Evaluating Projects Flashcards
15% (24 cards)
Capital Projects
Limited capital available, so businesses have to choose how to invest
^Is why there is a need for project appraisal
Project Appraisal (definition)
The process of systematically assessing the viability, feasibility, and potential of a proposed project before significant investment or implementation
Project Evaluation
To compare projects, analysis is needed. Analysis on:
- Capital Expenditure
- Running costs
- Revenue
- Termination costs (of removing machinery, scrap value etc.)
Also need to decide on what discount rate to use
Includes allowing for risk (three ways)
Cost of Capital
Is the discount rate used to evaluate projects
Important for financing and decisions on investing
Depends on capital structure (equity, gearing)
Need a weighted average
Usually use market values of equity
Uses complex calculations (to allow for tax rates and possible changes/growth in dividends)
Represents historic costs, current costs, company’s normal cost etc.
Weighted Average Cost of Capital
WACC
Average cost of capital determined from all sources
= Cost of equity + Cost of debt capital
Weighted by market value of debt and equity
Is rate of return achieved on profit if shareholders are to be no better/worse off
Aim is to minimise WACC
If NPV >0 when calculated at WACC or IRR > WACC, shareholder wealth increases
Can be calculated (percentage) as dividend rate x (share capital/total capital)
+ interest rate x (long term loan/total capital)
OR cost of equity x (equity/equity + debt)
+ cost of debt x (debt/equity+debt)
Stage 1: Cost of equity - dividend growth model
= (next ordinary dividend / share price) + dividend growth
= (ordinary div x growth)/share price + div growth
Stage 2: Cost of debt (after corporation tax) (USUALLY LOWER than cost of equity because equity shareholders take more risk)
= rate of interest on bank loan x net cost after tax
= rate of interest on bank loan x (1- corporation tax)
Stage 3: Weighing of capital
- Market value of equity = number of ordinary shares x market price
- Value of debt = value of bank loan (on balance sheet)
- Find equity and debt, and then find equity/(equity + debt) and debt/(equity + debt)
Stage 4:
WACC = cost of equity x (equity/equity + debt)
+ cost of debt x (debt/equity+debt)
Example on 0325 slide 36, 38, 43
WACC
How to find Cost of Equity
= (next ordinary dividend / share price) + dividend growth
WACC
How to find Cost of Debt
= rate of interest on bank loan x net cost after tax
WACC
How to find present value
Present value = next cashflow / (interest rate - growth rate)
WACC
How to find interest rate
Interest rate = (next cashflow / present value) + growth rate
Evaluation methods
- Net Present Value
- Payback Period and Discounted Payback Period
- Internal Rate of Return
- Shareholder value analysis
Net Present Value (NPV)
Model project cashflows
Discounted back to present day using cost of capital
(Project cash flows x discount factor, and then added up)
- Leads onto shareholder value approach
Payback Periods
Model project cashflows
Looks at time it takes for accumulated project cashflows to turn positive
Can only occur at cashflow point
Shorter payback period is preferred
Discounted Payback Period (DPP)
Same as payback period but if cashflows are discounted
Internal Rate of Return (IRR)
Allows for ranking
Return that gives a 0 net present value
Can compare to cost of capital (as a hurdle rate)
Can be tricky, or have multiple solutions, or the solutions could be nonsensical (e.g. negative)
Shareholder Value approach
Considers value added to shareholders, by comparing value of company before and after a project (impact of net asset value)
Complex mathematical modelling (do not need to do)
- Extension of net present value
Risk
Risk - probabilities and outcomes are known
Uncertainty - probabilities and outcomes are unknown
Cannot predict the future so risk needs to be considered (what if __ does not turn out the expected way?)
Three ways to look at risk:
- Sensitivity Analysis/Scenario Analysis
- Probability Analysis
- Certainty Equivalent
Sensitivity Analysis
Assesses how changes in one variable affect the NPV
Options tested one at a time
Example 0325 slide 22
Scenario Analysis
Assess how changes in multiple variables affect the NPV
Probability Analysis
e.g. Expected return of -15% with a probability of it happening of 20% = -15% x 20% = -3%
Need to add up expected return if they are part of one project (0325 slide 28)
Can be graphically represented (probability trees)
Certainty Equivalent
A value/guaranteed amount without higher risk (is why people who are reluctant to take risks like this one)
e.g. A = certain to get £100, B = 50% chance of getting £50, 50% chance of getting £200. B is a gamble
In practice, CE is calibrated to risk averseness (more risk averse = 50% chance of getting £80, less = 50% chance of £170
Checking if the discount rate is right
Important for discount rate to be right (fundamental to all calculations)
Project risk depends on project that you take part in, source of funds etc.
Similar projects should have similar risk
Cost of equity capital
Equity shareholders are rewarded for additional risk taken (higher return than debt holders)
Cost of equity, R:
Expected Return (R) = Rf + B(Rm - Rt)
= risk-free rate (AKA guaranteed return) + equity risk premium (AKA the additional payment for investing in the company/way of quantifying the risk)
^ Rf = risk free rate
^ (Rm - Rf) = market risk premium
^ B = beta = risk measure of stock compared to market
Uses CAPM model to try quantify risk too but describing expected return and risk
Cost of debt capital
Easy to figure out
What you have been charged, allowing for tax
Capital Asset Pricing Model (CAPM)
Describes expected return and risk on a stock compared to overall market
Splits risk into two (to quantity)
- Specific risk (risk involved in investing in that particular company); is reduced if you have a wide portfolio AKA invest in different companies that balance each other out
- Systematic risk (risk exposed to the stock market/equities in general); measured by Beta
