fm-pay back period etc

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PROJECT PLANNING & IMPLEMENTATION

SUB MODULE –3.4.1

FINANCIAL ASPECTS OF PROJECT MANAGEMENT

FINANCING A PROJECT

Project Report:

A project is a pre-investment and comprehensive study of investment proposals of an organization whichencompasses a through investigation relating to economic, technical, financial, social, managerial and commercialaspects. It is a working plan for implementation of project proposals after an organization has decided to undertakean investment project. It seeks to evaluate the socio-economic and technical viability of a project before it isundertaken. A project report deals with the various aspects of a new project with reference to:

Project Report provides:

1. It lays down objectives in various spheres of project.

2. It evaluates the objectives in the right perspective.

3. Component wise cost breakup of the project

4. It identifies constraints on resource, manpower

5. It identifies constraints on resources viz. manpower, equipment, financial and technological etc. well in advanceto take remedial measures in due course of time.

6. It paves the way for management to seek financial accommodation from financial Institutions and banksfinancial Institutions require a detailed project report a detailed project report to evaluate the desirability offinancing the project .Besides ,other financial intermediaries like merchant bankers and underwrites alsorequire project report to evaluate project viability for raising funds from Capital market.

7. Apart from this, the successful implementation of a project depends upon the line of action. Besides,comparison of results will depends upon the projected profitability and cash flows, production schedule andtargets as laid down in the project report.

JNNURM envisages to provide funds varying from 35% to 50% of project cost for identified 63 cities and balancehas to come form state govt. and ULB.

PROCUREMENT OF FUNDS

Own Funds

The traditional approach domain the scope of financial management and limited the role of the financial managersimply to fund raising. ULB financing are meet from State grants, Finance Commission Grants and the revenuegeneration through Municipal Taxes, which are too meager to meet high demand of funds related to infrastructure.

Therefore ULBs have raise funds to meet the ULB’s fund requirement for infrastructure development.

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Sources of generating funds by the local body are:Toll ChargesLand Instrument ( House Tax)User ChargesSurchargesSecuritization

TollsTolls are the tariff imposed by the local bodies on the persons for using certain type of infrastructural facilities.Generally it is imposed for availing the road facility. This increases the revenue aspect of government and used forfinancing the projects relating to the capital expenditure. Tolls shall be levied according to the distance traveled andthe type of vehicle. Member States may vary the toll rates according to vehicle emission classes and the time of theday.

User ChargesThe most obvious, and in many ways the most sensible recommendation that can be made with respect to revenuestructures at any level of government is that appropriate user charges should be employed whenever possible.While user charges are likely to be viewed by officials solely as a potential additional source of revenue, their maineconomic value is to promote economic efficiency by providing demand information to public sector suppliers andto ensure that what the public sector supplies is valued at least at (marginal) cost by citizens.

Types of user Charges:At least three types of user charges, broadly defined, exist almost everywhere:

(1) Service Fees : include such items as license fees (marriage, business, dog, vehicle) and various smallcharges levied by local governments for performing specific services, registering this or providing a copy ofthat.

(2) Public Prices : refer to the revenues received by local governments from the sale of private goods andservices. All sales of locally-provided services to identifiable private agents - from public utility charges toadmission charges to recreation facilities - fall under this general heading.

(3) Specific Benefit Charges are related in some way to benefits received by the taxpayer in contrast to suchgeneral benefit taxes as fuel taxes levied on road users as a class or local general business or property taxesviewed as a price paid for local collective goods.

SurchargesTo meet the cost of operation and maintenance, ULBs have to increase their sources of revenue. For this purposes,they generally impose an additional tax over other taxes which is known as surcharge. The amount received fromthis head is utilized for meeting the expenditure to be incurred on maintenance and operation of the system.

Securitization

Securitization is the process of pooling and repackaging of homogenous liquid financial assets into marketablesecurities that can be sold to investors.

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Borrowed Funds

Viability Gap Funding

It is a known fact that India does not have adequate Infrastructure of achieve GDP Growth of 7% to 8% on asustainable basis. Thus building Infrastructure is of utmost Importance to the Government. The Governmentseffort to rope in the Private Sector in the Country’s infrastructure building has met with limited success. A longGestation and payback Periods are the main reasons behind the private sectors lukewarm response. Keeping thisfact in mind one has to welcome the concept of Viability Gap Funding that seeks to bridge the gap betweenEconomic and Financial rates of Returns.

Government is promoting Public Private Partnerships (PPP) in Infrastructure Development through a special facilityenvisaging support to PPP Projects through viability gap funding. Primarily this facility is meant to reduce capitalcost of the projects by credit enhancement and to make them viable and attractive for private Investments throughSupplementary Grant funding. Provision for this facility is made on a year to year basis.

Criteria:

The criteria for eligibility for funding are:

a) The project must be implemented, i.e., constructed, maintained and operated during the project term, by anentity with at least 40 per cent private equity.

b) The project must belong to one of the following sectors:

(i) Roads

(ii) Water supply

(iii) Sewerage

(iv) Solid Waste Management

c) The projects should have been endorsed by the concerned line ministries in the Government of India

d) All central projects should have received requisite Government approval at the appropriate level.

e) The total Government support required by the project must not exceed twenty per cent of the total projectcost or the actual project cost, whichever is lower.

f) The implementing agency must be selected through a transparent and open competitive process. The extentof viability gap funding shall be determined on the basis of the net present value of the actual viability gapfunding required.

Viability gap funding can take various forms, including but not limited to capital grant, subordinated loans or interestsubsidy. A mix of capital and revenue support may also be considered.

POOLED FINANCE DEVELOPMENT SCHEMEIndia is going through a rapid urbanization process. The present level of urbanization of 28 per cent is expected toreach 40 percent by 2020. It is estimated that 60 per cent of the national income is contributed by urban India.Hence, in order to achieve the planned growth rate of 8-9 per cent it is necessary that urban India is managed well

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in order to give a further boost to the economy and in the process reduce poverty levels.

It is a well-known fact that ULBs all over the country are in a poor state and hence they have to restructure theirorganizations, functions and financial position. Hence, a major effort for reforms and capacity building is of utmostimportance. Secondly, the major investments will have to take place in urban areas in basic services like watersupply, sanitation, roads, solid waste management, street lighting etc., which will ultimately enhance economicactivity and contribute to the national income.

It was estimated by a GOI Committee in 1996 that the annual requirement of investment for urban infrastructurewas of the order of about Rs 28,000 crore each year. The estimate of requirement of investment in Karnataka asassessed by an Ad hoc Committee is about Rs 7,700 crore of capital expenditure and about Rs 1,000 crore peryear towards operations and maintenance. Surely, the ULBs mandated to handle this task will have to be empoweredand strengthened to take this responsibility.

Traditionally, ULBs have been dependent on funds from State Governments by way of grants, loans through Stateguarantees, etc., to meet capital expenditure. In this process the true costs of services have not been brought tofocus and citizens are provided services at heavily subsidized prices.

User charges seldom cover 0 & M expenditure. This resource gap has come in the way of the capacity of ULBsto incur capital expenditure for India is going through a rapid urbanization process. The present level of urbanizationof 28 per cent is expected to reach 40 per cent by 2020. It is estimated that 60 per cent of the national income iscontributed by urban India.

Hence, in order to achieve the planned growth rate of 8-9 per cent it is necessary that urban India is managed wellin order to give a further boost to the economy and in the process reduce poverty levels. It is a well-known fact thatULBs all over the country are in a poor state and hence they have to restructure their organizations, functions andfinancial position. Hence, a major effort for reforms and capacity building is of utmost importance.

Secondly, the major investments will have to take place in urban areas in basic services like water supply, sanitation,roads, solid waste management, street lighting etc., which will ultimately enhance economic activity and contributeto the national income.

It was estimated by a GOI Committee in 1996 that the annual requirement of investment for urban infrastructurewas of the order of about Rs 28,000 crore each year. The estimate of requirement of investment in Karnataka asassessed by an Ad hoc Committee is about Rs 7,700 crore of capital expenditure and about Rs 1,000 crore peryear towards operations and maintenance.

Surely, the ULBs mandated to handle this task will have to be empowered and strengthened to take this responsibility.Traditionally, ULBs have been dependent on funds from State Governments by way of grants, loans through Stateguarantees, etc., to meet capital expenditure. In this process the true costs of services have not been brought tofocus and citizens are provided services at heavily subsidized prices. User charges seldom cover 0 & M expenditure.This resource gap has come in the way of the capacity of ULBs to incur capital expenditure for urban infrastructureservices. In the recent years the extent of Government support towards urban infrastructure has been declining.The ceiling on government guarantees also restricts borrowings by the ULBs. Under these circumstances it isinevitable that ULBs explore new avenues to raise resources to meet their ever-increasing requirements for providingquality infrastructure services.

The identified new avenue is that of providing access to the capital markets wherein capital can be accessed

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through bonds. In order to make this instrument attractive, GOI offers tax exemption on the bonds floated byULBs. However, the smaller ULBs will find it difficult to directly access the market and hence the concept ofpooled finance has been developed whereby a group of ULBs join together and approach the capital marketsthrough a special purpose vehicle.

The ‘Pooled Finance Development Facility’ (PFDF), which is under the final stages of formulation, provides thestructure and the means to access capital markets by a group of ULBs. The scheme provides for credit enhancementfor borrowings that are bankable.

The concept of pooled finance has been successfully adopted in Tamil Nadu. The Greater Bangalore WaterSupply and Sanitation Project (GBWASP), which is now taken up for implementation has adopted the scheme inKarnataka.

The GBWASP plans an out lay of Rs 640 crore for the water supply and UGD components covering 8 ULBssurrounding Bangalore City but forming part of the Bangalore Metropolitan Area. The water supply component isestimated to cost Rs 340 crore. The 8 ULBs plan to raise Rs 100 crore from the market to meet part of the cost.Bonds are to be floated on behalf of the 8 ULBs through the Karnataka Water and Sanitation Pooled Fund Trust- a SPV constituted for this purpose. The Trust has appointed KUIDFC as the Fund Manager. The Trust is a GOKTrust which will raise Rs 100 crore by way of bonds on behalf of the 8 ULBs. The bonds are also to be listed in thestock exchange in order to make them tradable. The instrument has been assessed by ICRA, a rating agency andis to be rated as AA (SO).

A credit enhancement structure has been framed for the comfort of the investors. At the first level, 40 per centrevenue surplus from the 8 ULBs will be transferred to a water project account in order to maintain an amountequivalent to 1.5 times the annual debt commitments. At the next level a Bond Service Fund of Rs 25.5 crore willbe maintained to meet any shortfall. This fund will be contributed on a matching basis by GOI and GOK as per theguidelines of the proposed PFDF Scheme. In the third level, a state intercept will be provided to divert the statedevolution funds in case of default by a participating ULB. A guarantee from USAID covers 50 per cent principalamount, which will be tapped when necessary and subsequently replenished by state intercept of devolution offunds. The above mechanism will be monitored by a Bond Trustee who will be appointed by the Fund Manager.The structure and framework has been designed through the help of USAID and advice from ICRA.

The innovative financing structure adopted as above in the GBWASP is path breaking and its success should pavethe way to many such initiatives in future from the ULBs.

Land Based InstrumentsAs ULBs have substantial area of open land, they can use those for the purpose of finance. Banks and otherFinancial Organizations easily accept the instruments based on security of land. These instruments, thus, help infinancing a project.

Legal Framework for Municipal BorrowingMunicipal government borrowing in India is regulated by the Local Authorities Loans Act, 1914. This Act specifiesthe:

(i) Purposes for which local bodies may contract a loan,(ii) limits on the amount of loan,

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(iii) Duration of loans,

(iv) Security or collateral, and

(v) Repayment procedures.

Subject to the limits imposed by this Act, the state governments have the flexibility to determine the frameworkwithin which local governments – a term used to cover all forms of local bodies including the parastatals - canborrow from the market. The framework which is laid out in the state level municipal laws contains rules in respectof

(i) The nature of the funds on the security of which money may be borrowed;

(ii) The works for which money may be borrowed;

(iii) The manner of making applications for permission to borrow money;

(iv) The manner of raising loans,

(v) The sum to be charged against the funds, which are to form the security for the loan;

(vi) The attachment of such funds and the manner of disposing them; and

(vii) The accounts to be kept in respect of loans.

Credit Rating

The Urban Local Bodies (ULBs) own resources have been insufficient even to meet the operation and maintenancerequirements of these services. Since most urban infrastructure services have been treated as public services andthe concept of cost recovery has never been considered relevant, a commercial approach to these services has notbeen developed. Even if the facilities were funded by loans, the repayment of loans was generally book adjustmentsor paid out of grants made by state governments.

Even when user charges are levied, the price per unit is too low to cover even the variable cost of providing theservice. The fact that infrastructure services do not pay for themselves and the government continues to subsidiesthe beneficiaries has resulted in low availability of funds. With increasing requirements, this has meant deficiency involumes as well as quality of service. Consequently, a parallel, unorganized sector for provision of many of theseservices has developed, resulting in high prices and qualitatively deficient services. From a societal point of view,these are expensive solutions. It is high time that a commercial approach is adopted.

The Credit Rating is done by the following agencies:

Credit Rating Information Services of India Ltd. (CRISIL)

The Credit Rating Information Services of India Ltd. (CRISIL), a credit rating agency in India, drawingupon the experiences of its partner, the Standard and Poor’s Rating Services of USA, undertook an exploratoryexercise to evaluate the credit quality of municipal entities in India, with a view to explore the feasibility ofexpanding the horizons of its rating operations.

It involved the Ahmadabad Municipal Corporation (AHMC) and other municipal corporations in formulatingwhat it called, a framework for municipal credit evaluation and laid out the groundwork for credit rating of

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municipalities and project-specific debt issues. CRISIL studied the finances and operations of the AHMC,and assigned an “A+” credit rating to the proposed Rs. 1 billion bond issue, indicating a credit risk profile inthe adequate safety category. Since then, the bond market in India has seen a noticeable growth in terms ofissuers and investors, instruments and volume of transactions.

Investment Information and Credit Rating Agency (ICRA Ltd.)

