UNIT 1: OVERVIEW OF PROJECTS AND PROJECT ANALYSIS

Contents
1.0 Aim and Objectives
1.1 Introduction
1.2 Project Concept/Definition
1.3 Types of Capital Investments
1.4 Importance of Capital Investments
1.5 Difficulties of Capital Investments
1.6 Objectives of Capital Investments
1.7 Phases of Capital Investments
1.8 Summary
1.9 Answers to Check Your Progress Questions

1.0 AIMS AND OBJECTIVES

After completing this unit successfully, you will be able to:

 define the term project;
 understand project as a conversion process;
 understand the relationship between projects and plans;
 describe the role of projects in national development;
 understand the importance, objectives and difficulties of capital investments;
 explain the types and phases of long-term investments; and
 describe the facets of project analysis.

1.1 INTRODUCTION

Project is a means of implementing the firm‟s plans. As a means of plan implementation,

project involves a complex process. Before discussing the complex process of project, it is
reasonable to introduce basic concepts of projects. This unit highlights the nature of project,
types of projects, importance of projects, difficulties in projects, objectives of projects, the
phases of projects.

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1.2 PROJECT CONCEPT/DEFINITION

The term „project‟ may be defined as a complex of economic activities in which scarce
resources are committed in expectation of benefits that exceed the costs of resources
consumed. Projects require resources. They are also expected to derive benefits. Projects are
said to desirable if their benefits are greater than the costs incurred on them. A project can
also be referred to as a non-repetitive activity. A project is viewed as a conversion process.
This implies that a project involves a transformation of some form of inputs into an output.
(see the following diagram).

Constraints

Inputs Project Output

Mechanisms

In the above diagram, we observe that project is a conversion process which serves in
transforming inputs into outputs. Inputs represent want or need whereas outputs represent
satisfied need. Constraints consists of factors such as financial, legal, ethical, environmental,
time, and quality. Mechanisms include people, knowledge of expertise, capital, tools and
techniques, and technology.

Check Your Progress 1.1

a) Define the term project.
b) Discuss project as a conversion process.
c) What are the major constraints in projects?
d) What are the major mechanisms in projects?
e) What does “inputs:” and “output” represent in the conversion process?

1.3 TYPES OF CAPITAL INVESTMENTS/PROJECTS

The term capital refers to investments in fixed assets. Capital investments deal with the whole
process of identifying and analyzing which projects should be pursued. Capital investments

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may be classified in different ways. Capital investments may be classified into physical assets,
monetary assets, and intangible assets. Capital investments in physical assets include
investments in building, machinery, equipment, vehicles, and computers. Investments in
monetary assets include investments in debt or equity securities. Debt securities involve
bonds, notes, deposits etc whereas equity securities include equity shares (common stock and
preferred stock), options, warrants and the like.

Projects may also be classified into cost reduction (replacement) investments, revenue
expansion projects, or mandatory investments. Replacement investments aim at replacing the
worn out equipment with new equipment to reduce operating costs (material, labor and/or
overhead costs), increase the yield (productivity), and/or improve quality. An expansion
investment is meant to increase the capacity to cater to a growing demand in the form of
entering new markets (market development), introducing new products to the existing market
(product development), operating with the same products in the existing markets
(penetration), or introducing the new product for new market (diversification). A mandatory
investment is a capital expenditure required to comply with statutory requirements, such as
pollution control, fire fighting, medical dispensary and so on.

Projects may also be classified into development projects and business projects. While
business (industrial) projects aim at profit or value maximization of the owners, development
projects aim at reducing poverty and are pursued by the government or NGOs.

Check Your Progress 1.2

1. Differentiate investments in physical assets and monetary assets. Give at least two
examples for each.
2. What is the purpose of mandatory investments?
3. How do you think that expansion projects can be achieved?
4. Replacement investment primarily aims at increasing the revenue of the firm.
(True/False).
5. Business projects have profit as their basic motive. (True/False).

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1.4 IMPORTANCE OF CAPITAL INVESTMENT

Capital investment decisions have several importance. Among them are:

1. They have long-term effects
Capital investments have the consequences that extend far in to the future. They
provide the framework for future activities and have a significant impact on the basic
character of a firm.
2. Irreversibility. A wrong capital investment decision often cannot be reversed without
incurring a substantial loss. This is due to the fact that the market for used capital
assets (equipment) in general is ill-organized i.e., the investment may be sold below
purchase price or the market for such as second hand investment may be non-existent.
3. Substantial outlays
Capital investments require substantial outlays. This is especially the case with
investments in advanced technology.

