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FIN 650: Project Appraisal

Lecture 1

Introduction

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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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ActivitySchedule: FIN650Class Date Exams Paper

1 27 Jan

2 3 Feb

3 10 Feb

4 17 Feb Mid 1

5 24 Feb Lab Session

6 2 March Lab Session

7 9 March

8 16 March Mid2

9 23 March10 30 March

11 6 April

12 13 April Guest Lecturer Paper

13 21 Apr -3 May Final

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Make-up Policy

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There will be only one make-up for all examinations(mid-terms, final etc.) towards the end of the courseto accommodate force majeure. All examinationdates are pre-announced. Please make necessaryarrangements with your office.

Historically, the performance of students takingmake-up examinations were always poorer comparedto students taking examinations on schedule.

I hope you will appreciate that it is not practical to

offer a customized course for any or group ofindividual student(s).

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Aboutthe 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 5

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Project Appraisal

Nature of project appraisalGiven the limitation of resources, choices must bemade among the competing uses, andprojectappraisalis one methodof evaluating alternativesin a convenient and comprehensive fashion

Project appraisalassesses the benefits and cost ofa project and reduces them to a common yardstick.If benefits exceed costs, the project is acceptable;if not the project should be rejected

Societys objectiveGrowth: to increase total national incomeEquity: to improve the distribution of national income

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

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Project and Program Appraisal

Project and program sometimes usedinterchangeably

Project: Jamuna Bridge Project, Square Pharmaceuticals

Program: Literacy Program

Analysis by whom?Private

Investor

Lender

Government agency

Public-private partnership

Donor agency

Tools for analysis will vary

Private investor-capital budgeting

Government/donor agency- cost benefit analysis

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CBA and Capital Budgeting

Cost-Benefit AnalysisCost 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-terminvestments consistent with the firms goal of

shareholders wealth maximization

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8 Principles of Finance

1. Buy assets that add value, avoid buying assets that

dont add value

2. Cash is king

3. The time dimension of financial decisions is important

4. Know how to compute the cost of financial

alternatives

5. Minimize the cost of financing

6. Take risk into account

7. Markets are efficient and deal well with information

8. Diversification is important

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Capital Budgeting

Capital budgeting is primarily concerned withsizeable investments inlong-term assets. Tangible: Property, Plant or equipment Intangible: R&D, Patents or trademarks

Different from recurring expenditure in twoaspects: Projects are significantly large

Long-lived projects with their benefits or cashflows spreading over many years.

Capital budgeting decisions have significantimpact on firms performance and they arecritical to the firms success or failure

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Capital Budgeting

Capital budgeting is one of the mostsignificant financial activity of thefirm.

Capital budgeting determines the coreactivities of the firm over a long termfuture.

Capital budgeting decisions must bemade carefully and rationally.

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Capital Budgeting Within the Firm

The Position of Capital Budgeting

Capital Budgeting

Long Term Assets Short Term Assets

Investment Decison

Debt/Equity Mix

Financing Decision

Dividend Payout Ratio

Dividend Decision

Financial Goal of the Firm:

Wealth Maximisation

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Examples of Long Term Assets

Real EstatesAircrafts, Ships

Forest Plant and Machineries

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Aspects ofCapital 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.

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Capital Budgeting Uses:

Sophisticated forecasting techniques:-

Time series analysis by the application ofsimple and multiple regression, and movingaverages

Qualitative forecasting by the application ofvarious techniques, such as the Delphimethod

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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.

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Application of Simulation and Monte CarloAnalysis as extra risk analysis.Application of long term forecasting and riskanalysis to projects with very long lives.

Application of optimization techniques to projectswhich have constrained resources.Development and application of generic andspecific financial modelsApplication of cash flow forecasting, and NPVanalysis to all aspects of property investmentprojects.Application of NPV analysis under the additionalrisks associated with international investments

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Shareholder Wealth Maximization and NPV

The shareholder wealth maximization goalrequires that management should endeavor tomaximize net present value (NPV) of expected

future cash flows to the shareholders of thefirm.NPV represents discounted sum of theexpected net cash flows.

Cash outflows: capital outlaysCash inflows: proceeds from sales

Net cash flows are determined by subtractinga given periods cash outflows from that

periods cash inflows.

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Shareholder Wealth Maximization and NPV

The discount rate takes into account the timingand riskof the future cash flows resulting from theinvestment.

The longer it takes to receive a cash flow, thelower the present value to the investor.The greater the risk associated with receiving afuture cash flow, the lower the value investorsplace on that cash flow.

Shareholder wealth depends on magnitude, timingand riskassociated with the cash flows expected tobe received in future by the shareholders

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Class Exercise

Project Alpha requires an initial capitaloutlay of Tk. 45,000 and will have netcash inflows of Tk. 15,000, Tk. 20,000 andTk. 30,000 at the end of years 1,2, and 3respectively. The discount rate is 8% perannum.

