4 Main Aspects Project Appraisal by Financial Institutions

The following points highlight the four main aspects project appraisal by financial institutions. The aspects are: 1. Financial Feasibility 2. Technical Feasibility 3. Economic Feasibility 4. Management Competence.

Aspect # 1. Financial Feasibility:

The basic data required for a financial feasibility analysis can be grouped as under:

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(i) Cost of project and means of financing,

(ii) Cost of production and profitability,

(iii) Cashflow estimates during the period of loans outstanding, and 

(iv) Proforma balance sheets as at the end of each financial year during the period of loan.

Cost of Project:

The cost of the project can be broadly classified into the following:

(a) Land and Site Development:

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It includes the cost of the land, conveyance expenses, premium payable on leasehold land, cost of leveling the site and other site development expenses, cost of internal roads, cost of fencing and compound wall and cost of providing gates etc.

(b) Buildings and Civil Works:

It includes construction cost of main factory building, building for auxiliary services, factory administrative building, storehouse, workshops, godowns, ware­houses, open yard facilities, canteen, workers rest rooms, sanitary works, staff quarters etc.

(c) Plant and Machinery:

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It includes the cost of main plant and machinery, stores and spares, auxiliary equipment, transportation cost, installation cost, cost of testruns, foundation cost, cost of erection and commissioning,

(d) Technical know-how and Engineering Fees:

It includes fees payable to provide the technology and know-how and travelling expenses payable to technicians and foreign collaborators etc.

(e) Miscellaneous Fixed Assets:

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It includes the cost of office furniture and equipment like tables, chairs, air-conditioners, water coolers, miscellaneous stores items etc.

(f) Preliminary and Pre-Operative Expenses:

The preliminary expenses includes the cost of raising finances like public issue expenses, commission and fees payable to brokers and consultants in raising term-loans, expenses incurred for incorporation of the company, legal charges, underwriters commissions, cost of advertising the public issue etc.

The pre-operative expenses include salaries, establishment expenses, rent, trail-run expenses and other miscel­laneous expenses incurred before the commercial production.

(g) Provision for Contingencies and Escalation:

It includes the provision for meeting the unforeseen expenses and costs not provided in the other heads of the cost of the project. It also includes the cost of escalation of the major heads of cost like land and site development, building and civil works, plant and machinery, technical knowhow fees etc.

(h) Working Capital Margin:

The working capital margin required for the project, which is not being financed by the banks, will also be included in the cost of project.

Though machinery cost often constitutes a major element in the total project cost, its estimation need not pose major problems since this can be based on competitive quotations. On the other hand, cost of items such as land, site development expenses, ancillary facilities like power and water connections, intangibles like preliminary expenses and preoperative expenses, necessitate a careful inquiry and assessment.

A realistic assessment of project cost with built in cushions (say a reasonable contingency margin) for absorbing normal cost escalations, could take care of the ‘ consequences of delay and cost overrun.

Means of Financing:

There is no ideal pattern concerning means of financing for a project. The means of financing is determined by a variety of factors and considerations like magnitude of funds required, risk associated with the enterprise, nature of industry, prevailing taxation, laws etc.

The following are the sources of finance:

(a) Share capital,

(b) Subsidies,

(c) Long-term borrowing from financial institutions and banks,

(d) Loans from friends and relatives,

(e) Retained earnings, and 

Financial institutions specify certain debt-equity ratios and promoters will have to raise own finances to match these ratios.

Cost of Production and Profitability:

The next step is the assessment of the earning capacity of the project. The unit should be in a position to manufacture the product at a reasonable cost and sell them at a reasonable price which would allow adequate profit margin even in a competitive market.

The profitability of an enterprise depends on the total cost of production and the aggregate sale price of the output. The cost of production and sale estimates are also useful in working out the break-even point, the point at which the income from sales would cover the working costs of the project. At this point the unit begins to make profit.

Cashflow Estimates:

The cashflow estimates are essential to ensure availability of cash to meet the requirements of the project from time to time. The cashflow estimates will show the sources of funds including those arising from depreciation and profits as well as uses of funds including repayment of term loan instalments.

The debt service coverage ratio is arrived at by dividing cash accruals comprising net profits (after taxes, interest on term loans and depreciation added back) by total interest charges and instalments. This will indicate whether the cashflow would be adequate to meet the debt obligations and also provide sufficient margin of safety, the repayment of term loans being drawn taking into consideration the above aspect.

Proforma Balance Sheets:

Proforma balance sheets are drawn for existing concerns going for expansion, as well as, for new projects. However in the case of existing concerns going for expansion, the balance sheets for the past three years are also analyzed and compared, with the projections.

The projected balance sheets can be drawn for the cashflow estimates and profitabil­ity projections. Various ratios are derived from the balance sheets and inferences drawn therefrom.

Aspect # 2. Technical Competence:

The technology may be indigenous or imported through foreign collaboration. In the case of indigenous technology it should be ensured that suitable technical personnel are available.

For technology acquired through collaboration tie-ups, the key areas to be probed are:

(a) The standing of the collaborators and past experience concerning tie-up arrangements with them.

