(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

PREPARATION OF PROJE T, PROJE T I!ENTIFI ATION AN! FOR"#$ATION, PROJE T APPRAI%A$ & %O#R E% OF FINAN E
Mr. Rashmi Ranjan Panigrahi 1.

&Asst. Prof. In Finance, Department of MBA/ MFC (Master of Finance and Control)/ M.Com Education , Arya Sc ool of Mana!ement " I#, B u$anes%ar, India, contact no& '(()()'*(+]

Structure of the Chapter To understand the meaning of project. Present the classification of project. Discuss the steps in project selection. Present the meaning and contents of project report. Discuss identification of opportunity and feasibility study.

--------------------------------------------------- X --------------------------------------------------------"EANIN' OF PROJE T An entrepreneur ta es numerous decisions to con!ert his business idea into a running concern. "is#"er decision ma ing process starts $ith project#product selection. The project selection is the first corner stone to be laid do$n in setting up an enterprise. The success or failure of an enterprise largely depends upon the project. The popular %nglish pro!erb &$ell began is half done' applies to project selection also indicates the significant of good beginning. The dictionary meaning of project is that is a scheme( design a proposal of something intended or de!ised to be achie!ed. )e$man and his associates define that &a project has typically has a distinct mission that it is designed to achie!e and clear termination point( the achie!ement of the mission. *illinger defines project &as a $hole comple+ of acti!ities in!ol!ed in using resources to gain benefits'. According to %ncyclopedia of management( &a project is an organi,ed unit dedicated to the attainment of goal-the successful completion of a de!elopment project on time( $ithin budget( in conformance $ith predetermined programme specifications.' )o$( a project can be defined as a scientifically e!ol!ed $or plan de!ised to achie!e a specific objecti!e $ithin a specified period of time.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

Project can differ in their si,e( nature of objecti!es( time duration and comple+ity. "o$e!er projects parta e of the follo$ing three basic attributes. /i0 A course of action /ii0 Specific objecti!es and /iii0 Definite time perspecti!es. %!ery project has starting point( an end point $ith specific objecti!es. PROJE T $A%%IFI ATION Project classification helps in e+pressing and highlighting the essential features of project. Different authorities ha!e classified projects differently. The follo$ing are some of the important classification of projects. (() )uantifia*le and Non+)uantifia*le Projects 1uantifiable projects are those in $hich possible 2uantitati!e assessment of benefits can be made. )on-2uantifiable projects are those $here such assessment is not possible. Projects concerned $ith industrial de!elopment( po$er generation( mineral de!elopment fall in the first category $hile projects in!ol!ing health( education and defense fall in the second category. (,) %ectional Projects "ere the classification is based on !arious sectors li e 3 Agriculture and allied sector 3 4rrigation and po$er sector 3 4ndustry and mining sector 3 Transport and communication sector 3 4nformation technology sector 3 5iscellaneous This system of classification has been found useful in resource allocation at macro le!el. (-) Tec.no+Economic Projects Classification of projects based on techno-economic characteristic fall in this category. This type of classification includes factors Intensity-oriented classification, Causation oriented classification Magnitude-oriented classification as discussed belo$. /a0 Factor intensit/+oriented classification0 6ased on this projects may be classified as capital intensi!e or labor intensi!e if large in!estment is made in plant and machinery the project $ill be termed as capital intensi!e. 7n the other hand project in!ol!ing large number of human resources $ill be termed as &labor intensi!e'.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

/b0 ausation+oriented classification0 7n the basis of causation( projects can be classified as demand based and ra$ material based projects. The a!ailability of certain ra$ materials( s ills or other inputs ma es the project ra$-material based and the !ery e+istence of demand for certain goods or ser!ices ma e the project demand-based.
/c0 Magnitude-oriented classification0 This is based on the si,e of in!estment in!ol!ed in the projects( accordingly project are classified into large scale( medium-scale or small-scale projects. The selection of a project consists of t$o main steps. Project identification and project selection.

PROJE T I!ENTIFI ATION 7ften indenting entrepreneurs al$ays are in search of project ha!ing a good mar et but ho$ $ithout no$ing the product coat they determine mar et $hose mar et they find out $ithout no$ing the item i.e. product8 4dea generation about a fe$ projects pro!ides a $ay to come out of the abo!e tangle. I!EA 'ENERATION The process of project selection starts $ith idea generation. 4n order to select most promising and profitable project( the entrepreneur has to generate large number of ideas about the possible projects he can ta e. The project ideas can be disco!ered from !arious internal and e+ternal sources. These may include. /i0 9no$ledge of potential customer needs. /ii0 Personal obser!ation of emerging trends in demand for certain products. /iii0 Scope for producing substitute product. /i!0 Trade and professional maga,ines $hich pro!ide a !ery fertile source of project ideas. /!0 Departmental publications of !arious departments of the go!ernment. /!i0 Success stories of no$n entrepreneurs or friends or relati!es. /!ii0 A ne$ product introduced by the competitor. /!iii0 4deas gi!en by no$ledgeable persons. All these sources putting together may gi!e fe$ ideas about the possible projects to be e+amined among $hich the project must be selected. After going through these sources if an entrepreneur has been able to get si+ project ideas( one project idea $ill be finally selected going through the follo$ing selection process.
PROJE T %E$E TION

