Project Management Chapter 3 (Project Appraisal)

What is Project Appraisal?

Project Appraisal is the process of assessing a project’s feasibility, viability, and potential success before
committing resources to it. It involves evaluating technical, financial, economic, social, and environmental
aspects to ensure the project is worth pursuing.

Technical Appraisal
Technical appraisal broadly involves a critical study of the following aspects:

1. Selection of the Process/Technology

This involves identifying and evaluating different technological options or processes available to achieve the
project’s objectives. It is a critical step because the success and efficiency of the project depend largely on
the technology adopted. Some key consideration when selecting the process or technology are sustainability
of the projects, efficiency and productivity, cost effectiveness, scalability, compatibility, environmental
impact, technological advancement, etc.

Appropriate Technology: Appropriate technology refers to the technology that is suitable for the local
economic, social and cultural conditions. Appropriate technology can be identified by asking the following
questions.

 Does the technology make use of the locally available raw material?
 Can the technology by implemented and maintained by the locally available man power?
 Is the technology in tune with the local social and cultural conditions?
 Does the technology protects ecological balance etc .?

2. Scale of Operations

Scale of operations refers to the size or capacity at which a project will operate—how much it will produce
in a given time (daily, monthly, or annually). It plays a key role in determining the project's cost structure,
efficiency, and profitability. Key factors in determining scale of operations are Market Demand, Resource
Availability, Economies of Scale, etc.

Types of scale are: Small Scale (suitable for local markets), Medium Scale (suitable for regional markets),
and Large Scale (suitable for international markets).
3. Raw Material

The selection of raw material involves identifying the type, quality, source, availability, and cost of the basic
inputs required for the production process. It is crucial because raw materials directly affect product quality,
cost efficiency, and the smooth functioning of operations. Key considerations of selection of raw material
involve availability, quality, cost, transportation etc.

4. Technical Know-how

Technical know-how refers to the specialized knowledge, skills, and expertise required to operate the chosen
technology, machinery, and production process efficiently. It is vital for ensuring that the project runs
smoothly and achieves the desired quality and productivity.

Source of technical know-how are In-house experts, Technical consultants, Technology partners, foreign
collaborators, etc.

5. Collaboration Agreements

Collaboration agreements refer to formal partnerships with other companies, often domestic or foreign, to
obtain technology, technical assistance, training, equipment, or market access. These agreements are
especially important when the project lacks in-house technical expertise or resources.

Key Considerations of collaboration agreements are:

 Terms of the agreement (royalties, duration, exclusivity, etc.)

 Intellectual Property Rights (IPR) protection
 Regulatory compliance (especially for international deals)
 Cultural and managerial compatibility between partners

6. Product Mix

Product mix refers to the variety of products or product lines that a project plans to produce. It is an
important part of technical appraisal because it influences the plant design, machinery requirements, raw
material planning, marketing strategy, and overall profitability.

Key Considerations of Product mix is market demand, profit margins, production, capacity, flexibility, and
complementarity
7. Selection and Procurement of Plant and Machinery

(a) Selection of Machinery

The selection of machinery is the first step in determining the best equipment for the project. This decision
directly impacts the production process, efficiency, cost-effectiveness, and long-term sustainability of the
project.

Key factors to consider when selecting machinery:

 It should be compatible with the selected process/technology and production scale.

 Ensure low maintenance costs and availability of spare parts.
 The machinery should align with the project’s budget.
 The machinery must comply with safety, environmental, and industry-specific standards. Etc.

(b) Procurement of Machinery

Once the machinery has been selected, the next step is the procurement process, which involves purchasing,
transporting, and installing the machinery.

Key steps in the procurement of machinery:

1. Tendering and Bidding

2. Negotiation
3. Order Placement
4. Delivery and Transportation
5. Installation and Testing
6. Warranty and After-Sales Support

8. Plant Layout

Plant layout refers to the physical arrangement of machinery, equipment, workspaces, and facilities within a
production plant or factory. The layout plays a crucial role in ensuring efficient production processes,
minimizing material handling time, ensuring safety, and improving overall productivity.