1.5 DIFFICULTIES OF CAPITAL INVESTMENTS

What are the major difficulties in capital investments? What are the sources of these
difficulties?

Although capital investments are so important, they are not without difficulties. These
difficulties arise from three major sources; namely,
1. Measurement problems
It is difficult to identify and measure the costs and benefits of capital investment proposals.
2. Uncertainty
The costs and benefits of capital investments are characterized by a great deal of uncertainty.
It is impossible to predict exactly what will happen in the future.
3. Temporal spread
The costs and benefits with a capital expenditure decision spread out over a long-period of
time, such as 10 – 20 years, or 20 – 40 years this creates problems in estimating the discount
rates and establishing equivalences.

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Check Your Progress 1.3

1. Mention the importance of capital investments

2. List the difficulties of capital investments.
3. As costs and benefits of capital investments spread over a long period of time, so do
their risk. (True/False)

1.6 OBJECTIVES OF CAPITAL PROJECTS/INVESTMENTS

According to financial theory, the goal of financial management is to maximize the present
wealth of the firm‟s stockholders‟ equity. The wealth of equity stockholders is reflected in the
market value of the equity shares.

Wealth maximization, as objective of financial decision making, contributes to an efficient

allocation of capital. The expected return and risk serves as the bases for allocation of capital.
Since equity share prices are based on expected return and risk, efforts to maximize equity
share prices would result in an efficient allocation of resources. Thus, the objective of capital
investment decision is to maximize the value (wealth) of equity shareholders.

Should firms solely act to further the shareholders‟ welfare? In fact, firms may pursue several
goals at a time. Some of other goals the firms may pursue include:
- seek to achieve a high rate of growth
- increase market share
- attain product and technology leadership
- promote employee welfare
- further customer satisfaction
- improve community life and other societal problems

Most of the above goals are in congruence with the goal of maximizing the wealth of equity
shareholders. When they seem to conflict with wealth maximization, it is useful to know the
cost of pursuing these goals. However, it should be understood that wealth maximization is
regard as the normative goal from the financial point of view.

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Check Your Progress 1.4

a) What are the possible goals of capital investment decisions?

b) Which of the goals you listed under (a) above is the normative goal from financial
point of view?
c) What is the role of wealth maximization as the goal of capital investments in resource
or capital allocation?
d) Mention the two bases of capital allocation.

1.7 PHASES OF CAPITAL INVESTMENTS/CAPITAL BUDGETING

What are the major phases of capital budgeting? As it involves a complex process, capital
budgeting process is divided in to six broad phases.

Planning

Analysis

Selection

Financing

Implementation

Review

Each of them is described below:

1. Planning
This phase is concerned with the articulation of the firm‟s broad investment strategy and the
generation and preliminary screening of project proposals. The firm‟s investment strategy
delineates the broad areas or types of investments the firm plans to undertake. This provides

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the framework which shapes, guides, and circumscribes the identification of individual project
opportunities.

Followed by the identification of a project proposal, a preliminary project analysis is done

which is performed before the full blown feasibility study. The purpose of preminary project
analysis is:
a) to assess whether the project is prima facie (at first sight) worthwhile to justify a
feasibility study.
b) to assess what aspects of the project are critical to its viability and hence warrant an
in-depth investigation

2. Analysis
If the preliminary screening suggests that the project is prima facie worth while, a detailed
analysis of the project will be undertaken in terms of marketing, technical, financial,
economic, and ecological aspects. This phase involves the detailed analysis of the project. It
focuses on gathering, preparing, and summarizing relevant information about various project
proposals. The information developed in this analysis becomes the basis for costs and benefits
of the project.

3. Selection
The analysis of the project is followed by selection. Selection phase addresses the question.
“Is the project viable?” In order to select the project, a wide range of appraisal techniques can
be used. These techniques are classified into non-discounted criteria and discounted cash
flows techniques. These techniques will be discussed in detail in unit 7.

4. Financing
Once a project is selected, suitable financing arrangements have to be made. There are two
possible sources of financing the projects; namely, debt financing (loans, bonds etc) and
equity financing (common stock, preferred stock, retained earnings etc.)

The firm should decide on the optimal mix of debt and equity financing. The key business
considerations that influence the mix are flexibility, risk, income, control, and taxes (FRICT)
you can find a more detailed discussion on financing in unit 7.