Project selection starts once the entrepreneur has generated fe$ ideas of project. After ha!ing some ideas( these project ideas are analy,ed in the light of e+isting economic conditions( mar et conditions( and the go!ernment policy and so on. :or this purpose a tool is generated used $hat is called S;7T analysis. The intending entrepreneur analyses his strengths and $ea nesses as $ell as opportunities#competiti!e ad!antages and threats#challenges offered by each of the project ideas. 4n addition the entrepreneur needs to analy,e other related aspects also li e ra$

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

material( potential mar et( labor( capital( location and forms of o$nerships etc. %ach of these aspects has to be e!aluated independently and in relation to each of these aspects. 7n the basis of this analysis( the most suitable idea is finally selected to con!ert it into an enterprise. The process in!ol!ed in selecting a project out of fe$ projects is also termed as &<eroing in Process'.

Interdependent aspects of projects

FOR"#$ATION OF PROJE T REPORT A project report is li e a road map. 4t is an operating document. ;hat information and ho$ much information it contain depends upon the si,e of the enterprise( as $ell as nature of production. :or e+ample small-scale enterprises do not include technology $hich is used for preparing project reports of large-scale enterprises. ;ithin small-scale enterprises too( all information may not be homogeneous for all units. =inod *upta has gi!en a general set of information in his study &:ormation of a project report.'
According to *upta( project formulation di!ides the process of project de!elopment into eight distinct and se2uential stages as belo$.

/>0 *eneral information /?0 Project description /@0 5ar et potential /A0 Capital costs and sources of finance /B0 Assessment of $or ing capital re2uirements /C0 %conomical and social !ariables /D0 Project implementation The nature of formation to be collected and furnished under each of these stages has been gi!en belo$.
Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

(() 'ENERA$ INFOR"ATION The information of general nature gi!en in the project report includes the follo$ing. A. Bio-data of promoter0 )ame and address( 2ualifications( e+perience and other capabilities of the entrepreneur. Similar information of each partner if any. 6. Industry profile0 A reference analysis of industry to $hich the project belongs( e.g.( past performanceE present status( its organi,ation( its problems etc. C. Constitution and organi ation0 The constitution and organi,ation structure of the enterpriseE in case of partnership firm its registration $ith registrar of firms( certification from the directorate of industries district industry centre. D. Product details0 Product utility( product range( product design( ad!antage to be offered by the product o!er its substitutes if any. (,) PROJE T !E% RIPTION A brief description of the project co!ering the follo$ing aspects should be made in the project report. Site. Focation of the unitE o$ned( rented or leasehold landE industrial areaE no objection certificate from municipal authorities if the enterprise location falls in the residential area. Physical 4nfrastructure. A!ailability of the follo$ing items of infrastructure should be mentioned in the project report. /a0 Ra! material0 Ge2uirement of ra$ material( $hether inland or imported( sources of ra$ material supply. /b0 "#illed la$our0 A!ailability of s illed labour in the area i.e.( arrangements for training labourers in !arious s ills. /c0 %tilities. These include. >. Po!er0 Ge2uirement of po$er( load sanctioned( a!ailability of po$er ?. &uel0 Ge2uirement of fuel items such as coal( co e( oil or gas( state of their a!ailability and supply position. @. 'ater0 The sources of $ater( 2uality and 2uantity a!ailable. /d0 Pollution control0 The aspects li e scope of dumps( se$age system( se$age treatment plant( infiltration facility etc.( should be mentioned. /e0 Communication and transportation facility0 The a!ailability of communication facilities( e.g.( telephone( fa+( tele+( internet etc.( should be indicated. Ge2uirements for transport( mode of transport( potential means of transport( appro+imate distance to be co!ered( bottlenec s etc.( should be stated in the business plan. /f0 Production process0 A mention should be made for process in!ol!ed in production and period of con!ersion from ra$ material into finished goods. /g0 Machinery and e(uipment0 A complete list of machines and e2uipments re2uired indicating their si,e( type( cost and sources of their supply should be enclosed $ith the project report.
Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

