Ch 21 - Capital project appraisal (2) Flashcards
Calculating the required rate of return for a project
The use of the cost of capital to calculate the NPV in screening projects ensures that projects are only entered into that will enhance the return to shareholders, provided it is adjusted to reflect the project risk.
What should the weighted average cost of capital reflect?
- the weighted average cost of capital
- the degree of systematic risk associated with the project
How can systematic risk be allowed for?
It should be allowed for by varying the discount rates used in the model & the discount rate used should be greater than that which the company normally employs.
What might suitable adjustments to the discount rates be based on?
- discount rates used by any companies which habitually engage in such projects
- an arbitrary addition
- degree of cyclicality associated with the project (does the outcome depend on the state of the economy & business cycle?)
- the operating leverage of the project (does the project involve a high proportion of fixed costs?)
-CAPM (using an estimated beta for a project)
Why is it not uncommon for companies to use very high discount or hurdle rates when appraising proposed projects?
The use of a discount rate which is too high could distort the relative weights placed on the ST & LT thereby leading to mistaken decisions.
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It may be assumed, mistakenly, that the deliberate use of a very high discount rate provides a contingency margin which reduces the need for a rigorous risk analysis. This leads to the danger of the incorrect acceptance of a risky project with a high apparent NPV or the incorrect rejection of a low-risk projection with a negative NPV, which would have a positive NPV if this were calculated on a lower but more appropriate discount rate.
Certainty equivalents
Certainty equivalents can be used to replace the individual risky projected CF’s & then discounted at a uniform rate of return.
How can specific risks be determined?
Through the use of a RISK ANALYSIS of the report.
How does one deal with specific risks?
Risks may be upside as well as downside. In order to deal with them we need to:
-identify them
-analyse them
-mitigate them (the f+s of downside risks & any adverse consequences)
> consider the costs of possible mitigation options (whether financially viable or not)
If the project is accepted, the residual risks need to be controlled using a series of measures which include:
- regular monitoring of the risks
- plans for dealing with foreseeable & unforeseeable crises
- appointment of risk custodians
- regular management reviews
What does the risk identification process include?
i) undertaking a high-level preliminary risk analysis (to confirm that the project doesn’t have a high risk profile not worth analysing)
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ii) holding a brainstorming session (of experts & senior internal & external people who are used to thinking strategically about the LT)
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iii) carrying out a desktop analysis (to supplement results from the brainstorming session, by identifying further risks and mitigation options, using a general risk matrix-> f+s)
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iv) setting out all the identified risks in a risk register (with cross references to other risks where there is interdependency)
How do risk matrices categorise risks?
according to:
-the cause of the risk (columns)
-stage of the project at which the risk arises (rows)
What are the methods for mitigating risk?
-avoiding
-reducing
-insuring (via risk transfer)
-sharing (with another party)
-transferring
-researching (by reducing uncertainty)
Each option for mitigating a particular risk will be evaluated, assessing:
-likely effect of freq, consequence & expected value
-feasibility & cost of implementing the option
-any ‘secondary risks’ resulting from the option
-further mitigating actions to respond to secondary risks
-overall impact of each option on the distribution of NPVs