ICRA has assessed a number of municipal entities in terms of assigning credit rating for bond issues. Althoughthe criteria for evaluating bond issues by ICRA are not published, a study of the rating rationale gives anindication of the underlying rating philosophy and broad criteria.

ICRA looks at the overall profile of the issuer in terms of the area that it services together with its demographicand socio-economic profile. It conducts a detailed assessment of the financial performance of municipalitiesin terms of the organisation of accounts, past revenue and expenditure profiles, revenue surplus or deficit,past capital expenditure schedule, liquidity position and debt profile. Also studied are major revenue headsin terms of trends and composition and expenditure patterns of key operating departments. It also appraisesthe ongoing and proposed projects from the point of improvements in service delivery and funding arrangements.

The analytical methodology used by Standard and Poor’s focuses on the range of economic system andadministrative factors, budgetary performance and flexibility, and the financial position of the rating entity. Itevaluates sovereign-related factors as, in its view, the credit standing of sovereign governments has a significantimpact on the credit profile of sub-national and local governments. While evaluating local governments,Standard and Poor’s examines the parameters affecting the local economy, which include economic structure,growth prospects and demographic profile of population. It assesses the system structure and managementin terms of inter-governmental linkages, stability and supportiveness of the higher levels of government,revenue and expenditure balance, and management systems and policies. In evaluating the financialperformance, it analyses the revenue sources and flexibility therein, expenditure trends, liquidity, debt burdenand off-balance sheet liabilities.

Credit Analysis and Research Limited (CARE)

The CARE considers parameters such as the fiscal profile of bond-issuing municipal body, profile of theproject being financed and its related risk factors, revenue streams assigned for repayment of bonds, thelevel of local government autonomy and the administrative capability of local government, amongst otherfactors. It evaluates the legal set-up within which the local body operates including the power to raise debt,responsibility to repay debt, power to authorize specific issues, revenue raising powers, ending litigationsaffecting the status of debt and inter-governmental fiscal structure. While evaluating the fiscal profile, financialparameters such as the composition of revenue and expenditures, revenue surplus or deficit, margin ofsurplus or deficit, availability of general revenues to meet short-term delays in debt servicing of project-linked debt instruments, availability of financial resources to meet unforeseen contingencies and quantum ofstate budgetary support and the nature of operating expenses are examined. It also studies the debt specificfactors such as the delays in past loan repayments, current debt burden, debt service coverage ratio, degreeof reliance on short term borrowings, maturity profile and state government approvals for borrowings.

When the bond proceeds are to be used to finance a new project, viability of the new project in terms of theconstitution of the project as a special purpose vehicle (SPV) or as a departmental project, sources and

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allocation of funds for the project being financed and analysis of major project related revenues andexpenditures are assessed.

Also evaluated are factors such as the state of the local economy, local employment characteristics,demographics, development indicators, and prioritization of expenditure across projects. It looks at theadministrative and legal issues, such as organizational structure, management information system, tax billing,collection and enforcement mechanism, ability to implement plans and degree of autonomy given to the localbody. CARE’s methodology carefully analyses the linkages between the above-stated factors, while assigningan appropriate rating to the debt instrument.

In order to facilitate borrowings, the Credit Rating (Repayment Capability) of ULBs play an important role inextending funds for the project.

Municipal Bonds in India

A key development in the sphere of infrastructure financing in India has been the emergence of a municipal bondmarket. The bond market in India has grown significantly in recent years, in items of issuers and investors, instruments,trading volume and market awareness.

The central government issues treasury bills, zero-coupon bonds, floating rate bonds and inflation-indexed bonds.For public sector companies, the main issues comprise taxable and tax-free bonds, while the private sector companiesissue bonds and debentures, zero-coupon bonds and floating rate bonds. At sub-national levels, the state-levelpublic enterprises issue government-guaranteed bonds.

The concept of municipal bonds as an instrument for raising resources for urban infrastructure projects, which hadbeen playing a crucial role in creating urban infrastructure projects in the United States of America (USA) andCanada was initially outlined in a seminar held in 1995 and subsequently elaborated on by an Expert Group on theCommercialization of Infrastructure Projects, known as the India Infrastructure Report. This report noted thaturban infrastructure services are provided by local level agencies. Funds have generally been in the form of loansand grants from the central and state governments.

The fiscal incentives offered by the Government of India in the form of tax exemptions to eligible issuers, defined inthe Ministry of Urban Development’s Guidelines for Issue of Tax Free Municipal Bonds (2001), have given afurther stimulus to the municipal bond market. The guidelines stipulate that the issuers are to maintain a debt servicecoverage ratio of at least 1.25 throughout the tenure of the bond. This over collateralization and the provision of adebt service reserve account serve as measures to reduce risk to investors.

The nine municipal corporations which have accessed the capital market have thus far been able to raise Rs. 6185million, by issuing bonds. An important feature of municipal bonds is that with the exception of bonds issued by theBMC and Indore Municipal Corporation, other bonds have been issued without a state government or a bankguarantee.

Traditionally, lenders to entities in the infrastructure sector have sought a state or a sovereign guarantee as animportant security mechanism. The fact that municipal entities have begun to raise resources in the capital marketon the strength of their own credit standing and credit enhancements based on escrowing of the cash flows indicatesa growing acceptance in India of municipal bonds as an instrument for raising resources for financing infrastructureprojects. Municipal bonds in India are a securitized debt instrument, providing future revenue flows from the

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project as collateral.

At the heart of any credit system is a revenue stream that the borrower does not use for day-to-day operations.Borrowing for investment purposes is equivalent to capitalizing an income or revenue stream. The borrower receivesfunds today to pay for project construction. In return, he signs away the right to an annual revenue flow in the futurein favour of the lender. The more certain and predictable is the revenue stream, the greater is the security for a loan.

Credit Rating for Debt Financing

A credit rating11 is an independent opinion on the future ability, legal obligation and moral commitment of aborrower to meet its financial obligations of interest and principal in full and in a timely manner. Rating is importantto issuers for two key reasons:

(i) Investors are reluctant to buy bonds if they are not rated; in several countries, the central government doesnot permit sub-sovereigns to sell unrated bonds,12

(ii) The rating often serves, particularly in countries where interest regimes are allowed to operate freely, todetermine the interest rate at which sub-sovereigns can issue debt in the capital market.

The riskier the ability of a borrower to service debt payments, the higher the interest rate sub-sovereigns has topay. Credit rating is mandatory for debt instruments with a maturity exceeding 18 months. The three major creditrating agencies, viz., CRISIL, ICRA and CARE together with their partners (Standard and Poor’s, Moody, andFitch Ratings) serve the Indian market in terms of rating bonds and debentures and other papers. The frameworksthat they use are outlined below.

Key Features of Tax-Free Municipal Bonds

Key Features

Eligible Issuers Local self governments, other local authorities or public sector companies*duly constituted under an Act of Parliament or state legislature; other localauthorities constituted under relevant state government statutes like water supplyand sewerage board; and groups of local authorities through a financialintermediary.

Use of Funds Capital investments in urban infrastructure namely, potable water supply;sewerage or sanitation; drainage;solid waste management; roads, bridges andflyovers; and urban transport if it is a statutory municipalfunction.

RequirementsProject Development Project development consisting of an approved investment plan including phasing

and a financing plan; benchmarks for commencement and completion includingthe milestone dates for the proposed components of the project; completion ofthe process of pre-qualification of bidders; initiation of the process of Landacquisition and other statutory clearances.

Financial Viability Financially viable i.e., generation of a stream of revenues sufficient to financethe project; creation of an ESCROW account for debt servicing, appointmentof an Independent trustee for monitoring the Escrow account.

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Other Conditions Conformity with laws governing borrowing; maintenance of a Debt ServiceCoverage Ratio (DSCR)** of 1.25 Through the tenure of the tax-free municipalbond.

Project Account and Maintenance of a separate account as also establishment of a separate ProjectMonitoring Implementation Cell.

Investment, Maturity Minimum maturity of five years, with the option for buyback arrangements ofand Buy-Back the face value of the bonds.

Ceiling on Amount Maximum amount of tax-free bonds as a % of total project cost will be 33.3%or Rs. 50 crore whichever islower; debt-equity ratio not to exceed 3:1;contribution of 20% of project cost from internal resources or grants.

Credit Rating Mandatory to obtain an investment grade rating.

Legal and Administra- Adherence to guidelines issued by the Securities and Exchange Board of Indiative Requirements (SEBI).

Source (Financing Municipal Services – Reaching out to Capital Markets)

* Details list of ULBs where funds have been procured through Municipal Bonds refer to annexure-I

SELECTION OF APPROPRIATE SOURCE OF FINANCING

There are many sources for obtaining funds .However it is not possible to gather funds from all these source .Eachsource has its own pros and cons. Choice of the source depends on mainly three factors:-

1. Cost, 2. Risk and 3. Control

Cost refers to the procurement cost of fund. It generally reveals the expected amount of return, an investor wantson his investment.

Risk refers to the possibility of any uncertainty attached to the source of funds. Generally in case of borrowedfunds, investors may demand for the repayment of their investment at any time .This may knead to closure of theproject.

Control is also a significant aspect of Financial Sustainability .it refers to the decision making power related to theproject.

A proper analysis of all the above aspects has to make before making final selection of source of funds .The costof funds should be kept at minimum for proper balancing of risk and control . A cost benefit analysis incorporatingan overall result of the project during its whole period of operation should be made. Furthermore the tools ofCapital Budgeting should also be used for determining the financial viability of the source.

Capital Budgeting

Budgeting means evaluation of several plans or policies and making a choice of the best plan out of available plans.Capital budgeting involves a financial analysis of the various proposals regarding capital expenditure to evaluate

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their impact on the financial aspect of project .This Technique helps in taking decision as to whether or not moneyshould be invested in long term policies. It is done after the detailed cost estimation and implementation schedule ofthe project is made. For this purpose, Financial Manager uses the following technique:-

1. Pay Back Period2. Pay Back Reciprocal

3. Average Rate of Return

4. Net Present Value Method5. Profitability Index

6. Internal Rate of Return

Pay Back Period

It is one of the simplest at methods which calculates the period within which the cost of project will be completelyrecovered. It is the period in which the profit expected from the project will be equal to the cost of project.

This method has the following pros:

1. This method of evaluating proposals for capital budgeting is simple and easy to understand; it has the advantageof making it clear that there is no profit of any project unless the pay back period is over.

2. In the case of routine projects also use of payback period method favours projects, which generate cashinflows in earlier years Thus it, has practice approach.

By stressing earlier cash inflows the liquidity dimension is also considered in the selection criterion. However, thetechnique of payback period is not a very scientific method because of the following reasons:

1. It stresses capital recovery rather than profitability.

2. This is inadequate measure for evaluating two projects where the cash inflows are uneven.

3. It does not give any consideration to time value of money.

Illustration

Suppose a project costs Rs 20,00,000 and yields annually a profit of Rs 3,00,000 after depreciation @ 12 ½%(straight line method) but before tax @ 50%. The first step would be to calculate the cash inflow from this project.The cash inflow is Rs. 4,00,000 calculated as follows:

Rs.

Profit before tax 3,00,000

Less: Tax @ 50% 1,50,000

Profit after tax 1,50,000

Add: Depreciation written off 2,50,000

Cash Inflows 4,00,000

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While calculating cash inflow, depreciation is added back to profit after tax since it does not result in cash outflow.The cash generated from a project therefore is equal to profit after plus depreciation.

The payback period in this case is 5 years, i.e. Rs. 20,00,000 4,00,000

RemarksThe project with the lower payback period will be preferred. Sometimes the management has a set idea regardingwhat should be a maximum pay back period. Thus management may for example, decide that they will not acceptany project if the pay back period is more than 3 years.

EvaluationThis method has the following pros:

1. This method of evaluating proposals for capital budgeting is quite simple and easy to understand; it has theadvantage of making it clear that there is no profit of any project unless the pay back period is over.

2. In the case of routine projects also use of payback period method favours projects, which generate cashinflows in earlier years, Thus it has practice approach.

3. By stressing earlier cash inflows liquidity dimension is also considered in the selection criterion.

However, the technique of payback period is not a very scientific method because of the following reasons:

1. It stresses capital recovery rather than profitability.

2. This method becomes a very inadequate measure of evaluating two projects where the cash inflows areuneven.

3. The method does not give any consideration to time value of money.

Pay Back ReciprocalIt is a helpful tool for quickly estimating the rate of return of a project. It can be calculated as follows:-

PBR=Average Annual Cash Inflow

Initial Investment

The payback reciprocal is a useful technique estimate the true rate of return. But its major limitation is that everyinvestment project does not satisfy the conditions on which this method is based. When the useful life if the projectis not at least twice the payback period the payback reciprocal will always exceed the rate of return .Similarly itcannot be used as an approximation of the rate of return if the project yields uneven cash inflows.

IllustrationSuppose a project requires an initial investment of Rs. 20,00,000 and it would give an annual cash inflow of Rs4,000. The useful life of the project is estimated to 5 years. In this example payback reciprocal will be:

PI = Rs. 4,000 Rs. 20,000 = 20%

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Evaluation

The payback reciprocal is a useful technique to quickly estimate the true rate of return. But its major limitation isthat every investment project does not satisfy the conditions on which this method is based. When the useful life ofthe project is not at least twice the payback period, the payback reciprocal will always exceed the rate of return.Similarly, it cannot be used as an approximation of the rate of return if the project yields uneven cash inflows.

Average Rate of Return

It provides the average annual yields on the project. Under this method profit from a project as percentage of totalinvestment is considered. It is calculated as follow:-

ARR= Total Profiles*100

Net Investment in the project *NO. Of Years of profits

This method is quite simple and popular because it is easy to understand and includes income from the projectthroughout its life.

However, it is based upon a crude average of profits of the future years, it ignores the effect of fluctuation in profitsfrom to years .It thus ignores the time value of money.

Illustration

Suppose a project requiring an investment of Rs. 10,00,000 yields profit after tax and depreciation as follows :

Years Profit after tax And depreciationRs.

1 50,0002 75,0003 1,25,0004 1,30,0005 80,000

Total 4,60,000

In this case the rate of return can be calculated as follows

Total profits *100Net investments in the project * No. of years of profits

i.e. Rs. 4,60,000*100Rs. 10,00,000 * 5 years

= 9.2%

Remarks

This rate is compared with the rate expected on other projects, had the same funds been invested alternatively inthose projects.

