AMBO UNIVERSITY

DEPARTMENT OF PUBLIC ADMINISTRATION& DEVELOPMENT MANAGEMENT

COURSE TITLE: PROJECT ANALYSIS AND MANAGEMENT
COURSE CODE: PADM 3133
CREDIT HOURS: 3

Chapter one

1. General Introduction
1.1. The basic concept of project

The concept of project planning has originated some 70 years ago. It appeared in USA and
former Soviet Union in late 1930s. It has been widely adopted particularly in the external
funding agencies that finance public sector projects. The last 40 years extensive applications of
project analysis methods particularly in developing countries were observed. Currently
managing a project is becoming exciting new profession. Project managers are in great demand.
They are highly demanded nearly everywhere especially, in Publishing house, University,
Agricultural rural development, Social works and Individual construction projects. Project is
also appears that they are required wherever there is work. Any one holding a responsible
position in a project is a project manager, and if he pursues his own style in discharging his
project management responsibilities, he can hardly be blamed. Because what a project manager
does in one company is not the same as what another does in another company. In order to
understand issues related to project, we must first understand what a project really is. It is
common to hear Cement project, Power project, Refinery project, Road project and Etc.

While the term project is common to all of them, the plants are not. In each case the project is
for the plant. Which means as soon as the plant is operational the project is deemed to be
completed. The same is true for any other projects, say for a project for method improvement.
The project is completed when method improvement has been achieved.

For better understanding let us summarize how a project is conceived first,

In a business setting an organization must grow at least for the sake of its survival
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 The organization is therefore, continuously on the lookout for good business idea which
ensure growth either on
 Existing line of business or
 Diversified area
However, the idea must be technically feasible, economically viable, politically suitable,
socially acceptable and environmentally sustainable.
Once the idea pass these test then an investment proposal is made. When the investment
proposal is approved the project commences.
. Thus, a project is initiated to achieve a particular mission.
 Whatever the mission may be, the project is completed as soon as the mission is
accomplished.
 The project lives between these two cut-off points. The time span is known as project life
cycle.
1.2. What is project?
No definition of project will suit every situation. In other words, there are a number of ways
to define a project.
 According to USA Project Management Institute,
“Project is a one shot, time limited, goal directed, major undertaking, requiring the
commitment of varied skills and resources”.
 It is also a combination of human and non-human resources pooled together in a temporary
organization to achieve a specific purpose.”
 “Project is an effort that starts from scratch with a definite mission, generate activities
involving a variety of human and non-human resources all directed to words fulfilment of
the mission and stops once the mission is fulfilled.”
 ISO-8402 ( ISO document define project as) “A unique process consisting of a set of
coordinated and controlled activities with start and finish dates, undertaken to achieve an
objective conforming to specific requirement including constraints of time, cost and
resources”.
 A project is neither a physical nor the end result. It has something to do with the activities
that go on

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 1.3. Features of the project
 A project is an economic/development activity
 It requires a commitment of scarce resources
 It brings some benefit from its accomplishment
 The benefit should exceed its cost
 Implementation of a project needs resources or inputs.
 Every project converts the given inputs into outputs through the process of implementation
 The out puts in the short run lead to outcomes while in the long run it will result in impact
 Project is a big-work. There may be contribution from many people
 Wholeness despite diversity of work.
 A project has a fixed set of objectives. Once objectives are achieved project ceases to exist
 A project cannot continue endlessly. It has to come an end at one time.
 A project is a single entity and is normally entrusted to one responsibility centre, while
participants in the projects are many.
 Any project calls for team work
 No two projects are exactly similar even if the plants are exactly identical. They are differing
in terms of location, infrastructure, the agencies and the people make each project unique.
 A project sees many changes throughout its life while some of these changes may not have
any major impact, there can be changes which will change the entire course of the project.
 High level of sub contracting : A high percentage of a work in a project is done through
contractors The more complex is a project, the more will be the extent of contracting
1.4. Project Vs program

A project is normally originated from a plan which can be a national plan or corporate plan. In
many cases the term project is used for what should be termed as program or work package.
Some people use the term ‘project’ and ‘program’ interchangeably. However, there is a quite
difference between the two. Program in general is a group of related projects that are managed
in a coordinated ways to achieve certain objective. Any development plan can be considered as a
program. A program is thus, larger in scope, activity oriented, not necessarily time bound and its
objectives are broader

Example,

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 The national goal: Poverty Eradication

Strategy: Increase productivity ( in all sectors)

Development program: Increase agricultural productivity

This may result in a number of projects like,

Construction of dams ( irrigation infrastructure)

Upgrading the skill of agricultural practices

Construction of training centers

Health program may have a number of projects like, Construction of hospitals, Training of health
officers and Expansion of health centres

Program and Projects hierarchy

Plan: National, Regional or company plan with development target

program: specific program within the framework of national plan (health)

project: school project, power plant and housing project

work package: water supply and distribution package

Project: School project, Power plant or housing project

task: award of water contract, construction foundation

Activity

1.5. Classification of Project

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Project can come in many size and form. They may be very simple or complex. Major project
types are two. These are,

A. Revenue project: Are those which can be carried out within the normal organizational
structure and normally will be completed within the single accounting period.
B. Capital Project: Are those which cannot be carried out within the normal organizational
structure and are normally stretched over a number of accounting periods.

Capital project always require considerable capital investment. The main feature of capital
projects are,

 They usually occupy considerable time

 They usually employ huge capital investment

As a result they do not fit readily into conventional organizational structure but cut across
functional and time boundaries and thus, require an organizational structure particular to
themselves.

In general projects be it revenue or capital can be classified from different perspectives.

a) On the basis of time horizon project can be

Long term projects : Power plant project

Medium term projects : Construction of a factory

Short term project: Exhibition, trade fair

b) On the basis of the type of output:

Project producing tangible Products : Oil mill

Project providing services: Telecom project, Education etc.

c) On the basis of the scope of the project:

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 International project : Euro tunnel project

National Project: Eth Hydro power project

Regional Project: Elementary school project

d) Based on the economic sector:

Agricultural project: Irrigation project

Industry project : Cement Project

Service sector project : Bank projects

e) On the basis of technology:

Capital intensive project : Brewery project

Labour intensive project : Textile industry project

f) Based on location:

Rural Projects and Urban project

g) On the basis of the nature of the project

Independent project : Hospital, Hydroelectric power

Complementary project: Airport project, Run Way and airport services are different
projects which are complementary to each other.

1.6. Planning An overview

How project planning differs from organizational planning?

Project comes from the national / organizational plan (program) whereas project planning is one
element of the project management. One of the major function of project management is Project
planning. Thus, planning is a broader concept and its basic concepts are summarize as follows

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A nation or institution or business organization can succeed when it determines in advanced its
objectives, and Methods and resource for achieving them.

Planning is one of the functions of management which involves looking into the future,
anticipating it, and attempting to influence it through anticipatory decisions, in order to achieve
the desired goals. In other words planning involves determination of objective, formulations of
programs and courses of actions for their attainment, development of schedules and time of
action, and assignment of responsibilities for their implementation.

Planning is a process through which one attempts to determine objectives, resources will be
required, determination of tasks, activities, projects, programs etc required for attainments of
objectivities. Planning is the formulations of structures, policies, procedures methods, standards
and budgets for attainment of the above purpose. Planning is also essential pre requisite for the
performance control as it provides base line for evaluating performance.

1.6.1. Nature of planning

A. Planning is continuous and dynamic process.

B. Planning concerns all managers and workers.

C. Plans are arranged in a hierarchy.

D. Planning commits an organization into the future.

1.6.2. Steps in planning

The planning process comprises of a number of steps. There are:

1. Forecasting. It is an intelligent estimation and prediction of the future internal and external
environment. These forecasts is relate to aspects like, economic condition, technology,
population structure & growth, social norms & value, political and legal conditions.
2. Determination of objectives. Any plan starts with clearly defined objective

Objectives are broad statements that an organization or country wants to attain in the future.
Objective provides rational for the existence of an institution. Objective provides the basis and
direction for the performances of all other management functions: Objective uplifts the moral of

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the employees and motivates them; Objective serves as criteria for evaluating decisions. It also
provides a basis for control and evaluating performances against predetermined standards.

3. Means for attainments of planned objectives

The instruments of planning are policies, rules, procedures, Budget and Strategies: It may be any
decision or action taken after taking into account the probable or actual actions, policies and
strategies of competitors, suppliers, etc

a. Policies: it is a guide to decision making. They establish the broad framework within which
managers operate at various levels. Policy also set limits within which the decision maker
can operate. It channels all decisions towards the achievement of predetermined goals by
providing a framework for decision makings. Moreover, it ensures that all decisions are
consistent, uniform, and viable. Furthermore, it also provides criteria for evaluating decision.
b. Strategies differ from policies as it focus on action, where as policies provide guideline for
decision and action. Strategies also differ from tactic. Tactics represent a spontaneous and
short term decision to solve an unforeseen problem that emerges suddenly, where as
strategies are long-range plans aimed at goal achievement. Strategies and policies reduce the
need for tactical decision making.
c. Rules: Rules prescribe behavior, and define what should and what should not be done. It
does not provide any discretion. It does not provide any exceptions. It requires no decisions,
but only enforcement. Rules are also associated with penalties for violation
d. Procedures: Procedures are sequences of steps involved in making decisions and
performances of activities. Like strategies and policies, they aim at laying down mechanisms
for orderly performances and coordination of various organizational activities so as to avoid
random actions and operations.
e. Budget: Budgets are the most widely used instrument of planning as well as control. They are
quantitative in nature and usually called numerical plans. Budgets are the most precise and
important tools of planning as they show the needs of financial and non financial resources.
Financial budget: – it is related to expenses for activities which include revenue and
expenses. Non-financial budget: - includes material budget, sales budgets, manpower budget,
direct-labor hour’s budgets… etc.
4. Determination of resources

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Once means to achieve the objectives are clearly specified, the next step in the planning process
is the determination of resources that would be required for their implementations. These
resources are of four types;

a. Financial resources: - money necessary for the activities planned. It involves an estimation of
availability of financial resources, requirement of material resources, needs for additional
resources, methods of raising needed resources and allocation of financial resources for the
implementation of various functional
b. Equipment and facilities planning. Equipment and facilities planning related to aspects such
as technology to be used, size of the plant, its location and layout.
c. Materials and supplies planning: It involves identification of the types of materials required,
quantities amount required, availability of materials, their costs, handling and transportation.
d. Personnel planning. Personnel planning related to the requirement and availability of various
types of manpower resources and it’s up grading system. It also involves the allocation of
manpower resources for the implementation of various functional plans. In all cases the
realistic resources planning is critical to the success of the total planning effort
5. Implementation of plans

Plans will not produce any results if not implemented effectively. It only provides directions to
effort and the path for the accomplishment of the desired goals. Strategies, policies, programs,
project, and budget, constituting the instruments of planning, should be implemented effectively
in order to ensure the maximum utilization of resources for the achievement of predetermined
objectives.

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 Chapter Two
An Overview of Project Cycle
2.1. Meaning and Definition of Project Cycle

Every program, project, or product has certain phases of development. A clear understanding of
these phases permits managers and executives to better control total corporate resources in the
achievement of desired goals. The phases of development are known as life-cycle phases.
However, the breakdown and terminology of these phases differ.

What is project cycle?

Project Cycle: Is the various stage through which project proceed from inception to
implementation. It is a stage which project advance from inception to maturity stage. Some
authors (Choudhury 2005) presents the projects life cycle in to the life cycle curve. Inception
(concept, definition, organizing etc), Maturity (implementation) and it cover 85% and Decay
(clean up) covers (3%). A project cycle covers all the steps necessary to bring a project to the
point where its technical, economic and financial feasibilities have been established and it is
ready for appraisal.

