Ch 20 - Capital project appraisal (1)

Question 1

Capital project

Answer 1

def: involves an initial expenditure and then, once the project comes into operation, a stream of revenue less running costs.
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new projects undertaken by a company, requiring significant resources more than the normal budget, will be subject to cost justification to show that the expected benefits exceed the costs - if not, need to consider alternative projects.

Question 2

Initial appraisal

Answer 2

def: assesses whether the project is likely to satisfy the sponsors criteria (e.g):
> the financial results expected & risk these results may not be achieved
> achieving synergy or compatibility with others projects undertaken by the sponsor
>satisfying ‘political constraints’, both within & without projects undertaken by the sponsor
> having sufficient upside potential
> using scarce investment funds or management resources in the best way
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The first step of the appraisal is to define the project and its scope carefully and to assess its
likely length of operating life for the purpose of the appraisal.

Question 3

Evaluation of cashflows (expressed in PV money)

Answer 3

-capital expenditure
-running costs
-revenues
-termination costs

Question 4

Methods of project evaluation

Answer 4

1) NPV (net present value)
2) IRR (internal rate of return)
3) Annual capital charge
4) SH value approach
5) Payback period
6) Nominal returns
7) Strategic fit
8) Opportunity cost

Question 5

NPV (net present value)

Answer 5

def: models all CF’s of a project until completion and discounts these back to the present day using the cost of capital.
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A positive result indicates that the project will improve shareholder returns.

Question 6

IRR (internal rate of return)

Answer 6

def: interest rate that gives the project a zero NPV. This is compared to the cost of capital.
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if IRR > cost of capital , then the project may proceed.

Question 7

What are the practical problems with the IRR approach?

Answer 7

1) nonsense results can be obtained if the initial capital is small, giving very high positive (or negative) solutions, two solutions or no solutions at all.
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2) While the average NPV of a range of scenarios can be found simply by summing the value multiplied by the probability of the scenario, this is not the case for IRR.
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3) It should be noted that the IRR can sometimes have multiple solutions, especially if there are net negative CF’S at some points during the operating life of the project or at completion. This has helped to make it less popular than the NPV as a measure of project worth.

Question 8

Annual capital charge

Answer 8

def: expresses the capital outlay as an annual charge, thus writing off the capital steadily over time. This charge may then be offset against the benefits.
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if the net result >0, the project or capital expenditure can be approved.

Question 9

SH value approach

Answer 9

def: attempts to assess the impact of the project on the value of the company as a whole from the point of view of shareholders (current & future).
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P/E ratio
or price to net asset ratios give an indication of how a company stands in relation to its competitors.
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also use dividend yield

Question 10

Issues to be evaluated for value-added approach

Answer 10

• impact on ranking vs. competitors
• possible competitor reactions & change in level of competition
• impact on perception of management
• impact on analyst perceptions
• impact on debt rating
• enhancement or dilutions of earnings
• impact on dividend policy
• impact on stock beta

Question 11

Payback period

Answer 11

def: time that it takes for the accumulated CF to become neutral.
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NB for small companies to look at the speed of recouping investment
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project with a faster payback period will be preferred - > this method has very little use where the payback terms are over 3 years

Question 12

Nominal returns -> not really a method

Answer 12

def: compares the ratio of cash generated to cash consumed over a period.
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gives a quick idea of the relative profitability of projects & is an adequate approach where the ratio can be quickly seen to be high.

Question 13

Strategic fit

Answer 13

def: assesses how the project fits in with the rest of the company’s business, building
on its areas of expertise, resources or customer base.

Question 14

Opportunity cost

Answer 14

this method asks “What alternative ways could we spend this money & what return would be achieved?”
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key criteria required be that the project be the best use of scarce management time & resources.

Question 15

Hurdle rates -> not really a method

Answer 15

def: company sets a target rate of return - this could typically be quite high and well in excess of the true cost of capital.
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Companies sometimes assess the profitability of a project against a hurdle rate of return,

Question 16

Receipts/costs ratio

Answer 16

indicates the level of profit as a proportion of costs & therefore related, but different to the concept of profit margin.

Question 17

What would one consider satisfactory results for the different evaluation methods?

Answer 17

i) NPV -> if positive
ii) IRR -> if it exceeded a predetermined ‘hurdle rate’ set by the sponsor
iii) payback period -> if it was less than a predetermined period set by the sponsor

Question 18

To gain a fuller understanding of the viability of a project, what simulation techniques can be used?

Answer 18

1) SENSITIVITY ANALYSIS - takes each key assumption in turn & assesses the effect on the NPV of the most optimistic & pessimistic results occurring (varying individual sensitivities/assumptions).
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2) SCENARIO TESTING - involves changing plausible combinations of input values & seeing what effect these have on the project. [sensitivity analysis doesn’t consider inter-relationshps between input variables]
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3) MONTE CARLO SIMULATION - attempts to look at the entire distribution of possible project outcomes via numerical simulation. It’s critically dependent on an appropriate model design & appropriate assessment of the prob distribution of the inputs.

Question 19

Monte Carlo Simulation

Answer 19

def: look at entire distribution of possible project outcomes
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> model the project allowing for interdependencies & serial correlations
> specify probabilities for the distribution of the key variables
> simulate the CF’s many times using values extracted randomly from the distributions of possible variable inputs
> record & order the outputs to assess their prob distributions