FIN 650: Project Appraisal

Lecture 1

Introduction

Course Overview
Prerequisites  Bus635 and/or EMB 510 Requirements and Grading  Two Midterm Examinations (30%)
Mid1 examination in the computer lab

Final Examination (40%)  1 Paper (30%) Class Materials




Web-page: http://fkk.weebly.com

Office: NAC 751 Office hours: Tuesday, 1pm-2:30 pm Friday, 5-6:30 pm

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Activity Schedule: FIN650

Class 1 2 3 4 5 6 7 8 9 10 11 12 13 Date 27 Jan 3 Feb 10 Feb 17 Feb 24 Feb 2 March 9 March 16 March 23 March 30 March 6 April 13 April
Guest Lecturer

Exams

Paper

Mid 1 Lab Session Lab Session Mid2

Paper

21 Apr -3 May Final

Make-up Policy
There will be only one make-up for all examinations (mid-terms, final etc.) towards the end of the course to accommodate force majeure. All examination dates are pre-announced. Please make necessary arrangements with your office. Historically, the performance of students taking make-up examinations were always poorer compared to students taking examinations on schedule. I hope you will appreciate that it is not practical to offer a customized course for any or group of individual student(s).

About the Course

Investment decisions are important both for private and public entities. Goals are different.
 

Firms maximize shareholders wealth Government, NGOs, and multilateral institutions maximize net social benefits.

Capital budgeting Concerned with sizeable investment in long-term assets by firms Various investment criteria Choice between projects with different life span, Tax and depreciation issues. Cost benefit analysis  Shadow prices To correct for distortions in the market prices or put a price on non-marketed goods  The problem of aggregation of benefits and costs of different groups of individuals in the society.  Social discount rate Financial appraisal Economic appraisal Financial modeling with Excel spreadsheet

Project Appraisal
Nature of project appraisal Given the limitation of resources, choices must be made among the competing uses, and project appraisal is one method of evaluating alternatives in a convenient and comprehensive fashion Project appraisal assesses the benefits and cost of a project and reduces them to a common yardstick. If benefits exceed costs, the project is acceptable; if not the project should be rejected Societys objective
Growth:

to increase total national income Equity: to improve the distribution of national income

Projects should be assessed in relation to their net contribution to both of these objectives

Project and Program Appraisal

Project and program sometimes used interchangeably
Project:

Jamuna Bridge Project, Square Pharmaceuticals Literacy Program

Program:

Analysis by whom?
Private

Investor Lender
Government Donor

agency

Public-private partnership

agency investor-capital budgeting agency- cost benefit analysis

Tools for analysis will vary

Private Government/donor

CBA and Capital Budgeting

Cost-Benefit Analysis Cost benefit analysis is a program/project assessment method that quantifies in monetary terms the value, net social benefits, of all program /project consequences for all members of the society Capital Budgeting Is the process of evaluating and selecting long-term investments consistent with the firms goal of shareholders wealth maximization

Major Steps in CBA

Specify the set of alternative projects Decide whose benefits and costs counts (standing) Catalogue the impacts and select measurement indicators (units) Predict the impacts quantitatively over the life of the project Monetize (attach dollar/taka values to) all impacts Discount benefits and costs to obtain present values Compute the NPV of each alternative Perform sensitivity analysis Make a recommendation based on the NPV and sensitivity analysis

8 Principles of Finance
1.

2. 3. 4.

5. 6. 7. 8.

Buy assets that add value, avoid buying assets that dont add value Cash is king The time dimension of financial decisions is important Know how to compute the cost of financial alternatives Minimize the cost of financing Take risk into account Markets are efficient and deal well with information Diversification is important
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Capital Budgeting
Capital budgeting is primarily concerned with sizeable investments in long-term assets.
 

Tangible: Property, Plant or equipment Intangible: R&D, Patents or trademarks

Different from recurring expenditure in two aspects:

 

Projects are significantly large Long-lived projects with their benefits or cash flows spreading over many years.

Capital budgeting decisions have significant impact on firms performance and they are critical to the firms success or failure

Capital Budgeting
Capital budgeting is one of the most significant financial activity of the firm. Capital budgeting determines the core activities of the firm over a long term future. Capital budgeting decisions must be made carefully and rationally.

