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Project
financing in banking and development
finance institutions: appraisal and scope
By Aftab Ahmad Khan
Investment projects are basic building blocs
in the development process. Gittinger claims that development projects are
the cutting edge of development. Hirschman considers them “privileged
particles of the development process”. In economic development, projects
contribute to the integration of markets by linking productive activities,
provide the organisation and technology for transforming raw materials
into socially and economically useful goods and services and establish
infrastructure necessary to increase exchange among organisations and
geographical areas. Projects provide channels for public and private
investment, re-channel unused and under-employed resources into productive
uses, and offer expanded opportunities for entrepreneurs.
A well planned project passes through the following
cycle: identification and definition; formulation, preparation and design;
appraisal; selection and approval; activation and organisation;
implementation and operation; supervision, monitoring and control;
termination or completion; and evaluation and follow up analysis.
Banks and development finance institutions (DFIs) are
playing a very significant role in providing long term and short term
financial assistance to projects in local as well as foreign currencies.
Prior to approving financial assistance for projects,
banks and DFIs carry out detailed appraisals which includes:
(1)
Sponsors’ appraisal
(2)
Technical feasibility
(3)
Market justification
(4)
Financial appraisal
(5)
Sensitivity analysis
(6)
Economic appraisal
(1) Sponsors’ appraisal
The sponsors’ appraisal includes an assessment of
their qualifications, experience and management abilities. An essential
element of sponsors’ appraisal is their credit worthiness reports from
the financial system of the country.
(2) Technical feasibility
(a) While carrying out technical feasibility, the
banks and DFIs seek to ensure that the projects are soundly designed,
appropriately engineered and follow accepted technical standards. More
concretely, technical appraisal is concerned with questions of physical
scale, layout and location of facilities, the technology to be used,
including types of equipment and processes, the appropriateness to local
conditions of technical standards adopted, the approach to be followed for
the provision of services; the realism of the implementation schedule; and
the likelihood of achieving the expected levels of output.
(b) A critical part of the technical appraisal is a
review of the cost estimates, and the engineering and other data on which
they are based to determine whether they are adequate within an acceptable
margin and whether allowances for physical contingencies and expected
price increases during implementation are adequate. The technical
appraisal also reviews proposed procurement arrangements. In addition,
technical appraisal is concerned with estimating costs of operating
project facilities and services and with the availability of necessary raw
materials and other inputs. The potential impact of the project on the
human and physical environment is examined to make sure than any adverse
effect will be controlled and minimised.
(3) Market Justification
While examining market justification the banks and
DFIs analyse the actual consumption of the expected output of the proposed
investment project as well as the following factors:
(a)
Imports and local production
(b)
Nature and degree of competition (cost structure, price, quality,
products or services); merger possibilities.
(c)
Market studies or surveys (names and competence of research team).
(d)
Demand estimates for domestic and export markets:
(e)
Sales forecast
(f)
Marketing plan
(g)
Sales and distribution organisation
(h)
Retailers marketing expertise
(4) Financial appraisal
(i) Overview: financial appraisal of a project by a
bank/DFI is concerned with its financial viability. It seeks to determine,
will the project be able to meet all its financial obligations including
debt service to the banks? The financial viability is also analysed
through projections of the balance sheet, income statement and the cash
flow. Once the financial costs and benefits have been identified,
quantified and valued, they have to be expressed in the present worth form
and with the help of discount tables. This has to be undertaken to enable
the costs and benefits to be compared with - in fact at different time
periods. For example, costs generally have to be incurred in the earlier
life of the project, while benefits accrue after a time lapse. Now the
total discounted future costs can be compared with the total future
benefits. The tools of financial analysis thereafter can be applied to
determine the acceptability of the project.
The three main tools used in financial and economic
analysis are ‘benefit-cost ratio’, the net present worth and the
internal rate of return. (i) Benefit cost ratio
The benefit cost ratio is obtained by dividing the
discounted benefit flow by the discounted cost flow (dis-counted at a cost
that reflects the opportunity cost of the capital).
In order to be acceptable, the project’s benefit
cost ratio must be greater than one implying that the discounted benefits
exceed the discounted costs.
(ii) The net present worth (NPW): it may be computed
by finding the difference between the discounted benefit and discounted
cost streams (both streams being discounted at the opportunity cost of
capital). A project is acceptable if the NPW is positive.
(iii) Debit equity ratio: this is an important ratio,
which shows the relationship between debts and equity in the financial
structure. Debts have fixed interest rates and these have to be met even
in hard times.
As such, equity has to act as a cushion, which can
absorb losses. It is calculated as:
Equity
Long term liabilities plus equity
(iv) Debt service coverage ratio: this shows the
firm’s ability to meet debt obligations from operating funds. It is
calculated as:
Net Income plus depreciation plus Interest paid
Interest paid plus repayment of long term loans.
(5) Sensitivity analysis
Due to uncertainty, sensitivity analysis is also
undertaken to see the impact on the profitability of a project in case the
future course of events happens to be different from what is anticipated.
This analysis is undertaken by varying the different variables upwards and
downwards by a certain percentage to see how it affects the net present
value (NPV) of the project. The variables tested normally are changes in
the prices of inputs and outputs, cost over-runs, impact on benefits due
to time over-runs and changes in output yields etc.
(6) Economic appraisal
Economic appraisal of a project is concerned with the
desirability of carrying out the project from the standpoint of its
contribution to the development of the national economy. Whereas financial
analysis deals with only costs and returns to project participants,
economic analysis is concerned with costs and returns to society as a
whole. Economically efficient projects are those, which add to national
income. In economic analysis, taxes, duties and subsidies are treated as
transfer payments. Furthermore, some market prices are also changed to
reflect appropriate economic values. These adjusted prices are often
termed as “shadow” or “accounting” prices. Again, in this analysis
capital on interest is never separated and deducted from the gross return,
since it is a part of the total return to the capital available to the
society as a whole and it is that total return, including interest, which
this analysis is designed to estimate for the society as a whole.
The economic analysis basically allows for
remuneration to labour and other inputs at market prices or at shadow
prices, which are intended to approximate true opportunity costs. Implicit
objective of economic analysis is to determine the impact of the project
on the growth of the economy.
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