PROJECT MANAGEMENT &

OPERATIONS RESEARCH
 UNIT-II

Project Cost Estimation &

Project Financing
 CONTENTS

 Project Cost Estimation

 Cost of the Project

 Components of Capital Cost of a Project

 Project Financing

 Sources of Finance

 Role of Financial Institutions in Project Financing

 Covenants attached to Lending

 Cost of the Project

 The cost of the project represents the total cost of all items of outlay associated
with a project.

 The cost of the project should be accurately estimated, as under estimation leads
to shortage of funds during implementation and there is a risk of the project
coming to a grinding halt.

 In case of over estimation of costs there will be idle funds that will be invested
elsewhere by the promoter which will effect the speed of the project.

 Therefore there is a need for correct estimation of project cost.

 Components of Capital Cost of a Project
The following are the components that constitute the capital cost of any project.
1. Land
2. Land development
3. Buildings
4. Plant and machinery
5. Electricals
6. Transport and erection charges
7. Know-how/consultancy fees
8. Miscellaneous assets
9. Preliminary and preoperative expenses
10. Provision for contingencies
11. Margin money for working capital
 Components of Capital Cost of a Project
1.Land
 The project sponsor and investors will have the options of investing in land by purchasing outright or by leasing. These
two options are available to project of any size.
 The component Land comes into picture only after deciding to purchase land and construct building instead of starting
the project in a leased premise.
 When choosing land, project sponsor should ensure that the land is neither too large so as to inflate the project nor too
small so that there is no space for future expansion.
2.Land Development
 The land development, includes costs of levelling, laying internal roads, fencing and gates and landscaping. These
activities also need careful cost estimation.
3.Buildings
 The plant layout suited for the proposed project should be studied and analysed. The main factory building depends
upon the plant layout.
 There may be different buildings for different projects. Ex: Main factory building, Administrative buildings,
Laboratory, Toilet blocks, Overhead/underground storage tanks, health centre, canteen, rest rooms, guest houses,
quarters for essential staff etc.
 It must be ensured that the built-up area of different buildings proposed are sufficient to meet the requirements and no
unnecessary construction is made.
 The costing should include all aspects and designs of the building from its size to its heights and different materials
required to complete the building.
 Components of Capital Cost of a Project
4.Plant and Machinery
 When it comes to plant and machineries, project managers have to give careful
considerations to the different types of machinery that is required for the project.
 From evaluation and analysis carried out by the project team, some plant and machinery
can be purchased from local suppliers while others can be purchased from external
suppliers.
 Project managers can choose the correct plant and machinery for projects by studying the
reputation of the suppliers and through their past performance.
 Quotations from a few reputed machinery suppliers can be obtained and a comparative
study of the prices quoted by them can be done before deciding upon a particular supplier.
 When machines are to be purchased and imported from outside the country, then all
relevant costs have to be included such as import and freight charges etc. It is also
important to factor in spare parts and its expected cost
5.Electricals
 Project managers should ensure that all items related to electrical work such as cables,
panel boards, voltage stabilizers etc. If the project requires an electrician ,then this also
needs to be included into the electrical costs.
 Components of Capital Cost of a Project
6.Transport and erection charges
 The charges that will be incurred for transporting all the plant and machinery from the
suppliers to the project site.
 Erection charge includes machinery foundation cost and machinery assembling and
erection expenses.
7.Know-how/consultancy fees
The following are the expenses that are included under this head.
 Know-how fee for technical consultants
 Expenses of training employees in the production process.
8.Miscellaneous assets
 Miscellaneous assets are that do not form part of the plant and machinery but are allied to
the industrial activity.
Ex.: Office equipment, furniture, fire fighting equipment, water coolers, air-conditioners
etc. Also, bond fees paid as part of a lease or deposits in advances for power connectivity
and water supply etc.
 Components of Capital Cost of a Project
9. Preliminary and Pre-operative Expenses
 The expenses that are incurred before the project takes shape and starts commercial
