CHP 12

Question 1

1. Overview of capital project appraisal

Answer 1

A capital project means any project where there is initial expenditure and then a stream of revenues less running costs.
A capital project does not have to involve the construction of a physical asset.

Question 2

1. Overview of capital project appraisal steps

Answer 2

identify project opportunity
INITIAL APPRAISAL
Detailed appraisal
Investment submission

Question 3

2. Initial appraisal

Answer 3

Main purpose: ascertain if a proposed capital project is likely to satisfy the criteria of the sponsoring organization.
The criteria will typically be expressed in financial results expected and the risks of this not being achieved.

Question 4

In practice there may be additional criteria for initial appraisal

Answer 4

• Achieving synergy or compatibility with other projects
• Satisfying political constraints
• Having sufficient upside
• Using scarce investment funds or management resources in the best way.

These can often not be factored into a financial model, a subjective assessment will be needed.
During the appraisal process it will be necessary to investigate the risks of the project and mitigation of these (taking into account the cost of the mitigation).
The remaining risks will need to be listed for the benefit of the sponsor, lender and investors.

Question 5

3. Detailed appraisal

Answer 5

1st step: define the project and its scope and assess its likely length of operating life.

Question 6

3. Detailed appraisal

3. 2. Evaluation of cashflows

Answer 6

Evaluate the most likely cashflows for capital expenditure, running costs, revenues and termination costs.
Cashflows should allow for any consequential effects on the sponsor’s other activities or costs.
Accurate definition and evaluation of most likely cashflows is critical to success as this constitute the base line. Document all assumptions carefully.

Question 7

Appraisal techniques

Answer 7

After the initial cashflow projection, estimate the financial result of undertaking the project. A discounted cashflow approach is normally used, e.g.
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Payback period – time it takes for capital to be recouped from the net revenues without discounting
• Discounted payback period

Question 8

• Internal Rate of Return (IRR)

Answer 8

IRR could have multiple solutions – especially if there are negative cashflows. If there is not large start up capital needed, the IRR can be very big but the project could still make a small absolute profit. Thus IRR less popular than NPV.

Question 9

• Net Present Value (NPV)

Answer 9

NPV result will be satisfactory if it is positive and IRR is above the hurdle rate, the payback period will be good if shorter than the predetermined period.

Question 10

Appraisal techniques results

Answer 10

These calculations will result in an initial appraisal of the project. Broad sensitivities can be done, if unsatisfactory it could indicate the project is not worthwhile or needs redesign. If satisfactory, detailed analysis should start.
Sensitivity analysis – tests sensitivity to a single factor
Scenario testing – varies all assumptions in a mutually consistent manner.

Question 11

Sensitivity analysis

Answer 11

tests sensitivity to a single factor

Question 12

Scenario testing

Answer 12

varies all assumptions in a mutually consistent manner.

Question 13

4. Choice of risk discount rate

Answer 13

Normal practice is to factor inflation into the cashflows and use a nominal risk discount rate.

Question 14

4.2. Systemic (or systematic) risk and specific risk

Answer 14

This risk cannot be eliminated by investing in similar project many times over. (non-diversifyable risk) These risks can vary from one type of project to the next.

Question 15

4.3. Choosing the discount rate for projects with a normal degree of systemic risk

Answer 15

Assume the sponsor is a commercial company.
The starting point is the cost of raising incremental capital for the company to carry out projects. This is the rate that needs to be earned on a project to put shareholders in the same position as before.
This could be the company’s normal cost of raising capital, taking this as a weighted average where the weights are based on the optimum capital structure for the company as between equity and debt. If the structure is not currently optimum, it can be made optimum by a separate decision.

Question 16

The cost of debt should be taken as the cost in real terms of new borrowing.

Answer 16

This is calculated by taking an appropriate margin over the current expected total real return on index-linked bonds, taking into account the company’s credit rating and multiplying by (1-t).

Question 17

Cost of equity

Answer 17

Cost of equity is the current expected total real return on index-linked bonds plus a margin for the company’s risk.
This gives a real discount rate to be applied to cashflows expressed in present day monetary values, or adjusted by the assumed future inflation rate and used with cashflows in nominal terms.