Each stage follows the proceeding one and leads to the next

These different phases are identified by different institutions and authors. Some of the
phases as identified by different authors are,

2.2. The Baum Cycle (World Bank Procedures)

Baum (1970) model is the first basic model of a project cycle which has been adopted by the
World Bank. According to this model a project cycle consists of the following six stages

1. Identification: it is a stage where we are trying to identify potential projects. It is a process of

searching potential project ideas that can be prepared as a project proposal. In this model
project identification is justified as: Resource based identification, market based
identification, need based identification, project from technical experts/specialists, project
idea from ongoing and exiting projects and local leaders based.

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2. Preparation (formulation of the project): it involves both the prefeasibility study and a detail
feasibility study involving technical, economy, social, commercial, institutional, and
environmental feasibility analysis. The result of project preparation phase is to reject a
project or to have a tangible project proposal.
3. Appraisal and Selection: this stage is a critical review(re-examination) of the prepared project
in order to reach at a final decision from the perspective of the major stakeholders like the
funding agency.
4. Negotiation
5. Implementation: it is the project execution of a project which have passed the appraisal
checklist()
6. Evaluation: is the process of measuring the outputs at the intermediate, midterm or final
points

2.3. Process approach to project cycle

This model adopts change in the project planning. It consists of the following steps:

A. listening: making project idea/concept/ originates from local community and other project
beneficiaries as well as need and priority of local community.

B. piloting: starting in small scale projects with the trial of different techniques in holistic
approach to incorporating social, cultural, physical and institutional factors.

C. demonstrating: conducting a trial in representative scale (village or kebele) with established

mechanism through joint participation.

D. mainstreaming: deals with extending project to larger scale (woreda or region) based on
result of demonstration.

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 2.4. The European Commission/Europe Aid Approach

This approach consists of six phases and has been considered as the most recent approach
developed as guidelines for development projects

 Programming

 Identification

 Appraisal

 Financing

 Implementation

 Evaluation

2.5. UNIDO’s project cycle

United Nations industrial development organization (UNIDO)

1. pre-investment phase

2. Investment phase

3. Operation phase

1. The pre-investment phase

Careful study of the prospects for success of an industrial or commercial venture has not been the
rule throughout the world since the industrial age. Even in the industrialized countries direct
investment is often undertaken in haste, avoiding the trouble and cost of investigation, but
increasing the risk of failure. The pre-investment phase Comprise several stages

A. Identification of investment opportunity/opportunity study/

B. Analysis of project alternatives and preliminary project selection as well as project

preparation/pre-feasibility and feasibility study/

C. Project appraisal & investment decision /appraisal report

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 D. Support or functional studies, usually made separately for later incorporation in
prefeasibility or feasibility study.

A. Opportunity study (Where the opportunity is?)

A data required to develop a project idea in to a proposal is the opportunity study. Opportunity
study is the starting point in investment-related decisions. If done well it can attract potential
investors. Opportunity study is sketchy/ superficial in nature and rely more on aggregate estimate
than a detailed analysis. It should analyze natural resources, Existing agricultural base, Future
demand for consumer goods, possible inter-linkage with other industries, Possibility for
diversification, Industrial policies, Import substitution, Export possibility, Expansion of existing
capacity, and Environmental impact.

General opportunity study can be divided in to the following 3 categories

 Area study

 Industrial study

 Resource based study

Specific opportunity study is more common than general opportunity study. It is necessary to be
selective and incorporate data relating to each product.

B. Pre-feasibility study (intermediate stage)

Before assigning large funds a further assessment of the project idea is made under this stage. In
this stage;

 all possible project alternatives are examined or not

 All aspects are critical and need in-depth investigation

 All project idea are viable and attractive or not

This stage should be viewed as an intermediate stage between opportunity study and feasibility
study. In particular, the review should cover the various alternatives identified in the following
main fields (components) of the study, which includes; Project or corporate strategies and scope

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of project, Market and marketing concept, Raw materials and factory supplies, Location, site and
environment, Engineering and technology, Organization and overhead costs, Human resources,
in particular managerial (entrepreneurial) staff, labor costs and training requirements and costs,
and Project implementation schedule and budgeting.

C. Feasibility studies

Commercial, Technical, Financial and Environmental pre requisites for an investment project
should be defined and critically examined based on solutions already reviewed in the pre-
feasibility study

D. Appraisal report

All the above studies are appraised and report is prepared. The better the quality of the feasibility
study, the easier will be the appraisal work. It includes appraising whether pre-production
expenditures were well spent.

E. support/functional studies

The contents of the support studies differ based on the type, scope and purpose of project
conceived. Support studies look at the specialized area of operations and are also labeled as
functional study. It includes; Market studies of project, Raw material and factor supply studies,
Laboratory tests, Location studies, Environmental impact assessment, Economies of scale
studies, and Selection of equipment.
2. Investment phase

The investment phase can be divided into the following Stages;

Establishing the legal, financial and organizational basis for the implementation of the
project

Technology acquisition and transfer, including basic engineering

Detailed engineering design and contracting, including tendering, evaluation of bids and
negotiations

Acquisition of land, construction work and installation

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 Pre-production marketing, including the securing of supplies and setting up the
administration of the firm

Recruitment and training of personnel

Plant commissioning and start-up

In summary, it is to be noted that in the pre-investment phase, the quality and dependability of
the project are more important than the time factor, while in the investment phase, the time factor
is more critical in order to keep the project within the forecasts made in the feasibility study.

3. Operation phase

Includes all activities of the project form the implementation to the final termination and it
involves ongoing-monitoring, ongoing evaluation, revision and modification. Operational phase
relates to the initial after commencement of production.

The problems of the operational phase need to be considered from both a short- and a long-term
viewpoint.

Short-term view relates to the initial period after commencement of production when a number
of problems may arise concerning such matters as the application of production techniques,
operation of equipment or inadequate labor productivity owing to a lack of
qualified staff and labor.

The long-term view relates to chosen strategies and the associated production and marketing
costs as well as sales revenues.

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In general, in most literature and guide books the stages or phases of projects are divided into six
phases and this approach are preferred in this discussion:

Identification

Pre-feasibility study.

Feasibility study

Selection and project design

Implementation.

Ex-post evaluation

A. Identification

Project starts by generating potential idea that can be converted into a meaningful project.
Project identification involves finding project’s idea, which could contribute towards achieving
specified business/development objectives. In many cases many projects start as a simple idea
and later on it may grow up into a full-fledged project. Identification of promising investment
opportunities (projects) requires imagination, sensitivity to environmental changes and a realistic
assessment of what the firm can do.

If the project is a private project the initiating entity will define the concept, expectation and
objectives of the project. But, if the project is a public project, scrotal information is an
important source to define the concept, expectation and objective of the project.

Generally, the idea for project may come from the following sources

a. From the need to make profitable use of available resources ( this is for resources based
projects)
b. Market based projects arise from an identified demand in home or overseas market
c. Need based project may arise from the need of community (company) to make available
some basic materials (services) requirements.
d. Project ideas can also emanate from government policy and plan

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 e. From technical specialists like, entrepreneurs and local leaders are also common sources
of projects. Technical specialists and entrepreneurs can identify many areas where they
feel new investment might be profitable.

B. Pre feasibility study

After we have identified project ideas the next step is project preparation and analysis.

Project preparation includes both Pre-feasibility and Feasibility studies. Once a project idea is
identified a preliminary project analysis will be done (i.e., pre-feasibility study). Which means
the project idea must be elaborated in sort of study?

Why pre-feasibility study?

Because, undertaking a feasibility study that enables a definite decision to be made on the project
is a costly and time – consuming task. Therefore, before assigning larger funds for such a study,
preliminary assessment of the project idea might be made in a pre-feasibility study.

In the pre-feasibility study stage the analyst obtains rough estimation of the major components of
the project’s costs and benefits.

Some of the main components examined during the pre-feasibility study include:

 Availability of adequate market (or beneficiaries)

 project growth potential

 investment costs, operational cost and distribution costs

 demand and supply factors; and

 social and environmental considerations

If the project is appeared to be sound the next sages is a feasibly stage

C. Feasibility study

Pre – feasibility study should be viewed as an intermediate stage.

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A feasibility study should provide all data necessary for an investment decision.

The commercial, Technical, Financial, Economic and Environment for an investment project
should be defined and critically examined. Therefore, the structure of a pre – feasibility study
should be the same as that of a detailed feasibility study. The major difference between them lies
on the amount of work required in order to determine whether a project is likely to be viable or
not. Once the project is decided as viable using pre-feasibility study, a detailed analysis of issues
like, marketing, technical, financial, economic, and ecological aspects is undertaken in the
feasibility stage.

Feasibility study provides a comprehensive review of all aspects of the project and lays the
foundation for implementing of the project and evaluating it when completed. In the feasibility
study, a team of specialists, like Scientists, engineers, economists, sociologists, environmentalists
etc are needed to work together. If the project is viable, the next step is project design stage. in
the feasibility stage more accurate data need to be obtained in order to proceed to the next stage.

Finally, the feasibility report should include (but not limited) the following analysis: Market
analysis, Technical analysis, Organizational analysis, Financial analysis, Social – economic
analysis, and Environmental analysis

D. Selection (project appraisal)

After a project has been prepared, it is appropriate to forward for a critical review (external
review). This provides an opportunity to re-examine every aspect of the project plan to assess
whether the proposal is appropriate and sound before large sums are committed. projects,
appraisals cover the following aspects,

Technical – here the appraisal concentrate in verifying whether the proposal will work in the
way suggested or not.
Financial – this will try to see if money needed for the project have been calculated property,
their sources are all identified, and reasonable plans for their repayment are made where
necessary.
Commercial – the way the necessary inputs for the project are supplied and the arrangements
for the supply of the products are verified

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 Incentive – whether things are arranged in such a way that all those whose participation is
required will find it in their interest to take part in the project, at least to the extent envisaged
in the plan.
Economic – the appraisal here tries to see whether what is proposed is good from the
perspective of the national economic development. The effects (positive and negative) are
taken into account and check if all are correctly valued.
Managerial – this aspect of the appraisal examines if the capacity exists for operating the
project and see if those responsible ones can operate it satisfactorily. Moreover, it tries to see
if the responsible are given sufficient power and scope to do what is required.
Organizational – the appraisal examines the project how it is organized internally and
externally. This helps to if arrangement and its organization allow the proposals to be carried
out properly and to allow for change as the project develops. These issues are the subjects of
specialized appraisal report. And on the basis of this report, financial decisions are made –
whether to go ahead with the project or not.

E. Implementation

The objective of any effort in project planning and analysis is to have a project that can be
implemented to the benefit of the society. After the project prepared and evaluated the next step
is implementing the project. Implementation is the most important part of the project cycle. In
this stage, funds are actually disbursed to start the project and keep running and contracts are
signed. A major priority during this stage is to ensure that the project is carried out in the way
and within the period that was planned.

During the project implementation stage, the following important points should be considered:

 All the stages of implementation should be completed within the time schedule allotted.
 The output stream should be the same as contemplated.
 The physical targets are to be realized with in the financial allocation.
 Project analysts (manager) must keep an eye over changes in technology, taste, price,
profitability etc.
 In the case of private investments, profitability is to be so insured that investment funds are
expected from within.

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  However, Problems frequently occur when the economic and financial environment at
implementation differs from the situation expected during appraisal. For example, price or
political environment may change.
 Due to these facts, project implementation must be flexible and original proposals are
modified frequently to capture these changes.

Generally, project analysts divide the implementation phase into three time periods

The investment phase, where the major investments are made. This may extend from three
to five years.

The development phase which may also extend from three to five years.

The project life.

The implementation phase for an industrial project consists of several stages:

(i) Project and engineering designs, (ii) negotiations and contracting, (iii) construction (iv)
training, and (v) plant commissioning.

