CHAPTER FOUR

PROJECT PREPARATION

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INTRODUCTION
• Project preparation involves assessment of key aspects of a
project (pre-feasibility &feasibility studies).
• Major dimensions of feasibility studies:
o Commercial Dimension:
 Market & Demand Analysis

o Technical Dimension comprising

 Production Program and Plant Capacity
 Input (Raw Materials & Supplies) Study

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 CONT’D
Location & Site Studies and Environmental Impact
Assessment
Engineering & Technology Study
o Institutional & Managerial Dimension
o Financial Cost-Benefit Analysis
o Economic Analysis

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4.1. Market and Demand Analysis
INTRODUCTION

• The first step in project analysis is to estimate the potential

size of the market.
• Market and demand analysis is concerned with two broad
issues;
– what is the aggregate demand for the product?, and
– What share of the market will the project enjoy?
 The key step in market and demand analysis are :

1. Situational analysis & specification of objectives

• Analysis of customer, strategies of competitors,
Suppliers ,middlemen, & others in the industry.
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 key steps… cont’d
o Who are the buyers ?
o What is the total current demand for ?
o How is the demand temporarily distributed (pattern of
sales over the year) geographically?
o What prices will the customers be willing to pay for ?
o How can potential customers be convinced ?
o What channel of distribution are most suited?
o What trade margin will induce distributors to carry it?

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 key steps… cont’d
2. Collection of Information
• Relevant information should be obtained from secondary
and/or primary sources.
• Important source of secondary information useful for market
and demand analysis are:-
o Census of the country, national sample survey reports,
Statistical abstracts, annual survey of industries/agriculture,
economic survey, annual report by national bank, bulletin
on import and export, other publications, ..
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 key steps… cont’d
3. Conduct of Market Survey
 Steps in a Sample Survey
o Define the target population
o Select the sampling method and sample size
o Develop the questionnaire
o Recruit and Train the Field Investigators
o Obtain information
o Inspect the information gathered
o Analyze and Interpret the Information.

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 key steps… cont’d
4. Characteristics of the Market
• Described in terms of the following points:
o Effective demand in the past and present
o Breakdown of demand
o Price
o Methods of distribution and sales promotion
o Consumers
o Supply and competition
o Government policy
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 key steps… cont’d
5. Demand Forecasting
• Qualitative Methods (expert opinion, consumer survey,
sales opinion and Delphi method)
• Quantitative Methods
Time series (Trend, simple moving, weighted average
and exponential smoothing )
Causal methods

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4.2. Raw Materials and Supplies Study
• Materials and supplies are the major in put (ingredients) of
any project.
• Availability of raw material in terms of quantity and quality is
significant.
• Classification of raw materials and supplies
o Unprocessed and semi-processed
o Processed industrial materials and components
o Auxiliary materials factory supplies
(packaging ,containers…)

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 Raw materials… cont’d
o Utilities (electricity, water, fuel, and effluent disposal)
o Spare parts for regular maintenance of machinery

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4.3.Location, Sit& Environment Impact
Analysis(EIA)
• The term ‘location’ & ‘site’ should be distinguished.
• The choices of location are influenced by a variety of
considerations:
 Proximity to raw materials and market,
 Availability of infrastructure,
 Government policy
 Other factors (pollution, labor situation, climatic conditions
and general living condition).

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 Location and Sit… cont’d
• Site Inspection includes
– Assessing suitability of site
– Distance from transport, raw material, market
– Timely availability of utilities
– Safety and cleanness of the environment.
– Source of skilled and unskilled labor
– Availability of social infrastructure (residential
accommodation, school, hospital…)

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Environmental Impact Assessment (EIA)
• EIA is the type of assessment in which the nature, scale and
potential environmental impact of the proposed project will be
analyzed. The impact could be both positive and negative.
• The three most urgent areas of environmental concerns in
Ethiopia are:
 The considerable land degradation
 low quality and availability of water
 Urban environmental problems (lack of sanitary facilities,
west collection, and low standard of housing)
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 EIA … cont’d
• EIA there are four major stages
o Screening - is the initial review of a project to determine if
an EIA is required.
o Scoping :-assessing the likely major impacts of the project
on the environment.
o Impact Assessment & Evaluation- identification and
prediction of all environmental impact of the project
o Monitoring & Environmental Auditing

