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F I N A N C I A L E S T I M AT E S A N D P R O J E C T I O N S DR R SOUNDARA RAJAN
Out Line
Cost of Project Means of financing Estimates of sales and production Cost of production
Financial Projections
Balance Sheet Cash Flow Statement Cost of Project and Time Phasing Means of Finance and Time Phasing Interest and Loan Repayment Depreciation Cost of Production Working Capital Needs Production Plan Projected Sales
Interest on WCA
Tax Factor
Cost of Project
The cost of project represents the total of all items of outlay associated with a project which are supported by long-term funds. It is the sum of the outlays on the following:
Land and site development Buildings and civil works Plant and machinery Technical know-how and engineering fees Expenses on foreign technicians and training of Indian technicians abroad Miscellaneous fixed assets Preliminary and capital issue expenses
Pre-operative expenses
Margin money for working capital Initial cash losses
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5. 6.
Basic Cost + conveyance + allied charges Premium payable on leasehold and conveyance Cost of leveling and development Cost of laying roads Cost of compound wall Cost of tube wells Cost of land varies from one location to another. High in urban and low in rural
Building for
For plant and equipment Auxiliary services- steam, work shop, and water supply Godowns, ware house Non factory building canteen Garages Sewers drainage Tanks, wells etc
Cost depends on structure
Imported- Free On Board(FOB)+ Shipping Freight, Insurance + Import duty + Clearing + Loading and unloading and transportation Indigenous Free on Rail (FOR)+ Sales tax + Octroi + and other taxes Cost of stores and spares Foundation and installation
Based on latest available quote adjusted for inflation
Others
Technical know-how and engineering fees Expenses on foreign technicians and training of Indian
technicians abroad
Miscellaneous fixed assets ( furniture + office equipments + vehicles + railway sidings + etc)
Others
Preliminary and capital issue expenses ( survey, feasibility
Means of Finance
Key business To meet the cost of the project the considerations
following means ofDebt is are finance 1. Costcheaper available: Risk- financial 2. leverage Share capital3. Control 4. Flexibility- ability Term loans to raise further money- do not Debenture capital full debt exhaust capacity
Deferred credit
Incentive sources
The capacity utilization would be at 40-50 percent of the installed capacity in the first year, 50-80 percent in the second year, and 80-90 percent from the third year onwards. Production and sales will be equal.
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2. 3. 4. 5. 6. 7. 8.
Note : Production in the initial period should be assumed at a reasonable level of utilisation of capacity increasing gradually to attain full capacity in subsequent years.
Cost of Production
Given the estimated production, the cost of
Material cost
Production Process Material Input Based on 1. Theoretical consumption norms or standards 2. Experience 3. Performance Guarantee 4. Specifications of suppliers
Output
Step 1
Total Requirement Out put quantity multiplied by per unit requirement of input
Step2
Labour cost
1. 2. 3.
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5. 6. 7.
B Pay DA HRA, Conveyance Medical LTA PF, Gratuity, Bonus Consider- leaves, OT, Night shit allowance Calculated for year
Lower initially) Rent , Taxes , Insurance- at existing rates Factory expenses- provisions made, in addition contingency margin provided
The working capital requirement consists of raw materials and components, work-in-process, finished goods, consumable stores, debtors, and operating expenses. The principal sources of working capital finance are working capital advances provided by commercial banks, trade credit, accruals and provisions, and long-term sources of financing. There are limits to obtaining working capital advances from commercial banks. They relate to the maximum permissible bank finance for working capital and the amounts that can be raised against each individual current asset.
Working capital
Lack of adequate working capital is often stated as one of
the major reasons for sickness in industry (especially in case of SMEs). The counter arguments from the banks have been that most firms face problems of inadequate working capital due to credit indiscipline (diversion of working capital to meet long term requirements or to acquire other assets). In this context it would be pertinent to understand the method adopted by banks in computing the working capital requirement of the business and the quantum of bank financing to be provided by the bank.
