Chapter five

Project Planning and Control

 Contents
 Work Breakdown Structure
 Project Organization
 Network Scheduling
 Critical Path method
 Program Evaluation and Review Techniques
 Project Crashing
 Resource Allocation
 Project Risks
 Work Breakdown Structure (WBS)

 It is a methodology for converting a

large-scale project into detailed schedules
for its thousands of activities for
planning, scheduling, and control purpose

 The objective of developing a WBS is to

study the elemental components of a
project in detail
 Purposes of a WBS

To organize the work to be done

To illustrate the work to be done
To assure that all necessary work has been
identified
To divide the work into small, well defined
tasks
 Why Do a WBS?

To facilitate planning, estimating and

scheduling of the project
To identify contractual tasks and
deliverables
To provide a basis for data monitoring and
historical data collection
 Using a WBS for Estimating

To make sure that all tasks are estimated

To make sure that each element of the
estimate corresponds to a necessary task
To “roll up” costs of individual elements to
get total costs for sub-elements or for the
system as a whole
Using a WBS, a large project may be
broken down into smaller subprojects which
may, in turn, be further subdivided into
another, lower level of more detailed sub
component activities, and so on.
Eventually, all the tasks for every activity
are identified, commonalities are
discovered, and unnecessary duplication can
be eliminated.
Thus by applying the WBS approach, the
overall project planning and control can be
improved.
 Individual components in a WBS are referred
to as WBS elements and the hierarchy of
each is designated by a level identifier.
 Elements at the same level of subdivision are
said to be the same WBS level.
 Descending levels provide increasingly detailed
definition of project tasks. The complexity of
project and the degree of control desired
determine the number of levels in the WBS.
 Each WBS component is successively broken
down into smaller details at lower levels.
 Level 1: This level contains only the final
project purpose. This item should be
identifiable directly as an organizational
budget item.
 Level 2: This contains the major
subcomponents of the project. This
subdivision is usually identified by their
contiguous location or by their related
purposes.
 Level 3: Contains definable components of
the level 2 subdivisions.
 Subsequent levels are constructed in more
specific detail depending on the level of
control desired.
 If a complete WBS becomes too crowded,
separate WBSs may be drawn for level 2
components.
 Each WBS element is assigned a code that
is used for its identification throughout the
project life cycle.
 Alphanumeric codes may be used to indicate
element level as well as component group.
 Effective use of the WBS will graphically
outline the scope of the project and the
responsibility for each work package.
 Designing the WBS requires a delicate
balance to address the different needs of
various disciplines and project occasions.
 Necessarily there is no right or wrong
structure because what may be an
excellent fit for one discipline may be an
awkward burden for another.
Project Breakdown Structure
 Project Organization

 Like any organization, projects can be

managed and controlled by using different
type of organizational structure.

 Before selecting an organizational

structure, the project team should assess
the nature of the job to be performed
and its requirements.
The structure may be defined in terms of
functional specializations, departmental
proximity, standard management
boundaries, operational relationships, or
product requirements
Large and complex projects should be based
on well-designed structures that permit
effective information and decision
processes.
 Formal and informal structures: The formal
organization structure represents the
officially authorized structure of a
functional area.
 The informal organizations, on the other
hand, develop when people organize
themselves in an unofficial way to accomplish
an objective that is in line with the overall
project goals.
 Both formal and informal organizations are
placed in every project environment.
 Functional organization: This is the most
common type of formal organization,
whereby people are organized into groups
dedicated to a particular functions.
 Depending on the size and the type of
auxiliary activities involved in the project,
several minor, but supporting, functional
units can be developed for a project.
 The project home office or headquarters is
located in the specific functional
department.
 Product organization: Another approach to
organize a project is to use the end product
or goal of the project as the determining
factor for personnel structure.
 This is often referred to as the pure
project organization or, simply, project
organization.
 The project is set up as a unique entity
within the parent organization.
 It has its own dedicated technical staff and
administration.
 It is linked to the rest of the system
through process reports, organizational
policies, procedures, and funding.

 The interference between product-

organized projects and other elements of
organization may be strict or liberal
depending on the organization.
 This type of organization is common in
large project-oriented organizations or
organizations that have multiple product
lines.

 Unlike the functional structure, the

product organization decentralizes
functions. It creates a unit consisting of
specialized skills around a given project or
product.
 Matrix organization: the matrix
organization is a popular choice of
management professionals. A matrix
organization exists where there is multiple
managerial accountability and responsibility
for a job function.

 It attempts to combine the advantages of

the traditional structure and the product
organization structure.
 In pure product organization, technology
utilization and resource sharing are limited
because there is no single group
responsible for overall project planning.

 In the traditional organization structure,

time and schedule efficiency are
sacrificed.
 There are usually two chains of command:
horizontal and vertical.
 The horizontal line deals with the functional
line responsibility while the vertical line
deals with the project line of responsibility.
 The project manager has total responsibility
and accountability for the project success.
 The functional managers have the
responsibility to achieve and maintain high
technical performance of a project.
 The project that is organized under a
matrix structure may relate to specific
problems, marketing issues, product
quality improvement, and so on.

 The project line in the matrix is usually of

temporary nature while the functional line
is more permanent.
Matrix Organization Structure
 Network Scheduling

 The most common network scheduling

methods are Critical Path Method (CPM)
and Program Evaluation and Review
Technique (PERT).
 Two approaches may be used for the
assessment of duration for activity
completion.
The first approach is the deterministic
approach, in which we may assume that we
know enough about each job or operation, so
that a single estimate of their duration is
sufficiently accurate to give reasonable
results.
The second approach is the probabilistic
approach, in which one may only be able to
state limits with-in which it is virtually
certain that the activity duration will lie.
Between these limits we must guess what the
probability of executing the activity is.
 Both methods (CPM and PERT) are
extensively used as dynamic control tools
in the management of a large project.
 They give the project manager a
comprehensive picture of the project
status at any time.
 Network Diagram

 For a project plan to be effective it must

equally address the parameters of activity
time and network logic.
 As project becomes larger and more
complex, the Gantt chart was found to be
lacking as a planning and control tool,
because it could not indicate the logical
relationships between activities.
This logical relationship is required to model
the effect schedule variance will have down
stream in the project.
In the 1950‟s feedback from industry and
commerce indicated that project cost and
time overruns were all too common.
 It was suggested at the time that the
project estimates were on the optimistic
side in order to gain work. However, a
more important reason emerged which
indicated that the planning and control
technique, available to manage large
complex projects, were inadequate.
 With these shortcomings in mind, network
planning techniques were developed
 Why we Use Project Networks?
A convenient way to show activities and
precedence in relation to the whole project
Basis of project planning
• Responsibility allocation
• Definitions of subcontracting units
• Role of different players
Basic scheduling and establishment of work
time table
 Why we Use Project Networks?

