Project Appraisal

Week 4
IB125 Foundations of Financial Management
Jesús Gorrín

Key Readings: Hillier et al. Chapters 6.1-6.8, 7.1-7.4, 8.1-8.3

INTRODUCTION
 How should a business evaluate an investment in new plant, equipment, i.e. a new project?
 are the expected future cash flows worth more than the initial cost?

 Need to:
 estimate annual incremental cash flows associated with project
 discount these cash flows back to starting date for project

 So far we assumed that the capital market is perfect, which means:

 No taxes
 No transaction costs (i.e., costs incurred when buying or selling)
 No differences in information or opinions among different agents
 The capital market is competitive, which means that the decisions of individual agents
do not affect prices
 In the previous lecture, we continued to assume perfect markets but
 we allow for investors to be risk averse.

 In this lecture, we assume that the capital market is imperfect.

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REMINDER: NPV RULE
 For a stream of expected future cash flows C1, C2,.. . , CT and initial investment I
(or C0), the net present value (NPV) of the investment equals:

Cash Flows Time

Discount Rate

 NPV rule for capital investment:

 if capital is not rationed, accept all projects with NPV> 0

 Which cash flows should be included in project appraisal?

 After-tax cash flows that are incremental to project

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REMINDER: DISCOUNT RATE
 Discounting reflects both timing and uncertainty of future cash flows.

 What is the correct discount rate R?

 Rate of return on stock-market investments is calculated after…

 company has paid corporation tax on its profits
 shareholders have paid personal taxes on dividend income and capital gains

 Hence, we must use an after-tax cost of capital (e.g., imperfect market) to discount
expected incremental, after-tax cash flows associated with the project.

 Financial markets provide benchmark rate of return because they are highly
efficient at pricing securities

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RELEVANT CASH FLOWS
 Only after-tax incremental cash flows are relevant

Incremental = Firm’s CFs - Firm’s CFs

Cash Flows with Project without Project

 Idea: evaluate difference between two mutually-exclusive scenarios:

 “project goes ahead” vs.
 “project does not go ahead”

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CASH FLOWS: WHAT TO INCLUDE …
 Operating cash flows:
 additional after-tax profit
 adjustments for non-cash items
 Taxes:
 cash-flow savings from tax-deductible depreciation
 Capital expenditures and opportunity costs:
 cost of fixed assets to undertake the project
 opportunity cost of existing fixed assets
 management time spent on project

 Changes in Working Capital (ΔWC)

 current assets: cash, highly-liquid securities, stock, debtors
 current liabilities: short-term loans, trade creditors, tax liabilities, interest
payable on medium-term and long-term debt
 Net Working Capital = Current Assets − Current Liabilities

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WORKING CAPITAL AND LIQUIDITY
 Working Capital Management:
 day-to-day concern of financial manager
 short-term survival at lowest cost

 Hence…need for liquidity:

 Sufficient cash to meet short-term obligations

 Trade-off between . . .
 convenience yield of holding stock vs. opportunity cost of not having the
money in an interest-bearing bank account

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CASH FLOWS: WHAT NOT TO INCLUDE …
 Sunk costs
 Costs already incurred
 Non-recoverable (e.g., R&D costs)

 Accounting allocations:
 overheads (allocated costs)
 accounting figures of depreciation of fixed assets

 Cash flows associated with financing the capital investment:

 interest payments on debt
 dividends paid to shareholders

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INVESTMENT AND FINANCING DECISIONS
 Separate investment and financing decisions
 Ignore all financing costs, even if the project is partially financed with debt
 Treat the project as if it were all equity-financed
 Financing side effects will be considered later

 Use expected values if future cash flows are uncertain

 Don’t be conservative in order to be prudent
 The discount rate takes care of risk

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CALCULATING FREE CASH FLOWS
 Free Cash Flow = Cash Inflow – Cash Outflow

 Cash inflow = (Sales – Costs – Depreciation) x (1-T) + Depreciation

(Operating Cash Flow)
= EBIT x (1-T) + Depreciation

= (Sales-Costs) x (1-T) + Depreciation x T

 Cash outflow = Capital expenditure (CAPEX) + Changes in working capital (∆WC)

