b821 Block3unit5 Project Appraisal

B821 Financial Strategy Block 3 Finance and Investment
Unit 5
Project Appraisal
Masters
This publication forms part of an Open University course B821, Financial Strategy. Details of this and other Open University courses can be obtained from the Student Registration and Enquiry Service, The Open University, PO Box 625, Milton Keynes, MK7 6YG, United Kingdom: tel. +44 (0)1908 653231, email general-enquiries@open.ac.uk Alternatively, you may visit the Open University website at http://www.open.ac.uk where you can learn more about the wide range of courses and packs offered at all levels by The Open University. To purchase a selection of Open University course materials visit http://www.ouw.co.uk, or contact Open University Worldwide, Michael Young Building, Walton Hall, Milton Keynes MK7 6AA, United Kingdom for a brochure. tel. +44 (0)1908 858785; fax +44 (0)1908 858787; email ouwenq@open.ac.uk
The Open University Walton Hall, Milton Keynes MK7 6AA First published 1998. Second edition 1999. Third edition 2000. Fourth edition 2003. Fifth edition 2006. Reprinted 2007 Copyright # 1998, 1999, 2000, 2003, 2006, 2007 The Open University All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without written permission from the publisher or a licence from the Copyright Licensing Agency Ltd. Details of such licences (for reprographic reproduction) may be obtained from the Copyright Licensing Agency Ltd of 90 Tottenham Court Road, London W1T 4LP. Open University course materials may also be made available in electronic formats for use by students of the University. All rights, including copyright and related rights and database rights, in electronic course materials and their contents are owned by or licensed to The Open University, or otherwise used by The Open University as permitted by applicable law. In using electronic course materials and their contents you agree that your use will be solely for the purposes of following an Open University course of study or otherwise as licensed by The Open University or its assigns. Except as permitted above you undertake not to copy, store in any medium (including electronic storage or use in a website), distribute, transmit or retransmit, broadcast, modify or show in public such electronic materials in whole or in part without the prior written consent of The Open University or in accordance with the Copyright, Designs and Patents Act 1988. Edited and designed by The Open University. Typeset in India by Alden Prepress Services, Chennai. Printed and bound in the United Kingdom by Hobbs the Printers Limited, Brunel Road, Totton, Hampshire, SO40 3WX. ISBN 0 7492 1320 5 5.3
CONTENTS
1 Introduction Outline of Unit 5 Aims and objectives of the unit 2 Strategy and investment appraisal 2.1 Strategic investment process 2.2 Preparation 2.3 Authorisation 2.4 Implementation Summary 3 Issues in capital budgeting 3.1 Capital budgeting 3.2 Issues in appraisal techniques 3.3 Cash flows or accounting flows? 3.4 Cash flow time-periods 3.5 Relevant cash flows 3.6 Inflation 3.7 Taxation 3.8 International capital budgeting Summary 4 Capital Rationing 4.1 Capital rationing in practice 4.2 Competing projects Summary 5 Project discount rate 5.1 How to deal with risk? 5.2 Hurdle rate vs WACC 5.3 Adjusting hurdle rates for risk Summary 6 Risk issues in CAPEX 6.1 Adjusting for risk using probabilities 6.2 Expected net present value (ENPV) 6.3 Investment projects as options Summary 5
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7 Ace Company: Spreadsheet exercise 7.1 Exercise 8 Funding capital projects 8.1 Leasing 8.2 Lease vs buy and borrow decisions Summary 9 Project finance 9.1 The methods of project finance 9.2 Case study: liquid gas facility in Oman Summary 10 Funding public projects 10.1 Main means of financing public-sector capital
formation 10.2 The Private Finance Initiative 10.3 Evaluating PFI projects Summary Summary and Conclusions Answers to exercises References Acknowledgements
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1 INTRODUCTION
INTRODUCTION
The importance of capital investments cannot be overemphasised. Investments affect the operations and cash flows of organisations over long periods of time. However, capital investment per se does not necessarily improve organisational performance: success depends upon how efficiently and effectively capital resources are used. Organisations frequently spend large amounts of money on capital investments which may only give returns after a long period of time, and this increases the degree of uncertainty as to the returns on these investments. Moreover, an organisations capital resources are usually limited. Consequently, the resource allocation process is often critical to the organisations success. The process of making a capital expenditure (CAPEX) decision is a multifunctional undertaking. In most cases this process involves people in a range of functions within the organisation. Each of them provides input according to the type of project under consideration and their individual expertise. To clarify the issues described in this unit we make use of a range of case studies. These form the basis for explaining theory and provide means for illustrating the practical issues. The differences between public- and private-sector projects are now disappearing. Increasingly, public projects are valued in the same way as those in the private sector, although the profit motive of the private sector is replaced with value for money in the public sector. We devote a section to hybrid public/private sector projects known as Public Private Partnerships (PPP) and examine the issues involved. We also illustrate the link between capital expenditure and project financing, showing that capital expenditure is not a stand alone topic. For example, the choice of discount rate to use in project appraisal is closely linked to the WACC you have just studied in Unit 4. Project appraisal also requires a consideration of risk, and Block 4 of B821, which focuses on risk, will elaborate some of the issues discussed in this unit. Project appraisal is a holistic process, which affects and is affected by functions other than finance within the organisation. Some of the functional areas involved in the capital investment decision are:
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Holistic: tending to produce wholes from the grouping of structures.
Marketing which provides data estimates of sales volumes if, for example, the proposed investment is for a facility to produce new products. Production which can determine the use of scarce resources in the manufacture of the organisational output.
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UNIT 5 PROJECT APPRAISAL
Services departments, institutions, divisions and similar functional areas responsible for providing services (e.g. schools, department of transport). Accounting and finance which can provide data needed for the analysis of the project and the expertise to carry out quantitative analysis upon which the decision to invest is based. This function examines methods of evaluating and financing capital investment projects and estimates their effect on cash flows, taxes and profitability.
Management must recognise and integrate the decision-making process within the organisational environment and select the projects that meet the chosen investment criteria in order to achieve the strategic and operational objectives of the organisation.
Social/organisational rationality
Personnel
Ideas
Strategic planning
Pre-screening
The CI decision
Environment
Implementation
Feedback/ post-audit Financial analysis
Economic rationality
Political rationality
Figure 1.1
A universal model of the capital investment (CI) decision-making activity (Northcott, 1992)
The diagram in Figure 1.1 shows a range of factors which influence the decision to invest in capital projects. The level of influence these factors have on the investment process varies between different types of organisations, and may vary to a certain extent between different projects within one organisation. The principal purpose of the model is to illustrate the complexity of the decisionmaking process and the range of expertise which is needed to arrive at an investment decision that will contribute to achievement of the strategic objectives of an organisation. The three arrows symbolise the external influences on the decision-making process, and of course these vary according to the type of organisation as well as the individual project.
