation of feasibility study for expansion projects is the same as that of new projects, butthis time taking into consideration determinant factors existing in the enterprise.

Exercise 2.2

5. List the stages in the investment phase of the UNIDO project cycle.6. Why do we commission projects before going to full operation of the project? What are

the possible risks involved if we directly go to operation before start up production?7. Assume that you work for Kombolcha Meat Processing Factory (established during the

end of Haile Sellassie Era), what possible recommendations would you provide to thechief executive officer demanding to rehabilitate the factory machineries?

8. If you were a chief strategist to Dashen Beer, what would you advice the GeneralManager to meet the ever increasing demand for its beer?

17



CHAPTER THREE

MARKET AND DEMAND ANALYSIS

INTRODUCTION

In most cases, the first step in project analysis is to estimate the potential size of the market forthe product proposed to be manufactured (or service planned to be offered) and get an idea aboutthe market share that is likely to be captured. In other words, market and demand analysis isconcerned with two broad issues: What is the likely aggregate demand for the product/ service?What share of the market will the proposed project enjoy?

These are very important, yet difficult, questions in project analysis. Intelligent and meaningfulanswers to them call for an in-depth study and assessment of various factors like patterns ofconsumption growth, income and price elasticity of demand, composition of market, nature ofcompetition, availability of substitutes, reach of distribution channels, so on and so forth. Yet,in many cases project feasibility studies seem to make a short shrift if market is attractive” or “the demand is expected to exceed supply” as substitutes for a thorough market and demandanalysis in project evaluation exercises.

Given the importance of market and demand analysis, it should be carried out in an orderly andsystematic manner.

The key steps involved in market and demand analysis are depicted in Exhibit 4.1. This chapter

discusses these steps. It is organized into seven sections as follows:

Situational analysis and specification of objectives Collection of secondary information Conduct of market survey Characterization of the market Demand forecasting Uncertainties in demand forecasting Market planning

Learning Outcomes:

Dear distance learner, after reading this chapter you are expected to:

• Understand the objectives of market and demand analysis of a feasibility study• know the steps involved in market and demand analysis• understand how to specify objectives of the market study, gather information, forecast

demand and plan the marketing strategies• know the factors which vitiate demand forecasting and ways of tackling them

18



3.1 SITUATIONAL ANALYSIS AND SPECIFICATION OF

OBJECTIVES

Dear learner, here please make note that you understand what the informal study is, and how to set objectives before embarking to the formal market study.

In order to sense the relationship between the product and its market, the project analyst mayinformally talk to customers, competitors, middlemen, and others in the industry. Wherever possible, he may look at the experience of the company to learn about the preferences and purchasing power of customers, actions and strategies of competitors, and practices of themiddlemen.

If the above situational analysis generates enough data to measure the market and get a reliablehandle over projected demand and revenues, a formal study need not be carried out, particularlywhen cost and time considerations so suggest. In most cases, of course, a formal study of themarket and demand is warranted. To carry out such a study, it is necessary to spell out itsobjectives clearly and comprehensively. Often this means that the intuitive and informal goals

that guide situational analysis need to be expanded and articulated with greater clarity. Ahelpful approach to spell out objectives is to structure them in the form of questions. Of course,in doing so, always bear in mind how the information generated will be relevant in forecastingthe overall market demand and in assessing the share of the market that the project will capture.This will ensure that questions which are not relevant to the market and demand analysis willnot be asked unnecessarily.

Illustration: Suppose that a small but technologically competent firm has developed animproved hand pumps based on a new principle that appears to offer several advantages overthe traditional pumps. The chief executive of the firm needs information aboutFigure 1 Steps in market and demand analysis

19



Where and how to market the new hand pumps? The objectives of the market and demandanalysis in this case may be to answer the following questions:

o Who are the buyers of pumps?o What is the total current demand for pumps?o How is the demand distributed temporally (pattern of sales over the year) and

geographically?o What is the break-up of demand for pumps of different sizes?o What price will the customers be willing to pay for the improved hand pumps?o How can potential customers be convinced about the superiority of the new

pump?o What channels of distribution are most suited for the pump? What trade

margins will induce distributors to carry it?o What are the prospects of immediate sales?

Exercise 3.1

1. What are the basic questions that will be answered at the conclusion of market anddemand study?

2. Assume that a household honey processing machine manufacturing plant is importedfrom India to be planted in Amhara national Regional state. In your opinion what arethe basic questions you will raise in order to specify the objective of the market study?

3.2 COLLECTION OF INFORMATION

20



In this unit you will learn about the sources of information, methods of collecting

information and cares that must be taken while collecting information from primary and

secondary sources.

In order to answer the questions listed while delineating the objectives of the market study,information may be obtained from secondary and /or primary sources. Secondary informationis information that has been gathered in some other context and is already available. Primaryinformation, on the other hand, represents information that is collected for the first time to meetthe specific purpose on hand. It indicates what is known and often provides leads and cues forgathering primary information required for further analysis.

Evaluation of Secondary Information

While secondary information is available economically and readily (provided the marketanalyst is able to locate it); its reliability, accuracy, and relevance for the purpose underconsideration must be carefully examined. The market analyst should seek to know:

Who gathered the information? What was the objective? When was the information gathered? When was it published? How representative was the period for which the information was gathered? Have the terms in the study been carefully and unambiguously defined? What was the target population? How was the sample chosen? How representative was the sample? How satisfactory was the process of information gathering? What was the degree of sampling bias and non-response bias in the information gathered? What was the degree of misrepresentation by respondents?

CONDUCT OF MARKET SURVEY

Secondary information, though useful, often does not provide a comprehensive basis for marketand demand analysis. It needs to be supplemented with primary information gathered through amarket survey, specific to the project being appraised.

The market survey may be a census survey or a sample survey. The entire population iscovered. (The word ‘population’ is used here in a particular sense. It refers to the totality of all

units under consideration in a specific study. Examples: All industries using milling machines,all readers of the Adiss Admas).

Census surveys are employed principally for intermediate goods and investment goods whensuch goods are used by a small number of firms. In other cases a census survey is prohibitivelycostly and may also be infeasible. For example, it would be inordinately expensive – in factalmost impossible – to cover every user of Lifebuoy or every person in the income bracket Birr10,000 – 15,000.

21



Due to the above mentioned limitations of the census survey, the market survey, in practice, istypically a sample survey. In such a survey a sample of population is contacted or observedand relevant information is gathered. On the basis of such information, inferences about the population may be drawn.

The information sought in a market survey may relate to one or more of the following.

Total demand and rate of growth of demand Demand in different segments of the market Income and price elasticities of demand Motives for buying Purchasing plans and intentions Satisfaction with existing products Unsatisfied needs Attitudes toward various products Distributive trade practices and preferences Socio-economic characteristics of buyers

Steps in a Sample Survey

Typically, a sample survey consists of the following steps:

a. Define the target Population: In defining the target population the important termsshould be carefully and unambiguously defined. The target population may be divided intovarious segments which may have differing characteristics. For example, all television ownersmay be divided into three to four income brackets.

b. Select the Sampling Scheme and Sample Size There are several sampling schemes:

simple random sampling, cluster sampling, sequential sampling, stratified sampling, systematicsampling, and non-probability sampling. Each scheme has its advantages and limitations. Thesample size, other things being equal, has a bearing on the reliability of the estimates- the largerthe sample size, the greater the reliability.

c. Develop the Questionnaire The questionnaire is the principal instrument for elicitinginformation from the sample of respondents. The effectiveness of the questionnaire as a devicefor eliciting the desired information depends on its length, the types of questions, and thewording of the questions. Developing the questionnaire requires a thorough understanding ofthe product/service and its usage, imagination, insights into human behaviour, appreciation ofsubtle linguistic nuances, and familiarity with the tools of descriptive and inferential statistics to

be used later for analysis. It also requires knowledge of psychological scaling techniques if thesame are employed for obtaining information relating to attitudes, motivations, and psychological traits. Industry and trade market surveys, in comparison to consumer surveys,generally involve more technical and specialized questions.

Since the quality of the questionnaire has an important bearing on the results of the marketsurvey, the questionnaire should be tried out in a pilot survey and modified in the light of problems/difficulties noted.

22



Table 1: the questionnaire below is used to ask questions about the qualities of sesame oil being sold in the market.

1 2 3 4 5 Questions Very

good

Good Average Bad Very

bad 1. Which make(s) of oil do you buy most often? Write names of oil(s)

2. What do you think about the seed/s being usedto produce the oil?

3. Do you like the thickness of the oil?

4. What do you think about the flavor of the oil?

5. Do you like the bottle?

6. What do you think about the label?

7. What do you think about the price?

8. Is there anything else that you think is goodabout the oil that you buy at present?

Write answers

9. Is there anything else about the oil that you buythat you would like to see improved?

Write answers

23



Table 2: Another Sample questionnaire about market size and value is depicted as follows.

Questions Answers

About the market size: 1. How often do you buy this product? Daily/weekly/monthly

2. Do you buy different amounts at different times of the year? (Circle answer) Yes/No (Circle answer)

3. When are the times that you buy the most? Write answer

4. How much do you buy each time? Write amount in kg or No.

Packs

5. When are the times you buy the least? Write answer

6. How much do you buy each time? Write amount in kg or No.

Packs

7. What is the amount of food in the pack? Write amount in kg

About the market value:

8. How much do you pay for a pack of the food? Write the amount in currency

9. What is the price difference for larger or smaller packs? Write differences

10. Does the price change at different times of the year? Yes/No (Circle answer)

11. When is the price highest? Write answer

12. When is the price lowest? Write answer

About the customer:

13. Would you say that you have a low, medium or high income inyour household?

Low/medium/high (Circle

answer)

14. In which age group do you belong? Tick answer 1-20

21-40

41-60

Male/Female M/F (Circle answer)

About sales outlets:

15. Where do you usually buy this food: Tick answer

Market stall

Local shop

Kiosk

Supermarket

Street hawker

Directly from producer

Other Write answer

24



d. Recruit and Train the Field Investigators Recruiting and training of fieldinvestigators must be planned well since it can be time consuming. Great care must be taken inrecruiting the right kind of investigators and imparting the proper kind of training to them.Investigators involved in industry and trade market surveys need intimate knowledge of the product and technical background, particularly for products based on sophisticatedtechnologies.

e. Obtain Information as per the Questionnaire from the Sample of Respondents

Respondents may be interviewed personally, telephonically, or by mail for obtaininginformation. Personal interviews ensure a high rate of response. They are, however, expensiveand likely to result in biased responses because of the presence of the interviewer. Mailsurveys by snail mail or e-mail are economical and evoke fairly candid responses. Theresponse rate, however, is often low. Telephonic interviews, common in western countries,have very limited applicability in Ethiopia because telephone tariffs are high and telephoneconnections few.

f. Scrutinize the Information Gathered: Information gathered should be thoroughlyscrutinized to eliminate data which is internally inconsistent and which is of dubious validity.For example, a respondent with a high income and large family may say that he lives in a oneroom tenement. Such information, probably inaccurate, should be deleted. Sometimes datainconsistencies may be revealed only after some analysis. g. Analyze and Interpret the Information: Information gathered in the survey needs to be analyzed and interpreted with care and imagination. After tabulating it as per a plan ofanalysis, suitable statistical investigation may be conducted, wherever possible and necessary.For purposes of statistical analysis, a variety of methods are available. These may be dividedinto two broad categories: parametric methods and non-parametric methods. Parametricmethods assume that the variable or attribute under study conforms to some known distribution. Non-parametric methods do not presuppose any particular distribution.

Results of the data based on the sample survey will have to be extrapolated to the target population. For this purpose, appropriate inflationary factors, based on the ratio of the size ofthe target population to the size of the sample studies, will have to be used.

The statistical analysis of data should be directed by a person who has a good background instatistics as well as economics.

It may be emphasized that the results of the market survey can be vitiated by: (i) non-representative ness of the sample, (ii) imprecision and inadequacies in the questions, (iii)failure of the respondents to comprehend the questions, (iv) deliberate distortions in theanswers given by the respondents, (v) inept handling of the interviews by the investigators, (vi)cheating on the part of the investigators, (vii) slip-shod scrutiny of data, and (viii) incorrect andinappropriate analysis and interpretation of data.

Some Problems

25



A market researcher in a country like Ethiopia has to contend with the following problems:

Heterogeneity of the Country Since it is impossible to cover all the regions/states in an allEthiopia survey, the country has to be divided into broad territories going beyond the state boundaries. However, the heterogeneity of the country makes the task difficult.

Multiplicity of Languages Related to the above difficulty is the problem of multiplicity oflanguages confronted by a research agency interested in conducting an all Ethiopia survey.Design of Questionnaire Scaling techniques, commonly recommended in marketingresearch literature, involve a 5-point scale or a 7- point scale. Such refined scales are not easilyamenable to translation in regional languages. More important, they are often not easilyamenable to translation in regional languages. More important, they are often notcomprehensible to a vast majority of respondents who may lack the education andsophistication to understand them. Hence when refined scaling techniques are used, answerstend to be erratic and inconsistent. It is perhaps desirable to rely more on open-ended questionsand less on pre-coded questions on definite scales.

Exercise 3.2

1. Why do we gather both secondary and primary data when conducting a marketresearch?

2. If you are asked to collect information about customers’ satisfaction on the performance of earthmoving machines working in Oromia regional government, whichsurvey method ( census or sample) do you use? And why?

3. Mention the steps involved in the conduct of market survey.4. What are the likely questions that you want to answer about secondary sources of

information?

3.3 CHARACTERIZATION OF THE MARKET

As per the information gathered, the market researcher will now understand the market by

grouping and regrouping in to different characteristics. Dear distance learner please make

note the different characterizations of the market and why each classification is important in

understanding the market for further studies to come.

Based on the information gathered from secondary sources and through the market survey, themarket for the product/service may be described in terms of the following.

Effective demand in the past and present Breakdown of demand Price Methods of distribution and sales promotion Consumers Supply and competition Government policy

26



Effective Demand in the Past and Present

To weigh the effective demand in the past and present, the starting point typically is apparentconsumption which is defined as:

Production + Imports – Exports – Changes in stock level

The figure of apparent consumption has to be adjusted for consumption of the product by the producers and the effect of abnormal factors. The consumption series, after such adjustments,may be obtained for several years.

In a competitive market, effective demand and apparent consumption are equal. However, inmost of the developing countries, where competitive markets do not exist for a variety of products due to exchange restrictions and controls on production and distribution, the figure ofapparent consumption may have to be adjusted for market imperfections. Admittedly, this isoften a difficult task.

Breakdown of Demand

To get a deeper insight into the nature of demand, the aggregate (total) market demand may be broken down into demand for different segments of the market. Market segments may bedefined by:

(i) nature of product,(ii) consumer group, and(iii) geographical division.

Nature of Product One generic name often subsumes or holds many different products: steelcovers sections, rolled products, and various semi-finished products; commercial vehicles,

cover trucks and buses of various capacities; so on and so forth.