F. Ex-post evaluation

The final phase in the project cycle is evaluation. Once a project has been carried out the actual
progress with the plans should be evaluated in order to judge whether the decisions and actions
taken were responsible and useful. However, evaluation is not limited only to completed
projects. Ongoing projects could also be evaluated to find solutions for problems when the
project is in trouble. The evaluation may be done by, the project management, the sponsoring
agency, or other bodies. Moreover, evaluation should be undertaken when a project is
terminated or is well into routine operation. Some of the benefits which can be obtained from
evaluation are, The reality of the assumptions that were made will be evaluated; It provides an
experience that is highly valuable in future decision making; It suggests corrective action to be
taken in the light of actual performance; It helps in uncovering judgment biases; It induces a
desired caution among project sponsors.

Generally, weakness and strengths should carefully be noted so as to serve as important lessons
for future project analysis undertaking

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 Chapter three
Project Identification
3.1. Meaning of project identification
Project Identification is the Initial step of the project cycle and the birthplace of the project. It
is a process of searching for and subsequently finding projects that could feasibly generate
benefits in excess of cost accruing to the society and contributing towards the attainment of
specified development objectives.

3.2. The project identification process

It involves the following steps. These are:

Develop
Conduct
SWOT
selection
analysis
criteria

Screen
Scan
Profile
sourceVs
readily
ideas of
ideas
available
criteria
data

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 Furthe
•
r Rej
Study
ect
•
Re
wor
k
•
Lat
er
Accepta
reconsi ble
der
Needs precede projects i.e, the first step in identifying a project is to identify a need.

1. GENARATION OF IDEAS
The search for promising project ideas is the first step towards establishing a successful venture.
Often firms adopt a somewhat casual and haphazard approach to the generation of project ideas.
To stimulate the flow of project Ideas the following are helpful

A. SWOT Analysis
It represents a conscious, deliberate and systematic effort by an organization to identify
opportunities that can be profitably exploited by it. This analysis facilitates the generation of new
ideas.

Opportunities Threats

Economic Growth Regulatory Change

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 Growth Industrial sectors

New Markets Political Change

Regulatory change Change in Image

Political Change Recession

Decline in resources

Desirable Strengths and weaknesses

Market place Existing industry

Labor availability Financing

Premises and sites Quality of Life

Communications Availability of resources

Suppliers Stability

B. Clear Articulation of Objectives

A clear articulation and prioritization of objectives in channelling of employees and helps them
to think more imaginatively. Firm objectives can be of one or more of the following.

 Cost reduction

 Productivity improvement

 Increase in capacity utilization

 Improvement in contribution margin

 Expansion in to promising areas

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 C. Foster a Conducive Climate

Conducive organizational climate is essential to help tap the potential, creativity and
entrepreneurial urge of employees. Eg. Case of the Ethiopian Airlines providing recognition and
financial awards to individuals with entrepreneurial ideas for cost reduction, improved way of
doing, revenue enhancement etc..

D. Monitoring the environment

Proper environmental assessment provides a company the opportunity to understand the
competitive climate and help generate ideas for investment. Key sectors that need to be assessed
are discussed below.

• Economic Sector: includes; State of the Economy, Overall Rate of Growth, Growth Rate of
Primary, Secondary and Tertiary Sectors, Cyclical Fluctuations, Linkage with the World
Economy, Trade Surplus / Deficit, and Balance of Payment Situation

• Governmental Sector: includes; Industrial Policy, Government Programmes & Projects, Tax
Framework, Subsidies, Incentives and Concessions, Import & Export Policies, Financing
Norms, and Lending Conditions of Financial Institutions and Commercial Banks

• Technological Sector: includes; Emergence of New Technologies, Access to Technical

Know-How, Foreign as well as Indigenous, and Receptiveness on the Part of Industry

• Socio-Demographic Sector: includes; Population Trends, Age Shifts in Population, Income

Distribution, Educational Profile, Employment of Women, and Attitudes Towards
Consumption and Investment

• Competition Sector: includes; Number of Firms in the Industry and the Market Share of the
Top Few, Degree of Homogeneity and Differentiation Among Products, Entry Barriers,
Comparison with Substitutes in Terms of Quality, Price, Appeal and Functional Performance,
and Marketing Policies and Practices

• Supplier Sector: includes; Availability and Cost of Raw Materials and Sub-Assemblies,
Availability and Cost of Energy, and Availability and Cost of Money

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 E. Corporate appraisal

A realistic appraisal of corporate strengths and weaknesses is essential for identifying investment
opportunities. The broad areas of corporate appraisal and important elements to be considered
under each are discussed below.

• Marketing and Distribution: Market Image, Product Line, Market Share, Distribution
Network, Customer Loyalty, Marketing and Distribution Cost.

• Production and Operations: Condition and Capacity of Plant and Machinery, Availability of
Raw Materials, Sub-Assemblies and Power, Degree of Vertical Integration, Location
Advantage, Cost Structure, etc

• Research and Development: Research Capabilities of Firm, Track Record of New

Development, Laboratories and Testing Facilities, Co-ordination Between Research and
Operations

• Corporate Resources and Personnel: Corporate Image, Clout with Governmental and
Regulatory Agencies, Dynamism of Top Management, Competence and Commitment of
Employees, State of Industrial Relations

• Finance and Accounting: Financial Leverage and Borrowing Capacity, Cost of Capital, Tax
Situation, Relations with Shareholders and Creditors, Accounting and Control System, Cash
Flows and Liquidity

F. Profit potential of industries – porter model

 Threat of New Entrants
 Threat of Substitute Products
 Bargaining Power of Suppliers
 Bargaining Power of Buyers
 Rivalry among Existing Firms

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 3.3. SOURCES OF PROJECT IDEAS

Demand: Unsatisfied demand and the most effective ways to meet it.

Linkages: - Need for Upstream and downstream linkages, i.e. vertical integration - currently
procured inputs or products for which the current enterprise is a supplier.

Problems: - Problems/constraints in the development process due to shortages of essential

facilities, services and materials.

Resources: - Availability of resources cause for ideas

Development: - Need to complement development with support services, infrastructure, etc.

Trade: - Possibilities for import substitution and export potential

Technology: - New developments offer ideas, particularly in regard to modernization projects.

Government Policy: - Incentives to entrepreneurs – tax holidays, subsidies, grants for

development in sectors or regions and planned allocation, although this should not be the sole
basis for embarking on a business venture.

External Constraints: - External constraints lead government planners to adopt policies of self
–sufficiency in food production, energy generation or other goods and Services.

In general, the sources of project ideas can be broadly classified into,

3.3.1. Macro-level
 National policies strategies and priorities
 National, sectoral, sub – sectoral or regional plans and strategies supplemented by special
studies.
 General surveys, resource potential surveys, regional studies, master plan and statistical
publications which indicate directly or indirectly investment opportunities.
 Constraints on the development process due to shortage of essential infrastructure facilities.
 Government decision to correct social and regular inequalities.
 Unusual events such as, droughts, floods, earth – quakes, hostilities, etc.

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 From multilateral or bilateral development agencies and as a result of regional or
international agreements in which the country participate.
 Development experience of other nations
 A possible external threat that necessitates projects aiming at achieving, for example, self-
sufficiency in basic materials, energy, transportation, etc
3.3.2. Micro Level

The initiative of private or public enterprises in response to incentives provided by the

government;

The identification of unsatisfied demand or needs.

The need to remove shortages in essential materials, services or facilities that constrain
development efforts;

The necessity to complement or expand investments previously undertaken.

The suggestions of financial institutions and development agencies

Mergers and takeover

Underutilized resource and investigate local materials

Study of new Technological Development

3.4. SCREENING AND SELECTION CRITERIA

3.4.1. Preliminary screening

By using the tools suggested so far, it is possible to develop a long list of project ideas.
Preliminary screening is, therefore, required to identify most promising project ideas from those
not. The following are considered as a tool for achieving this purpose.

A. Compatibility with the Promoter

Idea must be compatible with the Personality, interest, and resource of the Entrepreneur. A real
opportunity has 3 characteristics.

 It fits the personality of the Entrepreneur

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  It is Accessible to Him
 It offers him the Prospect of Rapid Growth and High Return on the Invested Capital
B. Consistency with the Government Priorities

Projects would only be feasible when consistent with the national goals and government
regulations. Questions to be raised in this regard are:

 Is the Project Consistent with the National Goals and Priorities?

 Is there any Environmental Effects Contrary to Governmental Regulations?
 Can Foreign Exchange Requirements of the Project be Easily Accommodated?
 Will there be Any Difficulty in Obtaining the License of the Project?

C. Availability of Inputs

The resources and inputs required for the project must be reasonably assured. To verify this, the
following questions need to be raised.

 Are the Capital Requirements of the Project within Manageable Limits?

 Can Technical Know-How Required for the Project be obtained?
 Is the Raw Material Required for the Project Available Domestically at a Reasonable
Cost? If the Raw Materials Have to Be Imported, Will there be Problems?
 Is the Power Supply for the Project Reasonably Obtainable
D. Adequacy of Market

The size of the present market must offer the prospects of adequate sales volume, potential
growth and return on investment. To judge this, the following factors need to be examined:-

– Total Present Domestic Market

– Competitors and Their Market Share

– Export Markets

– Sales and Distribution System

– Projected Increase in Consumption

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 – Barriers to the Entry of New Units

– Economic, Social and Demographic Trends

– Patent Protection

E. Reasonableness of Cost

The cost structure of the project must be reasonable to ensure profitability. The factors need to be
analyzed are; Cost of Material Inputs, Labour Costs, Factory Overheads, General Administrative
Expenses, Selling and Distribution Cost, Service Cost, and Economies of Scale

F. Acceptability of Risk Level

 The desirability of a project is critically dependent on the its risk characteristics
 To address this concern the following factors be considered

i. Vulnerability of Business Cycles

ii. Technological Changes

iii. Competition from Substitutes

iv. Competition from Imports

v. Governmental Control Over Price and Distribution

3.4.2. Screening Criteria

Not all project ideas need to be analyzed in detail at a point of time for a particular region or for
an organization. For instance in border areas of our country the priority are for security against
external aggression, development of economy is the second priority. Preliminary screening is
required to eliminate ideas which are not prima facie promising. The parties or agents involved
in a project each determine their own criteria according to their priorities (promoter, investor,
financier, guarantor, government). Overriding all criteria is the element of risk and is of concern
to all.

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Investment promotion agency:

 Development goals of the country or the region which may be related to issues of security,
economic growth, and political stability may be a cause for prioritizing projects.
 Also socio-economic or distribution effects of the project may be an important criterion.

Investor:

 Projected profitability - higher return is better; Payback

 growth potential - an expanding market and general economic prosperity;
 magnitude of investment – the project investment must match the capital constraints of the
investor;
 Risk - tolerance to risk varies by investor.

Lender:

Banks and other financial institutions sometimes do opportunity studies and screen the resulting
investment ideas to assess the structure of their loan portfolios.

Criteria would include:

 Conformance to development objectives or with institutional experience;

 likelihood of default in servicing debt;
 client relations (interests of preferred clients);
 Magnitude of investment (if the investment is too large for the financier to handle,
syndication may be an option, if too small, the cost of administering the loan may be too
great.
3.4.3. Selection Criteria

The main factors to be considered for project selection are listed below:
• Viability of project
• ROI (Returns on Investments), maximization of returns.
• Maintaining minimum market share, increase or consolidate the existing market share.
• Enabling the company or economy to enter new markets or areas of operation.
• Maximum utilization of the workforce available.

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• Maximum or optimum utilization of technical resources (plant and machinery)
• Help the company or economy to improve its position.
• Risk and uncertainty are under the acceptable limits.
• Scope of the operations of the project is within the capabilities of a company or country.

Projects meeting screening criteria are selected for further study. On the Other hand there are
other options for ideas not accepted;

Reject: Some of the projects not acceptable at the present time would be rejected as unworkable.

Rework: Projects that need some refining of major features before serious consideration.

Consider later: Projects that are not currently timely but have a potential at future.

