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Assignment - Project Appraisal

Assignment - Project Appraisal

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Published by: veenamathew on Mar 11, 2010
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ASSIGNMENT: PROJECT APPRAISALQuestion: 1. Discuss the Key Business Consideration Relevant for Project Financing DecisionCorporate finance
is an area of financedealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is tomaximize corporate valuewhile managing the firm's financialrisks. Although it is in principle different from managerial financewhich studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.The discipline can be divided into long-term and short-term decisions and techniques.Capital investmentdecisions are long-term choices about which projects receive investment, whether tofinance that investment withequityor debt, and when or whether to paydividendstoshareholders. On the other hand, the short term decisions can be grouped under the heading "Working capital management". This subject deals with the short-term balance of current assetsandcurrent liabilities; the focus here is on managing cash,inventories, and short-term borrowing and lending (such as theterms on credit extended to customers).The terms corporate finance and
corporate financier
are also associated with investment banking. The typical role of aninvestment bank is to evaluate the company's financial needs and raise theappropriate type of capital that best fits those needs.
Capital investment decisions
Capital investment decisions are long-term corporate finance decisions relating tofixed assetsandcapital structure. Decisions are based on several inter-related criteria. (1) Corporate managementseeks to maximize the value of the firm by investing in projects which yield a positivenet present  valuewhenvaluedusing an appropriatediscount rate. (2) These projects must also befinanced  appropriately. (3) If no such opportunities exist, maximizing shareholder value dictates thatmanagement must return excess cash to shareholders (i.e., distribution via dividends). Capitalinvestment decisions thus comprise an investment decision, a financing decision, and a dividenddecision.
The investment decision
Management must allocate limited resources between competing opportunities (projects) in a processknown ascapital budgeting. Making this capital allocation decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cashflows.
Project valuation
In general, each project's value will be estimated using adiscounted cash flow(DCF) valuation, andthe opportunity with the highest value, as measured by the resultantnet present value (NPV) will be selected (applied to Corporate Finance by Joel Deanin 1951; see also Fisher separation theorem, John Burr Williams: theory). This requires estimating the size and timing of all of the incrementalcash flows resulting from the project. Such future cash flows are thendiscountedto determine their 
(see Time value of money). These present values are then summed, and this sum net of  the initial investment outlay is the NPV.The NPVis greatly affected by thediscount rate. Thus, identifying the proper discount rate - often termed, the project "hurdle rate" - is critical to making an appropriate decision. The hurdle rate is theminimum acceptable returnon an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured byvolatility of cash flows, and must take into account the financing mix. Managers use models such as theCAPMor theAPTto estimate a discount rate appropriate for a particular project, and use theweighted average cost of  capital(
) to reflect the financing mix selected. (A common error in choosing a discount ratefor a project is to apply a WACC that applies to the entire firm. Such an approach may not beappropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)In conjunction with NPV, there are several other measures used as (secondary)selection criteria in corporate finance. These are visible from the DCF and includediscounted payback period, IRR , Modified IRR , equivalent annuity, capital efficiency, andROI (see 
Valuing flexibility
In many cases, for exampleR&D  projects, a project may open (or close) paths of action to the company, but this reality will not typically be captured in a strict NPV approach. Management willtherefore (sometimes) employ tools which place an explicit value on these options. So, whereas in aDCF valuation themost likelyor average or scenario specificcash flows are discounted, here the “flexibile and staged nature” of the investment ismodelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project.The two most common tools areDecision Tree Analysis(DTA) andReal options analysis(ROA); they may often be used interchangeably:DTA values flexibility by incorporating 
 (or  states
) and consequent
. (For example, a company would build a factory given that demand for its productexceeded a certain level during the pilot-phase, andoutsourceproduction otherwise. In turn, givenfurther demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, bycontrast, there is no "branching" - each scenario must be modelled separately.) In thedecision tree,each management decision in response to an "event" generates a "branch" or "path" which thecompany could follow; the probabilities of each event are determined or specified by management.Once the tree is constructed: (1) "all" possible events and their resultant paths are visible tomanagement; (2) given this “knowledge” of the events that could follow, management chooses theactions corresponding to the highest value path probability weighted; (3) then, assumingrational  decision making, this path is taken as representative of project value. SeeDecision theory: Choice  under uncertainty.ROA is usually used when the value of a project is
on the
of some other asset or underlying variable. (For example, theviability of aminingproject is contingent on the price of gold; if the price is too low, management will abandon themining rights, if sufficiently high, managementwilldevelop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here:
(1) usingfinancial option theory as a framework, the decision to be taken is identified as corresponding to either acall optionor a put option; (2) an appropriate valuation technique is then employed - usually a variant on theBinomial options modelor a bespokesimulation model, while Black Scholestype formulae are used less often - seeContingent claim valuation. The "true" value of  the project is then the NPV of the "most likely" scenario plus the option value.
Quantifying uncertainty
Given theuncertaintyinherent in project forecasting and valuation, analysts will wish to assess the
of project NPV to the various inputs (i.e. assumptions) to the DCFmodel. In a typicalsensitivity analysisthe analyst will vary one key factor while holding all other inputs constant,
.The sensitivity of NPV to a change in that factor is then observed, and is calculatedas a "slope": ΔNPV / Δfactor. For example, the analyst will determine NPV at variousgrowth rates in annual revenueas specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and thendetermine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface" (or even a "value-space"), where NPV is then a function of several variables. See alsoStress testing. Using a related technique, analysts also runscenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product,exchange rates, commodity prices, etc...)
as well as
for company-specific factors (unit costs,etc...). As an example, the analyst may specify specific growth scenarios (e.g. 5% for "Worst Case", 10%for "Likely Case" and 25% for "Best Case"), where all key inputs are adjusted so as to be consistentwith the growth assumptions, and calculate the NPV for each. Note that for scenario based analysis,the various combinations of inputs must be
internally consistent 
, whereas for the sensitivity approachthese need not be so. An application of this methodology is to determine an "unbiased" NPV, wheremanagement determines a (subjective) probability for each scenario – the NPV for the project is thenthe probability-weighted averageof the various scenarios.
The financing decision
Achieving the goals of corporate finance requires that any corporate investment be financedappropriately. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm)will be affected, the financing mix can impact the valuation. Management must therefore identify the"optimal mix" of financing—the capital structure that results in maximum value. (SeeBalance sheet,WACC,Fisher separation theorem; but, see also theModigliani-Miller theorem.) The sources of financing will, generically, comprise some combination of debtandequity financing. Financing a project through debt results in aliabilityor obligation that must be serviced, thusentailing cash flow implications independent of the project's degree of success. Equity financing isless risky with respect to cash flow commitments, but results in adilutionof ownership, control andearnings. The
cost of equity
is also typically higher than the
cost of debt 
(seeCAPM andWACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cashflow risk.Management must also attempt to match the financing mix to theassetbeing financed as closely as possible, in terms of both timing and cash flows.

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