Chapter 12: Capital Project Appraisal Flashcards
Capital project
Any project where there is initial expenditure and then, once the project comes into operation, a stream of revenues less running costs.
Main purpose of INITIAL capital project appraisal
To ascertain whether a project satisfies the criteria that have been established by the sponsoring organisation for projects that it is prepared to authorise.
Criteria for initial appraisal are usually expressed in terms of
- FINANCIAL results and risks
- SYNERGIES with other projects
- STRATEGIC issues
- POLITICAL constraints
- sufficient upside POTENTIAL
- use of scarce RESOURCES
Final criteria may be expressed in terms of
- NPV
- IRR
- payback period
- discounted payback period.
Specific Risk
Probabilistic risk
The element of risk that can be eliminated either by repeated investment in the same project,
or - failing this - by diversification over a number of different projects.
Specific risk analysis
Consists of
- IDENTIFYING
- QUANTIFYING
the risks,
where possible:
- MITIGATING the risks
- MANAGING any residual risks that remain.
What must be done to specific risks ? They must be :
- identified
- analysed
- mitigated
Residual risks
Specific risks that cannot be mitigated.
They must be managed carefully and highlighted to the sponsors.
Specific risks can be identified using (5)
- high level PRELIMINARY RISK ANALYSIS
- BRAINSTORMING with experts
- DESKTOP ANALYSIS
- risk register
- risk matrix
Analysis of specific risks involves characterising them by (4)
- FREQUENCY of occurrence
- FINANCIAL consequences
- CORRELATIONS between risks
- CONTROLLABILITY
6 key methods of mitigating specific risk
- SHARING the risk
- TRANSFERRING the risk
- AVOIDING the risk
- REDUCING the risk (frequency and/or consequences)
- Further researching of the risk
- INSURING the risk
Each mitigation option for a particular risk will be evaluated, assessing:
FEASIBILITY and cost of implementing the option
likely EFFECT on frequency, consequence and expected value
- overall impact on the distribution of NPVs
any “SECONDARY RISKS” resulting from the option
- further mitigating actions to respond to secondary risks
Systematic risk
Element of risk that cannot be eliminated by diversification, no matter how widely we spread our investment and no matter how often a particular project is repeated.
Final investment decision will reflect…
- distribution of NPVs
- characteristics of the residual risks that cannot be mitigated.
Investment submission
Results of the detailed appraisal is written up in a document called the investment submission
Considerations in the investment decision, beyond the investment submission, might include…
- allowance for any likely bias or possible approximations in the estimates
- “hunch”
- knowledge not in the possession of those who have prepared the submission
- last-minute developments
- doubts about feasibility or quality of implementation
- overall project credibility.
Criteria involved in “initial appraisal”
- promising financial results
- acceptable risks that these results may not be achieved
- achieving synergy or compatibility with other projects undertaken by the sponsor.
- satisfying “political constraints” both within and without the sponsoring organisation
- having sufficient upside potential
- using scarce investment funds or management resources in the best way
Possible inclusions in the scope of a project
- to WHOM (or which departments) the goals of the project apply (and who should not be affected)
- exact RESPONSIBILITIES of the people involved in the project team
- a list of connected ISSUES for which the project team is not responsible.
- SUCCESS CRITERIA of the project and how these will be measured
- TIMESCALES involved including limits beyond which the project team’s responsibilities and powers will not extend
- BUDGET of the project
Evaluation of cashflows step
an evaluation of the most likely cashflows for the
- capital expenditure,
- running costs,
- revenues
- termination costs.
The cashflows should allow for any consequential effects on the sponsor’s other activities or costs.
Also might need to determine a risk discount rate to evaluate cashflows with:
Projects with normal systematic risk
- Find the WACC of the company
- If systematic risk > risk in the company, add risk prem.
Projects with above normal systematic risk
- Check the RDR used on similar projects of other companies
- If the other companies have experience with the project, add a risk premium to the RDR they used
If long term funds are being used to fund the project, expected long term equity returns is a good place to start to find the RDR for the project (plus other risk factors)
4 Appraisal techniques (financial criteria)
- Net present value (NPV)
- internal rate of return (IRR)
- payback period
- discounted payback period
payback period
the length of time before the capital expended on the project is recouped from the net revenues (consisting of the gross revenues less running costs), without discounting the cashflows.
discounted payback period
as per the payback period but with discounting of the cashflows
Sensitivity analysis
investigates how the profitability of the project changes in response to a change in a single assumption in isolation.
Scenario testing
constructs a series of future scenarios by varying several assumptions simultaneously and in a mutually consistent fashion.
4 Steps in risk identification
- High level preliminary risk analysis
- Brainstorming session
- Desktop analysis
- Risk register
High level preliminary analysis
made to confirm that the project does not obviously have such a high-risk profile that it is not worth analysing further.
Brainstorming session
Held with project experts and senior internal and external people who are used to thinking strategically about the long term
Aim of the brainstorming session
- IDENTIFY project RISKS, both likely and unlikely and upside & downside
- to discuss these risks & their INTERDEPENDENCY
- to attempt to place a broad initial EVALUATION on each risk, both for frequency of occurrence and probable consequences if it does occur.
- to generate initial MITIGATION OPTIONS and discuss them briefly.
Desktop analysis
To supplement the results from the brainstorming session, by
- IDENTIFYING further risks and mitigation options,
- researching SIMILAR PROJECTS undertaken by the sponsor or others in the past
- OBTAINING the considered OPINIONS of experts who are familiar with the details of the project and outline plans for financing it.
Risk matrix
Acts as a reminder to consider particular types of risk, which may not have been sufficiently considered.
Provides a convenient categorisation for risks.
The cells in the matrix can be ticked off to show whether the risk in question applies to the particular project, with a cross-reference to the appropriate entry in the risk register.