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1 INTRODUCTION
OUTLINE OF UNIT 5
The structure of this unit is as follows. Section 2, Strategy and investment appraisal, illustrates the importance of strategy in the capital investment decision-making process. Although this subject has already been examined in Units 1 and 2, it will be revisited in this unit. In Section 3, Issues in capital budgeting, we explore a range of issues in connection with techniques of investment appraisal and the principles of capital budgeting. The section also describes specific issues closely intertwined with investment appraisal, such as inflation and taxation. Specific appraisal problems deriving from international investment programmes are also dealt with in this section. Section 4, Capital rationing, builds on the issues of funding and explains the concept of capital rationing in a commercial context. This section also deals with issues surrounding competing projects. In Section 5 we consider how to arrive at a suitable discount rate for a project, discussing whether to use WACC and, if so, whether it should be adjusted to cater for the risk of the project. The discussion of risk issues in CAPEX is continued in Section 6. In this section we also describe the so-called options approach to capital investment, which is a relatively new approach to the process of project decision-making. In Section 7 you are asked to attempt a spreadsheet exercise. The task requires careful consideration of the aspects of CAPEX you will have covered in the unit and you will be able to practise working with Excel spreadsheets. The accompanying file provides you with a suggested solution to the exercise. In Section 8, Funding capital projects, we introduce the subject of leasing. This is a variation on debt that is an important tool for private, voluntary and public-sector organisations. You then have a choice as to whether to study Section 9 or Section 10. Section 9 discusses project finance; this is designed mainly for private-sector students, although we believe that those of you more concerned with the public sector would also find the material here useful. In Section 10 we introduce the Private Finance Initiative and PublicPrivate Partnerships, mechanisms to allow public-sector organisations to use the private sector to fund public-sector projects. We expect that public-sector oriented students will choose to study Section 10 instead of Section 9. However, since there is a fair chance that, if you are a private-sector manager, you may become involved with a PPP undertaking, we would recommend that if you have time you do read Section 10 too.
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Note that any relevant assessment question will be able to be answered using Section 9 or Section 10.
AIMS AND OBJECTIVES OF THE UNIT

By the end of this unit you should be able to:
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appreciate how organisations implement their capital appraisal procedures recognise the wide range of issues involved in capital investment decisions assess the strategic implications of investing in capital equipment and facilities understand how to apply project appraisal methods to various
types of projects in public and private sector organisations
appreciate the importance of, and the problems in identifying
and measuring, risk in the context of capital investment decision making understand the problems and opportunities of raising funds for capital projects in the private and public sectors.
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2 STRATEGY AND INVESTMENT APPRAISAL
STRATEGY AND INVESTMENT APPRAISAL
You have already been introduced to organisational strategy in your earlier studies. In this section we discuss how the capital investment appraisal process fits into the formulation and implementation of an organisations overall strategy. An organisations strategy is the formulation of its plan for achieving its mission, goals and objectives. It can be argued that strategy is mainly concerned with adjusting to the opportunities and changes in the business environment. However, strategy also has to be determined within the constraints of the organisations resources, or such resources as can be obtained. From this it follows that expenditure on capital projects must be integrally linked to these resources.
ACTIVITY 2.1
Each year the World Bank lends between US$15 and $20 billion for projects in the more than 100 countries with which it works. Projects range across the economic and social spectrum in these countries from infrastructure to education, from health to government financial management. The projects the Bank finances are conceived and supervised according to a well-documented project cycle, as shown in Figure 2.1. In this context, what in your opinion would be the actions associated with the different phases in such a project appraisal cycle? The full World Bank diagram shown in Figure 2.2 answers the Activitys question, but do not be surprised if your version differs somewhat. While you should be able to see general similarities between your ideas and the World Bank set, there are many sensible and consistent ways to follow through a project cycle. Thus your set of actions is unlikely to match in detail that in the diagram.
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Evaluation
Country Assistance Strategy
Implementation and completion The completed project cycle Implementation and supervision
Identification
Preparation
Negotiations and Board approval
Appraisal
Figure 2.1
World Bank: The Project Cycle
8 Evaluation The Banks independent Operations Evaluation Department prepares an audit report and evaluates the project. Analysis is used for future project design.
1 Country Assistance Strategy The Bank prepares lending and advisory services, based on the selectivity framework and areas of comparative advantage, targeted to country poverty reduction efforts.
7 Implementation and completion The Implementation Completion Report is prepared to evaluate the performance of both the Bank and the borrower.
Evaluation
Country Assistance Strategy
Implementation and completion The completed project cycle Implementation 6 Implementation and supervision and supervision The borrower implements the project. The Bank ensures that the loan proceeds are used for the loan purposes with due regard for economy, Negotiations efficiency and effectiveness. and Board approval 5 Negotiations and Board approval The Bank and borrower agree on loan or credit agreement and the project is presented to the Board for approval.
Identification
2 Identification Projects are identified that support strategies and that are financially, economically, socially and environmentally sound. Development strategies are analysed.
Preparation
Appraisal
3 Preparation The Bank provides policy and project advice along with financial assistance. Clients conduct studies and prepare final project documentation.
4 Appraisal The Bank assesses the economic, technical, institutional, financial, environmental and social aspects of the project. The project appraisal document and draft legal documents are prepared.
Figure 2.2
World Bank: The Project Cycle
If you are interested, the World Bank has detailed documents on its project cycle, and many of them can be viewed on the World Banks website www.worldbank.org.
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In general, strategy is understood to encompass the decisions made by governing bodies, senior management and persons who occupy similar positions in government and not-for-profit organisations (e.g. senior clinicians in hospital, senior officers in the armed forces) concerning the long-term relationship between the organisation and its environment. These decisions tend to be of a top-down nature. Strategy attempts to answer such questions as: What business should we be in? What course of action should we pursue? What is the optimal organisationenvironment fit? How can the organisation remain flexible? Strategic planning attempts to identify an operational environment in which the organisation has real competitive advantages. In the business sector, many large conglomerates have divested profitable divisions from their portfolios, thus foregoing opportunities, just because these particular operations did not fit into the overall group profile. In the government sector, post World War II strategies of economic intervention and in-house provision of services have now given way to more market-oriented policies and to the outsourcing of services. Many activities previously carried out by government have passed to the private sector via privatisation. Capital investment proposals essentially seek approval to proceed with specific building blocks for the implementation of the organisations strategic plan. The preparation of capital investment proposals is just one of three main elements in the financial implementation of a companys strategic plan (see Table 2.1). Table 2.1 Financial implementation of strategies
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In Unit 1 you learnt about strategic options that management may exercise to operate profitably using Porters (1985) competitive strategy model.
Privatisation is the transfer of government ownership of public sector units to the private sector. The UK led in the 1980s and 1990s in privatising its public utility companies, but this has now become a policy observed in many countries.
Capital investment proposals Budgets Cash flow and other ad hoc forecasts
Development of strategies
Strategic plan
It is important that this strategic perspective be maintained throughout the organisations financial management and that the different elements form a coherent whole. Capital investment proposals will typically contain cash flow forecasts for the next five to ten years, or to be more exact, contain forecasts that are consistent with the investment horizon for the business. The organisations investment programme will also be predicated upon the generation of sufficient cash flows; managements ability to meet this requirement may be judged on their success at delivery on past investment programmes.
2.1
STRATEGIC INVESTMENT PROCESS
Large organisations will have their own procedures for the preparation and submission of capital investment proposals. Typically, these will give discretion to local management up to a set
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limit, with amounts above this limit needing approval from divisional management, or whatever is the next stage up in the organisations hierarchy. However, because capital expenditure decisions are for the long term and normally impossible to reverse, major proposals of any size will need approval by a senior management tier of the organisation. Although the authorisation procedures will vary between organisations, they will almost always contain the steps shown in Figure 2.3.
Strategic plan
Strategic options Preparation
Assumptions
Capital investment proposal
Authorisation Authorisation
Implementation Implementation Post-implementation
Figure 2.3
Strategic investment authorisation procedures
The three main stages identified above are: 1 2 3 Preparation The formulation and preparation of a case to put to the directors of the organisation. Authorisation Presenting the business case to the directors and obtaining authorisation. Implementation Implementing the project and carrying out a post-implementation audit.
2.2
PREPARATION
If it is to survive, no business can afford to stand still. This applies equally to a family run business, a business unit within a large organisation or an organisation delivering public services.