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Evaluation

This method is quite simple and popular because it is easy to understand and includes income from the projectthroughout its life.

However, it is based upon a crude average of profits of the future years. It ignores the effect of fluctuations in profitsfrom year to year. It thus ignores the time value of money.

NET PRESENT VALUE

It is the best method for evaluation of investment proposals. It is the classical economic method of evaluating theinvestment proposals. It explicitly recognizes the time value money .It correctly postulates that cash inflows arisingat different time periods differ in value and are comparable only when their equivalents-present values –are foundout.

1. NPV method takes into account the time value of money

2. The whole stream of cash flows is considered.

3. The net present value can be seen as the addition to the wealth of share holders .The criterion of NPV is thusin conformity with basic financial objectives.

4. The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current rupees.

Illustration 1

Suppose a project will give profit as follows:-

Year End Profit (Cash Inflow)

1 2,30,000

2 2,28,000

3 2,78,000

4 2,83,000

5 2,73,000

6 80,000(Scrap Value)

Total 13,72,000

Again, let this project requires an initial investment of Rs, 10,00,000 and the rate of interest, supposed to beearned on this amount of Capital in Finance marked is 10% . This 10 % is our discounting rate.

Now, we calculate present value of various years on the basis of discounting rate as follows:-

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Year End (i) Cash Inflow (ii) Discount Factor Present Valueat 10% (iii) iv (ii * iii)

1 2,30,000 .909 2,09,070

2 2,28,000 .826 1,88,328

3 2,78,000 .751 2,08,778

4 2,83,000 .683 1,93,289

5 2,73,000 .621 1,69,533

6 80,000 .564 45,120

Total 10,14,118

Thus, the total present value of all cash inflows is Rs. 10,14,118 whereas total investment required is Rs. 10,00,000Hence, Rs. 14,118 is the Net Present Value.

Remarks

The project can be accepted if NPV is positive i.e. NPV>0 and rejected when NPV is negative i.e. NPV>0. IfNPV = 0, a project may be accepted. NPV = 0 implies that project generates cash flows at a rate just equal to theopportunity cost of capital.

Illustration 2

Assume that Project X Costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800,Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 percent.

The net present value for Project X can be calculated as follows :

STATEMENT OF NET PRESENT VALUE

Particulars Time P. V. Factor Amount Present ValueCash OutflowCost of Project 0 1 2500 2500Present Value of Cash Outflow (A) 2500Cash Inflows 1 .909 900 818

2 .826 800 6613 .751 700 5254 .683 600 4095 .621 500 310

Present Value of Cash in flows (B) 2725Net Present Value (B-A) 225

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Project X’ s present value of cash inflows (Rs 2,725) is greater than that of cash outflow (Rs 2,500). Thus, itgenerates a positive net present value (NPV = + Rs 225). Project X adds to the wealth of owners; therefore, itshould be accepted.

Evaluation

1. NPV method takes into account the time value of money.

2. The whole stream of cash flows is considered.

3. The net present value can be seen as the addition to the wealth of share holders. The criterion of NPV is thusin conformity with basic financial objectives.

4. The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current rupees.

PROFITABILITY INDEX

In certain cases we have to compare a number of proposals each involving different amount of cash inflows .Oneof the methods of comparing such proposals is to work out profitability index .It is calculated as below:-

Profitability Index=Sum of Discounted Net Cash Inflows

Initial Cash Outlay

This factor helps us in ranking us in ranking various projects

Profitability index as a guide in resolving capital rationing fails where projects are indivisible .

Illustration

Suppose we have three projects in view, each involving discounted cash outflow of Rs. 5,50,000, Rs. 75,000 andRs. 1,00,20,000. Suppose further that the sum of discounted cash inflows for these projects are Rs. 6,50,000,95,000 and 100,30,000. The desirability factors for the three projects would be as follows:

(a) Rs. 6,50,000 = 1.18

Rs. 5,50,000

(b) Rs. 95,000 = 1.27

Rs. 75,000

(c) Rs. 1,00,30,000 = 1.18

Rs. 1,00,20,000

Remarks

It would be seen that in absolute terms project (c) gives the highest cash inflows yet its desirability factor is low.This is because the outflow is very high also. The factor helps us in ranking various projects.

Evaluation

Profitability index as a guide in resolving capital rationing fails where projects are indivisible.

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INTERNAL RATE OF RETURN (IRR)

It is the rate expected to be earned from a project involving a certain a sum of cash out lay .At this rate discountedcash inflows are equal to the discounted cash outflows. Therefore in the method Net present Value is equal to zeroand the discount rate which satisfies this condition is determined. By trial and error method we try to calculate therate which satisfies our requirements. It is a popular investment criterion since it measures profitability as a % andcan be easily compared with the cost of capital. IRR method has the following merits:

The time value of money is taken into account.

All the cash flow in the project is considered.

IRR is easier to use as instantaneous understanding of desirability can be determined by comparing itwith the cost of capital.

Demerits

However, IRR method can give misleading and inconsistent results under certain circumstances. Here we brieflymention the problems that IRR method may suffer from:

The calculation process is tedious. If there is more than one cash outflow interspersed between thecash inflows; there can be multiple IRRs, the interpretation of which is difficult.

The IRR approach creates a peculiar situation if we compare to projects with different inflow outflowpatterns.

If mutually exclusive projects are considered as investment options which have considerably differentoutlays.

IllustrationSuppose a project costs Rs. 16000 and is expected to generate cash inflows of Rs. 8000, Rs. 7000 and Rs. 6000at the end of each year for next 3 years.

We know that IRR is the rate at which project will have a 0 NPV. As a first step, we try a 20 % (arbitrary) discountrate. The project’s NPV at 20 % is:

NPV= -Rs. 16000+Rs. 8000 (PVF1,0.20)+ Rs. 7000(PVF2,0.20)+Rs. 6000(PVF3,0.20)

= -Rs. 16000+Rs. 8000*0.8333+Rs. 7000*0.694+Rs 6000*0.579

= -Rs. 16000+ Rs. 14996

= - Rs. 1004

A negative NPV of Rs. 1004 at 20 % indicates that the project’s true rate of return is lower than 20%. Let us try16 % as the discount rate. At 16 %, the project’s NPV is:NPV= -Rs. 16000+Rs. 8000 (PVF1,0.16)+ Rs. 7000(PVF2,0.16)+Rs. 6000(PVF3,0.16) = -Rs. 16000+Rs. 8000*0.870+Rs. 7000*0.743+Rs 6000*0.641 = -Rs. 16000+ Rs. 15943 = - Rs. 57

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Since the project’s NPV is still negative at 16%, a rate lower than 16% should be tried. When we select 15% asthe trial rate, we find that the project’s NPV is Rs. 200:

NPV= -Rs. 16000+Rs. 8000 (PVF1,0.15)+ Rs. 7000(PVF2,0.15)+Rs. 6000(PVF3,0.15)

= -Rs. 16000+Rs. 8000*0.870+Rs. 7000*0.756+Rs 6000*0.658

= -Rs. 16000+ Rs. 16200

= - Rs. 200

The true rate of return should lie between 15 % -16 %. We can find out a close approximation of the rate of returnby the method of linear interpolation as follows:

PV required Rs. 16000

PV at lower rate, 15% Rs. 16200

PV at higher rate, 16% Rs. 15943

R = 15% + (16%-15%) 200/ 257

= 15% + 0.80%

= 15.8 %

Remarks

The accept – or - reject rule, using the IRR method, is to accept the project if its internal rate of return is higher thanthe opportunity cost of capital (r > k). Note that k is also known as the required rate of return, or the cut-off, orhurdle rate. The project shall be rejected if its internal rate of return is equal to the opportunity cost of capital. Thusthe IRR acceptance rules are:

Accept the project when r > k

Reject the project when r < k

May accept the project when r = k

Evaluation

IRR method is like the NPV method. It is a popular investment criterion since it measures profitability as a % andcan be easily compared with the cost of capital. IRR method has the following merits:

1. The time value of money is taken into account.

2. All the cash flows in the project are considered.

3. IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it withthe cost of capital.

However, IRR method can give misleading and inconsistent results under certain circumstances. Here we brieflymention the problems that IRR method may suffer from:-

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1. The calculation process is tedious. If there is more than one cash outflow interspersed between the cashinflows; there can be multiple IRRs, the interpretation of which is difficult.

2. The IRR approach creates a peculiar situation if we compare two projects with different inflow outflowpatterns.

3. If mutually exclusive projects are considered as investment options which have considerably different outlays.

SELECTION OF BEST METHOD

After making an in-depth study of merits and demerits of all the methods, we are now able to judge any financialprojects with the help of these methods. The methods analyzing a project depends, on the need of the person.However the Net Present Value Method is considered best. It is the most used technique.

It is considered superior because the best project is the one which adds most among the available alternatives, tothe owners’ wealth, which is the ultimate objective of Financial Management and NPV helps in arriving at thatproject.

The Profitability Index Method also gives the same result as that of the NPV method, because both method use thesame constituents, i.e. Cash Inflow and Cash Outflow. PI method states the result in terms of percentages whereasNPV method shows result in absolute terms.

Thus, Project budgeting is necessary step before taking any decision. As a Finance Manager having a number ofproposals regarding various projects. He has to compare and evaluate all these projects and decide which one totake up and which one to reject. However, apart from these financial considerations several other factors such aswelfare of the staff/society, requirement of law etc. also influence the decision of a Financial Manager.

Two Important Elements

For understanding the above concept the two important aspects are:

Time Value of Money

Discount Rate i.e. , Cost of Capital

TIME VALUE OF MONEY

The recognition of the Time Value of Money and risk is extremely vital in decision making. If the timing and risk ofcash flows is not considered, the firm may make decisions that may allow it to miss its objective of maximized theowners’ welfare.

A financial decision today has implications for a number of years, that is, it spreads into the future. For example,firms have to acquire fixed assets for which they have to pay a certain sum of money to vendors. The benefitsarising out of the acquisition of such assets will be spread over a number of years in the future, till the working lifeof the assets. On the other hand, funds have to be procured from different sources such as raising of capitalthrough new issues, bank borrowings, terms loans from financial institutions, sale of debentures and so on .

These involve a cash inflow at the time of raising funds as well as an obligation to pay interest/dividend and returnthe principal in future. It is on the basis of the comparison of the cash outflows (outlays) and the benefits (cash

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inflows) that financial decisions are made. For a meaningful comparison the two variables must be strictly comparable.One basic requirement of comparability is the incorporation of the time element in the calculation. In other words,in order to have a logical and meaningful comparison between cash flows that accrue in different time periods, it isnecessary to convert the sum of money to common point of time.

TIME PREFERENCE FOR MONEY

Most individuals value the opportunity to receive money now higher than waiting for one or more periods toreceive the same amount .Time preference for money is an individual’s preference for possession of a given amountof money now, rather than the same amount at some future time.

Three reasons may be attributed to the individual’s time preference for money:

Risk

Preference for Consumption

Investment Opportunities

Technique

The preceding discussion has revealed that in order to have logical and meaningful comparisons between cashflows that result in different time periods it is necessary to convert the sum of money to a common point in time.There are two techniques for doing this:

Compounding, and

Discounting

Compounding Technique:

Interest is compounded when the amount earned on an initial deposit (the initial principal) becomes part of theprincipal at the end of the first compounding period. The term principal refers to the amount of money on whichinterest is received.

Illustration

If Mr. X invests Rs. 1000 at 5% interest compounded annually, at the end of the third year its compounded valuewill be:

A = P (1+i) n

= Rs. 1000 (1+.05) 3

= Rs. 1000 * 1.157625

= Rs. 1157.625

Compounded Value of a Series of Payments

So far we have considered only the future value of a single payment made at time zero. In many instance we maybe interested in the future value of a series of payments made at different time periods.

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Illustration

Suppose, Mr X deposits each year Rs 500, Rs1,000, Rs1,500, Rs 2,000, and Rs 2,500 in his saving bankaccount for 5 years . The interest rate is 5 per cent. He wished to find the future value of his deposits at the end ofthe 5th year.

Following table presents the calculations required to determine the sum of money he will have.

Annual Compounding of a Series of Payments

End of Year Amount Number of years Compounded Future ValueDeposited compounded Interest Factor (2*4)

1 2 3 4 5Rs. Rs.

1 500 4 1.216 608.002 1000 3 1.158 1158.003 1500 2 1.103 1654.504 2000 1 1.050 2100.005 2500 0 1.000 2500.00

Total 8020.50

Column 3 of Table indicated that since the deposits are made at the end of the year, the first deposit will earninterest for four years, the second for three years and so on. The last payment of Rs 2,500 comes at the end of thefifth year and, therefore, the future value remains Rs 2,500. The future value of the entire stream of payments is thesum of the individual future values, that is, Rs. 8,020.50

Compound Sum of an Annuity

An annuity is a stream of equal annual cash flows. Annuities involve calculations based upon the regular periodiccontribution or receipt of a fix sum of money. The calculations required to find the sum of an annuity on whichinterest is paid at a specified rate compounded annually.

Illustration

Mr X deposits Rs 2,000 at the end of every year for 5 years in his saving account paying 5 per cent interestcompounded annually. He wants to determine how much sum of money he will have at the end of the 5th year.

Solution

Following Table presents the relevant calculations:

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Annual Compounding of Annuity

End of Year Amount Number of years Compounded Future ValueDeposited compounded Interest Factor (2*4)

1 2 3 4 5

Rs. Rs.

1 2000 4 1.216 2432

2 2000 3 1.158 2316

3 2000 2 1.103 2206

4 2000 1 1.050 2100

5 2000 0 1.000 2000

Total 11054

Thus, the future value of the entire stream of annuity is Rs. 11054.