Consumer Groups Consumers of a product may be divided into industrial consumers anddomestic consumers. Industrial consumers may be sub-divided industry-wise. Domesticconsumers may be further divided into different income groups.

Geographical Division A geographical breakdown of consumers is helpful, particularly for products which have a small value-to-weight relationship and for products which requireregular, efficient after-sales service.

Why is segmental analysis required? Segmental information is helpful because the nature ofdemand tends to vary from one segment to another. The demand from consumers in highincome brackets may not be sensitive to price variations whereas the demand from consumersin low income brackets may be very sensitive to price variations and different marketingstrategies may be appropriate for different market segments.

Price

27



Price statistics must be gathered along with statistics pertaining to physical quantities. It may be helpful to distinguish the following types of prices:

(i) manufacturer’s price quoted as FOB (free on board) price of CIF (cost, insurance,and freight) price,

(ii) landed price for imported goods,(iii) average wholesale price, and

(iv) average retail price.

Methods of Distribution and Sales Promotion

The method of distribution may vary with the nature of the product. Capital goods, industrialraw materials or intermediates, and consumer products tend to have different distributionchannels. Likewise, methods used for sales promotion (advertising, discounts, gift schemes,etc.) may vary from product to product.

The methods of distribution and sales promotion employed presently and their rationale must be specified. Such a study may explain certain patterns of consumption and highlight thedifficulties that may be encountered in marketing the proposed products.

Consumers

Consumers may be characterized along two dimensions as follows:Demographic

and sociological Attitudinal_______________

Age PreferencesSex IntentionsIncome HabitsProfession Attitudes

Residence Responses ________Social background___________________________________________

Supply and Competition

It is necessary to know the existing sources of supply and whether they are foreign or domestic.For domestic sources of supply, information along the following lines may be gathered:location, present production capacity, planned expansion, capacity utilization level, bottlenecksin production, and cost structure.

Competition from substitutes and near-substitutes should be specified because almost any

product may be replaced by some other product as a result of relative changes in price, quality,availability, promotional effort, and so on.

Government Policy

The role of the government in influencing the demand and market for a product may besignificant. Governmental plans, policies, and legislations, which have a bearing on the marketand demand of the product under examination, should be spelt out. These are reflected in: production targets in national plans, import and export trade controls, import duties, export

28





Jury of Executive Opinion Method

This method, which is very popular in practice, involves soliciting the opinions of a group ofmanagers on expected future sales and combining them into a sales estimate.

The advantages of this method are:(i) It is an expeditious method for developing a demand forecast.(ii) It permits a variety of factors like economic climate, competitive environment,

consumer preferences, technological developments, and so on, to be included in thesubjective estimates provided by the experts.

(iii) It has immense appeal to managers who tend to prefer their judgment tomechanistic forecasting procedures.

The disadvantages of this method are:(i) The biases underlying subjective estimates cannot be unearthed easily.(ii) The reliability of this technique is questionable.

Delphi Method

This method is used for eliciting the opinions of a group of experts with the help of a mailsurvey. The steps involved in this method are:

1. A group of experts is sent a questionnaire by mail and asked to express their views.2. The responses received from the experts are summarized without disclosing the identity ofthe experts, and sent back to the experts, along with a questionnaire meant to probe further thereasons for the extreme views expressed in the first round.3. The process may be continued for one or more rounds till a reasonable agreement emergesin the view of the experts.

Delphi method appeals to many organizations for the following reasons:(i) It is intelligible to users.(ii) It seems to be more accurate and less expensive than the traditional face-to- face

group meetings.

While the Delphi method is appealing, there are certain questions marks:(a) What is the value of the expert opinion?(b) What is the contribution of additional rounds and feedback to accuracy?

Trend Projection Method

The trend projection method involves (a) determining the trend of consumption by analyzing past consumption statistics, and (b) projecting future consumption by extrapolating the trend.

When the trend projection method is used, the most commonly employed relationship is thelinear relationship.

Yt = a + bTWhere Yt = demand for year t

T = time variablea = intercept of the relationship b = slope of the relationship

30



To estimate the parameters a and b of the linear relationship, the least squares method is used.To illustrate the use of this method, the following demand data for a product will be used asshown in the exhibit next page.

Table 3 Demand Data

Year Demand Year Demand1988198919901991199219931994

101

131417181819

1995199619971998199920002001

20222322242425

For purposes of linear trend analysis, it is convenient to change the time axis as shown below.

Table 5 Change in Time Axis

Actual Year Year for Analysis Actual Year Year for Analysis198819891990199119921993

1994

012345

6

199519961997199819992000

2001

789101112

13

According to the least squares method, the linear relationship is chosen in such a manner thatthe sum of the squared deviations of the observations from the line is minimized. _____________

1. In thousand units.2. The equations for a and b are derived as follows. The sum of the squared deviations is

Σ (Y – a-bT) 2 (1)

To minimize this with respect to a and b, the partial derivatives of this sum with respect to a and b are set equal tozero. This gives:

∑∑ =−−−=−−∂∂ 0)(2)( 2 bT aY bT aY a

(2)

∑∑ =−−−=−−∂

∂0)(2)( 2

bT aY T bT aY b

(3)

From the above equations we get the following:ΣY = Σ(a + bT) (4)

31



ΣTY = Σ(aT + bT2) (5)

Solving these two equations, referred to as normal equations, we get the values of a and b given .

∑∑

−

−=

22 T nT

TY nTY b

T bY a −= The calculation of a and b, for our example, is shown in the table 6.The advantages of the least squares method are: (i) It uses all the observations. (ii) The straightline is derived by an objective statistical procedure. (iii) A measure of goodness of fit isavailable.The limitations of the least squares method are:

(i) The method is somewhat more complicated than the methods discussed earlier.(ii) The results of such an analysis are valid only when certain conditions are satisfied.

Table 6 Calculations in the Least Square Method

T Y TY T2

0 10 0 01 13 13 12 14 28 43 17 51 94 18 72 165 18 90 256 19 114 367 20 140 498 22 176 649 23 207 81

10 22 220 10011 24 264 121

12 24 288 14413 25 325 169

ΣT =91 ΣY =269 ΣTY =1998 ΣT2=819

T = 6.5 Y = 19.21

097.15.591819

5.1748199822

=−

−=

−

−=∑∑

T nT

Y T nTY b

08.125.6097.121.19 =−=−= xT bY a

Where T = timeY = demand N = number of observations

T = mean of T

Y = mean of Ya = intercept b = slope

32



Exponential Smoothing Method

In exponential smoothing, forecasts are modified in the light of observed errors. If the forecastvalue for year t, Ft ,is less than the actual value for year t, S t , the forecast for the year t + 1, F t+1

,is set higher than Ft. If Ft> St, F t+1 is set lower than Ft. In general,

Ft + 1 = Ft + ae t

Figure 3 Least Squares Fitting

Where Ft +1 = forecast for year t + 1

a = smoothing parameter (which lies between 0 and 1)e1 = error in the forecast for year t = S t - F1

Table 7 shows how the forecasts would be arrived at, given an initial forecast of F 1 = 29 and a =0.2 (The choice of these will be discussed later.)

How should the first forecast (F1) and the smoothing parameter (a) be chosen? A simple and

reasonably satisfactory rule of thumb is to choose F1 as the mean of the warm-up sample. (The

warm-up sample consists of several observations preceding the period for which the forecastingexercise is begun.)

For choosing a1 consider several values in the range of 0 to 1 and choose the value whichminimizes the MSE (mean squared error) in the warm-up period. The mean squared error isdefined as

1/n = Σ(Si – Fi)2

Where Si = actual value of sales in period iFi = forecast value of sales in period i N = number of periods in the “warm – up’ sample

33



Table 7 Derivation of Forecasts

Data Forecast Error Forecast for t + 1T (S) (F) (et=St-Ft) Ft+1 = Ft+1 +ae et

1 28.0 29.0 -1.0 F 2 = 29.0 + 0.2 (-1.0) = 28.82 29.0 28.8 0.2 F3 = 28.8 + 0.2 (0.2) = 28.83 28.5 28.8 -0.3 F4 =28.2 + 0.2 (-0.3) = 28.84 31.0 28.7 2.3 F5 =28.07+ 0.2 (2.3) = 28.85 34.2 29.2 5.0 F6 =29.2+ 0.2 (5.0) = 28.86 32.7 30.2 2.5 F7 =30.2 + 0.2 (2.5) = 28.87 33.5 30.7 2.8 F8 =30.7 + 0.2 (2.8) = 28.88 31.8 31.3 0.5 F9 =31.3 + 0.2 (0.5) = 28.89 31.9 31.4 0.5 F10 =31.4 + 0.2 (0.5) = 28.810 34.3 31.5 2.8 F11 =31.5 + 0.2 (2.8) = 28.811 35.3 32.1 3.1 F12 =32.1 + 0.2 (3.1) = 28.8

Moving Average Method

As per the moving average method of sales forecasting, the forecast for the next period is equalto the average of the sales for several preceding periods.

In symbol,

n

S S S F nt t t

t 11

1

... +−−++

++=

Where Ft + 1 = forecast for the next periodSt = sales for the current periodn = period over which averaging is done

To illustrate the use of the moving average technique, consider the following time series. ______________________________________

Year Sales1 28.02 29.03 28.5

4 31.05 34.26 32.77 33.58 31.89 31.9

10 34.311 35.212 36.0 ___

34



If n is set equal to 4 (n has to be specified by the forecaster), the forecast for period 5 will beequal to

(28.0 + 29.0 + 28.5 + 31.0)/4 = 29.1(It may be noted that if n is equal to 4, the first forecast can be made only for period 5.)

The forecast for period 6 is equal to

(S5 + S 4 + S 3 + S 2)/4 = (34.2 + 31.0 + 28.5 + 29.0)/4 = 30.7Other forecasts follow as shown in Table 4.

Table 8 Forecasts

Data Forecast Forecast for t +1T St F t Ft + 1 = (St + S t -1 + St-2 S t-3)/41 28.02 29.03 28.54 31.0

F5 = (28.0 + 29.0 + 28.5 + 31.0) /4 = 29.15 34.2 29.1 F6 = (29.0 + 28.5 + 31.0 + 34.2) /4 = 30.76 32.7 30.7 F7 = (28.5 +31.0 + 34.2 + 32.7) /4 = 31.67 33.5 31.6 F8 = (31.0 + 34.2 + 32.7 + 33.5) /4 = 32.98 31.8 32.9 F9 = (34.0 + 32.7 + 32.7 + 31.8) /4 = 33.19 31.9 33.1 F10 = (32.7 + 33.5 + 31.8 + 31.9) /4 = 32.5

10 34.3 32.5 F11 = (33.5 + 31.8 + 31.9 + 34.3) /4 = 32.911 35.2 32.9 F12 = (31.8 + 31.9 + 34.3 + 35.2) /4 = 33.312 36.0 33.3

In the above illustration, we set n equal to 4. Why should not n be set equal to 3, 5, 6 or andother number? There seems to be no a priori way to determine n; the moving average equation,which is based on a simple arithmetic average, assumes all preceding values of sales areweighted equally. Should the more recent data not be accorded higher weightage? Forexample, it may make more sense to assign weights of 0.1, 0.2, 0.3, and 0.4 to the years t – 3, t-2, t-1, and t respectively. Here again experimentation seems to be the only way to decide thesystem of weights.

Chain Ratio Method

The potential sales of a product may be estimated by applying a series of factors to a measureof aggregate demand. For example, General Foods (US) estimated the potential sales for a new product, a freeze – fried instant coffee (Maxim), in the following manner:

Total amount of coffee sales : 174.5 million units Proportion of coffee used at home : 0.835 Coffee used at home : 145.7 million units Proportion of non-decaffeinated coffee used at home: 0.937 Non – decaffeinated coffee used at home : 136.5 million units

35



Proportion of instant coffee : 0.400 Instant non-decaffeinated coffee used at home : 54.6 million units Estimated long-run market share for Maxim : 0.08 Potential sales of Maxim : 4.37 million units

Another example of the chain ration method may be given. Several years ago a firm planningto manufacture stainless steel blades in India tried to estimate its potential sales in the followingmanner:

Adult male population in the country : 150 million Proportion of adult male population using shaving blades : 0.60 Adult male population using shaving blades : 90 million Number of times in a year a person, who uses shaving blades, shaves: 100 Total shavings done per year : 9,000 million Proportion of shavings done with stainless steel blades : 0.40 Average number of shavings per stainless steel blade : 6 Number of stainless steel blades used per year : 600 million

(9000 million x 0.40) /6 Proportion of the stainless steel blade market the firm could capture: 0.20 Potential sales : 120 million

The chain ratio method uses a simple analytical approach to demand estimation. However, itsreliability is critically dependent on the ratios and rates of usage used in the process ofdetermining the sales potential. While some of these ratios and rates of usage may be based onobjective proportions. Others will have to be subjectively defined.

Consumption Level Method

Useful for a product which is directly consumed, this method estimates consumption level onthe basis of elasticity coefficients, the important ones being the income elasticity of demandand the price elasticity of demand.

Income Elasticity of Demand The income elasticity of demand reflects the responsivenessof demand to variations in income. It is measured as follows:

EI =12

21

12

12

QQ

I I x

I I

QQ

+−

− +

Where E = income elasticity of demand I

Q 1= quantity demanded in the base yearQ2 = quantity demanded in the following yearI1 = income level in the base yearI2 = income level in the following year.

Example The following information is available on quantity demanded and income level:

36



Q1 = 50, Q2 = 55, I 1 = 1,000, and I 2 = 1,020. What is the income elasticity of demand? Theincome elasticity of demand is:

E1 = 81.45055

020,1000,1

000,1020,1

5055=

+

+

−

− x

The information on income elasticity of demand along with projected income may be used toobtain a demand forecast. To illustrate, suppose the present per capita annual demand for paperis 1 kg and the present per capital annual income is BR 18,200. The income elasticity ofdemand for paper is 2. The projected per capita annual income three years hence is expected to be 10 per cent higher (in real terms) than what it is now. The projected per capita demand for paper three years hence will be:

⎪⎭

⎪⎬

⎫

⎪⎩

⎪⎨

⎧

demand

capita

esentper Pr

⎪⎭

⎪⎬

⎫

⎪⎩

⎪⎨

⎧

+

denad of lincomeleve

elasticity xChangein

IncomePercapita

1

= (1) (1 + 0.10 x 2) = 1.2 kg

The aggregate demand projection for paper will simply be:

Projected per capita demand x projected population

The income elasticity of demand differs from one product to another. Further, for a given product, it tends to vary from one income group to another and from one region to another.Hence, wherever possible, disaggregative analysis should be attempted.