3.5. Key Aspects of Project Identification

The following are some:

a. Concentrate on best prospects: Focusing attention on a limited number of project ideas is a

better way to assure that pitfalls are avoided at early stage
b. Quick negative decision better than delay: Particularly where there is a sufficient array of
project ideas, it is better to quickly reject, or at least recycle, ideas that present difficult
obstacles from the outset.
c. Assure commitment of potential sponsor to implementation

CHAPTER FOUR
4. PROJECT PREPARATION

4.1. MARKET AND DEMAND ANALYSIS

In most cases, the first step in project analysis is to estimate the potential size of the market for
the product proposed to be manufactured and get an idea about the market share that is likely to
be captured.  To make an idea about these things an in depth study and assessment of various

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factors like patterns of consumption growth, income and price elasticity of demand, composition
of the market, nature of competition, availability of substitutes, reach of distribution channels
and so on is required. Market analysis of a project is a systematic inquiry seeking to gain
information about the whole environment in which the project is expected to operate and to
forecast the future trends to which the project is expected to adapt. Markets consist of all
potential customers who might be willing and able to engage in the transaction for satisfying
their need or want. A commodity or service has to be bought and sold which is only possible if
there are buyers and sellers who are willing to exchange. It is concerned not only with
individuals and organizations that are actual or potential consumers of the product of the project
also with competitors and all kinds of technical, material, political, legal and administrative
constraints with in which the project is expected to operated and grow

Market may be distinguished on the basis of:

• Area covered (local, national, international)
• Presence of competition (monopoly, duopoly, oligopoly, pure competition)
• Quantity involved (retail, wholesale)
• Period of transaction (ready, future)
• Demographic variable (age, sex, income, occupation, education, nationality, etc)

Market and demand analysis should be carried out in an orderly and systematic manner.  The key
steps in such analysis are as follows:

1. Situational analysis and specification of objectives

2. Collection of secondary information
3. Conduct of market survey
4. Characterization of the market
5. Demand forecasting
6. Market planning

4.1.1. Situational analysis and specification of objective

In order to get an idea about the relationship between the product and its market, the project
analyst may informally 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 the
middlemen.  If such a situational analysis generates enough data to measure the market and get a
reliable handle over projected demand and revenues, a formal study need not be carried out,
particularly when cost and time considerations so suggest.  The informal goals that guide
situational analysis need to be expanded and articulated with greater clarity. A helpful approach
to spell out objectives is to structure them in the form of questions. In doing so, always bear in
mind how the information generated will be relevant in forecasting the overall market demand
and assessing the share of the market the project will capture.

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Objectives of Market Analysis

The objective is to measure and forecast the market in order to determine whether the project
will produce the right product at the right time and the right place. In addition the specific
objectives of the market analysis are to know:-

The market size and the growth rate

The volume of output the project plans to produce and sell in light of the competition
The geographic or sectoral markets the project’s product is expected to compete
The method of distribution and marketing policy

The objectives must be clearly established for market and demand study. This may be possible if
we consider the following aspects:
Potential and prospective buyers
Current and projected demand
Demand distribution with respect to sales and geography
Break-up of demand
Estimated price and warranty
Channels of distribution Prospects for immediate sales
4.1.2. Collection of secondary information

Secondary information is information that has been gathered in some other context and is already
available. It provides the base and indicates what is known and often provides leads and clues for
gathering primary information required for further analysis. While Secondary information is
available economically and readily, its reliability, accuracy and relevance for purpose under
consideration must be carefully examined. The factors to be considered include objective, source
of information, timing of collection and publication, target population, choosing sample, editing,
tabulation and analysis.

The important sources of secondary information useful for market and demand analysis are;
National Census, National sample survey reports, Plan reports, statistical abstract of national
union, Statistical year book, Economic survey, Guidelines to industries, Annual survey of
industries, Annual reports of the Department of commerce and industry, The exchange directory,
Monthly bulletin of reserve bank, Publications of advertising agencies. Examples of secondary
information sources in Ethiopia includes; Ethiopian Economic Survey, Ethiopian Basic Facts,
Reports of Export on Various Industries, Census of Manufacturing Industries, Ethiopian
Statistical Yearbook, Monthly Statistical Bulletin, Annual Report of National Bank of Ethiopian,
Annual Reports of the Various Associations of Manufacturers, Etc…..

4.1.3. Conduct of Market Survey

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To be of any value, Secondary information must be supplemented with primary information
through market survey. Primary information represents information that is collected for the first
time to meet the specific purpose on hand. The market survey can be a census or sample survey

– Census Survey covers the entire population

– Sample Survey covers limited part of the total population

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 elasticity of demand
 Motives of 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 terms should
be carefully and unambiguously defined.  The target population may be divided into various
segments which may have differing characteristics.
b. Select the sampling scheme and sample size:  There are several sampling schemes: simple
random sampling, cluster sampling, stratified sampling, systematic sampling and non-
probability sampling.  Each scheme has its advantages and limitations.  The sample size has
a bearing on the reliability of the estimates- the larger the sample size, the greater is the
reliability.
c. Develop the questionnaire:   The questionnaire is the principal instrument for eliciting,
information from the sample of respondents.  The effectiveness of the questionnaire depends
on its length, the type of questions, the wording of the questions.   Developing the
questionnaire requires a thorough understanding of the product and its usage, imagination,
insight in to human behavior, the familiarity with the tools of descriptive and inferential
statistics to be used later for analysis.  Since the quality of the questionnaire has an
important bearing on the results of the market survey, the questionnaire should be tried out
in a pilot survey and modified in the light of problems/difficulties noted.

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 d. Recruit and train the field investigators: Recruiting and training of field investigators
must be planned well since it can be time consuming.  Great care must be taken in recruiting
the right kind of investigators and imparting the proper kind of training to them.
e. Obtain information as per Questionnaire from the sample of respondents: Respondents
may be interviewed personally, telephonically, or by mail for obtaining information. 
Personal interviews ensure a high rate of response.  But they are expensive and likely to
result in biased responses because of the presence of the interviewer.
f. Scrutinize the information gathered: Information gathered should be thoroughly
scrutinized to eliminate data which is internally inconsistent and which is invalid.
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 of
analysis, suitable statistical investigation may be conducted, if necessary.  For purposes of
statistical analysis, a variety of methods are available.  These may be divided into two broad
categories: parametric method and non-parametric methods.  Parametric methods assure 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 of the target population to the
size of the sample studies, will have to be used.

4.1.4. Characterization of the Market

Based on the secondary and primary data gathered, the market for the product or service can be
characterized as follows:-

Effective demand in the past and present- To gauge the effective demand in the past and
present, the starting point typically is apparent consumption 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.

Breakdown of demand – To get deeper insight into the nature of demand, the aggregate market
demand may be broken into demand for different segments of the market.  Market
segments may be defined by (i) nature of product, (ii) consumer group, and (iii) geographical
division.
Price - 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 price or CIF price, (ii) landed price for imported goods, (iii) average wholesale price, and
(iv) average retail price.

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Methods of distribution and sales promotion – The method of distribution may vary with the
nature of product, capital goods, Industrial raw materials or intermediates, and consumer
products tend to have differing distribution channels.  Further, for a given product, distribution
methods may vary.  Likewise, methods used for sales promotion may vary from product to
product.
Consumers – Consumers may be characterized along two dimensions viz, demographic and
sociological –age, sex, income, profession, residence, social background etc and attitudinal-
preferences, intentions, habits, attitudes, responses etc.

Supply and Competition- It is necessary to know the existing sources of supply and whether
they are foreign or domestic.  Competition from substitutes and near substitutes should also be
specified.
Government policy – The role of government in influencing the demand and market for a
product may be significant.  Government plans, policies, legislations etc. have a bearing on the
market and demand of the product under examination should be spelt out.

4.1.5. Demand Forecasting

After gathering information about various aspects of the market and demand from primary and
secondary sources, an attempt may be made to estimate future demand.  A wide range of
forecasting methods is available to the market analyst. 
Demand analysis identifies the need for an investment by assessing:
- Current demand (by using models and actual data);
- forecast demand (from macroeconomic and sector forecasts and elasticity estimates of demand
to relevant prices and income).
Both quantifications are an essential step in order to formulate a hypothesis concerning the
project’s induced demand and its productive capacity size. For example, it is necessary to
investigate which part of the demand for public services, rail transport, or disposal of waste
material will be matched by the project. Such hypotheses should be tested by analyzing the
conditions of both the present and coming supply that are independent from the project and the
technological options available. Often such options cannot be identified along a continuum of
factor combinations, but they consist of a relatively small number of alternatives characterized
by discontinuity.

Method of Demand Forecasting

Subjective or Qualitative Approach:
• Field Sales Force (Persons in direct contact with customer).
• Jury of Executives (Group of mangers help in expediting forecast)
• Users Expectations (Using questionnaires/ telephonic surveys).
• Delphi Method (Opinion of group of experts with a mail survey).
Quantitative or Statistical Approach:

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• Casual or Explanatory (Consumption level method, chain level method, end use method,
econometric method, leading indicator method, regression analysis)
• Time Series Projection:
 Smoothing (Moving averages (simple and weighted), exponential Smoothing)
 Decomposition (Additive, multiplicative)
 Trend projection
Qualitative Methods
These methods rely essentially on the judgment of experts to translate qualitative information
into quantitative estimates. The important qualitative methods are as follows.
A. Poll of Sale Force Opinion method
In this method, sales personnel from different sales territories are asked to provide sales
forecasts.  These individual sales forecasts are then combined, modified and refined by the top
executives to predict the total or master forecast for the firm.
Example of Sales force survey
• Sales personnel report that competitor’s price drop of 10 %
• Company’s sales will decline 3 %
• This year sales = $ 7 million
• Sales forecast = $ 6,790,000
B. Jury of Executive Opinion Method
It is very popular in practice. This method calls for the pooling of views of a group of executives
on expected future sales and combining them into a sales estimate.  A small number of top
executives are requested to register their individual opinions relating to the probable amount of
future sales.  A forecast is derived from the average of these figures.  As executives are fully
aware of the market conditions, capabilities of the firm etc., a forecast under this method gives a
better result.
Pros: it permits a wide range of factors to be considered and it appeals to managers
Cons: The biases cannot be unearthed easily and its reliability is questionable
Executive opinion
• In a meeting of 6 top executives
• 3 see strong growth (12 %)
• 3 see limited growth (3 %)
• Executives compromise on 6% growth
• This year sales = $ 11 million
• Sales forecast = $ 11,660,000

C. User Expectations

Also known as the buyer's intentions method of forecasting, the user expectations method relies
on answers from customers regarding their intent to purchase the product during the forecasting
time period. This method works best when attempting to estimate current market potential as

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well as to forecast demand, because it does not take into account the company's marketing and
advertising efforts which may affect consumers' intent to buy.

