Chapter 12: Capital Project Appraisal

Question 1

Capital project

Answer 1

Any project where there is initial expenditure and then, once the project comes into operation, a stream of revenues less running costs.

Question 2

Main purpose of INITIAL capital project appraisal

Answer 2

To ascertain whether a project satisfies the criteria that have been established by the sponsoring organisation for projects that it is prepared to authorise.

Question 3

Criteria for initial appraisal are usually expressed in terms of

Answer 3

• FINANCIAL results and risks
• SYNERGIES with other projects
• STRATEGIC issues
• POLITICAL constraints
• sufficient upside POTENTIAL
• use of scarce RESOURCES

Question 4

Final criteria may be expressed in terms of

Answer 4

• NPV
• IRR
• payback period
• discounted payback period.

Question 5

Specific Risk

Answer 5

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.

Question 6

Specific risk analysis

Answer 6

Consists of
- IDENTIFYING
- QUANTIFYING
the risks,

where possible:

• MITIGATING the risks
• MANAGING any residual risks that remain.

Question 7

What must be done to specific risks ? They must be :

Answer 7

• identified
• analysed
• mitigated

Question 8

Residual risks

Answer 8

Specific risks that cannot be mitigated.

They must be managed carefully and highlighted to the sponsors.

Question 9

Specific risks can be identified using (5)

Answer 9

• high level PRELIMINARY RISK ANALYSIS
• BRAINSTORMING with experts
• DESKTOP ANALYSIS
• risk register
• risk matrix

Question 10

Analysis of specific risks involves characterising them by (4)

Answer 10

• FREQUENCY of occurrence
• FINANCIAL consequences
• CORRELATIONS between risks
• CONTROLLABILITY

Question 11

6 key methods of mitigating specific risk

Answer 11

• SHARING the risk
• TRANSFERRING the risk
• AVOIDING the risk
• REDUCING the risk (frequency and/or consequences)
• Further researching of the risk
• INSURING the risk

Question 12

Each mitigation option for a particular risk will be evaluated, assessing:

Answer 12

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

Question 13

Systematic risk

Answer 13

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.

Question 14

Final investment decision will reflect…

Answer 14

• distribution of NPVs

- characteristics of the residual risks that cannot be mitigated.

Question 15

Investment submission

Answer 15

Results of the detailed appraisal is written up in a document called the investment submission

Question 16

Considerations in the investment decision, beyond the investment submission, might include…

Answer 16

• 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.

Question 17

Criteria involved in “initial appraisal”

Answer 17

• 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

Question 18

Possible inclusions in the scope of a project

Answer 18

• 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

Question 19

Evaluation of cashflows step

Answer 19

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)

Question 20

4 Appraisal techniques (financial criteria)

Answer 20

• Net present value (NPV)
• internal rate of return (IRR)
• payback period
• discounted payback period

Question 21

payback period

Answer 21

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.

Question 22

discounted payback period

Answer 22

as per the payback period but with discounting of the cashflows

Question 23

Sensitivity analysis

Answer 23

investigates how the profitability of the project changes in response to a change in a single assumption in isolation.

Question 24

Scenario testing

Answer 24

constructs a series of future scenarios by varying several assumptions simultaneously and in a mutually consistent fashion.

Question 25

4 Steps in risk identification

Answer 25

• High level preliminary risk analysis
• Brainstorming session
• Desktop analysis
• Risk register

Question 26

High level preliminary analysis

Answer 26

made to confirm that the project does not obviously have such a high-risk profile that it is not worth analysing further.

Question 27

Brainstorming session

Answer 27

Held with project experts and senior internal and external people who are used to thinking strategically about the long term

Question 28

Aim of the brainstorming session

Answer 28

• 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.

Question 29

Desktop analysis

Answer 29

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.

Question 30

Risk matrix

Answer 30

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.