/h0 Capacity of the plant0 The installed licensed capacity of the plant along $ith the shifts should also be mentioned in the project report. /i0 )echnology selected0 The selection of technology( arrangements made for ac2uiring it should be mentioned in the business plan. /j0 *ther common facilities0 A!ailability of common facilities li e machine shops( $elding shops and electrical repair shops etc should be stated in the project report. / 0 Research and de+elopment0 A mention should be made in the project report regarding proposed research and de!elopment acti!ities to be underta en in future. (-) "AR1ET POTENTIA$ ;hile preparing a project report( the follo$ing aspects relating to mar et potential of the product of the product should be stated in the report. >. ,emand and supply position0 State the total e+pected demand for the product and present supply position( $hat is the gap bet$een demand and supply and ho$ much gap $ill fill up by the proposed unit. ?. -.pected price0 %+pected price of the product to be reali,ed should also be mentioned. @. Mar#eting strategy0 Arrangements made for selling the product should be clearly stated in the project report. A. After sales ser+ice0 Depending upon the nature of the product( pro!isions made for aftersales should normally be stated in the project report. (2) APITA$ O%T% AN! %O#R E% OF FINAN E An estimate of the !arious components of capital items li e land and buildings( plant and machinery( installation costs( preliminary e+penses( margin of $or ing capital should be gi!en in the project report. The sources should indicate the o$ners funds together $ith funds raised from financial institutions and ban s. (3) A%%E%%"ENT OF 4OR1IN' APITA$ The re2uirement for $or ing capital and its sources of supply should clearly be mentioned. 4t is preferred to prepare $or ing capital re2uirements in the prescribed formats designed by limits of re2uirement. 4t $ill reduce the objections from ban erHs side.

(5) E ONO"I A$ AN! %O IA$ 6ARIA7$E% %!ery enterprise has social responsibility. 4n !ie$ of the social responsibility of business( the abatement costs( i.e.( the costs for controlling the en!ironmental damage should be stated in the

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

project. Arrangements made for treating the effluents and emissions should also be mentioned in the report. 4n addition the follo$ing socio-economic benefits should also be stated in the report. /i0 %mployment *eneration /ii0 4mport Substitution /iii0 Ancillaration /i!0 %+ports /!0 Focal Gesource Itili,ation /!i0 De!elopment of the Area

(8) PROJE T I"P$E"ENTATION %!ery entrepreneur should dra$ an implementation scheme or a time-table for his project to the timely completion of all acti!ities in!ol!ed in setting up an enterprise. 4f there is delay in implementation project cost o!errun. Delay in project implementation jeopardi,es the financial !iability of the project( on one hand( and props up the entrepreneur to drop the idea to set up an enterprise( on the other. "ence there is need to dra$ up an implementation schedule for the project and then to adhere to it. P%GT and CP5 discussed later in this chapter can be used to get better insight into all acti!ities related to implementation of the project.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

%O#R E% OF FINAN E 9 %O#R E% OF F#N!% Chapter 7bjecti!es Structure of the Chapter Sources of :unds 7rdinary /%2uity0 Shares Foan Stoc 6an Fending Feasing "ire Purchase *o!ernment Assistance =enture Capital :ranchising --------------------------------------------------- X ---------------------------------------------------------

Sourcing money may be done for a !ariety of reasons. Traditional areas of need may be for
capital asset ac2uirement - ne$ machinery or the construction of a ne$ building or depot. The de!elopment of ne$ products can be enormously costly and here again capital may be re2uired. )ormally( such de!elopments are financed internally( $hereas capital for the ac2uisition of machinery may come from e+ternal sources. 4n this day and age of tight li2uidity( many organi,ations ha!e to loo for short term capital in the $ay of o!erdraft or loans in order to pro!ide a cash flo$ cushion. 4nterest rates can !ary from organisation to organisation and also according to purpose. :APTER O7JE TI6E% This chapter is intended to pro!ide. An introduction to the different sources of finance a!ailable to management( both internal and e+ternal An o!er!ie$ of the ad!antages and disad!antages of the different sources of funds An understanding of the factors go!erning the choice bet$een different sources of funds.

%TR# T#RE OF T:E :APTER This final chapter starts by loo ing at the !arious forms of JsharesJ as a means to raise ne$ capital and retained earnings as another source. "o$e!er( $hilst these may be JtraditionalJ $ays of raising funds( they are by no means the only ones. There are many more sources a!ailable to

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

companies $ho do not $ish to become JpublicJ by means of share issues. These alternati!es include ban borro$ing( go!ernment assistance( !enture capital and franchising. All ha!e their o$n ad!antages and disad!antages and degrees of ris attached.

