Project Appraisal 3rd Ed.

Financial Strategy — Unit 5

The Open University

Publisher: The Open University, 2000, 80 pages

ISBN: 0-7492-9729-8

Keywords: Finance, Project Management, MBA

Last modified: Sept. 11, 2022, 3:10 p.m.

The success of a company depends, at least to a big part, on how efficiently and effectively it's capital resources are used and the CAPEX (captital expenditure) decisions within the company require several functions. This includes marketing, production, services, accounting and finance.

Within your CAPEX decision you need to take account for your strategy and you need to link your expenditure clearly to the resources that are available within the enterprise. This means that you might need to sell projects that do not fit your strategy and/or resources. Maccarone (1995) highlighted strategy in the process by saying that the formal CI (capital investment) system is influenced by organisational personnel and strategic planning. The process itself goes from (and back) identification of potential investment, project definition and screening, analysis and acceptance, implementation to monitoring and post audit.

Techniqques for investment appraisal include capital budgeting, known as the process of evaluating investments. In addition to a decision on spending money, the resulting expenditure requires decisions on where and in what form to raise funds. In your calculation you need to take into account both the timing of the money flows as well as your COC (cost of capital) and qualitative factors. For the calculation itself, the most commonly used techniques are NPV (net present value), IRR (internal rate of return), payback, ARR (accounting rate of return) and PI (profitability index).

NPV is arguably the best method while IRR seems to be the one preferred as it shows the yield of the invested capital. Payback is used a lot as it is so easy to use.

There are several things to take into account when using these techniques. For one, like needs to be compared to like. This means that in relation to inflation, real cash flows fit real discount rate and nominal to nominal. Just as a reminder, nominal means would be 4% for an increase from $100 to $104 while real would be 1% if you add 3% inflation to the mix, as the $104 would not be worth $104 in relation to the $100 you started with.

You also need to remember that interest on debt-funded investments is often tax deductible. These reductions can then be discounted as any cash flow. In internaltion situations, more things need to be taken into account. There might be a foreign project with a substantial cash flow which could not be carried over into the home country due to exchange controls. These might be circumvented via dividends, royalties or management fees, loan repayments or countertrade.

International taxation includes something called withholding tax, which is a tax levied by a country of source on income paid, usually on dividends remitted to the home country of the firm operating in a foreign country. This is part of the reason that taxation and incentives is a major concern for corporations investing abroad.

Capital rationing is about, as the term says, dealing with constraints due to several potential projects and insufficient funds to finance them all. You could say though that if there is a positive NPV, it is very likely that a company will be able to raise funds, with a major constraint being the fit with the corporate strategy as well as the ability to manage all projects. To choose which projects to do, PI (profitability index) and cost-benefit index are two methods that can be used.

PI = (Net Present Value) / Investment

If you need to invest less to get the same NPV, then this is the better projects. Take into consideration that resources might be constraint over longer or shorter periods of time and that projects might be mutually exclusive or dependent on each other. You also need to take opportunity costs into account, thinking about a make or buy decision, which can also be evaluated via a NPV calculation, taking into account savings in overhead costs. Also take into account that in fast changing markets, there might be flexibility lost by inhouse projects resulting in unexpected costs. Take into account your strategy. Does the project fit? Also consider that you might loose control over your business by outsourcing though? Is this an integral part of your strategy?

Then there are Risk issues to consider. Buckley (1998) argued that the DCF method does not allow for enough flexibility in a strategic sense, potentially seeing projects as investments into the future. Managers generally are risk-averse, and the discount rate says that a similar return can be achived through another investment at similar risk, which might not be certain. Many organisations use the WACC (weighted average cost of capital) not taking the opportunity cost of the specific project into account as it is difficult to specify correctly.

Ho and Pike (1991) suggest going though a series of steps in a logical mannger: risk identification, application of methods of reducing the risk, risk evaluation and integration of that into the project appraisal. You can use probalistic risk analysis (PRA) techniques like sensitivity analysis, probability analysis, decision tree analysis and Monte Carlo analysis. Greater risk should lead to greater required return. Normally the discount rate is raised or the payback period shortened. Some company use CAPM (capital asset pricing model) to determine the required discount rate. You can also take several scenarios and calculate an ENPV (expected NPV) including several results and their probabilities.

There might be a case where there is not a now or never NPV result, and in this case opportunites should be seen as options, the right to do something not the obligation. After having started a project it might be irreversible though. This means that the NPV of the project needs to be higher than the value attached to the option of keeping the investment opportunity available.

Funding capital projects

This is the second big part of all of this. You can only invest what you have. So where would it come from? This could be equity, medium- and long-term debt, leasing, grants or a combination of all of them.

In leasing there are several forms. In general the owner of the assets (lessor) allows the use of the asset to the lessee in return for a payment, but retains the ownership of the asset, sometimes resulting in leasing being cheaper than debt. A finance lease is the same as borrowing funds in that the lessor is assured to get her financial outlay plus return while the risks and rewards of ownership pass to the lessee. An operating lease is over a shorter period, less than the economic life of the asset and the lessor retains the rights and awards from ownership. While the benefits received by the lessor might not cover all costs of the assets, the lessor could sellthe asset at the end of the lease.