Advantages
It comes directly from customers

It is easy and inexpensive

Disadvantage
Customers may misjudge

Consumers may get confuse due to various alternatives

Example of Consumer survey

• 85% of current customers (1 million) say they will repurchase next year
• 3 % of non customers (10 million) say they will purchase next year
• Sales forecast = 1,150,000 customers
• Increase of 15 %
D. Delphi Method
This method involves converting the views of a group of experts, who do not interact face-to-
face, into a forecast through an iterative process.  The steps involved in this method are:
a. A group of experts is sent a questionnaire by mail and asked to express their views.
b. The responses received from the experts are summarized without disclosing the identity of
experts, and sent back to the experts, for reviewing their views in the light of other experts
opinion.
c. This process may be continued for one or more rounds till a reasonable agreement emerges in
the view of the experts.
Pros: It is intelligible to users and It seems to be more accurate and less expensive than the
traditional face-to-face group meetings
Cons
There are some question marks:
What is the value of the expert opinion?
What is the contribution of additional rounds and feedback to accuracy?
Quantitative/statistical method
Quantitative method refers to forecasting based on the analysis of historical data using statistical
principles and concepts. The quantitative forecasting approach is further sub-divided into two
parts: causal techniques and time series techniques. Causal techniques are based on regression
analysis that examines the relationship between the variable to be forecasted and other
explanatory variables. In contrast, Time Series techniques usually use historical data for only the
variable of interest to forecast its future values.
1. Causal/explanatory method

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These methods seek to develop forecasts on the basis of cause-effect relationships specified in an
explicit, quantitative manner.  The important methods under this category are as follows:
I. Chain Ratio Methods
In this method the sales of a product may be estimated by applying a series of factors to a
measure of aggregate demand.  For example, a firm planning to manufacture stainless steel
blades in India can be estimate its potential sales in the following manner.
Adult male population in the country                    : 150 million
Proportion of adult male using shaving blades            : 0.60
Adult male population using shaving blades                : 90 million
Number of times a person uses shaving blades in a year        : 100
Total shaving done per year                        : 9,000 million
Proportion of shaving done with stainless steel blades        : 0.40
Average number of shaving per stainless steel blade            : 4
Number of stainless steel blades used per year            : 900 million
Proportion of stainless steel blade market the firm could capture    : 0.20
Potential sales                                : 180 million
II. Consumption Level Method
This method is used for those products that are directly consumed. This method estimates
consumption level on the basis of elasticity coefficients, the important ones being the income
elasticity of demand and the price elasticity of demand.
 Income Elasticity: This reflects the responsiveness of demand to variations in income. It is
calculated as:
E1 = [Q2 - Q1/ I2- I1] * [I1+I2/ Q2 +Q1] 
Where:
E1 = Income elasticity of demand
Q1 = quantity demanded in the base year
Q2 = quantity demanded in the following year
I1 = income level in the base year
I2 = income level in the following year
 Price Elasticity: This reflects the responsiveness of demand to variations in price. It is
calculated as:
EP = [Q2 - Q1/ P2- P1] * [P1+P2/ Q2 +Q1] 
Where:
EP = Price elasticity of demand
Q1 = quantity demanded in the base year
Q2 = quantity demanded in the following year
P1 = price level in the base year
P2 = price level in the following year
III. End Use Method

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This method is suitable for estimating demand for intermediate products. The end use method,
also referred to 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 forecasts the demand based on the consumption coefficient of the various uses of
the product. Example of forecasting using end use method.

IV. 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 lagging
variables.  For example, the change in the level of urbanization may be used to predict the
change in the demand for air conditioners.
Two basic steps:
1. Identify the appropriate leading indicator(s)
2. Establish the relationship between the leading indicator(s) and the variable to forecast
V. Econometric Method
An econometric model is a mathematical representation of economic relationship derived from
economic theory.  The primary objective of econometric analysis is to forecast the future
behavior of the economic variables incorporated in the model.
1. Single Equation Model
Dt = a0 + a1 Pt + a2 Nt
Where
Dt = demand for a certain product in year t.
Pt = price of the product in year t.
Nt = income in year t.
2. .Simultaneous equation method
GNPt = Gt + It + Ct
It = a0 + a1 GNPt
Ct = b0 + b1 GNPt
Where
GNPt = gross national product for year t.
Gt = Governmental purchase for year t.

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 It = Gross investment for year t.
Ct= Consumption for year t.
Advantages
• Produce reliable and accurate result
• The process sharpens the understanding of complex cause – effect relationships
• This method provides basis for testing assumptions
Disadvantages
• It is expensive and time consuming
• Uses complex calculation
• To forecast the behaviour of dependant variable, one needs the projected values of
independent variables
Regression analysis
One obvious way to estimate the parameters is to fit the last m observations with a straight line.
This is similar to the moving average idea, except that in addition to a constant term it also
estimates the slope. The regression analysis aims at fitting a straight line in the set of points.
Since there are different ways of fitting the curve, an objective must be selected.
Example: The demand for a certain soft drink in the past four years in given in following on
a quarterly basis.

Year Period Demand Year Period Demand

(in
(in Millions) Millions)
1 Spring 15 3 Spring 20
Summer 25 Summer 30
Fall 16 Fall 18
Winter 8 Winter 11
2 Spring 17 4 Spring 18
Summer 29 Summer 32
Fall 14 Fall 19
Winter 10 Winter 12

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 Seasonal adjustment
i. Additive model: Adjustment is made by adding or deducting a specific amount from the
value obtained from the trend line to determine the forecast for the
respective season. This is very depended on experiences.
ii. Multiplicative model: This is made by multiplying the value estimated by the trend by a
factor of either more or less than one to forecast the demand for the season.
Ãj = SFj •D
Where, Ãj: the adjusted forecast for the
season j And SFj: the seasonal factor
2. Time Series Projection Methods
These methods generate forecasts on the basis of an analysis of the historical time series
- Moving Average Method
- Exponential Smoothing Method
- Trend projection Method
A. The moving average method:
Moving averages involve averaging the time series over a specific number of periods.
The forecast for the next period is equal to the average of the sales for several preceding periods.
Average several periods of data
Moving Average forecast = Sum of demand in previous n periods
n
Example
The monthly production of crude petroleum in Canada during 1989 is shown below. Compute
the three-month moving averages.
Month J F M A M J J A S O N D
Crude 5,886 5,485 6,269 5,776 6,109 5,867 6,196 6,045 5,839 6,180 6,192 6,362
Petroleum
Solution
Month Crude Petroleum Three-Month Moving Average
J 5,886 —
F 5,485 5,880.00
M 6,269 5,843.33
A 5,776 6,051.33
M 6,109 5,917.33
J 5,867 6,057.33
J 6,196 6,036.00
A 6,045 6,026.67
S 5,839 6,021.33
O 6,180 6,070.33
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N 6,192 6,244.67
D 6,362 —
One of the reasons why we frequently choose an odd number of periods is because that enables
us to place the moving average in the center of the periods being averaged. If the number of
periods is even, we must place the moving average between the two middle periods. This creates
graphing problems, which we solve by centering the moving averages.
Weighted Moving Average
Adjusts moving average method to more closely reflect data fluctuations (weights can be used to
place more emphasis on recent values). In the moving averages method, each observation in the
moving average calculation receives the same weight. One variation, known as weighted
moving averages, involves selecting a different weight for each data value and then computing a
weighted average of the most recent k values as the forecast. In most cases, the most recent
observation receives the most weight, and the weight decreases for older data values.

Weighted moving average = e(Weight for period n)(Demand in period n)

eWeights
Weighted Moving Average Example
Month Weight Actual
August 17% 130
September 33% 110
October 50% 90
November forecast
WMA 3 = (0.17)(130) + (0.33)(110) + (0.50)(90)
1 = 103.40
B. Exponential Smoothing Method
Exponential smoothing also uses a weighted average of past time series values as a forecast; it
is a special case of the weighted moving averages method in which we select only one weight—
the weight for the most recent observation. The weights for the other data values are computed
automatically and become smaller as the observations move farther into the past. It forecasts data
on a weighted average of past observations, but it places more weight on more recent
observations to make its estimates.
In exponential smoothing, forecasts are modified in the light of observed errors.
The exponential smoothing equation follows.
Ft+1 = aDt + (1 - a) Ft
Where,
Ft+1 = forecast for next period
Dt = actual demand for present period
Ft = forecast for present period
a = exponential smoothing constant
Ft+1 = aDt + (1 - a)Ft
Where,

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Ft+1 = forecast for 2010
Dt = actual demand for 2009 = 50,000
Ft = forecast for 2009 = 40,000
a = 0.4
F2010= 0.4(50,000) + 0.6(40,000)
= 44,000
Exponential smoothing is assumed that the future demand is the same as the forecast made for
the present period plus a percentage of the forecasting error made in the past period.
Ft+1 = Ft + ( Dt –Ft )
Where is smoothing factor
Example. Exponential Smoothing
A new product demand for January and February of this year has been 40,000 and 48,000
respectively. New product has no additional information. Forecast the demand for March with
=
0.4.
Solution:
FM = FF + ( DF –FF )
FF = FJ + ( DJ –FJ )
FJ is unknown, since no additional information is available, we assume
FJ = DJ = 40,000 and FF = FJ = 40,000
 FM = 4,000 + 0.4 (48,000 –40,000) = 43,200

C. Trend Projection Method

Although time series data generally exhibit random fluctuations, a time series may also show
gradual shifts or movements to relatively higher or lower values over a longer period of time.
If a time series plot exhibits this type of behavior, we say that a trend pattern exists. A trend is
usually the result of long-term factors such as population increases or decreases, changing
demographic characteristics of the population, technology, and/or consumer preferences.
The trend projection method involves determining the trend of consumption by analyzing past
consumption statistics, and projecting future consumption by extrapolating the past trend onto
the future.
When trend projection method is used, the most commonly employed relationship is the linear
relationship.
Yt = a + bT
Where Yt = Demand for the year t
    a = Interception of the relationship
    b = Slope of the relationship
    T = Time variable
To estimate the parameters a and b of the linear relationship, the least squares method is used.
The trend projection method involves
(a) Determining the trend of consumption by analyzing past consumption statistics
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(b) Projecting future consumption by extrapolating the trend.
To illustrate a time series with a trend pattern, consider the time series of bicycle sales for a
particular manufacturer over the past 10 years, as shown in Table 15.3 and Figure 15.3. Note that
21,600 bicycles were sold in year one, 22,900 were sold in year two, and so on.
In year 10, the most recent year, 31,400 bicycles were sold. Visual inspection of the time series
plot shows some up and down movement over the past 10 years, but the time series also seems to
have a systematically increasing or upward trend.

BICYCLE SALES TIME SERIES

Year Sales (1000s)
1 21.6
2 22.9
3 25.5
4 21.9
5 23.9
6 27.5
7 31.5
8 29.7
9 28.6
10 31.4
The trend for the bicycle sales time series appears to be linear and increasing over time, but
sometimes a trend can be described better by other types of patterns. For instance, the data in
Table 15.4 and the corresponding time series plot in Figure 15.4 show the sales for a cholesterol
drug since the company won FDA approval for it 10 years ago. The time series increases in a
nonlinear fashion; that is, the rate of change of revenue does not increase by a constant amount
from one year to the next. In fact, the revenue appears to be growing in an exponential fashion.
Exponential relationships such as this are appropriate when the percentage change from one
period to the next is relatively constant.
Uncertainties in demand forecasting

Demand forecasts are subject to error and uncertainties which arise from three principal sources,
such as:

1. Data about past and present market. The analysis of past and present markets, which
serve as the springboard for the projection exercise, may be vitiated by the following
inadequacies of data:
o Lack of Standardization: Data pertaining to market features like product, price, quantity, cost,
income, etc. may not reflect uniform concepts and measures.
o Few observations: observations available to conduct meaningful analysis may not be enough.
o Influence of abnormal factors: Some of the observations may be influenced by abnormal
factors like war or natural calamity.

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 2. Method of forecasting. Methods used for demand forecasting are characterized by the
following limitations:
o Inability to handle unquantifiable factors: most of the forecasting methods, being
quantitative in nature, cannot handle unquantifiable factors which sometimes can be of
immense significance.
o Unrealistic assumptions: Each forecasting method is based on certain assumptions. For
example, the trend projection method is based on the mutually compensating affects premise
and the end use method is based on the constancy of technical coefficients. Uncertainty arises
when the assumptions underline the chosen method tend to be realistic and erroneous.
o Exercise data requirement: In general, the more advanced a method, the greater the data
requirement. For example, to use an econometric model one has to forecast the future values
of explanatory variables in order to project the explained variable.
3. Environmental Change. The environment in which a business functions is characterized by
numerous uncertainties. The important sources of uncertainty are mentioned below:

o Technological Change: This is a very important and very hard-to-predict factor which
influences business prospects. A technological advancement may create a new product which
performs the same function more efficiently and economically, thereby cutting into the
market for the existing product. For example, electronic watches are encroaching on the
market for mechanical watches.
o Shift in Government Policy: Government resolution of business may be extensive. Changes
in government policy, which may be difficult to anticipate, could have a telling effect on the
business environment.
o Development on the International Scene: Development on the International Scene may have
a profound effect on industries.
o Discovery of New Sources of Raw Material: Discovery of new sources of raw materials,
particularly hydrocarbons, can have a significant effect on the market situation of several
products.
o Vagaries of the Weather: Weather plays an important role in the economy of a country, is
somewhat unpredictable. Extreme weather influences, directly or indirectly, the demand for a
wide range of 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.