 Free Cash Flow = Operating Cash Flow (OCF) – CapEx - ∆WC

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EXAMPLE: ESTIMATING CASH FLOWS
 You decide to invest into an innovative product

 Initial equipment costs £2,800 with estimated market

value of £500 after 5 years
 Depreciation (Cap. Allowances)=18%(Book Valuet-1)
 Please read the Appendix for more details about the
depreciation rate.
 Investment in working capital of £1,300
 Sales of £2,000 per year for next 5 years
 Gross margin: 50%
 IPhone case with
 Tax rate 30%
integrated bottle
 All-equity financed opener.
 Systematic risk is 50% higher than systematic risk of the
market
 Risk-free rate: 2.5%, MRP: 5%

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 CASH FLOWS
Step 1: Calculate taxes Step 2: Calculate cash flows
Sales 2,000
50% EBIT 496
- COGS 1,000
- Taxes 149
= EBITDA 1,000 18%
of
= EBIAT 347
- Depreciation 504 2800 + Depreciation 504
= EBIT 496 - CAPEX 0
x Tax rate 30% - Investment in WC 0
= Taxes 149 = FCFU 851

Rule: Depreciation is subtracted to calculate

earnings and taxable income, but all non-cash
items are added back to calculate cash flows.

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CAPITAL ALLOWANCE
Year 0 1 2 3 4 5
Writing-down schedule

Book value
2800-504 2296-413
2800 =2296 =1883 1544 1266
End value 500

Depreciation (Cap.
Allowances)
=18%(Book Valuet-1) 2800*0.18 2296*0.18 1266-500
=504 =413 339 278 =766

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EXAMPLE
Year 0 1 2 3 4 5
1 Sales 2000 2000 2000 2000 2000
2 Costs (=Sales*(1-Margin)) 1000 1000 1000 1000 1000

3 Depreciation
(Cap. Allowances) 504 413 339 278 766
4 EBIT = (1)-(2)-(3) 496 587 661 722 234
5 Taxes = 30% 149 176 198 217 70
6 OCF =(4)-(5)+(3) 851 824 802 783 930
7 Equipment (CapEx)
-2800 500
8 Investment in WC -1300 1300
9 Free Cash Flow -4100 851 824 802 783 2730
10 NPV @ 10% 187

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SENSITIVITY ANALYSIS
Cost of Equity
Margin 6% 8% 10% 12% 14%
20% -999 -1212 -1405 -1580 -1739
40% 180 -94 -344 -570 -777
50% 770 465 187 -66 -297
60% 1360 1024 718 439 184
80% 2539 2142 1779 1448 1145
 What does Sensitivity Analysis tell us?

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INFLATION
 Nominal vs. Real cash flows:
 nominal cash flows CT are measured in money of future dates
 real cash flows c T are measured in money of today and reflect purchasing power of
future cash flows
 If expected annual inflation rate over next T years equals i, then:
CT
cT =
(1 + i) T
 Nominal vs. real rates of return:
 nominal rate R reflects growth in nominal amount of money
 real rate r reflects growth in purchasing power

 Fisher relationship:
1+𝑅
 1 + 𝑅 = 1 + 𝑟 ∗ 1 + 𝑖 ⟺ 1 + 𝑟 = 1+𝑖

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INFLATION AND DISCOUNTING
 Can work in nominal or real terms: 1 + Nominal interest rate
Real interest rate = -1
1 + Inflation rate
 either discount nominal cash flows at nominal
rate
 or discount real cash flows at real rate Takes out
the effect of
CT cT inflation
=
(1 + R) (1+ r)T
T

 But . . . not all cash flows inflate at the same rate:

 cost of labor typically inflates faster than cost
Includes
of materials
the effect of
 capital allowances are not adjusted for inflation inflation

 Therefore, in practice discounting is best done in

nominal terms.

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 INFLATION AND DISCOUNTING - EXAMPLE
The nominal discount rate is 14 per cent, and
the inflation rate is forecast to be 5 per cent.
What is the value of the project?

