Project Appraisal And Monitoring

Project appraisal involves:

1. Appraisal of the borrower himself and his capabilities.
2. Careful analysis of the facts to ensure the technical feasibility and economic viability of the project and
3. Assessment of the Credit risks.

We have listed in the annexure sample questions for each appraisal item and these questions, more or less, cover the entire range of information normally required for appraisal and they act as a check-list. A project appraisal should include these, but not be limited to them, as during the appraisal many other questions will arise because of the project relations to other projects, different industrial areas and from the depth of the experience and knowledge of the Appraisal team.

Critical Aspects Of Project Appraisal

In each project, there are certain critical aspects which should be taken care of at the pre-implementation stage and at the post-implementation period. In this context, it is essential that there is a proper pre-credit appraisal and a post-credit supervision so that the risks of project failure are prevented or atleast minimised. Some of the critical aspects which lead to project failures are analysed below.

There are cases where project costs are deliberately over-estimated or under-estimated. Project costs are over-estimated with a view to obtaining more financial assistance than required so that own-funds are siphoned off. This is generally done through over-statement of costs to be incurred on civil works etc obtaining quotation for machinery for larger amounts and over-estimation of preliminary and pre-operative expenses which are difficult of being verified.

Project costs are also often under-estimated so as to fit the Promoters contribution as determined by the amount that can be mobilised by the Promoters. In such a case, the means of financing the project are tied-up in such a manner that leave little room for any upward revision in the project cost. This invariably results in cost-overrun which the promoters are well aware of in the beginning itself but it is announced as a matter of routine later. The term lending Institution/Banks are compelled to release additional loans without adequate or pro-rata contribution from the promoters, only to facilitate implementation. These loans are not sanctioned so easily but only after prolonged discussions and negotiation. Thereafter, the inevitable time over-run also occurs, sometimes shaking the very viability of the project.

There are instances where the promoters, in order to keep down the project cost, defer purchase of certain vital equipments/machinery and testing/quality control equipments, and also postpone creating adequate space for storing Raw Materials and Finished goods etc. Subsequently, when these expenditure have to be incurred, they are generally met, only by diversion of working capital.

The provision for pre-operative expenses such as salaries, interest and other charges during the construction period is generally not made on a realistic basis. Often, interest during the construction period is not adequately funded in the project cost but met during the post-implementation period by diverting working capital.

Inadequate provision of margin money for working capital requirement, at the time of finalising the project cost generally lead to liquidity problems at a later date. The margin money for working capital requirement, to be funded while computing the project cost, should be commensurate with the envisaged level of capacity utilisation for the second year of production and conform to the Second Method of Lending. While projecting the levels of current assets and current liabilities for arriving the working capital requirement, the promoters often overlook the selling pattern and purchase terms. They are surprised when they start their operations that they have to invest funds in hard-core areas such as Telephone Deposits, Electricity Deposits, Margin for guarantees etc. When these monies are to be provided, they are met out of working capital which affects the re-cycling of working capital funds effectively. Prudent promoters should anticipate and provide long term funds for these purposes which are likely to be hard-core on a permanent basis.

Not all projects start generating cash profits from the very first year of production. Often, they incur cash losses for one or two years till they reach break-even level of production. Many promoters make the mistake of projecting cash profits in the first year knowing well that cash losses are inevitable in the first year. This is done generally to avoid term lending institutions/banks from viewing the project as unviable. On the contrary, it is prudent to provide for initial cash losses till break-even level is reached, in the project cost and get them funded.

Delays in implementation of the project cause serious problems. These delays can be on account of various reasons like obtaining the necessary licences/approvals from the appropriate authorities, clearance from Pollution Control Board, sanction of power connection, erection of factory buildings and installation of machinery. The lead-time for acquiring critical machinery is often overlooked resulting in delays. There are also cases where delays have been on account of non-release of term loans by institutions owing to problems in the execution of security documentation.

Time over-run results in cost over-run to the extent of interest and other expenses pertaining to the period of time over-run. The provisions made for contingencies and pre-operative expenses are often wiped out and even the margin money earmarked for working capital gets eroded. Time over-run is normally viewed as a reflection of bad time management and the request for funding the resultant cost over-run is not acceded to by the term lending institutions/banks, without a detailed study. The additional cost burden which was not originally contemplated would affect the cash flow projections and absence of matching additional Promoters' contribution may lead to serious problems. While some of the projects which are highly profitable may withstand, most of the units become sick from the very beginning.

