FIN 650: Project Appraisal Lecture 1 Introduction

1. FIN 650: Project Appraisal Lecture 1 Introduction

2. Course Overview 2 • Prerequisites • Bus635 and/or EMB 510 • Requirements and Grading • 1 Paper (30%) • Two Midterm Examinations (40%) • Final Examination (30%) • Class Materials • Web-page: http://fkk.weebly.com • Office: NAC 751 • Office hours: Wednesday, 5pm-6:30 pm Monday, 5pm-6:30 pm

3. Activity Schedule: FIN650

4. Make-up Policy and Class Attendance • There will be only one make-up for all examinations (mid-terms, final etc.) towards the end of the course to accommodate force majeure. All examination dates are pre-announced. Please make necessary arrangements with your office. • Historically, the performance of students taking make-up examinations were always poorer compared to students taking examinations on schedule. • I hope you will appreciate that it is not practical to offer a customized course for any or group of individual student(s). • Please enter the class by 7:20 pm, after which the class room door will be closed. Late attendance is very disruptive for the class.

5. About the Course • Investment decisions are important both for private and public entities. • Goals are different. • Capital budgeting • Financial appraisal • 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 • Economic appraisal • Estimation of social surplus • Shadow prices • To correct for distortions in the market prices or put a price on non-marketed goods • Social discount rate • Environmental appraisal • Financial modeling with Excel spreadsheet

6. Project Appraisal • Nature of project appraisal Given the limitation of resources, choices must be made among the competing uses, and project appraisalis one method of evaluating alternatives in a convenient and comprehensive fashion • Project appraisal assesses the benefits and cost of a project and reduces them to a common yardstick. If benefits exceed costs, the project is acceptable; if not the project should be rejected • Society’s objective • Growth: to increase total national income • Equity: to improve the distribution of national income • Projects should be assessed in relation to their net contribution to both of these objectives

7. Project and Program Appraisal • Project and program sometimes used interchangeably • Project: Padma 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

8. CBA and Capital Budgeting • Cost-Benefit Analysis Cost 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-term investments consistent with the firm’s goal of shareholders wealth maximization

9. Major Steps in CBA • Specify the set of alternative projects • Decide whose benefits and costs counts (standing) • Catalogue the impacts and select measurement indicators (units) • Predict the impacts quantitatively over the life of the project • Monetize (attach dollar/taka values to) all impacts • Discount benefits and costs to obtain present values • Compute the NPV of each alternative • Perform sensitivity analysis • Make a recommendation based on the NPV and sensitivity analysis

10. 8 Principles of Finance • Buy assets that add value, avoid buying assets that don’t add value • Cash is king • The time dimension of financial decisions is important • Know how to compute the cost of financial alternatives • Minimize the cost of financing • Take risk into account • Markets are efficient and deal well with information • Diversification is important

11. Capital Budgeting • Capital budgeting is primarily concerned with sizeable investments in long-term assets. • Tangible: Property, Plant or equipment • Intangible: R&D, Patents or trademarks • Different from recurring expenditure in two aspects: • Projects are significantly large • Long-lived projects with their benefits or cash flows spreading over many years. • Capital budgeting decisions have significant impact on firm’s performance and they are critical to the firms success or failure

12. Capital Budgeting • Capital budgeting is one of the most significant financial activity of the firm. • Capital budgeting determines the core activities of the firm over a long term future. • Capital budgeting decisions must be made carefully and rationally.