Capital Budgeting Within the Firm

The Position of Capital Budgeting Financial Goal of the Firm: Wealth Maximisation
Investment Decison
Long Term Assets Short Term Assets

Financing Decision
Debt/Equity Mix

Dividend Decision
Dividend Payout Ratio

Capital Budgeting

Examples of Long Term Assets

Real Estates Aircrafts, Ships Forest Plant and Machineries

Aspects of Capital Budgeting

Capital Budgeting involves: Committing significant resources. Planning for the long term: 5 to 50 years. Decision making by senior management. Forecasting long term cash flows. Estimating long term discount rates. Analyzing risk.

Aspects of Capital Budgeting

Capital Budgeting:

Emphasizes the firms goal of wealth maximization, which is expressed as maximizing an investments Net Present Value Requires calculation of a projects relevant cash flows

Aspects of Capital Budgeting

Capital Budgeting Uses:
Sophisticated forecasting techniques:-

Time series analysis by the application of simple and multiple regression, and moving averages Qualitative forecasting by the application of various techniques, such as the Delphi method

Aspects of Capital Budgeting

Capital Budgeting requires: Application of time value of money formulae. Application of NPV analysis to forecasted cash flows. Risk Analysis Risk Adjusted Discount Rate(RADR) and Certainty Equivalent Application of Sensitivity and Break Even analyses to analyze risk.

Aspects of Capital Budgeting

Application of Simulation and Monte Carlo Analysis as extra risk analysis. Application of long term forecasting and risk analysis to projects with very long lives. Application of optimization techniques to projects which have constrained resources. Development and application of generic and specific financial models Application of cash flow forecasting, and NPV analysis to all aspects of property investment projects. Application of NPV analysis under the additional risks associated with international investments

Shareholder Wealth Maximization and NPV

The shareholder wealth maximization goal

requires that management should endeavor to maximize net present value (NPV) of expected future cash flows to the shareholders of the firm. NPV represents discounted sum of the expected net cash flows.
Cash outflows: capital outlays Cash inflows: proceeds from sales

Net cash flows are determined by subtracting a given periods cash outflows from that periods cash inflows.

Shareholder Wealth Maximization and NPV

The discount rate takes into account the timing and risk of the future cash flows resulting from the investment. The longer it takes to receive a cash flow, the lower the present value to the investor. The greater the risk associated with receiving a future cash flow, the lower the value investors place on that cash flow. Shareholder wealth depends on magnitude, timing and risk associated with the cash flows expected to be received in future by the shareholders

Class Exercise
Project Alpha requires an initial capital outlay of Tk. 45,000 and will have net cash inflows of Tk. 15,000, Tk. 20,000 and Tk. 30,000 at the end of years 1,2, and 3 respectively. The discount rate is 8% per annum. How much project Alpha will add to the firms value?

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Classification of Investment Projects

An independent project is one the acceptance or rejection of which does not directly eliminate other projects from consideration or affect likelihood of their selection Mutually exclusive projects- cannot be pursued simultaneously-the acceptance of one prevents the acceptance of the alternative proposal A contingent project is one the acceptance or rejection of which is dependent on the decision to accept or reject one or more other projects
 

Complementary projects, pharmacy and doctors clinic Substitute projects, Thai or Fast-food restaurant
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The Capital Budgeting Process

Corporate goal Strategic planning Identification of investment opportunities Preliminary screening of projects Financial appraisal of projects Qualitative factors in project evaluation The accept/reject decision Project implementation and monitoring Post-implementation audit
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The Capital Budgeting Process

`
Corporate goal Strategic Planning Investment opportunities Preliminary Screening Financial Appraisal Qualitative factors, Judgments Accept/Reject Decision on the project Accept Reject Implementation Monitoring Post implementation audit

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Why Cash Flows?

Cash flows, and not accounting estimates, are used in project analysis because:
   

They measure actual economic wealth. They occur at identifiable time points. They have identifiable directional flow: inflow and outflow. They are free of accounting definitional problems.

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The Meaning of RELEVANT Cash Flows.