How much project Alpha will add to the

firms value?

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Classification of Investment Projects

An independent projectis one the acceptance orrejection of which does not directly eliminateother projects from consideration or affectlikelihood of their selection

Mutually exclusive projects- cannot be pursuedsimultaneously-the acceptance of one preventsthe acceptance of the alternative proposal

A contingent projectis one the acceptance orrejection of which is dependent on the decision toaccept 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

RejectImplementation

Monitoring

Post implementation audit

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Why Cash Flows?

Cash flows, and not accountingestimates, are used in projectanalysis 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 willchange as a direct result of thedecision about a project.

A relevant cash flow is one which willoccur in the future. A cash flowincurred in the past is irrelevant. It issunk.

A relevant cash flow is the differencein the firms cash flows with theproject, and without the project.

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Cash Flows: A Rose by Any Other Name Is Just as

Sweet.

Relevant cash flows are alsoknown 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 intotwo categories: Capital cash flows

The initial investment Outflows, purchasing assets and initial working capital

Additional middle-way investments such as upgradesand 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, environmentalrehabilitation, 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 theprojects of the firm

Indirect of synergistic effects 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 topharmacy projects cash flows

Opportunity cost principle: the most valuablealternative that is given up if the proposedinvestment project is undertaken Use of existing resources, space, building, rental value,

market value

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Sunk cost, is an amount spent in the past inrelation to the project, but which cannot now berecovered or offset by the current decision Past consulting expenses

Overhead costs Utilities, executive salaries

With or without the project, incremental costs to beincluded

Treatment of working capital 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, opportunitycost

Capital flows, not operational flows, it is a fund

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After-tax cash flows Must be accounted for as a cash outflow, not

based on net cash flow but on taxable income

Treatment of depreciation Is not a cash flow

In project appraisal, what is relevant is not theaccounting depreciation but tax allowabledepreciation to measure the tax effect

Investment allowance, enhances NPV

Financing flows, excluded. doublecounting, included in the discount rate

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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 cashflows 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 year1will be timed as occurring at the end of year zero.

Inflation and consistent treatment of cash flowsand 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 discountrate

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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 accountingamortization of an initial capital cost.

Depreciation amounts are onlyaccounting journal entries.

Depreciation is measured in projectanalysis only because it reduces taxes.

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Other Cash Flow Issues.

Tax payable: if the project changestax liabilities, those changed taxes area flow of the project.

Investment allowance: if a taxing

authority offers this extradepreciation concession, then its taxsavings are included.

Financing flows: interest paid on debt,and dividends paid on equity, are NOTcash flows of the project.

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Other Cash Flow Issues.

In property investment, propertycash flows may be distinguished fromequity cash flows.

In project analysis, cash inflows are

timed as at the end of a year, andcapital outlays are timed as at the startof a year.

Forecast inflated cash flows must bediscounted at the nominal discountrate, not the real discount rate.

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Using Cash Flows

All relevant project cash flows are set outin a table.

The cash flow table usually reads across in

End ofYears, starting at EOY 0 (now) andending at the projects last year.

The cash flow table usually reads down incash flow elements, resulting in a NetAnnual 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 capitalY

0-2000;Y

1-2500;Y

2-3100;Y

3-3600; 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

Net operating cash flows Add back depreciation

Exclude depreciation from costs

Add tax shield of depreciation (tax rate xdepreciation)

Terminal cash flows Proceeds from sale of assets minus taxes on

sale of an assets plus recovery of workingcapital

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Asset Replacement Project Cash Flows

Initial investment Initial investment in plants and working capital

minus proceeds from sale of old asset plustaxes on sale of old assets

Incremental operating cash flows Operating cash flow of new assets minus

operating cash flow of old assets

Terminal cash flow

Proceeds from sale of new asset- proceedsfrom sale of old asset - taxes on sale of oldassets- taxes on sale of an assets-taxes onsale of old assets plus recovery of workingcapital

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Project Cash Flows: Summary

Only future, incremental,cash flows are Relevant.

Relevant Cash Flows areentered into a yearly cashflow table.

Net Annual Cash Flows arediscounted to give theprojects Net Present Value.

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Overarching principles:

We only need to estimate cash flowsthat change as a result of accepting the

project (incrementalcash flows).

The amount of, and the timing of thecash flowmust be estimated, not the

accounting profit/loss by ordinaryaccounting methods.


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There are generallythree kinds ofcash flows thatcan be affected by

acapital budgeting project:

1) Initial period cash flow

2) Operating cash flow

3) Terminal year cash flow


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Treatment ofTaxes

Since taxes are cash flows, we mustinclude taxes in our cash flow estimates.All estimated cash flows should be after-taxcash flow estimates!