Price Elasticity of Demand The price elasticity of demand measures the responsiveness

of demand to variations in price. It is defined as:

12

21

12

12

QQ

PP x

PP

QQ E p

+

+

−

−=

Where E p = price elasticity of demandQ1 = quantity demanded in the base yearQ2 = quantity demanded in the following yearP1 = price per unit in the base yearP2 = price per unit in the following year

Example The following information is available about a certain product: P1 = BR 600,Q1 = 10,000, P2 = BR 800, Q 2 = 9000. What is the price elasticity of demand? The priceelasticity:

37.0000,10000,9

800600

800600

000,10000,9=

+

+

−

−= x E p

37



The price elasticity of demand is a useful tool in demand analysis. The future volume ofdemand may be estimated on the basis of the price elasticity coefficient and expected pricechange. The price elasticity coefficient may also be used to study the impact of variable pricesthat may be obtained in future on the economic viability of the project. In using the priceelasticity measure, however, the following considerations should be borne in mind: (i) The price elasticity coefficient is applicable to only small variations (ii) The price elasticity measure

is based on the assumption that the structure and behavior remain constant.

End Use Method

Suitable for estimating the demand for intermediate products, the end use method, also referredto as the consumption coefficient method, involves the following steps:

Suitable for estimating the demand for intermediate products, the end use method, also referredto as the consumption coefficient method, involves the following steps:

1. Identify the possible uses of the product.2. Define the consumption coefficient of the product for various uses. 3. Project the output levels for the consuming industries.

4. Derive the demand for the product.

This method may be illustrated with an example. A certain industrial chemical, Indchem,is used by four industries, Alpha, Beta, Gamma, and Kappa. The consumption coefficients forthese industries, the projected output levels for these industries for the year X, and the projecteddemand for Indchem are shown in Table9.

Table 9 Projected Demands for Indchem

Consumption Projected Output Projected Demand forCoefficient3 in year X Indchem in year X

Alpha 2.0 10,000 20,000Beta 1.2 15,000 18,000Kappa 0.8 20,000 16,000Gamma 0.5 30,000 69,000

__________________3. This is expressed in tones of Indchem required per unit of output of the consuming industry.

As is clear from the foregoing discussion, the key inputs required for the application of the enduse method are: (i) projected output levels of consuming industries (units), and (ii) consumptioncoefficients. However, it may be difficult to estimate the projected output levels of consumingindustries (units). More importantly, the consumption coefficients may vary from one period to

another in the wake of technological changes and improvements in the methods ofmanufacturing. Hence, the end use method should be used judiciously.

Leading Indicator Method

Leading indicators are variables which change ahead of other variables, the lagging variables.Hence, observed changes in leading indicators may be used to predict the changes in the

38



lagging variables. For example, the change in the level of urbanization (a leading indicator)may be used to predict the change in the demand for air conditioners (a lagging variable).

Two basic steps are involved in using the leading indicator method:(i) Identify the appropriate leading indicator(s).(ii) Establish the relationship between the leading indicator(s) and the variable to the

forecast.

The principal good point of this method is that it does not require a forecast of an explanatoryvariable. Its limitations are that it may be difficult to find appropriate leading indicator (s) andthe lead – lag relationship may not be stable over time.

Econometric Method

An econometric model is a mathematical representation of economic relationship (s) derivedfrom economic theory. The primary objective of econometric analysis is to forecast the future behaviour of the economic variables incorporated in the model.

Two types of econometric models are employed: the single equation model and thesimultaneous equation model. The single equation model assumes that one variable, thedependent variable (also referred to as the explained variable), is influenced by one or moreindependent variables (also referred to as the explanatory variables). In other words, one-waycausality is postulated.

Exercise 3.4

1. Identify the types of forecasting methods discussed above and discuss the merits anddemerits of each method.

2. If you are required to forecast the demand for nigger seed (used as an input to produce edibleoil and animal feed) which method would you use and why?

3. The residents of Bahir Dar town have reached 300,000 in the year 2000. The town’smunicipality wants to determine the number of factory’s required to be constructed bycontractors so that the demand for processed milk (60% of the residents consume processedmilk) in the town will be met by production in the town. Per capita milk consumption in thetown is 1 liter per week. A liter of raw milk when processed gives 100 grams of cream, 50grams of cheese and 850 grams of milk. The population growth rate for the coming 5 years isexpected to be 4% per annum. What is the total demand for processed milk in 2005 in thetown to the nearest Birr?

3.5 UNCERTAINTIES IN DEMAND FORECASTING

Dear distance learner, forecasting is a difficult task prone to different errors. Hence in this

unit please make note of the different factors which could affect the reliability of a demand

forecast and also please carefully examine the subunit which underlines the mechanisms to

tackle the uncertainties.

39



Demand forecasts are subject to error and uncertainty which arise from three principal sources:

Data about past and present market Methods of forecasting Environmental change

Data about Past and Present Markets

The analysis of past and present markets, which serves as the springboard for the projectionexercise, may be vitiated by the following inadequacies of data:

Lack of Standardization Data pertaining to market feature like product price, quantity, cost,income, etc. may not reflect uniform concepts and measures.Few Observations Observation available to conduct meaning analysis may not be-enough. Influence of Abnormal Factors Some of the observations may be influenced by abnormalFactors like war or natural calamity.

Methods of Forecasting

Methods used for demand forecasting are characterized by the following limitations:

Inability to Handle Unquantifiable Factors Most of the forecasting methods, beingquantitative in nature, cannot handle unquantifiable factors which sometimes can be ofimmense significance.

Unrealistic Assumptions Each forecasting method is based on certain assumptions. Forexample, the trend projection method is based on the ‘mutually compensating effects’ premiseand the end use method is based on the constancy of technical coefficients. Uncertainty ariseswhen the assumptions underlying the chosen method tend to be unrealistic and erroneous.

Excessive Data Requirement In general, the more advanced a method, the greater the datarequirement. For example, to use an econometric model one has to forecast the future values ofexplanatory variables in order to project the explained variable. Clearly, predicting the futurevalue of explanatory variables is a difficult and uncertain exercise.

Environmental Changes

The environment in which a business functions is characterized by numerous uncertainties.

The important sources of uncertainty are mentioned below:

Technological Change This is a very important but hard-to-predict factor which influences business prospects. A technological advancement may create a new product which performsthe same function more efficiently and economically, thereby cutting into the market for theexisting product. For example, electronic watches are encroaching on the market formechanical watches.

40



Shift in Governmental Policy In Ethiopia, governmental regulation of business is extensive.Changes in governmental Policy, which may be difficult to anticipate, could have a significanteffect on the business environment: granting of licenses to new companies, particularly foreigncompanies may alter the market situation significantly; relaxation of price and distributioncontrols may widen the market considerably.

Developments on the International Scene Developments on the international scene may have a profound effect on industries. The most classic example of recent times is the OPEC price hikein the last two years (2007 and 2008) which led to a significant increase on the price ofconstruction materials.

Discovery of New Sources of Raw Material Discovery of new sources of raw materials canhave a significant impact on the market situation of several products.

Coping with Uncertainties

Given the uncertainties in demand forecasting, adequate efforts, along the following lines, may be made to cope with uncertainties.

Conduct analysis with data based on uniform and standard definitions. In identifying trends, coefficients and relationships, ignore the abnormal or

out-of-the-ordinary observations. Critically evaluate the assumptions of the forecasting methods and choose

a method which is appropriate to the situation. Adjust the projections derived from quantitative analysis in the light of

unquantifiable, but significant, influences. Monitor the environment imaginatively to identify important changes. Consider likely alternative scenarios and their impact on market and

competition. Conduct sensitivity analysis to asses the impact on the size of demand for

unfavorable and favorable variations of the determining factors from theirmost likely levels.

3.6 MARKET PLANNING

Dear distance learner, in this unit you will study about how you prepare your marketing

plan, in a strategic context. First you make note of the basics of strategic planning then you

carefully study how you can design you marketing strategy.

1. Introduction to Strategic Planning

If you don't know where your business is going, any road will get you there.

What is a Strategic Plan?

Entrepreneurs and business managers are often so preoccupied with immediate issues that theylose sight of their ultimate objectives. That's why a business review or preparation of a strategic

41



plan is a virtual necessity. This may not be a recipe for success, but without it a business ismuch more likely to fail.

Basic Approach to Strategic Planning

A critical review of past performance by the owners and management of a business and the preparation of a plan beyond normal budgetary horizons require a certain attitude of mind and predisposition.

As the precursor to developing a strategic plan, it is desirable to clearly identify the currentstatus, objectives and strategies of an existing business or the latest thinking in respect of a newventure. Correctly defined, these can be used as the basis for a critical examination to probeexisting or perceived Strengths, Weaknesses, Threats and Opportunities. This then leads tostrategy development covering the following issues discussed in more detail below:VisionMissionValuesObjectivesStrategiesGoalsPrograms

2. Key Steps towards a Strategic Plan

The preparation of a strategic plan is a multi-step process covering vision, mission, objectives,values, strategies, goals and programs. These are discussed below.

The Vision

The first step is to develop a realistic Vision for the business. This should be presented as a pen picture of the business in three or more year’s time in terms of its likely physical appearance,size, activities etc. Answer the question: "if someone from Mars visited the business, whatwould they see (or sense)?" Consider its future products, markets, customers, processes,location, staffing etc. Here is a great example of a vision:

The Mission

The nature of a business is often expressed in terms of its Mission which indicates the purposesof the business, for example, "to design, develop, manufacture and market specific productlines for sale on the basis of certain features to meet the identified needs of specified customergroups via certain distribution channels in particular geographic areas". A statement along theselines indicates what the business is about and is infinitely clearer than saying, for instance,"we're in electronics" or worse still, "we are in business to make money" (assuming that the business is not a mint !). Also, some people confuse mission statements with value statements(see below) - the former should be very hard-nosed while the latter can deal with 'softer' issuessurrounding the business. The following table contrasts 'hard' and 'soft' mission statements.

The Values

42



The next element is to address the Values governing the operation of the business and itsconduct or relationships with society at large, customers, suppliers, employees, localcommunity and other stakeholders.

The Objectives

The third key element is to explicitly state the business's Objectives in terms of the results itneeds/wants to achieve in the medium/long term. Aside from presumably indicating a necessityto achieve regular profits (expressed as return on shareholders' funds), objectives should relateto the expectations and requirements of all the major stakeholders, including employees, andshould reflect the underlying reasons for running the business. These objectives could covergrowth, profitability, technology, offerings and markets.

The Strategies

Next are the Strategies - the rules and guidelines by which the mission, objectives etc. may beachieved. They can cover the business as a whole including such matters as diversification,organic growth, or acquisition plans, or they can relate to primary matters in key functional

areas. Use SWOTs to help identify possible strategies by building on strengths, resolving weaknesses, exploiting opportunities and avoiding threats.

Example of a SWOT analysis of a new business in relation to competitors

My proposed business Competitor A Competitor B

Strengths Production likely to besited close to retailers candeliver at short notice.

Good brand imageand range of products.

Product is cheaper than Aand sells well They offergood margin to retailers.

Weaknesses Difficult to find good

packaging.

Products more

expensive than B.Uses syntheticcolors and preservatives.

Poor quality product,

poor label design. I'mtold by retailers thatsupplies are irregular andnot always the amountordered.

Opportunities Retailers say demand for products withoutadditives is increasing. Ican produce withoutadded colors.

Appears to be expandingdeliveries to new areasaccording to newspaperreports.

Threats Strong promotion by A.

There are few wealthyconsumers and price ismost important factor. Iam not yet sure of production costs.

Cheaper products

than B.

May have over-expanded

distribution network andfailing to makedeliveries.

The Goals

43



Next comes the Goals. These are specific interim or ultimate time-based measurements to beachieved by implementing strategies in pursuit of the company's objectives, for example, toachieve sales of $3m in three years time. Goals should be quantifiable, consistent, realistic andachievable. They can relate to factors like market (sizes and shares), products, finances, profitability, utilization, efficiency.

The Programs

The final elements are the Programs which set out the implementation plans for the keystrategies. These should cover resources, objectives, time-scales, deadlines, budgets and performance targets.

It goes without saying that the mission, objectives, values, strategies and goals must be inter-linked and consistent with each other. This is much easier said than done because many businesses which are set up with the clear objective of making their owners wealthy often lackstrategies, realistic goals or concise missions.

Marketing Strategies

You already know in your study of marketing principles that Marketing can be viewed as a setof functions that include product development, packaging, pricing, advertising, and selling,distribution and customer service. Marketing is also a way in which an organization determinesits best opportunities in the marketplace, given its objectives and resources.

The marketing process is divided into a strategic and a tactical phase. The strategic phase hasthree components: segmentation, targeting, and positioning (STP). The organization mustdistinguish among different groups of customers in the market (segmentation), choose which

group(s) it can serve effectively (targeting), and communicate the central benefit it offers to thatgroup (positioning).

The marketing process includes designing and implementing various tactics to achieve itsintended strategies. These tactics are commonly referred to as the “marketing mix”. Thesetactics are also referred to as the “5 Ps”: product, place/ (or market), promotion, price, anddistribution/ (or placement of the product).

The "Marketing Mix"

A comprehensive marketing strategy must address all components of the "MarketingMix": Otherwise the strategy is not complete. Calling it a mix reminds you to try and get the balance right between the different components.

Brand namesome products are sold today on the basis of brand name. A lot of people, for instance, buy Nike products because of the recognition of the Nike brand name and they want to be seenwearing that brand name. Brand name is an important strategy in retail clothing and manyother products or services. Having the brand name can be an important benefit to the

44



consumer. Often brands are associated with a "brand promise". For example, the Volvo brandis associated with automobile safety.

Price/Quality combination

The combination of Price and Quality can be a benefit. Yes, I am paying a higher price, but I

am getting a higher quality product or service (e.g. I am buying an IBM or COMPAQcomputer, because the IBM or COMPAQ name means something for me as opposed to buyinga clone where I am not sure if I am getting the right computer). Though higher price is charged,there is a higher quality benefit perceived by the consumer.Convenience & Accessibility

If it is everywhere, you don’t have to go far to get it and that can be an important package of benefits. Convenience stores are based a marketing strategy that is built wholly around theword "convenience". They are in every neighborhood and, while it costs more to shop fromthere, you only need to run down the street. You will buy certain groceries, odds and ends inthat kind of an outlet.Reliability

Reliability is an important benefit. When we buy transportation services, we want to be sure ofthe reliability of an airline. When we are planning a family vacation, we want to be sure thatwe are going to get there. Obviously there are some things that an airline cannot control, buteven in adverse conditions it gets you there although the flight may be a little late.

Other attributes

There are many other attributes and benefits that are important to the customer and these are notmutually exclusive. The key thing is that you are going to be able to see what the customersees in your products and services, because you cannot develop a good marketing strategywithout looking at the package of benefits that you want to offer, and your package of benefits

might be different from those of your competitors. Different groups (segments) of consumersmight place different emphasis on the various benefits.

Market

The aim of marketing for an organization is to meet certain needs, and in profit-orientedorganizations to meet those needs profitably. Companies must therefore first define whichneeds, and whose needs they can satisfy.

What is a market segment?