%O#R E% OF F#N!% A company might raise ne$ funds from the follo$ing sources.

>. The capital mar ets.

i0 )%; S"AG% 4SSI%S ii0 G4*"TS 4SSI%S ?. Foan stoc @. Getained earnings

A. 6an borro$ing B. *o!ernment sources C. 6usiness e+pansion scheme funds D. =enture capital K. :ranchising.
L (; OR!INAR< (E)#IT<) %:ARE% 7rdinary shares are issued to the o$ners of a company. They ha!e a nominal or MfaceM !alue( typically of N> or BO cents. The mar et !alue of a 2uoted companyMs shares bears no relationship to their nominal !alue( e+cept that $hen ordinary shares are issued for cash( the issue price must be e2ual to or be more than the nominal !alue of the shares. !eferred ordinar/ s.ares are a form of ordinary shares( $hich are entitled to a di!idend only after a certain date or if profits rise abo!e a certain amount. =oting rights might also differ from those attached to other ordinary shares. Ordinar/ s.are.olders put funds into their company. a0 6y paying for a ne$ issue of shares b0 Through retained profits.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

Simply retaining profits( instead of paying them out in the form of di!idends( offers an important( simple lo$-cost source of finance( although this method may not pro!ide enough funds( for e+ample( if the firm is see ing to gro$. A ne$ issue of shares might be made in a !ariety of different circumstances. a0 The company might $ant to raise more cash. 4f it issues ordinary shares for cash( should the shares be issued pro rata to e+isting shareholders( so that control or o$nership of the company is not affected8 4f( for e+ample( a company $ith ?OO(OOO ordinary shares in issue decides to issue BO(OOO ne$ shares to raise cash( should it offer the ne$ shares to e+isting shareholders( or should it sell them to ne$ shareholders instead8 i0 4f a company sells the ne$ shares to e+isting shareholders in proportion to their e+isting shareholding in the company( $e ha!e a ri! ts issue. 4n the e+ample abo!e( the BO(OOO shares $ould be issued as a one-in-four rights issue( by offering shareholders one ne$ share for e!ery four shares they currently hold. ii0 4f the number of ne$ shares being issued is small compared to the number of shares already in issue( it might be decided instead to sell them to ne$ shareholders( since o$nership of the company $ould only be minimally affected. b0 The company might $ant to issue shares partly to raise cash( but more importantly to floatM its shares on a stic e+change. c0 The company might issue ne$ shares to the shareholders of another company( in order to ta e it o!er. NE4 %:ARE% I%%#E% A company see ing to obtain additional e2uity funds may be. a0 An un2uoted company $ishing to obtain a Stoc %+change 2uotation b0 An un2uoted company $ishing to issue ne$ shares( but $ithout obtaining a Stoc %+change 2uotation c0 A company $hich is already listed on the Stoc %+change $ishing to issue additional ne$ shares. The methods by $hich an un2uoted company can obtain a 2uotation on the stoc mar et are. a0 An offer for sale b0 A prospectus issue c0 A placing d0 An introduction. OFFER% FOR %A$E.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

An offer for sale is a means of selling the shares of a company to the public. a0 An un2uoted company may issue shares( and then sell them on the Stoc %+change( to raise cash for the company. All the shares in the company( not just the ne$ ones( $ould then become mar etable. b0 Shareholders in an un2uoted company may sell some of their e+isting shares to the general public. ;hen this occurs( the company is not raising any ne$ funds( but just pro!iding a $ider mar et for its e+isting shares /all of $hich $ould become mar etable0( and gi!ing e+isting shareholders the chance to cash in some or all of their in!estment in their company. ;hen companies Mgo publicM for the first time( a MlargeM issue $ill probably ta e the form of an offer for sale. A smaller issue is more li ely to be a placing( since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional in!estors pri!ately. Ri=.ts issues A rights issue pro!ides a $ay of raising ne$ share capital by means of an offer to e+isting shareholders( in!iting them to subscribe cash for ne$ shares in proportion to their e+isting holdings. :or e+ample( a rights issue on a one-for-four basis at ?KOc per share $ould mean that a company is in!iting its e+isting shareholders to subscribe for one ne$ share for e!ery four shares they hold( at a price of ?KOc per ne$ share. A company ma ing a rights issue must set a price $hich is lo$ enough to secure the acceptance of shareholders( $ho are being as ed to pro!ide e+tra funds( but not too lo$( so as to a!oid e+cessi!e dilution of the earnings per share. Preference s.ares Preference shares ha!e a fi+ed percentage di!idend before any di!idend is paid to the ordinary shareholders. As $ith ordinary shares a preference di!idend can only be paid if sufficient distributable profits are a!ailable( although $ith Mcumulati!eM preference shares the right to an unpaid di!idend is carried for$ard to later years. The arrears of di!idend on cumulati!e preference shares must be paid before any di!idend is paid to the ordinary shareholders. :rom the companyMs point of !ie$( preference shares are ad!antageous in that. o Di!idends do not ha!e to be paid in a year in $hich profits are poor( $hile this is not the case $ith interest payments on long term debt /loans or debentures0. o Since they do not carry !oting rights( preference shares a!oid diluting the control of e+isting shareholders $hile an issue of e2uity shares $ould not. o Inless they are redeemable( issuing preference shares $ill lo$er the companyMs gearing. Gedeemable preference shares are normally treated as debt $hen gearing is calculated.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

