Chapter 12: Capital Project Appraisal Flashcards

1
Q

What is a capital project

A

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.

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2
Q

What are the main steps in a capital project appraisal?

A

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.
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3
Q

Criteria that a project should satisfy in the INITIAL APPRAISAL

A

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.
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4
Q

How to evaluate the cashflows of the project?

A

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

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5
Q

How would you set the risk discount rate to calculate the net present value?

A

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.

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6
Q

Effective risk identification exercise

A
  • Make a high level preliminary analysis
  • Hold a brainstorming session
  • Carry out a desktop analysis
  • Set out the risks in a risk register
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7
Q

6 Ways of mitigating risks

A
  • Further research
  • AVOID the risk
  • TRANSFER the risk
  • SHARE the risk
  • INSURE the risk
  • REDUCE the risk
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8
Q

Likely entries in the INVESTMENT SUBMISSION document

A

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

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9
Q

Further considerations (beyond the investment submission)

A
  • 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
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10
Q

How would you set the risk discount rate to calculate NPV for projects with a NORMAL DEGREE OF RISK?

A

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.

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11
Q

How should the debtholders’ required return be calculated?

A

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.

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12
Q

How should the shareholders’ required return be calculated?

A

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.

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13
Q

How would you set the risk discount rate to calculate NPV for projects with a HIGHER-THAN-NORMAL DEGREE OF RISK?

A

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.
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