production. Ex.: Investigation fees, services charges etc. Other expenses that may come
under this category would be pre financed fee that comes before loans are processed and
approved, Interest on term loans during implementation period, mortgage expenses,
expenses on capital issues, insurance charges and other miscellaneous expenses during the
project implementation stages.
10. Provision for contingencies
 There may be deviations to cost assumptions that may have been estimated against costs on
land, land development, building, plant and machinery, electrical, transport and erection etc.
 To take care of any deviation, project managers have to allow for any contingency cost
provisions. This is done by keeping a provision in the project cost which may vary from 5%
to 15% of the cost of non-firm items.
 A higher contingency provision is required if the implementation period is longer since the
chances of increase in the cost increases with the passage of time.
 Components of Capital Cost of a Project
11.Margin Money for Working Capital
 Any project need funds for two purposes. Firstly, funds are necessary for setting up of
the project and secondly, funds are required for maintaining the operation of the plant.
 Funds required for maintaining the operations of the plant consists of investment on
working capital.
 The share of promoters contribution to be brought in for availing working capital
assistance from bank is the margin money for working capital.
Ex: if the total working capital requirement is Rs.40.00 lakhs and if the bank that
finances the working capital requirement of the project stipulates a promoters
contribution of 25%, the promoters are to bring in Rs.10.00 lakhs towards their share of
working capital and the bank can finance the remaining 75% of
requirement.i.e.Rs.30.00 lakhs
 Problem on Capital Cost of a Project
ABC industries, a registered partnership firm proposes to set up a new industrial unit for undertaking
machining job works. The firm proposes to set up the unit in a rented premises. There are firm orders in
hand from reputed customers. The customers will supply raw material and take back the machined
components, paying the charges quoted by the firm. The firm proposes to purchase indigenous CNC
milling machine for the purpose. The other relevant details about the project are as follows.
 Monthly lease rent payable for the factory premises = Rs. 8,000/-
 Cost of machine including electricals = Rs. 25,22,000/-
 Transport and erection charges (estimated) = Rs. 1,05,000/-
 Miscellaneous assets proposed to be purchased = Rs. 19,000/-
 Advance payable to leaser of the premises = Rs. 80,000/-
 Electricity power charges per month (estimated) = Rs. 6,750/-
 Wages and salaries per month (estimated) = Rs. 55,000/-
 Administrative and other overhead expenses/month(estimated) = Rs. 9,000/-
 Insurance premium for machine = 0.6%
The partners of the firm have decided to invest their own capital for both meeting the fixed cost and the
working capital requirements of the project.
Estimate the capital cost of the project. Make suitable assumptions wherever required.
 solution
 Land ,Land development &Buildings : Not applicable (unit is proposed to set up in rented premises)
 Plant & Machinery : Rs.25.22 lakhs
 Electricals : ------
 Transport & Erection : Rs. 1.05 lakhs
 Contingency : Rs. 2.63 lakhs
(assuming 10% on plant & machinery, transport & erection)
 Know how/Consultancy : ------
 Miscellaneous assets (0.19+0.8) : Rs. 0.99 lakhs
 Preliminary & pre-operative expenses : Rs. 0.21 lakhs
[Insurance premium on fixed assets@6% = Rs. 0.17 lakhs, Interest/other financial charges = nil,
Other set up expenses = 0.04 lakhs ]
 Working capital margin : Rs. 0.90 lakhs
[Rent/month = 0.08 lakhs, Admin& overhead/month = 0.09 lakhs, wages & salaries/month = 0.55 lakhs,
power charges = 0.0675 lakhs, repairs & maintenance@5% on machinery cost/month = 0.11 lakhs]
Estimated project cost = Rs. 31.00 lakhs
 Problem on Capital Cost of a Project
ABC Industries Ltd, a newly incorporated company has proposed to set up a plant for the
manufacturing of plastic moulded chairs. The following are the details of the proposed project.
a) The company has entered into an agreement for the purchase 2 acres of land for the project at the rate of
Rs.2 lakhs per acre.

b) The company has proposed to import the plastic moulding machine, which is the main machine at the
value of Rs.80 lakhs. Import duty on c.i.f. is 30%. This injection moulding machine is capable of
producing moulded chairs at the rate of one chair per minute. Though the machine is capable of
producing chairs of different sizes, the company has proposed to concentrate only on the manufacturing
normal size due to the good market for the chairs.

c) The company proposes to acquire the following machinery indigenously.

