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 MBA – PM0012 :  List the advantages and disadvantage of project finance.

Answer:- The major advantages of project finance are:

· Allows the promoters to undertake projects without exhausting their ability to borrow amount for traditional projects.

· Limits financial risks to a project to the amount of equity invested.

· Enables raising more debts as lenders are sure that cash flows from the project will not be siphoned off for other corporate uses.

· Provides stronger incentives for careful project evaluation and risk assessment.

· Facilitates the projects to undergo careful technical and economic review.

· Eliminates the dependency on alternative nature of funding a project.

· Facilitates the arrangement of liability financing and credit improvement, accessible to the project but unavailable to the project sponsor.

· Enables the diversification of the project sponsor’s investments to reduce political risk.

· Gives more incentive for the lender to cooperate in an atmosphere of a troubled loan.

· Enables to have prolonged credit opportunities.

· Matches specific assets with specific liabilities.

Project finance[2] primarily benefits sectors or industries where, projects are structured as a separate entity, apart from their sponsors. Let us take the example of a stand-alone production plant. This is assessed in accounting and financial terms separately from the sponsors’ other activities. Generally, such projects tend to be relatively huge because of the time and other transaction costs involved in structuring, and because of the considerable capital equipment that needs long-term financing. In the financial sector, by contrast, the large volume of finance that flows directly to developing countries’ financial institutions has continued to be a part of the usual corporate lending kind.

All these do not mean that Project Finance is devoid of any disadvantages.

The major disadvantages of project finance are:

· Complexity of the process due to the increase in the number of parties and the transaction cost.

· Expensive as the project development and diligence process is a costly affair.

· Litigious with regard to negotiations.

· Complexity due to lengthy documentation.

· Requires broad risk analysis and evaluation to be performed.

· Requires qualified people for performing the complicated procedures of project finance.

· Obligations regarding the trust fund account need to clearly specify.

· Higher level of control which might be exercised by the banks, which might bring conflict with the businesses or contracts.

MBA – PM0012 : Classify projects based on the ways they influence investment decision process.

Answer: – Investment projects are classified into three categories on the basis, of the way they influence the investment decision process: independent projects, mutually exclusive projects and contingent projects.

Independent projects

An independent project is one, where the acceptance or rejection does not directly eliminate other projects from consideration or affect the likelihood of their selection. For example, if management plans to introduce a new product line, as well as, replace a machine which is currently producing a different product. These two projects can be considered independent of each other, if there are sufficient resources to adopt both, provided, they meet the firm’s investment criteria.

Mutually exclusive projects

The mutually exclusive projects are projects that cannot be followed at the same time. The acceptance of one prevents the substitute proposal from accepting. Most of them have ‘either or’ decisions. You will not be able to follow more than one project at the same time. The evaluation is done on a separate basis so that one that brings the highest value to the company is chosen.

Contingent projects

A contingent project is one where the acceptance or rejection depends on the decision to accept or reject multiple numbers of other projects. Such projects may be complementary or substitutes. Let us take the example of bio fuel plant cultivation in a large scale and the decision to set up a bio fuel manufacturing unit. In this case, the projects are complementary to each other. The cash flows of the plant cultivation will be enhanced by the existence of a nearby manufacturing plant. Conversely, the cash flows of the manufacturing unit will be enhanced by the existence of a nearby cultivation farm.

MBA – PM0012 :  what is credit risk appraisal? Explain the 5C’s of credit analysis.

Answer: – credit risk appraisal:-

Credit Appraisal is a process to determine the risks associated with the extension of the credit facility. It is generally carried out by the financial institutions which are involved in providing financial funding to its customers. Credit risk is a risk associated to non repayment of the credit acquired by the customer of a bank. Thus it is necessary to evaluate the credibility of the customer in order to mitigate the credit risk. Proper evaluation of the customer is performed and this measures the financial condition and the ability of the customer to repay back the loan in future. Generally the credits facilities are extended against the security know as collateral. But even though the collaterals return back the loans, banks are normally interested in the actual loan amount to be repaid along with the interest. Thus, the customer’s cash flows are ascertained to ensure the timely payment of the principal and the interest.