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The strategic plan will set the framework within which different strategic options will be generated. It is very easy for managers at the unit level to champion a particular course of action rather than step back and evaluate several options. For instance, consider a business unit within a financial services group which sells insurance products to travel companies. The management may consider upgraded information systems to be essential. However, the central board of directors may take a different perspective and ask, for instance:
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Has the possibility of outsourcing been investigated? Could this business be integrated in another way with other units within the group? An eventual upgrade may be essential, but would the benefits of waiting a year outweigh the costs?
All these options can be investigated and financial projections for each prepared. The presentation of these alternatives and the evidence that they have been actively considered all improve the case for authorisation. Note how difficult it is to separate this project from the overall strategy of the business unit and indeed the group. Here there is a case for the financial projections to be prepared for this unit as a whole, essentially treating the future of the whole business unit as the project. Having generated options, the next step will be to collect information for the business case. Whoever prepares the proposal, this step will involve a wide range of managers within the organisation, as inputs from operations, marketing, finance, information technology and human resources will be required. The collection of data should be aimed at justifying the assumptions made in the financial projections. Where management shows detailed understanding of the markets, services and technologies in which the unit operates, the financial projections gain enormously in credibility. The assumptions underlying the financial case will be both internal and external. Internal production and other operational assumptions can be derived from the records of the business. More difficult are the volume and pricing assumptions underlying the marketing plan, and the general assumptions about economic growth, inflation and commodity prices. One critical set of assumptions that it is easy to overlook are those relating to timing, for instance:
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Eventual sales volume projections may be realistic, but will they really build up as rapidly as is projected? Will the technology needed be available in the time-scale envisaged, or should more time be allowed? Are the resources really available to purchase, install, test, commission and train staff in the timescale envisaged?
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If the answers to these and similar questions are no, this may have a considerable effect on the cash flow projections and, in particular, the NPV of the project, as cash flows are moved back. An example of senior managements strategic view of investment is the decision of many large European or US manufacturing companies to invest in manufacturing capacity in emerging economies such as India and China. In Box 2.1 and Activity 2.2 we provide one such example: why Siemens finds it strategically meaningful to invest in manufacturing and R&D facilities in India.
BOX 2.1 SIEMENS TO INVEST $500M IN INDIAN EXPORT HUB

By Khozem Merchant in Mumbai
Unit 6 looks at company valuation. In this case a capital expenditure proposal of $500m is an alternative strategy to an acquisition of a local company.
Siemens is to invest up to $500m over the next three years in India, which the German engineering group said was emerging as its main regional export hub. The company said it would expand research and development, raising its force of Indian software engineers by a third to 4,000, and boost manufacturing capacity to meet domestic power demands. Siemens move, which was unveiled yesterday by Heinrich von Pierer, supervisory board chairman, in Mumbai, is the latest evidence of Indias appeal, often at the expense of China, as a base for the manufacture of engineering products. Last month, Swiss/Swedish rival ABB said it would expand its strong Indian manufacturing operations to meet rising demand for automation technology and control systems from customers in India and the Middle East, and strengthen its research and development presence in Bangalore, Indias technology capital. Indias economy is forecast to grow 66.5 per cent this year, with manufacturing recording a notable revival. Jrgen Schubert, managing director of Siemens Indian unit, told the FT that the fresh investment in India reflects our confidence in this market. He said the reason behind our confidence should become more apparent later this month when Indias budget is expected to strengthen official commitment to improving the countrys poor infrastructure, notably power. Siemens sales in India rose 26 per cent to Rs 17.9bn ($410m) while new orders nearly doubled to Rs 30.1bn in the year to September 2004. Analysts say Siemens and ABB are good examples of European manufacturers turning from mature home markets towards vibrant Asian markets, where economic growth is strong.
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Finlands Nokia, the worlds leading maker of mobile handsets, recently said it would start manufacturing in India, joining pioneers such as drug groups Novartis and AstraZeneca. Mr Schubert said Siemens wanted to double exports from India to about 20 per cent of output, strengthening the countrys position as a supplier of products such as transmission equipment and parts for turbines to south-east Asia and Germany. Two years ago Siemens exported almost nothing from India, he said. A senior foreign power industry executive said Siemens latest investment [in India] was unsurprising given the massive pent up demand for power in the country. The share price of Siemens Indian affiliate rose sharply in Mumbai on the investment announcement. Last year, Siemens had also announced an initial Rs1bn fund for fresh investments in India.
FT.com website; 9 February 2005
ACTIVITY 2.2
Put yourself in the position of a Siemens main board director considering the case for investment of the $500m in India. What strategic questions might you have asked of team of managers presenting the case? Your questions might have included the following:
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Do we want to stay in the business of producing engineering products? Why cannot we just export to India? Why not invest elsewhere in Asia? Would it be better to consider taking over a local company?
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2.3
AUTHORISATION
However sure local management is of the strength of its case, it must still persuade head office to approve the investment expenditure. The central document in achieving approval is the capital investment proposal or business case. The evaluation of the proposal will not take place in isolation: when a venture capitalist was asked what three things he looked for in a proposal, he is reported as replying the person, the person, the person, i.e. the personal qualities of the entrepreneur making the proposal are everything. Similarly, however convincing and well-argued the proposal, senior management will look primarily at the qualities of the local management team. This does not mean that the financial
projections are unimportant indeed, good management teams will use them to improve the quality of decision-making independent of the need to have central approval. The headings under which investment proposals are submitted will vary but those that are used by one multinational group are shown in Table 2.2. Table 2.2
1 2 3
Capital investment proposal headings

One page summary The aims and boundaries of the project What part of the organisations strategic plan the proposal seeks to implement The case supporting the marketing assumptions The resources at the companys disposal and how they will be used If the project requires new technology, the background and the R&D needed Availability of resources and timescales All the key assumptions upon which the proposal is based Probably in summary form with detailed projections as an appendix
Executive summary Project definition Strategic plan
4 5
Marketing plan Production plan
Technology
7 8 9
Implementation issues External and internal assumptions Financial projections
2.4
A Gantt chart is a type of bar chart, that shows the interrelationships of how a projects schedules progress over time.
IMPLEMENTATION
Project timetables in the form of Gantt or other charts should have been presented as part of the Implementation issues in the capital investment proposal document. These implementation proposals may contain some of the assumptions key to the success of the proposal. However beneficial a proposal is to a firm, it is of no use if the firm does not have the resources to implement the project. If the necessary management or technical skills necessary to implement a proposal are not currently available within an organisation, then the proposal should show whether these skills will be developed internally through training or whether recruitment is possible. Progress on the implementation of the project may be made through special reporting procedures and through the normal monthly management reports. Major projects may impact upon the
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organisations overall cash flows and require separate treasury planning. Finally, the groups internal auditors or another dedicated task force should carry out a post-implementation audit. The audit will compare what the capital proposal said would happen with what has actually happened. Questions to be asked would include:
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Was actual capital expenditure greater than that in the proposal? Are sales and expenses in line with the financial projections? Was the project implemented according to the time-scales set out in the proposal?
The purpose of a post-implementation audit is to learn lessons from what has happened so as to improve the quality of future proposals.
SUMMARY
The investment appraisal process forms an important part of the implementation of an organisations strategic plans. Project proposals should make this clear link to the organisations strategy. Large organisations will have formal procedures for the authorisation of investment proposals. The preparation of the proposal will usually involve all areas and disciplines within the organisation. The merits and demerits of alternative proposals will be carefully evaluated. Resource implications and timing are essential factors that are often given too little importance. Senior management or directors of an organisation considering a proposal will look as much at the quality of the local management team as at any accompanying financial projections, judging the accuracy of the latter by the impression of the former. If approved, progress on the implementation will need to be regularly monitored and assessed. A post-implementation audit may be carried out so that organisational learning takes place to the benefit of future projects.