Nominal Cash Flows Real Cash Flows

650/(1.05)2

£600 £650 600/1.05 Real Discount Rate: (1.14/1.05) – 1 =8.57%

NPV: £26.47   £1, 000  
1.14 (1.14) 2 £571.43 £589.57
NPV: £26.47   £1, 000  
1.0857143 (1.0857143) 2

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WHERE DO POSITIVE NPV COME FROM?
 If NPV> 0, project is said to earn an economic rent.

 In a perfectly competitive market, all assets are priced such that NPV = 0.

 Markets for real assets (e.g. product markets or labour markets) less than perfectly
competitive.

 Economic rents occur if firm enjoys competitive advantage:

 Barriers to entry (monopolies, quotas)
 Special resources, special knowledge
 Brand name and brand loyalty

 Can rents be sustained that long? What is the competition doing?

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INTERNAL RATE OF RETURN
 The internal rate of return (IRR) is the discount rate that makes NPV zero
T CFt
NPV   t
0
t 0
1  IRR 
 IRR rule for investment projects
 Accept project if IRR > R
 Reject project if IRR < R
 Advantages of IRR
 Many managers find IRR a more intuitive measure than NPV
 Usually gives the same signal as NPV
 Problems with IRR
 Borrowing or lending
 Multiple IRR
 Mutually exclusive projects
 Projects with different horizons
 Term structure – different discount rates for different horizons
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PROBLEM 1: BORROWING OR LENDING
 Suppose R = 10%
 Consider the following projects:
Year 0 1 2 IRR NPV
Project A -5,000 0 9,800 40% 3,099
Project B 5,000 0 -9,800 40% -3,099

 The IRR rule (e.g., accept project if

IRR>R) would accept both projects

 In project B we should accept when

IRR<R.

 But NPV would accept only Project A

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PROBLEM 2: MULTIPLE IRR
 Suppose R = 30%
 Consider the following projects:
Year 0 1 2 IRR NPV @ 30%

Project C -5,000 16,000 -12,000 20% 207

100%

 At the end of investment, the

firm must clean up the
environment, dismantle a
nuclear power plant

 One IRR accepts the project, and

the other rejects the project

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PROBLEM 3: MUTUALLY EXCLUSIVE PROJECTS
 Seminar exercise

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PROBLEM 4: DIFFERENT HORIZONS
 Suppose R = 10%
 Consider the following projects:
Year 0 1 2 IRR NPV
Project A -5,000 0 9,800 40% 3,099
Project D -5,000 8,000 0 60% 2,273

 The IRR rule would accept

Project D over Project A

 But NPV would accept Project A

over Project D

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REAL OPTIONS
 Discounted cash flow (DCF) techniques:
C C C
NPV = -I + 1
+ 2
+ ... + T

1+ R (1 + R) 2
(1 + R) T
 treats initial investment I as “now or never”

 Real projects: subsequent opportunities to expand, contract, postpone, or abandon the

project

 Managerial flexibility is valuable

 Examples of real options

1. trial runs (future growth option)
2. postponing a project (postponement option)
3. closing down operations early (abandonment option)
4. changing project technology e.g. dual fuel systems (switching option)

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CONCLUSIONS
 Need to estimate:
 expected future incremental (after-tax) cash flows
 (after-tax) cost of capital

 Either discount nominal expected cash flows at nominal rate, or real expected cash
flows at real rate. Since inflation does not impact all cash flows uniformly, better to work
in nominal terms.

 Competitive advantage is source of positive NPVs: but advantage is difficult to sustain.

 Discounted cash-flow (DCF) techniques are “static”:
 assume that initial investment is “now or never”
 ill-suited for capturing value of flexibility

 Where managerial flexibility is important, use option-pricing techniques to value real

options.

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APPENDIX: DEPRECIATION VS CAPITAL ALLOWANCE
 Need to differentiate between depreciation of fixed assets for:
 accounting purposes (normally equal spreading of the costs)
 tax purposes (so-called HMRC capital allowances)

 HM Revenue & Customs specifies writing-down schedule:

 18% reducing-balance method over economic life of new equipment (as of
April 2012) special rules for buildings

 Here, we refer to “depreciation” only in the sense of depreciation for tax purposes
(capital allowances)

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