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4.4.Production Program & Plant Capacity
• Plant capacity (design/ nominal and effective/ feasible
capacity)

• Several factors have a bearing on the time of capacity

decision.
 Technological requirements
 Input constrains
 Market condition
 Resource of the firm
 Governmental policy

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4.5. Technology Selection
• Normally the choice of technology is influenced by a variety
of consideration:
o Plant capacity and principal inputs
o Latest development, cost and ease of absorption/application

• Another issues related with technology

 Acquiring technology (licensing , purchases )
 Appropriateness of technology (economic, social and
cultural )

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4.6. Management & Organization Appraisal
• Management is one of the most vital inputs for the success of a
project.
• Management appraisal is concerned with integrity, ability,
resourcefulness, and quality of management.
• It assess the background, experience and managerial
capability.

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 Management & Organization… cont’d
• Forms of Project Organization
1. Functional Organization(FO)
• Peoples are grouped on the basis of similarities in skills,
activities, expertise, experiences etc.

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 Management & Organization… cont’d
2. Pure Project Organization
• Separate, temporary and special purpose organization
• Group of people having the required skills are organized into
an autonomous set-up with its own leadership, structure and
resources.

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 Management & Organization… cont’d
3. The Matrix/ Grid Organization
• A mixture of project and functional type of an organization.
• Network of intersections between the project team and the
regular functional departments

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4.7. Financial Analysis in Project Planning
• Project Financial Analysis includes
o The design of proper financial structure
o The adequacy of the financial plan, and
o The optimization of project financing from the
beneficiaries point of view.
• The scope of financial analysis includes determining,
analyzing and interpreting of all financial consequences of
an investment for the financing decisions.

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 Purpose of Financial … cont’d
• Financial analysis is undertaken for the following purposes:-
o It provides financing plan for the proposed investment.
o It determines the profitability of a project
o It provides information to both internal and external
users.
o It advises on methods of improving the financial
feasibility of a project.
o It illustrates the financial structure of the project and its
potential.
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4.7.1. Methods of Financial Analysis
• To assess financial feasibility of a project a variety of tools
and types of financial statements can be prepared. This
includes:-
o Resource flow statements,
o Profit and loss statements (income statement),
o Cash flow statements and
o Balance Sheet.
1. Resource Flow Statements shows:-
o The list of resources used in the project and

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 Methods of Financial Analysis … cont’d
o The resources generated by the investment on the project.
• The major elements of resource flow statements are:
Investment costs , Operating /Production Costs and Benefits.

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 Methods of Financial Analysis … cont’d
2. Operating Costs/Production Costs
• Is divided into two: Fixed and Variable costs.

Variable costs
• Includes materials, power, labor inputs required

Fixed costs
• Include maintenance, administration and managerial charges,
etc.
• The total operating costs is the sum of the fixed and variable
costs .
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Methods of Financial Analysis … cont’d

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 Methods of Financial Analysis … cont’d
3. Benefits
• Benefits of a project can be several.
• Benefits can be direct (production output) which include items
like:
o Main product, by product, residual & other income

• Benefits can also be indirect or external.

• The net benefit is computed by subtracting the investment,
operating and working capital costs from benefits.

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4.7.3.Project Financial Statements
• Financial analysis enable stakeholders to know whether the
projects worthy or not.
• Most commonly prepared financial statements are balance
sheet, loss and profit statement, and cash flow statements.
A) Profit and Loss Statements
• It‘s purpose is to calculate the profit or loss of enterprise or
project.
• It is the measure of the profitability of the project.