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3 ISSUES IN CAPITAL BUDGETING
ISSUES IN CAPITAL BUDGETING
In Section 3 we look at some of the issues in preparing the financial projections needed to support a capital investment proposal. The most important of these will be the cash flow projections detailing both the expenditure required to set up the project and the expected improved cash inflows in future years. You will already have learnt about cash flow projections in your earlier studies and will have the opportunity to practise further in Section 7 of this unit when you prepare projections for the ACE company. In this section we consider the following issues:
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What is meant by capital budgeting What are the capital budgeting (project appraisal) techniques Why cash flows rather than accounting measurements should be projected The choice of time periods for the projections. The identification of relevant cash flows. Whether cash flow projections should be prepared pre- or post-tax. The treatment of inflation in the preparation of cash flows. Issues in international capital budgeting decisions.
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Some of these issues are described in Section 4 of Vital Statistics and reference will be made back to this material where relevant.
3.1
CAPITAL BUDGETING
Capital budgeting is a widely used term for the process of evaluating investments in capital projects. These projects may account for a significant proportion of the total assets of an organisation. The range of possible investments includes expenditure on buildings, equipment, land, research and development, information technology, changes in stock levels, shares, retail outlets, hotels, roads, railways, coastal defences, mental health institutions and so on. Which particular types of expenditure are considered depends entirely on which type of organisation is planning the investment. In addition, the decision to invest or not to invest in capital projects may have a major impact on the financing of the organisation. Expenditure on assets requires management to make decisions about where and in what form to raise funds. A wise acquisition of capital assets together with appropriate funding of
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those assets can often mean the difference between a business that is competitively strong, with opportunities for growth and market expansion, and a business that is weak and uncompetitive; or, in the not-for-profit sector, an organisation delivering high-quality services responsive to public need, and an organisation that is ineffective and out of touch with its client base. The purpose of capital budgeting is to provide policy makers and management with a sound quantitative basis on which to found a capital investment decision. When an investment is made, a cash outlay is exchanged for benefits to be realised in the future in terms of cash or services for public consumption. Proposed investment projects should be judged by their expected return. In this context a number of questions must be asked which form the core of the capital investment decision. Will a particular investment meet the requirements of investors, creditors or members? Is the probable timing of cash inflows and outflows good enough to meet certain investment criteria? What should those criteria be? Will the effect of an investment decision be a gain to the companys share price (or, in the not-for-profit sector, an increase in, say, customer satisfaction)? In the commercial sector each proposed project is appraised in terms of the future cash flows that are expected to be generated by the investment in the project. The evaluation typically involves both the timing of returns and costs and the application of an appropriate hurdle or discount rate. Cash flow items are discounted according to their distance from the present and the rate of discount is applied to all changes in revenues and costs (including tax) that will occur if the project proceeds. These issues are liable to cause some controversy when the hurdle rate for a particular project is to be determined. Should the assessment use the average cost of capital for the firm, the WACC, the marginal cost of capital for the project in question or a discount rate which also takes account of specific risks? In practice, qualitative factors, as we saw earlier, may also carry weight in the decision-making process. For each investment proposal, senior management typically require that the expected future cash flows be supported by detailed economic, competitive and technical analyses. The quality of financial forecasts is no better than the assumptions used in their preparation. Hence the need to appreciate and challenge these assumptions and for managers to consider a range of questions such as: Do they make business sense? What would our forecasts look like on different assumptions? Does the project fit the organisational strategy? Finally, decision-makers must be aware that certain costs do not necessarily involve a cash outlay but involve an opportunity cost. If a currently unused building is to be part of a project but it could be sold now for 3m, net of tax, that amount should be treated as a cash cost (albeit an opportunity cost) at the outset of the project.
The hurdle rate is the adjusted cost of capital used as discount rate in project evaluation to reflect a projects particular risk assessment by the management. We discuss the choice of hurdle or discount rate in more detail in Section 5.
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Section 4 of Vital Statistics describes the most commonly used capital budgeting appraisal techniques in more detail. These are: net present value (NPV), the internal rate of return (IRR), payback, the annualised rate of return (ARR) and the profitability index (PI). However, in public-sector services, where costs are often more significant than user revenues, a common practice is to calculate the Equivalent Annual Charge of a project. This involves converting the annual capital outlay, or expenditure on fixed assets, to an annual amount. The annual amount is equal to the interest and principal repayments on an instalment loan repayable over the economic life of the assets at the cost of capital prevailing when the project would proceed. Putting it differently, this is the amount the public sector would pay if it leased the assets on an annual basis rather than purchasing them outright. This annual charge is added to the annual operating costs of the project (e.g. staff, materials, administration) and the total annual cost is compared with the quantity and quality of the services and other benefits generated by the project each year. Politicians must judge whether the value of the annual benefits exceed the annual costs. No doubt they also weigh up various political and social priorities, and the effect of their decisions on public opinion. Each of these appraisal techniques is based on certain assumptions and, therefore, has certain limitations. To compensate for these limitations, many organisations use more than one evaluation method. In the next section, we will see how organisations use these different capital budgeting techniques in practice.
You may wish to refer to Vital Statistics to revise these capital budgeting appraisal techniques.
3.2
ISSUES IN APPRAISAL TECHNIQUES
It is useful at this stage to summarise briefly the reasons for the use of the various financial appraisal methods.
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NPV is used by many firms and is theoretically the best method because: (i) it takes account of the time value of money (ii) it depends solely on the forecast cash flows of the projects, and the discount rate that should be used is the cost of capital (iii) since present values are all measured in todays monetary values, they can be added up the alternative methods do not have this additive property.
IRR appears to be the appraisal method preferred by practitioners, because it is seen to provide an instant indication of the rate of return or yield on the invested capital. However, there is no wholly satisfactory way of defining the true rate of return of a long-term asset (Brealey and Myers, 1996).
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Firms still use payback because it is easy to calculate when the initial investment outlay has been recovered by the projects cash inflows. This approach may encourage short-termism, since the faster the project pays back, the better it is deemed to be. Many firms use the payback method together with NPV or IRR appraisal techniques.
For the rest of this section you will be concentrating on some of the details of accurate investment appraisal, but before doing so it will be useful to remind yourself that as was shown in the World Bank diagram in Section 1 a project decision is based on much more than just crunching the numbers. A positive quantitative assessment is a necessary but not a sufficient condition for proceeding with an investment; without a proper economic appraisal one will not get an investment approved, but having such an assessment is just one element in the process. Other factors such as product strategy, corporate culture, team psychology, and so on, may also play important roles in the process. The following activity is intended to help you to remember that seeing both the wood (broad picture) and the trees (the details) is crucial to an effective project process.
ACTIVITY 3.1
Read the article in the Course Reader by Royer, entitled Why bad projects are so hard to kill. It discusses possible reasons why companies do not always reject or curtail capital projects which are likely to fail, and suggests procedures to be included in the project process to help forestall such problems.
3.3
CASH FLOWS OR ACCOUNTING FLOWS?
In carrying out capital investment appraisal, we are concerned with the return a project will make over a number of years; five- and ten-year projections are common forecasting periods. While profit is concerned with wealth created during a discrete time period, investment appraisal is concerned with returns over the life of the project as a whole and for this reason uses cash flow figures rather than profit. Over the life of a project as a whole, accounting flows should equal cash flows. It is worth showing a small example to illustrate this point. Just for the moment we will ignore discounting and the time value of money.