Factors such as seasonality of raw materials or of demand may require a high level of inventory being maintained by the company. Similarly, industry norms of credit allowed to buyers determine the level of debtors of the company in the normal course of business. 2. The level of activity of the business Inventories and receivables are normally expressed as a multiple of a days production or sale. Hence, higher the level of activity, higher the quantum of inventory, receivables and thereby working capital requirement of the business. So in order to arrive at the working capital requirement of the business for the year, it is essential to determine the level of production that the business would achieve. In case of well-established businesses, the previous years actual and the management projections for the year provide good indicators. The problems arise mainly in the case of determining the limit for the first time or in the initial few years of the business. Banks often adopt industry standard norms for capacity utilization in the initial years.
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Based on the level of activity decided and the unit cost and sales price projections, the banks calculate at the annual sales and cost of production. The quantum of current assets (CA) in the form of Raw Materials, Work-in-progress, Finished goods and Receivables is estimated as a multiple of the average daily turnover. The multiple for each of the current assets is determined generally based on the industry norms. The current liabilities (CL) in the form of credit availed by the business from its creditors or on its manufacturing expenses are deducted from the current assets (CA) to arrive at the Working Capital Requirement (WCR).
Norms of WC
Norms were fixed regarding the quantum of various
current assets for different industries (as multiples of the average daily output) and the Maximum Permissible Bank Financing (MPBF) was capped at a certain percentage of the working capital requirement thus arrived at.
Example
Let us now consider the following example to illustrate the application of all the above three methods: Current liabilities Creditors Other Current liability Bank borrowings 80 Current Assets 200 Raw Material Stocks Receivables Other Current Assets Total Liabilities Total Current Assets (TCA) Other current liabilities (OCL) 680 Total Assets 400 Finished Goods 300 100 150 100 50 700
Example
Method1 : The borrower should bring in 25% of the net working capital (current assets - current liabilities excluding bank borrowing) from its owned and long term liabilities. Method II. The borrower should finance 25% of all current assets from owned funds and long term liabilities and the balance he financed by the bank. Method III. The hard core current assets i.e., the current assets which are permanently required by the unit for its functioning must be exclusively financed by the borrower. The borrower should also provide 25% of the remaining current assets and only the balance will be financed by the bank
Solution
Lending under Method I Total current assets Less: Other current liabilities Working capital gap 25% of the above as margin from long term sources Maximum permissible bank finance (M.P.B.F.) Excess borrowings ( 400-315) Method II Total current assets Less: 25% of above as margin from long term sources Less : Other current liabilities Maximum permissible bank finance (MPBF) Excess borrowings (400-245) 700 280 420 105 315 85 700 175 525 280 245 155
Solution
Method III Total current assets Less : Core current assets (assumed figure) Balance current assets Less : 25% of above Less : Other current liabilities Maximum Permissible Bank Finance (MPBF) Excess borrowings(400-125) 700 160 540 135 405 280 125 275
Margin requirement
Varies with types of current asset No fixed formula
Current Assets Raw Materials WIP Finished Goods Debtors Margin 10-25% 20-40% 30-50% 30-50%
J Operating Profit (G - H - I)
K Other income L Preliminary expenses written off M Profit/loss before taxation (J+K - L) N Provision for taxation O Profit after tax (M - N) Less Dividend on - Preference capital - Equity capital P Retained profit
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5. 6. 7. 8. 9.
10. Sale of fixed assets 11. Sale of investments 12. Other income (indicate details) Total (A)
Disposition of Funds
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2. 3. 4.
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Multi-Year Projections
A new firm, ABC Limited, is being set up to manufacture alloy steel. The expected outlays and proposed financing during the construction and the first two operating years are shown in Exhibit 6.9. The projected revenues and costs for the first two operating years are shown in Exhibit 6.10. It may be assumed that (i) the tax rate for the firm will be 60 per cent, (ii) no deductions (reliefs) are available, (iii) preliminary and pre-operative expenses will not be written off during the first two operating years, and (iv) no dividend will be paid in the first two operating years.