A relevant cash flow is one which will change as a direct result of the decision about a project. A relevant cash flow is one which will occur in the future. A cash flow incurred in the past is irrelevant. It is sunk. A relevant cash flow is the difference in the firms cash flows with the project, and without the project.
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Cash Flows: A Rose by Any Other Name Is Just as Sweet.

Relevant cash flows are also known as: Marginal

cash flows.  Incremental cash flows.  Changing cash flows.  Project cash flows.

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Categories of Cash Flows

Project cash flows may be separated into two categories:


Capital cash flows

The initial investment
 Outflows, purchasing assets and initial working capital

Additional middle-way investments such as upgrades and increases in working capital investments Terminal cash flows
 Inflows, proceeds from sale, salvage value of the asset net of tax, recovery of remaining working capital  Outflows, cost of asset disposal, environmental rehabilitation, redundancy payment to employees 

Operating cash flows: cash inflows from sales, cash outflows for marketing and advertising, payments for wages, utilities, raw materials
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Essentials in Cash Flow Identification

Principle of the stand-alone project


Evaluation of the proposed project purely on its own merits, in isolation from any other activities or the projects of the firm Negative effects, new model of car, lower sales of existing model, must be deducted from future cash flows Positive effects, pharmacy adjacent to doctors clinic, favorable impact on clinics cash flows to be added to pharmacy projects cash flows

Indirect of synergistic effects

 

Opportunity cost principle: the most valuable alternative that is given up if the proposed investment project is undertaken


Use of existing resources, space, building, rental value, market value

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Essentials in Cash Flow Identification

Sunk cost, is an amount spent in the past in relation to the project, but which cannot now be recovered or offset by the current decision


Past consulting expenses Utilities, executive salaries With or without the project, incremental costs to be included Current assets (inventories, accounts receivables) minus current liabilities (accounts, wages payable) Increases in working capital is treated as cash outflows even though there is no actual cash outflow, opportunity cost Capital flows, not operational flows, it is a fund
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Overhead costs
 

Treatment of working capital

 

Essentials in Cash Flow Identification

After-tax cash flows


Must be accounted for as a cash outflow, not based on net cash flow but on taxable income Is not a cash flow In project appraisal, what is relevant is not the accounting depreciation but tax allowable depreciation to measure the tax effect

Treatment of depreciation
 

Investment allowance, enhances NPV Financing flows, excluded. double counting, included in the discount rate
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Essentials in Cash Flow Identification

Within-year timing of cash flows
 

Occurs at various points of time in a year Standard practice is to assume that capital expenditure occur at the beginning of the year and all other cash flows occur at the end of the year Points in cash flow timing is are set at the end of each year. An initial outlay of Tk. 50,000 at the start of year 1will be timed as occurring at the end of year zero.

Inflation and consistent treatment of cash flows and discount rates



 

Nominal returns, incorporating the inflationary effect is preferred over cash flow forecasts in real terms, excluding the inflationary effects Fisher effect Consistency, cash flow in nominal terms- use nominal discount rate; cash flow in real terms- use real discount rate
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Project Cash Flows: Yes and No.

YES:- these are relevant cash flows: Incremental future sales revenue. Incremental initial outlay. Incremental future salvage value. Incremental working capital outlay. Incremental future taxes.

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Project Cash Flows: Yes and No.

NO:- these are not relevant cash flows: Changed future depreciation. Reallocated overhead costs. Adjusted future accounting profit. The cost of unused idle capacity. Outlays incurred in the past.

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Cash Flows and Depreciation: Always a Problem.

Depreciation is NOT a cash flow. Depreciation is simply the accounting amortization of an initial capital cost. Depreciation amounts are only accounting journal entries. Depreciation is measured in project analysis only because it reduces taxes.

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Other Cash Flow Issues.

Tax payable: if the project changes tax liabilities, those changed taxes are a flow of the project. Investment allowance: if a taxing authority offers this extra depreciation concession, then its tax savings are included. Financing flows: interest paid on debt, and dividends paid on equity, are NOT cash flows of the project.
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Other Cash Flow Issues.