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• 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 assess the impact on the size of demand for unfavorable and
favorable variations of the determining factors from their most likely levels.
4.1.6. Market planning
To enable the product to reach a desired level of market penetration, a suitable marketing plan
should be developed. Broadly, it should cover pricing, distribution, promotion and service.  A
marketing plan usually has the following components:
Current marketing situation
Opportunity and issue analysis
Objectives
Marketing strategy
Current Marketing Situation
This part of marketing plan deals with the different dimensions of the current situation.  It
examines the market situation, competitive situation, distribution situation, and the macro
environment.
Market situation deals with size, the growth, the consumer aspirations, and buying behaviour in
the market under consideration.  Competitive situation exhibits who are major competitors, their
objectives, strategies, strengths, etc.  Distribution situation compares the distribution capabilities
of the competitors and available distribution systems which are suitable for our product.  Macro-
environment describes the effect of social, political, economic, technological, and other external
variables on the market.
Opportunity and Issue Analysis
The management should conduct a SWOT analysis for the product and the core issues before the
product be identified.  The strength may be the use of distribution channel already established for
the existing products.  The weakness may be its limited resources.  The opportunities might be
the favourable consumer preference.  The threat might be the competition from substitutes. The
core issues may be how to use our strengths to offset probable threats, how can succeed with the
product with identified weaknesses, and how to exploit the opportunities available.
Objectives
Objectives have to be clear-cut, specific, and achievable.  These objectives form the basis for
selection of marketing strategies.  Objectives should be expressed unambiguously, preferable
quantitatively and with an indication of time span within which the objectives are planned to be
achieved.
Marketing Strategy
The marketing strategy covers target segment, positioning, product line, price, distribution, sales
force, sales promotion, and advertising. The market segment the firm wants target should be
clearly specified.  It needs to be described clearly in terms of the psychographics. Positioning is
how a product is placed in the mind of the customer.  Having decided the target market, the
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positioning should be done in appropriate with its characteristics. Product line refers number of
similar products a firm offering.  So it has to decide whether to introduce the product with
varieties or a single variant. Price should be in a range existed within the segment.  It should
have a bearing on positioning also.
The various distribution channels may be available to our product.  Then decision has to be taken
to use an effective combination of distribution channels. Sales force should be planned in such a
manner that to achieve the objectives.  So strategy in this regard specifies their size, probable
abilities, and method training which are proposed to be given to them. Sale promotion strategies
should also be formulated. A balance should be made between dealer level sales promotion and
consumer level sales promotion.  Strategy should also be formulated regarding advertisement. 
The firm can choose from a large variety of advertisement media. Before selecting an
advertisement media the firm should analyze its effectiveness with respect to our product

4.2. Raw materials and supplies study

An important aspect of technical analysis is concerned with defining the materials and utilities
required, specifying their properties in some detail, and setting up their program. There is an
intimate relationship between the study of materials and utilities and other aspects of project
formulation, particularly those concerned with location, technology, and equipments.

Objective of input study

1. To determine type of raw materials and supplies required, availability of basic raw material
supplies, quantity and quality of raw materials needed.
2. To estimate the cost of raw materials and supplies needed.
3. To develop supply programs and device supply marketing skills.
Material input and utilities may be classified in to four broad categories:
i. Raw materials
a) Agricultural products
b) Mineral products
c) Livestock and forest products
d) 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. The
questions that may be raised in this context are: What is the present marketable surplus? What is
the 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 quantum
of exploitable deposits and the properties of the raw materials. The study should provide details
of the location, size, and depth of the deposits and the viability of open cast or underground
mining. In addition, information should be generated on the composition of the ore, level of
impurities, need for beneficiation, and physical, chemical and other properties.

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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 of
collection is somewhat difficult. Preliminary marine operations, essential for this purpose, have
to be provided for in the feasibility study.

ii. 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 of
industries. In studying them the following questions need to be answered: In the case of
industrial materials, what are their properties? What is the total requirement of the project?
What quantity would 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 likely future behavior of prices?
iii. Auxiliary materials and factory supplies
A manufacturing 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 the
feasibility study.
iv. Utilities
A broad assessment of utilities (power, water, steam, fuel, etc) may be made at the time of the
input study though a detailed assessment can be made only after formulating the project with
respect to location, technology, and plant capacity. Since the successful operation of a project
critically depends on the adequate availability of utilities, the following questions should be
raised while conducting the inputs study. What quantities are required? What are the sources of
supply? What would be the potential availability? What are the likely shortages/ bottlenecks?
What measures may be taken to augment supplies?
Supply marketing and supply program
Supply marketing: The objectives of supply marketing are basically cost minimization, risk
minimization (reliability of 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
proper volume 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.
This could have then a significant impact on the financial feasibility of the project by reducing
the net cash flows and net profits generated. Supply marketing is a vital factor for success.
(ii) Risk Minimization and Reliability of Supplies
Reliability as regards quantities, qualities, deadlines and prices is significant for the entire
manufacturing process. Late deliveries lack of quality or poor maintenance services may have
serious consequences for the entire manufacturing process. These risks must therefore also be

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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 or enterprise. 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 may have 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 quality requirements.
 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 supply program in the feasibility study is
to show how supplies of materials and inputs will be secured. Evidence should be presented to
justify the assumption 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
geographical location, ownership, main activities, financial strength and profitability production
capacity, output over the last years, key customers and business experience with the type of

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products and the country concerned. An estimate of the level of priority that the supplier is
likely to give the contract is crucial.

b) Agreement and Regulations

Letter of intent regarding supply contacts and obligation should be referred to and the general
terms of suggested agreements, such as period of validity, payment terms, currency conditions
and guarantees, outlined. Import policies and regulations including application procedures for
obtaining 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
described and their consequences for the project analyzed.

c) Consignments (delivering of goods to someone else)

The quantities and qualities that can be supplied from various sources should be indicated. This
means that a comparison with the specific input requirements must be made taking in to account
not 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 in
the study. The availability, capacity, reliability and technical condition of the facilities must be
analyzed. 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 the
company concerned in order to obtain 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, railway
stations, or other places. The study should indicate the capacity of such facilities describe their
utilization and present estimated quantities to be stored on the basis of anticipated production
levels 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, changed
import regulations and shortages of foreign exchange for imports.

4.3. Location, site and environmental impact assessment (EIA)

Location refers to a fairly broad area like a city, an industrial zone, or a coastal area, while site
refers to a specific piece of land where the project would be set up. The choice of location
influenced by variety of considerations: proximity to raw materials and markets, availability of
infrastructure, labor situation, governmental policies, and other factors like, climatic condition,
general living conditions, proximity to ancillary units and ease in coping with pollution.

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 Proximity to Raw Materials and Markets
An important consideration for location is the proximity to the sources of raw materials and
nearness to the market for the final products. In terms of a basic locational model, the optimal
location is one where the total cost (raw material transportation cost plus production cost
plus distribution 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 the source of
the basic material (for example, limestone in the case of a cement plant and iron-ore in the 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 of
consumption may not be very important. Petro-chemical units or refineries, for example, may be
located close to the source of raw material, or close to the centre of consumption, or at some
intermediate 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 a major 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 power available, the stability of the power supply, the structure of
the power tariff, and the investment required 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, adequate transport connections - whether by rail, road, sea, inland water, or air -
are required. The availability, reliability, and cost of transportation for various alternative
locations should be assessed.

Given the plant capacity and the type of technology, the water requirement for the project can
be assessed. Once the required quantity is estimated, the amount to be drawn from the public
utility system 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
depend abilities, and relative qualities. In addition to power, transport, and water, the project
should have adequate communication facilities like telephone and internet.

Labor Situation
In labor-intensive projects, the labor situation in a particular location becomes important. The
key factors to be considered in evaluating the labor situation are:

Availability of labor, skilled, semi-skilled and unskilled

Prevailing labor rates
Labor productivity
State of industrial relations judged in terms of the frequency and severity of strikes and
lockouts

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 Degree of unionization

Governmental Policies
Government policies have a bearing on location. In the case of public sector projects, location is
directly decided by the government. It may be based on a wider policy for regional dispersion of
industries. In the case of private sector projects, location is influenced by certain governmental
restrictions and inducements. The government may prohibit the setting up of industrial projects
in certain areas which suffer from urban congestion. More positively, the government offers
inducements for establishing industries in backward areas. These inducements consist of
subsidies, concessional finance, sales tax loans, power subsidy, income tax benefits, lower
promoter contribution, 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 and Ease in
coping with pollution. Once the broad location is chosen, attention needs to be focused on the
selection of a specific site. Two or three alternative sites must be considered and evaluated with
respect to cost of land and cost of site preparation and development.

The cost of land tends to differ from one site to another in the same broad location. Sites close
to a 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, the need to demolish
and relocate existing structures, and the work involved in obtaining utility connections to the
site. The last element, viz, the work involved in obtaining utility connections and the cost
associated with it should be carefully looked into. It may be noted in this context that the cost of
the following may vary significantly from site to site: power transmission lines from the main
grid, railway siding from the nearest rail-road, feeder road connecting with the main road,
transport of water, and disposal of effluents.

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

The key issues that need to be considered in environmental impacts 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?
4.4. Production program and plant capacity
Sales program as a base: sales program shows the level of sales forecast to be realized during the
specified life of the envisaged plant.
1. Sales program is projected under market analysis.

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2. Provides input for financial analysis after protecting sales for different stages of production a
feasibility study should define and come up with a detail production program.
Aspects in production program
1. Determining capacity utilization
2. Determining the type of product
3. Different approaches for different industries.
Factors considered in setting the production program
Production level(capacity utilization)
Production problem
Wastage and spoilage
Price vs. quantity

Plant capacity (production capacity) refers to the volume or number of units that can be
manufactured during a given period. It may be defined in two ways:
1 Feasible normal capacity (FNC) refers to the capacity attainable under normal working
conditions. This may be established on the bases of the installed capacity, technical
condition of the plant, normal stoppages, downtime for maintenance and tool changes,
holidays, and tool changes, and shift patterns.
2 Nominal maximum capacity (NMC) is the capacity which is technically attainable and
this often corresponds to the installed capacity guaranteed by the supplier of the plant.

Our discussion will focus on the feasible normal capacity; several factors have a bearing on the
capacity decision. These are:
 Technological requirement
 Input constraints
 Investment cost
 Market condition
 Resources of the firm
 Government policy
Technological Requirement: For many industrial projects, particularly in process type
industries, there is a certain minimum economic size determined by the technological factor.
For example, a cement plant should have a capacity of at least 300 tons per day in order to use
the rotary kiln method; otherwise, it has to employ 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 certain inputs. Power supply may be limited; basic raw materials may be scarce;
foreign exchange available for imports may be inadequate. Constraints of these kinds should be
borne in mind while choosing the plant capacity.
Investment Cost: When serious input constraints do not exist, the relationship between
capacity and investment cost is an important consideration. Typically, the investment cost per
unit of capacity decreases as the plant capacity increases. This relationship expressed as;

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 C1=C2 [Q1/Q2] a
Where C1 = derived cost for Ql units of capacity
C2 = known cost for Q2 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 manufacture of a
certain item is $ 1,000,000. What will be the investment cost for 10,000 units of capacity if the
capacity-cost factor is 0.6?
The derived investment cost for 10,000 units of capacity may be obtained as follows:
C1 = 1,000,000 * [10,000/5,000] 0.6 = $ 1,516,000
Market Conditions: The anticipated market for the product/ service has an important bearing
on the plant capacity. If the market for the product is likely to be very strong, a plant of higher
capacity is preferable. If the market is likely to be uncertain, it might be advantageous to start
with a smaller capacity. If the market, starting from a small base, is expected to grow rapidly,
the initial capacity may be higher 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 and managerial capability.
Government Policy: The capacity level may be influenced by the policy of the government.