13. Capital Budgeting Within the Firm

14. Examples of “Long Term Assets” • Real Estates • Aircrafts, Ships • Forest • Plant and Machineries

15. Aspects of Capital 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.

16. Aspects of Capital Budgeting Capital Budgeting: • Emphasizes the firm’s goal of wealth maximization, which is expressed as maximizing an investment’s Net Present Value • Requires calculation of a project’s relevant cash flows

17. Aspects of Capital Budgeting Capital Budgeting Uses: • Sophisticated forecasting techniques:- • Time series analysis by the application of simple and multiple regression, and moving averages • Qualitative forecasting by the application of various techniques, such as the Delphi method

18. Aspects of Capital Budgeting 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.

19. Aspects of Capital Budgeting • Application of Simulation and Monte Carlo Analysis as extra risk analysis. • Application of long term forecasting and risk analysis to projects with very long lives. • Application of optimization techniques to projects which have constrained resources. • Development and application of generic and specific financial models • Application of cash flow forecasting, and NPV analysis to all aspects of property investment projects. • Application of NPV analysis under the additional risks associated with international investments

20. Shareholder Wealth Maximization and NPV • The shareholder wealth maximization goal requires that management should endeavor to maximize net present value (NPV) of expected future cash flows to the shareholders of the firm. • NPV represents discounted sum of the expected net cash flows. • Cash outflows: capital outlays • Cash inflows: proceeds from sales • Net cash flows are determined by subtracting a given period’s cash outflows from that period’s cash inflows.

21. Shareholder Wealth Maximization and NPV • The discount rate takes into account the timing and riskof the futurecashflowsresulting from the investment. • The longer it takes to receive a cash flow, the lower the present value to the investor. • The greater the risk associated with receiving a future cash flow, the lower the value investors place on that cash flow. • Shareholder wealth depends on magnitude, timing and risk associated with the cash flows expected to be received in future by the shareholders

22. Class Exercise • Project Alpha requires an initial capital outlay of Tk. 45,000 and will have net cash inflows of Tk. 15,000, Tk. 20,000 and Tk. 30,000 at the end of years 1,2, and 3 respectively. The discount rate is 8% per annum. • How much project Alpha will add to the firm’s value?

23. Classification of Investment Projects • An independent project is one the acceptance or rejection of which does not directly eliminate other projects from consideration or affect likelihood of their selection • Mutually exclusive projects- cannot be pursued simultaneously-the acceptance of one prevents the acceptance of the alternative proposal • A contingent project is one the acceptance or rejection of which is dependent on the decision to accept or reject one or more other projects • Complementary projects, pharmacy and doctor’s clinic • Substitute projects, Thai or Fast-food restaurant

24. 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

25. The Capital Budgeting Process Corporate goal ` Strategic Planning Investment opportunities Preliminary Screening Financial Appraisal Qualitative factors, Judgments Accept/Reject Decision on the project Accept Reject Implementation Monitoring Post implementation audit

26. Why Cash Flows? • Cash flows, and not accounting estimates, are used in project analysis 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.

27. The Meaning of RELEVANT Cash Flows. • A relevant cash flow is one which will change as a direct result of the decision about a project. • A relevant cash flow is one which will occur in the future. A cash flow incurred in the past is irrelevant. It is sunk. • A relevant cash flow is the difference in the firm’s cash flows with the project, and without the project.

28. Cash Flows: A Rose by Any Other Name Is Just as Sweet. • Relevant cash flows are also known as:- • Marginal cash flows. • Incremental cash flows. • Changing cash flows. • Project cash flows.

29. Categories of Cash Flows • Project cash flows may be separated into two categories: • Capital cash flows • The initial investment • Outflows, purchasing assets and initial working capital • Additional middle-way investments such as upgrades and 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, environmental rehabilitation, redundancy payment to employees • Operating cash flows: cash inflows from sales, cash outflows for marketing and advertising, payments for wages, utilities, raw materials

30. 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 the projects 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 doctor’s clinic, favorable impact on clinics cash flows to be added to pharmacy project’s cash flows • Opportunity cost principle: the most valuable alternative that is given up if the proposed investment project is undertaken • Use of existing resources, space, building, rental value, market value

31. Essentials in Cash Flow Identification • Sunk cost, is an amount spent in the past in relation to the project, but which cannot now be recovered or offset by the current decision • Past consulting expenses • Overhead costs • Utilities, executive salaries • With or without the project, incremental costs to be included • 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, opportunity cost • Capital flows, not operational flows, it is a fund

32. Essentials in Cash Flow Identification • 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 the accounting depreciation but tax allowable depreciation to measure the tax effect • Investment allowance, enhances NPV • Financing flows, excluded. double counting, included in the discount rate

33. Essentials in Cash Flow Identification • 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 cash flows 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 year 1will be timed as occurring at the end of year zero. • Inflation and consistent treatment of cash flows and 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 discount rate

34. 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.