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Robert Teal Scenario 1

Robert Teal is considering launching a new product. It will involve an investment of 15,000 in plant with a life of four years, at the end of which it will have no value. Increased sales of 12,000 a year will be generated. The cost of sales will be equal to 30% of sales and increased expenses of 3,000 a year will be incurred. Customers will pay on average after sixty days. Taxes are ignored for simplicity. Table 3.1
Cash flow projections Year 0
Cash inflow Sales Cash outflow Capital expenditure Cost of sales Expenses (15,000) (15,000) (3,600) (3,000) (6,600) (3,600) (3,000) (6,600) (3,600) (3,000) (6,600) (3,600) (3,000) (6,600) (15,000) (14,400) (12,000) (41,400) 10,000 12,000 12,000 14,000 48,000
Year 1 Year 2 Year 3 Year 4 Cumulative
Net cash flow
(15,000)
3,400
5,400
5,400
7,400
6,600
Income statement projections

Sales Cost of sales Gross profit Less expenses Depreciation Other expenses
Year 1
12,000 (3,600) 8,400
Year 2
12,000 (3,600) 8,400
Year 3
12,000 (3,600) 8,400
Year 4
12,000 (3,600) 8,400
Cumulative
48,000 (14,400) 33,600
(3,750) (3,000) (6,750)
(3,750) (3,000) (6,750)
(3,750) (3,000) (6,750)
(3,750) (3,000) (6,750)
(15,000) (12,000) (27,000)
Profit
1,650
1,650
1,650
1,650
6,600
In the above example we can see that over the life of the project the cumulative net cash inflows of 6,600 equal the cumulative profits of 6,600. The cash flows show an immediate outflow of 15,000 and sales for only ten months in Year 1 because of the credit taken by customers. In contrast, the profit is constant over the life of the project.
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As you are aware, the decision whether or not to go ahead with the project will depend on cash flow and not profit. This is not to say that income statement and balance sheet projections are not to be considered. For external reporting purposes, it may be important not to have sudden falls in a companys profits, even though an investment may yield excellent long-term profits. Consider the case of Robert Teal if total sales over the four years were 48,000 but that these built up slowly.
Robert Teal Scenario 2

ACTIVITY 3.2
Restate the cash flow and profit and loss projections for Robert Teal, presuming all assumptions are the same but that sales are 6,000 in Years 1 and 2, 12,000 in Year 3 and 24,000 in Year 4.
Cash inflow Sales Cash outflow Capital expenditure Cost of sales Expenses
Year 1 Year 2 Year 3 Year 4
Net cash flow

Sales Cost of sales Gross profit Less expenses Depreciation Other expenses Profit
Year 1
6,000
Year 2
6,000
Year 3
12,000
Year 4
24,000
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SUGGESTED SOLUTION
Cash inflow Sales Cash outflow Capital expenditure Cost of sales Expenses (15,000) (1,800) (1,800) (3,600) (7,200) (3,000) (15,000) (14,400) (12,000) (41,400) 5,000 6,000 11,000 26,000 48,000
Year 1 Year 2 Year 3 Year 4 Cumulative
(3,000) (3,000) (3,000)
(15,000) (4,800) (4,800) (6,600) (10,200)
Net cash flow
(15,000)
200
1,200
4,400
15,800
6,600

Sales Cost of sales Gross profit Less expenses Depreciation Other expenses
Year 1
6,000
Year 2
6,000
Year 3
12,000
Year 4
24,000 (7,200) 16,800
Cumulative figure
48,000 (14,400) 33,600
(1,800) (1,800) (3,600) 4,200 4,200 8,400
(3,750) (3,750) (3,750) (3,000) (3,000) (3,000) (6,750) (6,750) (6,750)
(3,750) (3,000) (6,750)
(15,000) (12,000) (27,000)
Profit
(2,550) (2,550)
1,650
10,050
6,600
In this case, the total return of 6,600 is the same over the four years but it may be unacceptable for the company to show a loss in Years 1 and 2, particularly if investors in the company are looking for a steady stream of income. In practice, the company will probably have a range of projects and so the cash flows will even out over time, but for a major project the directors of the organisation will have to communicate carefully with its shareholders how the cash flow and key indicators may suffer in the early years of the project.
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3.4
CASH FLOW TIME-PERIODS
Cash flows in and out of an organisation every day as bills are paid and customer receipts are banked. From a treasury-management viewpoint, cash will be managed on a daily basis and daily forecasts of cash flows for, say, the next week may be appropriate. The owner-manager of a small business may have to watch the cash flow carefully so that the company is in a position to pay the wages bill at the end of the month. With a capital investment appraisal, cash flow forecasts stretch several years into the future and it is not practical nor useful to forecast on a daily basis. Such forecasts are usually prepared on an annual basis. In the Robert Teal example above, the forecast cash flows for each year have been accumulated and shown under the main headings. The only exception to this is the initial capital investment of 15,000, which, if it takes place at the beginning of the forecast period, will be treated as being made in Year 0. In many cases, however, it may be appropriate to show a monthly cash flow for the first twelve months. This will be the case particularly where the funding for the project is only just sufficient and it is important to establish the maximum borrowing requirement. For instance, for a manufacturer dependent on wholesale Christmas trade with a calendar year end, the cash flow position will be most favourable at the year end and will become less favourable during the year as it builds stocks for the autumn purchases by the wholesalers. This leaves the question as to how many years into the future we should forecast. Benefits may flow from the purchase of a piece of plant for the next twenty years. Should the forecast therefore be for twenty years? In practice, the answer is probably no as, although we can produce financial forecasts that look plausible on paper, the future becomes so uncertain the further the projection that the exercise has little value. Imagine a twenty-year forecast produced by an organisation in 1985 predicting the outcome for the year 2005 just how accurate would the economic, political and technological assumptions have been? Many companies will restrict the forecast period to five years or ten years. Once one does this there is a need to close the forecast off at the end of the final year. In the Robert Teal example above, the customers take 60 days credit so only ten months sales are shown in the first year. In the second year and third years twelve months receipts are shown as there are both opening and closing debtors. In the fourth year one would think twelve months receipts should again be shown. However, as the projection is only for four years all receipts after the end of the fourth year are rolled back into this year and fourteen months receipts are shown. Similarly, if plant purchases have a scrap value, then this value will be shown in the final year as a receipt even if there is no actual intention to dispose of the asset in that year.
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The production manager of a chemical company regularly put forward projects to build chemical reactors to the Company Board. Because there was no standard forecasting time horizon, the managers took advantage by varying the project life each time. The less profitable the project, the longer the life they assumed in order to be able to show a positive NPV!
3.5
RELEVANT CASH FLOWS
Section 4.4.1 of Vital Statistics discusses the identification of relevant costs and revenues and includes a worked example. Only the cash flows that occur as a consequence of making a proposed investment should be included sometimes called the opportunity cash flows or the incremental cash flows. For instance, if Robert Teal had already paid 1,000 for a marketing report into his new product this would not be included in the cash flow forecast as the marketing consultant would have to be paid whether or not the new project goes ahead. In practice, there can be great difficulties in identifying the relevant cash flows. Earlier we defined capital investment decisions as being central to the strategy of an organisation. As such, the effects of such investments are likely to impact on all parts of the organisation and it can become difficult to identify any cash flows that are not affected by the investment decision. If an organisation must either replace a piece of critical plant or simply stop trading, then it can be argued that the relevant cash flows for the decision are the cash flow projections for the whole company. The question for the organisation then becomes a fundamental one of whether they want to continue in this line of business. Relevant cash flows are also difficult to define in the public sector. When the Eurotunnel project was originally considered, only freight and train revenues were considered. A more comprehensive costbenefit analysis would have included increased tax revenues from increased tourism, for example.