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 Project Financial Statements… cont’d
XYZ Project
Profit and Loss Statements
On Sene 30, 2014 E.C
Project Period
No Items 1 2 3 4 5 6 n
1 Total sales
2 Variable production cost
3 Gross profit (1-2)
4 Other production costs
5 Corporate tax
6 Net profit after tax (3 – (4
7 + 5)
Dividend
8 Retained profit (6-7)
Project Financial Statements… cont’d
B) Balance Sheet
• It is a statement of the assets and liabilities of the enterprise.
• It gives "the net worth" of an enterprise at a point of time.
• The capital invested by shareholders are regarded as the
liabilities of the company and the use to which funds have
been put are the assets.
• Assets (what the project owned or possessed)
• Liabilities (what the project owed or debted).
 Project Financial Statements… cont’d

Years
No Items 1 2 3 4 5 6
1 Current Assets:
2 Cash
3 Inventories and supplies
4 Accounts receivables
5 Total current assets (2+3+4)
6 Fixed assets:
7 Building
8 Machinery and equipment
9 Other assets
10 Total fixed assets
(7 + 8 + 9)
11 Accumulated depreciation
12 Net book value of assets
(10 – 11)
 Project Financial Statements… cont’d
XYZ Project
Balance Sheet
On Sene 30, 2014 E.C

Years
No 1 2 3 4 5 6
Items
13 Current liabilities:
14 Short term loan
15 Loan
16 Tax payable
17 Total current liability
(14 + 15 + 16)
18 Networking capital
(5 – 17)
19 Employment of funds
(18 + 12)
20 Funds employed:
21 Owners equity
22 Retained earnings
23 Term loans
24 Total funds
(21 + 22 + 23)
 Project Financial Statements… cont’d
C) Cash flow statement
• Shows the cash flows associated with operating resources,
funding and investment.
• Cash flow statements are prepared for two reasons:

– For financial planning purpose ( during cash shortages or

excess).
– For the purpose of Net Present Value (NPV) and Internal
Rate of Return (IRR) calculation.

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 Project Financial Statements… cont’d
XYZ Project
Cash Flow Statement
On Sene 30,2014 E.C
Years
No 1 2 3 4 5 6 n
Items

1 Cash in flows XX XX XX XX XX XX

2 Cash out flow:

XX XX XX XX XX XX
- total investment outlay
- operating costs
- corporate tax
- total cash out flow
3 Net cash flow (1 – 2) XX XX XX XX XX XX
4 Present value (PV) XX XX XX XX XX XX
 Project Financial Statements… cont’d
• Present value is the net cash flow of the project over its life
subject to discounting.
Example
If the Net cash flow of the project is in its first year of operation
is Br. 100,000 and discounting rate is 10%.What is the present
value of this sum of money (at Zero period) ?

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Project Financial Statements… cont’d

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4.7.4 Measures of Project Worth
• Categories of measuring project worth(value)
– Discounting cash flow methods and
– Non discounted methods.
1. Non-Discounted Measure of Project Worth
A. Payback period
• Payback period defined as the period required to recover the
original investment cost.
• There are two methods of calculating the payback period.
• Unequal cash flows and
• Uniform Cash flows
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 Measures of Project Worth … Cont’d
 Unequal cash flows:
• Payback period = E + B/C

Where, E =number of years immediately preceding the year of

final recovery
B = the balance amount to be recovered
C = cash flow during the final recovery
Example:
A company is considering to invest on a particular project. The
alternative projects available are: Project A that costs Br. 100,000,
and Project B that Costs Br. 70,000. The net cash in flows
estimates are as follows:
 Measures of Project Worth … Cont’d
Net Cash Inflow
Year Project A Project B
1 30,000 7,000
2 30,000 15,000
3 35,000 20,000
4 35,000 56,000
5 40,000 45,000
Which project is good?
Solution:
Project A Project B
Year
Net cash Accumulated Net cash Net cash Accumulated Net
inflow inflow inflow cash inflow
1 30,000 30,000 7,000 7,000
2 30,000 60,000 15,000 22,000
3 35,000 95,000 20,000 42,000
4 35,000 130,000 56,000 98,000
5 40,000 170,000 45,000 143,000
 Measures of Project Worth … Cont’d
• Payback period for project A = E + B/C
Payback period = 3 years + 5000*

35,000
= 3.14 year or 3 years and 2 months
• Payback period for Project B = E + B/C
Payback Period = 3 years + 28,000
56,000
= 3.5 year or 3 years and 6 months
• Note: * represent the balance to be recovered from the cash
inflow in period four; i.e.,
100,000 – 95,000 = 5,000
• Project A is good.
 Measures of Project Worth … Cont’d
 Uniform Cash flows
• Where the annual cash flows are uniform, payback period can
be calculated using the formula:
PP = Original Investment
Annual Cash Flows
Example
A project requires an investment of Br. 200,000. It is expected to
generate an annual cash flow of Br. 50,000 per year over the life
of the project. How long will it take to recover the investment?