o The issue of preference shares does not restrict the companyMs borro$ing po$er( at least in the sense that preference share capital is not secured against assets in the business. o The non-payment of di!idend does not gi!e the preference shareholders the right to appoint a recei!er( a right $hich is normally gi!en to debenture holders. "o$e!er( di!idend payments on preference shares are not ta+ deductible in the $ay that interest payments on debt are. :urthermore( for preference shares to be attracti!e to in!estors( the le!el of payment needs to be higher than for interest on debt to compensate for the additional ris s. :or the in!estor( preference shares are less attracti!e than loan stoc because. o They cannot be secured on the companyMs assets o The di!idend yield traditionally offered on preference di!idends has been much too lo$ to pro!ide an attracti!e in!estment compared $ith the interest yields on loan stoc in !ie$ of the additional ris in!ol!ed. ,; $OAN %TO 1 Foan stoc is long-term debt capital raised by a company for $hich interest is paid( usually half yearly and at a fi+ed rate. "olders of loan stoc are therefore long-term creditors of the company. Foan stoc has a nominal !alue( $hich is the debt o$ed by the company( and interest is paid at a stated Jcoupon yieldJ on this amount. :or e+ample( if a company issues >OP loan stoc y the coupon yield $ill be >OP of the nominal !alue of the stoc ( so that N>OO of stoc $ill recei!e N>O interest each year. The rate 2uoted is the gross rate( before ta+. Debentures are a form of loan stoc ( legally defined as the $ritten ac no$ledgement of a debt incurred by a company( normally containing pro!isions about the payment of interest and the e!entual repayment of capital. !e*entures >it. a floatin= rate of interest These are debentures for $hich the coupon rate of interest can be changed by the issuer( in accordance $ith changes in mar et rates of interest. They may be attracti!e to both lenders and borro$ers $hen interest rates are !olatile. %ecurit/ Foan stoc and debentures $ill often be secured. Security may ta e the form of either a fi,ed c ar!e or a floatin! c ar!e. a) Fi?ed c.ar=e@ Security $ould be related to a specific asset or group of assets( typically land and buildings. The company $ould be unable to dispose of the asset $ithout pro!iding a substitute asset for security( or $ithout the lenderMs consent.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

*) Floatin= c.ar=e@ ;ith a floating charge on certain assets of the company /for e+ample( stoc s and debtors0( the lenderMs security in the e!ent of a default payment is $hate!er assets of the appropriate class the company then o$ns /pro!ided that another lender does not ha!e a prior charge on the assets0. The company $ould be able( ho$e!er( to dispose of its assets as it chose until a default too place. 4n the e!ent of a default( the lender $ould probably appoint a recei!er to run the company rather than lay claim to a particular asset. T.e redemption of loan stocA Foan stoc and debentures are usually redeemable. They are issued for a term of ten years or more( and perhaps ?B to @O years. At the end of this period( they $ill JmatureJ and become redeemable /at par or possibly at a !alue abo!e par0. 5ost redeemable stoc s ha!e an earliest and latest redemption date. :or e+ample( >KP Debenture Stoc ?OOD#OQ is redeemable( at any time bet$een the earliest specified date /in ?OOD0 and the latest date /in ?OOQ0. The issuing company can choose the date. The decision by a company $hen to redeem a debt $ill depend on. a) "o$ much cash is a!ailable to the company to repay the debt *) The nominal rate of interest on the debt. 4f the debentures pay >KP nominal interest and the current rate of interest is lo$er( say >OP( the company may try to raise a ne$ loan at >OP to redeem the debt $hich costs >KP. 7n the other hand( if current interest rates are ?OP( the company is unli ely to redeem the debt until the latest date possible( because the debentures $ould be a cheap source of funds. There is no guarantee that a company $ill be able to raise a ne$ loan to pay off a maturing debt( and one item to loo for in a companyMs balance sheet is the redemption date of current loans( to establish ho$ much ne$ finance is li ely to be needed by the company( and $hen. 5ortgages are a specific type of secured loan. Companies place the title deeds of freehold or long leasehold property as security $ith an insurance company or mortgage bro er and recei!e cash on loan( usually repayable o!er a specified period. 5ost organi,ations o$ning property $hich is unencumbered by any charge should be able to obtain a mortgage up to t$o thirds of the !alue of the property. As far as companies are concerned( debt capital is a potentially attracti!e source of finance because interest charges reduce the profits chargeable to corporation ta+. -; RETAINE! EARNIN'% :or any company( the amount of earnings retained $ithin the business has a direct impact on the amount of di!idends. Profit re-in!ested as retained earnings is profit that could ha!e been paid as a di!idend. The major reasons for using retained earnings to finance ne$ in!estments( rather than to pay higher di!idends and then raise ne$ e2uity for the ne$ in!estments( are as follo$s.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

