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Business Applications > Ch8-Capital Project Appraisal > Flashcards

Ch8-Capital Project Appraisal Flashcards

1
Q

Outline of the chapter

A
  1. Introduction
  2. Methods of evaluation
  3. Results of evaluation
  4. Risk Analysis
  5. Identification of risks
  6. Mitigation of risks
  7. Example
  8. Choice of discount rate
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2
Q

what costs are incurred in supporting the capital to finance the project?

the idea of Project Appraisal

A

the cost of capital is a measure of this cost expressed as an annual rate of interest

~there is an initial expenditure, then a project will operate generating a stream of revenues less running costs.
~the expected benefits of a project have to exceed the expected costs.
~the project has to satisfy the criteria set by the sponsors that authorize the project. and these are
-financial results expected and the risks
-synergies/compatibility with other projects
-political constraints(other products are banned from being traded/imported, it also depends on the type of the business)
-sufficient upside down potential
-use of scarce resources(resources available to them to generate return/ maximise profits)
~define the project and its scope carefully- to assess the length of operating life and evaluate the cashflows

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3
Q

What are the methods of evaluation?

A
  1. Net Present value

2. i

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3
Q

What are the methods of evaluation? (10)

S.O.P.H.I.A N.ever S.hops R.andomly at N.orthgate

A
  1. Net Present Value(NPV)
  2. Internal Rate of Return(IRR)
  3. Annual Capital Charge
  4. Shareholder Value Approach
  5. Payback
  6. Nominal Returns
  7. Strategic Fit
  8. Opportunity Cost
  9. Hurdle Rates
  10. Receipts/Costs Ratio
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4
Q

what is the NPV method?

A

~Discounts all cashflow to the present day using the cost of capital.
~if the results are positive, the project will improve shareholder return

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5
Q

What is the Shareholder Value Approach?

A

~Discounts all the future cash flows available to shareholders to determine the return to shareholders.
~looks at the before and after basis. The value-added approach adds in the new project. The impact on the NAV, future earnings, and debt is determined. The impact of the new project on the rating of the company is analyzed, ranking is also checked. There’s also the impact on how a company is perceived.

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6
Q

What is the opportunity cost?

A

~where else could the investment be done that could provide a higher return than the other project with the same risk profile
~can also be what alternative methods could we spend this money and what return would be achieved
~investing in one business and letting go of the other.

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7
Q

what is Payback method?

A

~the time it takes for the accumulated cash flows to become neutral
~determine the period of the project to be profitable.
~a project with faster payback period will be preffered

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8
Q

What is Hurdle Rate?

A

~the company has to set the target rate of return(hurdle rate). this is done before the commencement of the project. It depends on the type of the company.

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9
Q

What is the Internal Rate of Return?

A

~The rate is found by equating the equation of value to 0 and comparing it with the rate of the capital cost.
~this is the actual return achieved by the project.
~if it is higher than the cost of capital, then the project may proceed.

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10
Q

What is Annual Capital Charge?

A

~it expresses the capital outlay as an annual charge, writing it off on the length of the project.
~determines Capital outlay annually
~this charge can be offset against benefits, and if the result is positive, the project can be approved

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11
Q

What is Nominal Return?

A

~compare the ratio cash generated to cash spent.
~the period of evaluation is short
~gives an idea about relative profitability

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12
Q

What is Strategic fit?

A

~the project should fit with the industry of operation of the business
~sometimes a new departure into a business is based on how the industry is moving
~a business scenario is projected, a future good business response is developed. if the investment reaps good rewards, there are opportunities gained.

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13
Q

What is the Receipt cost?

A

NPV of the gross revenues/ NPV of the capital and running costs

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14
Q

When are the results of the evaluation considered satisfactory?

A
  1. When the NPV is positive
  2. When IRR exceeds a predetermined hurdle rate set by the sponsor
  3. When the payback period is less than a predetermined period set by the sponsor
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15
Q

Simulation

What is sensitivity analysis?

A

~ allows us to use different future conditions on a modeled project
~we change the key assumptions to see the effect on outcomes(which variables have the greatest effect)

16
Q

What is Scenario Testing?

A

~it considers the plausible combinations and sees the effect on the project. that is the interrelationship between input variables

17
Q

What is Monte Carlo Simulation?