A market segment is a group of customers that are alike in terms of:o the way they perceive the product benefits;o the way they value the product;o the way they use the product;o their buyer behavior.

45





customer. Some manufacturers may decide to go directly to the retailer or the consumer. Thereare many choices here in the distribution strategy. You can go through this chain where eachintermediary takes a share of the revenue versus trying to go more direct or skip a stage in thedistribution channel. Another factor in distribution is deciding how intensive you want thedistribution to be. How do you decide whether to use selective versus intensive distribution?

When we decide to use selective distribution, it means that there are fewer locations where thecustomer can buy our product. We are not everywhere. We take this approach when the cost tostock our product is very high. For example for home computers, you might sell through aretail outlet. The inventory cost is very high for that retailer so you don’t want to licenseseveral retail outlets in a small market to sell your product. Their inventory cost is so high andif you create all kinds of competition for them then you are weakening their position.Another consideration is whether customers are willing to travel to a location to purchase the product. For high ticket items like cars, furniture or computers, the customer may be willing totravel to a number of outlets. But for items like toothpaste, it had better beeverywhere. Because they are not willing to travel all around to buy toothpaste, it needs to beavailable in every outlet.

Exercise 3.5

1. What causes uncertainties in demand forecasting?2. What is the most widely used tool to depict the environmental scanning done

by a market researcher?3. What are the components of a market mix?4. What is a market segment? Discuss in detail.

47



CHAPTER FOUR

TECHNICAL ANALYSIS

INTRODUCTION

Analysis of technical and engineering aspects is done continually when a project is beingexamined and formulated. Other types of analysis are closely tangled with technical analysis.The broad purpose of technical analysis is to ensure that the project is technically feasible in thesense that all the inputs required to set up the project are available and to facilitate the mostoptimal formulation of the project in terms of technology, size, location, and so on.

While technical analysis is essentially the preserve of the technical expert, the financial analyst participating in the project appraisal exercise should be able to raise basic issues relating totechnical analysis using common sense and economic logic.

Learning Outcomes: Dear distance learners, after completing studying this chapter you areexpected to know about

• Manufacturing process/ technology• Technical arrangements• Materials and inputs• Product mix• Plant capacity• Location and site

• Machineries and equipments• Structures and civil works• Environmental aspects• Project charts and layouts• Project implementation schedule• Need for considering alternatives

4.1 MANUFACTURING PROCESS/ TECHNOLOGY

The most important points that you should ponder in this unit are existence of alternative technologies to produce a product, factors affecting choice of technology and important points

in selecting appropriate technology.

For manufacturing a product/ service often two or more alternative technologies are available. Forexample:

48



• Soap can be manufactured by the semi-boiled process or the fully boiled process.

Choice of Technology

The choice of technology is influenced by a variety of considerations:• Plant capacity• Principal inputs• Investment outlay and production cost• Use by other units• Product mix• Latest developments• Ease of absorption

Plant Capacity: Often, there is a close relationship between plant capacity and productiontechnology. To meet a given capacity requirement perhaps only a certain production technology

may be viable.

Principal Inputs: The choice of technology depends on the principal inputs available for the project. In some cases, the raw materials available influence the technology chosen. For example,the quality of limestone determines whether the wet or dry process should be used for a cement plant.

Investment Outlay and Production Cost: The effect of alternative technologies oninvestment outlay and production cost over a period of time should be carefully assessed.

Use by Other Units: The technology adopted must be proven by successful use by other units,

preferably in countries like Ethiopia.

Product Mix: The technology chosen must be judged in terms of the total product-mix

generated by it, including saleable by-products.

Latest Developments: The technology adopted must be based on the latest developments inorder to ensure that the likelihood of technological obsolescence in the near future, at least, isminimized.

Ease of Absorption: The case with which a particular technology can be absorbed can influencethe choice of technology; sometimes a high-level technology may be beyond the absorptive

capacity of a developing country which may lack trained personnel to handle that technology.

Appropriateness of Technology

Appropriate technology refers to those methods of production which are suitable to localeconomic, social, and cultural conditions. In recent years, the debate about appropriate

49



technology has been sparked off mainly by Schumacher and others. The advocates of appropriatetechnology urge that the technology should be evaluated in terms of the following questions:

• Whether the technology utilizes local raw materials?• Whether the technology utilizes local man power?• Whether the goods and services produced cater to the basic needs?• Whether the technology protects ecological balance?

• Whether the technology is harmonious with social and cultural conditions?

Exercise 4.1

1. While you are not a technical expert, why do you think you should study about technicalanalysis of a project?

2. Discuss the factors affecting choice of technology for a project?3. Why do you think a Bajaj taxi is an appropriate technology than a Toyota minibus in a

country like Ethiopia?

4.2 TECHNICAL ARRANGEMENTS

Here you make note of the aspects of technical arrangements that could be made between a

project’s sponsor and suppliers of machineries and or technical consultants. Assume that you

are to invest in a huge detergent plant in Dessie Town and try to point out the possible

technical arrangements that you could make as per the points pointed out below.

Satisfactory arrangements must be made to obtain the technical know-how needed for the

proposed manufacturing process. When collaboration is sought, among other things, thefollowing aspects of the agreement must be worked out in detail:

• The nature of support to be provided by the collaborators during the designing of the project, selection and procurement of equipment, installation and erection of the plant,operation and maintenance of the plant, and training of the project personnel.

• Process and performance guarantees in terms of plant capacity, product quality, andconsumption of raw materials and utilities.

• The price of technology in terms of one-time licensing fee and periodic royalty fee.• The continuing benefit of research and development work being done by the collaborator.• The period of the collaboration agreement.• The assistance to be provided and the restrictions to be imposed by the collaborator with

respect to exports.

• The level of equity participation and the manner of sharing management control,especially if the technical collaboration is backed by financial collaboration.

• Assignment of the agreement by either side in case of change of ownership.• Termination of the agreement or other remedies when either party fails to meet its

obligation.• Approach to be adopted in force majeure situations.

50



4.3 MATERIAL INPUTS AND UTILITIES

Dear distance learner in this unit you will learn about the classifications of material inputs

required for the production of out puts of the project understudy. In studying the types of

material inputs different attributes of each of the materials are discussed in brief. Besides, you should pay attention to the basic features of supply marketing and supply program.

An important aspect of technical analysis is concerned with defining the materials and utilitiesrequired, specifying their properties in some detail, and setting up their supply programme. Thereis an intimate relationship between the study of materials and utilities and other aspects of projectformulation, particularly those concerned with location, technology, and equipments.

Material inputs and utilities may be classified into four broad categories:(i) raw materials,(ii) processed industrial materials and components,(iii) auxiliary materials and factory supplies, and

(iv)

Utilities.

Raw Materials

Raw materials (processed and/ or semi-processed) may be classified into four types:(i) agricultural products,(ii) mineral products,(iii) livestock and forest products, and(iv) Marine products.

Agricultural products: In studying agricultural products, the quality must first be examined.

Then, an assessment of the quantities available, currently and potentially, is required. Thequestions that may be raised in this context are: What is the present marketable surplus? What isthe present area under cultivation? What is the likely increase in yield per hectare?

Mineral products: In assessing mineral raw materials, information is required on the quantumof exploitable deposits and the properties of the raw materials. The study should provide detailsof the location, size, and depth of the deposits and the viability of open cast or undergroundmining. In addition, information should be generated on the composition of the ore, level ofimpurities, need for beneficiation, and physical, chemical and other properties.

Livestock and Forest products: Secondary sources of data on livestock and forest products

often do not provide a dependable basis for estimation. Hence, in general, a specific survey may be required to obtain more reliable data on the quantum of livestock produce and forest products.

Marine products: Assessing the potential availability of marine products and the cost ofcollection is somewhat difficult. Preliminary marine operations, essential for this purpose, have to be provided for in the feasibility study.

51



Processed Industrial Materials and Components

Processed industrial materials and components (base metals, semi-processed materials,manufactured parts, components, and sub-assemblies) represent important inputs for a number ofindustries. In studying them the following questions need to be answered: In the case of industrialmaterials, what are their properties? What is the total requirement of the project? What quantitywould be available from domestic sources? What quantity can be procured from foreign sources?How dependable are the supplies? What has been the past trend in prices? What is the likelyfuture behavior of prices?

Auxiliary Materials and Factory Supplies

In addition to the basic raw materials and processed industrial materials and components, amanufacturing project requires various auxiliary materials and factory supplies like chemicals,additives, packaging materials, paint, varnishes, oils, grease, cleaning materials, etc. The

requirements of such auxiliary materials and supplies should be taken into account in thefeasibility study.

Utilities

A broad assessment of utilities (power, water, steam, fuel, etc,) may be made at the time of theinput study though a detailed assessment can be made only after formulating the project withrespect to location, technology, and plant capacity. Since the successful operation of a projectcritically depends on the adequate availability of utilities, the following questions should beraised while conducting the inputs study. What quantities are required? What are the sources ofsupply? What would be the potential availability? What are the likely shortages/ bottlenecks?What measures may be taken to augment supplies?

4.3.1 Supply Marketing and Supply Program

a) Supply marketing

The objectives of supply marketing are basically cost minimization, risk minimization (reliabilityor supplies) and the cultivation of relation with supplier.

(i) Cost Minimization

Input costs can be reduced, inter alia, by selecting appropriate suppliers and by choosing a propervolume and frequency of the orders. Any cost minimization opportunity not identified and

considered during the feasibility study is difficult to make up later during plant operation. Thiscould have then a significant impact on the financial feasibility of the project by reducing the netcash flows and net profits generated. Supply marketing is therefore a vital factor for success.

(ii) Risk Minimization and Reliability of Supplies

Reliability as regards quantities, qualities, deadlines and prices is significant for the entiremanufacturing process. Late deliveries lack of quality or poor maintenance services may haveserious consequences for the entire manufacturing process. These risks must therefore also be

52



considered in the purchasing strategy to ensure that supplies are in accordance with the production requirements.

(iii) Cultivating Relations with the Suppliers

Purchases should be focused not only on acceptable prices, but also on establishing smooth and productive relations with the supplier. In the long run, it can be very advantageous to establish a

relationship of mutual trust.

Supply marketing should be designed to reinforce the bargaining position of a project orenterprise. Purchasing prices and conditions largely depend on the bargaining power of the project and its management. Both short and long term considerations should prevail.

Supply marketing must be carried out all the more intensely in the following cases:

The higher the share of a product in the total purchase volume (the 20-80 rule).Therefore, any increase in the price of one of the goods in the 20 percent group mayhave severe consequences on the profitability of the total project.

The higher the risk of having additional processing costs or production failure (loses,damage,) because of delivery constraints or lack of quality.

Possible supply alternative purchases may be carried out as follows:

Directly by the individual enterprise Through agents, purchasing on their own account or on behalf of enterprise Through purchasing cooperative formed by a number of enterprise

Suppliers should be identified and the input quantities to be purchase from each should be

determined in the study, taking in to account:

Price competitiveness (including stock, transport, and insurances costs) Extras (condition of payment, warranty terms just in time delivery repair and spare

part service, customized packaging etc) Expected suppliers compliance with quality requirements

Risk to, further in-house processing in case of a deviation from specific qualityrequirements.

Expected stability of suppliers relations Reorganization cost incurred through a later change of supplier. Possibility of purchasing directly from manufacturers or wholesalers

Supply Program

The overall purpose of the outline of a supply program in the feasibility study is to show howsupplies of materials and inputs will be secured. Evidence should be presented to justify theassumption and suggestions. Cost estimates should be based on the supply program presented. A

supply program should deal with the following:

a) Identification of Supplying Sources and Suppliers

In the identification of a particular key supplier, consideration should be given to its geographicallocation, ownership, main activities, financial strength and profitability production capacity,output over the last years, key customers and business experience with the type of products andthe country concerned. An estimate of the level of priority that the supplier is likely to give thecontract is crucial.

53



b) Agreement and Regulations

Letter of intent regarding supply contacts and obligation should be referred to and the generalterms of suggested agreements, such as period of validity, payment terms, currency conditionsand guarantees, outlined. Import policies and regulations including application procedures forobtaining import licenses validity periods, permits to acquire or use foreign currency possible tax

exemptions, and duty free imports, the existence of import restrictions etc., should be describedand their consequences for the project analyzed.

c) Consignments

The quantities and qualities that can be supplied from various sources should be indicated. Thismeans that a comparison with the specific input requirements must be made taking in to accountnot only quantity but also environment and health aspects physical and chemical properties etc.

d) Means of Transport

Means of transport for key materials and inputs by air, water, road or rail should be identified inthe study. The availability, capacity, reliability and technical condition of the facilities must beanalyzed. The study should consequently not only identify existing means of transport but also

analyze their condition, describe how they can be used and suggest measures to be taken by thecompany concerned in order to obtained some confidence on the level of reliability and capacity.Loading and unloading facilities should be analyzed too.

e) Storage

Storage facilities are usually required at the plant, but may also be needed at ports, railwaystations, or other places. The study should indicate the capacity of such facilities describe theirutilization and present estimated quantities to be stored on the basis of anticipated productionlevels and delivered of materials and inputs

f) Risk Assessment Identification and assessment of risks and uncertainties in the supply program should be

presented. A distinction should be made between external and internal project risks factors,including failure of suppliers to meet their obligations, delayed consignments, supply shortages,quality defects, transport breakdown, utility malfunctions, strikes, climate variations, changedimport regulations and shortages of foreign exchange for imports.

Exercise 4.2

1. List down the classifications of material inputs.2. How are raw materials classified, discuss the points that should be considered for each of

the classes of raw materials?3. What are the objectives of supply marketing? State them.

4.4 PRODUCT MIX

The choice of product mix is guided by market requirements. In the production of most of theitems, variations in size and quality are aimed at satisfying a broad range of customers. Forexample, a garment manufacturer may have a wide range in terms of size and quality to cater todifferent customers. It may be noted that variation in quality can enable a company to expand itsmarket enjoy higher profitability. For example, a toilet soap manufacturing unit may, by variation

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in raw material, packaging, and sales promotion, offer high profit margin soap to consumers inthe upper-income brackets.

While planning the production facilities of the firm, some flexibility with respect to the productmix must be sought. Such flexibility enables the firm to alter its product mix in response tochanging market conditions and enhances the power of the firm to survive and grow under

different situations. The degree of flexibility chosen may be based on a careful analysis of theadditional investment requirement for different degrees of flexibility.

4.5 PLANT CAPACITY

Here you are to learn about the different aspects of plant capacity and the different factors

which have a bearing on the determination of plant capacity of a project.