5C’s of credit analysis:- Capacity to repay is the most critical of the five factors, it is the primary source of repayment – cash. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships – personal or commercial- is considered an indicator of future payment performance. Potential lenders also will want to know about other possible sources of repayment.

Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Interested lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

Collateral, or guarantees, are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can’t repay the loan. A guarantee, on the other hand, is just that – someone else signs a guarantee document promising to repay the loan if you can’t. Some lenders may require such a guarantee in addition to collateral as security for a loan.

Conditions describe the intended purpose of the loan. Will the money be used for working capital, additional equipment or inventory? The lender will also consider local economic conditions and the overall climate, both within your industry and in other industries that could affect your business.

Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered. The quality of your references and the background and experience levels of your employees will also be reviewed.

 MBA – PM0012 : Describe various types of financial risks.

Answer: The risks associated with finance are:

Liquidity Risk: The possibility that the cash available to a bank exceed by customer’s calls on it, or the income generated by a corporation, along with the funds raise through equity or debt issuance and/or borrowing, are insufficient to cover operating commitment forcing the corporation to stop operations. It can also be through thin markets sometimes resulting from distractions, which result in the unavailability of hedging instruments at economic prices.

Most institutions generally face two types of liquidity risk, the first relates to the depth of markets for definite products and the second to funding the financial-trading activities of the firm. For example, some firms have contract limits for every futures contract based on the volume of turnover and outstanding. Senior managers have to develop methods to identify and monitor the firm’s liquidity sources to ensure it can meet the funding demands of its activities. This is achieved by examining the differences in maturities between assets and liabilities and by analysing future funding requirements based on various assumptions, including the firm’s ability to settle down positions quickly in adverse conditions.

Credit Risk (Counterparty Risk): This risk may occur due to the non-payment by the borrower or counterparty such that loans, bonds or leases will not be repaid on time or in full or the counterparty will fail to perform on an obligation to the institution. The likelihood of this happening is calculated through the repayment record or default rate of the borrowing entity, determination of market conditions, and default rate of a loan portfolio of similar borrowers.

Sovereign Risk: This is the risk that a government action will interfere with repayment of a loan or security. This is measured, by the past performance of the nation and present default rate and situation such as political, social and economic. It is controlled by severe credit analysis, limiting exposure as a percentage of portfolios, and incorporating covenants into the loan documents.

Market Risk: This deals with unfavourable price or volatility that affects the assets contained in a firm’s or fund’s portfolio. It can be defined as the doubt of a financial institution’s earnings which results from changes in market conditions such as the price of an asset, interest rates, market volatility and market liquidity.

Settlement Risk: This refers to the risk that an expected settlement payment on a commitment will not be made on time due to bankruptcy, inability or time zone differential and it is related to credit risk but not identical. For example, a bilateral obligation in which one party makes a required settlement payment and the counterparty does not. Settlement risk provides an important inspiration to develop netting arrangements and other safeguards and is also called Delivery Risk.

Interest Rate Risk: The risk due to changes in interest rates results in financial losses related to asset or liability management. It is measured by past and present market instability and the profile of the asset or liabilities of the bank and its possible exposure through gap management.

Foreign Exchange Risk: The risk caused due to the rate change in the foreign exchange that cause foreign exchange denominated assets to fall in value or foreign exchange denominated liabilities to rise in expense. It is measured by marking-to-market the importance of the asset, or raise of the liability, by the actual movement of the exchange rate between the currency of the asset or liability and the currency of the booked or pending asset or liability, or country of earnings return.

Capital Risk: The risk may incur if the institution has insufficient capital for losses, which can result in bankruptcy or regulatory closure. It has a sub-optimal equity-debt capital profile which negatively impacts the market price of its stock. It is controlled by conditions and reserves from past earnings sufficient enough to cover operating losses; and by evaluating the loan, securities and trading operations accurately for any pending losses or deterioration.

Fraud Risk: The risk may occur if the banks own employees or its customers will defraud the bank. This is one of the most complicated situations to measure or control. It is controlled by dividing trading and settlement functions, periodic internal and external audits, and a centralised computer system to track and quickly or accurately resolve the bank’s position, portfolio and operations.