Critical path determination and selective

management control
• Deterministic vs probabilistic activity time

Resource planning for projects

• Project crashing with time cost tradeoffs
• Resource aggregation
• Resource leveling
• Limited resource allocation
 Why we Use Project Networks?
Project implementation:
• Time table for implementation
• Monitoring and reporting progress
• Updating of schedules and resources
• Coordination of work with different
agencies
The project network is thus a common
vehicle for planning, communicating and
implementing the project right from
inception.
 Network Diagram
 A network is a flow diagram consisting of
activities and events, connected logically
and sequentially.
 In the network diagram, an activity is
represented by arrows while events
represented, usually, by circles
 In network modeling of projects, the arrow
diagram is of primary importance. Some of
the advantages of network diagram or
arrow diagram are:
 It clearly shows the inter-relationship
between events.
 The project is seen as integrated whole,
thus making it easier for control.
 It can be used even for highly complicated
projects consisting of a large number of
activities.
 It directly indicates the time required in
between two activities.
 Event : it is defined to be an instant in
time. In a project, an event, may mark the
initiation of an activity, the completion of
an activity, or the time after which an
activity may be initiated.
 Design completed, pipe line laid, electricity
installed, etc are examples of events. It is

o
represented by a circle „ ‟ in a network
which is also known as a node or connector.
An event can be further classified into the
following categories:
Merge event: When more than one activity
come and join an event, such event is known as
merge event.
Burst event: When more than one activity
leave an event, such event is known as a burst
event.
Merge and burst event: An activity may be a
merge and burst event at the same time as
with respect to some activities it can be a
merge event and with respect to some other
activities it may be a burst event.
Different types of event formation
 Activity: Any individual operation, which
utilizes resources and has a beginning and
an end, is called activity.
 A project may be divided into activities
that are time consuming tasks or
subprojects like: assembly of parts, mixing
of concrete, preparing budget, etc.
 Each activity in a project must be under
the direction of a single individual. The
other criterion is that an activity must be
performed in a single shop.
 An arrow is commonly used to represent
an activity with its head indicating the
direction of progress in the project.

A
k

 An arrow representing an activity “A”

whose estimated duration is “k” unit of
time. Usually an activity can be classified
into the following four categories.
 Predecessor activity: Activities that must
be completed immediately prior to the
start of another activity are called
predecessor activities.
 Successor activity: Activities that cannot
be started until one or more of other
activities are completed, but immediately
succeed them are called successor
activities.
 Concurrent activities: Activities that can
be accomplished simultaneously are known
as concurrent activities. It may be noted
that an activity can be a predecessor or
successor to an event or it may be
concurrent with one or more of the other
activities.
 Dummy activity
Dummy activity: An activity which does not
consume any kind of resource but merely
depicts the technological dependence is called
a dummy activity.
 It may be noted that the dummy activity
is inserted in the network to clarify the
activity pattern in the following two ways:
 one is to make the activities with common
starting and finishing points
distinguishable, and
 the other one is to identify and maintain
the proper precedence relationship
between activities that are not connected
with arrows
 For example, consider a situation where A
and B are concurrent activities, C is
dependent on A, and D is dependent on A
and B both.
 Such a situation can be handled by using a
dummy activity
Dummy Activities
 Another situation, consider a case where
B and C have the same job reference and
they can be started independently on
completion of A.
 But, D could be started only completion
of B and C.
Dummy Activities
 An event is that particular instant of time
at which some specific part of a project
has been or is to be achieved.
 While an activity is actual performance of
a task. An activity requires time and
resource for its completion.
Correct & Incorrect Use of Network Dummies.
 Rules for Drawing Network Diagram
 In order to draw a network diagram, the
following general rules have to be
considered:
1. Each activity is represented by one and
only one arrow in the network:
 This implies that no single activity can be
represented twice in the network.
 This is to be distinguished from the case
where one activity is broken into
segments.
2. No two activities can be identified by the
same events: For example, activities a and
b have the same end events. The
procedure is to introduce a dummy activity
either between a and one of end events or
between b and one of the events.
 Modified representations after introducing
a dummy activity d is shown in figure
Sequence of Activity
 As a result of using the dummy, activities a
and b can now be identified by unique end
events.

 It must be noted that a dummy activity does

not consume any time or resource.

 Dummy activities are also useful in

establishing logical relationship in the arrow
diagram which otherwise cannot be
represented correctly.
Suppose jobs a and b in a certain project
must precede the job c, on the other hand,
the job e is preceded by the job b only
 Shows the correct way since, though the
relationship between a, b and c are
correct, the diagram implies that the job
must be preceded by both the jobs a and
b.
 The correct representation using the
dummy d is shown that indicate
precedence relationships are justified.
3. Check the precedence relationship: In
order to ensure the correct precedence
relationship in the arrow diagram, the
following questions must be checked
whenever any activity is added to the
network.
 What activity must be completed immediately
before this activity can start?
 What activities must follow this activity?
 What activities must occur simultaneously with
this activity?
 Apart from this, a few important
suggestions for drawing good networks
are:
 Try to avoid arrows which cross each
other.
 Use straight arrows.
 Do not attempt to represent duration
of activity by arrow length.
 Use arrows from left to right (or right
to left). Avoid mixing two directions,
vertical and standing arrows may be
used if necessary.
 Use dummies freely in rough draft but
final network should not have any
redundant dummies.
 The network has only one entry point-
called the start event and one point of
emergence-called the end event.
 In many situations, all these may not be
compatible with each activity and some of
them are violated.
 The idea of having a simple network is to
facilitate easy reading for all those who
are involved in the project.
 Common Errors in Drawing Networks

 Three types of errors are most commonly

observed while drawing network diagrams.
 Dangling: To disconnect activity before
the completion of all activities in a
network diagram is known as dangling.
 As shown in the figure below, activities (b
- c) and (d - e) are not the last activities
in the network. So the diagram is wrong
and indicates the error of dangling.
Drawing error diagram
 Looping (or Cycling): Looping errors is also
known as cycling errors in a network
diagram.
 Drawing an endless loop in a network is
known as an error of looping as shown in
the following figure.
Looping or cycling
error diagram
 Redundancy: Unnecessarily inserting the
dummy activity in a network diagram is
known as the error of redundancy as
shown in the following diagram.
Redundancy Error
 Example: Draw the network diagram

 A project consist of six activities (jobs)

designated from A to F, with the following
relationships

1. A is the first job to be performed

2. B and C can be done concurrently and must follow
A
3. B must Precede D
4. E must succeed C, but it cannot start until B is
complete
5. The last operation F is dependent on the
completion of both D and E
Example: Construct network diagram
1. A is the first operation
2. B and C can be performed in parallel are
immediate successor to A
3. D,E and F follows B
4. G follows E
5. H follows D, but it cannot start until E is
complete
6. I and J succeed G
7. F and J precede K
8. H and I precede L
9. M succeeds L and K
10.The last operation N succeeds M and C
 Critical Path Method (CPM)
 The Critical Path Method (CPM) was developed in
1957 by Remington Rand Univac as a management
tool to improve the planning and control of a
construction project

 CPM was initially set-up to address the time cost

trade-off dilemma often presented to project
managers, where there is a complex relationship
between project time to complete and cost to
complete.
 CPM enables the planner to model the
effect various project time cycles have on
direct costs.