PRESENT VALUE OR DISCOUNTING TECHNIQUE

The concept of the present value is the exact opposite of that of compound value. While in the letter approachmoney invested now appreciates in value because compound interest is added, in the former approach (presentvalue approach) money is received at some future date and will be worth less because the corresponding interestis lost during the period .In other words, the present value of a Rupee that will be received in the future will be lessthan the value of a rupee in hand today. Thus, in contrast to the compounding approach where we convert presentsums into future sums, in present value approach future sums are converted into present sums .Given a positive rateof interest , the present value of future rupees will always be lower. It is for this reason, therefore that the procedureof finding present values is commonly called discounting. It is concerned with determining the present value of afuture amount, assuming that the decision maker has an opportunity to earn a certain return on his money. Thisreturn is designated in financial literature as the discount rate, the cost of capital or an opportunity cost.

IllustrationMr. X has been given an opportunity to receive Rs 1,060 one year from now. He knows that he can earn 6 per centinterest on his investments. The question is: what amount will he be prepared to invest for this opportunity?To answer this question, we must determine how many rupees must be invested at 6 per cent today to have Rs1,060 one year afterwards.Let us assume that P is this unknown amount, and using the compound technique, we have: P (1+0.06) = Rs 1,060Solving the equation for P, P = Rs 1,060

1.06

= Rs 1,000

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Thus, Rs 1,000 would be the required investment to have Rs 1,060 after the expiry of one year. In other words, thepresent value of Rs 1,060 received one year from now, given the rate of interest of 6 per cent, is Rs 1,000.

Mr X should be indifferent to whether he receives Rs 1,000 today or Rs 1,060 one year from today. If he caneither receive more than Rs 1,060 by paying Rs 1,000 or Rs 1,060 by paying less than Rs 1,000, he would do so.

DISCOUNT RATE i.e., COST OF CAPITAL

The discussions relating to capital budgeting have shown the relevance of a certain required rate of return as adiscussion criterion. Such a rate is the cost of capital of a firm. Apart from its usefulness as an operational criterionto accept / reject an investment proposal, cost of capital is also an important factor in designing capital structure.

IMPORTANCE AND CONCEPT

Definition

In operational; terms cost of capital refers to the discount rate that is used in determining the present value of theestimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. In thissense it may be defined as the minimum rate of return that a firm must earn on its investment for themarket value of the firm to remain unchanged.

The cost of capital is composed of several elements. These elements are different sources of capital from which itis produced. Each source of fund has its own cost of capital which is known as specific cost of capital. When thesespecific costs are combined to arrive at overall cost of capital, it is known as weighted cost of capital. Actually,wherever the term cost of capital is used it means Composite cost of capital.

Importance

As mentioned above, the cost of capital is an important element, basic input information, in capital investmentdecisions. In the present value method of discounted cash flow technique, the cost of capital is used as the discountrate to calculate the NPV. The profitability of index or benefit-cost ratio method similarly employs it to determinethe present value of future cash flows. When the internal rate of return method is used, the computed IRR iscompared with the cost of capital. The cost of capital, thus, constitutes an integral part of investment decisions. Itprovides a yardstick to measure the worth of investment proposal capital. It is also referred to as cut-off rate,target rate, hurdle rate minimum required rate of return, standard return, opportunity cost and soon.

The cost of capital, as an operational criterion, is related to the firms’ objective of wealth maximization. The acceptreject rules requires that a firm should avail only such investment opportunities as promise the rate of return is higherthan the cost of capital.

Conversely, the firm would be well advised to reject proposals whose rates of returns are less than the cost ofcapital. If the firm accepts a proposal having a rate of return higher than the cost of capital, it implies that theproposal yields returns higher than the minimum require by the investors and the prices of shares will increase, andthus, the shareholders’ wealth. By virtue of the same logic, the shareholders’ wealth will decline on acceptance ofa proposal in which the actual return is less than the cost of capital. The cost of capital, thus, provides a rationalmechanism for making optimum investment decision. In brief, the cost of capital is important because of its practicalutility as an acceptance- rejection decision criterion.

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The considerable significance of cost of capital in terms of its practical utility not with standing, it probably the mostcontroversial topic in financial management. There are varying opinions as to how this can be computed.

COST OF CAPITAL

As we know the term of cost of capital is the overall cost. This is the combined cost of the specific costs associatedwith specific sources of financing. The computation of cost of capital, therefore, involves two steps:

1. The computation of the different elements of the cost terms the cost of different sources of finance and

2. The calculation of overall cost by combining the specific cost into a composite cost.

Cost of Different Elements of Capital

From the view point of capital budgeting decisions in the long term sources of funds are relevant as they constitutesthe major source of financing the fixed assets. Long term sources of finance can be divided into the following twoparts:

1 Borrowed fund

2. Owned fund

Cost of Borrowed fund

The cost of fund rose through borrowing or debt in the form of long term loan from financial institutions mainlyconstitutes the interest payable. Here, the debt can be either perpetual or redeemable.

Cost of Perpetual debt

It is the rate of return, which the lenders expect. The debt carries a certain rate of interest. The coupon interest orthe market yield on debt can be said to represent an approximation of the cost of debt. Finally, the Bonds andDebentures (debt) can be issued at (i) Par (ii) Discount, and (iii) Premium. The coupon rate of interest will requireadjustment to find out the true cost of debt. Symbolically,

Ki = I___ SV

Ki = Before cost tax of debt

I = annual interest payment

SV= sale proceeds of the bond / debenture

Cost of Redeemable Debt

In the case of calculation of cost of redeemable debt, account has to be taken, in additions to interest payments,of the repayment of the principal. When the amount of the principal is repaid in one lump-sum at the time of maturitythe cost of debt would be given by solving following equation:

K d = I + (F + D + Pr - Pi) / Nm

(RV + SV) / 2

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where

Kd = Cost of debt

I = annual interest payment

RV = Redeemable value of debt

SV = Net sales proceeds from the e issue of debt

Nm = Term of Debt

F = Flotation cost

D = discount on issue of debentures / loan

Pi = Premium on issue of Debentures

Pr = premium on redemption of debentures

Tax Adjustment

The interest paid on debt is tax deductible. The higher the interest charges, the lower will be the amount of taxpayable by the firm. This implies that the government indirectly pays a part of the lenders required rate of return. Asa result of the interest tax shield, the after tax cost of debt to the firm will be substantially less than the investorrequired rate of return. The before tax cost of debt, Kd should, therefore, be adjusted for the tax effect as follows

After tax cost of Debt = Kd (1-T)

Where T is the corporate tax rate, if before tax cost of bond in our example is 16.5%, and the corporate tax rateis 35 %, the after tax cost of bond will :

Kd (1-T) = 0.1650 (1-0.35) = 0.1073 or 10.73%

It should be noted that the tax benefit f interest deducibility would be available only when the firm is profitable andis paying taxes. An unprofitable firm is not required to pay any taxes. It would not gain any tax benefit associatedwith the payment of interest, and its true cost of debt is the before tax cost.

Cost of Owned Capital

In case of ULBs no return is expected from the investment since it is guided by the service motive. It is, therefore,assumed that there is no cost involved for procuring capital from owned capital no return has to be given on it.Apart from the absence of any commitment to pay return , it is free from the risk of repayment. It may, thereforeprima facie, appear that capital does not carry any cost. But this is not true. Capital, like other sources of fund,does certainly involve a cost to the firm which is in the form of opportunity cost of capital.

Opportunity cost is the value of the best alternative that was not chosen in order to pursue the current endeavor -i.e., what could have been accomplished with the resources expanded in the undertaking. It represents opportunitiesforegone.

In fact, there is no obligation to pay a return on the fund invested by the organisation. But there are other investmentoptions available in which these funds can be invested. If benefit from that opportunity is higher than the benefit

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accrued from the investment, obviously, fund will be invested in that opportunity. Here, the ULB has to arrange allits projects in terms of benefit derived from them and use the fund accordingly to derive maximum benefit.

As far as, a commercial organization is concerned, the cost of its capital is in the form of the return, they expectedto derive. Because of higher risk, the cost of capital is highest among all the sources funds.

Conceptually, the cost of equity capital may be defined as the minimum rate of return that a firm must earn on theequity financed portion of an investment project in order to leave unchanged the market price of the share of thefirm.

Illustration

Let dividend per share of a firm is expected to be Re. 1 per share. If the market price per share is Rs. 25 the castof equity capital will be

= D P

= 1 25

= 0.04 or 4%

Here,

D = Dividend to be received

P = Net Amount Received

THE WEIGHTED AVERAGE COST OF CAPITAL

Once the components cost have been calculated, they are multiplied by the proportions of the respective sourcesof capital to obtain the weighted average cost of capital WACC). The proportions of capital must be based ontarget capital structure. WACC is the composite or overall cost of capital.

The following steps are involved for calculating the firm’s WACC:

Calculate the cost of specific sources of funds

Multiply the cost of each source by its proportion in the capital structure.

Add the weighted component costs to get the WACC.

In the financial decision making, the cost of capital should be calculated on an after tax basis. Therefore, thecomponent costs should be the after tax costs. If we assume that a firm has only debt and equity in its capitalstructure, then the WACC (ko) will be:

Where ko is the WACC, Kd (1-T) and ke are, respectively, the after tax cost of debt and equity, D is the amountof debt and E is the amount of equity.

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Illustration

A firm’s after tax cost of capital of the specific sources is as follows:

Cost of Debt 8%

Cost of Equity Capital 17%

The following is the capital structure:

Source Amount

Debt Rs. 400000

Equity Capital Rs. 600000

Rs. 1000000

Computation of Weighted Average Cost of Capital

Sources of Amount Proportion Cost (%) WeightedFund cost (3*4)

1 2 3 4 5

Rs.

Debt 400000 0.4 0.08 0.032

Equity 600000 0.6 0.17 0.102

1000000 1.0 0.134

Weighted Average Cost of Capital = 13.4 %

FINANCIAL DECISIONFinancial decision is the second important function to be performed by he financial manager. Broadly, he or shemust decide when, where from and how to acquire funds to meet the firm’s investments needs. The central issuebefore him or her to determine the appropriate proportion of equity and debt. The mix of debt and equity is knownas the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimumcapital structure for his or her firm. The firm’s capital structure is considered optimum when the market value ofshares is maximized.

In the absence of debt, the shareholder’s return is equal to firm’s return. The use of debt affects the return and risksof share holders. It may increase the return on equity funds, but it always increase risks as well. The change in theshareholder’s return cause by change in profits is called financial leverage. A proper balance will have to be struckbetween return and risks. When the e shareholder’s is maximized with given risks, the market value per share willbe maximized and the firm’s capital structure would be considering optimum. The financial manager is able todetermine the best combination of debt and equity, he or she must raise the appropriate amount through the bestavailable sources. In practice, a firm considers many other factors such as control, flexibility, loan covenants, legalaspects etc. in deciding its capital structure.

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Dividend Decision

Dividend decision is the third major financial decision. The financial manager must decide whether the firm shoulddistribute all profits, or retain them, distribute a portion and retain the balance. The proportion if profits distributeda dividends is called the dividend- payout ratio and the retain portion of profits is known as the as retention ratio.Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders value.

The optimum dividend policy is one that maximizes the market value of the firm’s share. Thus, if shareholders arenot indifferent to the firm’s dividend policy, the financial manager must determine the optimum dividend payoutratio. Dividends are generally paid in cash. But the firm may issue bonus shares. Bonus shares are share issued totake the existing shareholders without any charge. The financial manager should consider the questions of dividendstability, bonus shares and cash dividends in practice.

However, in the case of ULBs, there is not much importance of this function. It is because of the fact that they havenot to take any returns on the investments. In fact, they are guided by service motive whose main aim is to getmaximum welfare from the investment of the firm. For them, the real benefit lies in long life period of infrastructuralassets. They have not to distribute the surplus rather they have to reinvest it in other projects having large socialwelfare.

Liquidity Decision

Investment in current assets affects the firm’s profitability and liquidity. Current assets management that affects afirm’s liquidity is yet another important finance function. Current assets should be managed efficiently for safeguardingthe firm against the risks of illiquidity. Lack of liquidity in extreme situation can lead to the firm’s insolvency. Aconflict exists between profitability and liquidity while managing current assets .If may become illiquid and therefore,risks .But it would lose profitability ,as idle current assets would not earn anything .Thus ,a proper trade –off mustbe achieved between profitability .The profitability and liquidity trade –off requires that the financial managershould develop sound technique of managing current assets .He or she should estimate firm’s needs for currentassets and make sure that funds would be made available when needed.

The term profitability used in this context is measured by profits after expenses. The term risk is defined as theprobability that a firm will become technically when they become due for payment \.

The risk of becoming technically insolvent is measured using Net Working Capital .It is assumed that the greater theamount of net working capital ,the more liquid is the firm and therefore ,the less likely it is to become technicallyinsolvent .Conversely, lower levels of net working capital and liquidity are associated with increasing levels of risk.The relationship between liquidity, net working capital and risk is such that if either net working capital or liquidityincreases the firm’s risk decrease .

Nature of Trade –offIf an ULB wants to increase its profitability, it must also increase its risk .If it is to decrease risk it must decreaseprofitability ,The trade –off between these variables is that regardless of how the ULB increases its profitabilitythrough the manipulation of working capital the consequence is a corresponding increase in risk as measured by thelevel of net working capital.

In evaluating the profitability risk trade –off related to the level of net working capital ,three basis assumptions,which are generally true ,are :

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1. That we are dealing with a manufacturing firm;

2. That current assets are less profitable than fixed assets ; and

3. That shout term funds are less expensive than long term funds.

On sum, financial decisions directly concern the firm’s decision to acquire or dispose off assets and requirementscommitment or recommitment of funds on a continuous basis. It is in this context that finance function are said toinfluence production, marketing and other functions of the firm. Hence finance function may affect the size, growth,profitability and risks of the firm and ultimately value of the firm.

Scope of Financial managementSound financial management is the essential in all types of organizations whether it be profit or non-profit. Financialmanagement is essential in a Planned Economy as well as in capitalist set up as it involves efficient use of theresources.

From time to time it is observed that many firms have been liquidated not because their technology was obsolete orbecause their products were not in demand or their labour was not skilled and motivated, but that there was amismanagement of financial affairs. even in a boom period, when a co. make high profits there is also a fear ofliquidation because of bad financial management .

Financial management optimizes the output from the given input of funds. In a country like India where resourcesare scarce and the demand for funds are many, the need of proper financial management is required. In case ofnewly started companies with the high growth rate it is more important to have sound financial management sincefinance an alone guarantees their survival.