Plant capacity (also referred to as production capacity) refers to the volume or number of units

that can be manufactured during a given period. Plant capacity may be defined in two ways: feasible normal capacity (FNC) and nominal maximum capacity (NMC). The feasible normalcapacity refers to the capacity attainable under normal working conditions. This may beestablished on the basis of the installed capacity, technical condition of the plant, normalstoppages, downtime for maintenance and tool changes, holidays, and tool changes, holidays, andshift patterns. The nominal maximum capacity is the capacity which is technically attainable andthis often corresponds to the installed capacity guaranteed by the supplier of the plant. Ourdiscussion will focus on the feasible normal capacity; several factors have a bearing on thecapacity decision. These are:

• Technological requirement• Input constraints• Investment cost

• Market conditions• Resources of the firm• Governmental policy

Technological Requirement

For many industrial projects, particularly in process type industries, there is a certain minimumeconomic size determined by the technological factor. For example, a cement plant should have acapacity of at least 300 tones per day in order to use the rotary kiln method; otherwise, it has toemploy the vertical shaft method which is suitable for lower capacity.

Input Constraints

In a developing country like Ethiopia, there may be constraints on the availability of certaininputs. Power supply may be limited; basic raw materials may be scarce; foreign exchangeavailable for imports may be inadequate. Constraints of these kinds should be borne in mindwhile choosing the plant capacity.

Investment Cost

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When serious input constraints do not exist, the relationship between capacity and investmentcost is an important consideration. Typically, the investment cost per unit of capacity decreases asthe plant capacity increases. This relationship may be expressed as follows:

a

QQC C

⎭⎬⎫

⎩⎨⎧

=2

121

Where C1 = derived cost for Q 1 units of capacityC2 = known cost for Q 2 units of capacity

a =a factor reflecting capacity-cost relationship. This is usually between 0.2 and 0.9.

Example Suppose the known investment cost for 5,000 units of capacity for the manufacturer ofa certain item is BR1, 000,000. What will be the investment cost for 10,000 units of capacity ifthe capacity - cost factor is 0.6?

The derived investment cost for 10,000 units of capacity may be obtained as follows:

000,516,1000,500,10000,000,1

6.0

1 BR xC =⎟ ⎠ ⎞⎜

⎝ ⎛ =

Market Conditions

The anticipated market for the product/ service has an important bearing on the plant capacity. Ifthe market for the product is likely to be very strong, a plant of higher capacity is preferable. Ifthe market is likely to be uncertain, it might be advantageous to start with a smaller capacity. Ifthe market, starting from a small base, is expected to grow rapidly, the initial capacity may behigher than the initial level of demand - further additions to capacity may be effected with the

growth of the market.

Resources of the Firm

The resources, managerial and financial, available to a firm define a limit on its capacity decision.Obviously, a firm cannot choose a scale of operations beyond its financial resources andmanagerial capability.

Government Policy

The capacity level may be influenced by the policy of the government.

Exercise 4.3

1. What affects the product mix for a product?2. While planning the production facilities of the firm, some flexibility with respect to the

product mix must be sought. Why? Discuss.3. Plant capacity may be defined in two ways: feasible normal capacity (FNC) and nominal

maximum capacity (NMC). How are they different?4. List the factors affecting capacity decisions for a project.

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4.6 LOCATION AND SITE

Dear learner please make note of the meaning of site and location in this course context. Plus

what factors might be assessed when selecting location and site of a project. Please try to see your self studying a feasibility study for an investor and how you consider these factors in

selecting the appropriate location for this project.

The choice of location and site follows an assessment of demand, size, and input requirement.Though often used synonymously, the terms 'location' and 'site' should be distinguished. Locationrefers to a fairly broad area like a city, an industrial zone, or a coastal area; site refers to a specific piece of land where the project would be set up.

The choice of location is influenced by a variety of considerations: proximity to raw materialsand markets, availability of infrastructure, labour situation, governmental policies, and otherfactors.

Proximity to Raw Materials and Markets

An important consideration for location is the proximity to the sources of raw materials andnearness to the market for the final products. In terms of a basic locational model, the optimallocation is one where the total cost (raw material transportation cost plus production cost plusdistribution cost for the final product) is minimized. This generally implies that:

(i) a resource-based project like a cement plant or a steel mill should be located close to thesource of the basic material (for example, limestone in the case of a cement plant and iron-ore inthe case of a steel plant); (ii) a project based on imported material may be located near a port; and(iii) a project manufacturing a perishable product should be close to the centre of consumption.

However, for many industrial products proximity to the source of raw material or the centre ofconsumption may not be very important. Petro-chemical units or refineries, for example, may belocated close to the source of raw material, or close to the centre of consumption, or at someintermediate point.

Availability of Infrastructure

Availability of power, transportation, water, and communications should be carefully assessed before a location decision is made.

Adequate supply of power is a very important condition for location-insufficient power can be amajor constraint, particularly in the case of an electricity-intensive project like an aluminum plant. In evaluating power supply the following should be looked into: the quantum of poweravailable, the stability of the power supply, the structure of the power tariff, and the investmentrequired by the project for a tie-up in the network of the power supplying agency.

For transporting the inputs of the project and distributing the outputs of the project, adequatetransport connections - whether by rail, road, sea, inland water, or air - are required. The

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availability, reliability, and cost of transportation for various alternative locations should beassessed.

Given the plant capacity and the type of technology, the water requirement for the project can beassessed. Once the required quantity is estimated, the amount to be drawn from the public utilitysystem and the amount to be provided by the project from surface or sub-surface sources may

determine. For doing this the following factors may be examined: relative costs, relative dependabilities, and relative qualities.

In addition to power, transport, and water, the project should have adequate communicationfacilities like telephone and internet.

Labour Situation

In labour-intensive projects, the labour situation in a particular location becomes important. Thekey factors to be considered in evaluating the labour situation are:

• Availability of labour, skilled, semi-skilled and unskilled

• Prevailing labour rates• Labour productivity• State of industrial relations judged in terms of the frequency and severity of strikes and

lockouts• Degree of unionization

Governmental Policies

Government policies have a bearing on location. In the case of public sector projects, location isdirectly decided by the government. It may be based on a wider policy for regional dispersion ofindustries.

In the case of private sector projects, location is influenced by certain governmental restrictionsand inducements. The government may prohibit the setting up of industrial projects in certainareas which suffer from urban congestion. More positively, the government offers inducementsfor establishing industries in backward areas. These inducements consist of subsidies,concessional finance, sales tax loans, power subsidy, income tax benefits, lower promotercontribution, and so on.

Other Factors

Several other factors have to be assessed as well before arriving at a location decision.

These are:• Climatic conditions• General living conditions• Proximity to ancillary units• Ease in coping with pollution

Climatic Conditions: The climatic conditions like temperature, humidity, wind, sunshine,rainfall, snowfall, dust, flooding, and earthquakes have an important influence on location

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decision. They have a bearing on the cost as they determine the extent of air-conditioning, de-humidification, and refrigeration, special drainage, and so on required for the project.

General Living Conditions: The general living conditions like the cost of living, housingsituation, safety, and facilities for education, health care, transportation and recreation need to be

assessed carefully.

Proximity to Ancillary Units: Most firms depend on ancillary units for components and parts.If the ancillary units are located nearby coordination becomes easy, transportation costs arelower, and inventory requirements become considerably less.

Ease in Coping With Environmental Pollution A project may cause environmental pollution in various ways: it may throw gaseous emissions; it may produce liquid and soliddischarges; it may cause noise, heat, and vibrations. The location study should analyze the cost ofmitigating environmental pollution to tolerable levels at alternative locations.

Site Selection

Once the broad location is chosen, attention needs to be focused on the selection of a specific site.Two to three alternative sites must be considered and evaluated with respect to cost of land andcost of site preparation and development.

The cost of land tends to differ from one site to another in the same broad location. Sites close toa city cost more whereas sites away from the city cost less. Sites in an industrial area developed by a governmental agency may be available at a concessional rate.

The cost of site preparation and development depends on the physical features of the site, theneed to demolish and relocate existing structures, and the work involved in obtaining utilityconnections to the site. The last element, viz, the work involved in obtaining utility connectionsand the cost associated with it should be carefully looked into. It may be noted in this context thatthe cost of the following may vary significantly from site to site: power transmission lines fromthe main grid, railway siding from the nearest rail-road, feeder road connecting with the mainroad, transport of water, and disposal of effluents.

4.7 MACHINERIES AND EQUIPMENT

Dear learner in this unit please make note of relation ship between technology selection and

plant capacity, and determination of the machineries and equipments for a project.

The requirement of machineries and equipment is dependent on production technology and plantcapacity. It is also influenced by the type of project. For a process-oriented industry, like a petrochemical unit, machineries and equipment required should be such that the various stagesare matched well. The choice of machineries and equipment for a manufacturing industry issomewhat wider as various machines can perform the same function with varying degrees ofaccuracy. For example, the configuration of machines required for the manufacture of

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refrigerators could take various forms. To determine the kinds of machinery and equipmentrequired for a manufacturing industry, the following procedure may be followed:

(i) Estimate the likely levels of production over time.(ii) Define the various machining and other operations.(iii) Calculate the machine hours required for each type of operation.(iv) Select machineries and equipment required for each function.

The equipment required for the project may be classified into the following types:(i) plant (process) equipment,(ii) mechanical equipment,(iii) Electrical equipment,(iv) Instruments,(v) Controls,(vi) internal transportation system, and(vii) others.

In addition to the machineries and equipment, a list should be prepared of spare parts and toolsrequired. This may be divided into: (i) spare parts and tools to be purchased with the original

equipment, and (ii) spare parts and tools required for operational wear and tear.

Constraints in Selecting Machineries and Equipment

In selecting the machineries and equipment certain constraints should be borne in mind: (i) theremay be a limited availability of power to set up an electricity-intensive plant like, for example, alarge electric furnace; (ii) there may be difficulty in transporting heavy equipment to a remotelocation; (iii) workers may not be able to operate, at least in the initial periods, certainsophisticated equipment such as numerically controlled machines; (iv) the import policy of thegovernment may preclude the import of certain machineries and equipment.

Procurement of Plant and Machinery

For procuring the plant and machinery, orders for different items of the plant and machinery may be placed with different suppliers or a turnkey contract may be given for the entire plant andmachinery to a single supplier. The factors to be considered in selecting the supplier (s) of the plant and machinery are the desired quality of machinery, the level of technologicalsophistication, the relative reputation of the various suppliers, the expected delivery schedules,the preferred payment terms, and the required performance guarantees. If in house technicalexpertise is inadequate, external consultant (s) may be employed to select the plant andmachinery and supervise the installation of the same.

4.8 STRUCTURES AND CIVIL WORKS

Structures and civil works may be divided into three categories: (i) site preparation and

development, (ii) buildings and structures, and (iii) outdoor works.

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Site Preparation and Development

This covers the following: (i) grading and leveling of the site; (ii) demolition and removal ofexisting structures; (iii) relocation of existing pipelines, cables, roads, power lines, etc., (iv)reclamation of swamps and draining and removal of standing water; (v) connections for thefollowing utilities from the site to the public network: electric power (high tension and low

tension), water for drinking and other purposes, communications (telephone, telex, internet, etc.),roads, railway sidings; and (vi) other site preparation and development work.

Buildings and Structures

Buildings and structures may be divided into: (i) factory or process buildings; (ii) ancillary buildings required for stores, warehouses, laboratories, utility supply centers, maintenanceservices, and others; (iii) administrative buildings; (iv) staff welfare buildings, cafeteria, andmedical service buildings; and (v) residential buildings.

Outdoor Works

Outdoor works cover (i) supply and distribution of utilities (water, electric power,

communication, steam, and gas); (ii) handling and treatment of emission, wastages, and effluents;(iii) transportation and traffic signals; (iv) outdoor lighting; (v) landscaping and (vi) enclosureand supervision (boundary wall, fencing, barriers, gates, doors, security posts, etc).

4.9 ENVIRONMENTAL ASPECTS

A project may cause environmental pollution in various ways: it may throw gaseous emissions; itmay produce liquid and solid discharges; it may cause noise, heat, and vibrations.

Projects that produce physical goods like cement, steel, paper, and chemicals by convertingnatural resource endowments into saleable products are likely to cause more environmentaldamage. Hence the environmental aspects of these projects have to be properly examined. The

key issues that need to be considered in this respect are:

• What are the types of effluents and emissions generated?• What needs to be done for proper disposal of effluents and treatment of emissions?• Will the project be able to secure all environmental clearances and comply with all

statutory requirements?

Exercise 4.4

1. What is the difference between location and site?

2. What affects the choice of location for a project? Discuss briefly.3. What must be examined in selecting a site for a project?4. In determining the kinds of machinery and equipment required for a manufacturing

industry what aspects are considered?5. What constraints will you face in selecting machineries and equipments?6. Discuss about the classifications of structures and civil works.7. How a project may affect its environment?

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CHAPTER SIX

FINANCIAL ESTIMATES AND PROJECTIONS

INTRODUCTION

The previous two chapters covered technical appraisal and market and demand appraisal. In thischapter you will study about the discussion on financial appraisal which will be covered throughthe next chapter.

In this chapter we will discuss the estimates and projections required for financial appraisal. Thediscussion is guided to a large extent by the information required by financial institutions when

promoters seek financial assistance from them.

Learning Outcomes: Dear distance learner, at the end of your study of this chapter you areexpected to know about:

• cost of project• Means of financing• Estimates of sales and production• Cost of production• Working capital requirement and its financing• Profitability projections• Projected cash flow statements

• Projected balance sheets

Before we dwell on the above financial estimates and projections, it is helpful to know how theyare interrelated. Figure 1 presents a schematic diagram showing the interrelationship.

6.1 COST OF PROJECT

This unit you will learn about the types of capital expenditures called costs of the project. Please make note that cost of a project is costs incurred for which the goods/services are

believed to serve the project for a long period of time. For a detailed discussion of the topic

please refer your financial accounting I module; accounting for balance sheet part.

Conceptually, the cost of project represents the total of all items of outlay associated with a project which are supported by long-term funds. It is the sum of the outlays on the following.

• Land and site development

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• Buildings and civil works• Plant and machinery• Technical know-how and engineering fees• Expenses on foreign technicians and training of technicians abroad• Miscellaneous fixed assets• Preliminary and capital issue expenses• Per-operative expenses• Margin money for working capital• Initial cash losses”

Figure 6.1. Financial projections

Balance Sheet

Cash FlowStatement

Means of Financeand Time phasing

Cost of Project andTime Phasing

Interest and LoanRepayment

Depreciation

Estimate ofWorking Results

Interest on WCACost of Production

Working Capital Needs Working Capital

Advance WCA

Production plan

Projected Sales

Tax Factor

1. Land and site development

The cost of land and site development is the sum of the following:

• Basic cost of land including conveyance and other allied charges

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• Premium payable on leasehold and conveyance charges• Cost of leveling and development• Cost of laying approach roads and internal roads• Cost of gates• Cost of tube wells

The cost of land varies considerably from one location to another. While it is very high in urban andeven semi-urban locations, it is relatively low in rural locations. The expenditure on site developmenttoo varies widely depending on the location and topography of the land.