 Shortening the project duration will

reduce indirect costs, but may increase
the direct costs.

 This technique is often called Project

crashing or acceleration
 Time Estimate and Critical Path in
Network Analysis
 Once the network of a project is
constructed, the time analysis of the
network becomes essential for planning
various activities of the project.
 An activity-time is a forecast of the time
an activity is expected to take from its
starting point to its completion under
normal conditions.
The main objective of the time analysis is to prepare a
planning schedule of the project, which should include
the following factors:
 Total completion time for the project.
 Earliest time when each activity can start.
 Latest time when each activity can be started
without delay of the total project.
 Float for each activity, i.e., the amount of
time by which the completion of an activity can
be delayed without delaying the total project
completion.
 Identification of critical activities and critical
path.
 The following notations are used for the basic
scheduling computation techniques:
(i, j )= Activity (i, j) with tail event i and head event j.

= Earliest occurrence time of event i.

TE or E i

TL or L j = Latest allowable occurrence time of event j.

Dij = Estimated completion time of activity (i , j)

( E S )=ij Earliest starting time of activity (i , j)

( E f =) ij Earliest finish time of activity (i , j)

( LS =) ij Latest starting time of activity (i , j)

( L f )=ij Latest finish time of activity (i , j)

 Thus the basic scheduling computation can be put
under the following three categories.

i)Forward Pass Computations: Before starting

computations, the occurrence time of initial
network event is fixed. Then, the forward pass
computation yields the earliest start and earliest
finish time for each activity (i, j), and indirectly
the earliest expected occurrence time for each
event. This is mainly done by using the following
steps:
Step 1. The computations begin from the „start‟ node
and move towards the „end‟ node.
Step 2. a) Earliest starting time of activity (i, j) is
the earliest event time of the tail end event
i.e.,
( E S ) ij  Ei
b) Earliest finish time of activity (i, j) is the earliest
starting time plus the activity time. i.e.,

( E f ) ij  ( E S ) ij  Dij
or

( E f ) ij  Ei  Dij
c) Earliest event time for event j is the maximum of the
earliest finish times of all activities ending into that
event. That is,

E j  max.i [(E f )ij for all immediate predecessor of (i, j) ]or E j

 max.i [E i  Dij ]

The computed ‘E’ values are put over the respective

circles representing each event.
ii) Backward Pass Computations
 The latest event time, (L) indicates the time by
which all activities entering into that event must
be computed without delaying the computation of
the project. These can be computed by reversing
the method of calculation used for earliest event
times. This is done in the following steps:
 Step 1. For ending event assume

EL
Remember that all E’s have been computed by forward
pass computations.

Step 2. Latest finish time of activity (i, j) is equal to the

latest event time of event j. i.e.,

( L f ) ij  L j
Step 3. Latest starting time of activity (i , j) = the latest
completion time of activity (i , j) – the activity time, or
( LS ) ij  ( L f ) ij  Dij or

( LS )ij  L j  Dij

Step 4. Latest event time for event i is the minimum of

the latest start time of all activities originating from the
event, i.e.,
Li  min. j [(LS )ij for all immediate successors of (i, j)]  min. j[(Lf )ij - Dij ]
 min. j[ L j  Dij ]
The computed ‘L’ values are put over the respective
circles representing each event.
iii) Determination of Floats and Slack Times
 When the network diagram is completely drawn,
properly labeled, and earliest (E) and latest (L)
event times are computed as discussed so far,
the next objective is to determine the float and
slack times of a project.
 There are mainly five kinds of floats.

 Total float: The amount of time by which the

completion of an activity could be delayed beyond
the earliest expected completion time without
affecting the overall project duration time.

 Mathematically, the total float of an activity (i ,

j) is the difference between the latest start time
and the earliest start time of that activity.
Hence the total float for an activity (i , j),
denoted by
 (T f ) ij can be calculated by the formula:

(T f ) ij  ( Latest start  Earliest start )

for activity (i - j)

(T f ) ij  ( LS ) ij  ( E S ) ij or

( T f )ij  ( L j  Dij )  Ei
 Free float: The time by which the
completion of an activity can be delayed
beyond the earliest finish time without
affecting the earliest start of a
subsequent (succeeding) activity.
 Mathematically, the free float for activity (i, j), denoted by

( F f ) ij can be calculated by the formula :

( F f ) ij  ( E j  Ei )  Dij

In other words,

Free float for(i, j )

 (Earliest time for event j  Earliest time for event i)  Activity time for(i, j )

This float is concerned with the commencement of subsequent activity.

 Independent float: The amount of time by
which the start of an activity can be
delayed without affecting the earliest
start time of any immediately following
activities, assuming that the preceding
activity has finished at its latest finish
time.
 Mathematically, independent float of an activity (i, j), denoted by

( I F ) ij
, can be calculated by the formula :

( I F ) ij  ( E j  Li )  Dij
The negative independent float is always taken zero.
This float is concerned with prior and subsequent activities.
 Interfering float: Utilization of float of
an activity may affect the float time of
the other activity in the network.
Interfering float is that part of total
float which causes a reduction in the float
of successor activities.

 It is the difference between the latest

finish time of activity in question and the
earliest starting time of the following
activity or zero whichever is larger.
 Event slacks: For any given event, the
event slack is defined as the difference
between the latest event and earliest
event times. Mathematically, for a given
activity (i, j),
 Head event slack  L j  E j

Tail event slack  Li  Ei

All the floats defined earlier can be represented in
times of head and tail event slacks also.