(i)Scrap Grinder (at a price of Rs.5 lakhs)
(ii)Mixing Machine (at a price of Rs.4 lakhs)
(iii)Power Generator (at a price of Rs.35 lakhs)

d) The cost of electric motors, starters, switches, cables and other electrical items Rs.7 lakhs

e) The cost of dies required for the plant is estimated at Rs.30 lakhs
 Problem on Capital Cost of a Project
f) The company has proposed to construct the following buildings.
(i)Main factory building with an open area (375 square metres)
(ii)Store room for storage of raw materials and finish product (95 square metres)
(iii)Office and administrative blocks with reinforced cement concrete (70 square metres)
(iv)Other amenities like toilet block, compound wall, gate, underground water tank

g) The raw materials required for the project is polypropylene granules, which is costing around
Rs.60 per kg. Wastages of raw material during the manufacturing process is estimated at about 3%

h) The total power requirement (connected load) is estimated at 200 H.P.

i) The selling price of moulded chairs is around Rs.350 per chair in the retail market. The company
has tied up a selling price of Rs.280 per chair with a network of dealers across the country.

Estimate the cost of the project and make suitable assumptions wherever necessary.
 SOLUTION

For arriving at the project cost, each component of the project cost is to be taken up separately and assessed.
a) Land
Extent of land proposed : 2.0 acres
Cost of land (at agreed price of Rs.2 lakhs per acres) = 4.00 lakhs
Add: Registration Charges at 13% of the cost of lands
(13% of Rs.40,000) = 0.52 lakhs
= Rs.4.52 lakhs
b) Land Development Charges: It has not been indicated that the land needs any developmental work.
Hence no provision is made.
c) Building:
1)Main factory Building: Built up area - 375 sq. m.
Cost of construction at the rate of Rs.3750 per sq. m. (estimated cost per sq. m. of construction is to be arrived at based on
either detailed estimate or by making an assessment of the prevailing construction cost of similar constructions)
= 375 x 3750 = Rs.14.062 lakhs (A)
2) Store Room: Built-up area: 95 sq. m
Cost of construction at the rate of Rs.3750 per sq. m.
= 95 x 3750 = Rs.3.56 lakhs (B)
3) Office and Administrative Blocks: Build-up area: 70 sq. m
Cost of Construction at the rate of Rs. 5300 per sq. m
= 70 x 5300 = Rs. 3.17 lakhs (C)
4) Other Amenities:
Toilet Block (Lump sum) Rs.1.50 lakhs
Compound Wall (Lump sum) Rs.3.00 lakhs
Gate (Lump sum) Rs.0.50 lakhs
Underground Water Tank Rs.1.25 lakhs
Rs. 6.25 lakhs (D) .
Total Investment required for Building (A + B + C + D) = Rs. 27.58 lakhs
d) Plant and Machinery:
1)Imported machinery
C.I.F value = 80.00 lakhs
Customs Duty at 30% = 24.00 lakhs
*Clearing Charge = 0.50 lakhs
= Rs.104.50 lakhs
Clearing Charges are the charges payable to the clearing agents for their services rendered in clearing
the goods from the port and this may be in the range of 0.5% to 1%.
2) Indigenous Machinery
Scrap grinder = 5.00 lakhs
Mixing machine = 4.00 lakhs
Power Generator = 35.00 lakhs
Dies = 30.00 lakhs
74.00 lakhs
Total Investment on Plant and Machinery = Rs. 178.50 lakhs
e) Electricals
Electric motors, starters, switches, cables and other electrical items for electrical work = Rs. 7.00 lakhs
f) Transport and Erection Charges:
Expenditure under this head is to be estimated by studying to real situation. The main machine is proposed to be
imported. Hence this machine is to be carried to the factory site from the nearest port
= Rs.8.00 lakhs
g) Contingencies
Contingencies provision is made to take care of probable increase in cost due to new additions or due to escalation in
prices. Such provision allows certain percentage in increase say 10% to 15% on the overall cost of the project or in most
cases under the different headings such as:
Ex using our illustration above, if we decided to put 5% contingencies for building and say 10% on plant and
machinery (indigenous), electrical, transport and erection and 15% on plant and machinery (imported), we would have
calculation as follows;
Building - 5% of Rs.27.58 lakhs = Rs.1.374 lakhs
Plant & Machinery and others
10% of (74.00 + 7.00 + 8.00) lakhs = Rs.8.900 lakhs
Plant & Machinery (Imported)
15% of 104.50 lakhs = Rs.15.675 lakhs