Key considerations of plant layout are:

 The layout should ensure a smooth, logical flow of raw materials through the production process,
minimizing backtracking and delays.
 The layout should comply with safety regulations, ensuring safety zones, proper ventilation, and
emergency exits.
  Machines and equipment should be arranged to minimize downtime and allow easy access for
maintenance and operation.
 The arrangement should support ergonomics and easy access to tools and materials to minimize
worker fatigue and improve productivity.
 Future Expansion or future growth in production capacity and ensure that the layout can
accommodate future upgrades or changes

9. Location of Projects

Choosing the right location is crucial for the success of a project. A good location can reduce costs, improve
efficiency, and ensure access to markets and resources. There are two major factors in location of projects:
Regional factors, Site factors.

Regional Factors

These refer to broader geographical and economic aspects of a region that influence the overall suitability
for setting up a project.

Key Regional Factors:

Proximity to Raw Materials: Reduces transportation cost and ensures timely supply.

Market Access: Nearness to major markets ensures faster delivery and lower distribution costs.

Availability of Labor: Presence of skilled and unskilled workers in the region.

Infrastructure: Quality of roads, power supply, water, communication, and logistics.

Government Policies: Incentives, subsidies, tax benefits, and ease of doing business.

Social and Political Stability: A peaceful environment supports long-term investment.

Example: A cement plant may prefer a region close to limestone mines and major roadways.
Site Factors

These are specific physical and environmental conditions of the chosen land or site within the selected
region.

Key Site Factors:

Topography and Soil Condition: Flat, stable land is preferable for construction and heavy machinery.

Land Availability and Cost: Sufficient and affordable land is essential for present and future needs.

Access to Utilities: Availability of water, electricity, drainage, and waste disposal systems.

Environmental Impact: Compliance with environmental laws, minimal disruption to local ecosystems.

Safety and Security: The site should be safe from floods, earthquakes, or other hazards.

Example: For a food processing plant, the site should have clean water, good drainage, and low pollution
risk.

Project Scheduling
Project scheduling is the process of organizing project activities in a time-based sequence to ensure efficient
implementation. It involves planning key steps such as land acquisition, site development, construction,
machinery installation, and the start of commercial operations. Each activity requires time, money, and
effort, so proper scheduling is essential to minimize resource wastage. Financial institutions often require a
detailed project schedule as part of their appraisal process.

Commercial Appraisal
Commercial appraisal focuses on evaluating the market potential of a project's product or service. Its
primary aim is to determine whether the offering can achieve commercial success, which is vital for the
project's viability. Commercial appraisal plays a central role in overall project evaluation. This appraisal
examines key aspects such as:

a) Demand for the product.

b) Supply position for the product.
c) Distribution channels.
d) Pricing of the product.
e) Government policies.
f) Market Share.
Demand
Demand refers to the consumer's desire for a product backed by purchasing power. It is a critical factor
influencing a firm’s profitability. Regardless of efficient production, financial management, or employee
relations, a business cannot succeed without adequate demand for its products. Therefore, analyzing and
estimating future demand is a vital part of project planning and appraisal. Demand is typically measured by
the number of units consumers are willing to buy within a specific time frame under certain conditions.

Demand Forecasting Techniques for Projects

Demand forecasting is an essential process for predicting future demand for situation. It helps businesses
and project managers make informed decisions regarding production, inventory, resources, and planning.
Some forecasting techniques are:

1. Survey Methods

(a) Jury of Expert’s Method

Overview: This method involves gathering a group of experts, such as industry professionals, salespeople, or
senior managers, to provide their opinions on future demand.

Process: The experts discuss their views, and based on their collective knowledge and experience, they
estimate future demand. This can be done through meetings, interviews, or questionnaires.

(b) Delphi Technique

Overview: A more structured version of the jury method, the Delphi Technique involves a series of surveys
or questionnaires completed by a group of experts, followed by rounds of feedback.

Process: The experts provide their forecasts independently, and after each round, a facilitator summarizes
the responses and feeds them back to the group. The experts revise their forecasts in subsequent rounds,
ultimately leading to a consensus on demand.

