Project Formulation and Appraisal

Unit-V
Project Financing

Prof. Purvesh Raval

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Content
• Introduction importance and
• Sources difficulties
• Project and Corporate • Financial statement
finance • Working capital
• Special schemes management
• Financial indicators • Financial estimate
• Capital investments • Projections
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Sources
• Key Features: Non-recourse or limited recourse structure.

• Focuses on cash flows generated by the project.

• Importance: Enables large-scale, capital-intensive projects like power

plants, airports, and roads.

• Difference from Corporate Finance:

Project Finance: Separate legal entity, cash flow reliance.
Corporate Finance: Based on the company’s balance sheet, assets,
and equity.
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 Equity Shares

Long Term Retained Earning

Preference Shares

Equity Debentures

On Loan from financial Institutions

the Medium
Loan from Bank

Basis Public Deposits

of Term Loan from financial Institutions

Period Trade Credit

Short Term Factoring

Banks

Commercial Papers

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 Equity Shares

On the Basis of Ownership

Owner Fund
Retained Earning

Debentures

Loan from Bank

Loan from financial

Borrowed Funds
Institutions

Public deposits

Lease financing

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 Equity Shares Capital

Internal Sources

Retained Earning
On the Basis
of Sources of
Generation Loan from Bank
Public Deposits
Financial Institutions
Preference Shares
External Sources
Trade Credit
Factoring
Commercial Papers
Lease Financing
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Special schemes
• Infrastructure Investment Trusts (InvITs)
• Real Estate Investment Trusts (REITs)
• National Infrastructure Pipeline (NIP)
• Pradhan Mantri Awas Yojana (PMAY) – Urban and Rural
• Viability Gap Funding (VGF)
• Smart Cities Mission
• NABARD – Rural Infrastructure Development Fund (RIDF)
• Affordable Rental Housing Complexes (ARHCs)
• Swachh Bharat Mission – Urban and Gramin

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Special schemes
• Special Window for Affordable and Mid-Income Housing
(SWAMIH) Fund
• Atal Mission for Rejuvenation and Urban Transformation
(AMRUT)
• Credit Linked Subsidy Scheme (CLSS)
• National Investment and Infrastructure Fund (NIIF)
• Housing Infrastructure Fund (HIF)
• Indian Railway Finance Corporation (IRFC)

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Financial indicators
Project financial analysis is what happens before a project is approved,
and is a way of making sure that the company is spending its investments
wisely by making smart choices about what projects to take forward.
Thorough analysis is important to ensure that you don’t end up doing
projects that lose money.

According to The Harvard Business Review Project Management

Handbook: How to Launch, Lead, and Sponsor Successful Projects by past
PMI Chair Antonio Nieto-Rodriguez, there are 5 common financial
metrics: opportunity costs, payback period, IRR, NPV, and ROI.

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Opportunity Costs
• Opportunity costs represent what won’t be done due to
resources being allocated to this project.
• If other projects offer higher value, consider putting this project
on hold in favor of those.
• Requires a mature portfolio management approach to:
• Identify alternative projects to be put on hold
• Conduct budget/resource assessments for those projects
• Assess potential benefits of alternative projects
• Businesses with limited preliminary project evaluations may face
challenges with this approach.
• Include a financial evaluation note that highlights the impact on
other projects if this project proceeds.
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Payback Period
• This measure indicates how long it takes for the project to start
generating a return.
• In a program, returns may start before completion, as individual
projects deliver benefits.
• The organization should set a target payback period:
• If the project earns back the investment within this period, it’s
considered a good investment.
• If the payback takes longer, reassessment may be needed.
• Generally, shorter payback periods are preferred:
• They indicate a quicker return on investment.