The cost over-run cuts into pay-back period in respect of projects which are having shorter pay-back period. Highly vulnerable projects in the Electronics/Computer industry are classic examples where substitutes, technological changes, improved models etc, totally take away the competitiveness of the existing products and consequent viability. These projects become ab initio failures. Such projects are worthwhile to be abandoned rather than pursued, but this does not generally happen and the misery is passed on to the financing Institution/Bank at the end.

Some promoters make the mistake of going in for concealed misery in the form of cheap machinery or second-hand machinery. (It is only by experience that financial Institutions/banks have started asking for credit reports on machinery suppliers. Promoters with fraudulent intention manage to divert large funds from the very beginning in collusion with the so called machinery suppliers who supplied sub-standard and third rated junk). The above practices often result in sub-optimal capacity on account of either inferior machinery or the mismatches or both, it then becomes necessary to indulge in backward integration and go in for balancing equipments and in the process large funded debt obligations become inevitable. Such units and their promoters seldom come out of trouble, resulting in the project objectives being changed or even in the promoters themselves being replaced.

In several cases, creation of production facilities for manufacture of goods like packing materials towards captive consumption is undertaken. There are instances where manufacture of goods for captive consumption proved to be uneconomic and unwarranted in view of availability of these goods at cheaper prices in the market.

In many cases, the promoters find difficult to bring in their contribution in full. They raise equity by resorting to interest bearing private borrowings. When the project does not yield projected cash inflows and cash profits, the promoters struggle to repay the funds borrowed towards equity. They are then forced to resort to ways and means of withdrawals which are culpable diversions affecting the smooth implementation and viability of the project. They also hasten release of Term Loan by the Financial institutions/banks by convincing them to release pro-rata to their contribution. There are instances, where the promoters, taking advantage of the lack of proper monitoring by the term lenders, manage to re-cycle the funds already released and bring them as their contribution to influence further term loan disbursements. When they are apprehended, the confidence in the management is shaken.

Many promoters have gone to backward area locations mainly to take advantage of attractive incentives. Various relevant considerations like availability of infrastructure, proximity to raw material source or market for the proposed products etc., are relegated to the background. Many such units suffered heavy setbacks owing to recurring invisible costs, though the burden is felt at a much later stage. The available labour force does not possess the basic skills needed leading to production loss, wastages etc. The location of the unit should be decided not only on subsidies / incentives, but also on other powerful adverse factors.

The projects located in Free Trade Zones enjoy various concessions including exemption of customs duty for the machinery imported. When the advance granted to such units becomes difficult of recovery the sale of machinery for liquidation of the dues, generally pose a serious problem in view of incidence of customs duty at the time of sale.

The various reasons for failure of a project during the post-implementation period can be broadly divided into two categories - external causes and internal causes.

Some of the external factors are given below :

• Decline in the market demand
• Shortage of raw-materials
• Inadequate power supply
• Changes in Government policies
• Changes in fiscal levy structures
• Transport bottlenecks
• Labour unrest - Natural calamities
• Political changes

The internal factors can be broadly classified as follows:

1. Production Inappropriate product-mix, poor quality control, poor capacity utilisation, high cost of production, high wastages.
2. Marketing : Dependence on a single customer or a limited number of customers, poor sales realisation, defective pricing policy, lack of market feed-back and market research, unscrupulous sales and purchase practices.
3. Administration : Over centralisation, lack of professionalism, lack of controls, lack of timely diversification, divided loyalties, dissension within the management, incompetent management, dishonest management.
4. Financial: Poor resources management and financial planning, faulty costing, liberal dividend policy, general financial indiscipline and application of funds for unauthorised purposes, deficiency of funds, over-trading, unfavourable gearing or keeping adverse debt-equity ratio, inadequate working capital, absence of cost consciousness, lack of effective collection machinery.

Conclusion

Various causes for project failures can now be identified and even predicted. To a great extent, Financial Institutions/Banks have sharpened their skills enabling them to take correct preliminary decisions, Proper sensitivity analysis can reasonably predict survival hopes, if certain critical factors move adversely. Evolution of Single Window approach can help avoid delays and consequent time over-run / cost over-run of projects Banks associating themselves with the Institutions even during the preliminary stage of appraisal can help proper assessment of working capital requirement and funding of required margin. Effective pre/post disbursement scrutiny and inspection mechanism can help monitoring of projects and their implementation.

A. Information sought for by the bank

1. Promoters

Mr. X, the main promoter is not technically qualified and he does not have industrial experience how he will be in a position to take care of the technical aspects of the project and run the unit successfully?

2. Products

Utilisation of 85% in the very first year. How does the Company propose to achieve the

3. Industry

What is the present status of Building Materials Industry?