(c) Consumer Survey Method

Overview: This method gathers data directly from consumers through surveys or interviews to assess their
purchasing intentions.

Process: Questions are asked about the consumer’s future buying behavior, preferences, and needs. The
responses are analyzed to predict demand.
Sales forecast = (Total population size / Sample size) × [No. of respondents who said ‘yes’] × [% of those
who said ‘yes’ who will actually purchase] × [Average quantity that will be purchased by a buyer]

(d) Sales Forecast Composite

Overview: This method involves aggregating the sales forecasts from various departments or salespeople in
an organization.

Process: Salespeople or regional managers provide their forecasts, which are then compiled to form an
overall sales forecast. The forecasts may include both quantitative data and qualitative insights.

Statistical Methods

1. Trend Analysis

Trend analysis identifies patterns or trends in past data to forecast future demand.

(a) Curve Fitting

Curve fitting is a statistical method used in trend analysis to model the relationship between variables,
typically time (independent variable) and demand (dependent variable). The goal is to identify a
mathematical function (curve) that best represents the historical data pattern, allowing for future demand
projections.

Illustration 3.3

Step-by-Step Solution

1. Given Data

197 198
Year (x) 1980 1982 1983 1984 1985
9 1

Demand (y) (in

600 825 970 1,210 1,440 1,790 2,070
'000s)

2. Data Transformation

To simplify calculations, define:

 X=x−1982X=x−1982

This centers the data around 1982 (so ∑X=0∑X=0):

Year
X = x - 1982 Demand (Y = y) X² XY
(x)

1979 -3 600 9 -1,800

1980 -2 825 4 -1,650

1981 -1 970 1 -970

1982 0 1,210 0 0

1983 1 1,440 1 1,440

1984 2 1,790 4 3,580

1985 3 2,070 9 6,210

Summations:

 ∑Y=8,905∑Y=8,905

 ∑X=0∑X=0

 ∑X2=28∑X2=28

 ∑XY=6,810∑XY=6,810

3. Solving Normal Equations

The least squares method gives:

1. ∑Y=n⋅a+b⋅∑X∑Y=n⋅a+b⋅∑X
2. ∑XY=a⋅∑X+b⋅∑X2∑XY=a⋅∑X+b⋅∑X2

Substituting values:

1. 8,905=7a+08,905=7a+0 → a=1,272.14a=1,272.14

2. 6,810=0+28b6,810=0+28b → b=243.21b=243.21

Trend Line Equation:

Y=1,272.14+243.21XY=1,272.14+243.21X

Convert back to original years (X=x−1982X=x−1982):

y=243.21x−480,770.88y=243.21x−480,770.88

4. Forecasting Demand for 1995

Substitute x=1995x=1995:

y=243.21×1995−480,770.88y=243.21×1995−480,770.88y=4,433.07 (in ’000s)y=4,433.07

(in ’000s)Actual Demand=4,433,070 unitsActual Demand=4,433,070 units

(b) Moving Average Method

The Moving Average Method forecasts future demand by taking the average of demand over a specific
number of past periods. It "moves" because with each new period, the oldest data point is dropped, and the
most recent one is added.

Fₜ₊₁ = (Aₜ + Aₜ₋₁ + Aₜ₋₂ + ... + Aₜ₋ₙ₊₁) / n

Where:

 Fₜ₊₁ = Forecast for next period

 Aₜ = Actual demand in period t
 n = Number of periods in the moving average

Example (3-Year SMA):

Year Actual Sales 3-Year Forecast

2018 2,219 -

2019 2,302 -

2020 2,007 -

2021 2,198 (2,219+2,302+2,007)/3 = 2,176

2022 - (2,302+2,007+2,198)/3 = 2,169

(c) Weighted Moving Average Method

The Weighted Moving Average forecasts future demand by assigning different weights to past periods,
typically giving more weight to recent data. This makes the forecast more responsive to recent changes in
demand.

