Chapter 12: Capital Project Appraisal Flashcards

1
Q

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.

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2
Q

Main purpose of INITIAL capital project appraisal

A

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

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3
Q

Criteria for initial appraisal are usually expressed in terms of

A
  • FINANCIAL results and risks
  • SYNERGIES with other projects
  • STRATEGIC issues
  • POLITICAL constraints
  • sufficient upside POTENTIAL
  • use of scarce RESOURCES
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4
Q

Final criteria may be expressed in terms of

A
  • NPV
  • IRR
  • payback period
  • discounted payback period.
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5
Q

Specific Risk

A

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.

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6
Q

Specific risk analysis

A

Consists of
- IDENTIFYING
- QUANTIFYING
the risks,

where possible:

  • MITIGATING the risks
  • MANAGING any residual risks that remain.
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7
Q

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

A
  • identified
  • analysed
  • mitigated
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8
Q

Residual risks

A

Specific risks that cannot be mitigated.

They must be managed carefully and highlighted to the sponsors.

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9
Q

Specific risks can be identified using (5)

A
  • high level PRELIMINARY RISK ANALYSIS
  • BRAINSTORMING with experts
  • DESKTOP ANALYSIS
  • risk register
  • risk matrix
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10
Q

Analysis of specific risks involves characterising them by (4)

A
  • FREQUENCY of occurrence
  • FINANCIAL consequences
  • CORRELATIONS between risks
  • CONTROLLABILITY
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11
Q

6 key methods of mitigating specific risk

A
  • SHARING the risk
  • TRANSFERRING the risk
  • AVOIDING the risk
  • REDUCING the risk (frequency and/or consequences)
  • Further researching of the risk
  • INSURING the risk
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12
Q

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

A

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

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13
Q

Systematic risk

A

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.

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14
Q

Final investment decision will reflect…

A
  • distribution of NPVs

- characteristics of the residual risks that cannot be mitigated.

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15
Q

Investment submission

A

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

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16
Q

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

A
  • 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.
17
Q

Criteria involved in “initial appraisal”

A
  • 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
18
Q

Possible inclusions in the scope of a project

A
  • 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
19
Q

Evaluation of cashflows step

A

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)

20
Q

4 Appraisal techniques (financial criteria)

A
  • Net present value (NPV)
  • internal rate of return (IRR)
  • payback period
  • discounted payback period
21
Q

payback period

A

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.

22
Q

discounted payback period

A

as per the payback period but with discounting of the cashflows

23
Q

Sensitivity analysis

A

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

24
Q

Scenario testing

A

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

25
Q

4 Steps in risk identification

A
  • High level preliminary risk analysis
  • Brainstorming session
  • Desktop analysis
  • Risk register
26
Q

High level preliminary analysis

A

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

27
Q

Brainstorming session

A

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

28
Q

Aim of the brainstorming session

A
  • 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.
29
Q

Desktop analysis

A

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.
30
Q

Risk matrix

A

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.