Reasons for leasing might be:

  • funds not available and no access to alternative sources
  • considerable tax advantage, also maybe via owning of the asset by the lessor who might have a better tax shield (think derivative SWAPs here, which come later)
  • no wish to own
  • off-balance-sheet financing and potentially higher ROCE and AUR

All this could be said to be lease versus buy and borrow. You can calculate the NPV of all in and outflows of cash to see what is the better solution.

Project finance means that you only take earnings and assets of the project as collateral for loans and finance. International banks do that for toll roads, tunnel projects (e.g. Channel Tunnel), theme parks, power stations, …. A good example is a new exposition of a running miniature rail road which cost 2 million EURs to build but it now taking in 7 millione EURs a year through 700.000 yearly visitors. It was financial entirely by banks. This is normally more expensive than convential debt but could still be lower than a company's overall WACC. Non-resource financing means that financors only have access to cash flows from the project, which is almost unatainable, mostly resulting in limited resource financing. The difference is when a project is abandoned.

In general lenders are attracted because of high fees attached. A lenders analysis will include several types of risks, namely internal (operational, raw material handling, completion/construction) and externally derived (country/political, off-take, market, financial, documentary, force major) risk. A case study in this part of the course is the financing of a liquid gas facility in Oman. Here the risks are too high even for large banks and the risk is reinsured. The principal banks, called arranging banks, underwrite the project and then syndicate to further banks who then sub syndicate for even more banks. The arranging banks take the biggest chunk but distribute the rest.

The banks will take a project base scenario based on reasonable assumptions and build DCFs on a range of financial forecasts. Risk appraisal forms a major part of all of this. The banks might also require contractors to sign off completion guarantees. Country risk is tied to political risk, which is evaluated partly on preceeding deals with the country, and for example a list published in the economist about the risk attached to countries. Perhaps the Word Bank will be involved. Off-take risk is essentially about guaranteeing purchases from the end customers. Market risk is about being able to service interest payments.

The banks (mostly the principal ones) get an arrangement fees, an underwriting fee, a participation fee, a loan spread, commitment fee on the undrawn portion, technical bank fee and administrative roal fee.

Funding public projects

Private equity could also fund public sector projects. This can be in the form of Public Private Partnerships (PPP), which is about exploiting the full range of private sector management, commercial and creative skills.

Public bodies will contract directly with a private organisation, which will accept some of the project's risk against the option to make a profit. The operator might be part of a consortium of different companies and banks who haved bidded for the project together.

Characteristics of this include:

  • contractor provides capital investment
  • funded by consortium members
  • some of the construction risk assumed by operator
  • operator has an operating license
  • ownership of facility goes to private sector

The interest for the public body is:

  • less constraints by government controls in relation to expenditure and borrowing
  • exploit the added value via specialist

The public body might get access to funding in the short term but need to pay out large shares of future revenues. The PPP costs and benefits are often ring-fenced like in project finance. The process to go into a PPP is often very complicated and the bidding process can take well over a year. PPP schemes have been both hailed and criticised. A critique might be the money burned in case of the german Arbeitsamt in its consulting deal with Accenture for example, with the project being well 165 million EURs over budget.

  1. Introduction
    • Outline of Unit 5
    • Aims and objectives of the unit
  2. Strategy and Investment Appraisal
    • 2.1 Example of Strategic and Financial Appraisal
    • 2.2 The Capital Investment (CI) Model
  3. Techniques of Investment Appraisal
    • 3.1 Capital Budgeting
    • 3.2 Issues in Appraisal Techniques
    • 3.3 London Transport Case Study
      • Introduction
      • LR decision-making process
      • Funding issues
    • 3.4 Inflation and Taxation
      • Inflation
      • Taxation
    • 3.5 International Capital Budgeting
  4. Risk Issues in CAPEX
    • 4.1 How to Deal with Risk?
    • 4.2 Investment Projects as Options
  5. Funding Capital Projects
    • 5.1 Equity/Debt Funding and Leasing
      • Equity/debt funding
      • Leasing
        • Reasons for leasing
      • 'Lease v. buy and borrow' decision
      • Summary
    • 5.2 Project Finance
    • 5.3 Liquid Gas Facility in Oman Case Study
      • Project funding arrangements
      • The decision-making process
        • Completion risk
        • Country/political risk
        • Off-take risk
        • Market risk
      • Financial statement issues for the lending banks
    • 5.4 The Private Finance Initiative
      • A hospital case study
  6. Capital Rationing
    • 6.1 Capital Rationing in Practice
    • 6.2 Competing Projects
    • 6.3 Organisational Growth v. Growth by Acquisition
  7. ACE Company: Spreadsheet Exercise
    • 7.1 Introduction
    • 7.2 Exercise
    • 7.3 New Product Development
    • 7.4 Extending the Development Period for Model Z
    • 7.5 Other Considerations


Project Appraisal

Reviewed by Roland Buresund

Decent ****** (6 out of 10)

Last modified: May 21, 2007, 3:20 a.m.

MBA material, what do you expect?


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