Cost of Project and Means of Finance in a Company

When a company or promoter intend to set up a new project or undertaking expansion, diversification, modernization or rehabilitation scheme, it is necessary to ascertain the scheme of the project i.e., cost of project and means of finance.

Cost of Project:

Cost of project is the aggregate of costs estimated to be incurred on various heads for bringing the project into existence. Establishing the cost of project constitutes a critical step in project planning, on the basis of which means of finance is worked out.

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The cost of project usually comprises the following items:

(a) Land and site development,

(b) Factory building,

(c) Plant and machinery,

(d) Escalation and contingencies,

(e) Other fixed assets or miscellaneous fixed assets,

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(f) Technical know-how fees,

(g) Interest during construction,

(h) Preliminary and pre-operative expenses, and 

(i) Margin money for working capital.

Means of Finance:

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For implementation of the project, it is required to raise finance from various sources of finance. After consideration of various aspects attached to different sources of finance, the scheme of finance will be determined.

The scheme of means of finance will generally consist of raising of amounts from the following:

(a) Equity share capital.

i. Promoters, and 

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ii. Public.

(b) Term loans from all India or state level financial institutions.

(c) Debentures.

(d) Unsecured loans.

i. Promoters, and 

ii. Others.

(e) Others.

A hypothetical scheme of cost of project and means of finance is given below:

Illustration 1:

Weldon Ltd. is setting up a project with a total project cost of Rs. 16 crore.

Its cost of project and means of finance are given below:

Margin Money:

The banks and financial institutions maintain a margin while financing the project cost by asking the borrower to bring a certain amount say 20% of the cost of project cost as margin money to safeguard from the changes in the value of assets that are being financed and provided as a security. The quantum of margin money depends on the creditworthiness of the borrower and the nature of security provided to the institution.

The margin money will be brought by the promoters in project financing. Margin money is one of the important factors which are evaluated by financial institutions while considering the project for financial assistance. The margin money required for working capital of the project will be provided in the project cost. In working capital financing, the working capital margin money is to be brought as per the guidelines prescribed by RBI.

The elements of cost of project are divided into tangible assets and non-tangible assets to find out the margin money as illustrated below:

Illustration 2:

Bright Star Ltd. is setting up a project with a total project cost of Rs. 100 lakhs.

The details of its project cost are given below:

Tangible assets are those which are physically present and whose cost can be allocated to either of the above heads. Serial(a) to serial(g) constitute the tangible assets. It is only the escalation and contingencies, which is estimated and may give rise to some scope of error while evaluating margin money.

Interest during construction period pertaining to the interest which the project is required to bear during the implementation of the project. This payment is allowed to be capitalised and is distributed on pro rata basis to the various elements of the cost of the project as mentioned at serial (a) to (f).

Technical know-how fees are also required to be capitalised and the normal choice of capitalising it is to be made to the head of ‘plant and machinery’.

In the above scheme tangible assets constitute 80% of the cost of project and the non-tangible items constitute 20% of the cost of project.

Normally the financial institutions do not finance the non-tangible assets, and it is to be financed by the promoter/borrowing concern.

The tangible assets will be financed between 70% to 85% of the value of the each item of asset.

Suppose if the financial institution maintains the 2: 1 debt-equity ratio, then percentage of margin money is calculated by applying the following formula:

Tangible Assets = Rs. 80 lakhs

Term Loan = RS. 66 Lakhs

Suppose, if the financial institution may like to keep margin of 25% on tangible assets, in such case promoters contribution is calculated as shown below:

Tangible assets 80% Non-tangible assets 20%

Therefore, it is advisable that while planning the project financing, the norms of margin money should be kept in mind to establish a suitable debt-equity ratio and promoters contribution.

Promoters Contribution:

An entrepreneur who promotes the project will also participate in the scheme of finance of the project. The extent of promoter’s participation is considered as sign of interest the promoters show in the project. When the bank/financial institution is asked to participate in the scheme of finance, they would ask the promoters to bring a certain portion, normally between 25 to 50% of the project cost into the equity share capital of the company.