In property investment, property cash flows may be distinguished from equity cash flows. In project analysis, cash inflows are timed as at the end of a year, and capital outlays are timed as at the start of a year. Forecast inflated cash flows must be discounted at the nominal discount rate, not the real discount rate.
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Using Cash Flows

All relevant project cash flows are set out in a table. The cash flow table usually reads across in End of Years, starting at EOY 0 (now) and ending at the projects last year. The cash flow table usually reads down in cash flow elements, resulting in a Net Annual Cash Flow. This flow will have a positive or negative sign.

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Delta Project Cash Flows

Project start date 2001 Capital outlay in year 1 is $ 1 million; year 3 is $0.5 million Economic life 8 years Working capital Y0-2000; Y1-2500; Y2-3100; Y33600; Y4-4000; Y5-4300;Y6-4500; Y7-3000, Y8-0. Salvage value in Y8: $16,000 Depreciation on initial investment is 12.5% p.a. upgrade depreciates @$100,000 for years 4-8. Sales forecasts After tax salvage value Accounting income Workbook 2.1
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Asset Expansion Project Cash Flows

Initial investment


Initial investment in plants and working capital Add back depreciation Exclude depreciation from costs Add tax shield of depreciation (tax rate x depreciation) Proceeds from sale of assets minus taxes on sale of an assets plus recovery of working capital
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Net operating cash flows

  

Terminal cash flows



Asset Replacement Project Cash Flows

Initial investment


Initial investment in plants and working capital minus proceeds from sale of old asset plus taxes on sale of old assets Operating cash flow of new assets minus operating cash flow of old assets Proceeds from sale of new asset- proceeds from sale of old asset - taxes on sale of old assets- taxes on sale of an assets-taxes on sale of old assets plus recovery of working capital
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Incremental operating cash flows



Terminal cash flow



Project Cash Flows: Summary

Only future, incremental, cash flows are Relevant. Relevant Cash Flows are entered into a yearly cash flow table. Net Annual Cash Flows are discounted to give the projects Net Present Value.
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Project Cash Flows: Summary Overarching principles:

We only need to estimate cash flows that change as a result of accepting the project (incremental cash flows). The amount of, and the timing of the cash flow must be estimated, not the accounting profit/loss by ordinary accounting methods.
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Project Cash Flows: Summary There are generally three kinds of cash flows that can be affected by a capital budgeting project:
1) Initial period cash flow 2) Operating cash flow 3) Terminal year cash flow

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Treatment of Taxes
Since taxes are cash flows, we must include taxes in our cash flow estimates. All estimated cash flows should be aftertax cash flow estimates!

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Cash Flow Type 1: Initial Period Cash Flows

These are simply any cash flows that occur in the initial period of the projects life (period 0). For example, assume that a new investment project would require spending $20 million for new capital machines, plus $3 million for additions to working capital (increases in cash balances, inventory, and accounts receivable). The initial period cash flow = -$20 + -$3 = -$23 million.

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Cash Flow Type 2: Operating Cash Flow

Accounting income for a period could be a measure of cash flow, except that depreciation (an expense, but not a cash flow) was subtracted in calculating it. Operating cash flow equals Net Income + Depreciation

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Operating Cash Flow

Operating cash flow will be affected whenever a revenue or expense is changed on the income statement.
For example, operating cash flow is increased/decreased if a project results in increased/decreased sales revenues. Operating cash flow is decreased/increased if a project results in increased/decreased expense of some kind.

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Continuing with the Example Project:

Assume the business currently has sales of $95 million and cash operating expenses of $65 million, plus $15 million of depreciation expense. Assume the tax rate = 30%. Net income = ($95 - $65 - $15) x (1 - .3) = $10.5 million. Operating cash flow = Net income + depreciation = $10.5 + $15 = $25.5 million per year.