3.6
INFLATION
The correct treatment of inflation requires that we compare like with like in the financial appraisal. This means that real cash flows should be discounted at a real discount rate or nominal cash flows discounted at a nominal rate. There is clearly potential for a mismatch of assumptions regarding cash flows and discount rates. The most obvious pitfall is to use a nominal discount rate derived from financial market data and apply this to current price or real cash flows. This would result in NPV values being understated. In some cases this could contribute to the rejection of project
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proposals. The converse situation can also occur where nominal cash flows are discounted at the real discount rate. This mismatch will result in NPV calculations being overestimated. Even if the cash flows and discount rates are correctly specified (both in real terms or both in nominal terms), cash flow and discount rate estimates must include a consistent estimate of expected inflation. Any mismatch of inflation assumptions embedded in cash flows and in the discount rate can have a pronounced effect on longer-term projects because the effects of the failure to allow for inflation in cash-flow estimates compound with time. Under these circumstances distant cash flows have present values which may be seriously distorted compared with nearer ones.
EXERCISE 3.1
Suppose you are forecasting a project which will generate sales growing at around 6.5% per year for ten years. The discount rate you have been asked to use is based on a riskfree rate from a quoted 10-year government bond of 5%. You are also aware that 10-year index-linked government bonds have a real yield of 1.5%. What is the implied real growth rate in sales?
3.7
Issues in international capital budgeting and taxes are discussed later in the unit.
TAXATION
Although Section 4.4.3 of Vital Statistics explains the mathematical treatment of taxation in the capital budgeting appraisal procedure, some additional comments may help you to understand this important topic. The main point that we stress in this unit, and indeed in the whole of this course, is that if an organisation can produce high cash flows for its stakeholders it is valuable. Since taxes typically represent a large cash flow that goes to one stakeholder (the tax collector) at the expense of others, it is important to understand the basics of the taxation system, for the following reasons:
l
Virtually every financial decision changes the amount of taxes the organisation or its stakeholders will pay. It is unrealistic to evaluate a decision in financial terms without including the impact of taxes. If there are more ways than one to accomplish a goal, and if they differ in their tax impact, the amount of the tax cash flows must enter the decision-making process for the comparison to be complete. Tax authorities require only what is specified by law, and the organisation fully satisfies its tax obligations by paying the specified amount. An organisation that pays more tax than it needs is taking value away from the other stakeholders.
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European Union countries are facing challenging task of harmonising tax structures but meanwhile the companies operating across the European Union may gain or lose because of different tax systems in the individual countries. Marks & Spencer are currently involved in such a case in the UK, as is shown from the article in Box 3.1.
BOX 3.1 MARKS & SPENCER TAX DISPUTE MAY FORCE EU STATES TO CHANGE RULES
April 6 2005 (Bloomberg) The European Unions highest court will signal tomorrow whether a U.K. tax dispute will force EU nations to refund billions of euros to multinational companies. Marks & Spencer Group Plc, the Britains largest clothing retailer, is seeking a rebate of more than 30 million ($56 million), arguing that it should have been allowed to deduct losses made at its Belgian, French and German units. An aide to the European Court of Justice in Luxembourg will tomorrow say whether UK laws barring such deductions are legal. Tax rules in most other EU member states broadly follow the UK rule, so this appeal will have a major impact on tax systems around Europe, Guy Brannan, a tax lawyer at Linklaters, a UK law firm that advised on European mergers last year worth more than $193 billion, said in a statement. About 300 other companies, including BT Group Plc, Caterpillar Inc. and BNP Paribas SA, have made separate claims at the UK High Court that tax authorities discriminate between domestic and overseas units, according to court documents. Another group of companies, including Wal-Mart Stores Inc., Ford Motor Co. and PepsiCo Inc., are preparing similar actions. The final ruling, which follows the advisers opinion in about 85 percent of cases, is expected later this year. Marks & Spencer argued at a 1 Feb hearing that the UK law breaks the 25-nation blocs single-market rules.
Rebates
This has a potentially huge budgetary effect, said Johann Mueller, a tax lawyer at Dutchtax.net, a consultancy. Every company in Europe that has a cross-border subsidiary could benefit. Thousands of EU companies could follow the U.K. retailers example. Rebates running into billions of euros may follow if the court upholds Marks & Spencers claim, Howard Liebman, an international tax lawyer at Jones Day in Brussels, said in an interview before the February hearing.
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With the exception of Denmark, Austria and Italy, a majority of countries in the then 15-member bloc could lose billions of euros in revenue, he said. In May 2004, the EU added 10 mainly Eastern European nations. Christine Scheel, the head of a German parliamentary committee, said in February that Germany may be forced to change its law if the U.K. retailer wins.
Tax discrimination
Marks & Spencer expanded from its U.K. market and established subsidiaries in Belgium, France, Germany and Spain. In the late 1990s, these units incurred increasingly heavy losses, according to court documents. In early 2001, the retailer decided to close the businesses. The company sought to offset losses between 1998 and 2001 through group tax relief under UK law. The rule allows a member of a group of UK companies to transfer a loss to another member, a process known as tax consolidation. The request was refused. British authorities said group relief can only be claimed for losses in the UK Marks & Spencer appealed, arguing the legislation harms companies that have subsidiaries outside the country, a violation of EU law. The UK High Court referred the case to the EU tribunal. If Marks & Spencer wins, it would harm the cohesion of the UKs tax system, Eoghan Fitzsimons SC, a lawyer for the Irish government, said during the hearing. Tax relief should be granted only where the government has the power to tax. Since the UK doesnt tax foreign-based subsidiaries, no deductions for losses should be granted, he said. The case is C-446/03 Marks & Spencer Plc v. U.K. Inspector of Taxes.
Section 4.2 of Unit 4 introduced the issue of taxation in the context of the capital structure of the firm. The text notes that debt financing is cheaper, after tax, than equity. This concept can be carried forward into the context of capital investment funding. Taxation can have an important influence on the capital investment decision, in that there exists a fundamental difference between debt and equity funding. If, for example, a capital project is funded by equity capital, no tax benefits will accrue, whereas interest on debt-funded investments is usually tax deductible. In one sense, the impact of the tax deductibility of interest expense is to create a sort of asset, normally referred to as a tax shield, because the expected future post-tax cash flows are increased. As with all assets, it is possible to derive a value for this debt-created tax shield by calculating the present value of its expected future cash flows. The expected future cash flows can be estimated by
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computing the expected reduction in future tax payments caused by the required interest payments on the debt financing. Alternatively, if the tax rate and debt/equity ratio are assumed constant throughout the life of the project, as was the case in Unit 4, the value of the tax shield can be included through the factor (1 T) in the WACC formula. If the WACC is used as a discount rate, no allowance should be made for the tax shield in the cash flows to be discounted. The (1 T ) term in the WACC allows for this.
ACTIVITY 3.3
For which type of project is use of the WACC with a tax shield inappropriate? A new single project company such as a cable company which is unlikely to have a tax liability (and hence possibility of tax shield) in its early years. Essentially, such a company is unlikely to meet the constant debt/equity ratio condition. It is better in such conditions to include tax shield effects explicitly through the cash flow figures, rather than relying on tax-adjusting the cost of capital.
However, it should be noted that tax deductible allowances or capital allowances, as well as changes in tax rates, affect after-tax cash flows. Capital allowances, although not cash flows, provide a tax shield for revenues. In order to improve the realism of investment appraisals, DCF methods should use after-tax cash flows in the assessment of project proposals. However, the tax rates and allowable depreciation rates valid when analysing an investment may not be the ones in effect when the project is implemented. Any such changes can cause the actual NPV and IRR amounts to differ from those originally estimated for the project. Finally, you may now be under the impression that tax must be considered in every project appraisal. Note, however, that many organisations are not legally required to pay tax, including charities and many public sector organisations. Nevertheless, these types of organisations spend funds on capital projects. In addition as you saw in the activity above, new or loss-making companies may not be liable to tax either. However, their circumstances are different again, in that losses can be carried forward under the assumption that eventually the company will become profitable in the future.