Total float  L j  Ei  Dij

 Free float  E j  Ei  Dij  ( L j  Ei  Dij )  ( L j  E j )

 Total float - Head event slack

Independent float  E j  Li  Dij  ( E j  Ei  Dij )  ( Li  Ei )

 Free float - Tail event slack

 iv) Time Scale Representation of Floats
and Slacks
 The various floats and slacks for an
activity (i, j) can be represented by the
following time scale figure
Time scale representation of float and slacks
Value of total float
 Determination of the Critical Path
i) Critical event: Since the slack of an event is the
difference between the latest and earliest event times.
i.e.,

Slack(i)  Li  Ei
the events with zero slack times are called critical
events. In other words, the event i is said to be
critical if

E i  Li
ii) Critical activity: Since the difference between
the latest start time and earliest start time of
an activity is usually called as total float, the
activities with zero total float are known as
critical activities.

 Obviously, a non-critical activity is such

that the time between its earliest start
and its latest completion dates (as allowed
by the project) is longer than its actual
duration. In this case, non-critical activity
is said to have a slack or float time.
iii) Critical path: The sequence of critical activities
in a network is called the critical path. The
critical path is the longest path in the network
from the starting event to ending event and
defines the minimum time required to complete
the project. By the term „path‟ we mean a
sequence of activities such that it begins at the
starting event and end at the final event. The
length of the path is the sum of the individual
times of the activities lying on the path.
 If the activities on a critical path are
delayed by a day, the project would also
be delayed by a day unless the times of
the future critical activities are reduced
by a day by different means.

 The critical path is denoted by double or

darker lines to make distinction from the
other non-critical paths.
 Thus the critical path has two features:
 If the project has to be shortened, then some of
the activities on that path must also be
shortened. The application of additional resources
on other activities will not give the desired result
unless that critical path is shortened first.
 The variation in actual performance from the
expected activity duration time will be completely
reflected in one-to-one fashion in the anticipated
completion of the whole project.
 The critical path identifies all critical
activities of the project. The method of
determining such a path is explained by
the following numerical example.
 Example
 Consider the following project to
manufacture a simple mobile stone
crasher. The list of each activities, their
relationship, and the time required to
complete them are given in the following
table. We are interested to find the time
it will take to complete this project. What
jobs are critical to the completion of the
project in time, etc?
List of Activities
Activity Symbol Duration Restriction
(weeks)
Preliminary design A 3 A < B, Cl
Engineering analysis B 1 B < Dl, F, H
Prepare layout I Cl 2 Cl < C2, Dl
prepare layout II C2 2 C2 < E
Prepare material request Dl 1 Dl < D2
Receive requested material D2 1 D2 < E
Fabricate Parts E 4 E<J
Requisition Parts F 1 F<G
Receive Parts G 2 G<J
Place subcontracts H 1 H<I
Receive subcontracted parts I 5 I<J

Assemble J 2 I<K
Inspect and test K 1
 Solution

 First the network diagram is constructed

 Then, it is necessary to find out the
earliest and latest completion time of for
each activity in the net work.
 The earliest and the latest times are re-
calculated by using „forward pass‟ and
„backward pass‟ computations, respectively.
 The solution now starts by the forward
pass computation.
 Step1. Determination of Earliest Time
(E j )
 Forward Pass Computation
 The purpose of the forward pass computation is to find out
earliest start times for all the activities.
 For this, it is necessary to assign some initial value to the
starting node 10.
 Usually this value is taken to be zero so that the subsequent
earliest time could be interpreted as the project duration up to
that point in question.
 Rules for the computation are as follows:
Rule 1. Initial event is supposed to occur at time
equal to zero, that is,

E10  0
Rule 2.Any activity can start immediately when all
preceding activities are completed.

for node j is given by

Ej

E j  Max.[ Ei  Dij ]
 Rule 3.Repeat step2 for the next eligible activity
until the end node is reached.

E10  0
and

E20  Max.[ Ei  Di 20 ]
For node 20, node 10 is the only predecessor and hence

i  10
contains only one element. Therefore,
E j  Max.[ E i  Dij ]

E 20  E10  D10, 20  0  3  3

E 21 ,  E 20  D20, 21  3  2  5

E 30 ,  E 20  D20,30  3  1  4

E 50  E30  D30,50  4  1  5

E 60  E 30  D30, 60  4  1  5
Consider node 31, where there are two
emerging activities, i.e.
E 31  Max.[ E i  Di ,31 ]
The collection i consists of node 21 and 30 that are
preceding node 31, Therefore,

E31  Max.[ E 21  D21,31  5  0  5, E30  D30,31  4  0  4]  5

and values of E32 can be computed as:

E32  E 31  D31,32  5  1  6

Once again, for node 40 and 70;

 E 40  Max.[ E 21  D21, 40  5  2  7, E32  D32, 40  6  1  7]  7

E 70  Max.[ E 40  D40, 70  7  4  11, E50  D50, 70  5  2  7, E 60  D60, 70  5  5  10 ]  11

and values of E80 , and E90 can be computed as:

E80  E 70  D70,80  11  2  13

E90  E80  D80,90  13  1  14

 From this computation, it can be inferred that this job will
take 14 days to finish as this the longest path of the network.
 Activities along this longest path are: 10 – 20 – 21 – 40 – 70 –
80 – 90. This longest path is called the critical path. In any
network, it is not possible that there can be only one critical
path.
 For example, if in the above network, let

E 30  5
 days, then 10 – 20 – 30 – 60 – 70 – 80 – 90 can be also
critical, in that case two critical paths exist having the
same duration for completion of the project.
 Step2.Determination of Latest Time
( Li )
Backward Pass Computation
 In forward pass computation, the earliest time when
a particular activity will be completed is known.
 It is also seen that some activities are not critical to
the completion of the job.
 The question a manager would like to ask is: Can
their starting time be delayed so that the total
completion time is still the same?
 Such a question may arise while scheduling the
resources such as manpower, equipment, finance and
so on.
 If delay is allowable, then what can be the maximum delay? For
this, the latest time for various activities desired.

 The backward pass computation procedure is used to

calculate the latest time for various activities.

 In forward pass computation, assignment of was arbitrary,

likewise for the backward pass computation, it is possible
to assign the project terminal event the date on which the
project should be over.

 If no such date is prescribed, then the convention is of

setting latest allowable time determined in forward pass
computation.
 Rule 1. Set
Li  Ei or TS

Where TS is the scheduled date for completion and

Ei is the earliest terminal time.

Rule 2. Li  Min. j [ L j - Dij ]

i.e. the latest time for activities is the minimum of

the latest time of all succeeding activities reducing
their activity time.

Rule 3.Repeat rule 2 until starting activity reached.

