After carrying out the detailed analysis of the market, production, management, technical analysis of the project and determining the size of operations envisaged, the next stage is to determine the capital costs.
Thereafter, promoters should determine the financial feasibility and commercial viability of the proposed project. This involves the process of assessing the financial implications of the project, the financing options available either in form of loan, equity or lease and the overall financial viability of the project.
In doing this, the capital cost of the project is estimated. The main objective is to ascertain the various types of assets required for establishing the project, the number of these assets, their sources and costs.
However, in project formulation, the widely accepted norm is to get quotations for equipment and machinery from at least three reputable suppliers or fabricators either from domestic or external sources.
The objective is to ensure that the equipment is not only appropriate, but affordable and sustainable.
The other reason is to ensure that the equipment suppliers or fabricators have a good track record in supplying similar equipment and can be trusted to deliver, install and commission the machinery and equipment according to the terms and conditions mutually agreed upon.
Besides, the equipment suppliers or fabricators should also give the necessary assurances for the supply of spare parts and regular training of the technical staff to handle the equipment.
They will also enter into a performance bond with the buyers.
The basic data required in estimating the financial requirements can be broadly classified as the total project capital costs and the financing plan.
After this, an estimation of the profitability or otherwise of the proposed business is made.
The broad classification of the estimation of the profitability or otherwise of the proposed business is as follows:
a) Total Capital Costs.
The total project capital costs include fixed, working capital and intangible assets whether it is to be acquired from loan, equity, equipment leasing or other sources and whether the promoters already have them or can source the assets as part of their own contributions to the project.
b) Financing Plan.
The financing plan for the project is a summary of the capital costs estimate. It shows in percentage terms the expected contributions of the owners and injection of capital in form of loan or equity from external sources.
The percentage contribution or equity is also used to determine the return to the different categories of shareholders in the proposed business.
It is also a helpful tool in ascertaining the quantum of debt or leverage injected into the business and the implication of the repayment of loan, interest and other charges on the future cash flow and profitability of the business.
c) Revenue and Profitability Projections
Revenue and profitability projections shows the amount of working capital required to run the business, the profit and loss indices including the estimate of revenue and production costs, the estimated cash flow forecast including the sources and application of funds and the projected balance sheet.
The format for the presentation of the capital costs estimate should be in a tabular form to facilitate an understanding of the various types of assets, the parties responsible for procuring these assets and their estimated costs, the description of the assets, the promoters contribution or equity columns, the value of other assets to be acquired through long term loan or equity from the bank or other financial institutions and the total costs column.
A detailed description of the various assets is as follows:
a) Land Acquisition and Development
Acquisition and development of land for construction of the factory complex include the actual amount paid by the promoters for the purchase of the land. This includes payment for legal expenses, taxes paid to the government for acquiring title to the land, surveyor’s fees and other professional fees including reclamation, drainage and costs of access roads.
Other costs include basic improvement to the land such as clearing, leveling, fencing, land filling etc. In almost all cases, external investors will not assist project promoters to acquire land for a project. They normally expect the promoters to acquire the land, do the legal documentation and include it in the capital costs estimate as part of their contribution to the establishment of the project.
b) Business Premises ( Build, Lease or Rent)
The choice of whether to build, lease or rent a factory or business premises is a decision to be taken by the promoters at the early stages of project planning. Constructing a factory building, offices and other structures in a business premises is usually highly capital intensive especially for most small and medium enterprises (SME) operators. As a result of the increased cost of building materials, an entrepreneur should carefully weigh the option of whether to build, lease or rent a factory or business premises until such a time that the business is financially buoyant enough to embark on building construction.
There are various options available to project promoters who want to lease or rent, rather than to build a business premises. They could lease factory premises from a government controlled industrial estates, industrial layouts, Technology Incubator Centers (TIC) and other abandoned or underutilized warehouses owned by States and Local Governments. Sometimes, project sponsors can also lease or rent commercial or industrial premises owned by individuals or private organizations.
In leasing or renting a business premises, it is advisable to enter into a long term lease agreement of five years or more with the owners to avoid arbitrary rent increases and frequent disruption in the business operations. However, whether the factory or business premises is purposely built or leased from a third party, adequate provision should be made for a borehole to supply clean water to augment pipe-borne water from public utility agency.
Other facilities to be provided include fencing of the entire premises to provide security, outdoor lighting etc.
c) Plant and Machinery.
For a manufacturing project, plant and machinery is the biggest element of the capital costs. The choice and procurement of equipment should be approached with utmost care. Estimates and specification should be supported by pro-forma invoices obtained from at least three suppliers or fabricators. The estimates should include the cost of the equipment, spare parts, transportation, installation and commissioning, custom duties, taxes and handling charges in the case of imported machinery.
Specifically, adequate provision should be made for spare parts especially for new industrial projects where the workers are inexperienced and mostly unfamiliar with operation of the new machines. However, while the requirement of spare parts would vary from one industry to another, under no circumstances should the estimated costs of spare parts be more than 20% of the total costs of machinery and equipment.