Financial management is very important in case of non-profit organizations, which do not pay adequate attentionsto financial management .

However a sound system of financial management has to be cultivated among bureaucrats, administrators ,engineers,educationalists and public at large.

FINANCIAL MANAGEMENT OBJECTIVES

Efficient financial management requires the existence of some objectives, which are as follows:

1. Profit Maximization-As profit oxygen for any organization. An organization cannot expect to run longwithout making profit .Profit maximization is the primary objective of an organization. While making a decision,the manager will select the solution which result in more profit and reject others. The reason behind this issimple that profit is a test of economic efficiency. It provides the yardstick by which economic performancecan be judged.

Even though, Profit maximization cannot viewed as sole objective of business. Specialy in case of publicsector. Only financial viability of a project is not enough to justify it commitment to project as it belongs to thewhole nation and evolves huge cost. So it has to be implemented in the long term interest of the nation. Profitmaximization on the cost of social benefit may prove evil for the organization.

Also, profit is vague term in itself. Its precise meaning defers from one sector to another.

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Another difficulty in considering Profit maximization as objective of financial management is that it ignores timevalue of money. A penny held in present is more valuable than a penny receivable in future because the penny heldin present can be invested in profitable ventures.

It also ignores risk factor as profit is the counter part of risk profit and risk go hand by hand. It cannot be separated.A profitable investment is risky too.

Thus, an alteration of it which can overcome these shortcomings , is required. Such an alternative is WealthMaximization.

2. Wealth Maximization –The Wealth Maximization criterion is based the concept cash flows generated bythe decisions rather than accounting profit which is the basis of the measurement of benefit in the case ofprofit maximization criterion. The worth of an action can be judge only in the terms of benefit it produces lessthe cost of undertaking it. Thus, the term used in Wealth Maximization i.e., cash flow precise term withdefinite connotation. It also incorporate the time value of money i.e., required adjustment in the cash flowpattern in order to incorporate the risk and secondly to make an allowances for differences in the timing ofbenefit .

The value of a course of action must be viewed in terms of its work to those providing the resourcesnecessary for its undertaking .In the public sector ,resources generated to various means from public .thus anundertakings which reveals greater benefit to the public in large should be accepted. The benefit of WealthMaximization is in creation of assets, basically infrastructural assets in public sector so that infrastructuralfacilities can be improved.

To conclude, in considering the wealth maximization as objective of financial management following benefitwill occur:

1. It takes account of uncertainty of risk

2. It considers the time value of money.

FINANCIAL CLOSURES

Financial Closure is the stage in the project development cycle when the principal stakeholders (sponsors,government, and lenders) reach a formal agreement on the fundamental business structure of the project and theunderlying terms and condition of the projects financing plan.

A project can not be operated solely by one of the party. It is the fruit of joint efforts of various groups. Thesegroups are associated with the project for their own interest .Their purposes may differ from each other. Butcompletion of the projects is necessary to fulfill these purposes.

Certain terms and condition are prepared to bind these parties, so that project can be carried over smoothly. Thefinal stage when all the parties of the project becomes agree as to a formal agreement shows the constituents,structures, terms and condition of reference etc. This agreement is prepared with mutual understanding

Of the parties after a number of revisions. When final draft becomes accepted by all, it is the financial closure.

Differing closure speed reflects differences in country commitment, investor experience and project size. Generallyclosure has been faster for smaller projects. in countries with prior ppp experience or strong political commitment

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.Delays have resulted from difficulties in resolving issues of risk allocation among the various participants of aproject .This has taken even longer where investors ,lenders or government officials have been inexperienced,political charges have affected government commitment and anti PPP protests were stronger than anticipated.

The efficiency of the financial closing process and the need to allocate risks among the lenders and the developers,will depend on a large part on how the developers has structured risks and in the outcome of the due diligencetaken by the lenders.

If the risks in question has a direct impact on the project viability or operating margins, the lender may imposefinancial incentives and penalties on the developer, for example if the lender believes that additional fuel sourcesmight be necessary for the long term operation of a cogeneration facility the lender might insist that all or a percentagesof a project sponsors development fee and equity distribution be placed in a reserve account until the additionalfuel sources are secured .The use of the reserve accounts to address specific risk imposes on the developersufficient incentive to resolve outstanding issues and gives protection to the lender though an ability to an ability todraw 0 the reserve to repay loans if the developer does not implement the upon solution by a certain date.

Covenants and reserve accounts offer both the lender and the developer the ability to allocate risks over time aswell as the flexibility to resolve risks after financial closing has occurred .Flexibility will often be necessary giventhe need to close a transaction before costs escalate often must be prepared to fund commencement of constructionby a date certain on face cost escalation under the construction contract .Even more crucial a project might berequired to meet a targeted date of commercial operation pursuant to the power purchase agreement or otherwiseface the consequence of an obligation to pay damages to the purchasing utility or possible termination of theagreement .

Importance of Financial Closure:

This is very significant part of the project, because it provides foundation for the commencement of the project .Itsend is start of implementation of project. Because unless and until this final agreement is made, no works will bedone as a part of the project. This stage indicates the ways in which work is being done and by whom, in whatmanner .All these are important for starting a project .Its importance is as:

1. It is here where the investment starts assuming that the disbursements of fund are met.

2. A dynamic “link “between transaction and policy evolution often starts.

3. Completed transactions on the other hand attract publicity and spur the interest or other investors andlenders.

Conversely, failure to close may send negative signals about investment climate to potential investors, if governmentdelays are the cause rather than poorly structured or uncompetitive projects proposals.

Issues in reaching Financial Closure

Being such an important task, attempt should be made to reach these stages as soon as possible .Efforts should bemade collectively from all the parties since there are various groups associated with this project, the priorities ofthem.

Achieving Financial Closure involves appraisal and negotiations to meet the requirement of three major partiesconcerned namely the government investors and lenders.

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There are several issues that can delay the projects these are;

In experience

Reaching financial closure requires good understandings of the project financial techniques, infrastructure regulationand country risks. While government officials ,investors and lender may possess expertise in one or two of thesefields, seldom does each of the party has expertise in all the three areas .Delays can result from unrealistic expectationsor the need to adapt procedures.

Government Support Arrangements

When PPP project are selling to or purchasing from state-owned companies ,which are in the best of financialhealth ,and where government reform will take time to improve credit worthiness ,financiers may ask for governmentsupport in the from of guaranties .While such guarantees can help in the starting if PPP projects. They may at thetime be politically controversial.

E.g.: Delays in determining the availability and the kind of government support have affected India‘s power programs.

Legal Frameworks

Inadequate legal infrastructure has contributed to delay in achieving financial closure in many projects.

Intra Government Co-ordination

Several projects have been be set by delays arising from poor coordinator between different part of the government,both at the central and at the local level.

Delays have tended to be longer when a regional government entity was awarded a concession but needed a policyagreement to conclude the transaction.

Size

Large projects may take longer to close because of the need for extensive public consultation, the large no. offinancers required and the complexity of co-coordinating numerous government agencies and technical studies.

Assessing the Market

This mainly affects transport projects (ports, railroads, roads, airports and mass transit) and new investments,where there is no track record of cash flows.

Lenders in particulars would be concerned whether debt services would be covered in the event of lower thanexpected volumes and traffic. They therefore may require independent market assessment, may prefer moreconservative projections than those of the sponsors and may also require some sponsor to cover the debt servicein the event of inadequate cash flow.

Tenders Security

It is often difficult for lenders to establish mortgage claim over the physical assets of a project. This may serve asamatory constraint in securing funds from lenders.

Weakness in laws relating to claim on intangible assets (such as concession agreement and other constructionarrangements) and absence of efficient registers have also created problems foot loan security.

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Apart from the above listed factors there are also certain sector specific issues:

Inter-connection rights forward & backward Linkages

Some projects get delayed because state ownered operator takes a long time to negotiate the inter connectionrights with the private entrants.

For e.g., In a power generation project this can be important particularly, where fuel is being supplied by one stateownered co. and power is being purchase by another and therefore the linkages need to be tied up before poweris generated.

Land Development Rights

This can be important factor for projects relating to roads, bridges etc.

The regularly Regime of Tariff

This has been a major in several sectors particularly in water projects, where tariff tend to below cost and adjustmenthas a high political profile, similarly negotiation on the level of road tolls have also delayed closures on some roadprojects.

Financial closure for an infrastructure projects draws the project development to a close. Therefore successfulclosure also implies that an infrastructure project has been made bankable after a rigorous project developmentprocess.

Advantages of Financial Closure

It indicates the ways in which work is being done and by whom, in what manner.

Completed transactions attract publicity and spur the interest or other investors and lenders.

It is here where the investment start assuming that the disbursement of funds are met.

Due to this a dynamic “link” between the transaction and policy evolutions often starts.

Receipt and Payments

Receipt and payment account is the Cash summary for a particular period. It starts with the opening Cash andBank Balances, shows all types of collections and payments during the period and closing Cash and Bank balances.

Some distinct features are:

It is an abbreviated copy of the Cash Book, usually merging Cash and Bank items, contras betweenCash and Bank are eliminated.

All receipts and payments, whether of a revenue or a capital nature are included.

The balance of Receipts and Payments Account must be debit, being cash in hand and at Bank, unlessthere is a Bank Overdraft.

Income and Expenditure

Income and Expenditure Account is similar to Profit & Loss A/c.

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Income includes fees, donations, subscriptions, grants etc.

Expenditure includes salaries, honorarium, entertainment, expenses, sports expenses etc.

Only items of revenue nature pertaining to the period of account are included therein.

Non Cash items e.g. depreciation etc. Is also brought into account.

The preparation of account requires adjustment in relevant accounts of outstanding income andexpenditure as also exclusion of amounts paid in advance before these are included in Income &Expenditure Account.

If Income is higher than expenditure, the excess is shown as surplus or Excess of Income overExpenditure.

If the expenditure is higher than income it is designed as deficit or Excess of Expenditure over Income.

Refund Of Specific Grant

Specific grants sometimes become refundable because certain conditions are not fulfilled. A specificgrant that becomes refundable is treated as an extraordinary item.

The amount refundable in respect of a specific grant related to revenue is applied first against anyunamortized deferred credit remaining in respect of the grant.

The amount refundable in respect of a specific grant related to a specific fixed asset is recorded byincreasing the book value of the asset or by reducing the capital reserve or the differed income balance,as appropriate by the amount refundable.

Where a grant which is in the nature of promoter’s contribution becomes refundable, in part or in full,to the government or non-fulfillment of some specified conditions, the relevant amount recoverable bythe granting agency is reduced from the capital reserve.

* Case Study attached as Annexure- II

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SUB MODULE-3.4.2

FINANCIAL MANAGEMENT

PROJECT BUDGETING

Budget generally refers to a list of all planned expenses and revenues .In other terms budget is an organizationalplan stated in monetary terms.

Objectives of Budgeting:

1 The process of budgeting is initiated with the establishments of specific targets of performance and is followedby executing plans to achieve such desired goals and from time to time comparing actual results with thetargets of performances/ goals.

2 Establishing specific targets for future operations is part of the planning function of management, while executingactions to meet the goals is the directing function of management.

APPROACH TO BUDGETING

The objective of the budgeting system of an ULB is to arrive at a scientific basis for building linkage between thenature of receipts and payments with the function/ services or other budget control centers. Budget shall reflect theprinciples and programs of the ULB. Budget must also enable ULB in measuring and promoting accountability inrespect of service delivery. Public expenditure must be spent in the most productive way. Decentralize planningwhich citizens participation facilitates in achieving this objective.

Any receipt payment shall reflect the above said objectives. To facilitates this, three broad categories of BudgetingCenters are defined. Budgets shall establish a close linkage between the Accounting subjects (nature of receiptsand payments) and

The function

The functionary as identifiable of personnel responsible for any function

The field as identifiable by the geographical boundaries over which the cost is incurred.

Budgeting Process:

Budget shall reflect the estimated inflows, outflows, surplus/deficit under the various Receipt and payment head,opening and closing balances. The receipt and payment shall classified under four broad heads revenue receipts,revenue expenditure, capital receipts and capital expenditure. The receipt and payment shall be estimated for each

of the accounting subjects under every budgeting centre. Hence a budget code is defined as a combination ofbudget centre and account code.

The budget shall be prepared for each of the revenue and capital account heads This form is to be prepared byindividual budgeting units for each of the major and minor heads of account along with the details of the functionsand functionaries functionary, major heads minor heads, are mandatory. It is advisable to have the budgets whether

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budget would be prepared at the field level like zones, circles or wards. In the term, ULBs are advice to movetowards decentralizes budgeting at the field level. In addition, if the state and ULB maintain separate fund wiseonly.

The budgets heads are hence are integrated with the account head. The accounting system can hence providedetails actual against each budget heads.

Bottom up Budgeting

The basic for preparing the budget will be the inputs from various departments/units. Budget preparation shall bebased on bottom up approach. Estimates shall be made from the lowest unit and then consolidated at the headoffice.

Budgeting Calendar

The budget preparatory process follows a budget calendar. The “budget calendar” provides various details ofdead lines dated by various officials in the ULB need to prepare and place the budget before the concernedauthorities.

The time schedule for preparation, placing and revision of the budget and budget approval by Standing Committee/Councils would be governed by the provisions of the state laws of acts governing the ULBs.

The budgeting activity for any financial year shall commence by September or any other month (as may be specifiedin the State Laws or acts governing the ULB) of the financial year preceding it. The various stages of budgetpreparation and approval should be within the time limits as stipulated in the regard by the relevant State Laws/Acts governing the ULBs.

APPROVAL OF BUDGET

The Budget is the key document of any governmental set up. The State Laws or governing Acts shall define shalldefine the approving authority for approval of the budgets of the ULBs. A budget may not be a valid documentunless it is properly approved /authorized by an approving authority. Generally in the cases of ULBs. The approvingauthority may be the Municipal Councils.

BUDGET REVISION

Once a budget has been prepared subsequent revisions to the amount budgeted may arise. The State laws or Actgoverning the ULBs may define the circumstances for revision of budgets. Some of the forms in which budgetallocations are changed are Re-appropriation, Additional Budget, reduction on Budget and Budget Cut.

