Unit -4

Financial Appraisal

project costs are the total funds needed to

monetarily cover and complete a business
transaction or work project.
Project costs involve:
Direct cost
Direct costs are those directly linked to doing the work of the
project. For example, this could include hiring specialised
contractors, buying software licences or commissioning your
new building.

Indirect cost
These costs are not specifically linked to your project but are the
cost of doing business overall. Examples are heating, lighting,
office space rental (unless your project gets its own offices hired
specially), stocking the communal coffee machine and so on.

Fixed cost
Fixed costs are everything that is a one-off charge. These fees
are not linked to how long your project goes on for. So if you
need to pay for one-time advertising to secure a specialist
software engineer, or you are paying for a day of Agile
consultancy to help you start the project up the best way, those
are fixed costs.
Variable cost
These are the opposite of fixed costs - charges that change with
the length of your project. It's more expensive to pay staff
salaries over a 12 month project than a 6 month one. Machine
hire over 8 weeks is more than for 3 weeks. You get the picture.

Sunk cost
These are costs that have already been incurred. They could be
made up of any of the types of cost above but the point is that
they have happened. The money has gone. These costs are often
forgotten in business cases, but they are essential to know about.
Having said that, stop/continue decisions are often (wrongly)
based on sunk costs. If you have spent £1m, spending another
£200k to deliver something that the company doesn't want is just
wasting another £200k. Epstein and Maltzman write:
"Sunk cost is a loss which should not play any part in
determining the future of the project." Unfortunately, project
sponsors and other senior executives (and even project
managers) often value completion over usefulness and it does
take courage to suggest to your sponsor that you stop a project
that has already seen significant investment.
 Project Finance
The structure of project financing relies on
future cash flows for repayment of the project
finances. The assets or rights held under the
project act as collateral for the finance.
Governments or companies prefer project
finance for long gestation projects or for joint
venture arrangements or collaboration
arrangements
Project Financing is a long-term, zero or limited recourse
financing solution that is available to a borrower against
the rights, assets, and interests related to the concerned
project.
If you are planning to start an industrial, infrastructure, or
public services project and need funds for the same,
Project Financing might be the answer that you are
looking for.
The repayment of this loan can be done using the cash
flow generated once the project is complete instead of the
balance sheets of the sponsors. In case the borrower fails
to comply with the terms of the loan, the lender is entitled
to take control of the project. Additionally, financial
companies can earn better margins if a company avails
this scheme while partially shifting the associated project
risks. Therefore, this type loan scheme is highly favoured
by sponsors, companies, and lenders alike.
In order to bridge the gap between sponsors and lenders,
an intermediary is formed namely Special Purpose
Vehicle (SPV). The main role of the SPV is to supervise
the fund procurement and management to ensure that the
project assets do not succumb to the aftereffects of project
failure. Before a lender decides to finance a project, it is
also important that all the risks that might affect the
project are identified and allocated to avoid any future
complication.