A part of the contribution can be arranged by the promoters from outside sources like arranging investment in capital from friends and relatives. For eligibility of financing, the financial institutions will stipulate minimum promoters contribution which is to be arranged by the promoter. The financial institutions always press for the slightly higher participation in the project.

This is to ensure a long and continued involvement of the promoter in the project. Promoters contribution indicates the extent of their involvement in the project in terms of their own financial stake. The promoters contribution will be provided in the form of subscribing to equity and preference shares issued by the company, unsecured loans, seed capital assistance, venture capital assistance, internal accrual of funds.

Social Cost Benefit Analysis:

‘Social cost’ is a sacrifice or detriment to society. Whether economic, internal or external, social costs are the sacrifices of the society for which the business firm is responsible like air-pollution, water pollution, deficiency due to bankruptcy, depletion and destruction of animal resource, soil erosion, deforestation, impairment of human factor of production, monopoly and social losses, production of dangerous products and explosives, deterioration in the law and order conditions in the industrial estates etc. ‘Social benefit’ is a compensation made to the society in the form of increase in per capita income, employment opportunities, etc.

Social cost benefit analysis (SCBA) is a systematic evaluation of an organization’s social perfor­mance as distinguished from its economic performance. It is concerned with the possible influences on the social quality of life instead of economic quality of life. It analyses all such activities which have a social or macro impact.

The development of an economy not only depends on the quantum of investment but also on the rational and prudent allocation of resources among various competing projects.

The technique is most popular for making socially viable decisions of selection or rejection of projects is based on an analysis of social costs and social benefits of projects. In other words, social cost-benefit analysis is an important technique of comparing economic alternatives.

It is used to determine, (a) which alternative or choice is socially viable (or most suitable) and (b) which alternative is the optimal or the best solution. The need for SCBA arises due to the reason that the criterion used to measure commercial profitability that guides the capital budgeting in the private sector may not be an appropriate criteria for public or social investment decisions.

Private investors are more interested in minimizing the private costs and therefore, take into account only those elements which directly affect, their private gain i.e., private expenses and private benefits. Both the private benefits and private expenses are valued at prevailing market prices. But the existence of externalities in benefits and expenses introduces bias in market-price based investment decisions.

The total benefits expected from a project to the society are composed of the private benefits (internal profit or returns) accruing to owner of the project plus the external benefits (also known as externalities or spillovers). Thus social benefits or returns equals to internal benefits to the owner plus the external benefits to the society as whole.

SCBA is a systematic evaluation of an organization’s social performance as distinguished from its possible inferences on the social quality of life instead of economic quality of life. It analyses all such activities which have a social or macro impact.

The development of an economy not only depends on the quantum of investment but also on the rational and prudent allocation of resources. The technique is most popular for making socially viable decisions of selection or rejection of projects based on an analysis of social cost and social benefits of projects.

As an aid to planning, evolution and decision making, the cost-benefit analysis is a scientific quantitative appraisal of a project to determine whether the total social benefits of the project justify the total social cost. United Nations Industrial Development Organization (UNIDO) and Organization of Economic Cooperation and Development (OECD) have extensively conducted studies on SCBA.

Indicators of Social Desirability of a Project:

A project is also assessed from the social angle in addition to assessment of its commercial viability.

The following social desirability factors will be considered in accepts or reject decisions of a project.

1. Employment Potential:

The employment potential of a project is looked into. A project with high employment potential is considered highly desirable.

2. Foreign Exchange Earnings:

A project with potential to earn foreign exchange to the country or an import substitution project which saves the country’s foreign exchange reserves is highly desirable.

3. Social Cost-Benefit Analysis:

A project with net benefits to the society over the costs to the society is preferred.

4. Capital-Output Ratio:

If the value of expected output in relation to the capital employed is high, the project is given priority over the others.

5. Value Added per Unit of Capital:

The amount invested in the project should generate the value addition to the capital employed by earning surplus profits which can be used for further capital investments to contribute development of the national economy.

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