2. Buildings and civil works

Buildings and civil works cover the following:• Buildings for the main plant and equipment• Buildings for auxiliary services like steam supply, workshops, laboratory, water supply, etc• Go downs, warehouses and open yard facilities• Non-factory buildings like canteen, guest houses, time office, excise house, etc

• Quarters for essential staff • Silos, tanks, wells, chests, basins, cisterns, hoppers, bins, and other structures necessary for

installation of the plant and equipment • Garages• Sewers, drainage, etc• Other civil engineering works.

The cost of the buildings and civil works depends on the kinds of structures required which, in turn,are dictated largely by the requirements of the manufacturing process. Once the kinds of structuresrequired are specified, cost estimates are based on the plinth area and the rates for various types ofstructures. These rates, of course, vary with the location to some extent.

3. Plant and machinery

The cost of the plant and machinery, typically the most significant component of the project cost,consists of the following:

• Cost of imported machinery: This is the sum of (i) FOB (free on board) value, (ii)shipping, freight, and insurance cost, (iii) import duty, and (iv) clearing, loading,unloading, and transportation charges.

• Cost of indigenous machinery: if any and (ii) railway freight and transport charges to thesite.

• Cost of stores and spares• Foundation and installation charges

The cost of the plant and machinery is based on the latest available quotation adjusted for possible escalation, generally, the provision for escalation is equal to the following product:(latest rate of annual inflation applicable to the plant and machinery) x (length of the delivery period).

4. Technical Know-How and Engineering Fees

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Often it is necessary to engage technical consultants or collaborators from Ethiopia and/or abroadfor advice and help in various technical matters like preparation of the project report, choice oftechnology, selection of the plant and machinery, detailed engineering and so on. While theamount payable for obtaining the technical know-how and engineering services for setting up the project is a component of the project cost, the royalty payable annually, which is typically a percentage of sales, is an operating expense taken into account in the preparation of the projected

profitability statements.

5. Expenses on Foreign Technicians and Training of Technicians Abroad

Services of foreign technicians may be required in Ethiopia for setting up the project andsupervising the trial runs. Expenses on their travel, boarding, and lodging along with their salariesand allowances must be shown here. Likewise, expenses on technicians who require training abroadmust also be included here.

6. Miscellaneous Fixed Assets

Fixed assets and machinery which are not part of the direct manufacturing process may bereferred to as miscellaneous fixed assets. They include items like furniture, office machinery andequipment, tools, vehicles, railway siding, diesel generating sets, trans formers, boilers, pipingsystems, laboratory equipment, workshop equipment, effluent treatment plants, fire fightingequipment, and so on. Expenses incurred for the procurement or use of patents, licenses, trademarks, copyrights, etc and deposits made with the electricity board may also be included her.

7. Preliminary and Capital Issue Expenses

Expenses incurred for identifying the project, conducting the market survey, preparing thefeasibility report, drafting the memorandum and articles of association and incorporating thecompany are referred to as preliminary expenses.

Expenses borne in connection with the raising of capital from the public are referred to as capitalissue expenses. The major components of capital issue expenses are underwriting commission, brokerage fees to managers and registrars, printing and postage expenses, advertising and publicity expenses, expenses, listing fees, and stamp duty.

8. Pre-Operative Expenses

Expenses of the following types incurred till the commencement of commercial production arereferred to as pre-operative expenses: (i) establishment expenses, (ii) rent, rates, and taxes, (iii)traveling expenses, (iv) interest and commitment charges on borrowings, (v) insurance charges,(vi) mortgage expenses, (vii) interest on deferred payments, (viii) start up expenses, and (ix)miscellaneous expenses.

Pre- operative expenses are directly related to the project implementation schedule. So, delays in project implementation, which are fairly common, tend to push up these expenses. Appreciative

65



of these financial institutions allow for some delay (20 to 25 percent) in the projectimplementation schedule and accordingly permit a cushion in the estimate for pre- operativeexpenses.

Pre-operative expenses incurred up to the point of time the plant and machinery are set up aretreated as revenue expenditure. The firm may, however, treat them as deferred revenue

expenditure and write them off over a period of time.

9. Provision for contingencies

A provision for contingencies is made to provide for certain unforeseen expenses and priceincreases over and above the normal inflation rate which is already incorporated in the costestimates.

To estimate the provision for contingencies the following procedure may be followed: (i) Dividethe project cost items into two categories, vise, ‘firm’ cost items and ‘non-firm’ cost items (firmcost items are those which have already been acquired or for which definite arrangements have been made). (ii) set the provision for contingencies at 5 to 10 percent of the estimated cost of non-firm cost items. Alternatively, Make a provision of 10 percent for all items (including the marginmoney for working capital) if the implementation period is one year or less. For every additionalone year, make an additional provision of 5 percent.

10. Margin money for working capital

The principal support for working capital is provided by commercial banks and trade creditors.

However, a certain part of the working capital requirement has to come from long-term sources of

finance. Referred to as the’ margin money for working capital’ this is an important element of the project cost.

The margin money for working capital is sometimes utilized for meeting over-runs in capital cost.This leads to a working capital problem (and sometimes a crisis) when the project iscommissioned. To mitigate this problem, financial institutions stipulate that a portion of the loanamount, equal to the margin money for working capital, be blocked initially so that is can bereleased when the project is completed.

11. Initial cash losses

Most of the projects incur cash losses in the initial years. Yet, promoters typically do not disclosethe initial cash losses because they want the project to appear attractive to the financialinstitutions and the investing public. Failure to make a provision for such cash losses in the project cost generally affects the liquidity position and impairs the operations. Hence prudencecalls for making a provision, overt or covert, for the estimated initial cash losses.

Exercise 6.1

1. What are the basic components of cost of a project?

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2. Discuss the basic similarities between a Preliminary and capital issue expenses andorganization cost that you learned in Financial Accounting Part I of your study.

3. Why do you think initial cash losses are to be capitalized than treated as recurrentexpenditures?

4. Try to depict the diagram indicating aspects of financial projections.

6.2. MEANS OF FINANCE

This part of the chapter deals with the possible sources of financing a project. Different means

of finance are resorted and discussed briefly. The means of finances are Share capital, Term

loans, Debenture capital, deferred credit, Incentive sources and miscellaneous sources. Here

you have to also ponder the points about how to plan the means of finance.

1. Means of Finance

Share capital : There are two types of share capital- equity capital and preference capital. Equity capital represents the contribution made by the owners of the business, the equityshareholders, who enjoy the rewards and bear the risks of ownership. Equity capital being a riskcapital carries no fixed rate of dividend. Preference capital represents the contribution made by preference shareholders and the dividend paid on it is generally fixed.

Term loans: Term loans are provided by development, mortgage and commercial banks. Termloans represent secured borrowings which are very important source (and often the major source)for financing new projects as well as for the expansion, modernization, and renovation schemesof existing firms.

Debenture Capital: Debenture capital similar to promissory notes, debentures is instruments forraising debt capital. There are two broad types of debentures: non-convertible debentures and

convertible debentures. Non convertible debentures are straight debt instruments. Typically theycarry a fixed rate of interest and have a maturity period of 5 to 9 years. Convertible debentures, asthe name implies, are debentures which are convertible, wholly or partly, into equity shares. Theconversion period and price are announced in advance

Deferred Credit: Many a time, the suppliers of the plant and machinery offer a deferred creditfacility under which payment for the purchase of the plant and machinery can be made over a period of time, such type of arrangements are what we call deferred credits.

Incentive sources: The government and its agencies may provide financial support as anincentive to certain types of promoters or for setting up industrial units in certain locations these

incentives may take the form of seed capital assistance (provided at a nominal rate of interest toenable the promoter to meet his contribution to the project), or capital subsidy (to attractindustries to certain locations), or tax deferment or exemption for a certain period. For examplethe government of Ethiopia provides many incentive packages to investors in selected industriessuch as flower farming, construction, hospitals and education sectors. These incentives includetax holiday for a certain period of the life of a project, duty free import of machineries andequipments, and lease free delivery of lands.

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Miscellaneous sources: A small portion of the project finance may come from miscellaneoussources like unsecured loans, public deposits, and leasing and hire purchase finance. Unsecuredloans are typically provided by the promoters to bridge the gap between the promoters’contribution (as required by the financial institutions) and the equity capital the promoters cansubscribe to. Public deposits represent unsecured borrowings different from the conventional termloans and debenture capital.

2. Planning the means of finance

We have described the various means of finance that can be tapped for a project. How should yougo about determining the specific means of finance for a given project? The guidelines andconsiderations that should be borne in mind for this purpose are as follows:

• Norms of regulatory bodies and financial institutions

• Key business considerations

Norms of regulatory bodies and financial institutions: In some countries, the proposedmeans of finance for a project must either be approved by a regulatory agency or conform tocertain norms laid down by the government or financial institutions in this regard. The primary purpose of such regulations is to impart prudence to project financing decisions and provide ameasure of protection to investors. In addition, the norms of financial institutions, which often provide substantial assistance to projects significantly shape and circumscribe project financingdecisions. In Ethiopia, the regulatory body for all financial institutions is National Bank ofEthiopia which outlines loan policies to be followed by banks. And Development Bank ofEthiopia is especially established to grant loan to development projects. It has also its ownnorms under the umbrella of national policies.

Key business considerations: The key business considerations which are relevant for the

project financing decision are: cost, risk, control and flexibility.

Cost in general: The cost of debt funds is lower than the cost of equity funds. Why? The primaryreason is that the interest payable on debt capital is a tax-deductible expense whereas the dividend payable on equity capital is not

Risk : The two main sources of risk for a firm (or project) are: business risk and financial risk.Business risk refers to the variability of earnings before interest and taxes and arises mainly fromfluctuations in demand and variability of prices and costs. Financial risk represents the riskarising from financial leverage. It must be emphasized that while debt capital is cheap it is alsorisky because of the fixed financial burden associated with it.

Generally the affairs of the firm are, or should be, managed in such a way that the total risk borne by equity shareholders, which consists of business risk and financial risk, is not unduly high. Thisimplies that if the firm is exposed to a high degree of business risk, its financial risk should bekept low. On the other hand, if the firm has a low business risk profile, it can assume a highdegree of financial risk.

Control: From the point of view of the promoters of the project, the issue of control is important.They would ordinarily prefer a scheme of financing which enables them to maximize their

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• Labour cost

• Factory overhead cost

Materials

The most important element of cost, the material cost comprises the cost of raw materials,chemicals, components, and consumable stores required and the prices payable for them thequantities in which these materials are required and the prices payable for them. While estimatingthe material cost, the following points should be borne in mind:

1. The requirements of various material inputs per unit of out put may be establishedon the basis of one or more of one or more of the following: (a) theoreticalconsumption norms, (b) experience of the industry (c) Performance guarantees, and(d) specification of machinery suppliers.

2. The total requirement of various material inputs can be obtained by multiplying the

requirements per unit of out put with the expected out put during the year.3. The prices of material inputs are defined in CIF (cost insurance, and freight) terms.4. The present cost of various material inputs is considered. In other words, the factor

of inflation is ignored. It may be recalled that the factor of inflation is ignored inestimating the sales estimating the sales revenues too.

5. If seasonal fluctuations in prices are regular, the same must be considered inestimating the cost of material inputs.

Utilities

Utilities consist of power, water and fuel. The requirements of power, water, and fuel may bedetermined on the basis of the basis of the norms specified by the collaborators, consultants, etc,or the consumption standards in the industry, whichever is higher.

The cost of power shown here would include only the cost of bought out power and it may beestimated on the basis of power tariff structure of the concerned electricity boards. The cost ofcaptive power would naturally be reflected in the cost of fuel, etc. the cost payable to localauthorities and charges payable to some other firms for water and/or steam supply may be shownseparately.

Labour

Labour cost is the cost of all the manpower employed in the factory. Labour cost naturally is afunction of the number of employees and the rate of remuneration. The requirement of workersdepends on the number of operators/ helpers required for operating various machines andmanning various services. The number of supervisory personnel and administrative staff may becalculated on the basis of the general norms prevailing in the industry.

In estimating remuneration rates, the prevailing rates in the industry/ area should be taken intoaccount. The remuneration should include, besides basic pay, dearness allowance, house rentallowance, contribution allowance, medical reimbursement, leave travel concession, provident

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fund contribution, gratuity contribution and bonus payments. In addition, account should be takenof vacations, overtime work, night work, work on holidays etc. sometimes labour cost isestimated by adding a certain percentage, on a global beginning labour cost estimates may beraised at the rate of 5 per cent per annum to allow for annual increment, etc.

Labour cost may be calculated for the year in which the maximum capacity utilisation is first

achieved, for the earlier years, when the capacity utilisation tends to be low, some that lowerlabour costs, but not proportionately lower in relation to capacity, may be assumed.

Factory overheads

The expenses on repairs and maintenance, rent, taxes, insurance on factory assets, and so on atecollectively referred to as factory overheads. Repairs and maintenance expense depends on thestate of the machinery—this expense tends to be lower in the initial years and higher in the lateryears. Rent, taxes insurance, etc. may be calculated at the existing rates. A provision should bemade for meeting miscellaneous factory expenses. In addition, a contingency margin may be provided on the items of factory overheads.

Exercise 6.2

If you are required to prepare estimates of costs of production and sales of an edible oilmanufacturing project,

1. How will you determine the cost of raw materials, assuming that the raw material for producing the oil is nigger seed? (State the items to be considered in determiningthe cost of nigger seed in your locality)

2. If the factory uses electric power bought from Ethiopian Electric Power Corporation, howdo you determine the cost of power in this regard?

3. How do you think will you finance the requirements of working capital in your locality?( First identify the possible sources of finance and discuss whether these possible sources

could be found in your region/locality)

6.4. WORKING CAPITAL REQUIREMENT AND ITS FINANCING

In this unit you will learn about the determination of the requirements of the working capital

of a project that is how you determine the amount of working capital sufficient to finance

operations, and how the working capital is financed

In estimating the capital requirement and planning for its financing, the following points have to be born in mind:

1. The working capital requirement consists of the following: (i) raw materials and components(indigenous as well as imported), (ii) stocks of finished goods. (iv) Debtors, (v) operatingexpenses and (VI) consumable stores.

2. The principal sources of working capital finance are: (i) working capital advances provided bycommercial banks, (ii) trade credit,(iii) accruals and provisions, and (iv) long term sources offinancing.

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3. There are limits to obtaining working capital advances from commercial bands. They are in twoforms (i) the aggregate permissible band finance is specified as per the norms of lending,followed by the lending, followed by the lending bank, (ii) against each current asset a certainamount of margin money has to be provided by the firm.

4. The margin requirement varies with the type of current asset. While there is no fixed formulafor determining the margin amount, the ranges with in which margin requirements for various

current assets lie are as follows:

Raw materials 10-25 percentWork-in-process 20-40 percentFinished goods 30-50 percentDebtors 30-50 percent

6.5. PROFITABILITY, CASH FLOW AND BALANCE SHEET

PROJECTIONS

Given the estimates of sale revenues and cost of production as discussed above, the next step is

to prepare the profitability projections or estimates of working results (as they are referred to

by term-lending financial institutions in Ethiopia).Once the income statement is projected the

next step will be the preparation of cash flow statements and cash flow statements over the

same periods as the income statement.