4. Location

How the proposed location of the project is suitable?

5. Raw-Materials

It has been stated that the main raw-material would be procured from a nearby fertilizer plant What is the monthly requirement of the main raw-material. and whether any contract has been entered for this

6. Utilities and Man-power

7. Marketing

What is the export potential for the products and whether they can be exported at competitive prices?

8. Schedule of implementation

What is the time schedule of implementation of the project. Vision for contingencies is hardly 4.5% of the overall fixed assets portion of the project cost

9. Margin Money for Working Capita

10. Contingencies

11. Promoters contribution

Future Internal accruals to the extent of Rs.100 lakhs indicated as one of the sources of Promoters' contribution is not acceptable as the entire Promoters' contribution should be brought in at the project stage itself. Whether this amount could be brought in by way additional equity or sub-ordinated unsecured loans before the commencement of commercial production?

12. Break-even point

What is the break-even point in terms of capacity utilisation and how does it compare with the projected levels of capacity utilisation.

13. Selling & administration expenses

The projected levels of selling and administration expenses around 40% of sales appear to be excessive. What are the reasons for projecting high levels of selling expenses?

14. Debt service coverage Ratio

The projected debt service coverage ratio during the second year of operation, is low at only 1.28:1 even after assuming a high capacity utilisation of 90%. Is there any need to extend the holiday period for term loans from the projected 12 months to say 18 months?

15. Security

What is the security offered and how does the company propose to cover customs duty exemption available to it (in view of project location in FT2) by way of collaterals?

B. Company's Reply to the Observations made by the bank

Shri X, the main promoter and Chairman of the company would be assisted in the management of the company by the Board of Directors comprising persons with technical, professional, commercial and administrative experience. His son, Shri Y, who is the Managing Director of the Company, is a civil engineer and having 15 years of experience in construction and other industries. The day to day affairs would be looked after by Shri Y.

India has a vast market for building materials and there is an enormous market potential for Gypsum products. Considering the limited capacity to be installed by the Company as against enormous market potential and working of the plant to full capacity from the beginning guaranteed by the technical collaborator, we do not foresee any difficulty in achieving 85% capacity utilisation in the very first year.

The performance of the Building Materials Industry is linked to the growth in Construction Industry. With the relaxations recently made by RBI under FERA, permitting NRI's and foreign national bodies to invest in immovable properties in India, the construction activity and the demand for building materials are expected to grow in future.

The project is located at the GIDC Industrial estate, a fully developed and fully equipped Estate with all infrastructure facilities. The project site is in proximity to the source of main raw-material and it is well connected by road and rail.

The main raw-material viz Phosphogypsum is an industrial waste from phosphatic fertilizer plants. The Company would require 4,500 tonnes of phosphogypsum per month at full capacity and the fertilizer plant from which the company has proposed to purchase this material, is already having a stock of over three million tonnes. A formal contract would be entered into with the raw-material supplier at the appropriate time.

The company has received 'in principle' consent from the State Electricity Board for supply of 600 KVA. The company has also made a provision for standby DG sets for 200 KVA in the project cost. Regarding supply of required quantities of water, the bore wells have already been sunk at the project site. Key personnel for project implementation have already been recruited. The company does not envisage any difficulty in obtaining the required technical and non-technical staff.

Efforts are being made to explore the possibility of exporting the products to countries in the Middle East and the Far East. As the products similar to what the company proposes to manufacture, already find acceptance in the markets in the above countries, the company is confident of tapping this potential.

Civil work has already commenced and is expected to be completed by February 1994. Orders for imported equipment / components would be placed by January 1994 and delivery would be completed by July 1994. Commissioning and trial runs are scheduled for October 1994 and commercial production by November 1994.

A provision of 15% towards the contingency escalation has already been included in the cost estimates of each item of fixed asset viz, Buildings, Machinery and Miscellaneous fixed assets. We shall segregate and group the individual provisions made, under the head 'Provision for contingencies'. We are sure that the provisions made are adequate to cover all unforeseen expenses.

In view of the need for higher provision for working capital margin, we propose to raise non-interest bearing unsecured loans to meet the additional margin money requirement.

We are agreeable to bring in sub-ordinated unsecured loans before the commencement of commercial production in the place of future internal accruals to the extent of Rs.100 lakhs indicated as one of the means of financing the project cost.

The average break-even point in terms of capacity utilisation is 66.52% which is very much lower than the projected levels of capacity utilisation i.e., 85% during I year, 90% during II year and 95% from the III year onwards.

