Project identification is an important step in project formulation. These are conceived with the objective of meeting the market demand, exploiting natural resources or creating wealth. The project ideas for developmental projects come mainly from the national planning process, where as industrial projects usually stem from the identification of commercial prospects and profit potential.
As projects are a means to achieving certain objectives, there may be several alternative projects that will meet these objectives. It is important to indicate all the other alternatives considered with justification in favor of the specific project proposed for consideration. Sectoral studies, opportunity studies, support studies, project identification essentially focuses on screening the number of project ideas that come up based on information and data available and based on expert opinions and to come up with a limited number of project option which are promising.
Project Formulation
Project Formulation Concept
“Project Formulation” is the process of presenting a project idea in a form in which it can be subjected to comparative appraisals for the purpose of determining in definitive terms the priority that should be attached to a project under severe resource constraints.
Project Formulation involves the following steps (Figure 1).
Opportunity Studies
Pre-feasibility Studies / Opportunity Studies
Feasibility Study
Economic and Market Analysis
In market analysis, a number of factors need to be considered covering – product specifications, pricing, channels of distribution, trade practices, the threat of substitutes, domestic and international competition, opportunities for exports etc. It should aim at providing analysis of future market scenarios so that the decision on project investment can be taken in an objective manner keeping in view the market risk and uncertainty.
Technical Analysis
Technical analysis is based on the description of the product and specifications and also the requirements of quality standards. The analysis encompasses available alternative technologies, selection of the most appropriate technology in terms of optimum combination of project components, implications of the acquisition of technology, and contractual aspects of licensing. Special attention is given to technical dimensions such as in project selection. The technology chosen should also keep in view the requirements of raw materials and other inputs in terms of quality and should ensure that the cost of production would be competitive.
Environmental Impact Studies:
All most all projects have some impact on the environment. The current concern of environmental quality requires environmental clearance for all projects. Therefore environ impact analysis needs to be undertaken before the commencement of the feasibility study.
Objectives of Environmental Impact Studies:
• To identify and describe the environmental resources/values (ER/Vs) or the environmental attributes (EA) which will be affected by the project (in a quantified manner as far as possible).
• To describe, measure and assess the environmental effects that the proposed project will have on the ER/Vs.
• To describe the alternatives to the proposed project which could accomplish the same results but with a different set of environmental effects, The environmental impact studies would facilitate providing necessary remedial measures in terms of the equipment and facilities to be provided in the project to comply with the environmental regulation specifications.
Financial Analysis
The Financial Analysis examines the viability of the project from financial or commercial considerations and indicates the return on the investments. Some of the commonly used techniques for financial analysis are as follows.
• Pay-back period.
• Return on Investment (ROI)
• Net Present Value (NPV)
• Profitability Index(PI)/Benefit Cost Ratio
• Internal Rate of Return (IRR)
Pay-back Period
This is the simplest of all methods and calculates the time required to recover the initial project investment out of the subsequent cash flow. It is computed by dividing the investment amount by the sum of the annual returns (income – expenditure) until it is equal to the capital cost.
Example1. (Uniform annual return)
A farmer has invested about Rs. 20000/- in constructing a fish pond and gets annual net return of Rs.5000/- (difference between annual income and expenditure). The pay back period for the project is 4 years (20000/ 5000).
Example 2.(Varying annual return)
In a project Rs.1,00,000/- an initial investment of establishing a horticultural orchard. The annual cash flow is as under.
The drawback in this method is that it ignores any return received after the payback period and assumes an equal value for the income and expenditure irrespective of the time. It is also possible that projects with a high return on investments beyond the pay-back period may not get the deserved importance i.e., two projects having the same pay-back period –one giving no return and the other providing a large return after a pay-back period will be treated equally, which is logically not correct.
Return on Investment (ROI);
The ROI is the annual return as a percentage of the initial investment and is computed by dividing the annual return with investment. It is calculation is simple when the return is uniform.
For example, the ROI of the fish ponds is (5000/ 10000) X 100 = 50%. When the return is not uniform the average of annual returns over a period is used. For horticultural orchard average return is (1,30,000/3) = 43333. ROI = (43333/100000) X 100 = 43.3 %.
The computation of ROI also suffers from similar limitations as of the pay-back period. It does not differentiate between two projects one yielding immediate return (lift irrigation project) and another project where the return is received after some gestation period say about 2-3 years (developing new variety of crop).
Both the pay-back period and ROI are simple ones and more suited for quick analysis of the projects and sometimes provide inadequate measures of project viability. It is desirable to use these methods in conjunction with other discounted cash flow methods such as Net Present Value (NPV), Internal Rate of Return (IRR) and Benefit-Cost ratio.
Discounted Cash Flow Analysis:
The principle of discounting is the reverse of compounding and takes the value of money over time. To understand his let us take an example of compounding first.
