Chapter 12: Capital Project Appraisal Flashcards
What is a capital project
Any project where there is INITIAL EXPENDITURE and then
- once the project comes into operation -
a STREAM OF REVENUES less running costs.
A capital project does not have to involve the construction of a physical asset.
What are the main steps in a capital project appraisal?
INITIAL APPRAISAL, to see whether the project satisfies the sponsor’s criteria.
If it does, a DETAILED APPRAISAL is carried out:
- Defining the SCOPE of the project
- Evaluating cashflows
- Identifying, analysing and mitigating RISKS
- Producing an INVESTMENT SUBMISSION
- Making a DECISION whether or not to go ahead.
Criteria that a project should satisfy in the INITIAL APPRAISAL
The project should
- be financially viable
- achieve synergies with other projects
- satisfy political constraints
- have significant upside potential
- use scarce funds / management resources in the best way.
How to evaluate the cashflows of the project?
Define the most likely CASHFLOWS:
- the capital outlay,
- running costs,
- revenues
- and termination costs
Consider the CONSEQUENTIAL EFFECTS on the sponsors other activities
Document any ASSUMPTIONS made
Calculate results such as NPV, IRR, Payback and Discounted payback periods.
- – compare these against benchmarks
- – e.g. is IRR greater than a hurdle rate
SENSITIVITY TESTS, by varying the assumptions made
How would you set the risk discount rate to calculate the net present value?
The risk discount rate should reflect the systematic risk together with any inherently high risks that cannot be sufficiently taken into account via specific risk analysis.
A real discount rate should be used to discount real cashflows.
A nominal discount rate should be used to discount cashflows that include inflation.
Effective risk identification exercise
- Make a high level preliminary analysis
- Hold a brainstorming session
- Carry out a desktop analysis
- Set out the risks in a risk register
6 Ways of mitigating risks
- Further research
- AVOID the risk
- TRANSFER the risk
- SHARE the risk
- INSURE the risk
- REDUCE the risk
Likely entries in the INVESTMENT SUBMISSION document
FINANCIAL results (expected NPV, distribution of NPVs)
RISKS identified
- – best combination of risk mitigation options
- – residual risks, especially those that can be catastrophic, despite having a low probability of occurrence
the details surrounding the FINANCING of the project
the likely effects on INVESTORS after allowing for inflation, borrowing costs and tax
Further considerations (beyond the investment submission)
- allowance for any bias or approximations in the estimates
- a hunch
- knowledge not held by those producing the submission
- last-minute developments
- doubts over feasibility
- the overall project credibility
- whether upside potential has been estimated realistically
How would you set the risk discount rate to calculate NPV for projects with a NORMAL DEGREE OF RISK?
For projects with a NORMAL DEGREE OF RISKS, this would be
the current cost of raising incremental capital from the sponsoring company to fund this project.
This should be the company’s
… normal weighted average cost of capital,
… where the weights reflect the optimal capital structure of the company
… between debt and equity.
How should the debtholders’ required return be calculated?
The DEBTHOLDERS REQUIRED RETURN should be the
… expected return on an index-linked government bond
… plus a debt risk margin.
This should be adjusted for corporation tax.
How should the shareholders’ required return be calculated?
The SHAREHOLDERS REQUIRED RETURN should be
… the expected return on an index-linked government bond
… plus an equity risk margin.
This then gives a real risk discount rate which can be adjusted for future inflation to make it into a nominal rate of interest.
How would you set the risk discount rate to calculate NPV for projects with a HIGHER-THAN-NORMAL DEGREE OF RISK?
For projects that have a HIGHER-THAN-NORMAL degree of risk, the sponsoring company should use a higher-than-normal discount rate.
- It could consider the rates used by other companies engaging in similar projects,
or - if that information is hard to obtain - make an arbitrary adjustment.