Capital Project Appraisal

Question 1

Capital Project

Answer 1

Any project where there is initial expenditure and then, once the project comes into operation, a stream of revenues less running costs. (It does not have to involve the construction of a physical asset - for example a life insurer developing a new product)

Question 2

Capital Project Appraisal

Answer 2

The process of deciding whether a particular project should or should not go ahead.

Question 3

Purpose of Initial Appraisal

Answer 3

Determining whether the project is likely to satisfy the sponsoring organisation’s authorisation criteria for projects it is prepared to authorise.

Question 4

Common initial appraisal criteria:

Answer 4

• Financial results expected
• Risk that these results may not be achieved.
• Achieving synergy or compatibility with other sponsor projects
• Satisfying “political constraints”, both within and without the sponsoring organisation
• Having sufficient upside potential
• Best utilization of investment funds or management resources

Question 5

6 Stages of Detailed Appraisal

Answer 5

• Project definition and scope
• Evaluation of cashflows
• Risk Identification
• Analysis of Risks
• Risk mitigation
• Investment submission

Question 6

Possible project definition and scope inclusions:

Answer 6

• Success criteria and how these will be measured
• Budget of the project
• Timescales involved including limits beyond which the project team’s responsibilities and powers will not extend.
• To whom (or which departments) the goals of the project apply (and who should not be affected)
• Responsibilities of those involved
• Exact responsibilities of the people involved in the project team.
• Connected issues for which the team is not responsible.

Question 7

Evaluation of cashflows stage

Answer 7

There should be an evaluation of the most likely cashflows for capital expenditure, running costs, revenues and termination costs.
The cashflows should allow for any consequential effects on the sponsor’s other activities or costs.

Question 8

4 Important calculations when evaluating cashflow (Discounted cashflow approach)

Answer 8

• Net present value (NPV - will be regarded as satisfactory if it is positive)
• Internal rate of return (IRR - will be regarded as satisfactory if it exceeds a predetermined “hurdle rate” )
• Payback period
• Discounted payback period

Question 9

Net Present Value Calculation

Answer 9

Models all cash flows of a project until termination and discounts these back to the present day using the cost of capital as discount rate.

If the result is positive then the project will improve shareholder returns.

Question 10

Internal Rate of Return (IRR) Calculation

Answer 10

Similar to NPV, but rather than discounting the cost of capital, a solution is found for the interest rate that gives the project a zero NPV.
This method has the benefit of highlighting the return achieved by the project.

Question 11

Practical problems with the IRR approach

Answer 11

• Nonsense results can be obtained if the initial capital is small giving very high positive (or negative) solutions, two solutions or none at all.
• The average NPV of a range scenarios can be found simply by summing the value multiplied by the probability of the scenario. The same is not true for IRR.

Question 12

Pay Back period

Answer 12

Time it takes for the accumulated cashflow to become neutral.
(The project with the fastest payback period will be preferred, the method can also be used to identify the project that generates the most funds over a specific time period)

Question 13

Sensitivity analysis

Answer 13

Analyses how the value of the project changes with differing future conditions. We take each key assumption in turn and assess the effect on the NPV of the most optimistic and pessimistic results occurring. In this way, we can identify which are the variables which have the greatest effect on the outcome of the project & determining where more information is needed.

Question 14

Sensitivity analysis calculation

Answer 14

We take each key assumption in turn and assess the effect on the NPV of the most optimistic and pessimistic results occurring. In this way, we can identify which are the variables which have the greatest effect on the outcome of the project & determining where more information is needed

Question 15

Scenario testing calculation

Answer 15

Consider plausible combinations of input values and see what effect these have on the project.

Question 16

(Monte Carlo) simulation

Answer 16

Analysis to consider all possible combinations.

The entire distribution of thousands of possible project outcomes are considered.

Question 17

4 Risk identification stage steps

Answer 17

• Make a high-level preliminary risk analysis.
• Hold a brainstorming session of project experts and senior internal and external people who are used to thinking strategically about the long term.
• Carry out a desktop analysis to supplement the results from the brainstorming session, by identifying further risks and mitigation options, researching similar projects undertaken by the sponsor or others in the past.
• Set out all identified risks in a risk register, with cross-references to other risks where there is independency.