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Cash FlowType 1: Initial Period Cash Flows

These are simply any cash flows that occur inthe initial period of the projects life (period0).

For example, assume that a new investmentproject would require spending $20 million fornew capital machines, plus $3 million foradditions to working capital (increases in cashbalances, inventory, and accounts receivable).

The initial period cash flow = -$20 + -$3= -$23 million.

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Cash FlowType 2: Operating Cash Flow

Accounting income for a period could bea measure of cash flow, except thatdepreciation (an expense, but not a

cash flow) was subtracted in calculatingit.

Operating cash flow equals

Net Income + Depreciation

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Operatingcash flow will be affectedwhenever a revenue or expense is

changed on the income statement.

For example, operating cash flow isincreased/decreased if a project resultsin increased/decreased sales revenues.

Operating cash flow isdecreased/increased if a project resultsin increased/decreased expense ofsome kind.

Operating Cash Flow

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Continuing withthe 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 millionper year.

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Assume thatacceptingthe new

investment project would increase the

business sales by$10 million, andincrease the operatingcosts by$4

million, plus increase depreciation

expense by$2million. What is theincremental operatingcash flow for

the project?

Class Exercise

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Operatingcash flow withthe newproject = ($105 - $69 - $17) x (1-

.3) + $17 = $30.3 million.

The incrementaloperating cash flowfor the project equals the change incash flows from before accepting theproject to after accepting it = $30.3 -$25.5 = $4.8 million per year.(Assume these benefits continue thesame each year for 10 years.)

Answer

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It is usuallyeasiestto compute thisincremental cash flowbyjust usingthe

incremental numbers themselves. Thus,

The relevant incremental operating cash flowfor 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

An Alternative Way

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Notice thatthis method ofcalculatingthe

incremental operatingcash flow requires

you to simplyidentifyeveryitem in thecompanys income statementthatchanges,

and then to calculate the change in net

income that results. Finally, the operatingcash flow equals the change in net income plus

the change in depreciation.

Operating Cash Flow

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Cash FlowType 3: Terminal Year Cash Flows

These cash flows consist of any residualvalues (salvage values) recovered fromthe project at the end of its useful life.

For our example, assume that at theend of the projects life, the machinescould be sold to net $100,000 aftertaxes, and that the working capital ($3million) is recovered in full.

Thus, the terminal year cash flow (year10) for the project = $3.1 million.

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The complete cash flows for the

example projectare:

Periods:0 1-10 10

- $23 + $ 4.8 + $ 3.1

Assume thatthe cost ofcapital forthe project equals 10%, the NPV is

calculated to be $7.69 million.

Total Cash Flows

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Since the NPV > 0 we knowthe project is a goodone.

We could alternatively have made the decisionusing the IRR method. IRR of the project canbe calculated to be 17%. Since this is > the10% cost of capital, the project should beaccepted.

We could also have (alternatively) made thedecision using the PI method. PI = 1.33,which is > 1.00.

What to Do with the Project?

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Consider another example: Assume the Widget Company is considering an

investment to replace a production machine witha more efficient one.

Assume the new machine costs $100,000, andthe old machine has a book value of $15,000 anda current salvage value of $25,000.

Assume the tax rate is 30%.

What are the relevant cash flows for the projectanalysis, and should the replacement beaccepted?

Class Exercise 2

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First, determine the initial periodcash flows:

The $100,000 purchase price of the new machineis an immediate cash outflow.

The $25,000 salvage value of the old asset wouldbe 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.

Initial Period Cash Flows

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The total initial period (period 0)

incremental cash flows for the

replacement projectare:

-$100,000 + $25,000 - $3,000 = -$78,000.

Initial Period Cash Flows

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Next, we calculate the operatingcash flows: Assume the new machine would reduce

operating costs by $35,000 per year for thenext 8 years, compared to using the oldmachine. Depreciation expense would alsoincrease 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, for8 years.

Note that this is an annuityof benefits.

Operating Cash Flows

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Assume thatboththe old machine and

the new one would be fullydepreciated

after 8years.

With the new machine, sale in year 8 for$5,000 => taxable gain on the sale equal tothe 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 thesalvage value minus the book value = ($500 0) = $500.Tax on this gain = $500 x .3 =

$150.

Calculation of Taxes

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Altogether, then, the total terminalyear 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 cashflow of that year (alreadycomputed).

Terminal Year Cash Flows

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Important: While in general, any cash flow affected

by a project is relevant, we do notinclude any cash flows that arefinancing 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 thecost of capital used to find NPV (or used

to compare to IRR). To include thefinancial cash flows and then discountthem to PV would be to double counttheir impact.

Documents

Fin650 Lectures 1-2