Budget Utilization should be reviewed at quarterly and such other periodic rests as may be determined by State /Act to identify and plan for any budgetary revision well in advance would be in accordance with the provisions laidout in this regard by the State /Act in this regard.

BUDGETARY CONTROLS

In keeping with the objectives, the following control requirements are to be built into the budgeting system:

No expenditure can be incurred unless backed by a budget;

Any expenditure prior to being incurred must be identified to its budget head for allocation of money.

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Any expenditure prior to being incurred should be backed by appropriate sanctions (administrative /technical sanctions as the case may be) in accordance with the procedures lay down by the State /Actin this regards.

Salient Features of Budgetary ControlDetermining the objectives to be achieved, over the budget period, and the policy or policies thatmight be adopted for achievement of these ends.

Determining the variety of activities that should be undertaken for the achievement of the objectives.

Drawing up a plan or a scheme of operation in respect of each class of activity, in physical as well asmonetary terms for the full budget period and its parts.

Laying out a system of comparison of actual performance by each person, section or department withrelevant budget and determination of causes for the discrepancies, if any.

Ensuring that corrective action will be taken where the plan is not being achieved and, if that be notpossible, for the revision of the plan.

It is a system to assist management in the allocation of responsibility and authority, to provide it withaid for making, estimating and planning for the future and to facilitate the analysis of the variationbetween estimated an actual performance.

Limitations of Budgetary Control SystemBudgets may or may not be true, as they are based on estimates.

Budgets are considered as rigid document.

Budgets cannot be executed automatically.

Staff co-operation is usually not available during budgetary control exercise.

Its implementation is quite expensive.

Fund Flow Management in a Project:Information about the cash flows of a project is useful in providing users of financial statements with a basis toassess the ability of the urban local body to generate cash and cash equivalents and the need of the project to utilizethose cash flows.

The statement classifies the cash flows during the period from Operating, Investing and Financing activities.

Cash and Cash Equivalents:Cash equivalents are held for the purpose of meeting short term cash commitments rather than for investment orother purpose. For an investment to qualify as cash equivalent it must be readily convertible to known amount ofcash and be subject to an insignificant risk of changes in value.

Benefits of cash flows:A cash flow statement, when used in conjunction with the other financial statements provides information thatenables users to evaluate the changes in net assets of an urban local body, its financial structure (including itsliquidity and solvency).

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An enterprise should prepare a cash flow statement and should present it for each period for which financialstatements are presented.

Information about the cash flows of an enterprise is useful in providing users of financial statementswith a basis to assess the ability of the enterprise to generate cash & cash equivalents and the needs ofthe enterprise to utilize those cash flows.

The statement deals with the provision of information about the historical changes in cash & cashequivalents of an enterprise by means of cash flow statement which classifies cash flows during theperiod from operating, investing and financing activities.

Cash equivalents are held for the purpose of meeting short-term cash commitments rather than forinvestment or other purposes.

For an investment to qualify as a cash equivalent, it must be readily convertible to a know amount ofcash and be subject to an insignificant risk of changes in value.

An investment normally qualifies as a cash equivalent only when it has a short maturity of, say, 3months or less from the date of acquisition.

Cash flows exclude movements between items that constitute cash or cash equivalents because thesecomponents are part of cash management of an enterprise rather than part of its operating, investingand financing activities.

Cash management includes the investment of excess cash in cash equivalents.

PROJECT’S CASH FLOW STATEMENT

1. Operating Activities: The amount of cash flows arising from operating activities is a key indicator of theextent to which the operations of the enterprise have generated sufficient cash flow to maintain the operatingcapability of the enterprise, repay loans and make new investments without recourse to external sources offinancing. Cash flows from operating activities are primarily derived from the principal revenue-producingactivities of the enterprise. Therefore they generally results from the transactions and other events that enterinto the determination of net profit or loss.

2. Investing Activities: The separate disclosure of cash flows arising from investing activities is importantbecause the cash flows represent the extent to which the expenditures have been made for resources intendedto generate future income and cash flows. (Procurement of raw material, construction tools/ plants etc.)

3. Financing Activities: The separate disclosure of cash flows arising from financing activities is importantbecause it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings)to the ULB’s. (Mobilization advance, advance payments against railway receipts for material used inconstruction)

Reporting Cash Flows from Financing and Investing Activities

An ULB should report separately major classes of gross cash receipts and gross cash payments arising frominvesting and financing activities, except to the extend that cash flows are reported on a net basis

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Reporting Cash Flows on a Net Basis

Cash flows arising from the following operating, investing or financing activities may be reported on a net basis:

a Cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customerrather than those of the enterprise; and

b Cash receipts and payments of items in which the turnover is quick, the amounts are large, and the maturitiesare short.

MONITORING AND MANAGING LEAKAGES, COST OVER-RUN.

Monitoring and Managing Leakages

After implementation of a project, its monitoring is also necessary unless a regular watch on the project is made ittimely a regular watch on the project is uncertain. To remove avoidable delay, an eye-sight of the project workshould be made on a regular basis so that any deviation can be found from its inception point. Detection of defectat its earlier stage helps in maintaining quality as well as quantity of work of a project. Daily, weekly And monthlyreport helps to monitor the outcome of the project. These help us to detect the errors as and when they occur sothat corrective measures can be taken timely. However for this purpose, a standard of work done has to beprepared against which actual work can be measured. These standards must be sets with a high degree ofcautious because a minor degree of defect may impact overall cost of the project.

The evaluation of work done against these standards reveals the deviations, which should be removed intime. Timely detection of deviations helps in taking timely corrective measures. Thus, it avoids not only delay incompletion but also the cost incurred in the project. It provides benefit in order of time as well as money.

Evaluation of work done can be made through completion certificate and utilization certificates, submitted by therework manager. These certificates state the amount of the work done as well as the amount of the resourcesreleased on the work. Thus, a project manager can make the estimates about the time and resources required tocomplete the remaining work. This estimate helps the project manager to make a management for additionalresources, in advance, so that, that the project work may not be hurdled.

Cost Overrun

Defined as access of actual cost over budget. Cost Overrun is also sometimes called “ cost escalation,” “costincrease, “or “budget overrun.”

Cost Overrun is common in infrastructure, building, and technology projects. One of the most comprehensivestudies of Cost Overrun that exists found that 9 out of 10 projects had overrun, 50 to 100 % were common,overrun was found in each of 20 nations and five continents covered by the study, and overrun had been constantfor the 70 years for which the data were available.

Spectacular examples of Cost Overrun are the Suez Canal with 1900 %, the Sydney Opera House with 1400%,and the Concorde supersonic aero plane with 1100%.

Three types of explanation of Cost Overrun exist:1. Technical explanations account for Cost Overrun in terms of imperfect forecasting techniques, inadequate

data, etc.

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2. Psychological explanations account for overrun in terms of optimism bias with forecasters.

3. Finally, political economic explanations see overrun as the result of strategic misrepresentation of budgets.

Cost Overrun is typically calculated in one of the two ways.

Either as a percentage, mainly actual cost minus budgeted cost, in percent of budgeted cost.

Or as a ratio, viz. actual cost divided by budgeted cost.

For example, if the budget for building a new bridge was Rs.100 million and the actual cost was Rs.150 million thenthe Cost Overrun may be expressed as 50% or by the ratio 1.5.

Types of Variances:

1. Controllable: These are the variances which can be controlled by the departmental heads.

Example: If the production controller has failed to place orders in time and extra payment has been madefor it.

2. Un-controllable: These are the variances which are beyond the control of departmental heads.

Example: Price increase is due to fluctuations of prices in the market.

Types Of Variances

Material

Labour

Overhead

Material

Material Usage Variance arises due to variations in the quantity of materials consumed when compared withwhat should have been consumed as per the established standards.

Material Price Variance arises due to differences between the planned and the actual material prices paid to thesuppliers.

Mix Variance: If two or more materials are mixed in a process, an optimum or standard mixture is decided uponby the production planning department.If actual mix is different from the standard mix , a variance arises.

Yield Variance : In some industries the finished product can be related to the raw material input in terms ofunits,weight,volume etc. and consequently the standard loss of material can be readily computed. This relationshipis known as the yield .When the standard yield is given and the actual consumption deviates from standardconsumption, the difference is known as yield variance.

LabourLabour efficiency variance measures the efficiency of labour by identifying the difference between the actualhours worked and the hours which should have been worked as per the established standards.

Labour Rate Variance measures the deviations in the actual rate of pay and the ones estimated.

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Overhead

Overhead variances arise due to the difference between actual overheads and absorbed overheads. They can bebroadly classified into:

Variable Overhead Variances: These variances arise due to the difference between the standard variableoverhead for actual output and the actual variable overhead. If the standard variable overhead exceeds the actualvariable overhead, the variance is favorable and vice versa. They can be further classified into:

Variable Overhead Budget or Expenditure

Variance

Variable Overhead Efficiency Variance

Fixed Overhead Variances :

It can be divided into two parts

1. Expenditure Variance

It represents the difference between the fixed overheads as per budget and the actual fixed overheads incurred.

2. Volume Variance

It arises mainly because of the use of pre-determined overhead recovery rate based on a normal volume of activityand of the activity being less or more than normal volume so selected

BUDGET VARIANCE REPORT (BVR)

An important budgetary control tool used for monitoring and measurement is Budget variance report (BVR) andshall be prepared at the following levels:

At an overall ULB level;

At each of the Budgeting centers.

The BVR forms the bases of control as it can provide information on:

a. Positive variance shall be analyzed for reasons. For instance actual tax collection is more than the projectedsay in ward or a Zone .The reasons for the same can be analyzed and replicated.

b. Negative variance, shall be analyzed for reasons. For and cost control measures identified .For instance theincrease in maintenance expenses or finance charges could indicate lack of planning or implementationfollow-up .

The BVR should be prepared on a monthly basis or such periods as the State laws/Acts governing the ULB maydefine .Review mechanisms for disposing of the unfavorable variances would add value to the Management ofULB. We can understand all these budgeting process by taking a fiduciary illustration –for preparing budget

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estimates of any financial Year data have to collect from the lowest unit of ULB. A detailed estimate of revenuelikely to be collected from differences sources such as tax, rent etc; is collected ward wise .Similarly amount forexpenditure is also collected .In all these process, a time schedule is also made for completion of different aspectsof Budge. Within the stipulated time schedule all units are required to submit their estimations. This informationcollected from different Zones is consolidated at Head Office for ultimate preparation of Budget.

WORK COMPLETION AND PAYMENT CERTIFICATES

All the projects have a Work completion certificates & payment certificates as an essential part of it. Thesecertificates help the project manager to identify the progress of work. It reveals the stage of completion of the workon the basis of which the payments to the contractors has to made. Thus a completion certificates is not importantonly for the project manager but is equally useful for the contactor. When payment is made payment certificates ismade to provide an authenticated proof of the payment made. Depending upon the terms & conditions both thecertificates must be issued but a designated authority.

PROJECT COMPLETION REPORT

1) Name of the project:

2) Name of the project head:

3) Implementing agency and other collaborating agency:

4) Date of commencement:

5) Planned date of Completion:

6) Actual date of completion:

7) Objectives as stated in the project proposal:

8) Deviation made from original objectives if any, while implementing projects and reasons thereof:

9) Experimental work giving full details of experimental set up, methods adopted, data collected supportedby necessary table, charts, diagrams, design & photographs:

10) Detailed analysis of results indicating contributions made towards successful completion of theproject:

11) Conclusions summarizing the achievements and indication of scope for future work:

12) S & T benefits accrued:

13) Manpower trained on the project

14) Patents taken, if any

15) Financial Position:

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No. Financial position/ budget head Funds sanctioned Expenditures % of total cost

I Salaries/ Manpower costs

II Equipments

III Supplies & materials

IV Contingencies

V Travel

VI Overhead expenses

VII Others if any

Total 100%

1. Procurement/ usage of Equipment

a)

S no. Name of Make/ Cost Cite of Utilization Remarks regardingEquipment model (FE/Rs) installation Rate (%) maintenance/

breakdown

b) Plans for utilizing the equipment facilities in future

Name and Signature with Date

a. ______________________

(Projects head)

b. ______________________

(Project Engineer)

Work Certified

In large contracts it is usual for the contractor to obtain sums time to time from the contractee. As the workproceeds, the surveyor appointed by the contractee issues certificates to the effect that to so much portion hasbeen completed .The contractor will get money according to this certificate.

Mathematically:

Cost of Work Certified=Cost of work to date – (Cost of work uncertified+ Material in hand + Plant at site)

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Work Uncertified

It represents the cost of the work which has been carried out by the contractor but not has been certified by thecontratee’s architect .It is always shown at cost price. The cost of work uncertified may be ascertained as follows:

Rs.

Total costs to date ____

LESS: Costs of work certified _____

Material in hand. _____

Plant in site. _____ ____

Cost of work uncertified.

* Format of Utilization Certificate attached as Annexure - III)

Retention Money & Progress Payments

Retention are amounts of progress billings which are not paid until the satisfaction of conditions specified inthe contract for the payment of such amounts or until defects have been rectified.

Contractee retains some amount (say 10% to 20%) to be paid, after some time when it is ensured that thereis no fault in the work carried out by the contractor.

Retention money provides a safeguard against the risk due to faulty workmanship.

Progress billings are amount billed for work performed on a contract whether or not they have been paid bythe customer.

Work-In –Progress

In contract accounts, the value of the work –in-progress consists of:

The cost of work completed both certified and uncertified

The cost of work not yet completed ; and

The amount of profit taken as credit.

Determination of Stage of Completion

The enterprise can uses the method that measures reliably the work performed depending on the nature of thecontract:

Surveys or work performed.

Completion of a physical proportion of the contract work.

The proportion that contract costs incurred for work performed upto the reporting date bear to estimatedtotal contract costs.

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Disclosure

An enterprise should disclose the following for contracts in progress at the reporting date:

The aggregate amount of costs incurred and recognized profits (less unrecognized losses) upto the reportingdate;

The amount of advances received ; and

The amount of retentions.

PROJECT ACCOUNTING

Project accounting (sometimes referred to as job cost accounting) is the practice of creating financial reportsspecifically designed to track the financial progress of projects, which can then be used by the managers to aidproject management.