Question 18

4.4. Choosing the discount rate for projects with a higher than normal degree of systemic risk

Answer 18

Higher risk requires higher discount rate. How to know how much to increase the discount rate:
Look at other companies
Life insurance companies

Question 19

4.4. Choosing the discount rate for projects with a higher than normal degree of systemic risk
Look at other companies

Answer 19

What discount rate is used by companies that regularly engage in such projects. In practice, this data may not be available thus an arbitrary number may need to be added.

Question 20

4.4. Choosing the discount rate for projects with a higher than normal degree of systemic risk
Life insurance companies

Answer 20

Often projects are financed from the long term insurance fund. (sometimes for with-profits companies, or companies with large free reserves and always for mutual funds)
Here the question is, can the capital be used better elsewhere after allowing for risk? The starting point for the risk discount rate (in nominal terms) might therefore be the expected long-term return on equity-type investments.

Question 21

RDR 4.5. Other factors to consider

Answer 21

Companies sometimes use very high hurdle rates when appraising projects.
Using a discount rate that is too high distorts the longer and shorter term cashflows and could lead to wrong decisions as it does not generate a uniform contingency margin.
Too much precision in the risk discount rate is onerous as NPV is not very sensitive to small changes. It is usually appropriate to carry out NPV calc at two rates and if both are satisfactory then there is no need to worry about the appropriate risk discount rate.

Question 22

5. Risk identification

Steps for effective identification of risks facing a project:

Answer 22

• Make a preliminary high-level risk analysis – to make sure that the project could be viable.
• Brainstorm with experts and senior internal people who thinks strategically about the long term.
The aim will be to:
o Identify project risks – both likely and unlikely, upside and downside
o Discuss these risks and their interdependency
o Attempt to put initial evaluation on each risk – frequency of occurrence and probable consequences
o Generate initial mitigation options
• Carry out a desktop analysis to supplement the brainstorming results by identifying further risks and mitigating actions, research similar projects undertaken by the sponsor or others, obtain expert opinions
• Set out risks in a risk register, with cross reference to other risks where there is interdependency.

Question 23

6. Analysis of risks

Answer 23

• Frequency of occurrence
• Consequences if risk event occurs
• Correlations between risks
• Controllability of the risks

Question 24

6.1. Distribution of NPVs

Answer 24

Scenario analysis – construct future scenarios and test effects.
Stochastic modeling - model risks stochastically and get NPV’s for each.

Question 25

7.1. Ways of mitigating risk

Answer 25

For each risk, consideration would be given to identifying the main mitigation by:
• Avoid the risk
• Reduce the risk – reduce probability of the risk or the consequences of both.
• Reduce uncertainty
• Transfer risk – e.g. engage with a contractor for a fixed price
• Insure risk
• Sharing the risk with another party.

Question 26

Each mitigation option will be evaluated by assessing:

Answer 26

• Likely effect on frequency, consequence and expected value
• Feasibility and cost of implementing the option
• Secondary risks resulting from the option
• Further mitigating action to respond to secondary risk
• Overall impact of each option on the distribution of NPVs

Question 27

7.2. The financial consequences of risk mitigation

Answer 27

Adopting a particular option will usually reduce downward volatility of the NPV’s and also either increase or decrease the expected NPV. If it increases NPV, the mitigation option is beneficial and should be built into the project.
For the second option, use judgment to decide on whether to include or not.

Question 28

8. The investment submission

Answer 28

The investment submission is the basis on which the decision whether the project should proceed is taken. The assumption is that the best combination of mitigating options will be implemented.

Question 29

8. The investment submission should include:

Answer 29

• The NPV – allowing for upside and downside risk and contingency margin to cover probabilistic risks that have not been fully analysed.
• Probability distribution of the NPV’s

Question 30

The residual risks should be fully identified and analysed.

Answer 30

Pay particular attention to the submission of remaining risks that could have a catastrophic or serious effect on the outcome of the project (even if it has a low probability).
Specify the method proposed to finance the project and include analysis of the effect of this on investors (tax, price inflation, borrowing etc.).

Question 31

Aim of the investment submission is to discuss the how the project relates to the sponsor’s criteria for judging whether or not to proceed with the project
Consider intangible considerations outside the scope of formal analysis:

Answer 31

• Allowance for likely bias or approximations in the estimates
• Hunch
• Knowledge not in the possession of those who prepared the submission
• Last-minute developments
• Doubts about feasibility or quality of implementation
• Overall project credibility
Consider if the upside potential have been estimated realistically.
Judgment after taking all the aspects into account – should the project proceed.