Having regard to the vast scope for expansion in the light of enormous market potential for the products and to avoid competition in the future, we propose to establish sales offices through out the country. The expenses to be incurred on the sales offices constitute a substantial portion of the projected levels of selling and administration expenses and cost of sales. The benefits of expenses to be incurred on sales offices are expected to accrue over a period of time.

No extension of holiday period / reschedulement of Term Loan instalments is required and we would undertake to meet the shortfall if any, in the projected cash accruals towards meeting the Term Loan interest/ instalment obligations.

The Term Loan will be secured by First charge on the block assets on pari passu basis in favour of the Financial Institution / bank. The working capital facilities will be secured by First charge on the current assets in favour of the bank. We are agreeable to provide suitable collateral security to cover the customs duty exemption available.

1. Location of the proposed project

It will be found that the technical feasibility of a project depends to a great extent on location.

QUESTIONS

i. Is the proposed location economically close to raw-materials, labour, and services?

ii. Are there available highways, rivers, railroads and truck transportation?

2. Physical and natural resources involved.

The availability of physical and natural resources presents special problems which may cost a project out of consideration.

QUESTIONS

i. Are any raw materials requiring special treatment?

ii. Is electric power available or possible?

iii. Is fuel available?

iv. Is water available for processing, sanitation and human consumption?

v. Are all these available at an economical cost in necessary quantities and quality?

Such materials must be considered as the major hurdle to be overcome because non-availability of one can negate a project.

QUESTIONS

i. What raw materials are needed and in what quantities?

ii. Does delivery schedule call for advanced procurement or stock-piling?

iii. Is proper storage provided for such inventory?

iv. Is the cost of indigenous raw materials higher than imported raw materials?

v. How does the quality of indigenous materials compare to imported material?

vi. Will the project requirements promote expansion of raw-materials production?

vii. Is adequate use of indigenous raw materials indicated?

viii. Is there an excess of unjustifiable use of imported raw materials?

3. Present state of the industry.

Before approving a project, the industry involved should be considered as a whole and in relation to the project.

QUESTIONS

i. Is the industry as a whole decling?

ii. Is obsolecence occuring through failure to advance in technology of processing and equipment?

iii. Is the market declining becase of substitution of raw materials or better products?

4. Machinery and equipment

QUESTIONS

i. Is the machinery and equipment obsolete or near obsolete from age, use or technological points?

ii. Will the proposed equipment produce the quality and quantity of product desired at a competitive price?

iii. Has provision been made for adequate spare parts?

iv. Is the plant and plant lay out designed for possible expansion?

v. Is the machinery fairly priced for current and scheduled procurement time?

vi. Is the cost of installation included as a machinery and equipment cost?

vii. Has provision been made for adequate maintenance?

viii. Has the lead time for acquiring and installing the machines and equipment been considered?

5. Projected time for implementation.

It is necessary that the scheduled time for implementation and maximum capacity be properly judged to avoid confusion and mis-application of funds.

QUESTIONS

i. Is the scheduled time for implementation based on all related factors of Procurement lead time, installation lead time, raw materials - imported, raw materials - indigenous, manpower availability, services?

6. Costs.

All known and expected future costs should be considered to the extent possible so that proper allocation of funds may be made.

QUESTIONS

i. Are all known or projected costs indicated?

ii. Are these costs reasonable?

iii. Are there any concealed costs, particularly those concerned with scarce or limited materials and resources?

iv. Has the cost of installation of machines, equipment and services been included and shown separately?

v. Have material costs been compared?

vi. Have building and rental costs been considered and found reasonable?

7. Resources available.

The availability of resources affects the economics of a project to the point where it could be the major deciding factor as to acceptance and implementation of a project.

QUESTIONS

i. Are raw materials available in quantity and quality necessary near the project site?

ii. Are all services currently available in quantity and type necessary? Is there sufficient water available near the project location?

iii. Will it be necessary to install systems for water, light or power? How will the raw materials be obtained and delivered?

8. Expected Products.

The expected products should be described as specifically as possible to determine if machines, equipment and processes will produce them in quantities and quality stated.

QUESTIONS

i. What is the product or products?

ii. How will they be packaged?

iii. Will there be by-products?

iv. Can the by-products be sold to reduce costs?

v. Can the by-products be utilised as services to reduce costs?

vi. Does the finished product require special transportation or storage?

vii. Is the production process complete?

9. Plant capacity.

Care must be taken to determine that the plant is capable of producing the estimated production within the forecast time.