Formula:

Fₜ₊₁ = (w₁×Aₜ + w₂×Aₜ₋₁ + ... + wₙ×Aₜ₋ₙ₊₁) / (w₁ + w₂ + ... + wₙ)

Example (4-Year WMA with weights 0.6, 0.7, 0.8, 0.9):

Weigh
Year Actual Sales Weighted Value
t

2017 2,182 0.6 1,309.2

2018 2,219 0.7 1,553.3

2019 2,302 0.8 1,841.6

2020 2,007 0.9 1,806.3

2021 Forecast - - (1,309.2+1,553.3+1,841.6+1,806.3)/4 = 1,627.6

(d) Exponential Smoothing Method

Exponential Smoothing is a sophisticated weighted moving average technique that:

  Prioritizes recent data more heavily than older observations
 Automatically adjusts forecasts based on past errors
 Requires minimal data storage (only needs the last forecast + last actual demand)

If the value of α (alpha) is not given, you can determine it using one of these methods:

Illustration 3.4: Exponential Smoothing Forecast Example

Given Data

Actual Demand (1991-2000)

Actual Demand
Year
(Aₜ)

1991 20,500

1992 20,200

1993 20,310

1994 20,450

1995 20,610

1996 20,720
 Actual Demand
Year
(Aₜ)

1997 20,815

1998 21,005

1999 21,090

2000 21,180

Parameters:

 Smoothing constant (α) = 0.32

 Initial forecast (F₁₉₉₁) = 19,980 (warm-up period average)

Exponential Smoothing Formula

Ft+1=α⋅At+ (1−α) ⋅Ft

Where:

Ft+1= Next period's forecast

At= Current period's actual demand

Ft= Current period's forecast

The table of forecast as under:

Yea Actual Forecast Difference (Aₜ -

Calculation
r (Aₜ) (Fₜ) Fₜ)

1991 20,500 19,980 520 (Initial)

1992 20,200 20,146 54 0.32×20,500 + 0.68×19,980

1993 20,310 20,164 146 0.32×20,200 + 0.68×20,146

1994 20,450 20,210 240 0.32×20,310 + 0.68×20,164

1995 20,610 20,287 323 0.32×20,450 + 0.68×20,210

Yea Actual Forecast Difference (Aₜ -
Calculation
r (Aₜ) (Fₜ) Fₜ)

1996 20,720 20,390 330 0.32×20,610 + 0.68×20,287

1997 20,815 20,496 319 0.32×20,720 + 0.68×20,390

1998 21,005 20,598 407 0.32×20,815 + 0.68×20,496

1999 21,090 20,728 362 0.32×21,005 + 0.68×20,598

2000 21,180 20,844 336 0.32×21,090 + 0.68×20,728

2. Regression Technique

A regression model is an equation relating a dependent variable to many independent variables.

For example, anticipated sales (dependent variable) may be expressed as a function of independent variables
like disposable income of consumers, price relative to the price of competitive products, level of advertising
etc., and the relationship can be expressed as

Y = a1 + (b1. X1) + (b2. X2) + (b3. X3) +..... (bn . xn)

Where Y represents sales

a1, b1, b2..... bn are constants

And x1, X2, X3..... Xn are independent variables which affect the dependent variable Y.

Example:

House Price Size Bedrooms Distance

(Y) (x₁) (x₂) (x₃)

$350,000 1800 3 5
House Price Size Bedrooms Distance
(Y) (x₁) (x₂) (x₃)

$420,000 2200 4 3

$310,000 1500 2 8

$500,000 3000 4 2

The general form of the multiple regression equation is:

Price=a+b1⋅(Size)+b2⋅(Bedrooms)+b3⋅(Distance)Price=a+b1⋅(Size)+b2⋅(Bedrooms)+b3⋅(Distance)

Price=50,000+150⋅(Size)+20,000⋅(Bedrooms)−10,000⋅(Distance)

Price=50,000+150⋅(2000)+20,000⋅(3)−10,000⋅(4)=50,000+300,000+60,000−40,000=50,000+300,000+60,0
00−40,000=$370,000

=$370,000

Other Methods for Forecasting

(1) End use method

The End Use Method of Forecasting is a demand forecasting technique that estimates future demand by
analyzing the consumption behavior of the final users or customers.