a0 The management of many companies belie!es that retained earnings are funds $hich do not cost anything( although this is not true. "o$e!er( it is true that the use of retained earnings as a source of funds does not lead to a payment of cash. b0 The di!idend policy of the company is in practice determined by the directors. :rom their standpoint( retained earnings are an attracti!e source of finance because in!estment projects can be underta en $ithout in!ol!ing either the shareholders or any outsiders. c0 The use of retained earnings as opposed to ne$ shares or debentures a!oids issue costs. d0 The use of retained earnings a!oids the possibility of a change in control resulting from an issue of ne$ shares. Another factor that may be of importance is the financial and ta+ation position of the companyMs shareholders. 4f( for e+ample( because of ta+ation considerations( they $ould rather ma e a capital profit /$hich $ill only be ta+ed $hen shares are sold0 than recei!e current income( then finance through retained earnings $ould be preferred to other methods. A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable di!idend( in line $ith realistic e+pectations( e!en if the directors $ould rather eep the funds for re-in!esting. At the same time( a company that is loo ing for e+tra funds $ill not be e+pected by in!estors /such as ban s0 to pay generous di!idends( nor o!ergenerous salaries to o$ner-directors. 2; 7AN1 $EN!IN' 6orro$ings from ban s are an important source of finance to companies. 6an lending is still mainly short term( although medium-term lending is 2uite common these days. Short term lending may be in the form of. a0 An o!erdraft( $hich a company should eep $ithin a limit set by the ban . 4nterest is charged /at a !ariable rate0 on the amount by $hich the company is o!erdra$n from day to dayE b0 A short-term loan( for up to three years. 5edium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term ban lending to large companies $ill be a set margin( $ith the si,e of the margin depending on the credit standing and ris iness of the borro$er. A loan may ha!e a fi+ed rate of interest or a !ariable interest rate( so that the rate of interest charged $ill be adjusted e!ery three( si+( nine or t$el!e months in line $ith recent mo!ements in the 6ase Fending Gate. Fending to smaller companies $ill be at a margin abo!e the ban Ms base rate and at either a !ariable or fi+ed rate of interest. Fending on o!erdraft is al$ays at a !ariable rate. A loan at a !ariable rate of interest is sometimes referred to as a floatin! rate loan. Fonger-term ban loans $ill sometimes be a!ailable( usually for the purchase of property( $here the loan ta es the form

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

of a mortgage. ;hen a ban er is as ed by a business customer for a loan or o!erdraft facility( he $ill consider se!eral factors( no$n commonly by the mnemonic PART%; - Purpose - Amount - Repayment - Term - %ecurity P The purpose of the loan A loan re2uest $ill be refused if the purpose of the loan is not acceptable to the ban . A The amount of the loan. The customer must state e+actly ho$ much he $ants to borro$. The ban er must !erify( as far as he is able to do so( that the amount re2uired to ma e the proposed in!estment has been estimated correctly. R "o$ $ill the loan be repaid8 ;ill the customer be able to obtain sufficient income to ma e the necessary repayments8 T ;hat $ould be the duration of the loan8 Traditionally( ban s ha!e offered short-term loans and o!erdrafts( although medium-term loans are no$ 2uite common. % Does the loan re2uire security8 4f so( is the proposed security ade2uate8 $EA%IN' A lease is an agreement bet$een t$o parties( the JlessorJ and the JlesseeJ. The lessor o$ns a capital asset( but allo$s the lessee to use it. The lessee ma es payments under the terms of the lease to the lessor( for a specified period of time. Feasing is( therefore( a form of rental. Feased assets ha!e usually been plant and machinery( cars and commercial !ehicles( but might also be computers and office e2uipment. There are t$o basic forms of lease. Joperating leasesJ and Jfinance leasesJ. Operatin= leases 7perating leases are rental agreements bet$een the lessor and the lessee $hereby. a0 The lessor supplies the e2uipment to the lessee b0 The lessor is responsible for ser!icing and maintaining the leased e2uipment c0 The period of the lease is fairly short( less than the economic life of the asset( so that at the end of the lease agreement( the lessor can either i0 Fease the e2uipment to someone else( and obtain a good rent for it( or ii0 sell the e2uipment secondhand.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

