Assessing Project Cost Sources of Finance

Assessing Project Cost
Sources of Finance
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Assessing Project Costs
Project costs include:
 Direct costs:
 operational costs, raw material, direct labour
 Indirect costs:
 Design, Marketing, Accounts, R&D, etc.
 tie ups with local bodies, labour unions,
shopping center committee, chamber of
commerce
 Cost of finance, local taxes, municipal fee(water,
other utilities, etc.), other charges
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Assessing Project Costs
Necessary steps reqd. to obtain the cost estimate:
 Identify Cost Categories: production, marketing,
design, R&D, sales, promotion, etc.
 Gather cost data: unit cost list can be drawn from
various data sources (market survey, statistical
collection, vendors, consultants, other cost studies,
etc.)
 Adjust costs to local conditions: e.g. costs
estimated in past years must be escalated to
account for inflation, local market conditions, etc.
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Ideal Approach - Comparing Costs
and Benefits
Determining Present Value of Project Costs and
Benefits
 Project costs and benefits are incurred at different
times during a project’s life
 the process of discounting allows the expression
of a stream of costs or benefits as one number in
present value terms
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Ideal Approach - Comparing Costs
and Benefits
Comparing Costs and Benefits
Benefit and cost streams form the basis of several
measures of project viability:
1. Net Present Value (NPV)
2. Benefit – Cost Ratio (BCR)
3. Internal Rate of Return (IRR)
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1. Net Present Value (NPV)
 NPV is the value resulting from subtracting the
expected cost from the expected benefits
 Projects with a NPV greater than zero are worth
undertaking
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2. Benefit – Cost Ratio (BCR)
 It’s the ratio of the present value of benefits to
the present value of costs
 for a project to be acceptable, BCR > 1
 Example: a BCR of 1.25 indicates that for every
Rs.100 of cost, project will return Rs.125 of
benefit
 BCR is a relative measure of viability
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3.Internal Rate of Return (IRR):
 the IRR is the discount rate at which the present
value of costs equals the present value of benefits
 Alternatively, IRR is the discount rate at which
NPV = 0 and BCR = 1.0
 If IRR exceeds the opportunity cost of the capital,
the project is considered to be economically
sound and worth pursuing
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Sources of finance for a
start-up business
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 Often the hardest part of starting a business is
raising the money
 You have a great idea and you have a clear idea of
how to turn it into a successful business
 However, if sufficient finance can’t be raised, the
business can’t get off the ground!
Introduction
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The entrepreneur needs to decide:
 How much finance is required?
 When and how long the finance is needed for?
 What security (mortgage) can be provided?
 Whether the entrepreneur is prepared to give up
some control (ownership) of the start-up in return
for investment?
Careful planning….
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 Set-up costs : costs that are incurred before the
firm starts to trade (office, people, phone, etc.)
 Starting investment in capacity : fixed assets that
the firm needs before it can begin to trade
 Working capital: stocks needed – e.g. raw
materials, salaries, logistics, credit, etc.
 Growth and development - E.g. extra investment
in capacity
Finance needs of a start-up
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Internal sources
External sources
Sources of Finance
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Personal sources
Savings and other “nest-eggs”
Borrowing from friends and family
Credit cards
Retained profits
Share capital – invested by the founder
Internal sources
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Loan Capital: Bank Loan or Bank Overdraft
Share Capital – Outside Investors
Debentures
Business Angels
Venture Capital
External sources
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Internal sources
Personal sources
most start-ups make use of the personal
financial arrangements of the founder
personal savings
other accumulated cash
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Internal sources
Retained profits (reinvestment of profits)
In case of a firm trading profitably some part of
the profit may not be disbursed to shareholders
This ‘retained amount’ may be reinvested for
expansion or diversification of business activities
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Internal sources
Savings and other “nest-eggs”
e.g. redundancy, an inheritance, personal
savings
mortgaging - most popular way of raising loan-
related capital for a start-up, flipside  if the
business fails, property will be lost!
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Internal sources
Borrowing from friends and family
Friends and family who are supportive of the
business idea may provide money either directly
to the entrepreneur or into the business
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Internal sources
Credit cards
an ingenious way of financing a start-up
E.g. Each month, the entrepreneur pays for
various business-related expenses on a credit
card.
One can use it for credit-free period OR
rotate the credit from one credit card to
another
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Internal sources
Share capital
Initially the founding entrepreneur may provide
all the share capital of the firm taking help from
personal sources to invest in the shares
Post investment, the firm owns the money
Other contributors (if any) become share
holders and are known as members of the firm
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Internal sources
Share capital
Shareholder(s) obtain(s) a return on this
investment through dividends or through value
of the firm when it is eventually sold
Before shares are issued, directors of the firm
have to decide on the following matters:-
The amount of capital which is to be raised by issue
of shares.
The types of shares which will be issued.
The time of issuing shares. 22