The End Use Method is a technique used to forecast demand for intermediate products, which are items used
in the production of final goods but have no standalone utility.

Examples

1. Automobile Horns (Coefficient = 1)

Final
Consumption Coefficient Projected Output Demand for Horns
Product

Mopeds 1 25,000 25,000

Scooters 1 40,000 40,000

Motorcycles 1 45,000 45,000

Total 110,000 110,000

2. Indicator Lamps (Coefficient = 4)

Final
Consumption Coefficient Projected Output Demand for Lamps
Product

Mopeds 4 25,000 100,000

Scooters 4 40,000 160,000

Motorcycles 4 45,000 180,000

Total 110,000 396,000

Paper Board for Cones (Coefficient = 1.33)

Used in textile spinning mills for paper cones.

If 40g of paper board is needed for a 30g cone, the coefficient is 4030=1.333040=1.33.

(2) Leading Indicator Method

The Leading Indicator Method is a technique used to predict future demand by analyzing the relationship
between leading indicators (variables that change first) and lagging indicators (variables that respond to
those changes).

Examples: Personal income is a leading indicator. As income increases, demand for consumer goods (a
lagging indicator) usually increases.

Merits of the Leading Indicator Method:

 Efficiency: Avoids costly market surveys by relying on existing data.

 Trend Accuracy: Correctly chosen indicators reliably predict demand direction.
 Broad Applicability: Useful for sectors like agriculture, education, and manufacturing.

Demerits of the Leading Indicator Method:

 Indicator Selection Risk: Wrong leading indicators lead to flawed forecasts.

 Dynamic Relationships: Lead-lag patterns may shift due to economic changes.
 Continuous Monitoring Required: Relationships need regular validation.

(3) The Chain-Ratio Method

The Chain-Ratio Method is a demand forecasting technique that uses secondary data to estimate market
potential by applying sequential reduction factors to a broad population base. It systematically narrows
down the total population to the target customer segment through a series of ratios.

Step-by-Step Process

Begin with Total Population

Start with the broadest relevant population data

Example: 400,000,000 total population

Apply Demographic Filters

Multiply by population proportions

Example:

Female proportion (49%) → 196,000,000

Employed women (15%) → 29,400,000

College students (19%) → 37,240,000

Apply Behavioral Filters

Factor in ownership/usage patterns

Example:

Employed women without mopeds (68%) → 19,992,000

Students without mopeds (78%) → 29,047,200

Apply Affordability Filters

Include purchasing capability

Example:

Employed women who can afford (55%) → 10,995,600

Students who can afford (30%) → 8,714,160

Calculate Total Potential Market

Sum all qualified segments → 19,709,760

Estimate Company Share

Apply expected market capture (20%) → 3,194,195 units

Practical Example: Moped Demand Forecast

Calculation Step Ratio Applied Result

Total Population - 400,000,000

× Female Proportion 0.49 196,000,000

× Employed Women 0.15 29,400,000

× Don't Own Mopeds 0.68 19,992,000

Calculation Step Ratio Applied Result

× Can Afford 0.55 10,995,600

× Student Proportion 0.19 37,240,000

× Don't Own Mopeds 0.78 29,047,200

× Can Afford 0.30 8,714,160

Total Potential Market Sum 19,709,760

Company Estimate
×0.20 3,194,195
(20%)

Industry Demand vs. Firm Demand

Aspect Industry Demand Firm Demand
Total demand for a product or service in an entire Demand for a product or service from a
Definition
industry specific firm
Scope Broad – includes all companies in the industry Narrow – limited to a single company
Focus Entire market One company's share of the market
Depends on Consumer preferences, economic conditions, etc. Product price, quality, promotion by the firm
Demand for Samsung smartphones in
Example Total demand for smartphones in Bangladesh
Bangladesh
Used for market analysis and industry growth Used for business planning and sales
Usefulness
forecasting forecasting

Economic Appraisal
Economic appraisal refers to evaluating a project's impact on the overall economy, especially focusing on
how scarce national resources—like capital and foreign exchange—can be allocated most efficiently. This
concept is particularly important in developing and underdeveloped countries, where such resources are
limited.
Financial Appraisal
Financial appraisal is the process of evaluating a project’s financial viability to determine whether it will be
profitable and sustainable from the investor’s or business’s point of view.