PP = Original Investment = 200,000 Br = 4 Years

Annual Cash Flows 50,000

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 Measures of Project Worth … Cont’d
B) Simple Rate of Return (SRR)
• SRR is defined as the ratio of net profit in a normal year of full
operation or production to the original investment.
• Also known as the return on equity capital (ROE)
ROEt = NPt x 100
Qt

Where:-
ROE = Return on equity capital
NP = Net profit
Q = The value of equity capital
 Measures of Project Worth … Cont’d
C) Benefit cost ratio (B/C)
• This is a measure of efficiency and used for comparison of
different projects. It is given by the formula:
B/C = Benefits
Cost of the project
 Measures of Project Worth … Cont’d
2. Discounted Measure of Project Worth
• Money is one of the basic resources of an organization that
has a time value.
• Changes in the time value of money, represented by terms
"present value" or "future value" .
• The discount rate is the reciprocal of the compound factor and
it is given by the following formula:
PV = FV or FV (1 + r)-t
(1 + r)t

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 Measures of Project Worth … Cont’d
• The commonly used discounting methods are:
– Net Present Value (NPV)
– Internal Rate of Return (IRR) and
– Benefit Cost Ratio (BCR)

Example 1: NPV calculation

XYZ company is considering to invest in a particular project. The
initial investment cost is Br. 100,000. It is expected that the
project may generate a benefit for 5 years as shown below:

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 Measures of Project Worth … Cont’d

Given: The discounting rate is 10%

Required: Calculate the NPV

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 Measures of Project Worth … Cont’d
• The approach is discounting the cost and revenue streams
separately. This is shown as follows.

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 Measures of Project Worth … Cont’d
• Net present value of the project = PV of Revenue – PV of
Costs
= 124,251 – 119,462
= Br. 4,789
• Decision: If you are talking about only one project, the
decision is to accept this project since its NPV is positive (Br.
4,789).
• A project's NPV varies with the discount rate usually the
higher the discount rate then the smaller the NPV.
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 Measures of Project Worth … Cont’d
Internal Rate of Return (IRR):
• IRR method finds out the rate at which the present value of
cash inflows taken together should equal with the present
value of the cost of investment.
Example 2: IRR Calculation
• Using the same project data as in the example 1 above,
determine the IRR? New line IRR can be estimated
approximately by interpolation from a few NPV calculations.

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 Measures of Project Worth … Cont’d
• The arithmetic rule for interpolation between two discount
rates, one of which gives a positive NPV and the other of
which gives a negative NPV, is as follows:
• IRR =Lower rate DR + Difference between  NPV LDR
NPV LDR - NPV HDR
Where: DR = Discount rate
• Using the above data, it was found that the NPV at 10% was
Br. 4789.

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 Measures of Project Worth … Cont’d
• Adopting a second trial rate of discount 12%, the NPV is
found to be (Br. 3201) which is negative.

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 Measures of Project Worth … Cont’d
• NPV at a 12% rate in 115,525 – 118,726 = (Br. 3201)
4789
4789 –(-3201)
• Therefore, IRR lies between 10% and 12% using the above
formula, you can calculate IRR of the project as follows:
IRR = 10% + (12% - 10%)  4789
7990
= 10% + 2 %(0.5994)
= 11.2% The IRR of the project is, therefore 11.2%

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4.8.Project Economic Analysis
• Economic analysis is one of the important tool of analyzing
the feasibility of a project from the society or national
viewpoint.
• Economic analysis (Social Cost Benefit Analysis) is done
because of the existence of the following factors in an
economy.
o Inflation (price increase of commodities)

o Currency over valuation(Are costs and benefits to the

economy as a whole)
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 Project Economic Analysis … cont’d
o Existence of under employment

o Existence of income/wealth inequality

o Externalities

o Existence of tariffs, customs and duties

• Opportunity cost is the most important concept underlying

economic analysis (land, labor & capital).

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