Standard accounting is primarily aimed at monitoring financial progress of organizational elements (geographical orfunctional departments, divisions and the enterprise as a whole) over defined time periods (typically weeks, months,quarters and years)

Projects differ in that they frequently cross organizational boundaries, may last for anything from a few days orweeks to a number of years, during which time budgets may also be revised many times. They may also be one ofa number of projects that make up a larger overall project or program.

Consequently ,in a project management environment costs (both direct and overhead) and revenues are alsoallocated to projects, which may be sub-divided into a work break down structure, and grouped together intoproject hierarchies. Project accounting permits reporting at any such level that has been defined, and often allowscomparison with historical as well as current budgets.

Project accounting is commonly used at Government Contractors, where the ability to account for costs by contracts(and sometimes contract lying item, or CLIN) is usually a requirement for interim payments.

Percentage of completion is frequently independently assessed by a project manager. Funding advances and actualto budget costs variances are calculated using the project budget adjusted to % of completion.

Where labour costs are a significant portion of overall cost project, it is usually necessary for employees to fill outa time sheet in order to generate the data to allocate the project costs.

The capital budget processes of corporations and governments are chiefly concerned with major investment projectsthat typically have upfront costs and other longer term benefits. Investments go/ no –go decisions are largely basedon Net Present Value (NPV) assessments. Project accounting of the costs and benefits can provide cruciallyimportant feed back on the quality of these important decisions.

An interesting specialized form of project accounting is production accounting, which tracks the costs of individualmovie and television episode film production costs. A movie studio will employ production accounting to track thecosts of its many separate projects.

A real estimate of project can be made only when proper accounts maintained for the work done. To maintainaccounts for a project is a different aspect as a project is not a going concern and has a limited period. We have to

RCUES, LUCKNOW 237


make closing of accounts at the vary point the project is completed.

Accounts should be maintained project vise so that the financial result of each project can be found separately.Accounting principles and policies can be taken into consideration for its preparation. Besides following accountingconvention should be considered:

Convention of consistency

Convention of full disclosure

Convention of conservatism and prudence

Convention of materiality

Projects may be of two types

Cost plus project is a project in which the value of project is ascertained by adding a certain percentage ofprofit over the total cost of the work. It is generally adopted in those cases where the probable cost ofproject cannot be completed in advance with a project cannot be completed in advance with a reasonabledegree of certainty. The government prefers to give project on costs plus basis

Fixed Price Project: It is rather a project in which the projector agrees a fixed price for the project.

The accounting methods for maintenance of accounts are generally of two types:

Percentage of Completion Method:-Under this method revenue is recognised with reference to stage ofcompletion of the project at the end of each period and expenditure as well.

Completed Contract Method: - under this method, revenue is recognised only when the contract iscompleted. Thus it reduces the risk of recognition of unrealized profit.

A comparative evaluation may be made of both methods and suitable method may be selected accordingly.

The project manager may use both methods simultaneously for different projects depending circumstances. Whilemaking estimates of total project costs, its revenues indicate a loss, provision is made for entire loss on the projectirrespective of the stage of completion of project. An escalation clause should also propose in respect of contingentlosses uncertainties.

Whatever method is selected, the main objective of preparing accounts for the project is to know its Profit or Lossi.e. difference between the project revenue and project costs.

Project Revenue

It should comprise:

The initial amount of revenue agreed in the contract and

Variation in contract work, claims and incentive payments.

To the extend that it is probable that they will result in revenue, and they are capable of being reliably measured fora change in the scope of work to be performed under the contract. This may lead to an increase or decrease incontract revenue.

238 RCUES, LUCKNOW


A claim is an amount that contract seeks to collect as reimbursement for costs not included in contract price fromany party. A claim may be arising from, for example errors in specification or design and disputed variation incontract work.

Incentive payable is additional amount payable to the project developer specified performance standards are metor exceeded.

Contract CostsContract costs should compromise:

Costs that relate directly to a specific contract ;

Costs specifically chargeable to the customer under the terms of contractCosts that are attributable to contract activity in general and can be allocated to the contract; and

Costs Directly Related To a Specific ContractSite labour costs, including site supervision;

Costs of material used in construction.Depreciation of plant and equipment used on the contract.

Costs of moving plant, equipment and materials to and from the contract site.

Costs of hiring plant and equipment.Costs of design and technical assistance that is directly related to the contract.

The estimated costs of rectification and guarantee work, including expected warranty costs; andClaims from third parties.

Costs Attributable to Contract Activity In General and can be allocated to specific contracts include:InsuranceCosts of design and technical assistance that is not directly related to a specific contract and Constructionoverheads.Costs that are specifically chargeable to the customer under the terms of the contract may include somegeneral administration costs and development costs for which reimbursement is specified in the terms of thecontract.Costs That Can Not Be Allocated and Attributed to a Contract activity or cannot be allocated to a contractare excluded from the costs of a construction contract. Such costs include:

General administration costs for which reimbursement is not specified in the contract;Selling costs,Research and development costs for which reimbursement is not specified in the contract; andDepreciation of idle plant and equipment that is not used on a particular contract.Contract costs include the costs attributable to a contract for the period from the date of securing thecontract to the final completion of the contract. However, costs that relate directly to a contract andwhich are incurred in securing the contract are also included as a part of the contract costs.

RCUES, LUCKNOW 239


Auditing is a specialized function having complex legal economic and ethical implications. The auditors examineand report on economic information relating to organizations in which millions of people have a stake.

With proper accounting projects, its auditing is equally necessary as auditing reveals the financial frauds and errors.Audit has been conceived to provide a highly useful technical service to the economy to know performances infinancial and other appropriate terms in a reliable manner.

The project carried by Government should be audited periodically in order to check the efficiency status of thework .As these projects are large enough and huge amount is invested in it, it is necessary to keep check on it.Audit is a mean to find out frauds and errors and indicate the way in which corrective actions have to be taken inadvance so as to avoid re-occurrence of such frauds.

The audit work should be planned properly in advance .The basic elements of auditing are:

Collection of evidences

Evaluation of Audit Evidence

Formation of judgment

Collection of Evidence

Evidence includes all influences of an auditor, which affect his judgment about the truthfulness of propositionssummated to him for review .Basically auditing is concerned with the verification and examination of quantitativeinformation. In this process, an auditor collects and evaluates evidences to establish facts and to draw conclusionsand inferences.

1. Physical Verification

Direct examination, inspection or counting is a strong evidence of the existence of tangible assets. For example, ifan auditor counts the cash in hand on a surprise visit, it would constitute a good evidence to sup[port the existenceof cash .however there are following limitations:

Such evidences can not be used for each type of checking.

It does not prove ownership of assets since mere existence is not indication of ownership.

2. Statement by independent third parties

An auditor can have strong evidence if an independent party makes a written or oral statement in support of certainfacts, provided that the party is competent to make such a statement. Sundry creditors, bills receivables, balancewith banks can be verified by obtaining written statements from competent parties. Statement s by independent &competent parties provides highly evidence to the auditor.

3. Authorities documents

These constitutes the main source of evidence available to man auditor. Authoritative documents include purchaseinvoices, cancelled cheques , cash- memos, and all other documents which are created as various transactions takeplace.

240 RCUES, LUCKNOW


4. Statement by officers and employees of the enterprises under audit

In the absence of auspicious circumstances, an auditor can rely to some extent, on the statement by officers andemployees of the enterprise under audit. This evidence is not as the statements made by independent parties.Yet,inmany cases it may be quite useful since some explanations and affirmations can be provided only by the officersand employees of the enterprise under the audit.

5. Calculation by the auditor

The assertions regarding mathematical accuracy can be supported best by recalculation of amounts by the auditor.

6. Satisfactory internal control system

By evaluating the internal control system an auditor can determine the degree of reliance that he can place on thevarious system and procedures. A satisfactory internal control system provides assurance to the auditor that therecords are reliable. Consequently, the reliability of the data generated but such records increases.

7. Subsequent actions by the enterprise under audit and others

An auditor can find evidence for a no. of assertions in certain actions and events taking place after the balance sheetdate .The Subsequent realization of sundry debtors is evidence regarding the reliability of such debtors on theBalance sheet date .Such events and action gives the auditors the advantages of hindsight.

8. Subsidiary or Detailed Records with no significant Indications of Irregularity

Subsidiary or detailed records such as stores ledger, finished stock ledger, etc., maintained properly and withoutany prima facie indications of irregularity, provide supporting evidence to the auditor that the main data supportedby such records are reliable.

9. Interrelationship with other data

Often, accounting data can be interrelated with other data .For example ,the production records show the quantityof raw material consumed .By valuing it at average cost ,this quantity can be roughly to the total cost of rawmaterial consumed as shown in the accounting statements.

Evaluation of raw audit Evidence

Having collected the evidence ,the auditor should evaluate it critically with regard to its sufficiency and appropriateness.Sufficiency refers to the quantum of audit evidence obtained .Appropriateness relates to its relevance and reliability.An auditor has to use evidence to support events which have happened primarily in the past .Most of these eventsare not accessible to observation .Only inference can be drawn about them from testimony and intuition .Hence, anauditor should question and evaluation the evidence carefully.

Formation of Judgment:The last phase is to from an opinion on the various assertions, on the basis of valid evidence collected by theauditor. For this purposes he should find evidence which assures a reasonable and competent man that the accountingdata under report fairly represent the reality as for as it can be determined.

For proper control over the work ,internal control system should also be developed by the project promoter

RCUES, LUCKNOW 241


because it has a great effect on the work of audit as, it determine the checkpoints where loopholes can be expectedas well as the procedures which should be carried to conduct audit.

Internal controls can be applied by two methods

1. Internal checks

2. Internal Audit

1. Internal checks

Internal checks are operated when the work is divided among employees so that work done by one is automaticallychecked by others. The employees should also be rotated period wise.

2. Internal Audit

When the work of audit is got carried by the management itself ,it is known as internal audit .As the volume of workis increasing ,it is not possible for an auditor to check each and every aspect .In such situation internal auditor helpsa lot as on auditors now can concentrate only on the point reported in the internal auditors report .Considering thelarge size of the operation and multiplicity of spending units, management oversight will be strengthened by internalaudit reports .The Internal auditor will assess the operation of the project financial management system and willreview internal control mechanism. Issues arising in the external and internal audits would need to be promptlyaddressed and acted upon in a timely manner by the project authorities.

Audit DevelopmentsRecent Corporate accounting and financial scandals have led to sweeping regulatory changes –and dramaticallyincreases audit requirements. Whether the auditors are an outside auditors or part of the Internal Audit Team ,hisaudit process should be under intense security.

To be effective, the project plan must include detailed tasks, roles and responsibility and critical dependencies aswell as draw attention to check point meeting and critical target dates.

Specially designed audit templates for projectsThe objective of this template is to identify & correlate the activities required for an audit preparation process.

The templates are observed on a Phased methodology which uses phase completion mile stone as a mechanism forreporting.

The template is organized into following phase’s methodology which uses phase completion mile stone as a mechanismfor reporting. (Milestone; A reference point making a major event in a project and used to monitor the projectprogresses. Any task with zero duration is automatically displayed as a mile stone. The auditor can also mark anytask of any duration as a milestone.)

The template is organized into following phases.

Phase 1 Identification of AUDIT firm Related Matters, Auditing Process, Schedules and Fees

Phase 2 Pre audit view by Management, Internal Staff and Audit Firm

Phase 3 Implementation of Pre Audit Preview

Phase 4 Final Audit Performances

242 RCUES, LUCKNOW


Accrual Based Double Entry Accounting System

Statutory Mandate For Accrual Based Double Entry Accounting System :-

In the year 2001, in response to a writ petition before it, a Bench of the Hon’ble Supreme Court of Indiaordered that the Municipal Corporation of Delhi and the New Municipal Corporation “will be required tomaintain accounts as per the mercantile system of accounting”. The Hon’ble Court also stated thatnecessary amendments to the regulations be carried out by the Government of India.

For this purpose a Task Force was constituted by Comptroller and Auditor General of India (CAG) torecommend budget and accounting formats for Urban Local Bodies (ULBs) in India. The CAG Task Forcehad issued a ‘Report on Accounting and Budget Formats for ULBs’.

Following recommendations were made by the Task Force:

The ULBs should uniformly follow the suggested formats for presentation of annual financial statements.

Budget formats with codification need to be adopted uniformly by all ULBs.

Suggested formats for determining the cost of important utilities and services like Water Supply, PrimarySchools & Hospitals, etc. be adopted by all the ULBs and presented as supplementary information.

Significant accounting principles to be followed by the ULBs shall be given as a separate schedule formingpart of the accounts.

Double entry Accounting System:

A systematic record of the daily event of a entity leading to presentation of a complete & true financial pictures isknown as accounting.

A transaction may be defined as the actions and reactions having monetary implications of one person to anotherperson. A transaction involves transfer of money or money’s worth (Goods or services) from one person toanother.

There are two system for recording transaction

Single entry Accounting System

Under single entry accounting system some transactions are not recorded at all, while some transactions arerecorded in only one of their aspects-either debit aspect or credit aspect.

Double entry Accounting System

Double entry Accounting system recognizes the fundamental fact that a transaction is double sided affairs that isboth the debit and credit aspects of the transaction is recorded.

Accrual System of Accounting

Accrual System of Accounting means a method of recording financial transactions based on accrual, i.e., onoccurrence of claims and obligation in respect of incomes or expenditures, assets or liabilities based on happening

RCUES, LUCKNOW 243


of any event, passage of time, rendering of services, fulfillment (partially or fully) of contracts, diminution invalues(depreciation), etc., even though actual receipts or payments of money may not have taken place.

Lets Take An Example:

A ULB prepares its annual accounts for the period 1st April to 31st March. On 31st March 2007 when books ofaccounts are being closed, it is found that rent for the month of March’07 Rs.5,00,000/- has not been paid andproperty tax amounting Rs.2,60,000/- for the period Jan. to Mar.’07,has not been received.

Now if the Expenses of Rent and Income from property tax for the current year 2006-07 are not recordedin books of accounts, the statements of Income & Expenditure for 2006-07 will not give the correct positionof profit/loss or surplus/deficit.