FINAN E $EA%E% :inance leases are lease agreements bet$een the user of the leased asset /the lessee0 and a pro!ider of finance /the lessor0 for most( or all( of the assetMs e+pected useful life. Suppose that a company decides to obtain a company car and finance the ac2uisition by means of a finance lease. A car dealer $ill supply the car. A finance house $ill agree to act as lessor in a finance leasing arrangement( and so $ill purchase the car from the dealer and lease it to the company. The company $ill ta e possession of the car from the car dealer( and ma e regular payments /monthly( 2uarterly( si+ monthly or annually0 to the finance house under the terms of the lease. 7ther important characteristics of a finance lease. a0 The lessee is responsible for the up eep( ser!icing and maintenance of the asset. The lessor is not in!ol!ed in this at all. b0 The lease has a primary period( $hich co!ers all or most of the economic life of the asset. At the end of the lease( the lessor $ould not be able to lease the asset to someone else( as the asset $ould be $orn out. The lessor must( therefore( ensure that the lease payments during the primary period pay for the full cost of the asset as $ell as pro!iding the lessor $ith a suitable return on his in!estment. c0 4t is usual at the end of the primary lease period to allo$ the lessee to continue to lease the asset for an indefinite secondary period( in return for a !ery lo$ nominal rent. Alternati!ely( the lessee might be allo$ed to sell the asset on the lessorMs behalf /since the lessor is the o$ner0 and to eep most of the sale proceeds( paying only a small percentage /perhaps >OP0 to the lessor. 4./ "i=.t $easin= 7e Popular The attractions of leases to the supplier of the e2uipment( the lessee and the lessor are as follo$s. o The supplier of the e2uipment is paid in full at the beginning. The e2uipment is sold to the lessor( and apart from obligations under guarantees or $arranties( the supplier has no further financial concern about the asset. o The lessor in!ests finance by purchasing assets from suppliers and ma es a return out of the lease payments from the lessee. Pro!ided that a lessor can find lessees $illing to pay the amounts he $ants to ma e his return( the lessor can ma e good profits. "e $ill also get capital allo$ances on his purchase of the e2uipment. o Feasing might be attracti!e to the lessee. i0 4f the lessee does not ha!e enough cash to pay for the asset( and $ould ha!e difficulty obtaining a ban loan to buy it( and so has to rent it in one $ay or another if he is to ha!e the use of it at allE or

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

ii0 4f finance leasing is cheaper than a ban loan. The cost of payments under a loan might e+ceed the cost of a lease. Operatin= leases .aBe furt.er adBanta=es. o The leased e2uipment does not need to be sho$n in the lesseeMs published balance sheet( and so the lesseeMs balance sheet sho$s no increase in its gearing ratio. o The e2uipment is leased for a shorter period than its e+pected useful life. 4n the case of hightechnology e2uipment( if the e2uipment becomes out-of-date before the end of its e+pected life( the lessee does not ha!e to eep on using it( and it is the lessor $ho must bear the ris of ha!ing to sell obsolete e2uipment secondhand. o The lessee $ill be able to deduct the lease payments in computing his ta+able profits. 3; :IRE P#R :A%E "ire purchase is a form of instalment credit. "ire purchase is similar to leasing( $ith the e+ception that o$nership of the goods passes to the hire purchase customer on payment of the final credit instalment( $hereas a lessee ne!er becomes the o$ner of the goods. "ire purchase agreements usually in!ol!e a finance house. i0 The supplier sells the goods to the finance house. ii0 The supplier deli!ers the goods to the customer $ho $ill e!entually purchase them. iii0 The hire purchase arrangement e+ists bet$een the finance house and the customer. The finance house $ill al$ays insist that the hirer should pay a deposit to$ards the purchase price. The si,e of the deposit $ill depend on the finance companyMs policy and its assessment of the hirer. This is in contrast to a finance lease( $here the lessee might not be re2uired to ma e any large initial payment. An industrial or commercial business can use hire purchase as a source of finance. ;ith industrial hire purchase( a business customer obtains hire purchase finance from a finance house in order to purchase the fi+ed asset. *oods bought by businesses on hire purchase include company !ehicles( plant and machinery( office e2uipment and farming machinery. 5; 'O6ERN"ENT A%%I%TAN E The go!ernment pro!ides finance to companies in cash grants and other forms of direct assistance( as part of its policy of helping to de!elop the national economy( especially in high technology industries and in areas of high unemployment. :or e+ample( the 4ndigenous 6usiness De!elopment Corporation of <imbab$e /46DC0 $as set up by the go!ernment to assist small indigenous businesses in that country. 8; 6ENT#RE APITA$