Refer to Unit 4. Capital allowances is the UK term for tax-deductible depreciation allowances.
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ACTIVITY 3.4
Discuss what in your opinion is the impact of taxation on the Channel Tunnel project. Because the Channel Tunnel is a project of a long-term nature it will be subject to a range of changing tax factors over time. In the early years it has been loss-making, building up tax losses against which any eventual future profits may be offsettable. Taxation rates may change over time, which could alter the profile of the tax payments. All these factors will impact upon the taxation charges and, in addition, managers will be able to make decisions which will affect the tax flows. Also, since the company is unlikely to be paying taxes, the (1 T) factor in the WACC should not be used for the cost of debt, since tax relief is not likely to be available. One should note that, despite errors in the sales forecasts, the Tunnel does usually make an operating profit. It is the cost of the huge debt that has made the overall results so problematic.
3.8
INTERNATIONAL CAPITAL BUDGETING
No discussion about capital budgeting is complete without considering it in an international context. In the same way as for domestic capital investment decisions, international capital budgeting focuses on expected incremental cash flows linked to the project. The same difficulties apply to assessing these cash flows but international project appraisal is often more complex, in that, for example, a multinational company must consider factors specific to the international environment, including financial issues such as cross-border taxation and foreign currency risk. Additional complexities inherent in international capital budgeting include the following:
l
differing project and parent cash flows (due to difficulties in remitting cash to the parent because of exchange controls) exchange rates may not be constant throughout the projects life different tax rates may apply in the host country and the parents country.
Block 4 will deal with the topic of foreign exchange rates.
l l
Exchange controls
Exchange controls relate to controls on trading and movement of currencies, usually used by governments through their central banks to stabilise the exchange rates of the domestic currency.
A project may generate substantial cash flows abroad, but because of exchange control restrictions, it may be impossible to repatriate some or all of these foreign cash flows back to the parent company. If you appraise a foreign project under these conditions, the potential project cash flows may still encourage investment. However, is this good enough? It is generally accepted that the
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present value of a project is a function of future cash flows distributable to the investors or owners. But if the greater part of the foreign cash flows were blocked by exchange controls, only the residual cash flows could be transmitted back to the parent company. Which cash flows should be considered? International capital projects can be viewed from two standpoints incremental project cash flows or incremental parent cash flows. First, project cash flows can be determined from the foreign divisions standpoint, as if it were an independent entity, and solely analysed from within the host country. The second stage moves to the parent company and focuses on the amount and timing of distributable cash flows. If no exchange controls exist in the host country, all foreign project cash flows should be repatriable. If exchange controls are in place, further complexities are added to the decision-making process. There are ways by which remittances to the parent can be achieved despite exchange controls. For example:
l l l l
repatriating dividends from abroad to host country payment of royalties and management fees loan repayments countertrade.
Countertrade involves a reciprocal agreement for the exchange of goods or services and may be used as a way to remit profits. The parties involved may be companies or governments, and these agreements can take a number of forms, for example, barter, counter purchase, industrial offset (reciprocal arrangements to buy materials or components from sources in the foreign country). Such methods to avoid unremittable profits may change the project from being undesirable to acceptable.
International taxation
We have discussed international capital budgeting from the standpoint of the parent company. Any project cash flows will in the first place be subject to host country taxes. Then, upon distribution (or presumed distribution) to the parent, the cash flows may be subject to a withholding tax (a tax levied on dividends paid abroad which are expatriated to another country) and finally to corporation tax of the parents home country. Let us provide an example which illustrates this procedure. Assume that a firm with a proposed project abroad has provided an earnings forecast equivalent to 1m in pre-tax profit. With a tax rate in the host country of 15%, a withholding tax rate of 10% and a home country corporation tax rate of 30%, we show the numbers to be incorporated in the investment appraisal in Table 3.2.
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Table 3.2 Project appraisal parent company cash flows net of taxes
Profit generated before tax Foreign tax charge at 15% Witholding tax charge 1m 6 85% (foreign post-tax profit = 850,000 at 10%) (150,000) (85,000) (235,000) Home country tax 1m @30% Foreign tax credit (300,000) 235,000 (65,000) Providing net of tax home country profit 700,000
1,000,000
NB: Foreign tax credit is the amount of tax paid in a foreign country claimed by the company as a credit against home country tax.
Please note that in Table 3.2 we have ignored any potential capital
allowances which might accrue to the firm.
We assume that the above investment scenario takes place under
a tax regime in which all foreign taxes paid are credited against
home country tax liabilities. This may not always be the case and
will depend on the particular tax treaty in operation between
the two countries concerned. If full double tax relief were not
available, for example, the project proposal might not generate a
positive NPV for the parent company. However, the project might
look acceptable by, for example, rerouting funds around the world
without being returned to the home country, thus avoiding the
30% tax charge. Relevant tax information such as this ought to be
included in the decision-making process and will enhance
managers ability to make optimal international investment
decisions.
One could infer from the above scenario, which exemplifies a
heavy tax regime as well as difficulties in the repatriation of profits
to the home country, that many countries discourage direct foreign
investment. On the contrary, many countries are now competing
with each other to attract multinational organisations and
investments. These countries offer a range of incentives which
include:
l l l l
low corporate taxation rates (Isle of Man)

tax relief on a range of inward investments (UK)
subsidies (regional grants and European Union grants)
taxation holidays (i.e. firms can operate for five years in the
guest country without paying taxes, e.g. Ireland).
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Indeed, two major factors for multinationals deciding whether or not to invest in a country/location are the tax regulations and incentives. In recent years with opening up of economies in China, India, and several Central European and Latin American countries, multinational companies have increased direct foreign investments in these countries. The main reasons for increasing international investments are the cost advantages and large domestic demand for goods and services. Tax issues have not been seen to be a disadvantage. Finally, there is evidence that multinational organisations charge all of their foreign projects (for investment appraisal purposes) with a hypothetical average home tax rate that smoothes out anomalies (Buckley, 1998). Perhaps the best appraisal approach for projects abroad is to apply the harshest tax treatment to a base case and then apply sensitivity analysis assuming either zero home country tax or the average home country tax rate. This type of exercise would provide additional data to decision-makers in their continual quest for perfect capital appraisal techniques. International capital budgeting is also an issue for governmental organisations. Most developed countries provide foreign aid to less developed countries, often in the form of aid projects in which expertise and fixed assets are supplied from the donor country to the recipient country. These projects are weighed up in part on the basis of the benefits to the recipient country and of the costs to the donor country. No doubt, also, matters of international politics and diplomacy play a part. One issue they raise is how and how much donor country taxpayers benefit from projects and services provided in host countries.
SUMMARY
In this section we discussed a range of inter-related issues on the subject of investment appraisal techniques. We studied a range of appraisal techniques used by organisations. Not only must we understand the use of the correct appraisal techniques, but also the overall context of the CAPEX decision process in which the choice of technique takes place. The article you were asked to read as Activity 3.1 provides some insights into a projects implementation and review phase. It shows why a decision to go for a project needs to be reviewed dispassionately when early warnings for the potential failure of a project are visible. In real life when managers attach emotional importance to completion of a project rather than its possible consequences on owners wealth, the company may lose substantial value. In some organisations managers manipulate the process in order to advance their own project proposals in a financially constrained environment. Inflation and taxation add to the complexity of project evaluation and they were briefly discussed in the context of CAPEX. Under conditions of inflation, cash flows and discount rates are difficult to
estimate. We also examined aspects of taxation in the context of CAPEX appraisals and the potential effect tax has on the cash flow profiles over the life of a project. Finally, as many organisations operate in an international environment, it is important to review aspects of international capital budgeting, since managers have an additional range of complicating factors in their decision-making process. At the same time, international taxation is an important consideration for multinational organisations in their foreign investment programmes. Competition for global market share is driving force for large capital investments by multinational organisations in international context.
