CORPORATE FINANCE a Managerial Perspective

Chapter 2 – The Future Asset Structure and Capital

Project Appraisal
P43-90
Chapter Preview (p43)........................................................................................................... ....1
1. Introduction (p44)................................................................................... ...............................1
2. Organising Investment Decisions (p44).............................................................................. ....1
3. Appraising Investment Opportunities (p46)..........................................................................2
4. Assessing the Quality of Input Data (p49)..............................................................................2
5. Determining the cash flows (p50)..........................................................................................2
6. Project Monitoring, Control and Post Audit (p53)....................................................................2
7. Project Appraisal Techniques (p54)........................................................................................ .3
8. Using Annuity tables (p68)...................................................................................... ...............3
9. Project Appraisal in Practice (p70)....................................................................................... ...3
10. Differences between NPV and IRR (p71)..............................................................................3
11. Effect of Inflation (p77) – TO DO........................................................................................ ...4
12. The Treatment of Taxation (p82) – TO DO.............................................................................4
13. Putting Together a Business case for a Project (p85)............................................................4
14. Key Issues in Capital Project Appraisal (p87) – TO DO..........................................................4

Chapter Preview (p43)

• Describe need for org to identify, evaluate and invest in high quality capital projects.
• For project appraisal:
- Prepare main financial variable list
- Identify main points to consider when assessing data input quality
- Calculate cash flows
• Project monitoring, control, & post completion audit is important.
• Appraisal methods: payback period, accounting rate of return, net present value,
profitability index, internal rate of return.
• Understand differences between NPV and IRR when evaluating projects.
• Describe reasons for making inflation and taxation adjustments to project appraisals
and applying them.

1. Introduction (p44)
• Business growth by internal development requires sound commercial judgement. Future
returns must exceed the financing costs. Managers must test judgement v. Difficulties
(e.g. highly unpredictable / uncertain future).
• Are there tools / techniques available to assess investments?
• What are the differences between the techniques?
• Spend needs to be weighed against other spending priorities (Cost / benefit) then post.

2. Organising Investment Decisions (p44)

• Investment Stimulus <- concern re: future business performance (if investment not
made).
 • 4 categories: asset replacement (cash/profits can suffer if not), cost saving (key where
sales reached max. in market), expansion (desire to achieve growth), reactive (due to
commercial/legislative forces).
• Shorter term finances can be delegated. Longer-term for top management (balance
debt v equity => minimise cost of capital).
• Delegation of manager responsibility for evaluations of Cap. Ex. -> Cut-off levels (e.g.
“up to 100k”).

3. Appraising Investment Opportunities (p46)

• Financial requirements:
- Project must meet business objectives satisfactorily w.r.t risks involved.
- Expected return must excess financing costs
- Most financially desirable project must be selected from range of available
opportunities
• However for many investments, non-financial factors may be v. important.
• Main financial variables of project appraisal (or capital expenditure):
- Initial capital outlay (fixed assets, working capital, deliberate start-up losses)
- Expected useful economic life of project
- Residual value of assets
- Amounts & timings of all cost & revenue components
- Expected price level changes
- Taxation assumptions / regional grants affecting corporate position
- Cost of capital (cost of financing the project)
- Likely estimated variations of above variables
• Note: Good quality input data essential (the techniques have limits & do not
compensate bad input data!)

4. Assessing the Quality of Input Data (p49)

• Main points to consider:
- Future orientation (ignore past/sunk costs, all future costs are “variable” until project
implemented).
- Attributable costs and revenues (not always clear).
- Differential costs and revenues (common costs/revenues can be ignored).
- Opportunity costs (OC) and benefits (e.g. sales may be lost as a result of project =
lost contribution = OC).
- Financing costs should not be included with estimating operating costs.
- Uncertainty and inflation (need allowances for risk, uncertainty and inflation).
- Qualitative issues (e.g. quality improvement impacting corporate image) should not
be ignored.

5. Determining the cash flows (p50)

• Determine capital outlay (equipment, services, contingency, expenses)
• Annual volumes (sales / no. of units)
• Annual costs (set-up + production costs, fixed costs, materials)
• Annual cash flows (sales - costs)

Or, forecasting using “drivers”:

Sales – profit – tax = profit margin

Profit margin + depreciation = operating cash flow
Free cash flow = operating cash flow – replacement capex – additional fixed capex – additional
working capital

6. Project Monitoring, Control and Post Audit (p53)

Appraisal must be followed up by appropriate monitoring and control procedures to ensure
effective use of funds.
Post project audit is useful to learn lessons (e.g. over/under-estimations, sensitivity & risk,
forecast savings, recommendations for improvements).

7. Project Appraisal Techniques (p54)

1. Payback period (time value of money is ignored!)
2. Accounting rate of return
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)

Payback period = capital outlay / net cash inflow (e.g. £18M / £6M per year => 3 years)
A project paying back before end of its life may be better than one that pays back at the
end(?).

Accounting rate of return = ( Average annual profit / capital outlay ) x 100%

NPV = Value of discounted cash flows – capital outlay

NPV tends to indicate a later payback than the “payback period” approach.
Profitability index = present value of cash net inflows / capital outlay
Internal rate of return (IRR) = discount cash flow method that determines the discount rate
where NPV = 0.
Irregular cash flows can make this measure less useful.

8. Using Annuity tables (p68)

Give cumulative discount factors over a specific period of time. (annual cash flows must be
identical)
e.g. You can calculate

i) IRR = capital / annual savings (18M/6M) and find figure in tables for 5 years (e.g. 3
=> 2.991 => 20% (p335))
ii) minimum annual savings = 18M / 2.991
iii) maximum capital outlay = 6M x 2.991

9. Project Appraisal in Practice (p70)

• Payback is often used in practice.
• IRR is more popular than NPV.
• Qualitative judgement is important.
• ARR is used despite potential ambiguities in definition.
• Typically companies have a capital budgeting manual of practice.
• Inflation or taxation adjustments can be made.
• Risk analysis is important (sensitivity of key inputs, underlying economic assumptions).

10.Differences between NPV and IRR (p71)

• NPV assumes reinvestment at cost of capital e.g. 10% but IRR assumes reinvestment at
IRR.
• Modified internal rate of return (MIRR) overcomes this.
• IRR can incorrectly rank mutually exclusive projects.
• You can calculate the NPV at various discount rates, draw a graph and see what the
incremental IRR is where Project X = Project Y (p76). Choose project with highest NPV
provided company’s cost of capital is less than incremental IRR.
11.Effect of Inflation (p77) – TO DO

12.The Treatment of Taxation (p82) – TO DO

13.Putting Together a Business case for a Project (p85)

Business case:

What is the project about?

Why do it? (rationale?)
When is it to be done? (timing?)
How will it be done? (implementation plan)
Where in the organisation will it be done?
Who will do it? (Responsibilities / accountabilities?)

Typical structure:

• Objectives / aims, Rationale for why / why now, vision / mission fit, key risks /
uncertainties.
• Definition and scope, Strategy / Finance / Operations perspectives
• Alternative options
• Assumptions
• Implementation plan
• Evaluation (financial evaluation techniques + appropriateness + relevant qualitative /
non-financial factors

14.Key Issues in Capital Project Appraisal (p87) – TO DO

Cash flow projections should recognise market developments and competitor reactions.