35. 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.

36. Cash Flows and Depreciation: Always a Problem. • Depreciation is NOT a cash flow. • Depreciation is simply the accounting amortization of an initial capital cost. • Depreciation amounts are only accounting journal entries. • Depreciation is measured in project analysis only because it reduces taxes.

37. Other Cash Flow Issues. • Tax payable: if the project changes tax liabilities, those changed taxes are a flow of the project. • Investment allowance: if a taxing authority offers this ‘extra depreciation’ concession, then its tax savings are included. • Financing flows: interest paid on debt, and dividends paid on equity, are NOT cash flows of the project.

38. Using Cash Flows • All relevant project cash flows are set out in a table. • The cash flow table usually reads across in End of Years, starting at EOY 0 (now) and ending at the project’s last year. • The cash flow table usually reads down in cash flow elements, resulting in a Net Annual Cash Flow. This flow will have a positive or negative sign.

39. 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 capital Y0-2000; Y1-2500; Y2-3100; Y3-3600; 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

40. 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 x depreciation) • Terminal cash flows • Proceeds from sale of assets minus taxes on sale of an assets plus recovery of working capital

41. Asset Replacement Project Cash Flows • Initial investment • Initial investment in plants and working capital minus proceeds from sale of old asset plus taxes 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- proceeds from sale of old asset - taxes on sale of old assets- taxes on sale of an assets-taxes on sale of old assets plus recovery of working capital

42. Project Cash Flows: Summary • Only future, incremental, cash flows are Relevant. • Relevant Cash Flows are entered into a yearly cash flow table. • Net Annual Cash Flows are discounted to give the project’s Net Present Value.

43. Overarching principles: Project Cash Flows: Summary • We only need to estimate cash flows that change as a result of accepting the project (incremental cash flows). • The amount of, and the timing of the cash flow must be estimated, not the accounting profit/loss by ordinary accounting methods.

44. There are generally three kinds of cash flows that can be affected by a capital budgeting project: Project Cash Flows: Summary 1) Initial period cash flow 2) Operating cash flow 3) Terminal year cash flow

45. Treatment of Taxes • Since taxes are cash flows, we must include taxes in our cash flow estimates. All estimated cash flows should be after-tax cash flow estimates!

46. Cash Flow Type 1: Initial Period Cash Flows • These are simply any cash flows that occur in the initial period of the project’s life (period 0). • For example, assume that a new investment project would require spending $20 million for new capital machines, plus $3 million for additions to working capital (increases in cash balances, inventory, and accounts receivable). • The initial period cash flow = -$20 + -$3 = -$23 million.

47. Cash Flow Type 2: Operating Cash Flow • Accounting income for a period could be a measure of cash flow, except that depreciation (an expense, but not a cash flow) was subtracted in calculating it. • Operating cash flow equals Net Income + Depreciation

48. Operating cash flow will be affected whenever a revenue or expense is changed on the income statement. Operating Cash Flow • For example, operating cash flow is increased/decreased if a project results in increased/decreased sales revenues. • Operating cash flow is decreased/increased if a project results in increased/decreased expense of some kind.

49. Continuing with the 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 million per year.

50. Assume that accepting the new investment project would increase the business sales by $10 million, and increase the operating costs by $4 million, plus increase depreciation expense by $2 million. What is the incremental operating cash flow for the project? Class Exercise