Therefore, an entry for both transactions has to be recorded on the accrual basis by creating liability for rentand receivable for property tax.

BENEFITS OF ACCRUAL SYSTEM OF ACCOUNTING

1. Revenue is recognized as it is earned and thus “Income” constitutes both revenue received and receivable.

2. Expenditure is recognised as and when the liability for payment arises and thus it constitutes both amountpaid & payable.

3. Expenses are matched with the income earned in the financial year.

4. A distinct difference is maintained between items of revenue nature and capital nature . This helps in correctpresentation of financial statement , viz , the Receipt & Payment Account, the Income and Expenditurestatement and the Balance Sheet.

5. The surplus or deficit as shown at the year end represents the correct Financial position of the ULB arisingout of the various transaction during the year.

6. It presents a true picture of the financial position of an ULB and helps in better financial management.

7. Ease in financial appraisals by the financial institutions. It also facilitates credit rating through approved creditrating agencies, which is a pre-requisite for mobilizing funds in the financial markets through debts instru-ments.

8. It facilitates proper financial analysis and reporting.

9. It helps in providing timely, right quality and nature of information for planning, decision making and controlat each level of management.

10. It assists in effective follow up of the receivables by the municipal body and proper ascertainment of payablesby the municipal bodies.

* For Case Study on DEAS refer annexure-4

244 RCUES, LUCKNOW


ANNEXURE - 1

City

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ANNEXURE - 2

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Source (Financing Municipal Services – Reaching out to Capital Markets)

246 RCUES, LUCKNOW


ANNEXURE-2Case Study: Rajasthan

Privatization of Street Light MaintenanceJaipur Municipal CorporationFor improving the level of illumination in the city, Jaipur Municipal Corporation decided to privatize the mainte-nance of street lights. The initiative in its first phase was experimented in six municipal wards only. As a result ofprivatization the municipal corporation is now able to provide a better level of service using less of its internalresources.Situation before the InitiativeThe area of Jaipur Municipal Corporation encompasses around 46,000 acres and to illuminate this, it has around62,014 tube lights and around 28,016 sodium lights. In case of a complaint, a driver with one vehicle and twohelpers, and a lineman would visit the fault point, diagnose the fault and then report to the junior engineer. The juniorengineer would in turn report this fault to the store keeper for the particulars of the material required for carrying outthe repairs. The Store keeper would issue the material to the lineman who would then go to the fault point and carryout the repairs.The whole process was too lengthy and cumbersome. The cost of maintenance, including cost of material andestablishment, of one tube light per year was more than Rs 80. The efficiency level was 70 to 75 per cent in themaintenance of the tube lights. The corporation procured material worth almost Rs 150 lakh annually.Description of the InitiativeThe Jaipur Municipal Corporation decided to privatize maintenance of street lights and issue contracts ward wise.In the first phase of the project, only 6 out of the 70 wards were given on contract. The contract includes materials,labour and other services like transport, etc. Payment by the corporation is based on the maintenance of each tubelight.Results AchievedThe results of the privatization are overwhelming. The efficiency level in the maintenance of the tube lights andsodium lights has increased from 70 to 99 per cent, while expenditure has reduced by more than 50 percent.After the success of the pilot testing in the first phase, further privatization of maintenance of street lights wasundertaken in phases and till date 52 wards have been privatized and given on contract. There are around 9 controlrooms spread all over the city for redressal of complaints regarding thestreet lights. Twenty contractors are in-volved in maintaining the street lights. The initiative of privatizing the maintenance of street lights has remarkablyincreased the efficiency. Taking these efforts ahead, a street light policy is also under formulation for other cities ofRajasthan State. Further to the privatization initiatives of the maintenance of street lights, the corporation hasintroduced solar timers in the city to bring about energy efficiency and cost savings. A total of 706 street light timershave been installed. These timers have been set according to the time of sunrise and sunset. The maintenance ofthese solar timers has also been given on contract.Lessons Learned

Privatization of maintenance of street lights has reduced operation costs.An efficient complaint redressal system can impart 100 per cent efficiency to the system.Significant energy saving can be achieved by implanting timers and through timely switching on/off of thesame.

RCUES, LUCKNOW 247


Modern Carcass Utilization Plant & Slaughter HouseJaipur Municipal CorporationSchedule XII of the 74 Constitution Amendment Act states that provision of slaughter houses is one of the manda-tory functions of any urban local body. However, since many cities do not have a proper facility with moderntechnology for the purpose, illegal slaughtering is widely rampant in cities. Rajasthan is famous for its leatherproducts. The provision of a modern carcass plant that provides a clean environment to the workers and which isnot a nuisance to the nearby area is a good initiative.Situation before the InitiativeBefore the commissioning of the carcass plant, Jaipur Municipal Corporation had contracted the lifting of car-casses from all parts of the city to a private contractor. For this the Corporation was taking a leasing amount ofabout Rs 50,000 to Rs 1 lakh per year Despite several measures, illegal slaughtering of animals was widelyrampant. On an average, about 40 carcasses are lifted from the city per day. Even though the process wascontracted to a private party, the contractor did not have a proper place to de-skin the could lead to serious healthand environment hazards. The carcasses emanated a foul smell; they were also being attacked by other animals. Allthis added to their nuisance value.Description of the InitiativeA carcass utilization plant costing Rs 2.33 crore has been set up at Chainpur, 17 kms from Jaipur, to solve theproblem of disposal of dead animals. Of the total budget the State Agricultural Department provided financialsupport of Rs 148 lakh and the remaining Rs 85 lakh was funded by the Jaipur Municipal Corporation. The planthas been operational since 2000. A contractor has been appointed for processing and maintenance of the carcassplant. The contractor gives the leasing amount to the Jaipur Municipal Corporation. Jaipur city has 8 points fromwhere a request for lifting of any carcass lying in public places can be lodged. For lifting the carcasses the JaipurMunicipal Corporation has provided the contractor with 3 vehicles, covering the 6 zones in the city, and eachvehicle has about 10 persons. After the carcasses are collected from different parts of the city, their skin is removedand after cleaning, they are put for sale. The sale proceeds are kept by the contractor. The remaining carcass isthen crushed and reduced to a dry powder form. During this process, the fat of the dead animal is sold for themanufacture of soaps and detergents. The dry powder is used as feed in poultry farms, etc. The money from thesale of the fat and the dry powder also goes to the contractor. The contractor is required to lift the carcass within12 hours, failing which he is charged a fine of Rs 1,000 per day. Regular inspection of the carcass plant is carriedout by the health department of the corporation.Results AchievedThe city has benefited as it now has a clean environment, free from foul smell. For Jaipur Municipal Corporation,after the recovery of the initial investment in the commissioning of the plant, this initiative would in future be one ofthe sources of revenue generation, as the contract will be renewed every year. (The lease amount of the carcassplant which was Rs 5 lakh till 2002, has been increased to Rs 1,105,786 per year in 2003)

Lessons Learned

Commissioning of a proper plant with modern technology can give the city a clean environment.

(Source: Urban Finance, Quarterly Newsletter, of the National Institute of Urban Affairs, Vol. 8No. 2, April-june 2005)

248 RCUES, LUCKNOW


ANNEXURE - 3

Utilization CertificateThis certificate provides the necessary information regarding the utilization of the resources received for the pur-pose of the project. Thus it helps in making estimates of additional resources to be utilized in the project and timelyarrangement of those of those. It should be issued on the following format:

FORMAT OF UTILISATION CERTIFICATION

Utilization Certificate

(For the financial year ending 31st March….)

(Rs. In lakh)

1. Title of the project/scheme :

2. Name of the Organization :

3. Project Head :

4. Sanction order No. &date of sanctioning the project :

5. Amount brought forward from theprevious financial year quotingletter No. & date in whichauthority to carry forward the saidamount was given :

6. Amount received from duringthe financial year(Please give No. and dates of sanctionorders showing the amounts paid). :

7. Other receipts /interest earned ,if any, on the grants :

8. Total amount that was available forexpenditure during the financialyear( Sl. nos. 5,6,7) :

9. Actual expenditure( excludingcommitments) incurred during thefinancial year.(Statement of expenditure enclosed) :

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10. Unspent balance refunded,if any(Please give details ofCheque No. etc.) :

11. Balance amount available atthe end of the financial year :

12. Amount allowed to be carriedforward to the next financialyear vide letter No. & Date :

Certified that the amount of Rs. ………mentioned against col.9 has been utilized on the project /scheme for thepurpose for which it was sanctioned and the balance of Rs……….remaining unutilized at the end the year has beensurrendered to Govt.(Vide No……………….dated ……………………)/will be adjusted towards –in-aidpayable during ………………… the………………………..next ………………. year.

Certified that I have satisfied myself that the condition on which the grants-in –aid was sanctioned have been dulyfulfilled /are being fulfilled and that I have exercised the following checks to see that the money was actually utilizedfor the purpose for which it was sanctioned.

Kind of checks exercised:

1.

2.

3.

4.

5.

(PROJECT HEAD) ( FINANCE OFFICER)

250 RCUES, LUCKNOW


ANNEXURE-4

CASE STUDY

Implementation of Accrual Based Double Entry Accounting System at Nagar NigamMeerut under GOI-UNDP Project, “Capacity development for decentralised

Urban Governance”.

Situation Before the Initiative

Before applying Accrual Based Double Entry Accounting System in Nagar Nigam Meerut the Accounting wasfollowed on Single Entry System.

There was a problem of performance monitoring on better and more efficient utilization of resources because itwould be difficult to know to whom money is owing and who owes money. Generally , no impersonal accountsrelating to assets, expenses, gains etc., are kept. It is not possible to know what the total payments or receipts are.Completeness of records as is possible under Accrual Based Double Entry System was absent. Hence the singleentry system was subject to the following defects:-

I. No trail Balance can be prepared and hence, arithmetic accuracy of books can not be proved.

II. In the absence of real and nominal accounts the Receipts & Payments Account, Income & ExpenditureAccount and the Balance Sheet cannot be prepared.

III. Any information obtained under single entry system was not free from doubt.

IV. In single entry system it was a difficult task to fix the proper value of assets.

Description of the Initiative

Meerut Nagar Nigam was selected under GOI-UNDP project, “Capacity Development for Decentralized UrbanGovernance.” For the implementation of this project a Financial Consultant was appointed.

Steps In Implementation

Identification & Analysis of Functions:

The Nagar Nigam Meerut is divided into three Zones namely Mukhyalaya zone, Kankar Khera zone and Shastrinagar zone consisting seventy wards along with three dispensaries and one school.

Different functions and functionaries (responsibility centers/ department ) where identified and analyzed.

Preparation of Opening Balance Sheet:

A cut off date (Ist April 2006) was fixed for preparation of opening Balance Sheet.

Mapping of Fixed Assets:

Information regarding the Fixed Assets have been ascertained on the basis of information in the Twenty NineForms provided in the National Municipal Accounting Manual. These forms contains the detailed information withregards to the specific assets, for e.g., description of the assets, where it is located, dimensions of the assets, costof construction /acquisition by the ULB, date of acquisition etc.,

RCUES, LUCKNOW 251


Installation of Hardware and Software:

A proper space was provided by the Nagar Nigam officials, where six computer peripherals were installed onLocal Area Network Facility. One of the computer system of the accounts department was connected with LAN.Tally 9.0 (multiuser) was installed. A specific software for implementation of accrual based Double Entry Account-ing System is being prepared by CMC limited. Discussions were held with the officials of CMC limited and it wasclarified that the data feeded on Tally 9.0 will be compatible with the software being prepared by the CMC limited.

Punching of Data

Feeding of entry for the financial year 2006-07 on accrual based Double Entry Accounting System wasstarted.

Feeding of demand and collection register was started to determine the true position of property tax receiva-bles as well as water tax receivables.

Nagar Nigam Meerut has seventeen Bank Accounts which were not reconciled and hence preparation ofBank Reconciliation statement of all these bank accounts were prepared.

Conducting of Training Programmes:

Specific orientation and Training programmes were conducted for the departmental heads as well as for the ac-countants.

Some of the topics covered during the training programmes were as under:-

Significance of accrual based double entry accounting system.

Need for double entry accounting system.

Merits of double entry accounting system.

Discussions on Uttar Pradesh Municipal Accounts Manual.

Accounting concepts and conventions.

Simultaneously, online training was provided to the accounts personnel on a regular basis, as one of the systems inthe accounts departments was connected with LAN.

Up-dation of Opening Balance Sheet:

The opening Balance Sheet was updated as certain assets and liabilities were identified after preparation of draftopening Balance Sheet these new assets and liabilities were accounted for under the accounts head “Adjustmentsto opening Balance Sheet’’, and were shown as an addition to the municipal fund at the time of preparation of theBalance Sheet.

Preparation of Financial Statements:

For the financial year ending 31st march 2007, the following financial statements were prepared :-

a. Receipts and Payments Accounts

b. Income And Expenditure Accounts

c. Balance Sheet

252 RCUES, LUCKNOW


Constraints in Implementation of Accrual Based Double Entry Accounting System

Few transitional issues were encountered while transforming data from manual system of accounting to a compu-terized data environment. :-

I. Non Availability of historical data/ past records were not kept in good conditions due to which completeinformation with regards to the Fixed Assets could not be ascertained.

II. The knowledge and understanding capacity of the staff members was lacking due to which retrieval ofinformation became difficult.

Suggestions:

1. Attendance of the staff members should be monitored by the departmental heads in the training programmes.

2. Formats for the preparation of Opening Balance sheet should be circulated well in advance to the respectivedepartmental heads, so that information can be collected on time.

3. At least two staff members from the accounts departments should be designated on this specific project, toensure smooth shift to the new computerized accounting system.

4. Regular physical verification of fixed assets as well as of inventories should be undertaken and the respectiveregisters should be updated.

5. Monthly Bank Reconciliation Statements of all the Bank accounts should be prepared.

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Notes & References:National Municipal Accounting Manual

Financing Municipal Services – Reaching out to Capital Markets

Financial Management By M.Y. Khan & P.K. Jain

Advanced cost and Management Accounting By V.K. Saxena & C.D. Vashistha

RCUES, LUCKNOW 253


fm-pay back period etc

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