It involves identifying all costs associated with the project, such as land, buildings, machinery, manpower,
working capital, etc., and providing a clear picture of the total investment required to implement the project.

Management Appraisal
Management appraisal is the evaluation of the competence, experience, and effectiveness of the
management team involved in a project or business. It assesses whether the managers and leaders are
capable of successfully planning, executing, and operating the project.

While other appraisal techniques are quantitative and objective in nature, management appraisal is purely
qualitative and subjective in nature.

Social Cost-Benefit Analysis (SCBA)

Social Cost-Benefit Analysis (SCBA) is a method used to evaluate the overall impact of an investment
project on society, beyond just financial profitability. While private companies focus solely on commercial
profitability, SCBA aims to determine whether a project is socially beneficial, taking into account broader
socio-economic effects. It is particularly relevant for public sector projects like roads, bridges, railways,
irrigation systems, etc.

The main objective of SCBA is to measure maximum possible returns to society from an investment project,
rather than just profits to private investors.

Types of Costs and Benefits:

 Direct Costs/Benefits: Immediate, measurable costs/returns (e.g., material costs, labor, revenues).
 Indirect Costs/Benefits: Long-term or societal impacts (e.g., pollution, health effects, improved
connectivity).

Differences between Commercial Profitability Analysis and Social Cost-Benefit Analysis (SCBA)

 The main difference between commercial profitability analysis and social cost-benefit analysis lies in
the treatment of costs and benefits. While commercial analysis uses market prices, including
subsidies and controlled prices, social cost-benefit analysis uses 'real' costs and benefits. It adjusts for
subsidies (e.g., power charges) and controlled prices to reflect the true economic value to society,
ensuring a more accurate assessment of a project's overall impact.
  While commercial profitability analysis focuses only on direct costs and benefits, social cost-benefit
analysis also considers indirect costs and benefits that affect the nation as a whole. Although difficult
to measure, these indirect factors are essential in evaluating a project's broader impact. For instance,
a pharmaceutical company may only account for the financial returns from selling a life-saving drug,
but from a social perspective, the drug's contribution to public health and well-being may far exceed
its market price—representing a significant indirect social benefit.

Example

Project Commercial View Social View

Bridge Construction Cost: Materials, labor Cost: Land displacement, ecological disruption

Benefit: Toll revenue Benefit: Reduced traffic, economic growth

Objectives of Social Cost Benefit Analysis (SCBA)

SCBA aims to appraise the total impact that a project will have on an economy. Accordingly, SCBA focuses
on the following objectives that a project is expected to fulfill.

 Contribution of the project to the GDP (Gross Domestic Product) of the economy.
 Contribution of the project to improve the benefits to the poorer sections of the society and to reduce
the regional imbalances in growth and development.
 Justification of the use of scarce resources of the economy by the project.
 Contribution of the project in protecting/improving the environmental conditions.

Shadow Prices: A shadow price is an estimated price for a good, service, or resource that does not have a
market price or is not traded in a conventional market. It reflects the true economic value of that item in
terms of opportunity cost or social benefit, rather than what people actually pay for it in the market.

Example: Suppose a government is evaluating a project that would pollute a river. There’s no market for
clean river water, but the damage to health, fishing, and biodiversity has real costs. A shadow price is
assigned to the clean water to reflect its true social value, even though no one buys or sells river water
directly.
The Little-Mirrlees Approach
It was designed to help evaluate public investment projects in developing countries, especially where market
prices do not accurately reflect social costs or benefits.