The same requirement is applicable to other assets such as axillary and utility equipment, vehicles, furniture and fittings etc. The actual cash payment or disbursement of funds for the assets procured for a project by banks and funding agencies are usually made directly to the equipment suppliers and not to the promoters or through the promoters or their agents. The reason for this strategy is very obvious. It is to prevent the incidence of fraud, embezzlement or loan diversion for other uses by the entrepreneurs. Besides, lending institutions usually enter into a formal legal agreement with the equipment supplier or fabricators to ensure compliance with the terms and conditions for the equipment purchased.
d) Intangible Assets
In some situations, project promoters may enter into technical agreements with other established companies for the use of their brand name, trademarks, patents, copyrights, franchise and joint venture. The cost of these intangible assets should be mutually agreed upon by the two partners and included in the computation of the estimated capital costs. In determining the costs, the promoters should engage the services of an accountant or valuation expert to determine the real value of the intangible asset. The same principle also applies to the determination of the current market value of an ongoing business enterprise. However, while the costs of tangible assets are depreciated as part of the expenses incurred during business operations, the costs of intangible assets are amortized over a reasonable period of time.
e) Preliminary or Pre-operating Expenses.
As stated earlier, project sponsors undertake many activities towards attaining their objectives. Very often, these activities involves costs which are incurred at the preliminary stages of the project formulation. In industrial parlance, these costs which are the actual expenditures incurred are referred to as preliminary or pre-operating expenses. Some of these include the costs of planning, investigations, technical, economic and market research, engineering advice and machinery procurement.
Other pre-operating expense include the cost of incorporating the limited liability company, the cost of preparing a pre-investment proposal (PIP) or a full-fledged feasibility study, hotel and project related travel expenses, audit, valuation and professional fees to ascertain the actual value of the assets already procured by the promoters, the cost of training employees prior to project start up and sometimes the payment or capitalization of interest and front end fee on borrowed funds to banks during construction period.
Frequently, these expenses are either ignored or seriously underestimated by promoters. Yet they represent some of the most essential requirements for successfully establishing a new project. These expenditures including those incurred on intangible assets, will be amortized over a period of about five years or more depending on the statutory regulation of the government in respect of depreciation, capital allowance and amortization of fixed and intangible assets.
f) Contingency Allowance
Regardless of how carefully capital costs are estimated, experience have shown that very few projects can be fully implemented for the amount originally estimated. Some items that are forgotten in the estimates will be discovered and added on while subsequent changes made in the acquisition of machinery, equipment and other assets will require additional expenditure. In other instances, the quoted price for the equipment might have gone up at the time of purchase due to inflation in the economy. Therefore, adequate provision should be made for these unforeseen costs in form of contingencies to take care of errors, commissions or omissions and price increases due to inflation, underestimation and so on.
In practice, a provision of about ten percent of capital costs which is usually limited to the long term loan or equity expected from external investors is considered adequate. The contingency provision does not include items of capital in form of assets expected from the promoters as their equity contribution. However, the ten percent contingency rule is not sacrosanct. The safety valve depends on factors such as the length of construction period, the inflationary level, the prospect of price increase and the thoroughness of planning, estimation and assumption made in the project formulation.
g) Front End Fee
The front-end fee is an acronym for some of the administrative charges by the bank which is added to the fund disbursed to the promoters. The front-end fee should also be capitalized and treated as part of the principal loan repayment in the future.
h) Interest During Construction
The interest during construction period is charged on the actual amount of the approved loan disbursed for the acquisition of fixed assets during the construction period prior to the actual take-off of the project. In most cases, the promoters may not be in a position to pay the amount of interest accrued on loan during construction period. This is because the business has not commenced full operation and is therefore not in a position to generate enough revenue for the payment of interest on loan disbursed.
Nevertheless, since the interest is the cost of funds actually disbursed to the promoters through third parties for asset acquisition, the lender will charge the interest on the loan and add it on to the capital borrowed for subsequent repayment in the future.
Security for the Loan.
Development banks and other lending institutions normally have a first legal charge on the fixed assets of the project and a second charge on the floating assets. For overdraft facilities or short-term loan obtained from commercial banks for financing working capital, development finance institutions normally allow a second charge on the fixed assets and a first charge on the floating assets. Other collateral securities accepted for the term loan include personal guarantee of the promoters and directors of the company, reputable bank guarantee, government securities such as treasury bills and stocks of blue chip companies quoted on the Stock Exchange.
Project Financing Plan.
The promoters’ equity contribution to any one project varies from one development finance institution to the other. Generally, it should not be less than 30% of the total capital costs of the project. The purpose of this is to reduce the principal and interest repayments burden and its effects on the future cash flow of the business.
The implementation phase covers the period from the decision to invest to the start of commercial production. The primary objective of implementation scheduling is to determine the financial implications of the implementation phase with a view to securing sufficient finance to float the project until and beyond the commencement of production. There must be an implementation schedule to guide the activities of the implementation phase. The main elements of these activities include incorporation, land acquisition and building construction, rental of business premises, engineering design, equipment procurement, installation, testing, commissioning and staff training. These schedules and time frame for completion of each activity should be considered along with variations in working conditions.
The implementation schedule should permit easy understanding, follow up and control of the actual project as it is implemented. Breaking down all activities into their subsections as contained in the feasibility study and establishing their interdependence sequentially is the logical method to plan. In doing this, the Programme Evaluation and Review Technique (PERT) and the Critical Path Method (CPM) are the two major techniques used by promoters and the project analyst for proper planning, scheduling and controlling various activities essential for execution of projects. All possible activities from project identification to commencement of production should be listed.