Total for Contingencies = Rs.25.954 lakhs = Rs.26 lakhs

h)Miscellaneous Fixed Assets
The given data does not contain any information on the investment under this heading.
The following assumptions are made.
Miscellaneous Assets Price
Office furnitures = 1.25 lakhs
Office equipments = 1.40 lakhs
Deposit to Electricity Board = 0.75 lakhs
= Rs. 3.40 lakhs
i)Preliminary and Pre-Operative Expenses
The following assumptions are made.
a) Insurance premium on fixed assets : 0.75% per annum
b) Commitment Charges on term loan : 1.00%
c) Rate of Interest on term loan : 15% per annum
d) Project Implementation period : 11 months
e) Service charges on term loan : 0.75%
a) Insurance premium on fixed assets : 0.75% per annum
[0.75/100 x (27.58+178.50+7.00+8.00+26.00)] = Rs.1.85 lakhs
Term loan component (80% of fixed assets) = 80% x 251.60 = 201.28 lakhs = 200 lakhs (say)
b)Commitment Charges on term [email protected]% = 2.00 lakhs
c) Interest during implementation period@15% per annum = 15% x 11/12 x 200 x ½ = 13.75 lakhs
e) Service charges on term [email protected]% = 1.50 lakhs
Total Expenses = 1.85 + 2.00 + 13.75 + 1.50 = 19.25 lakhs = Rs.20.00 lakhs(say)
j)Working Capital Margin
 Before arriving at the working capital margin, which is the last component of the project cost, the
working capital requirement for the first year of operation is required to be arrived at.
 From the working capital requirement, if the likely working capital loan component is deducted
the balance represents the working capital margin.
 For arriving at the working capital requirement/margin, usually the data relevant to the first year of
operation are taken into account.
 Project Financing