External sources
Loan capital
This can take several forms, but the most
common are a (i) bank loan or (ii) bank overdraft
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External sources
Bank loan (commercial banks)
long-term finance (bank states the time period,
rate of interest, timing & amount of repayments)
Banks ask for security (personal guarantees can
be provided by the entrepreneur)
good for financing investment in fixed assets,
generally low rate of interest than bank overdraft,
low flexibility
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External sources
Bank overdraft (cash credit)
short-term and flexible source of finance
when the firm’s bank balance goes below zero,
bank provides money in return for charging a
high rate of interest
best for handling seasonal fluctuations in cash
flow or when the business runs into short-term
cash flow problems
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Share capital – outside investors
friends and family
main source of outside (external) investor in
the share capital of a firm
Downside  Almost inevitably, tensions
develop with family and friends as fellow
shareholders.
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business angels
professional investors, typically invest 10L – 5CR
invest in high growth businesses
make money by setting up and then selling the
business
Angels may provide skills, experience & contacts
Getting the backing of an Angel: BIG advantage,
FLIPSIDE - loss of control over the business
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Venture Capital (private equity)
It’s a specific kind of share investment made by
funds managed by professional investors
rarely invest in start-ups or small businesses
minimum investment > 10cr
prefer to invest in established firms
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Debentures
A type of debt instrument that is not secured by
physical asset or collateral
The rate of interest paid by the firm is pre-
determined and fixed unlike shares
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Source of Short-Term Finance
Trade Credit
Interest free credit from suppliers (purchase of
supplies without immediate payment)
credit period depends on the nature of product,
location of the customer, degree of competition in
the market, financial resources of the suppliers
and the eagerness of suppliers to sell his stocks.
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Instalment Credit
supplier of equipments may allow payments in
instalments
down payment + 8/12 instalments
supplier charges interest on the instalment
credit
ownership of the equipment transfers to the
buyer upon payment of last instalment
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Accounts Receivable Financing
money is advanced by a financing company on
security of accounts receivable
Usually advances are up to 60% of the value of
the accounts receivable
Debtors firm financing company
$ $
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Discounting of bills
Commercial banks finance the business concern
by discounting their credit instruments like bills of
exchange, promissory notes and hundies
These documents are discounted by the bank at
a price lower than their face value
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Customer Advance
Customers make a part payment in advance to
the manufacturer, particularly in cases of special
order or big orders
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Source of Long-Term Finance
Capital Market
transactions take place among individuals and
various organisations
companies raise funds by issuing shares and
debentures of different types
primary market/secondary market
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Special Financial Institutions (Development
Banks)
provide long-term financial assistance to
industrial enterprises
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national level
Industrial Finance Corporation of India (IFCI)
Industrial Credit and Investment Corporation of
India (ICICI)
Industrial Development Bank of India (IDBI), etc.
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State level
State Financial Corporations (SFCs)
State Industrial Development Corporations
(SIDC)
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Other institutions
(a.k.a. 'Investment Companies' or 'Investment
Trusts' which subscribe to the shares and
debentures offered to the public by companies
Life Insurance Corporation of India (LIC);
General Insurance Corporation of India (GIC);
Unit Trust of India (UTI), etc.
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Leasing Companies
lease agreement is made whereby plant,
machinery and fixed assets may be purchased by
the leasing company and allowed to be used by
the manufacturing concern for a specified period
on payment of an annual rental
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Leasing Companies
At the end of the period the manufacturing
company may have the option of purchasing the
asset at a reduced price
The lease rent includes an element of interest
besides expenses and profits of the leasing
company
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Foreign Sources (Foreign Collaborators )
If approved by the GOI, Indian companies can
secure capital from foreign collaborator through
a) share capital, or
b) by way of supply of technical knowledge,
patents, drawings and designs of plants or
supply of machinery
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International Financial Institutions:-
World Bank & International Finance Corporation
(IFC) provide long-term funds for the industrial
development all over the world
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World Bank
grants loans only to the Governments of
member countries or private enterprises with
guarantee of the concerned Government
IFC
assists private undertakings w/o the guarantee
of member countries.
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Non-Resident Indians
persons of Indian origin and nationality living
abroad are also permitted to subscribe to the
shares and debentures issued by the companies
in India.
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Fixed Capital - definition
 It refers to any kind of real or physical capital
(fixed asset) that is not used up in the
production of a product as against variable
cost
 Fixed capital is employed in assets of durable
nature for repeated use over a long period
 Also called fixed investment
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Definition :
The management of fixed assets such as land,
buildings, fixtures, vehicles and machinery, which
can not be converted to a fair cash value in a
timely manner.
Fixed Capital Management

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Fixed capital is a concept in economics and
accounting
Fixed assets can be purchased, leased, hired or
rented
Over long term, fixed assets may also be resold
and re-used, which often happens with vehicles
and planes
Fixed Capital Management

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The nature of the undertaking: the nature of the
business certainly plays a role in determining fixed
capital requirements. A florist, for example, needs
less fixed capital than a vehicle-assembly factory
The size of the undertaking: a general rule
applies: the bigger the business, the higher the
need for fixed capital
Factors which influence fixed-
capital requirements

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The stage of development of the undertaking:
the requirement of capital for a new undertaking is
usually greater than that needed for an established
business that has reached optimum size.
Factors which influence fixed-
capital requirements

Assessing Project Cost Sources of Finance

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