Chapter 12: Capital Project Appraisal

Question 1

What is a capital project

Answer 1

Any project where there is INITIAL EXPENDITURE and then
- once the project comes into operation -
a STREAM OF REVENUES less running costs.

A capital project does not have to involve the construction of a physical asset.

Question 2

What are the main steps in a capital project appraisal?

Answer 2

INITIAL APPRAISAL, to see whether the project satisfies the sponsor’s criteria.

If it does, a DETAILED APPRAISAL is carried out:

• Defining the SCOPE of the project
• Evaluating cashflows
• Identifying, analysing and mitigating RISKS
• Producing an INVESTMENT SUBMISSION
• Making a DECISION whether or not to go ahead.

Question 3

Criteria that a project should satisfy in the INITIAL APPRAISAL

Answer 3

The project should

• be financially viable
• achieve synergies with other projects
• satisfy political constraints
• have significant upside potential
• use scarce funds / management resources in the best way.

Question 4

How to evaluate the cashflows of the project?

Answer 4

Define the most likely CASHFLOWS:

• the capital outlay,
• running costs,
• revenues
• and termination costs

Consider the CONSEQUENTIAL EFFECTS on the sponsors other activities

Document any ASSUMPTIONS made

Calculate results such as NPV, IRR, Payback and Discounted payback periods.

• – compare these against benchmarks
• – e.g. is IRR greater than a hurdle rate

SENSITIVITY TESTS, by varying the assumptions made

Question 5

How would you set the risk discount rate to calculate the net present value?

Answer 5

The risk discount rate should reflect the systematic risk together with any inherently high risks that cannot be sufficiently taken into account via specific risk analysis.

A real discount rate should be used to discount real cashflows.
A nominal discount rate should be used to discount cashflows that include inflation.

Question 6

Effective risk identification exercise

Answer 6

• Make a high level preliminary analysis
• Hold a brainstorming session
• Carry out a desktop analysis
• Set out the risks in a risk register

Question 7

6 Ways of mitigating risks

Answer 7

• Further research
• AVOID the risk
• TRANSFER the risk
• SHARE the risk
• INSURE the risk
• REDUCE the risk

Question 8

Likely entries in the INVESTMENT SUBMISSION document

Answer 8

FINANCIAL results (expected NPV, distribution of NPVs)

RISKS identified

• – best combination of risk mitigation options
• – residual risks, especially those that can be catastrophic, despite having a low probability of occurrence

the details surrounding the FINANCING of the project

the likely effects on INVESTORS after allowing for inflation, borrowing costs and tax

Question 9

Further considerations (beyond the investment submission)

Answer 9

• allowance for any bias or approximations in the estimates
• a hunch
• knowledge not held by those producing the submission
• last-minute developments
• doubts over feasibility
• the overall project credibility
• whether upside potential has been estimated realistically

Question 10

How would you set the risk discount rate to calculate NPV for projects with a NORMAL DEGREE OF RISK?

Answer 10

For projects with a NORMAL DEGREE OF RISKS, this would be

the current cost of raising incremental capital from the sponsoring company to fund this project.

This should be the company’s
… normal weighted average cost of capital,
… where the weights reflect the optimal capital structure of the company
… between debt and equity.

Question 11

How should the debtholders’ required return be calculated?

Answer 11

The DEBTHOLDERS REQUIRED RETURN should be the
… expected return on an index-linked government bond
… plus a debt risk margin.

This should be adjusted for corporation tax.

Question 12

How should the shareholders’ required return be calculated?

Answer 12

The SHAREHOLDERS REQUIRED RETURN should be
… the expected return on an index-linked government bond
… plus an equity risk margin.

This then gives a real risk discount rate which can be adjusted for future inflation to make it into a nominal rate of interest.

Question 13

How would you set the risk discount rate to calculate NPV for projects with a HIGHER-THAN-NORMAL DEGREE OF RISK?

Answer 13

For projects that have a HIGHER-THAN-NORMAL degree of risk, the sponsoring company should use a higher-than-normal discount rate.

• It could consider the rates used by other companies engaging in similar projects,
  or - if that information is hard to obtain - make an arbitrary adjustment.