Latest times for activities of the network are calculated below:
By rule1, set

L90  14
.Applying rule 2, it is to determine

L80 L40
L70
L32
L60
L31
L50
L80  Min. j {L j - D80, j }  14  1  13 for j  90

L 70  Min. j{L j - D 70, j}  L80 - D 70,80  13  2  11

(j contains only one node 80)

L60  Min. j {L j - D60, j }  L70 - D60,70  11  5  6

(j contains node 70)

L50  Min. j {L j - D50, j }  L50 - D50,70  11  2  9

(j contains node 70)
L40  Min. j {L j - D40, j }  L40 - D40,70  11  4  7
(j contains node 70)

L32  Min. j {L j - D32, j }  L32 - D32,40  7  1  6

(j contains node 40)

L31  Min. j {L j - D31, j }  L31 - D 32,32  6  1  5

(j contains node 32)

Now consider node21, for this node, there are two
succeeding activities, namely 21 – 40, and 21 – 31.
Hence,
  L40  D21, 40  7  2  5
L21  Min. j (31,40) {L j - D21, j }  Min.   Min.  5
 L31  D21,31  5  0  5 

Similarly, for node 20, and 30,

 L21  D20, 21  5  2  3
L20  Min. j (21,30) {L j - D21, j }  Min.   Min.  3
 L30  D20,30  4  1  3 

 L31  D30,31  5  0  5
 
L30  Min. j (31,50,60) {L j - D30, j }  Min. L31  D50,31   Min.5  1  4   4
L  D  5  1  4 
 31 60, 31 
 and like the other one, for node 10,

L10  Min. j {L j - D10, j }  L20 - D10,20  3  3  0

The minimum value of L10  0

is no surprising result. Since, started with Li  E i

, it is always possible to have L10  0

If this is not so, it means that some error is made in calculations

of forward pass or backward pass values.
Network diagram with critical path
Recall that path 10 – 20 – 21 – 40 – 70 – 80
– 90 was defined as the critical path of this
network. Along this path, it is observed that
the latest and earliest times are the same
implying that any activity along this path
cannot be delayed without affecting the
duration of the project.
 Step 3. Computation of Float (L f )

By definition, for activity 60 – 70, the float is one day

L60  E60  6  5  1
This float represents the amount by which this particular activity
can be delayed without affecting the total time of the project.
 Also, by definition, free float, if any will exist
only on the activities merge points.
 To illustrate the concept of free float, consider
path 10 – 20 – 30 – 50 – 70, total float on
activity 50 - 70 is four days and since this is
the last activity prior to merging two activities,
this float is free float also.
 Similarly, consider the activity 30-50 which has
a total float of 4 days but has zero free float
because 4 day of free float is due to the activity
50-70.
 If activity 30-50 is delayed up to four
days, the early start time of no activity
in the network will be affected.
 Therefore, the concept of free float
clearly states that the use of free float
time will not influence any succeeding
activity float time.
 Step 4. To Identify Critical Path

 Identifying the critical path is a

byproduct of boundary time calculations.
A critical activity has no leeway in
scheduling and consequently zero total
float. It is important to note that the
value of slack, associated with an event,
determines how critical that event is. The
less the slack, the more critical an event
is.
 The earlier calculation shows that the path or
paths which have zero float are called the critical
ones or in other words, a critical path is the one
which connects the events having zero total float
or a minimum slack time.
 If this logic is extended further more, it would
provide a guide rule to determine the next most
critical path, and so on.
 Such information will be useful for managers in the
control of project. In this example, path 10 – 20 –
30 – 60 – 70 – 80 - 90 happens to be next to
critical path because it has float of one day on
many of its activities.
 Program Evaluation and Review
Techniques (PERT)
The US Navy set up a development team
with the Lockheed Aircraft Corporation,
and a management consultant Booz ,Allen &
Hamilton, to design PERT as an integrated
planning and control system to manage their
Polaris Submarine project.
The PERT technique was developed to apply
a statistical treatment to the possible
range of activity time durations
 A three time probabilistic model was developed, this includes:

Optimistic time t 0 limit of completion time if every thing goes all-right.

Pessimistic time t p limit of completion time if every thing goes all-
wrong (in case climatic conditions, explosions,
accidents, etc., come into effect to retard the
activity).

Most likely time t l the duration that would occur most often if
the activity was repeated many times under
the same conditions.
The three times were imposed on a normal
distribution to calculate the activity‟s
expected time te as,

(t o  4t l  t p )
te 
6
Normal Probability distribution
Each activity in a PERT network also has a
variance with its completion of time. This
variance measures the dispersion of
possible duration. A large variance means
a wide variation in the outside limits of
estimate and indicates less confidence in
estimating:

 t p  to
2

  
2

 6 
99.7 % within t e  3
95.0 % " t e  2
68.0 % "
te  
 Example
A contractor has received order for
constructing a cottage on a sea side resort.
The delivery of materials must be planned
and the complete job finished in 13 weeks.
The work involves and the time required to
complete each activities are given in the
table below.
Job Description Time, days
to tl tp

A Buying bricks and cement 8 10 14

B Roof tiles 20 24 30
C Preparing foundation 12 14 16
D Erecting shell structure of building 18 20 24
E Laying drains 12 14 15
F Wiring for electrical 16 20 26
G Constructing roof 8 8 10
H Plastering 12 12 18
I Landscaping 4 4 6
J Painting and cleaning 10 12 14
K Laying pathway 4 4 4
L Installing doors and fittings 4 4 4
M Plumbing 20 24 30
N Flooring 8 10 12
 Question

a) construct a logical PERT diagram.

b) find the critical path and project duration.
c) determine whether the project is
completed within the planed estimated time
or not?
 Solution:

Before constructing the PERT diagram, the

expected time (te) for each of the
activities has to be calculated by using the
following formula
 (t o  4t l  t p )
te 
6
where
to = optimistic time

tl = most likely time

tp = pessimistictime
and also the precedence of the activities has to be determined.
Job Description Immediate Time, days (t o  4t l  t p )
te 
predecessors to tl t p
6

A Buying bricks and cement - 8 10 14

B Roof tiles buying - 20 24 30 24
C Repairing foundation A 12 14 16 14
D Erecting shell structure of C 18 20 24 20
building
E Laying drains C 12 14 15 14
F Wiring for electrical G 16 20 26 20
G Constructing roof D 8 8 10 8
H Plastering G 12 12 18 13
I Landscaping K 4 4 6 4
J Painting and cleaning B,F,I,N 10 12 14 12
K Laying pathway E 4 4 4 4
L Installing doors and fittings G 4 4 4 4
M Plumbing G 20 24 30 24
N Flooring H,L,M 8 10 12 10
Network Diagram
 Start Finish Total Float
Activity Duration
(i - j)
Dij
Earliest Latest Earliest Latest
(1) (2) (3) E i (4)  (6) - (2) (5)  (3)  (2) (6) L j (7)  (4) - (3)

A 0 0 10 10 0
B 24 0 20 24 44 20
C 14 10 10 24 24 0
D 20 24 24 44 44 0
E 14 24 64 38 78 40
G 8 44 44 52 52 0
H 13 52 63 65 76 11
I 4 42 82 46 86 40
J 12 86 86 98 98 0
K 4 38 78 42 82 40
L 4 52 72 56 76 20
M 24 52 52 76 76 0
N 10 76 76 86 86 0
 Project Crashing
The crash time estimate is the shortest
time that could be achieved if all effort
were made to reduce the activity time. The
use of more workers, better equipment,
overtime, etc, would generate higher direct
cost for individual activities.