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Internal Rate of Return (IRR)
• IRR Reflects the project’s “earnings” for the business.
• IRR is expressed as a percentage and indicates investment
efficiency.
• Concept: If the project budget were placed in a bank, it would
earn minimal interest.
• IRR Calculation: Shows the project’s potential “interest rate”
return compared to safe bank interest.
• Decision Rule:
• If IRR > bank interest, the project is a better investment.
• If IRR < bank interest, investing the funds in the bank may be
more beneficial.
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Net Present Value (NPV)
• NPV Assesses project financials in terms of today’s money
value.
• Positive NPV Indicates the project is expected to generate future
cash at an acceptable rate.
• NPV Targets and Rates
• May be set by industry standards or finance team guidelines.
• Confirm if specific variables (e.g., minimum or discount rates)
need to be used.
• NPV Output: Expressed as a financial value, indicating potential
project profitability.
• Note: Use an NPV calculation template from finance to
streamline the process.
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Return on Investment (ROI)
• ROI Measures financial return relative to the project
investment.
• Calculation: Often includes total project costs and Year
1-5 operating expenses (OPEX).
• Exact calculation may vary based on finance team
criteria.
• Purpose of ROI: Clarifies the financial gain the business
receives from its investment.
• Ideal ROI: Higher ROI indicates greater income from the
project, reflecting a better payoff.
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Financial indicators
• Gross Profit Margin:
• Gross profit margin = (Net sales – cost of goods sold (COGS))/Net salesx100%
• Return on Sales (ROS)/Operating Margin:
• Return on sales = (Earnings before interest and taxes(EBIT)/Net sales) x 100%
• Net Profit Margin:
• Net profit margin = (Net income / Revenue) x 100%
• Operating Cash Flow Ratio (OCF):
• Operating cash flow ratio = Operating cash flow / Current liabilities
• Current Ratio:
• Current ratio = Current assets / Current liabilities

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Financial indicators
• Working Capital:
• Working capital = Current assets – Current liabilities
• Quick Ratio/Acid Test:
• Quick ratio = Quick assets / Current liabilities
• Gross Burn Rate:
• Gross burn rate = Company cash / Monthly operating expenses
• Current Accounts Receivable (AR) Ratio:
• Current accounts receivable =
(Total accounts receivable – Past due accounts receivable) / Total accounts receivable
• Current Accounts Payable (AP) Ratio:
• Current accounts payable =
(Total accounts payable – Past due accounts receivable) / Total accounts receivable

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Financial indicators
• Accounts Payable (AP) Turnover:
• Accounts payable turnover =
Net Credit Purchases / Average accounts payable balance for period
• Average Invoice Processing Cost:
• Average invoice processing cost =
Total accounts payable processing costs / Number of invoices processed for period
• Days Payable Outstanding (DPO):
• Days payable outstanding = (Accounts payable x 365 days) / COGS
• Accounts Receivable (AR) Turnover:
• Accounts receivable turnover =
Sales on account / Average accounts receivable balance for period
• Days Sales Outstanding (DSO):
• Days sales outstanding = 365 days / Accounts receivable turnover

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Financial indicators
• Inventory Turnover:
• Inventory turnover = COGS / Average inventory balance for period
• Days Inventory Outstanding (DIO):
• Days inventory outstanding = 365 days / Inventory turnover
• Cash Conversion Cycle:
• Operating cycle = Days inventory outstanding + Days sales outstanding
• Budget Variance:
• Budget variance = (Actual result – Budgeted amount) / Budgeted amount x 100
• Payroll Headcount Ratio:
• Payroll headcount ratio = HR headcount / Total company headcount

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Financial indicators
• Sales Growth Rate:
• Sales growth rate = (Current net sales – Prior period net sales) / Prior period net
sales x 100
• Fixed Asset Turnover Ratio:
• Fixed asset turnover = Total sales / Average fixed assets
• Return on Assets (ROA):
• Return on assets = Net income / Total assets for period
• Selling, General and Administrative (SG&A) Ratio:
• SGA = (Selling + General + Administrative expense) / Net sales revenue
• Interest Coverage:
• Interest coverage = Earnings before interest and taxes (EBIT) / Interest expense