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 5. Implementation
For industrial projects, the implementation phase involves setting up of manufacturing
facilities that consists of the following stages.
a) Project and engineering designs
b) Negotiations and contracting
c) Construction
d) Training
e) Plant commission (start the actual operation)

6. Review
Once the project is commissioned, the review phase has to be set in motion. Performance
review should be done periodically to compare actual performance with projected
performance. Review is helpful:
a) to throw light on how realistic were the assumptions underlying the project
b) to provide a documented log of experience that is highly valuable in future
decision making
c) to take corrective action in light of actual performance
d) in uncovering judgmental biases
e) to induce a desired caution among project sponsors.
The phases of capital budgeting that are suggested by World Bank and United Nations
Industrial Development Organization (UNIDO) will be discussed at great length in unit 2.

Check Your Progress 1.5

From the following list of capital investment phases, match the appropriate phase with the
statements described below:
Planning Selection Implementation
Analysis Financing Review
1. Articulation of the project‟s broad investment strategy
2. Generation of project ideas and preliminary screening of project proposal.
3. Focuses on gathering, preparing, and summarizing relevant information about various
project proposal
4. Deals with decision as to whether the project is worthwhile.

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 5. Uses discounted cash flow techniques and non discounted techniques.
6. Provides the framework which shapes, guides, and circumscribes the identification of
individual project opportunities.
7. The basis for defining project costs and benefits.
8. The detailed investigation of the project is undertaken in terms of marketing, technical,
financial, economic, and ecological aspects.
9. Deals with the decision on the optional mix of debt financing and equity financing.
10. Deals with assessing whether the project is prima facie worthwhile to justify a feasibility
study.
11. Involves setting up manufacturing facilities.
12. Deals with performance review of the project.
13. Plant commission.
14. Aims at taking corrective actions.
15. Negotiation and contracting.

1.8 SUMMARY

Project is a complex of economic activities in which scarce resources are committed in

expectation of benefits that are expected to be greater than the costs of resources consumed. A
project is viewed as a conversion process in which inputs (want or need) are converted to
outputs (satisfied need or want) using people, knowledge of expertise, capital, tools, and
technology under constraints such as financial, legal, ethical, environmental, time, and
quality.

Projects may be classified in various ways. They may be classified into cost reduction,
revenue expansion, and mandatory projects. On the other hand, projects may be classified into
physical monetary, and intangible. Projects may also be classified into industrial projects and
development projects.

The importances of project are their long-term effects, their irreversibility and their
requirement for huge investments. Some of the difficulties of projects are measurement
problems, uncertainty, and temporal spread.

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The objective of capital investment decision is the maximization of the wealth of equity
shareholders. Projects involve six major phases; namely, planning, analysis, selection,
financing, implementation, and review.

1.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

CYP 1.1
a. A project is a complex of economic activities that requires the commitment of scarce
resources in anticipation of future benefits that exceed the associated costs.
b. A project is considered as a conversion process, which is used to transform inputs into
outputs using different mechanisms under certain constraints.
c. The constraints in projects include financial factors, legal factors, ethical factors,
environmental factors, time factors and the like.
d. The mechanisms in projects include people, knowledge of expertise, capital, tools,
techniques, technologies etc.
e. Inputs represent wants or needs whereas outputs represents satisfied needs or wants.

CYP 1.2
1. Physical assets include equipment, machinery, buildings, vehicles, computers and
similar assets. Monetary assets are investments in debt or equity securities such as
bonds, notes, common stock, preferred stock etc.
2. To comply with legal requirements
3. Through increase the capacity for the purpose of penetration, market development,
product development, or diversification
4. False. It aims primarily at reducing operating costs
5. True

CYP 1.3
1. Long-term effects, irreversibility, and substantial outlays.
2. Measurement problems, uncertainty, and temporal spread
3. True

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CYP 1.4
a. Wealth maximization (maximize the equity share price), growth, increase market share,
attain product and technology leadership, promote employee welfare etc.
b. Maximize the wealth of the shareholders.
c. Enables to achieve efficient resource allocation.
d. Expected return and risk.

CYP 1.5
1. Planning 5. Selection 9. Financing 13. Implementation
2. Planning 6. Planning 10. Planning 14. Review
3. Analysis 7. Analysis 11. Implementation 15. Implementation
4. Selection 8. Analysis 12. Review

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