4.5. Technology selection

The choice of technology is influenced by a variety of considerations:
Plant capacity, Principal input, Investment outlay and production cost, Use by other units and
Product mix and ease of absorption

Appropriateness of technology
Appropriate technology refers to those methods of production which are suitable to local
economic, social, and cultural conditions. In recent years, the debate about appropriate
technology has been sparked off mainly by Schumacher and others. The advocates of appropriate
technology 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 condition?
4.6. Financial and economic analysis
In financial analysis, which is conducted from the view points of the private project-operator, we
will evaluate project in terms of its contribution to the net income (profit) of the private owner.
The basic objectives of financial analysis are:
 Assessment of financial incentives and impacts

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  Judgment of efficient resource use.
 Provision of sound financial plan.
4.6.1. Initial investment cost
Defined as sum of fixed assets (fixed investment costs plus pre production expenditures) and net
working capital. The amount of total investment cost is, in fact, smaller than total assets, since its
composed of fixed assets and networking capital, the latter being the difference between current
assets and current liabilities.

The total investment costs of a project consist of:

 The cost of land purchase and development

 The costs of physical buildings, site preparation and civil works.
 The cost of plant machinery and equipment including auxiliary equipment
 The cost of certain incorporated fixed assets such as industrial property rights.
The preproduction capital expenditures include the following components:
 Preliminary capital issue expenditures
 Expenditures for preparatory studies
 Other preproduction expenditures such as salaries fringe benefits, social security
contribution, consultant fees, travel expenses, preparatory installation pre production
marketing costs training costs, etc…

Working capital refers to the physical stocks needed to allow continuous production. There are
three components of working capital- initial stock of materials, final stocks of output and work in
progress.

NET WORKING CAPITAL =Current assets (inventories, accounts receivable and cash) –
Current liabilities (accounts payable)

4.6.5. Production cost

Given the estimated production, the cost of production may be worked out. The major
components of costs of production include:
I. Material costs – comprises the cost of raw materials, chemicals, components and
consumable stores required for production.
II. Labor costs – is the cost of all the manpower employed in the factory. Labor cost
naturally is a function of the number of employees and the rate of remuneration.
III. Factory overheads – the expense on repair and maintenance, rent taxes, insurances on
factory assets and so on.
4.6.6. Selling and administrative costs
It is necessary to estimate the various selling and administrative expenses that could be incurred
in distributing the project outputs. Though some of such costs are inventor able and included in
the cost of products, some of them could be periodic in their nature and could be expensed in the
period they are incurred.

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4.6.7. Analysis of financial statement
Types of Financial Statements are:
a. Cash-Flow Table: Shows the INFLOW and OUTFLOW of cash through a period of time.
Format for the Pro-Forma Cash Flow Statement
 There is no set format for the fro-forma cash flow statement. It is expected to have sufficient
detail so that the financial cash flows to be prepared could easily be adjusted for the
economic and distributive appraisal.
 Receipts must be identified as traded and non-traded goods, taxes, tariffs and subsidies
should be detailed. Financial charges, such as interest, must be excluded from the cost of
inputs and presented in a separate line. Example of mine (investment plan was given in the
following Table), Life of the mine is 7 years, Liquidation value of the mine is $1,000,000 and
Land has no value after being mined. The table in next page gives the financial cash flow
statement of the mine project.
Cash flow projection

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 (Thousands of dollars)
Item Year 0 1 2 3 4 5 6 7
RECEIPTS:
Sales: Traded 2000 3000 3500 3000 2000 0
Change in account receivables -500 -250 -250 +250 +250 +500
Liquidation Value (scrapped assets) 1000
CASH INFLOW (+) 1500 2750 3250 3250 2250 1500
EXPENDITURES:
a) Site preparation, exploration and
development:
Materials:
Traded material 500 500
Tariffs (traded) 75 75
Sales Taxes (traded) 29 29
Non-traded material 400 300
Sales taxes 20 15
Equipment:
Traded-Net 600 2000
Sales Tax 66 220
Tariffs 60 200
b) Material Purchases
Traded 600 750 800 700 600
Non-traded 200 250 320 200 200
Tariffs 60 75 80 70 60
Taxes 20 25 32 20 20
c) Labor Operating Cost
Skilled Labor 100 150 200 150 125
Unskilled Labor 50 70 90 80 60
d) Labor :Construction cost
Skilled Labor 150 100
Unskilled Labor 200 250
e) Change in Account Payables 0 -160 -40 -100 +100 +50 +150
f) Change in Cash held as working 20 10 15 5 -5 -25 -20
capital
CASH OUTFLOW (-) 2100 3709 880 1295 1427 1315 1090 130

NET CASH FLOW -2100 -3709 -620 +1455 +1823 +1935 +1160 +1370

a. Income Statement: Shows the Revenues and Expenditures for a period of time.

INCOME STATEMENT
REVENUES
Sales revenue +
Other revenues +
EXPENDITURES
Cost of goods sold -
Administrative costs -

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 Gross Profit (profit before tax) (- / +)
Net Taxes
NET PROFIT
b. Balance Sheet: Shows the ASSETS and the LIABILITIES at a certain period of
time

BALANCESHEET Date 31.12.2000

ASSETS LIABILITIES
Liquid assets Short term Liabilities
Cash at Bank Accounts Payable
Bonds and stocks Short Term Credits
Inventories
Fixed Assests Long Term Liabilities
Building Loan Term Liabilities
Mechineries Owner’s Equity
4.6.8. Financial evaluation
1. Net Present Value (NPV)

The NPV is the algebraic sum of the discounted values of the incremental expected positive and
negative net cash flows over a project’s anticipated lifetime.
What does net present value mean?
– Measures the change in wealth created by the project.
– If this sum is equal to zero, then there will be no change in wealth
 The cash flows estimated for the project are in the future; they are not yet realised
 The question then is, what is the value of these future estimated cash flows in the present or
current period, or better still today?
 future estimated cash flows would have to be ‘brought’ to the current or present period
 The future is not here yet, but decisions would have to be taken in the present time

Where :
T
Bt - Ct Bt is periodic benefit
NPV =  Ct is periodic cos t
t=1 (1+ r)t
 is the summation sign
 The value of NPV suggests how much a project is adding in value terms to an existing entity
or how much value the project is creating.
 A positive NPV means that the project is expected to add value to the firm and will therefore
increase the wealth of the owners.
 Since the goal of projects is to add value or increase owner’s wealth, NPV is a direct measure
of how well this project will meet the goal.

Decision Rule:

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 – NPV > 0; project is viable, accept.
– NPV < 0; project is not viable, reject.
– NPV = 0; project is neither viable nor not viable
Interpretation in Economic sense can be different

• Use as a decision criterion to answer following:

a. When to reject projects?
b. Select project(s) under a budget constraint?
c. Compare mutually exclusive projects?
d. How to choose between highly profitable mutually exclusive projects with different
lengths of life?
a. When to Reject Projects?

Rule: “Do not accept any project unless it generates a positive net present value when
discounted by the opportunity cost of funds”
Examples: Project A: Present Value Costs $1 million, NPV + $70,000
Project B: Present Value Costs $5 million, NPV - $50,000
Project C: Present Value Costs $2 million, NPV + $100,000
Project D: Present Value Costs $3 million, NPV - $25,000
Result: Only projects A and C are acceptable. The investor or country is made worse off if
projects B and D are undertaken
b. When You Have a Budget Constraint?

Rule: “Within the limit of a fixed budget, choose that subset of the available projects which
maximizes the net present value”

Example:
If budget constraint is $4 million and 4 projects with positive NPV:
Project E: Costs $1 million, NPV + $60,000
Project F: Costs $3 million, NPV + $400,000
Project G: Costs $2 million, NPV + $150,000
Project H: Costs $2 million, NPV + $225,000
Result: Combinations FG and FH are impossible, as they cost too much. EG and EH are within
the budget, but are dominated by the combination EF, which has a total NPV of $460,000. GH is
also possible, but its NPV of $375,000 is not as high as EF.

c. When You Need to Compare Mutually Exclusive Projects?

Rule: “In a situation where there is no budget constraint but a project must be chosen from
mutually exclusive alternatives, we should always choose the alternative that generates the
largest net present value”

Example: Assume that we must make a choice between the following three mutually exclusive
projects: Project I: PV costs $1.0 million, NPV $300,000

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Project J: PV costs $4.0 million, NPV $700,000
Projects K: PV costs $1.5 million, NPV $600,000
Result: Projects J should be chosen because it has the largest NPV
Considering the following cash flow stream of projects, and the cost of capital k to be 30%

Year 0 1 2 3 4 5 6 7

A -100 30 30 40 20 10 0 0

B -100 30 30 30 30 30 10 10

The
Cash flow Analysis for Project A and B
Cash flow Discount Factor Discounted Cash flow
Year A B (1+0.30)^-t A B
0 -100 -100 1.0000 -100.00 -100.00
1 30 30 0.7692 23.08 23.08
2 30 30 0.5917 17.75 17.75
3 40 30 0.4552 18.21 13.65
4 20 30 0.3501 7.00 10.50
5 10 30 0.2693 2.69 8.08
6 0 10 0.2072 0.00 2.07
7 0 10 0.1594 0.00 1.59
NPV -31.2691 -23.2675

NPV of the projects is calculated as follows

Advantages
Takes opportunity cost of money into account.
A single measure, which takes the amount and timing of cash flows into account.
With NPV one can consider different scenarios.
Results are expressed in value terms units of currency. So one is able to know the impact the
value that the project would create.
It is based on cash flows, which are less subjective than profits.

Disadvantages
 Complex to calculate and communicate.
 Meaning of the result is often misunderstood.

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 Only comparable between projects if the initial investment is the same.
 It can be difficult to identify an appropriate discount rate.
 Cash flows are usually assumed to occur at the end of a year, but in practice this is over
simplistic.

2. Internal Rate of Return (IRR)

IRR is the discount rate (K) at which the present value of benefits are just equal to the
present value of costs for the particular project

Bt −Ct
IRR ¿
(1+ K ) t

Common uses of IRR

(a) If the IRR is larger than the cost of funds then the project should be undertaken

(b) Often the IRR is used to rank mutually exclusive projects. The project with the highest
IRR should be chosen

IRR is the rate of return or discount rate that makes the NPV = 0. Decision Rule: Accept the
project if the IRR is greater than the required return. This is the most important alternative to
NPV. It is often used in practice and is intuitively appealing. It is based entirely on the
estimated cash flows and is independent of interest rates found elsewhere. Without a financial
calculator, this becomes a trial and error process. A critical thing to note is that there should be
at least one change of sign in order to realise IRR. There should be a negative net cash flow
among positive net cash flows or a positive cash flow among negative cash flows.

Difficulties with the Internal Rate of Return Criterion

First Difficulty: Multiple rates of return for project

Bt - C t
+300
-100 Time
-200
Solution 1: K = 100%; NPV= -100 + 300/(1+1) + -200/(1+1)2 = 0

Solution 2: K = 0%; NPV= -100+300/(1+0)+-200/(1+0)2

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 Difficulties With The Internal Rate of Return Criterion (Cont’d)

Second difficulty: Projects of different sizes and also mutually exclusive

with perpetual life

Year 0 1 2 3 ... ... 