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Class Exercise

Assume that accepting the new investment project would increase the business sales by $10 million, and increase the operating costs by $4 million, plus increase depreciation expense by $2 million. What is the incremental operating cash flow for the project?
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Answer

Operating cash flow with the new project = ($105 - $69 - $17) x (1.3) + $17 = $30.3 million.
The incremental operating cash flow for the project equals the change in cash flows from before accepting the project to after accepting it = $30.3 $25.5 = $4.8 million per year. (Assume these benefits continue the same each year for 10 years.)
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An Alternative Way It is usually easiest to compute this incremental cash flow by just using the incremental numbers themselves. Thus,
The relevant incremental operating cash flow for the example project =
+ Inc. in sales revenue $10 million - Inc. in op. costs (expenses) .. 4 million - Inc. in depreciation expense 2 million = Inc. in EBT . 4 million - Inc. in taxes (@ 30%) ..... 1.2 million = Inc. in EAT ... 2.8 million + Inc. in depreciation expense 2 million = Inc. in operating cash flow .. $ 4.8 million
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Operating Cash Flow

Notice that this method of calculating the incremental operating cash flow requires you to simply identify every item in the companys income statement that changes, and then to calculate the change in net income that results. Finally, the operating cash flow equals the change in net income plus the change in depreciation.
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Cash Flow Type 3: Terminal Year Cash Flows

These cash flows consist of any residual values (salvage values) recovered from the project at the end of its useful life. For our example, assume that at the end of the projects life, the machines could be sold to net $100,000 after taxes, and that the working capital ($3 million) is recovered in full. Thus, the terminal year cash flow (year 10) for the project = $3.1 million.
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Total Cash Flows

The complete cash flows for the example project are: Periods: 0 1-10 10 - $23 + $ 4.8 + $ 3.1 Assume that the cost of capital for the project equals 10%, the NPV is calculated to be $7.69 million.
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What to Do with the Project? Since the NPV > 0 we know the project is a good one.
We could alternatively have made the decision using the IRR method. IRR of the project can be calculated to be 17%. Since this is > the 10% cost of capital, the project should be accepted. We could also have (alternatively) made the decision using the PI method. PI = 1.33, which is > 1.00.
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Class Exercise 2

Consider another example:

Assume the Widget Company is considering an investment to replace a production machine with a more efficient one. Assume the new machine costs $100,000, and the old machine has a book value of $15,000 and a current salvage value of $25,000. Assume the tax rate is 30%. What are the relevant cash flows for the project analysis, and should the replacement be accepted?

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Initial Period Cash Flows

First, determine the initial period cash flows:

The $100,000 purchase price of the new machine is an immediate cash outflow. The $25,000 salvage value of the old asset would be an immediate cash inflow. Taxes on the gain from sale of the old asset is also an immediate cash outflow. Taxes = 30% x (SV-BV) = .3 x (25,000-15,000) = $3,000.

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Initial Period Cash Flows

The total initial period (period 0) incremental cash flows for the replacement project are:
-$100,000 + $25,000 - $3,000 = $78,000.

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Operating Cash Flows

Next, we calculate the operating cash flows:

Assume the new machine would reduce operating costs by $35,000 per year for the next 8 years, compared to using the old machine. Depreciation expense would also increase by $12,500 per year for 8 years. Net income will increase by ($35,000 12,500) x (1-.3) = $15,750. Op. CF = Net Income + Depreciation = $15,750 + $12,500 = $28,250 per year, for 8 years. Note that this is an annuity of benefits.
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Calculation of Taxes

Assume that both the old machine and the new one would be fully depreciated after 8 years.
With the new machine, sale in year 8 for $5,000 => taxable gain on the sale equal to the salvage value minus the book value = ($5,000 0) = $5,000. Tax on this gain = $5,000 x .3 = $1,500. With the old machine, sale in year 8 for $500 => taxable gain on the sale equal to the salvage value minus the book value = ($500 0) = $500.Tax on this gain = $500 x .3 = $150.

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Terminal Year Cash Flows

Altogether, then, the total terminal year cash flow equals

= incremental salvage value of $4,500 incremental taxes of $1,350 = $4,500 - $1,350 = $3,150. This cash flow in year 8 is in addition to the regular $28,250 operating cash flow of that year (already computed).
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Important:
While in general, any cash flow affected by a project is relevant, we do not include any cash flows that are financing costs. For example, we do not include interest expense or lease payments. The reason for this is that all financial cash flows are implicitly included in the cost of capital used to find NPV (or used to compare to IRR). To include the financial cash flows and then discount them to PV would be to double count their impact.
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