 Sources of Finance

 Role of Financial Institutions in Project Financing

 Covenants attached to Lending

 Project financing
Project financing may be defined as the raising of funds required to finance an
economically separable capital investment proposal in which lenders mainly rely on
the estimated cash flow from the project to service their loans.
 Sources of finance
The following are the main sources of project finance.
1.Ordinay shares
2.Preference shares
3.Debentures
4.Bonds
5.Term loans
6.Deferred credits
7.Capital investment subsidy
8.Lease financing
9.Unsecured loans
10.Internal accruals
11.Bridge loans
12.Public deposits
 Sources of finance
1.Ordinay shares or Equity shares
 Equity shares are shares which do not enjoy any preferential right in the matter of
payment of dividend or repayment of capital.
 The equity shareholder gets dividend only after the payment of dividends to the
preference shares.
 Equity shareholders are the real owners of the company. They have a control over the
management of the company and voting rights.
 Equity shareholders are eligible to get dividend if the company earns profit.
2.Preference shares
 Preference Shares are the shares which carry preferential rights over the equity shares.
These rights are (a) receiving dividends at a fixed rate, (b) getting back the capital in case
the company is wound-up.
 Investment in these shares are safe, and a preference shareholder also gets dividend
regularly.
 They do not have any voting rights in the company’s management.
 Sources of finance
3.Debentures
 Whenever a company wants to borrow a large amount of fund for a long but fixed period,
it can borrow from the general public by issuing loan certificates called Debentures.
 These are offered to the public to subscribe in the same manner as is done in the case of
shares.
 A debenture is issued under the common seal of the company. It is a written
acknowledgement of money borrowed. It specifies the terms and conditions, such as rate
of interest, time repayment, security offered, etc.
 The cost of debenture is generally less than equity share and these are less risky.
debenture holders do not have voting right.
4.Bonds
 The bond is more or less similar to a debenture and these two terms are frequently
interchangeable.
 Sources of finance
5.Term loans
 Term loan denotes long term loans offered for project financing. The period of principal repayment of
such long term loans vary from 5 to 10 years depending upon the nature of the project.
 Initial moratorium (holiday period) for the repayment of principal of one to two years is normally
provided. The length of moratorium period depends upon the period of implementation of the project.
 Term loans are offered by All India Financial Institutions (like
IDBI,SIDBI,ICICI,IFCI,LIC,UTI),State Financial Corporations, State Industrial Development
Corporations and Commercial Banks.
 The promoters contribution is fixed by the institutions keeping in view the nature of the project, its
location, its repayment capacity etc. A minimum promoters stake in the project is expected so that
they get involved in the project.
 The term lending institutions normally appoint their staff as a nominee director in the board of
borrowing companies in order to monitor the implementation of the project and to monitor effectively
the operations of the unit to safe guard the interests of the institutions.
 Repayment of principal and interest on term loan is obligatory on the part of the borrowing company
as in the case of debentures. But in the event of difficulties faced by the project promoters ,the term
lending institutions normally take a practical and sympathetic view and lend a helping hand by way of
offering rehabilitation package to see that the project comes out of the woods.
 Sources of finance
6.Deferred credits
 Some machinery suppliers provide the facility of deferred credit, provided the credit-taker offers
a Bank guarantee.
 A project promoter who wants to avail the deferred credit facilities offered by a machinery
supplier should approach a Bank for offering guarantee for the repayment of deferred
instalments to the machinery supplier.
 Bank examine the viability of the project proposal before giving their guarantee.
 Normally, banks obtain mortgage of additional securities from the credit-takers to ensure that the
bank does not stand to loose in event of the guarantee being invoked by the machinery supplier
due to non-repayment of deferred instalments.
7.Capital investment subsidy
Government provides subsidy for the setting of industries. The subsidy offered in two
ways.1.Area subsidy 2.Product subsidy
1.Area subsidy:
Area subsidy is available for projects set-up in notified backward areas(based on industrial
activity) by offering certain incentives.
 Sources of finance
 Any industry that is set up in such notified areas are eligible for capital investment
subsidy. The subsidy is in the range of 15% to 20% on the investment on the fixed assets.
2.Product subsidy:
 Product subsidy is available for the projects that manufacture specified products.
 The products that are eligible for subsidy are identified by the government by keeping in
view the potential for the economic development of the country in such sectors of
industries and notified by the government.
 The product subsidy is in the range of 10% to 20% on the investment on the fixed assets.
 Both the subsidies are disbursed by the government to the eligible project through the
operating agencies of government.
 Out of the two types of subsidies, a project can select only one subsidy.
 Since the subsidy given by the government is meant for the creation of fixed assets for
the project, it is a source of finance.
 Sources of finance
8.Lease financing
 A lease is a contractually enforceable agreement whereby a one party, the owner of an
asset, grants the other party the right to use the asset in exchange for a monthly
payment.