Project -A2,000 +600 +600 +600 +600 +600 +600
Project-20,000
B +4,000 +4,000 +4,000 +4,000 +4,000 +4,000

NPV and IRR provide different Conclusions:

Opportunity cost of funds = 10%
0
NPVA : 600/0.10 - 2,000 = 6,000
- 2,000 = 4,000
0
NPVB : 4,000/0.10 - 20,000 = 40,000- 20,000 = 20,000
Hence, NPV 0
B > NPV
0
A
IRRA : 600/K
A - 2,000 = 0 or A =K0.30
IRRB : 4,000/K
B - 20,000 = 0 B or= K0.20
Hence,AK>KB
Third difficulty: Projects of different lengths of life and mutually exclusive

Opportunity cost of funds = 8%

Project A: Investment costs = 1,000 in year 0
Benefits = 3,200 in year
Project B: Investment costs = 1,000 in year
Benefits = 5,200 in year 10
NPVA : -1,000 + 3,200/(1.08)5 = 1,177.86
NPVB : -1,000 + 5,200/ (1.08)10 = 1,408.60

Hence, NPV >

NPV
IRRA : -1,000 + 3,200/(1+KA)5 = 0 which implies that kA = 0.262
IRRB : -1,000 + 5,200/(1.08)10 = 0 which implies that kB =0.179
Hence, kA>kB
Fourth difficulty: Same project but started at different times

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Fourth difficulty:
Project A: Investment costs = 1,000 in year 0
Benefits = 1,500 in year 1
Project B: Investment costs = 1,000 in year 5
Benefits = 1,600 in year 6

NPV 0 : - 1,000 + 1,500/(1.08) = 388.88

A 5
0
NPV
B : - 1,000/(1.08) + 1,600/(1.08) 6 = 327.68
0
Hence, NPV > NPV 0
A B

IRR
A: - 1,000 + 1,500/(1+K A
) = 0 which implies that K
A = 0.5
IRR 1,000/(1+K 6
B: - B)5 + 1,600/(1+K B) = 0 which implies that K B = 0.6
Hence, K
B >KA
IRR FOR IRREGULAR CASHFLOWS

For Example: Look at a Private BOT Project from the perspective of the Government

Year à 0 1 2 3 4
Project A 1000 1200 800 3600 -8000
IRR A 10%
Compares Project A and Project B?
Project B 1000 1200 800 3600 -6400
IRR B -2%
Project B is obviously better than A, yet IRR A > IRR B
Project C 1000 1200 800 3600 -4800
IRR C -16%
Project C is obviously better than B, yet IRR B > IRR C
Project D -1000 1200 800 3600 -4800
IRR D 4%
Project D is worse than C, yet IRR D > IRR C
Project E -1325 1200 800 3600 -4800

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 IRR E 20%
Project E is worse than D, yet IRR E > IRR D
Advantages of IRR

 It takes into account the time value of money, which is a good basis for decision-making.
 Results are expressed as a simple percentage, and are more easily understood than some
other methods.
 If the IRR is high enough, you may not need to estimate a required return, which is often a
difficult task.
 It is a simple way to communicate the value of a project to someone who doesn’t know all
the estimation details.
 If the IRR is high enough, you may not need to estimate a required return, which is often a
difficult task.
 It indicates how sensitivity decisions are to change in interest rates.

Disadvantages
 For mutually exclusive projects: timing and scale differences. This may lead to incorrect
decisions in comparisons of mutually exclusive investments.
 Assumes funds are re-invested at a rate equivalent to the IRR itself, which may be
unrealistically high.
 IRR will produce more than one mathematically correct rate for each year in which inflows
are followed by outflows and vice versa. This is common with projects with unconventional
cash flows. This can create some confusion to the user.

Conflicts between NPV and IRR

NPV directly measures the increase in value to the firm.
Whenever there is a conflict between NPV and another decision rule, you should always use
NPV.
IRR is unreliable in the following situations

– Non-conventional cash flows:- cash flow signs change more than once

– Mutually exclusive projects

Initial investments and Timing of cash flows are substantially different

If you choose one, you can’t choose the other. Example: You can choose to attend graduate
school next year at either Legon or Central, but not both.
When the cash flows change sign more than once, there is more than one IRR. When we
solve for IRR it would be noticed that we are solving for the root of an equation and when we
cross the x-axis more than once, there will be more than one return that solves the equation.
Therefore, IRR may be unreliable if we have any negative cashflows after our original
investment.

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 Intuitively you would use the following decision rules:
 NPV – choose the project with the higher NPV
 IRR – choose the project with the higher IRR

Period Project A Project B

0 -500 -400
1 325 325
2 325 200
• IRR 19.43% 22.17%

• NPV 64.05 60.74

The required return for both projects is 10%. Which project should you accept and why? (Accept
Project A because of NPV). Suppose an investment will cost ¢90,000 initially and will generate
the following cash flows: Year 1: 132,000, Year 2: 100,000 and Year 3: -150,000

The required return is 15%. Should we accept or reject the project?

Year 0 -90,000
Year 1 132,000
Year 2 100,000
Year 3 -150,000
IRR 10.11% reject
NPV fx 15% 91,770
Less inv. -90,000
NPV at 15% 1,770 accept
IRR says to reject, but NPV says to accept. Go with NPV.

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 3. Benefit-Cost Ratio (R)
As its name indicates, the benefit-cost ratio (R), or what is sometimes referred to as the
profitability index, is the ratio of the PV of the net cash inflows (or economic benefits) to the
PV of the net cash outflows (or economic costs):
PV of Cash Inflows (or Economic Benefits)
R=
PV of Cash Outflows (or Economic Costs)

Cash flow Analysis for Project A and B

Cash flow Discount Factor Discounted Cash flow
Year A B (1+0.30)^-t A B
0 -100 -100 1.0000 -100.00 -100.00
1 30 30 0.7692 23.08 23.08
2 30 30 0.5917 17.75 17.75
3 40 30 0.4552 18.21 13.65
4 20 30 0.3501 7.00 10.50
5 10 30 0.2693 2.69 8.08
6 0 10 0.2072 0.00 2.07
7 0 10 0.1594 0.00 1.59
Sum of +ves 68.7309 76.7325
Sum of -ves 100.00 100.00
NBIR 0.687309 0.767325

Basic rule: If benefit-cost ratio (R) >1, then the project should be undertaken.

Problems

Sometimes it is not possible to rank projects with the Benefit-Cost Ratio

Mutually exclusive projects of different sizes

Mutually exclusive projects and recurrent costs subtracted out of benefits or benefits reported
gross of operating costs
Not necessarily true that RA>RB that project “A” is better

First Problem: The Benefit-Cost Ratio Does Not Adjust for Mutually Exclusive Projects of
Different Sizes. For example:
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Project A: à PV0of Costs = $5.0 M, PV0 of Benefits = $7.0 M
NPV0A = $2.0 M RA = 7/5 = 1.4
Project B: à PV of Costs = $20.0 M,
0
PV of Benefits = $24.0 M
0

NPV B = $4.0 M
0
RB = 24/20 = 1.2
According to the Benefit-Cost Ratio criterion, project A should be chosen over project B because
RA>RB, but the NPV of project B is greater than the NPV of project A. So, project B should be
chosen

Second Problem: The Benefit-Cost Ratio Does Not Adjust for Mutually Exclusive Projects and
Recurrent Costs Subtracted Out of Benefits or Benefits Reported As Gross of Operating Costs.
For example:

• Project A: PV0 Total Costs = $5.0 M PV0 Recurrent Costs = $1.0 M

(i.e. Fixed Costs = $4.0 M) PV0 of Gross Benefits= $7.0 M
RA = (7-1)/(5-1) = 6/4 = 1.5
• Project B: Total Costs = $20.0 M Recurrent Costs = $18.0 M
(i.e. Fixed Costs = $2.0 M) PV of Gross Benefits= $24.0 M
0

RB = (24-18)/(20-18) = 6/2 =3
• Hence, project B should be chosen over project A under Benefit-Cost Criterion.

Conclusion: The Benefit-Cost Ratio should not be used to rank projects

In the case of BCR, the discounted cash inflow is expressed in terms of the discounted cash
outflow. This can be viewed as: how many times the discounted cash inflow covers the
discounted cash outflow over the project horizon.

Decision criteria

 For a single project, a B/C ratio which is greater than 1 indicates acceptability
 For multiple (competing) projects, the project(s) with the highest B/C ratios (greater than
1) should receive highest priority

NPV measures totals, indicates the amount by which benefits exceed (or do not exceed) costs.
B/C measures the ratio (or rate) by which benefits do or do not exceed costs. They are clearly
similar, but not identical. With multiple projects, some may do better under NPV analysis, others
under B/C.

4. Pay-back period
The pay-out period measures the number of years it will take for the undiscounted net benefits
(positive net cash flows) to repay the investment. A more sophisticated version of this rule
compares the discounted benefits over a given number of years from the beginning of the project
with the discounted investment costs. An arbitrary limit is set on the maximum number of years

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allowed and only those investments having enough benefits to offset all investment costs within
this period will be acceptable.

Amount not recovered

PBP=no of full years of operation+
total amount of cash flow of next period

Example: a machine costs $100000. The following uneven cash inflows have been received.
Find out the payback period.

Year 1 2 3 4 5

Cash inflows after tax 500000 700000 400000 400000 400000

1000000−500000
PBP=1+ = 1.71
700000

Disadvantages of payback period

1. It fails to consider and amount of net benefits after the payback period.
2. It does not adequately take in to account the time value of money even in payable
periods.

Consider the following alternative projects.

Alternative Year Investment cost Net incremental Cumulative net

Projects benefit incremental benefit
Project A 0 20000 -
1 2000
2 8000
3 12000
4 9000 29000
Project B 0 20000 -
1 200
2 12000
3 8000
4 12000 32000
Project C 0 20000 -
1 1000
2 5000
3 6000
4 8000
5 10000
6 5000
7 2000 37000

Note that the incremental net benefit could be financial or economic incremental net benefits.
Project A and B have a payback period of 3 years. But project C has a payback period of 4 years.

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Thus, project A and B have equal higher rank than project C. therefore the method fails to
consider the time and amount of net incremental benefit after the payback period of project C.

In addition, the method results equal rank for two projects. Yet we would choose project B
because more of the returns are realized earlier.

5. Accounting rate of return (ARR)

It has many variants due to differences in how it is computed. All variants, however, have
two features in common;

1. Use of accounting concepts in calculating benefits

2. No adjustment for time value of money
i. Proceeds per unit of outlay – investments are ranked by the proceeds per unit of outlay.
It is the total value of incremental net benefits divided by the total amount of investment.
In the previous example, project A, B, & C have a proceeds per outlay of 1.45, 1.6 and
1.85, respectively. Hence, project C will be ranked first.
ii. Average annual proceeds per unit of outlay – in this case, first the total net incremental
benefits will be divided by the time it will be realized to arrive at average annual net
incremental benefits, and then this average value will be divided by total investment
costs. In this method, project A, B and C will have average annual proceeds per unit of
outlay of 0.36, 0.40 and 0.26 respectively. Hence, project B will be chosen.
iii. Average income on book value of investment – is the ratio of average income to the
book value of assets (i.e. the value after subtracting depreciation) stated in percentage
terms. In the above example, assuming straight line depreciation for all project, average
income on book value can be calculated as follows:

Project Average net value of Annual Net average Average Average income
incremental benefit depreciation income book value on book value
A 7250 5000 2250 1000 0.225
B 8000 5000 3000 1000 0.300
C 5285.7 2857.1 2428.6 1000 0.242
6. Break-even analysis
In sensitivity analysis we ask what will happen to the project if sales decline or costs increase or
something else happens. A financial manager will also be interested in knowing how much
should be produced and sold at a minimum to insure that the project does not “lose money” such
an exercise is called break-even analysis and the minimum quantity at which loss is avoided is
called the break-even point. The purpose of break-even analysis is to determine the equilibrium
point at which sales revenues equal the costs of products sold. When sales are below this point,
the firm is making a loss, and at the point where revenue equal costs, the firm is break-even.

Deciding on a Project
• We should consider several investment criteria when making decisions.

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• NPV and IRR are the most commonly used primary investment criteria.
• Payback is a commonly used secondary investment criteria, but only because of its ease of
use.
• For a single project, a positive NPV indicates acceptability.
• For multiple (competing) projects, the project(s) with the highest NPVs should receive
highest priority.

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