(b) Adequacy of the scope and competitiveness of the terms of the collaboration in relation to the requirements of the project, project engineering, equipment specifications, drawings, process know-how, erection and commissioning of the plant, trial-run operations and performance test, training facilities etc.

(c) Performance guarantee and it’s adequacy in relation to rated capacity of plant and machinery.

(d) Reasonableness of financial and other costs by way of down payment, royalties etc.

The cost of the project should provide for the know-how fee, training expenses, foreign trips etc.

The project needs to be examined with particular reference to the following points regarding the technical feasibility:

Location:

The success of a project generally depends on its proper location yielding the advantages of nearness to the sources of raw material, labour; availability of power and transport facilities and market. The subsidies and other concessions available at certain specified areas are to be compared with these basic infrastructure aspects.

Land and Building:

The land should necessarily be sufficient to take care of future expansion. If the land is on lease, the terms and conditions of the lease to be verified and so also whether the municipal laws regarding construction of building are complied. Actual plant lay out is to be studied before deciding on the size of the building.

Plant and Machinery:

The important aspect to be noted in examining the list of plant and equipments is to ascertain the appropriateness of the process of technology, capacity and the related sectional balances amongst various assembly lines.

It has to be ensured that the cost of equipment is based on proper quotations from suppliers and that suitable provisions have been made for insurance, freight, duty and transportation to site, erection charges and allied expenses. Adequate provision for spare parts is also essential especially if the same have to be imported.

Aspect # 3. Economic Feasibility:

The economic feasibility basically deals with the marketability of the product. Basic data regarding demand and supply of a product in the domestic market so also marginal and also artificial.

Manmade shortages are not to be reckoned as genuine demand and the market analysis is an essential part of a full appraisal. Projection or forecasting of demand is no doubt a complicated matter but is of vital importance. Equally important is to examine the sales promotion proposed by the enterprise and its adequacy.

Aspect # 4. Managerial Competence:

The success of a business enterprise depends largely on the resourcefulness, competence and integrity of its management. However assessment of managerial competence has to be necessarily qualitative, calling for understanding and judgment. The managerial requirements are the experience and capability of the principal promoters to implement and run the project.

The adequacy of the management set up for day-to-day operations like production, maintenance, marketing, finance etc. and also the homogeneity of the management set up.

For a new entrepreneur it will always be advisable to build up a competent team of specialists in the required discipline to join hands with an entrepreneur who has the requisite organizational and managerial expertise in the implementation and operation of the project.

Project Appraisal under Inflationary Conditions:

The project cash flows will arise over a period of time in future. Normally the cash flows are estimated and projected income statement and balance sheet are prepared without considering the uncertainty in projections due to inflation factor. But inflationary situation over the period of projections will make us to take wrongful investment and financing decisions.

Therefore it is necessary to consider the following factors while project appraisal is made under inflationary conditions:

(a) During periods of inflation all the input costs like raw material, wages, power, establishment expenses will be escalated.

(b) Simultaneously the sales realization will also be higher, even though there is no increase in the capacity utilization.

(c) The value of opening and closing stock of finished goods will also be required to show at escalated cost due to increase in cost of production.

(d) The amounts shown in receivables will also have increase due to increase in sales, in proportion to credit sales.

(e) The projected profitability may not be correct if calculations are made without considering the inflation.

(f) During inflation, the working capital requirements of the concern will also be much higher than what is projected under normal circumstances.

(g) The discount factor selected for calculation of NPV, to be fixed at a higher rate, by adding the risk premium to normal discount rate.

(h) During the periods of inflation, the project should be selected on the basis of early payback period. The longer the payback period means higher the risk carried with the cash flows.

(i) A provision is to be included in the cost of project to meet the escalation in project cost and contingencies due to unforeseen circumstances during periods of implementation of the project.

(j) The financial institutions take great care in fixing the interest rates for long-term financing. They will put a covenant in the loan agreement to revise the lending rates of interest in future considering the inflation factor.

(k) The borrower is required to carefully select the sources of finances to see that the cost of capital is minimized and at the same time the financial risk of the concern to be with in the manageable limits.

(l) Proper adjustments are to be carried in the financial projections to give consideration for influence of inflation on the profitability and cash flows.

(m) The desirable rate of return is to be determined keeping in view the inflationary pressures on the cash flows. Such rate must be above the overall cost of capital of the firm and earn a surplus profit for the growth of the concern.

(n) The inflation will erode the purchasing power of money and ultimately the consumers may prefer to cheaper varieties of products or may switch over to other products which are cheaper. Therefore selling prices cannot be much inflated while preparation of projected cash flow and profitability statements.

There is no specific approach prescribed for preparation of projected profitability and cash flow statements, in conditions of inflation. But as a precautionary measure and to reduce the uncertainty of the estimates, it is to be adjusted to inflationary conditions. The financial institutions will appraise and finance the project only when the inflationary tendencies are considered and incorporated into the financial projections.

Restrictive Covenants in Long-Term Loan Agreement:

Once the appraisal of the project has been undertaken by the financial institutions and the competent sanctioning authority has approved the case for the necessary financial assistance, the institution communicates its decision about the sanction of financial assistance giving broadly the terms and conditions of the sanctions. This is known as ‘letter of intent’ or ‘letter of sanction’.