Question 18

The purpose of high level preliminary risk analysis

Answer 18

To confirm that the project does not obviously have such a high-risk profile and that it is not worth analysing further.

Question 19

4 Aims of the brainstorm session with project experts:

Answer 19

• Identify project risks
• Discuss risks and their interdependency
• Place a broad initial evaluation on each risk.
• Generate initial mitigation options

Question 20

2 Considerations in evaluating a risk:

Answer 20

• Frequency of occurrence

- Probable consequences

Question 21

Analysis of specific risks will confirm:

Answer 21

• Frequency of occurrence
• Consequences if the risk occurs
• Correlations between risks
• Controllability of the risks

Question 22

Process of risk analysis

Answer 22

• Concentrate on independent risks. Regard dependent risks as consequences of them.
• Express financial consequences in present-day money values
• Prioritize risks for further analysis. Discard risks with lower expected NPV’s, with the intention of allowing for them in a general contingency allowance later.

Question 23

6 Methods of risk mitigation

Answer 23

• Risk avoidance
• Risk reduction i,e. either reducing the probability of the occurrence or the consequences or both
• Reducing Uncertainty
• Transferring risk
• Insuring risk
• Sharing risk with another party

Question 24

What is to be assessed in mitigation option evaluation? 5 points

Answer 24

• Likely effect on frequency, consequence and expected value,
• Feasibility and cost of implementing the option
• Any “secondary risks” resulting from the option (side effects)
• Further mitigating actions to respond to secondary risks
• Overall impact of each option on the distribution of NPVs

Question 25

Contents of the investment submission

Answer 25

• Assumes that the best possible combination of mitigation options will be implemented

Contains:

• Expected NPV
• Probability distribution of NPVs
• Identification & analysis of residual risks
• Proposed finance method
• Analysis of the likely effect on investors (after taking account of expected price inflation, borrowing, tax etc.)

Question 26

The essential aim of the investment submission

Answer 26

To discuss how the project relates to the sponsor’s criteria for judging whether or not to proceed with a project.

Question 27

Two distinct components of project-associated risk

Answer 27

Systemic risk

Specific risk

Question 28

Systemic risk

Answer 28

That part of the variability of return on a project which cannot be eliminated by investing in the same type of project many times over, or by diversification, because investing in a number of projects cannot reduce this part of the variability to zero.

Question 29

Specific risk (or probabilistic risk)

Answer 29

Element of risk that can be eliminated either by repeated investment in the same project, or by diversification over a number of different risk.

Question 30

Weighted average cost of capital =

Answer 30

(Market value of debt)/(Market value of debt & equity) x Debtholders’ required return x (1 - t)
+
(Market value of equity)/(Market value of debt & equity) x Shareholders’ required return

Question 31

The cost of debt capital is taken as…

Answer 31

the cost in real terms of new borrowing by the company.

Question 32

The cost of debt calculation

Answer 32

Calculated by taking an appropriate margin over the current expected total real return on index-linked bonds, and multiplying by (1 - t)

t = assumed rate of corporation tax.

Question 33

The cost of equity

Answer 33

The current expected total real return on index-linked bonds plus a suitable margin to allow for the additional return that equity investors seek to compensate them for the risks they run.

Question 34

5 Steps to produce a probability tree

Answer 34

1. Map the possible choices, beginning from the initial project decision and branching out to represent all the possible subsequent options.
2. Assign estimated cashflows associated with each future possible choice
3. Estimate the probabilities associated with each future cashflow
4. Use standard expected value calculations, incorporating both the time value of money and the probabilities to assess the optimal choices in each future time period, based on the knowledge of the intervening events.
5. Work backwards from the latest decision point to the present day in order to establish the best route to follow at the outset.

Question 35

Three project appraisal considerations

Answer 35

Financial
Political
Strategic