The Little-Mirrlees Approach, developed by I.M.D. Little and James A. Mirrlees, is a method for analyzing
industrial projects in developing countries. It uses a numeraire of "present uncommitted social income
measured in terms of convertible foreign exchange of constant purchasing power." This approach rejects the
'Consumption' numeraire of the UNIDO approach, which considers all groups' consumption. The approach
recognizes only "uncommitted social income" and uses convertible foreign exchange to measure public
income, as foreign aid and loans are a significant part of investment in developing countries. The
numeraire's value remains constant over time.

Economic Rate of Return (ERR)

The Economic Rate of Return (ERR) is a way to measure how profitable a project or investment is from the
overall economic perspective — not just financial profits for a company, but benefits and costs to society as
a whole.

In simple terms, ERR is the discount rate (interest rate) at which the economic benefits of a project are equal
to its economic costs, when both are measured over time. It's similar to the Internal Rate of Return (IRR)
used in finance, but ERR focuses on real economic values, often adjusted to remove taxes, subsidies,
inflation distortions, or externalities.

 If the ERR is higher than the opportunity cost of capital (basically, the return you could get from the
next best use of money), then the project is considered economically worthwhile.

In ERR, the discount rate is used to evaluate financial viability, comparing private projects to social ones.
ERR can be better than market prices, indicating a project's true economic value.

Domestic Resource Cost (DRC)

Domestic Resource Cost (DRC) is an economic indicator that measures how efficiently a country uses its
domestic resources (like labor, land, and capital) to earn or save foreign exchange through production.

In simple words, DRC tells us whether it’s better (or worse) for a country to produce something at home or
import it. It shows the real cost of using domestic resources compared to the value of what you could earn or
save in international trade.
If the DRC is lower than the foreign currency exchange rate, it suggests that indigenous product
manufacturing is advisable due to lower costs.

Let us see an example to clarify our understanding.

Value added at domestic price per unit of the proposed product : Rs. 50

Value added at world price per unit of the proposed product : Rs. 100

Exchange rate : 1 US$ = Rs. 50

Therefore, Domestic Resource Cost : (50/100) × 50

: Rs. 25

Since the DRC (Rs. 25) is less the exchange rate (Rs. 50), it is worthwhile to implement the project for the
manufacture of the proposed product.

On similar lines, it is not worthwhile to manufacture a product, if the DRC is more than the exchange rate.

Effective Rate of Protection (ERP)

The Effective Rate of Protection (ERP) is a concept used to measure how much protection a country's
policies (like tariffs, subsidies, or import controls) actually provide to domestic industries — after
considering not just the final product, but also the inputs used to make it.

The costs of inputs that go into a product are affected by such controls and concessions. Controls and
concessions impact product input costs, revealing competitive strength in the world market. In the absence
of concessions and controls, the value added to a product when measured at domestic prices and when
measured at international prices will be the same. If there is any difference in value addition when measured
in terms of domestic prices and international prices, it indicates the measure of protection.

EPR is measured by the following relationship:

When the value added at domestic prices is the same as the value added at the world prices, the ERP is zero.
ERP zero indicates that the project does not enjoy any protection from international competition. When the
value added at domestic prices is higher that the value added at world prices, the ERP takes a positive value.
Positive value of ERP indicates that the project enjoys protection from international competition. Higher the
positive value of ERP, higher the protection enjoyed by the product.
Project Risk Analysis
Project Risk Analysis is the process of identifying, assessing, and managing potential uncertainties that
could affect a project's outcomes, timeline, cost, or objectives. It's a key part of project planning and
decision-making—especially in public investment or development projects.

Risk analysis is a crucial component of project appraisal because all projects inherently involve uncertainty.
Project evaluations are based on assumptions, as no two projects are exactly alike. These assumptions are
necessary due to the uniqueness of each project, which prevents direct comparisons with past projects.

Common assumptions in project appraisal include:

 Periodic cash inflows: Estimated based on assumed selling prices and projected output over time.
 Periodic cash outflows: Calculated by estimating raw material prices, labor costs, power
consumption, etc.
 Life of machinery
 Salvage value of machinery

Risk vs. Uncertainty

Risk

 Definition: A situation where the outcomes are unknown, but the probabilities of different outcomes
are known or can be estimated.
 Example: Investing in a stock market where historical data allows you to estimate the chance of gain
or loss.
 Key Point: Measurable — You can assign probabilities.