QUESTIONS

i. Can the plant produce the stated capacity?

ii. Is the stated capacity total or partial full capacity?

iii. Will a similar plant operating more shifts or days be as economical?

iv. Will the stated capacity and intended production be more than the indicated market?

v. If there is excess capacity, will the market potential justify installing it from a cost and availability stand point?

vi. Will the plant operate seasonally, year round and how many shifts?

vii. What is the expansion potential? What is the minimum economic entry?

10. Market.

Before project investment is programmed or implemented the potential absorption of the product must be known.

QUESTIONS

i. What is the current market for the product?

ii. What is the import share of the market? What

iii. Is the domestic market? what is the export market?

iv. What is the possibility of expanding the country's share of each of these markets?

v. If a new product, can a market be established or part of an existing market captured?

vi. What is the current cost (indigenous and imported) of the products or similar competitive ones?

11. Manpower

Without available management, technical and skilled labour a project is practically doomed from its inception.

QUESTIONS

i. Is there a sufficient local supply of all types of manpower available locally?

ii. Can shortages of any type be filled by training or obtaining from other sections of the country.

iii. Are the manpower costs sound and do they ensure the obtaining of qualified personnel?

iv. Are training costs included in total costs?

v. Are there facilities for training the required skills?

vi. Will the project jobs be new additional jobs?

vii. Will the project jobs draw from the same or other industries to no advantage?

12. Social Implication.

All development projects have social implications and tend to add to or detract from existing social conditions.

QUESTIONS

i. Will this project tend to increase the level of living?

ii. Will this project tend to increase the standard of living?

iii. Will this project provide a healthy improvement?

iv. Will this project provide an educational improvement?

v. Will this project provide a service improvement?

13. Transportation.

Too many projects are proposed for locations where they cannot exist economically and technically because of the lack of or high cost of adequate transportation.

QUESTIONS

i. Has transportation been considered from the points of plant location, highways, railways, air and is it to be project owned or rented?

ii. Have requirements for special types of transportation been considered?

14. Marketing.

Without a plant or program for marketing the products a project can only succeed by accident.

QUESTIONS

i. How is it planned to market the product?

ii. Are the market unite and package types acceptable to current consumers?

iii. Are special storage and transportation necessary to prevent spoilage?

iv. Will units sizes and package appeal to export and import alike or will there be different requirements causing greater costs?

v. Will production be balanced to provide sufficient production for local, national and export markets?

vi. Will there be domestic competition?

vii. Will there be import competition?

viii. What is the export potential and can the product be marketed internationally at a competitive price?

ix. Have packaging and delivery containers been considered and included as costs?

15. Relationship to same industry.

A project may provide needed competition to invigorate an existing industry, fill a lack of capacity, or provide a support function to other producers in the same industry.

QUESTIONS

i. Is there a current lack of capacity to meet local, national or export markets?

ii. Is there a tendency for current producers to hold down production for higher prices and some profits?

iii. Will the project make the product more available at a lower consumer cost?

iv. Will the product support another plant in the same industry as raw material, semi-finished material, parts, components, or services?

16. Relationship to other industries.

No industry stands alone. Each depends on one or more other industries for material, machine, service or distribution and marketing support.

QUESTIONS

i. Will raw material or prime materials requirements utilize existing excess or force expansion?

ii. Will this project support component, spare part, or services industries?

iii. Can this project be a base for other new industries or expansion of existing ones?

17. Relationship to the national economy.

If an individual project fails to indicate a positive contribution to the national income it is almost positive to result in a reduction of the national income.

QUESTIONS

i. Is there a foreseeable net profitable return to the country?

ii. Will there be direct or indirect increases in productive employment?

iii. Will there be eventual increased taxes and other revenues from the project?

iv. What will be the effect of reduced imports?

v. What will be the effect of increased exports?

vi. Will the project result in a shift of labour?

18. Special Problems

Such problems may be of social, physical, resource, location, or other nature which have a peculiar and important effect on a specific project or group of projects.

An example of this could be a project proposed for glass manufacture. This project would require continuous supply of large quantities of potable water. The water situation does not lend itself normally to the fulfillment of such a requirement. Therefore, this becomes automatically a special problem of supply and cost.

19. Advantages.

Here a listing of the advantages for approval and implementation should be made in a clear concise manner. The items will evolve from the total appraisal.

20. Disadvantages.

As with the advantage items the disadvantages should be clearly and concisely listed for comparison. The source of items will be the total appraisal.

21. Findings.

The findings will be the result of a judgement comparison of advantages and disadvantages. Here should be cited the reasons for the findings whether they indicate approval, delay or rejection.

Source : A Hand book for utilising a method of appraisal of projects by W.N. Egan.