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

=enture capital is money put into an enterprise $hich may all be lost if the enterprise fails. A businessman starting up a ne$ business $ill in!est !enture capital of his o$n( but he $ill probably need e+tra funding from a source other than his o$n poc et. "o$e!er( the term M!enture capitalM is more specifically associated $ith putting money( usually in return for an e2uity sta e( into a ne$ business( a management buy-out or a major e+pansion scheme. The institution that puts in the money recognises the gamble inherent in the funding. There is a serious ris of losing the entire in!estment( and it might ta e a long time before any profits and returns materiali,e. 6ut there is also the prospect of !ery high profits and a substantial return on the in!estment. A !enture capitalist $ill re2uire a high e+pected rate of return on in!estments( to compensate for the high ris . A !enture capital organi,ation $ill not $ant to retain its in!estment in a business indefinitely( and $hen it considers putting money into a business !enture( it $ill also consider its Je+itJ( that is( ho$ it $ill be able to pull out of the business e!entually /after fi!e to se!en years( say0 and reali,e its profits. %+amples of !enture capital organi,ations are. 5erchant 6an of Central Africa Ftd and Anglo American Corporation Ser!ices Ftd. ;hen a companyMs directors loo for help from a !enture capital institution( they must recognise that. o The institution $ill $ant an e2uity sta e in the company o it $ill need con!incing that the company can be successful o it may $ant to ha!e a representati!e appointed to the companyMs board( to loo after its interests.

The directors of the company must then contact !enture capital organisations( to try and find one or more $hich $ould be $illing to offer finance. A !enture capital organisation $ill only gi!e funds to a company that it belie!es can succeed( and before it $ill ma e any definite offer( it $ill $ant from the company management. a0 A business plan b0 Details of ho$ much finance is needed and ho$ it $ill be used c0 The most recent trading figures of the company( a balance sheet( a cash flo$ forecast and a profit forecast d0 Details of the management team( $ith e!idence of a $ide range of management s ills e0 Details of major shareholders f0 Details of the companyMs current ban ing arrangements and any other sources of finance g0 Any sales literature or publicity material that the company has issued.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar

(Preparation of project, project Identification and formulation, project appraisal & sources of Finance)

A high percentage of re2uests for !enture capital are rejected on an initial screening( and only a small percentage of all re2uests sur!i!e both this screening and further in!estigation and result in actual in!estments. C; FRAN :I%IN' :ranchising is a method of e+panding business on less capital than $ould other$ise be needed. :or suitable businesses( it is an alternati!e to raising e+tra capital for gro$th. :ranchisors include 6udget Gent-a-Car( ;impy( )andoMs Chic en and Chic en 4nn. Inder a franchising arrangement( a franchisee pays a franchisor for the right to operate a local business( under the franchisorMs trade name. The franchisor must bear certain costs /possibly for architectMs $or ( establishment costs( legal costs( mar eting costs and the cost of other support ser!ices0 and $ill charge the franchisee an initial franchise fee to co!er set-up costs( relying on the subse2uent regular payments by the franchisee for an operating profit. These regular payments $ill usually be a percentage of the franchiseeMs turno!er. Although the franchisor $ill probably pay a large part of the initial in!estment cost of a franchiseeMs outlet( the franchisee $ill be e+pected to contribute a share of the in!estment himself. The franchisor may $ell help the franchisee to obtain loan capital to pro!ide his-share of the in!estment cost. The ad!antages of franchises to the franchisor are as follo$s. o The capital outlay needed to e+pand the business is reduced substantially. o The image of the business is impro!ed because the franchisees $ill be moti!ated to achie!e good results and $ill ha!e the authority to ta e $hate!er action they thin fit to impro!e the results. The ad!antage of a franchise to a franchisee is that he obtains o$nership of a business for an agreed number of years /including stoc and premises( although premises might be leased from the franchisor0 together $ith the bac ing of a large organi,ationHs mar eting effort and e+perience. The franchisee is able to a!oid some of the mista es of many small businesses( because the franchisor has already learned from its o$n past mista es and de!eloped a scheme that $or s.

Mr. Rashmiranjan Panigrahi, Lecturer in Finance, ASMIT, Bhubaneswar