Legal Risk: This risk is caused because of claims from dissatisfied employees, clients, improper documentation; criminal or negligent conduct, workplace regulations or environmental defect will severely disrupt the company’s operations.

Operations Risk: The risk that human or machine, error or failure will result in financial losses due to documentation scarcity, securities processing, clearing issues, and systems failure. It is difficult to measure errors but the loss can be substantial related to settlement problems or customer liability suits. It is controlled through back-up data processing systems, computerised accounting or audit system that can flag a problem, and reserves for related losses.

Overhead Risk: The risk that overhead expenses excessively saddle the company’s capability. It is measured by the ratio of total expenses or net interest income and total of other income; other expenses tend to rise faster than income in a time of inflation.
Regulatory Risk: The risk that changes in regulations will negatively affect. It is measured by the way a change affect an established operation or restricts entry into a new operation, or affects capital reserve requirements, or operating requirements of the respective national banking regulator.

Economic Conditions Risk: The risk, that an undesirable change in economic conditions can unduly put the bank at risk. It is measured by how the loan portfolio will perform, what interest rates will do, how the securities portfolio may refuse in market value, how liabilities may raise, deposit withdrawals increase resulting in liquidity problems.

MBA – PM0012 : Describe the types of tools and techniques used in cost management.
Types of Tools and Techniques used in cost management:

• Cost aggregation
• Reserve analysis
• Expert judgment
• Historical relationships
• Funding limit reconciliation
• Cost performance baseline
• Project funding baseline

Cost aggregation: Individual costs are aggregated in many different ways for budgeting purposes, including at the deliverable, work package, summary activity, or other classification levels.

Reserve analysis: Reserves are time or cost buffers in the project schedule or budget that help the project counter or respond to uncertainties. Reserve analysis monitors these buffers and will reduce, use, or eliminate them based on the current situation.

Expert judgment: Expert judgment is based upon the experience and knowledge of subject matter experts. It is used to assess and evaluate the inputs and the information the experts contain.

Historical relationships: A historical relationship refers to the characteristics of the current and past projects that can be used to develop models that aid in budgeting.

Funding limit reconciliation: Funding limit reconciliation matches the project’s planned need for funding with the organisation’s ability to provide that funding. It can be thought of as “resource levelling” for finances because it reschedules activities to make sure that the budget for the scheduled activities does not exceed the available budget for that period. For instance, if the estimated cost for scheduled activities in the second month of a project is estimated to be Rs 50,000, but the organisation can only provide funding for Rs 40,000 then there is Rs 10,000 of work that has to be rescheduled to another month.
Cost performance baseline: The cost performance baseline is a duration-phased budget that is used for project cost management, monitoring, and reporting. Though they are both derived from the same source, the project budget and project cost baseline are not interchangeable terms. The cost baseline is a component of the project performance baseline.
In addition to knowing the project funding requirements, the performing organisation needs to know when the project will need money.
The project cost baseline can effectively show many different views of project performance. A project will have several different cost-related baselines that will focus on specific cost categories, such as labour costs, raw material costs, or any other cost classification that is necessary for monitoring. Just as with all other baselines, the cost baseline reflects all approved changes.
Project funding baseline: Project funding baseline refers to the entire estimated cost of the budget, including any contingency or management reserves.
The performing organisation needs to know the financial costs of the project so that it can compute appropriate money. The entire estimated cost of the budget, including any contingency or management reserves, is the project funding requirements. When we are referring to the project’s budget, we are usually talking about project’s base costs.
Every organisation will each have different requirements and terminology for the contents and categorisation of the project budget, but a budget is usually classified in the same categories as what was used by the resource breakdown structure. At a broad level, the budgetary classifications are generally:
• Reserves
• Labour/Personnel
• Professional, Contracted, or Outside Services
• Supplies, Materials
• Equipment, Hardware, and Software
• Training, Travel
• Licenses, fees
• Indirect Costs

The performing organisation will also need to know when it can expect project costs to be incurred, so the project’s budget is also shown by calendar periods. When the project cost is broken down into a time-phased budget, it serves as the project cost performance baseline.


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