Key Features of Project Financing

Since a project deals with huge amount funds, it is
important that you learn about this structured
financial scheme. Below mentioned are the key
features of Project Financing:
 Capital Intensive Financing Scheme: Project
Financing is ideal for ventures requiring huge
amount of equity and debt, and is usually
implemented in developing countries as it leads
 to economic growth of the country. Being more
expensive than corporate loans, this financing
scheme drives costs higher while reducing
liquidity. Additionally, the projects under this
plan commonly carry Emerging Market Risk and
Political Risk. To insure the project against these
risks, the project also has to pay expensive
premiums.
 Risk Allocation: Under this financial plan, some
of the risks associated with the project is shifted
towards the lender. Therefore, sponsors prefer
to avail this financing scheme since it helps
them mitigate some of the risk. On the other
hand, lenders can receive better credit margin
with Project Financing.
 Multiple Participants Applicable: As Project
Financing often concerns a large-scale project, it
is possible to allocate numerous parties in the
project to take care of its various aspects. This
helps in the seamless operation of the entire
process.
 Asset Ownership is Decided at the Completion
of Project: The Special Purpose Vehicle is
responsible to overview the proceedings of the
project while monitoring the assets related to
the project. Once the project is completed, the
project ownership goes to the concerned entity
as determined by the terms of the loan.
 Zero or Limited Recourse Financing Solution:
Since the borrower does not have ownership of
the project until its completion, the lenders do
not have to waste time or resources evaluating
the assets and credibility of the borrower.
Instead, the lender can focus on the feasibility
of the project. The financial services company
can opt for limited recourse from the sponsors
if it deduces that the project might not be able
to generate enough cash flow to repay the loan
after completion.
 Loan Repayment With Project Cash Flow:
According to the terms of the loan in Project
Financing, the excess cash flow received by the
 project should be used to pay off the
outstanding debt received by the borrower. As
the debt is gradually paid off, this will reduce
the risk exposure of financial services company.
 Better Tax Treatment: If Project Financing is
implemented, the project and/or the sponsors
can receive the benefit of better tax treatment.
Therefore, this structured financing solution is
preferred by sponsors to receive funds for long-
term projects.
 Sponsor Credit Has No Impact on Project: While
this long-term financing plan maximises the
leverage of a project, it also ensures that the
credit standings of the sponsor has no negative
impact on the project. Due to this reason, the
credit risk of the project is often better than the
credit standings of the sponsor.
What Are the Various Stages of Project Financing?
[Link]-Financing Stage
[Link] of the Project Plan - This
process includes identifying the strategic
 plan of the project and analysing whether
its plausible or not. In order to ensure that
the project plan is in line with the goals of
the financial services company, it is crucial
for the lender to perform this step.
[Link] and Minimising the Risk - Risk
management is one of the key steps that
should be focused on before the project
financing venture begins. Before investing,
the lender has every right to check if the
project has enough available resources to
avoid any future risks.
c. Checking Project Feasibility - Before a
lender decides to invest on a project, it is
important to check if the concerned project
is financially and technically feasible by
analysing all the associated factors.
[Link] Stage
Being the most crucial part of Project Financing, this
step is further sub-categorised into the following:
 [Link] of Finances - In order to take
care of the finances related to the project,
the sponsor needs to acquire equity or loan
from a financial services organisation whose
goals are aligned to that of the project
[Link] or Equity Negotiation - During this
step, the borrower and lender negotiate the
loan amount and come to a unanimous
decision regarding the same.
c. Documentation and Verification - In this
step, the terms of the loan are mutually
decided and documented keeping the
policies of the project in mind.
[Link] - Once the loan documentation is
done, the borrower receives the funds as
agreed previously to carry out the
operations of the project.
[Link]-Financing Stage
[Link] Project Monitoring - As the project
commences, it is the job of the project
 manager to monitor the project at regular
intervals.
[Link] Closure - This step signifies the end
of the project.
c. Loan Repayment - After the project has
ended, it is imperative to keep track of the
cash flow from its operations as these funds
will be, then, utilised to repay the loan
taken to finance the project.

Project Viability Definition

A project is viable if it is able to meet its objectives
within the constraints of available resources. In
other words, a viable project is one that can be
completed successfully given the time, money, and
other resources that are available.
There are a number of factors that can impact the
viability of a project, including its scope, complexity,
and the skill level of the team working on it.
Additionally, the availability of resources can also
play a role in determining whether or not a project
is viable.
If a project is found to be non-viable, it may be
necessary to make changes to its scope or budget in
order to make it more achievable. In some cases, it
may also be necessary to bring in additional
resources or expertise in order to increase its
chances of success.