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Financial indicators
• Earnings Per Share (EPS):
• Earnings per share = Net income / Weighted average number of shares
outstanding
• Debt-to-Equity Ratio:
• Debt-to-equity ratio = Total liabilities / Total shareholders’ equity
• Budget Creation Cycle Time:
• Budget creation cycle time = Date budget finalized – Date budgeting activities
started
• Number of Budget Iterations:
• Number of budget iterations = Total amount of budget versions created

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Importance of capital investments
• Long-Term Growth: Drives expansion and future profitability.
• Competitive Advantage: Enables acquisition of new assets,
technology, and infrastructure.
• Revenue Generation: Provides resources needed to start or
expand revenue-generating projects.
• Operational Efficiency: Improves productivity and reduces costs
over time.
• Strategic Alignment: Supports the organization’s long-term
goals and vision.

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Difficulties in capital investments
• High Initial Costs: Requires significant upfront funding, often
impacting cash flow.
• Risk and Uncertainty: Project returns are not guaranteed,
increasing financial risk.
• Long Payback Periods: Benefits may take years to realize,
affecting short-term financial metrics.
• Complex Decision-Making: Involves assessing financial,
technical, and market uncertainties.
• Resource Allocation Challenges: Competes with other projects
for limited financial and human resources.
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Financial statement

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Financial statement: Balance sheet

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Financial statement: Income statement

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Financial statement: Cashflow statement

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Working capital management
• Estimation of Working Capital Needs
• Risks on the requirement of working capital
• Management of the working capital

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Estimation of Working Capital Needs
Introduction
• Working capital is the amount of money a company needs to cover its
daily operational expenses.
• In the context of construction, working capital is essential to ensure
that a construction project can proceed smoothly and without
interruption.
Methods for Estimating Working Capital Needs
• There are several methods that can be used to estimate working
capital needs, including the Gross Method, Net Method, Operating
Cycle Method, and Project-Specific Method.
Estimation of Working Capital Needs
A. Gross Method
• This method estimates working capital needs based on the difference between
the company's current assets and current liabilities.

• This method is simple and straightforward, but it may not accurately represent a
company's actual working capital needs.

• For example, if a construction company has $100,000 in current assets and

$75,000 in current liabilities, its working capital would be $25,000 ($100,000 -
$75,000).
Estimation of Working Capital Needs
B. Net Method
• This method estimates working capital needs based on the difference between a
company's current assets and current liabilities, taking into account the net
change in each category over a specified period of time.

• This method accurately represents a company's working capital needs but may be
more complex and time-consuming to implement.

• For example, if a construction company's current assets increased by $10,000 and

its current liabilities increased by $15,000 over the past year, its net working
capital would decrease by $5,000 ($10,000 - $15,000).
Estimation of Working Capital Needs
C. Operating Cycle Method
• This method estimates working capital needs by determining the time it takes for
a construction company to turn its inventory into cash, including the time to
purchase raw materials, produce goods, sell goods, and collect payment from
customers.

• This method provides a more detailed representation of a company’s working

capital needs but may be more complex and time-consuming to implement.

• For example, if a construction company has a 30-day operating cycle, it may need
to have 30 days of working capital on hand to ensure that it can meet its daily
operational needs.
Estimation of Working Capital Needs
D. Project-Specific Method
• This method estimates working capital needs for a specific construction project
by taking into account the unique characteristics of the project.

• such as the type of project, the size of the project, and the length of the project.
This method provides a more accurate representation of a company's working
capital needs for a specific project but may not be suitable for estimating overall
working capital needs.