A

~considers all possible combinations. The distribution of all possible project outcomes
-we need to:
~model the project(allow interdependencies and serial connections)
~specify probabilities
~Simulate the cash flows many times
~Record and order the outputs to assess their probabilities

18
Q

What is systematic risk?

what is specific risk?

A

~risk in the system and which affect the whole area of the business into which the project falls e.g price of land for a building project

~specific to the project and which can be diversified away by the company e.g risk of a cold summer reducing ice-cream sales diversified by also selling hot dogs

19
Q

What are the steps for Risk Analysis?

C.R.I.M.A

A
  1. Identify
  2. Analyse (by estimating the frequency of occurrence and the consequences)
  3. Mitigate (reducing the frequency of occurrence and adverse consequences)
  4. Costs of the possible mitigation options (to see if they are financially viable or not)
  5. Residual risks (they need to be controlled since they can’t be mitigated)
19
Q

What are the steps for Risk Analysis?

A
  1. Identify
  2. Analyse (by estimating the frequency of occurrence and the consequences)
  3. Mitigate (reducing the frequency of occurrence and adverse consequences)
  4. Costs of the possible mitigation options (to see if they are financially viable or not)
  5. Residual risks (they need to be controlled since they can’t be mitigated)
20
Q

how can residual risks be controlled?

A

~regular monitoring
~plan to deal with foreseeable and unforeseeable crises
~appointment of risk custodian
~regular management review

21
Q

What are the steps necessary to achieve an effective identification of the risks facing the project?
(4 options)

A
  1. Make a high-level preliminary risk analysis- to confirm a project does not have a high-risk profile
  2. Hold a brainstorming session of project experts and senior people- to identify both likely and unlikely risks
  3. Carry out a desktop analysis to supplement the results from brainstorming session - identify further risks and mitigation options, use the risk matrix, research similar projects
  4. Set out all the identified risks in a risk register with cross-references to other risks
22
Q

What column headings are in the risk matrix?

P.B.E.P.N.F.C
B.E.N P.lays P.ool F.C

A

~political- can be war, corruption
~Business- the way a business is supposed to be conducted
~Economic- supply and demand issues, stock market fluctuations
~Project- risk of not producing positive cash flows
~Natural- disasters e.g drought
~Financial- not enough funds to repay the loan
~Crime- theft of product

23
Q

What row headings are there in the risk matrix?

C.P.R.C.O.R.D.P.D
2 C.O.R.D with 2 P.lugs

A
  1. Contract Negotiations
  2. Project Approval
  3. Raising of capital
  4. Construction
  5. Operation and maintenance
  6. Receiving revenues
  7. Decommissioning
  8. Promotion of the concept
  9. Design
24
Q

What are the main methods of mitigating the risks?

T.R.I.S.A.R.
R.I.sing S.T.A.R

A

~Avoiding the risk (redesign the project)
~Reducing the risk (reduce the probability of occurrence. Modify the design)
~Reducing uncertainty (conduct further research)
~Transferring risk (engage a sub-contractor on a fixed price contract)
~Insuring risk
~Sharing the risk (share with another party that is able to control the risk to some extent)

25
Q

What is evaluated in each option?

A

~effect of frequency- consult experts
~feasibility and cost of implementing the risk
~consequences if the risk occurs- find NPV
~rank risks

26
Q

What is a discount rate?

when is the cost of capital equal to the rate of return?

What is the net cost of borrowing after allowing for tax reliefs?

what is the weighted average cost?

A

~the cost of capital to calculate the NPV to screen projects that will only enhance the return to shareholders.

~if all capital were to be raised from internal reserve or rights issue.

~if all capital were to be raised fixed-interest borrowing

~if part of the capital were raised through equity and part through borrowing.

27
Q

What is allowing for systematic risk?

A

~is the risk of the project consistent with the company’s existing risk profile.
~the risk of the project is not diversifiable.
~systematic risk is allowed for by varying the discount rates used in the model
~we have to allow for possible unfavourable outcomes in calculating the expected cashflow
~ and make arbitrary addition to the discount rate

28
Q

Issues to consider are:

A
  1. Cyclicality- does the outcome of the project depend strongly on the state of the economy and the business cycle?
  2. Operating leverage- does the project involve a high proportion of fixed costs?
29
Q

What is the Practical Experience?

A

~using different costs of capital can lead to internal friction

Business Applications (9 decks)

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