The following are sequence of steps required

to crash an activity:
Step1. Identify the activities that need to
be crashed (where an activity has negative
float for instance). This can happen at any
time from the initial project planning phase
to project completion.
Step 2. Identify the critical path. To crash
non-critical activities is a waste of financial
resource because it will simply increase the
float on that activity without affecting the
end date of the project.
Step 3. Prioritize the activities to be
crashed. When there are many activities
which can be crashed, it is necessary to
know which activity will be crashed first?
This can be done by selecting the activity

with the least cost per day to crash.

That is the easiest to crash.
which can be crashed soonest to bring the project
back on course.
As project manager you do not want to approach
the end of the project with a number of
activities running behind schedule and the
prospects of further problems during
commissioning
Step 4. Crash activities one day at a time,
then re- analyze the network to see if any
other activities have gone critical.

Continue this iterative process until there

are no activities with negative float. These
crashing steps may vary with the different
types of projects.
 Time Cost Trade-off Theory

Before discussing the time cost trade-off

concept, it is necessary to define some
terminologies used.
Normal Time: This is the normal office
hour, for example eight hour a day, and six
days a week.
Normal Cost: The cost of activity working
on normal time.
Direct Cost: Costs attributed directly to
the project labor and materials. These costs
usually group when the activity is crashed
due to overtime, shift allowance, etc.
Indirect Cost: This is overhead cost which
can not be directly attributed to the
project, for example, office rent, and
management salaries. These costs are usually
linear with time, therefore, if the time
reduces, the indirect costs also reduce.
Crash Time: The duration the activity can
be reduce to, by crashing the activity.
Crash Cost: The new cost of the activity
after crashing.
i) Crashing direct cost: The duration has been
reduced but the costs have increased.
These additional costs are caused by
overtime, shift work and a reduction in
productivity
Crashing Direct Costs
ii) Crashing indirect cost: The duration has
been reduced but the time and the costs
have also reduced. The benefit has come
from reduced office rental, equipment hire
etc. Unfortunately project costs are usually
split 80% direct, and 20% indirect cost, so
the advantage of crashing indirect costs is
usually overwhelmed by the far greater
direct costs
Crashing indirect costs
When the direct costs and indirect costs
are combined on the same graph an optimum
position is derived.
Combined direct and indirect costs
Time cost trade-off: The time cost trade-off
figure outline graphically four different time
costs positions.
The time cost trade-off
The total cost of the project can be calculated by:

C total  C N total  m  d cp
where
C N total = total sum of normal cost
m = indirect cost slope

d cp = number of days in critical path.

 Example:

The following example depicts how direct

costs increase while indirect costs reduced
during crashing. Consider the following
activity to manufacture a motor driven
hollow block machine.
When working normal time the activity will
take;
Five men working eight hours per day,
 Six days per week for five weeks =1,200 man hrs.
 The activity‟s normal costs will be:
 Labor at 5 birr per hour x 1200 man hours =6,000
Birr.
 Material = 4,500 Birr
 Administration and office expense Birr 1000 per
week
 Birr 1000 x 5 weeks = 5000 Birr
Total=15,500 Birr
If the client now wants to manufacture the
machine in less time, the crash cost can be
quantified in steps of one day. To reduce
the duration the men will have to work
overtime, say 10 hours per day (2 hours
overtime which is calculated with one and a
half time). Assume the additional hours do
not affect the productivity.
The total man hours will still be the same
i.e.
 1200 man hours
 24 days or 4 weeks
5 men  10 hours per day 

The extra hours worked per day will reduce the duration from
30 working days to 24 working days.
The crashing costs will be:
Labor:

5 Birr  24 days  5 men  8 hrs = 4800 Birr (normal time)

5 Birr  24 days  5 men  2 hrs  1.5 (over time) =

 Material =

Adm. and Off. expense :

___________
Total = 15,600 Birr

With this information calculate the additional

cost to crash the activity by on day, will be

Additional crash cost per day 

(Difference in cost)

(15,600 - 15500)  17 Birr per day
(Difference in time) (30 - 24)
This example clearly shows that to reduce
the project by one week or six days the
direct costs will increase while the indirect
costs reduce. The overall effect is to
increase the costs by 17 Birr per day.
The project time-cost model seeks to
shorten the length of a project to the point
where the saving in direct project costs is
offset by the increased direct expenses.
 Resource Allocation
While developing the PERT and CPM
networks we have generally assumed that
sufficient resources are available to
perform the various activities.
In every production enterprise, resources
are always limited and the management
always wants to assign these various
activities in such a manner that there is
best possible utilization of available
resources.
At a certain time the demand on a
particular resource is the cumulative
demand of that resource on all the
activities being performed at that time.
Proceeding according to the developed plan,
the demand on a certain type of resource
may fluctuate from very high at one time
to very low at another.
If it is material or unskilled labor which
has to be procured from time to time, the
fluctuation in demand will not affect the
cost of the project much.
But, if it is some personnel who cannot be
hired and fired during the project or machines
which are to be hired for the entire duration
of the project, the fluctuation in their demand
will affect the cost of the total project due to
high idle time.
In order to reduce the idle time, the activities
on non-critical paths are shifted by making use
of the floats and alternative schedule is
generated comparing the more important
resources with the objective of smoothening
the demand on resources.
Depending upon the type of constraints the
resource allocation procedure can be
categorized into two main activities:
resource smoothing and resource leveling.
 Resource Smoothing
If the constraint is the total project
duration, then the resource allocation only
smoothens the demand on resources in
order that the demand of any resource is
as uniform as possible.
The periods of maximum demand for
resources are located and activities
according to their float values are shifted
for balancing the availability and
requirement of resources.
So the intelligent utilization of floats can
smoothen the demand of resources to the
maximum possible extent. Such type of
resource allocation is called “Resource
smoothing or Load smoothing”.
Resource Smoothing Steps.
The following are steps which are used to
smoothen the resources of a project.
Step1. The first step in resource
smoothing is to determine the maximum
requirement. One way is to draw the time
scale version of the network and assign the
resource requirements to activities.
Step2. Then, below the time scaled
network, the cumulative resource
requirements for each time unit are
plotted.
Step3. The resource histogram is plotted
on the basis of the early start times or
the late start times of the activities.
These resource histograms establish the
frame work under which the smoothing or
leveling must occur.
 Resource Leveling