Assuming a return of 10 %, Rs 100 would grow to Rs110/- in the first year and Rs 121 in the second year. In reverse the statement, at a discount rate of 10% the return of Rs.110 in the next year is equivalent to Rs100 at present. In other words the present worth of next years return at a discount rate 10 % is only Rs.90.91 i.e., (100/110) Similarly Rs121 in the second year worth Rs 100/- at present orthe present value of a return after two years is Rs. 82.64 (100/121). These values Rs.90.91 andrs.82.64 are known as present value of of future annual return of Rs.100 in first and second year respectively. Mathematically, the formula for computing present value (PV) of a cash flow “Cn” in
“nth” year at a discount rate of “d” is as follows;
PV= Cn / (1+d)n
The computed discount factor tables are also available for ready reference. In the financial analysis, the present value is computed for both investment and returns. The results are presented in three different measures ie. NPV, B-C Ratio, and IRR.
Net Present Value (NPV)
Net Present Value is considered as one of the important measure for deciding the financial viability of a project. The sum of discounted values of the stream of investments in different years of project implementation gives present value of the cost (say C). Similarly sum of discounted returns yields the present value of benefits (say B). The net present value (NPV) of the project is the difference between these two values (B- C). Higher the value of NPV is always desirable for a project.
Benefit-Cost Ratio (B-C Ratio) or Profitability Index (PI);
The B-C Ratio also referred as Profitability Index (PI), reflect the profitability of a project and computed as the ratio of total present value of the returns to the total present value of the investments (B/C). The higher the ratio better is the return.
Internal Rate of Return (IRR):
Internal Rate of Return (IRR) indicates the limit or the rate of discount at which the project total present value of return (B) equals to total present value of investments ( C ) i.e. B-C= Zero. In other words it is the discount rate at which the NPV of the project is zero. The IRR is computed by iteration i.e. Computing NPV at different discount rate till the value is nearly zero. It is desirable to have projects with higher IRR.
Risk and Uncertainty
Risk and Uncertainty are associated with every project. Risk is related to occurrence of adverse consequences and is quantifiable. It is analysed through probability of occurrences. Where as uncertainty refers to inherently unpredictable dimensions and is assessed through sensitivity analysis. It is, therefore, necessary to analyse these dimensions during the formulation and appraisal phase of the program.
Factors attributing to risk and uncertainties of a project are grouped under the following;
• Technical –relates to project scope, change in technology, quality and quantity of inputs, activity times, estimation errors etc.
• Economical- pertains to market, cost, competitive environment, change in policy, exchange rate etc.
• Socio-political- includes dimensions such as labour, stakeholders etc.
• Environmental – factors could be level of pollution, environmental degradation etc.
Economic Benefits:
Apart from the financial benefits (in terms of Return on Investment) the economic benefits of the project are also analyzed in the feasibility study. The economic benefits include employment generation, economic development of the area where the project is located, foreign exchange savings in case of import substitutes or earning of foreign exchange in case of export-oriented projects and others.
Management Aspects:
Management aspects are becoming very important in project feasibility studies. The management aspects cover the background of promoters, management philosophy, the organization set up and staffing for project implementation phase as well as operational phase, the aspects of decentralization and delegation, systems and procedures, the method of execution and finally the accountability.
Time Frame for Project Implementation:
The feasibility study also presents a broad time frame for project implementation. The time frame influences preoperative expenses and cost escalations which will impact the profitability and viability of the project.
Feasibility Report:
Based on the feasibility studies the Techno-economic feasibility report or the project report is prepared to facilitate project evaluation and appraisal and investment decisions.
Project Appraisal
The project appraisal is the process of critical examination and analysis of the proposal in totality. The appraisal goes beyond the analysis presented in the feasibility report. At this stage, if the required compilation of additional information and further analysis of project dimensions are undertaken. At the end of the process an appraisal note is prepared for facilitating decision on the project implementation.
The appraisal process generally concentrates on the following aspects.
• Market Appraisal: Focusing on demand projections, adequacy of marketing infrastructure and competence of the key marketing personnel.
•Technical Appraisal: Covering product mix, Capacity, Process of manufacture engineering know-how and technical collaboration, Raw materials and consumables, Location and site, Building, Plant and equipment, Manpower requirements and Break-even point.
•Environmental Appraisal: Impact on land use and micro-environment, the commitment of natural resources, and Government policy.
•Financial Appraisal: Capital, rate of return, specifications, contingencies, cost projection, capacity utilization, and financing pattern.
•Economic Appraisal: Considered as a supportive appraisal it reviews economic rate of return, the effective rate of protection and domestic resource cost.
•Managerial Appraisal: Focuses on promoters, organization structure, managerial personnel, and HR management.
•Social Cost-Benefit Analysis (SCBA):Social Cost-Benefit Analysis is a methodology for evaluating projects from the social point of view and focuses on social cost andbenefits of a project. There often tend to differ from the costs incurred in monetary terms and benefits earned in monetary terms by the project SCBA may be based onUNIDO method or the Little-Mirriles (L-M) approach. Under UNIDO method the net benefits of the project are considered in terms of economic (efficiency) prices also referred to as shadow prices. As per the L-M approach the outputs and inputs of aproject are classified into (1) traded goods and services (2) Non traded goods and services; and (3) Labor. All over the world including India currently the focus is on Economic Rate of Return (ERR) based on SCBA assume importance in project formulation and investment decisions.
Detailed Project Report (DPR)
Once the projects are appraised and the investment decisions are made a Detailed Project Report (DPR) is prepared. It provides all the relevant details including design drawings, specifications, detailed cost estimates etc. and this would act as a blue print for project implementation.