Current Assets Margin

1. The Estimate of working results

The estimates of working results may be prepared along the following lines:A. Cost of productionB. Total administrative expensesC. Total sales expensesD. Royalty and Know-how payableE. Total cost of production (A+B+C+D)F. Expected salesG. Gross profit before interestH. Total financial expensesI. DepreciationJ. Operating Profit (G-H-I)K. Other incomeL. Preliminary expenses written offM. Profit/loss before taxation(J+K-L) N. Provision for taxationO. Profit after tax (M-N)

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2. Preliminary expense in excess of 2.5 percent of the project cost (excluding workingcapital margin) should be added to fixed assets proportionately to ascertain the value offixed assets for determining the depreciation charge.

3. The income tax Act specifies that the written down value method 4 should be usedkinds of assets.

4. For company law (financial purporting) purposes, depreciation may be either the

written down value (WDV) method or the straight line (SL) method.

Other income: this represents income arising from transactions not part of the normal operations

of the firm. Examples of such transactions are: sale of machinery, disposal of scrap, etc. except

disposal of scrap, which can be reasonably anticipated and estimated, the effects of other non-

operating transactions can hardly be estimated. of course, when non-operating transactions result

in a deficit, other income would be negative-put differently there will be a non-operating loss.

Write-off preliminary expenses: preliminary expenses up to 2.5 percent of the cost of projector capital employed whichever is higher can be amortized in ten equal annual installments.

Profit/loss Before Taxation: this is equal to: operating profit +other income –write-off preliminary expenses.

Provision for taxation: to figure out the tax burden, a sound understanding of the Income taxact-a complicated legislation-and relevant case laws is required. While calculating the taxableincome, a variety of incentives and concessions have to be taken in to account. Once the taxableincome as per the income tax act, is calculated, the tax burden can be figured out fairly easily byapplying the appropriate tax rates. Details pertaining to tax calculation are discussed in anappendix at the end of the book.

Profit after Taxation: this is simply profit/loss before taxation minus provision for taxation. A part of profit after tax is usually paid out as dividend on preference capital and dividend on equitycapital. Retained profit the deference between profit after tax and dividend payment is referred toas retained profit. It is also called ploughed back earnings.

2. Projected Cash Flow Statement

The cash flow statement shows the movement of cash in to and out of the firm and its net impacton the cash balance with in the firm. The format for preparing the cash flow statement is really acash flow budget. As shown in exhibit 6.2, this format calls for preparing the cash flow statementon a half-yearly basis for the construction period and on an annual basis for the operating period(for the construction period and on a half-yearly basis for the first 2 to 3 operating years formanagerial purposes. This would facilitate better financial planning, project evaluation, and fundcontrol.

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Illustration

To illustrate how the projected cash flow statement is prepared let us consider a simple example.The balance sheet of Bahir Dar Enterprises at the end of year n is as follows:

Share capital 100 Fixed assets 180Reserves and surplus 20 Investments -Secured loans 80 Current assets 180Unsecured loans 50 cash 20Current liabilities 90 Recevables 80Provisions 20 Inventories 80

-------- --------360 360

The projected income statement and the distribution of earnings for the year n+1 are given below:

Liabilities and Capital Assets

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Figure 6.2 Cash flow statements

Sources of funds1. share issue

2. Profit before taxation with interest added back3. Depreciation provision for the year4. Development rebate reserve5. Increase in secured medium and long-term borrowings for the project6. Other medium/ long-term loans7. Increase in unsecured loans and deposits8. Increase in bank borrowings for working capital9. Increase in liabilities for deferred payment (including interest) to machinery suppliers10. Sale of fixed assets11. Sale of investments12. Other income ( indicate details)

Total (A)

Disposition of funds1. Capital expenditure for the project2. Other normal capital expenditure3. Increase in working capital*4. Decrease in secured medium and long-term borrowings

- all Ethiopia institutions- SFCs- Banks

5. Decrease in unsecured loans and deposits6. Decrease in bank borrowings for working capital7. Decrease in liabilities for deferred payments ( including interest ) to machinery suppliers8. Increase in investments in other companies9. Interest on term loans

10.

Interest on bank borrowings for working capital11. taxation12. Dividends

- Equity- Preference

13. Other expenditure (indicate details)Total (B)

- Opening balance of cash in hand and at bank- Net surplus/deficit (A-B)- Closing balance of cash in hand and at bank

* Working capital here is defined as: (Current assets other than cash) - Current liabilities other than bank borrowings)

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Sales 400Cost of goods sold 300Depreciation 20Profit before interest and taxed 80Interest 20Profit before tax 60Tax 30Profit after tax 30Dividends 10Retained earnings 20

During the year n+1, the firm plans to raise a secured term loan of 20, repay a previous term loan

to the extent of 5, and increase unsecured loans by 10.Current liabilities and provisions areexpected to remain unchanged further, the firm plans to acquire fixed assets worth 30 andincrease its inventories by 10. Receivables are expected to increase by 15. Other assets wouldremain unchanged, excepting, of course, cash. The firm plans to pay 10 by way of equity divided.

Given the above information, the projected cash flow statement of Bahir Dar Enterprises is shownin Figure 6.3

Figure 6.3 Projected Cash Flow Statements of Bahir Dar Enterprises

A Sources of Funds

Profit before tax with interest added back 80Depreciation 20Increase in secured loans 15Increase in unsecured loans 10Total (A) --------------- 125

B Disposition of funds

Capital expenditure 30Increase in working capital 25Interest 20Taxation 30Dividends—Equity 10

Total (B) ------------------ 115

Opening balance of cash in hand and at bank 20 Net surplus/deficit (A-B) 10Closing balance of cash in hand and at bank 30

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3. Projected Balance sheet

The balance sheet, showing the balance in various asset and liability accounts, reflects thefinancial condition of the firm at a given point of time. The liabilities side of the balance sheetshows the sources of finance employed by the business. Share capital consists of paid-up equityand preference capital. Reserves and surplus represent mainly the accumulated retained earnings.They are shown in different accounts like the capital reserve, the investment allowance reserve,and the general reserve. Secured loans represent the borrowings of the firm against which securityhas been provided. The important components of secured loans are debentures, term loans fromfinancial institutions, and loans from commercial banks. Unsecured loans represent borrowingsagainst which no specific security has been provided. The important constituents are: fixeddeposits from public and unsecured loans from promoters. Current liabilities are obligationswhich mature in the near future, usually a year. These obligations arise mainly from items whichenter the operating Cycle: payables from acquiring materials and supplies used in production, andaccruals of wages, salaries, and rentals. Provisions include mainly tax provision, provision for provision for provident fund, precision for pension and gratuity, provision for proposeddividends.

The assets side of the balance sheet shows how funds have been used in the business. The majorasset components may be described briefly. Fixed assets are tangible long- lived resourcesordinarily used for producing goods and services. They are shown at original cost lessdepreciation. Investments represent financial securities owned by the firm. Current assets, loansand advances consist of cash, debtors, inventories of different kinds, and loans and advancesmade by the firm. Miscellaneous expenditures and losses represent outlays not covered by the previously described asset accounts and accumulated losses, if any.

For preparing the projected balance sheet at the end of year n+1 we need information about thefollowing:

• The balance sheet at the end of year n• The projected income statement and the distribution of earnings for the year

n+1The sources of external financing proposed to be tapped in the year n+1.• The proposed repayment of debt capital (long-term, intermediate term, and

short-term ) during the year during the year n+1• The outlays and the disposal of fixed assets during the year n+1• Changes in the level of current assets during the year n+1• The changes in other assets and certain outlays like preoperative and preliminary

expenses ( which are capitalized) during the year n+1• The cash balance at the end of year n+1

Exercise 6.3

1. What are the types of financial projections you are to prepare in order to judge thefinancial viability of a project?

2. Depict the format for preparing cash flow statement of a project?

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CHAPTER SEVEN

INVESTMENT APPRAISAL

INTRODUCTION

In capital budgeting, Also known as "investment appraisal ,(The process in which a businessdetermines whether projects such as building a new plant or investing in a long-term venture areworth pursuing. ) Oftentimes, a prospective project's lifetime cash inflows and outflowsare assessed in order to determine whether the returns generated meet a sufficient target benchmark. There are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.

Figure 7.1

As the picture above illustrates, the capital budgeting decision may be thought of as a cost-benefitanalysis. In essence, we are placing the cash inflows and outflows on a scale (similar to the oneabove) to see which is greater. A complicating factor is that the inflows and outflows may not becomparable: cash outflows (costs) are typically concentrated at the time of the purchase, whilecash inflows (benefits) may be spread over many years. The time value of money principle statesthat a Birr today is not the same as a Birr in the future (because we would all prefer possessingBirr today to receiving the same amount of Birr in the future). Therefore, before we can place thecosts and benefits on the scale, we must make sure that they are comparable. We do this bytaking the present value of each, which restates all of the cash flows into "today's dollars." Onceall of the cash flows are on a comparable basis, they may be placed onto the scale to see if the benefits exceed the costs.

Learning Outcomes:

Dear distance learner, after reading this chapter you will be able to:

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• Why projected cash flows must be judged using an acceptable criteria• Know the types of investment decision criteria; discounted and non discounted

techniques• Understand the merits and demerits of each technique and know the difference between

the discounted and discounted techniques

7.1 CAPITAL IS A LIMITED RESOURCE

In the form of either debt or equity, capital is a very limited resource. There is a limit to thevolume of credit that the banking system can create in the economy. Commercial banks andother lending institutions have limited deposits from which they can lend money to individuals,corporations, and governments. In addition, the Federal Reserve System requires each bank tomaintain part of its deposits as reserves (you can see this balance in any of the commercial banks’financial statements in Ethiopia). Having limited resources to lend, lending institutions areselective in extending loans to their customers. But even if a bank were to extend unlimited loansto a company, the management of that company would need to consider the impact thatincreasing loans would have on the overall cost of financing.

In reality, any firm has limited borrowing resources that should be allocated among the bestinvestment alternatives. One might argue that a company can issue an almost unlimited amountof common stock to raise capital. Increasing the number of shares of company stock, however,will serve only to distribute the same amount of equity among a greater number of shareholders.In other words, as the number of shares of a company increases, the company ownership of theindividual stockholder may proportionally decrease.

The argument that capital is a limited resource is true of any form of capital, whether debt orequity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be deniedmore credit or be charged a higher interest rate, making borrowing a less desirable way to raisecapital.

Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management mustidentify the projects that will contribute most to profits and, consequently, to the value (or wealth)of the firm. This, in essence, is the basis of capital budgeting.

7.2 A RECAPITULATION AT THE TIME VALUE OF MONEY

Recall your study in financial management that the interaction of lenders with borrowers sets

an equilibrium rate of interest. Borrowing is only worthwhile if the return on the loan exceeds

the cost of the borrowed funds. Lending is only worthwhile if the return is at least equal to that

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which can be obtained from alternative opportunities in the same risk class. And here you are

to recapitulate about the time value of money.

The interest rate received by the lender is made up of:

i. The time value of money: the receipt of money is preferred sooner rather than later.Money can be used to earn more money. The earlier the money is received, the greaterthe potential for increasing wealth. Thus, to forego the use of money, you must get somecompensation.

ii. The risk of the capital sum not being repaid. This uncertainty requires a premium as ahedge against the risk; hence the return must be commensurate with the risk beingundertaken.

iii. Inflation: money may lose its purchasing power over time. The lender must becompensated for the declining spending/purchasing power of money. If the lenderreceives no compensation, he/she will be worse off when the loan is repaid than at thetime of lending the money.

a) Future values/compound interest

Future value (FV) is the value in dollars at some point in the future of one or more investments.

FV consists of:

i. The original sum of money invested, andii. The return in the form of interest.

The general formula for computing Future Value is as follows:

FVn = V o (l + r )n

Where: Vo is the initial sum investedr is the interest raten is the number of periods for which the investment is to receive interest.

Thus we can compute the future value of what Vo will accumulate to in n years when it iscompounded annually at the same rate of r by using the above formula.

We can derive the Present Value (PV) by using the formula:

FVn = Vo (I + r)n

By denoting Vo by PV we obtain:

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FVn = PV (I + r)n

by dividing both sides of the formula by (I + r)n we derive:

Rationale for the formula:

As you will see from the following exercise, given the alternative of earning 10% on his money,an individual (or firm) should never offer (invest) more than Br10.00 to obtain Br11.00 withcertainty at the end of the year.

Now attempt exercise 7.1

Exercise 7.1 Future values/compound interest and present values

i. What is the future value of Br10 invested at 10% at the end of 1 year?ii. What is the future value of Br10 invested at 10% at the end of 5 years?

iii. What is the present value of Br 11.00 at the end of one year?iv. What is the PV of Br16.10 at the end of 5 years?

7. 3 CAPITAL BUDGETING TECHNIQUES

In this unit you will learn about the different capital budgeting techniques or what we call

them the investment criteria. Please make note that each of the criteria are used by different

parties as they find them appropriate. But each of them has their own merits and demerits and

if used wisely they supplement one another.

Once the stream of costs and benefits for a given project is defined in the form of cash flows, the project’s worthiness can be decided and investment decision can be made. The financial viabilityof a project could be determined using different methods. These methods could be classified as

discounted cash flow methods and non-discounted cash flow methods.

7.3.1 Non-discounted cash flow methods

The most common non-discounted measures of project worth are:♦ Pay Back Period (PP), and♦ Accounting Rate of Return (ARR)

A. Pay Back Period (PP)

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The CIMA defines payback as 'the time it takes the cash inflows from a capital investment projectto equal the cash outflows, usually expressed in years'. When deciding between two or morecompeting projects, the usual decision is to accept the one with the shortest payback.

Payback is often used as a "first screening method". By this, we mean that when a capitalinvestment project is being considered, the first question to ask is: 'How long will it take to pay

back its cost?' The company might have a target payback, and so it would reject a capital projectunless its payback period was less than a certain number of years.

When the annual cash inflow is a constant sum, the payback period is simply the initialinvestment outlay divided by the annual cash inflow. That is,

PP= Initial Investment outlay/Annual cash inflow.

Examples:

1) Assume a proposal for investment requires an initial outlay of Birr 100,000 and isexpected to bring in an annual cash flow of Birr 25,000 for 8 years. Clearly it will take 4years for the initial investment to be recovered and therefore, the PB is 4 years.

2) Another project worth with a similar outlay of Birr 100,000 but with an annual cash flowof 50,000 Birr for 3 years. It will take 2 years to recover its initial investment, and willtherefore, be preferred than the former. Notice that the PP method ignores the fact thatthe latter project has a lower total cash flow.