• For example, a large, complex construction project may require a higher level of
working capital than a smaller, simpler project.
Estimation of Working Capital Needs
- Essentiality to estimate working capital needs
1. Maintaining liquidity
2. Planning for growth
3. Managing risk
4. Improving financial performance
5. Building relationships with stakeholders
Estimation of Working Capital Needs
- Steps for the calculation of working capital needs
1. Determine current assets: This includes cash, accounts receivable, inventory,
and any other assets that are expected to be converted into cash within a year.
2. Determine current liabilities: This includes accounts payable, wages payable,
taxes payable, and any other debts that are expected to be paid within a year.
3. Calculate the difference: Subtract current liabilities from current assets to
calculate the working capital. The resulting figure will estimate the amount of
money the Organization/construction project will need to cover its daily
operational expenses.
4. Consider project-specific factors: When calculating working capital needs for
any project, it is important to take into account any project-specific factors that
may affect the amount of working capital required. For example, the size of the
project, the type of work being performed, and the length of the project can all
impact the amount of working capital required.
Estimation of Working Capital Needs
5. Evaluate historical financial performance: To get a more accurate estimate of
working capital needs, consider the company's historical financial performance,
such as past sales and expenses. This information can help you determine the
company's average operating cycle and the amount of working capital it has
typically needed in the past.

6. Factor in growth and expansion: Finally, take into account any growth or
expansion plans for the company. A growing company will typically require
more working capital than a company that is not expanding, so it is important
to factor in any growth plans when estimating working capital needs.
Risks on the requirement of working capital
• Introduction: Working capital is a critical component of financial
management in construction projects, and it is defined as the amount of
funds required to support the day-to-day operations of a business.
• In construction projects, working capital is used to pay for ongoing
expenses, such as employee salaries, suppliers, and other operating costs.
However, the requirements for working capital can vary depending on
various factors, such as project size, type of contract, and market
conditions.
• Risk on the Requirements of Working Capital: Several risks can impact the
requirements for working capital in construction projects, and it's
important for construction companies to understand and manage these
risks effectively.
Risks on the requirement of working capital
• The following are some of the most significant risks:
8. Cost Overrun Risks
1. Project Delays 9. Foreign Exchange Risks
2. Cost Overruns [Link] Risks
3. Market Fluctuations [Link] Risks
4. Credit Risk [Link] Risks
5. Financial Instability [Link] Risks
6. Cash Flow Risks
7. Interest Rate Risks
Risks on the requirement of working capital
• Project Delays:
Project delays can result in increased costs and the need for additional
working capital to support the extended period of operations. For
example, if a construction project is delayed, it may require additional
funds to pay for additional materials, labor, or other expenses that
result from the delay.
• Cost Overruns:
Unforeseen costs, such as unexpected materials or labor costs, can also
result in an increase in working capital requirements. For example,
suppose a construction project experiences unexpected costs, such as
the need for additional materials or labor. In that case, the company
may need to secure additional working capital to cover these costs.
Risks on the requirement of working capital
• Market Fluctuations:
Changes in market conditions, such as increased competition or
fluctuating commodity prices, can impact the demand for construction
services and result in a need for additional working capital. For
example, if a construction company operates in a market that
experiences declining demand, it may need to secure additional
working capital to support its ongoing operations.
• Credit Risk:
A construction company struggling to secure favorable credit terms can
need additional working capital to support operations. For example, if a
construction company cannot secure favorable credit terms, it may
need additional working capital to cover its operating expenses.
Risks on the requirement of working capital
• Financial Instability:
Economic downturns or other financial crises can reduce credit
availability and increase working capital requirements. For example, it
may be more difficult for a construction company to secure credit
during a financial crisis, which can increase working capital
requirements.
• Cash Flow Risks:
Cash flow risk is one of the primary risks associated with the requirement of
working capital on infrastructure projects. Infrastructure projects typically require
significant upfront investments, and the revenue generated from the project may
only be realized once the project is completed. This delay in cash flow can create a
significant cash flow risk, making it difficult for the project to finance its ongoing
operations.
Risks on the requirement of working capital
• Interest Rate Risks:
Infrastructure projects often require long-term financing, which
exposes them to interest rate risks. If interest rates rise, the project’s
financing cost increases, which can create significant financial pressure
on the project. In addition, if the project is financed using floating-rate
debt, then the cost of financing can fluctuate, creating uncertainty and
financial risk.
• Cost Overrun Risks:
Infrastructure projects are often subject to cost overruns due to
unexpected delays, changes in the scope of the project, or unforeseen
events. These cost overruns can significantly strain the project's
working capital requirements, making it difficult to finance ongoing
operations.
Risks on the requirement of working capital
• Foreign Exchange Risks:
Infrastructure projects are often carried out in foreign countries, which
exposes them to foreign exchange risks. Changes in foreign exchange
rates can impact the project's working capital requirements, making it
difficult to finance ongoing operations.
• Regulatory Risks:
Infrastructure projects are often subject to significant regulatory
oversight, which can impact the project's working capital requirements.
Changes in regulations, permits, or other requirements can impact the
project's cash flow and financing requirements, creating significant
financial risks.
Risks on the requirement of working capital
• Political Risks:
Infrastructure projects are often subject to political risks, including
changes in government policies, political instability, or changes in
political leadership. These political risks can impact the project's
working capital requirements and make it difficult to finance ongoing
operations.
• Construction Risks:
Infrastructure projects are subject to construction risks, including
delays, cost overruns, and construction defects. These construction
risks can impact the project's working capital requirements, making it
difficult to finance ongoing operations.
Risks on the requirement of working capital
• Operational Risks:
Infrastructure projects are subject to operational risks, including
changes in demand, changes in technology, and other operational
issues. These operational risks can impact the project's working capital
requirements, making it difficult to finance ongoing operations.
Management of the working capital
• The unique aspects of working capital management in the context of
the construction sector and the strategies and tools available to
manage working capital effectively in this industry.