Uncertainty

 Definition: A situation where neither the outcomes nor their probabilities are known.
 Example: Introducing a completely new product in a market with no prior data — you don't know
what will happen or how likely it is.
 Key Point: Unmeasurable — No reliable probability can be assigned.

Kinds of Project Risks

1. Project Completion Risk

 Definition: The risk that the project won’t be finished on time, within budget, or as planned.
 Causes: Poor planning, delays in approvals, contractor failure, unforeseen events.
 Impact: Cost overruns, loss of investor confidence, penalties.
2. Resource Risk

 Definition: The risk that essential resources (labor, materials, equipment) will not be available or
will be insufficient.
 Causes: Labor strikes, supplier issues, logistical delays.
 Impact: Interruptions in execution, increased costs.

3. Price Risk

 Definition: The risk of changes in the prices of inputs (materials, fuel, etc.) or outputs
(goods/services).
 Causes: Inflation, market volatility, policy changes.
 Impact: Affects cost estimation, profitability, and feasibility.

4. Technology Risk

 Definition: The risk that the technology used is unproven, fails, or becomes obsolete.
 Causes: Innovation failure, incompatibility, lack of skilled personnel.
 Impact: Increased costs, operational failure, delays.

5. Political Risk

 Definition: The risk of changes in government policies, instability, or conflict affecting the project.
 Causes: Nationalization, new regulations, war, corruption.
 Impact: Loss of investment, legal challenges, project suspension.

6. Interest Rate Risk

 Definition: The risk that fluctuations in interest rates will impact project financing costs.
 Causes: Monetary policy changes, inflation control.
 Impact: Higher borrowing costs, reduced profitability.

7. Exchange Rate Risk

 Definition: The risk that foreign currency fluctuations will affect the cost or return of a project.
 Causes: Volatile forex markets, economic instability.
 Impact: Budget distortions, losses in cross-border projects.
Techniques of Risk Analysis
 Break Even Point Analysis
 Sensitivity Analysis
 Decision Tree Analysis
 Monte-carlo Technique
 Game Theory

Break Even Point Analysis

Break-Even Analysis is a financial tool used to determine the point at which a project or business neither
makes a profit nor incurs a loss. This point, known as the Break-Even Point (BEP), is calculated by equating
total revenue with total costs (fixed and variable).

Break even analysis divided the total project costs into two broad head: fixed costs, and variable costs.

Fixed Costs: These are those costs that remain constant irrespective of the changes in the volume of output.
Following are some of the fixed costs:

 Rent payable for land

 Rent payable for factory
 Insurance premium for fixed assets
 Interest payable on long –term borrowing/deposits
 Administrative expenses
 Annual maintenance charges payable for machinery maintenance
 Deprecation
 Property tax. Etc.

Variable Costs: These are those costs that vary directly with the level of output. Some variable costs are as
under:

 Raw material costs

 Consumable stores
 Power, fuel, water charges
 Selling expenses. Etc.

Sales Realization = Fixed Costs + Variable Costs

Contribution: Contribution is the difference between the sales realization and the variable cost.

Solution:
Sensitivity Analysis

Sensitivity Analysis measures the change in a project's profitability due to changes in factors affecting cash
inflows. A project is considered more sensitive if a small change significantly affects profitability. Less
sensitive projects are preferred, as a small change can reduce estimated profit or even turn it into loss.
Sensitivity of a project is checked by observing the response of any measure of profitability (NPV, DSCR,
BEP or any other measure) to changes in critical factors. For example, the sensitivity of a project can be
studied as under.

 What happens to the NPV if the demand for the product drops down?
 What happens to the NPV if the economic life of the project reduces?
 What happens to the DSCR if the selling price for the product falls down? Etc.,

Sensitivity analysis provides management with crucial information on critical factors that may impact
project profitability.