There are various activities in a project

demanding varying levels of resources. The
demand on certain specified resources
should not go beyond the prescribed level.
This operation of resource allocation is
called „Resource Leveling‟ or „Load Leveling‟.
Although the overall resources of the
organization are limited, but these should
not go below the amount required to
perform an activity among all the activities
in the process, otherwise that particular
activity cannot be computed.
In the process of resource leveling,
whenever the availability of a resource
becomes less than its requirement, the only
alternative is to delay the activity having
large float.
Incase, two or more activities require the
same resources, the activity with minimum
duration is chosen for resource allocation.
To illustrate the resource smoothing
operation, let us consider the following
example:
 Example: Resource Leveling

Consider the activities of a project given in

the table below. For simplicity, only one
kind of resource, manpower required, has
been considered.
And the manpower required for each
activity is also given in the table.
Level the resource for the activities if the
total man power required is equal to 12
Activity Crew Size
0-1 2
0-3 6
0-5 9
0-7 3
1-2 4
2-6 0
3-4 5
4-6 1
5-4 0
6-8 8
7-8 0
 Solution:

In order to level the resource with the

available manpower, we have to shift all
jobs with a slack and which can make a
difference in the manpower allocation.
Thus, job 3 has a slack of 7 days, shift
job 3 to the right by 6 days. Then shift
job 4 and job 9 to the right by 2 days. By
so doing the resource will be leveled with
an extra man-hour of (2x2 = 4).
 Project Risks

However small the percentage may be,

there is always uncertainty in any venture.
Identification and management of risks is
fundamental to any project.
Before undertaking a project, all
participants want to identify the risks
involved, as well as the steps that may be
taken to manage them.
There is direct relation between the
project risk and expectation of return.
If the risk of the project is in line with
the average risk of the company, then the
expected rate of return would be the
weighted average cost of capital of the
firm.
If the risk is higher the expected rate of
return would be higher.
The expected rate of return is determined
by comparing it against similar project of
other companies
It is difficult to generalize about the risk
characteristics of projects.
Each host country and in deed each specific
project has its own risk profile.
i) General (or country) Risks: General or
country risks refer to the ones that affect
the overall sectors of the country.
Factors such as a country‟s economic
growth, its political environment, the tax
code, the legal system and the prevailing
currency exchange rate are classified under
this category.
The general risks may be divided into three
major divisions. The importance of these
risks can vary substantially from country to
country and from project to project.
Political risks: These are related to the
internal and external political situation and
the stability of the host country. These
risks include the government‟s attitude
towards allowing private sector profits from
projects, changes in the host country‟s
fiscal regime, including taxation, the risk
of expropriation and nationalization of the
projects by the host country, cancellation
of the concession, and similar factors.
Country commercial risks: These are risks
related to the convertibility of revenue
from the project into foreign currencies,
foreign exchange and interest fluctuation
and inflation.
Country legal risks: The risks to sponsors
and lenders is that legislation that is
relevant to the project (for instance,
environmental legislation or property
legislation) may change after a project has
been implemented
ii) Special Project Risks: In addition to the
general risks discussed above, sponsors and
lenders face specific project risks that may
be generally within the control of the
sponsors. The specific project risks may
be broadly divided into the following three
categories in accordance with phases of a
project cycle.
Development risks: These are risks
associated with the bidding competition
that occurs in the initial stage of the
process. The development risks also
include losses caused by delays in planning
and approval, which can be particularly
acute in the case of transnational projects,
where project sponsors have to deal with
the authorities of two or more
governments.
Construction/completion risks: The primary
risks here are the following:
The actual cost of construction may be
higher than projected (cost overruns).
Completion takes longer than projected
(completion delays).
The construction of the project may not be
completed at all.
Operating risks: operating risks result from
insufficiency in performance, revenue
income, material supply etc. and from
higher than-expected operating costs.
They may be divided into six main
categories:
Associated-infrastructure risks: These
risks are associated with facilities outside
the project, such as approach roads and
transmission lines, for which construction
responsibility lies with third parties rather
than the project sponsors themselves.
Technical risks: These include design
defects and latent defects in project
equipment.
Demand risks: Most projects that rely on
market-based revenues face demand risks
related to volume and/or prices, thereby
lowering the rate of return of the project.
Supply risks: Because they are also market
risks, supply risks have two components,
volume and prices.
Management risks: The quality of
management in every project is always a
critical success factor.
Force major risks: Force major risks
denote losses from certain exceptional
types of events beyond the control of the
parties to the project that impeded the
performance of their obligations.
 Risk Identification Check – List

General or Country Risks

Political Risks
Political support risks
Taxation risks
Expropriation/nationalization risks
Forced buy-out risks
Cancellation of concession
Import/export restrictions
 Failure to obtain or renew approvals
 Country Commercial Risks
 Currency inconvertibility risks
 Foreign exchange risks
 Devaluation risks
 Inflation risks
 Interest rate risk
 Country Legal Risks
 Changes in laws and regulations
 Law enforcement risk
 Delays in calculating compensation
Specific Project Risks
Development Risks
Bidding risks
Planning delay risks
Approval risks
Transnational risks
Construction/Completion Risks
Delay risk
Cost risk
Re-performance risk
Completion risk
Force major risk
Loss or damage to work
Liability risk
Operating Risks
Associated infrastructure risks
Technical risks
Demand risk (volume and price)
Cost escalation risks
Management risks
Force major risk
Loss or damage to project facilities
Liability risk
 Risk Management