Normally, the institutions have two sets of conditions:

(i) Standard conditions of the institution which are normally applied to all the sanctions.

(ii) Specific conditions which are applied to the particular sanction.

The institutions have standardized the format and have got them printed so far as the standard conditions concerned. Before the institutions take up the case for financing, one of the important requirements is completion of the legal documentation.

The important covenants of the loan agreement would be as follows:

1. Amount of Loan:

The agreement will specify the amount of term loan sanctioned by the institution, and agreed to borrow by the borrower.

2. Interest:

The borrower shall pay interest to the institution at a specified rate on the amounts of loans outstanding from time to time, generally quarterly in each year.

3. Additional Interest:

The loan agreement may also contain a convent for the payment of additional interest in specified circumstances.

4. Commitment Charges:

The commitment charge payable by the borrower to institution on the principal amounts of the loans which have not been drawn by the borrower from time to time or have not been cancelled by the institution.

5. Reimbursement of Costs etc.:

The borrower would be required to pay and reimburse all taxes, duties, costs, charges and expenses in connection with or relating to the loan transaction including costs of investigation of title and protection of institutional interests.

6. Last Date of Withdrawal:

The loan agreement will contain a covenant unless the institution otherwise agrees, the right to make drawls from loans will cease on specified date.

7. Repayment:

The borrower will undertake to repay the principal amounts of loans in accordance with the amortisation schedule specified in the loan agreement.

8. Conversion Right:

Reservation of right by the institution to convert loan into fully paid up equity shares in the borrower company and the rate of conversion and events on which the Institution can exercise such conversion right viz., (i) Default in payment of principal and interest, (ii) Mismanagement in borrowing company affecting the Institution’s interest, (iii) In case of closure of the unit, will also be mentioned in the loan agreement.

9. Security for the Loans:

The loans together with all interest, liquidated damages, commitment charges, premium for prepayment or on redemption, costs and expenses and other monies shall be secured by first mortgage on all borrower’s property, both present and future.

10. Nominee Directors:

The institution will have a right to nominate a director on the board of directors of the borrower company who will not be liable to retire by rotation or removal.

11. Restriction on Payment of Dividends:

The borrower shall not declare any dividends unless it has paid the principal and interest dues to the institution or has made satisfactory provision for this purpose.

12. Expansion or Diversification:

The borrower shall not undertake any new project or expansion without the prior approval of the institution during the period of loan.

13. Inspection of Books and Property:

The institution can carry out periodically technical and financial inspection of the factory both during construction and operating periods of the project and inspection of books of account and records.

14. Investment of Funds:

The borrower shall neither lend its funds to any one, nor invest the same for purchase of shares etc.

15. Change in Scheme:

The borrower shall not make any alterations or modifications in the scheme submitted by it and as approved by the institution without its prior approval.

16. Managing Director:

The appointment of M.D. or any whole time director and the terms of such appointment or reappointment and any changes therein shall be subject to prior approval of the Institution.

17. Changes in Memorandum and Articles of Association:

The borrower shall not make any amendment to its memorandum of association and articles of association during the period when the loan is outstanding, without prior permission of the institution.

18. Unsecured Loans:

The borrower shall undertake not to repay the unsecured loans from the directors during the tenure of loan. The loans from the directors shall not bear any interest.

19. Raising of Resources:

The borrower shall arrange to bring in resources by way of internal generation for implementation of the scheme. In case of any deficit in meeting this requirement or in case of cost overrun in implementation of the project, the directors shall arrange to meet the same from non-interest bearing sources.

20. Physical and Financial Progress:

The borrower shall intimate the institution periodically about the physical progress as well as expenditure incurred on the project and agrees and undertakes to furnish the institution such information or data as may be required.

21. Review of Project Cost:

The institution shall have the right to review the cost of the project before the final disbursement of loans.

22. Withhold Disbursement:

The institution have power to withhold disbursement of the amount of loan equivalent to the provision against margin money for working capital in the cost of the project till such time as the project is completed and build up of working capital commences.

23. Change in Contacts:

The borrower shall obtain prior concurrence of the institution to any modification or cancellation of the borrower’s agreement with its various suppliers.

24. Maintenance of Property:

The borrower shall ensure proper maintenance of the property and is properly insured.

25. Merger Compromise:

The borrower shall not undertake or permit any merger, consolidation, reorganization or amalgamation scheme or compromise with its creditors or shareholders.

26. Material Happenings:

The borrower shall promptly inform the material happenings like strike, lockout, winding up petition, decline in profit, sales, production etc. to the institution.

27. Creation of Subsidiary:

The borrower shall not create any subsidiary or permit any company to become its subsidiary.

28. Raising of Funds:

The borrower shall not issue any debentures, raise any loans, accept deposits from public, issue of equity or preference capital, change its capital structure or create any charge on its assets or give any guarantee without prior approval of lead institution.

The basic objective for incorporating the above covenants in the long-term loan agreement is to protect the interest of the financial institution.

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