project profitability
A project is considered profitable if it yields a
financial gain for your organization, meaning the
project is bringing in more money than it costs to
execute it. All projects involve costs, such as
materials, labor, and other resources. Preventing
your costs from ballooning beyond expectations is
the key to profitability.
Project-based businesses, such as creative agencies,
may fall into the trap of taking on too many projects
at once in the hope of accelerating the growth of
their business. In reality, taking on projects you’re
 not equipped to handle can actually result in a loss
that works against your goal of turning a profit.
3 Main Measures of Project Profitability.
 Net Present Value. NPV is based on the fact that with time,
money loses value. ...
 Internal Rate of Return. The IRR relies on the same principle and
formula, except it reduces the NPV of a project to zero. ...
 Payback Period.

key elements of profitability

Profitability has two elements, namely, income and
expenses. Income also called revenue is the earnings
from selling products or providing a service. A company
needs to use resources to generate income, resources are
used to produce the products that the company sells or to
deliver the services.

Break-Even Analysis

A break-even analysis is an economic tool that is used to

determine the cost structure of a company or the number of units
that need to be sold to cover the cost. Break-even is a
circumstance where a company neither makes a profit nor loss
but recovers all the money spent.
The break-even analysis is used to examine the relation between
the fixed cost, variable cost, and revenue. Usually, an
organisation with a low fixed cost will have a low break-even point
of sale.

Importance of Break-Even Analysis

 Manages the size of units to be sold: With the help of break-even
analysis, the company or the owner comes to know how many units
need to be sold to cover the cost. The variable cost and the selling
price of an individual product and the total cost are required to
evaluate the break-even analysis.
 Budgeting and setting targets: Since the company or the owner
knows at which point a company can break-even, it is easy for them
to fix a goal and set a budget for the firm accordingly. This analysis
can also be practised in establishing a realistic target for a company.
 Manage the margin of safety: In a financial breakdown, the sales of
a company tend to decrease. The break-even analysis helps the
company to decide the least number of sales required to make
profits. With the margin of safety reports, the management can
execute a high business decision.
 Monitors and controls cost: Companies’ profit margin can be
affected by the fixed and variable cost. Therefore, with break-even
analysis, the management can detect if any effects are changing the
cost.
 Helps to design pricing strategy: The break-even point can be
affected if there is any change in the pricing of a product. For
example, if the selling price is raised, then the quantity of the product
to be sold to break-even will be reduced. Similarly, if the selling price
is reduced, then a company needs to sell extra to break-even.

Components of Break-Even Analysis

 Fixed costs: These costs are also known as overhead costs. These
costs materialise once the financial activity of a business starts. The
fixed prices include taxes, salaries, rents, depreciation cost, labour
cost, interests, energy cost, etc.
  Variable costs: These costs fluctuate and will decrease or increase
according to the volume of the production. These costs include
packaging cost, cost of raw material, fuel, and other materials related
to production.

Uses of Break-Even Analysis

 New business: For a new venture, a break-even analysis is
essential. It guides the management with pricing strategy and is
practical about the cost. This analysis also gives an idea if the new
business is productive.
 Manufacture new products: If an existing company is going to
launch a new product, then they still have to focus on a break-even
analysis before starting and see if the product adds necessary
expenditure to the company.
 Change in business model: The break-even analysis works even if
there is a change in any business model like shifting from retail
business to wholesale business. This analysis will help the company
to determine if the selling price of a product needs to change.

Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost –
Variable cost

Example of break-even analysis

Company X sells a pen. The company first determined the
fixed costs, which include a lease, property tax, and
salaries. They sum up to ₹1,00,000. The variable cost
linked with manufacturing one pen is ₹2 per unit. So, the
pen is sold at a premium price of ₹10.
Therefore, to determine the break-even point of Company
X, the premium pen will be:
Break-even point = Fixed cost/Price per cost –
Variable cost
= ₹1,00,000/(₹12 – ₹2)
= 1,oo,000/10
= 10,000
Therefore, given the variable costs, fixed costs, and selling
price of the pen, company X would need to sell 10,000
units of pens to break-even.