• Managing Cash Flows: Cash flow management is critical to effective

working capital management in construction. This includes careful
monitoring of cash inflows and outflows, maintaining sufficient
reserves, and implementing effective cash management strategies,
such as cash pooling or cash sweeps.
Management of the working capital
• Managing Accounts Receivable: Effective management of accounts
receivable is essential to managing working capital in the construction
sector. This includes implementing effective credit policies,
maintaining accurate records of outstanding invoices, and using
effective collections strategies, such as early payment discounts or
factoring.
• Managing Accounts Payable: Effective management of accounts
payable is also essential to managing working capital in the
construction sector. This includes negotiating favorable payment
terms with suppliers, maintaining accurate records of outstanding
invoices, and implementing effective payment strategies, such as
vendor financing or electronic payment systems.
Management of the working capital
• Managing Inventory: Effective inventory management is critical to
managing working capital in the construction sector. This includes
implementing effective inventory control systems, minimizing excess
inventory levels, and implementing effective procurement strategies,
such as just-in-time inventory management.

• Managing Short-term Financing: Short-term financing can be an

effective tool for managing working capital in the construction sector.
This includes utilizing lines of credit or short-term loans to manage
cash flow gaps or fund inventory purchases.
Management of the working capital
• Managing Long-term Financing: Long-term financing can also be an
important tool for managing working capital in the construction
sector. This includes securing long-term loans or bonds to fund capital
expenditures or project financing.

• Managing Risk: Effective risk management is critical to managing

working capital in the construction sector. This includes identifying
and addressing potential risks, such as project delays or cost
overruns, and implementing effective risk management strategies,
such as contingency planning or project insurance.
Management of the working capital
• Utilizing Technology: Technology can be an important tool for
managing working capital in the construction sector. This includes
utilizing software to automate financial processes, such as accounts
payable or accounts receivable, or implementing electronic payment
systems to streamline cash flow management.
Financial Estimate
• Foundation for Budgeting: Provides a baseline for determining
project costs and funding needs.
• Cost Control: Helps manage expenses by setting realistic budget
limits.
• Risk Mitigation: Identifies potential financial risks early, allowing
for contingency planning.
• Investment Justification: Assists in demonstrating the financial
viability of the project to stakeholders.

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Financial Projections
• Future Cash Flow Forecasts: Estimates future inflows and
outflows to assess financial health.
• Investor Confidence: Projects potential returns, helping to
secure financing from investors.
• Performance Benchmarking: Sets financial goals to track project
performance over time.
• Decision-Making Support: Guides resource allocation and
prioritization based on expected returns.

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