When designing the risk allocation and

management structure of a project three
overriding considerations have to be made.
First, it is the cost of the project in its
entirety that should decide any particular
risk allocation. A particular risk should be
borne by the party most suited to deal with
it, in terms of control or influence and
costs
 In some cases, the party in the best
position to financially bear a particular risk
may prefer some method of risk allocation
that, in the interest of the project, does
not reduce the other party‟s incentive to
perform efficiently.
Secondly, since the solutions to the risk
management of a project do not in principle
rely on unconditional guarantees from any
one party alone, the financial structure of
the project must consider the following
requirements
 All substantial project risks have to be
identified, allocated and managed; and the
project risks have to be managed by a
combination of financial resources and firm
contractual commitments. Thirdly, the risk
structure has to be sufficiently sound to
withstand the ups and downs of a project
implementation.
In this section we will see how to manage
some of the risks encountered in the
financial aspect. A wide range of capital
market instruments, such as swaps, options
and futures, are now available for
management and hedging of currency and
interest rate risks. What these
instruments offer are the following.
Forward Market: Forward Rate is an agreed
rate between the bank and a customer for a
specific sum to be traded in a specific time
in the future. By entering in forward
agreement, a company eliminates its
potential foreign exchange loss. However, it
also eliminates its potential gain in case
exchange rate goes in its favour.
The rate that dealers buy currency is called
bid, the rate they sell currency is called
offer. Difference between spot and forward
is shown as point. If bid is greater than
offer in point, currency is in premium as may
be seen in the following data, but if offer is
greater than bid in point, currency is in
discount as can be seen in the following
 Bid Offer
Spot 1.8215 1.8225
Three months 1.8040 1.8056
Points 175 169
Options: In the option market an individual
has a right to buy (or sell) currency at a
certain rate.
The risk would be the cost of the option,
while potential gain is infinite
A call option is the right to buy at a
certain rate, a put option is the right to
sell at a certain rate. Strike price is the
price that option can be exercised. Break-
even point is the exercise price plus the
premium.
Call Options
iii) Money Market Hedge: The firm borrows
(deposites) in the foreign market
equivalent of their receivable(payable).
Fund then is exchanged to home currency
at the spot rate. The future value of the
fund indicated the actual receivable. To
consider the future value the deposit rate
is used if the company is cash rich and
Weighted Average Cost of Capital (WACC)
is used if the company is cash poor.
 WACC  E V   re  D V   (1  t )  rd
Where
E = value of equity
D = value of debt
V = value of firm (debt + equity)
rd = cost of debt
t = tax rate

re  cost of equity

 rf   rm  rf 

rf  risk free interest rate

rm  market rate rate of return

 = risk factor particular to the company.

iv) Other Methods
a) Reinvoicing Centre and Netting Process:
All projects and subsidiaries would settle
their exchange rate exposure with the
headquarters. The reinvoicing centre would
hedge the residual. This would minimize
firm‟s cost of exchange rate hedging.
b) Leading and Lagging: The fund transfer
between the headquarters and the project
could be adjusted based on the sort term
interest rate change. For example, if
there is expectation of foreign currency
devaluation, parent company would slow
down sending fund to the project. At the
same time, fund transfer from project to
parent company would be speeded up.
The forgoing methods can best be explained
using the following example.
Financial Strategy in Dealing with Exchange
Rate Risk
A company, MH, is awarded a contract to
build a number of constructions in Addis
Ababa. The project is cost plus, which
means that after all expenses are paid, MH
will have a 6.25 million Birr profit, which it
will bring back to its U.S. headquarters (all
costs are in Birr).
The contract was awarded on January 1st
and is expected to be completed by
December 31st of the same year. The
exchange rate on January 1st was 0.16
$/Birr and is expected to become 0.156
$/Birr for December 31st. MH can borrow
or lend money in Ethiopia at the rate of 8%
and in the U.S. at the rate of 3%.
 Example
Financial Strategy in Dealing with Exchange
Rate Risk
A company, MH, is awarded a contract to
build a number of constructions in Addis
Ababa. The project is cost plus, which
means that after all expenses are paid, MH
will have a 6.25 million Birr profit, which it
will bring back to its U.S. headquarters (all
costs are in Birr).
The contract was awarded on January 1st
and is expected to be completed by
December 31st of the same year. The
exchange rate on January 1st was 0.16
$/Birr and is expected to become 0.156
$/Birr for December 31st. MH can borrow
or lend money in Ethiopia at the rate of 8%
and in the U.S. at the rate of 3%.
i) Unhedged Position: When no action is taken
on covering the currency exposure, it is
called open exposure. This is highly risky,
since events could change future exchange
rates. In this case, the company is highly
exposed.
With an unhedged risk:
Today Birr 6.25 x 106 x 0.16 = $1
Million is the value that MH owns
By the end of the year the value in dollar
that MH will have is
Birr 6.25 x 106 x 0.156 = $ 0.975 Million
or $975,000, which is a 2.56% decline.
However, if the Birr goes down to 0.144,
the impact would be even more substantial.
Birr 6.25 x 106 x 0.144 = $0.9 Million or
$900,000 which is 11% lower than today‟s
return.
ii) Forward Market Hedge: At Dollar/Birr
rate of 0.1528, it is possible to hedge the
risk by buying dollars in the forward
market. Birr 6.25 x 0.1528 = $0.955 or
$955,000
While this is $20,000 less than an
unhedged position, it is $55,000 higher
than if exchange rate goes to 0.144
$/Birr. In essence, $20,000 is the cost
of buying insurance against a decline of the
Birr.
iii) Option Market Hedge: Buying out option
(to sell Birr) on December 31st is another
alternative. Assuming the cost/Birr is 0.8
cents or $0.008, then the total cost of
hedge is:
6,250,000 x 0 .008 = $50,000
At the end of the year, MH is assured
6,250,000 x 0.16 - $50,000 = $950,000
While this cost is higher than using a
forward market hedge or a money market
hedge, it provides an opportunity for
company to have substantial gain in case
the Birr becoming stronger, relative to the
dollar by the end of the year, since MH
has bought a right to sell Birr at 0.16 Birr
without having an obligation to do so.
iv) Money Market Hedge: In money market
hedge, funds are borrowed in the country
where the company is expected to receive
payment in the future. In the example,
borrowing takes place in Ethiopia. Funds
are then exchanged to home currency at
the prevailing rate and are put in an
interest-yielding instrument for the
duration of the project (or longer). Upon
receiving payment in foreign currency, debt
is paid.
Firms can actually use the money for
working capital or capital investments as
opposed to putting it in an interest-yielding
instrument. In this case, the opportunity
cost of money should be considered as
opposed to the interest.
Borrow present value of Birr 6.25 at
market rate of interest 8%
Present value Birr 6.25/1.08 = 5.787
Change the amount to dollar
5.787 x 0.16 = 0.926 or $926,000
Put the $926,000 in an interest yielding
instrument at 3% annually
926,000 x 1.03 = $953,780
So at the end of the year, MH will have
$953,780 compared to an unhedged position
of $975,000 or forward market hedge of
$955,000.
While both forward and money market
hedges eliminate risk, in this case, a
forward market hedge is less expensive.
Everything being equal, this instrument is
prepared.