 In other terms, it is the rental of an asset for a certain amount of time. The party who
owns the assets is known as the ‘lessor,’ while the party who utilises the assets is
known as the ‘lessee.’
 The lessee pays the lessor a predetermined periodic sum known as lease rental in
exchange for the usage of the asset.
 The lease contract includes the terms and conditions that regulate the lease agreement.
At the end of the lease agreement, the asset will be returned to the owner.
 Lease financing is a critical tool for the firm’s modernization and diversification.
 Sources of finance
9.Unsecured loans
 If there is a short fall in the means of finance, the promoters can mobilise the funds from
their friends, relatives and well-wishers in the form of loan. Such loans are unsecured.
The lenders can not have any charge over the assets of the company.
 Banks and financial institutions view unsecured loans with an eye of caution.
 Banks/Financial institutions also stipulate the maximum limit for unsecured loan.
Normally it is 50% of the equity capital.
10.Internal accruals
 As existing company that goes for expansion, project may opt to finance a portion of the
capital investment out of internal cash accruals.
 Profits retained after payment of dividends is the main source of internally generated
funds.
 Estimate of internal cash accruals shall be done by ensuring the project implementation
is not held up due to shortage of these funds.
 Sources of finance
11.Bridge loans or Bridge Finance
 This is a temporary loan meant for tying up the capital cost of a project. Bridge
loans are sanctioned by banks and financial institutions in order to help speedy
implementation of project.
 The necessity for bridge finance arises in situations where finance from a
particular source is getting delayed. However, the availability from that source is
certain.
12.Public deposits
 It is a very old source of finance in India. When modern banks were not there,
people used to deposit their savings with business concerns of good repute.
 Even today it is a very popular and convenient method of raising medium term
finance.
 Interest rates on public deposits are often higher than those on bank deposits.
 Sources of finance
 Deposits are beneficial to both the depositor and the organisation. While depositors
receive higher interest rates than banks, the cost of deposits to the corporation is
lower than the cost of borrowing from banks.
 The period for which business undertakings accept public deposits ranges between six
months to three years.
 Any member of the public can fill up the prescribed form and deposit the money with
the company. The company in return issues a deposit receipt.
 This receipt is an acknowledgement of debt by the company. The terms and conditions
of the deposit are printed on the back of the receipt.
 Role of Financial institutions
 Normally the projects are financed by a combination of equity capital and debt capital. Debt
capital is borrowed from individuals and organizations for a fixed tenure and equity capital
is the funds raised by the company in exchange for ownership rights for investors.
Roles/Functions
 The main function is to provide term loans for the acquisition of land, building, plant and
machinery and other assets.
 Promotion of self-employment.
 To encourage new and technically/professionally qualified women entrepreneurs in setting
up industrial projects.
 To finance expansion, modernization and upgradation of technology in the existing units.
 To provide financial assistance for the rehabilitation of sick units.
 To assist for the promotion or expansion of industry by the rural and urban artisans.
 To provide financial assistance for transport vehicles strictly for captive use, depending on
the requirement of the projects.
 Role of Financial institutions
 Providing seed capital assistance under the scheme of IDBI.
 Providing sort-term loan to cover the equity gap to help small-scale industrial units.
 Undertaking the various promotional activities, including the organization of
entrepreneurial development programmes and seminars etc.
 Interest subsidy for self-development, self-employment of young persons, adoption of
indigenous technology in small and medium sector and encouraging quality control
measures in small-scale industry
 To promote development institutions in the state/region which will accelerate the process
of socio-economic growth.
 Covenants attached to Lending

 The bank/financial institution that extends term loan for the setting up of a project
imposes certain conditions to be fulfilled by the borrower and these
conditions(covenants) are contained in the term loan sanction orders executed by the
borrower in favour of the bank/financial institution.
 The covenants depend upon the nature of the project and the financial soundness
of the borrower.
Some of the typical conditions normally stipulated are as under:
 The project sponsor(promoter) shall offer collateral security as required by the
financial institution.
 The project promoter should furnish periodic information about the project.
 The project sponsor should use the borrowed funds only for the project
implementation and for the specific purposes intended.
 The project sponsor should maintain all the assets in good condition, should insure
the assets against fire, burglary and natural calamities.
 Covenants attached to Lending

 The project sponsor should not dispose off any of the assets of the project without
the prior approval of the bank/financial institution.
 The project sponsor should get the consent of the bank/financial institution before
declaring dividends on equity shares.
 Unsecured loans raised if any, for funding the project should not be repaid as long
the dues to the bank/financial institution remain unpaid.
 If interest is paid on unsecured loans, the rate of interest should not be in excess of
the rate of payable to the bank/financial institution.