If two projects are mutually exclusive (are alternatives as for instance both are office enlargementschemes) ranking becomes useful. Ranking is also necessary when capital rationing is applied.If annual receipts fluctuate overtime (as they often do) we must add together to workout thelength of time taken for initial outlay (Investment cost) to be recovered.Example: Consider two projects A & B each with initial outlay and expected cash flow as set out below.

Year Project A Project B0 Initial Investment 15000 120001 Cash flow 6000 30002 Cash flow 6000 50003 Cash flow 3000 20004 Cash flow 500 10005 Cash flow 300 1000

Question:

a) What is the pay back period for each project? b) Which of the two projects would you choose? Why?

Answer:a) Project A has a PP of 3 years & project B has a PP of 5 years. b) Project A should be preferred to be if the two projects are mutually exclusive or if the

capital cannot cover both. The same will apply if the firm doesn’t wish to expose itscapital to risk beyond a maximum period of 4 years.

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Advantages of the Payback period

♦ Payback can be important: long payback means capital tied up and high investmentrisk. The method also has the advantage that it involves a quick, simple calculationand an easily understood concept.

Limitations of the payback period

♦ It fails to give any considerations to cash proceeds earned after the payback date.It simply emphasizes quick financial returns.

♦ It is a measure of the project’s capital recovery, not profitability.♦ It fails to take into account the time value of money.♦ It is unable to distinguish between projects with the same payback period.♦ It may lead to excessive investment in short-term projects

B. The Accounting Rate of Return

The ARR method (also called the return on capital employed (ROCE) or the return on investment(ROI) method) of appraising a capital project is to estimate the accounting rate of return that the project should yield. If it exceeds a target rate of return, the project will be undertaken.

Note that net annual profit excludes depreciation.

Example:

A project has an initial outlay of Birr 1 million and generates net receipts of Birr 250,000 for 10years.

Assuming straight-line depreciation of Birr100, 000 per year:

000,000,1

000,100000,250 Br Br investment totalon RRthe

−=

= 15%

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= 308 Birr

Our decision is we accept the project since NPV is > 0. In other words, since its present net worthis positive.

Note that a project’s NPV clearly varies with the discount rate used. Usually the higher the

discount rate, the smaller the NPV will be. When NPV=0 the project could be selected because atthis NPV the project is at least able to repay its loan. So, even though the absolute return is zero itcould be possible to undertake the project as it pays the capital outlay.

Decision Rule of NPV for Independent projects and mutually exclusive projects

♦ Independent projects are projects that are not in any way substitutes for each other. In suchcases the decision rule is selecting projects that have a positive NPV, if there is no budgetconstraint.

♦ Mutually exclusive project is a project that can only be implemented at the expense of analternative project as they are in some sense substitutes for each other. Mutually exclusive projects are two versions of the same project with different technology and scale. The decisionrule for such projects is to accept the project with the highest NPV.

Advantages of NPV

♦ The cash flows from the beginning to the end of the project are considered,♦ It gives a measure of the discounted absolute surplus from an Investment,♦ It is particularly used for comparison and selection from among mutually exclusive projects

that are of the same size,♦ It discounts cash flows by the cost of capital which gives explicit recognition to the returns

required by investors,♦ Since it is expressed in Birr the decision maker can easily understand it than percentage and

ratio.

Disadvantages of NPV

♦ The NPV method can be employed in selecting from mutually exclusive projects only whenthe projects are of the same size. If the levels of investment are different deciding theacceptability of the project only on the basis of NPV is misleading.

♦ The discount rate needs to be obtained externally to the method of calculation. That is r isdetermined exogenously.

♦ The opportunity cost of capital (r) is assumed to remain constant throughout the life of the project. But usually the cost of capital changes over the lifespan of the project.

♦ It does not show the exact profitability rate of the project.

B. BENEFIT COST RATIO (BCR)

The second widely used discounted measure of project worth is the benefit cost ratio. This isobtained by dividing the present worth of the benefit stream by the present worth of the coststream. The formal mathematical statement is given as:

BCR = ∑ B i/(1+r)n

∑ C i/ (1+ r)n

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If the IRR is computed for financial appraisal in which all values are measures in market prices, itis called the financial internal rate of return (FIRR). When economic prices are used instead, itwill be termed as economic internal rate of return (EIRR).

NB: An IRR of a series of values such as a cash flow can exist only when at least one value isnegative. If all the values are positive no discount rate can make the NPV equal to zero. No

matter how high the discount rate the NPV of a series would have to be positive if it includes nonegative number. Thus, we need to treat the initial investment as negative.

How do we compute IRR?

The arithmetic rule for computing the IRR relies on using two discount rates. In the NPVcalculation we assume that the discount rate (cost of capital) is known and determine the NPV. Inthe IRR calculation, we set the NPV equal to zero and determine the discount rate that satisfiesthis condition.

To illustrate the calculation of IRR, consider a project that has cash flows of the following

amount of Birr.Year 0 1 2 3 4Cash flow (100,000) 30,000 30,000 40,000 45,000

The IRR is the value of r that satisfies the following equation:

100,000 = 30,000 + 30,000 + 40,000 + 45,000(1+r) 1 (1+r) 2 (1+r) 3 (1+r)4

The calculation r involves a process of trial and error. We try different values of r till we find thatthe right-hand side of the above equation is equal to 100,000. Let us, to begin with, try r=15

percent. This makes the right-hand side equal to:30,000 + 30,000 + 40,000 + 45, 000 = 100,802(1.15) (1.15)2 (1.15)3 (1.15)4

This value is slightly higher than our target value, 100,000. So we will increase the value of rfrom 15 percent to 16 percent. (In general, a higher r lowers and a smaller r increases the right – hand side value). The right had sides becomes the following value at 16% interest rate;

30,000 + 30,000 + 40,000 + 45, 000 = 98,641(1.16) (1.16)2 (1.16)3 (1.16)4

Since this value is now less than 100,000, we conclude that the value of r lies between 15 percentand 16 percent. For most of the purposes this indication suffices.

If a more refined estimate of r is needed, use the following procedure:1. Determine the net present value of the two closest rates of return. In our example

the NPV at 15% is 802 Birr and NPV at 16% is 1,3592. Find the sum of the absolute values of the net present values obtained in step 1.

that is, in our example, 802+1,359 = 2,161.3. Calculate the ratio of the net present value of the smaller discount rate, identified

in step 1, to the sum obtained in step 2. That is, 802/2,161 = 0.37

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4. Add the number obtained in step 3 to the smaller discount rate. That is, 15+0.37= 15.37 percent.

The internal rate of return, calculated in this manner, is a very close approximation to the trueinternal rate of return.

The other alternative formula for computing IRR is

⎥⎦

⎤⎢⎣

⎡⎟⎟ ⎠

⎞⎜⎜⎝

⎛

−−+=

21

1121 )(

NPV NPV

NPV X r r r IRR

Where: r 1 is the lower discount rater 2 is the higher discount rate NPV1 is NPV at the lower discount rate NPV2 is NPV at the higher discount rate

Decision Rule

The formal selection criteria of independent projects based on IRR is to accept a project havingan IRR equal to or greater than the opportunity cost of capital, and it goes:

i) If IRR > cost of capital, we accept the project.ii) If IRR < cost of capital, we reject the project,iii) If IRR = cost of capital, indifferent.

Advantages of IRR

♦ It is clearly understood and it is closer to business man’s rate of return measure,♦ It is determined internally as part of the calculation method, i.e, it conveys direct message

about the yield on the project♦ It is a useful measure to calculate where there is uncertainty about the correct discountrate.

Disadvantages of IRR

♦ It omits a consideration of the size or scale of an investment because it is a ratio.♦ It requires specification of an opportunity cost of capital to make a decision.♦ It might be tedious to calculate

D. MODIFIED IRR (MIRR)

The MIRR is similar to the IRR, but is theoretically superior in that it overcomes twoweaknesses of the IRR. The MIRR correctly assumes reinvestment at the project’s cost ofcapital and avoids the problem of multiple IRRs. However, please note that the MIRR is notused as widely as the IRR in practice.

There are 3 basic steps of the MIRR:

(1) Estimate all cash flows as in IRR.

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(2) Calculate the future value of all cash inflows at the last year of the project’s life.(3) Determine the discount rate that causes the future value of all cash inflows determined in

step 2, to be equal to the firm’s investment at time zero. This discount rate is know asthe MIRR.

Project L:

MIRR S = 16.9%.

MIRR is better than IRR because

1. MIRR correctly assumes reinvestment at project’s cost of capital.

2. MIRR avoids the problem of multiple IRRs.

0 1 2 310%

-100.00 10 60 80.00

100.00Br 0.00 = NPV

PV outflows = Br100

TV inflows = Br158.10.

MIRR = 16.5%

66.0012.10

$158.10 = TV ofinflows

PV costs =( )nMIRR 1

TV

+

E. PROFITABILITY INDEX (PI)

The profitability index, or PI, method compares the present value of future cash inflowswith the initial investment on a relative basis. Therefore, the PI is the ratio of the present

value of cash flows (PVCF) to the initial investment of the project.

investmentInitialPVCF

PI =

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In this method, a project with a PI greater than 1 is accepted, but a project is rejected when itsPI is less than 1. Note that the PI method is closely related to the NPV approach. In fact, ifthe net present value of a project is positive, the PI will be greater than 1. On the other hand,if the net present value is negative, the project will have a PI of less than 1. The sameconclusion is reached, therefore, whether the net present value or the PI is used. In otherwords, if the present value of cash flows exceeds the initial investment, there is a positive net

present value and a PI greater than 1, indicating that the project is acceptable.

PI is also known as a benefit/cash ratio.

Project L

0 1 2 310%

-100.00 10 60 80

PV1 9.09PV2 49.59PV3 60.11

118.79

coastinitial

flowscashof PV

PI =

10.1100

79.118==

Accept project if PI > 1.

Reject if PI < 1.0

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F. EQUIVALENT ANNUAL ANNUITY

What do you do when project lives vary significantly? An easy and intuitively appealingapproach is to compare the “equivalent annual annuity” among all the projects. Theequivalent annuity is the level annual payment across a project’s specific life that has a

present value equal to that of another cash-flow stream. Projects of equal size but differentlife can be ranked directly by their equivalent annuity. This approach is also known asequivalent annual cost, equivalent annual cash flow, or simply equivalent annuity approach.The equivalent annual annuity is solved for by this equation:

Equivalent Annuity = PV (Cash Flows) / (present value factor of n-year annuity)

Exercise 7.3

Case Construction Company wants to purchase new equipment by disposing the old one.

Use the following information to answer the questions that follow.

Case Construction, Inc.The cash outflows of the new assembly line are:

Cost of new asset Br 88,000

Shipping 2,000

Working Capital 4,000

Sale Proceeds of the old asset (24,100)

Tax on Sale of Old Asset 1,000

Present value of the Cash Outflows Br70, 900.

The cash inflows are:

Year 1 Br15,750

Year 2 20,070

Year 3 17,172

Year 4 16,140

Year 5 16,140Year 6 19,888

Using the interest rate of 12%, Compute:

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a. The present value of these cash inflows. b. The net present value of the new asset andc. The internal rate of returnd. Should we accept the purchase of the new equipment? Why?

7.3.3 Net present value vs. internal rate of return

Do the IRR and the NPV rules lead to identical decisions? Yes, provided two conditions aresatisfied;

i) The cash flow of the project must be conventional , implying that the first cash flow(initial investment) is negative and the subsequent cash flows are positive,

ii) The project must be independent, meaning that the project can be accepted orrejected without reference to any other project.

Independent vs. dependent projects

NPV and IRR methods are closely related because:

i) Both are time-adjusted measures of profitability, andii) their mathematical formulas are almost identical.

So, which method leads to an optimal decision: IRR or NPV?

a) NPV vs. IRR: Independent projects

Independent project: Selecting one project does not preclude the choosing of the other.

With conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and IRRlead to the same accept/reject decisions.

Figure 2.1 NPV vs. IRR Independent pro jects

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Agritex is considering building either a one-storey (Project A) or five-storey (Project B) block ofoffices on a prime site. The following information is available:

Initial Investment Outlay Net Inflow at the Year End

Project A -9,500 11,500

Project B -15,000 18,000

Assume k = 10%, which project should Agritex undertake?

55.954.500,91.1

500,11 Br NPV A =−=

64.363,1000,15

1.1

000,18 Br NPV B =−=

Both projects are of one-year duration:

500,91

500,11: Br

R IRR

A

A =+

Br11, 500 = Br 9,500 (1 +R A)

A R+= 1500,9

500,11

19500

500,11−= A R

= 1.21-1

Therefore IRRA = 21%

000,15.1

000,18 Br

R IRR

B

B =+

Br.18, 000 = Br15,000(1 + R B)

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1000,15

000,18− B R

= 1.2-1

Therefore IRRB = 20%

Decision:

Assuming that k = 10%, both projects are acceptable because:

NPVA and NPV B are both positiveIRR A > k AND IRR B > k

Which project is a "better option" for Agritex?

If we use the NPV method:

NPVB (Br1, 363.64) > NPV A (Br954.55): Agritex should choose Project B.

If we use the IRR method:

IRR A (21%) > IRR B (20%): Agritex should choose Project A. See figure 7.3.

Figure 7.3 NPV vs. IRR: Dependent projects

Birr Value

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Decision:

Conflicting, as:

NPV prefers B to AIRR prefers A to B

NPV IRR

Project A Br 3,730.50 36%

Project B Br 17,400.00 21%

See figure 7.4.

Figure 7.4 Scale of investments

To show why:

i) The NPV prefers B, the larger project, for a discount rate below 20%

ii) The NPV is superior to the IRR

a) Use the incremental cash flow approach, "B minus A" approach b) Choosing project B is tantamount to choosing a hypothetical project "B minusA".

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0 1 2 3

Project B - 14,000 7,000 7,000 7,000

Project A - 2,500 1,500 1,500 1,500

"B minus A" - 11,500 5,500 5,500 5,500

09.2

500,5

500,11min == Aus B IRR

= 20%

c) Choosing B is equivalent to: A + (B - A) = B

d) Choosing the bigger project B means choosing the smaller project A plus an additional outlayof Br11,500 of which $5,500 will be realized each year for the next 3 years.

e) The IRR "B minus A" on the incremental cash flow is 20%.

f) Given k of 10%, this is a profitable opportunity, therefore must be accepted.

g) But, if k were greater than the IRR (20%) on the incremental CF, then reject project.

h) At the point of intersection,

NPVA = NPV B or NPV A - NPV B = 0, i.e. indifferent to projects A and B.

i) If k = 20% (IRR of "B - A") the company should accept project A.

This justifies the use of NPV criterion.

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Exercise 7.4

1. Discuss the merits and demerits of the net present value under alternative scenariosdiscussed above.

2. Under what circumstances is the IRR the preferred method than the NPV?

3. Please go to the nearby branch of Development Bank of Ethiopia or Business andConstruction Bank and enquire as to how they evaluate the financial viability of projects approaching them for financing and evaluate the method against what youlearned in this unit.

Documents

Project Module.PDF