Based on the above information, the projected profit and loss statements, projected cash flow statements, and projected balance sheets may be prepared as shown in Exhibits 6.11, 6.12, and 6.13.
Exhibit 6.11
Exhibit 6.12
Exhibit 6.13
Review
1. What is a Capital Projects ? Essentially a capital project represents a scheme for investing resources that can be analyzed and appraised reasonably independently 2. What are the basic characteristics of a Capital Project ? The basic characteristic of a capital project is that it typically involves a current outlay (or current and future outlays) of funds in the expectation of a stream of benefits extending far into the future. 3. Why capital Budget decisions are Important ? Their importance stems from three inter-related reasons: Long-term effects, Irreversibility
Review
4. While capital expenditure decisions are extremely important, they pose difficulties What are They ? Measurement problems, Uncertainty and Temporal spread. 5. Capital budgeting is a complex process which may be divided into six broad phases- What are they ?: Planning, Analysis, Selection, Financing, Implementation and Review. 6. One can look at capital budgeting decisions at three levels Explain the levels operating, administrative, and strategic.
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Financial analysis,
Economic analysis, and Ecological analysis.
Poor alignment between strategy and Capital budgeting; Deficiencies in analytical techniques; No linkage between compensation and Financial measures; Reverse financial engineering; Weak integration between capital budgeting and expense budgeting; Inadequate post-audits.
Review
9.
To Judge a project from the financial angle What information is needed? : a. cost of project, b. means of financing, c. estimates of sales and production, d. cost of production, e. working capital requirement and its financing, f. estimates of working results (profitability projections), g. break- even point, h. projected cash flow statements, and i. projected balance sheets. 10. The Cost of project represents the sum of a. land and site development, b. buildings and civil works, c. plant and machinery, d. technical know-how and engineering fees, e. expenses on foreign technicians and training of Indian technicians abroad, f. miscellaneous fixed assets, g. preliminary and capital issue expenses, h. pre-operative expenses, provision for contingencies, i. margin money for working capital, and j. initial cash losses.
Review
11. To meet the cost of project, what source of finance is looked at ? a. Share capital (equity capital and preference capital), b. Term loans (rupee term loans and foreign currency term loans), c. Debenture capital (non-convertible debentures and convertible debentures), d. Deferred Credit, e. Incentive sources (seed capital assistance, capital subsidy, and tax deferment f. or exemption) and g. Miscellaneous sources (unsecured loans, public deposits and lease and hire purchases finance) 12. To determine the specific means of finance for a given project, what are the things should be borne in mind: (i) Norms of regulatory bodies and financial institutions, (ii) Key business considerations, namely cost, risk, control, and flexibility.
Review
13. What is the starting point of profitability projections ? Forecast for sales and revenues. In estimating sales it is reasonable to assume that capacity utilization would be somewhat low in the first year and rise thereafter gradually to reach the maximum level in the third or fourth year of operation. 14. What are the major cost of production ? The major components of cost of production are: a. Material cost, b. Utilities cost, c. Labour cost, and factory overhead cost. The material cost comprises the cost of raw materials, chemicals, components, and consumable stores required for production. The cost of utilities is the sum of the cost of power, water, and fuel. The labor cost includes the cost of all manpower employed in the factory. The expenses on repairs and maintenance, rent, taxes and insurance on factory assets, and so on are collectively referred to as factory overheads.
15. What are the factors considered for working capital requirement ? In estimating the working capital requirement and planning for its financing, the following must be borne in mind: The build up of current assets till the rated level of capacity utilization is reached, The maximum permissible bank finance as per the second method of lending recommended by the Tandon Committee, and the margin requirements against
Case Study
Group-1 GroupII Group III Present of Estimation for a software project problems and challenges