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4 CAPITAL RATIONING
CAPITAL RATIONING
So far we have implicitly assumed that all project proposals which have a positive NPV should be implemented. In this section we examine why an organisation may not be able to undertake all the investment projects it may want to because of a shortage of investment funding. Organisations may also face other constraints which force them to make choices between competing projects. We examine the issues surrounding the shortage of investment capital to which most, if not all, organisations are subject most of the time. Capital rationing involves the selection of an optimal array of investment projects under financial and other resource constraints. We discuss competing projects and the make or buy decision, where an organisation has the opportunity to outsource its production or services as opposed to producing its products in-house. In the same context we review aspects of competing projects. We expand the issues further by examining the private sector question of whether a company should grow organically or through the acquisition route.
4.1
CAPITAL RATIONING IN PRACTICE
A capital rationing problem is defined as a situation where there are insufficient funds to finance all available beneficial projects. A major problem which may face private sector organisations is cash shortage. On the other hand, public-sector organisations can be constrained by central government ideology and policy from raising loan finance. If an organisation identifies several projects that are beneficial (i.e. have a positive NPV or benefits which outweigh costs), it would like to undertake all of them. However, it may be prevented from doing so through a lack of funds. The restriction is a practical one. In theory, if a profit-oriented project proposal shows a positive NPV, there should be no problem raising the cash for its implementation. A positive NPV indicates how much better off a business would be after adequately rewarding all suppliers of capital. In practice, a business will find its capital rationed mostly for internal reasons rather than external constraints. The organisation must choose which projects to invest in so that its objectives are met as fully as possible. In addition, an organisation may also be constrained by its inability to manage all projects it would like to undertake in other words, management skills themselves are also a scarce resource.
Some organisations have excess cash and not enough attractive projects to invest cash in. In such cases they may return excess cash through special dividends or share repurchase schemes. Microsoft Inc. did so in 2004 and is one of many examples.
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The profitability index method is discussed in detail in Section 4.4.4 of Vital Statistics.
There are a number of techniques available to enable management to decide, in principle, which projects can be undertaken under conditions of a shortage of investment capital. We will illustrate one such method, called the profitability index (PI) or costbenefit index method. It has its limitations, but is a useful instrument to assist management in their decision-making tasks. Let us look at the following simple example: A firm has a cost of capital of 10% and has the option of three investment proposals A, B and C, outlined in Table 4.1. Table 4.1
Project
A B C
Investment (m) T0
10 5 5
Inflow (m) T1
+ 30 +5 +5
Inflow (m) T2
+5 + 20 + 15
NPV (m)
+ 21 + 16 + 12
All three projects are attractive i.e. they all have positive NPVs. But the firm has a limit on its CAPEX spending of 10m, so it can invest either in project A or in projects B and C, but not in all three. Although individually B and C have lower NPVs than project A, when added together their NPVs are higher. The PI is expressed by the following simple formula:
PI =
Net present value Investment
For the three above projects the PI can be calculated as in Table 4.2. Table 4.2
Project
A B C
Profitability index
Initial investment at T0 (m)
10 5 5
NPV (m)
+ 21 +16 +12
PI
2.1 3.2 2.4
Project B has the highest PI, and C the next highest. Therefore, if our CAPEX budget limit is 10 million, we should accept these two project proposals. When projects have positive NPVs they will also have positive PIs. All projects with a positive PI would be acceptable, but where choices have to be made the magnitudes can determine a ranking of projects.
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4 CAPITAL RATIONING
However, there are limitations to the use of PI under certain circumstances, such as when resources are constrained over more than one period, or when two proposed projects are mutually exclusive or when one project is dependent on another. Nevertheless, the simplicity of PI does allow for rankings to be established in many situations. A more complex capital rationing problem is illustrated by the following example. Let us look at Table 4.3: Table 4.3
Year
0 1 25 cumulative inflows NPV at 10%
Multi-period capital rationing

Project A Present value of cash flows ()
(8,000) (4,000) 28,000 16,000
Project B Present value of cash flows ()

(6,000) (8,000) 29,000 15,000
Note that each project needs funding in two periods and each produces a positive NPV when discounted at 10%. If there were no shortage of funds both projects should be undertaken, as both are worthwhile. Assume, however, that only 10,000 is available at time 0. Assuming that projects must be undertaken as a whole or not at all, project A should be chosen as it will produce an NPV of 16,000. Although project B uses up only 6,000 of the funds at time 0, whereas project A consumes 8,000, we have no other project on which to spend leftover cash and merely leaving it in the bank earning interest at an (almost) risk-free rate will give a zero NPV. This discussion about capital rationing by no means covers the subject in full. The problem of investment decision-making in the face of capital rationing over more than one period is both complex and, at present, not completely resolved. We have described a decision rule to determine the best use of scarce investment capital and how best to select projects which generate the highest positive NPV. In addition, we can apply sensitivity analysis to the range of relevant cash flows of the comparative projects, and use the results to decide which project to select. In the public sector, managers also have to choose between competing projects where criteria other than positive NPVs may also be relevant. The bottom lines of public service projects
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include such criteria as the ability to defend and attack; the ability to keep order; the ability to educate the young and the not-so-young; and the ability to keep people and products on the move. One could argue that benefitcost techniques provide a quantitative equivalent to NPV, but applying a benefitcost approach may involve inputting values on keeping people alive, having people educated to certain standards, protecting people and property from wrongdoers, or shortening travelling times. These inputed values, apart from being technically and socially controversial (Who can put a value on human life?), may give a spurious quantitative accuracy to analyses which are entirely subjective. In the end, it is often up to politicians, government administrators and professional people employed in government (soldiers, doctors, teachers, social workers, engineers) to reach subjective decisions through co-operative, competitive/political and democratic means, using criteria which are social and political as well as economic.
4.2
COMPETING PROJECTS
This sub-section deals with the choice organisations must make in the case of competing projects which, for example, offer a specific output but use a different technology to achieve this output. We also describe the situation when an organisation has to determine if it is profitable to invest in, for example, additional plant and machinery, or buy in the products from an outside supplier. This classic problem in the application of DCF methods is known as the make or buy problem. It illustrates the way that opportunity costs can be taken into account within a single project DCF framework (see Box 4.1).
BOX 4.1 DELTA

For simplicity we have ignored tax in this example. A cost-saving project typically has tax implications in the same way as a revenuegenerating project.
Delta is considering producing an in-house component that it needs in an assembly operation. Its manufacture requires additional plant costing 400,000 which would last for four years, with a residual value of 200,000, which would be received in the following year. Manufacturing costs in each year would be 500,000, 700,000, 800,000 and 900,000 respectively. If Delta outsources the components the costs are forecast to be 900,000, 1,000,000, 1,100,000 and 1,400,000 in each year. However, the plant will occupy floor space which can be put to other uses generating 200,000 in each of the four years. This opportunity is lost if the make option is adopted. If the WACC is 13%, should Delta make or buy the component?
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4 CAPITAL RATIONING
Costs of making in-house (000) Year

Plant Manufacturing cost Floor space opportunity costs Total making in-house costs Discount factor of 13% WACC DCF - 400 1.0 -400
0
- 400
1
0 -500 -200
2
0 -700 -200
3
0 -800 -200
4
0 -900 -200
5
200
-700 0.8850 -619
-900 0.7831 -705
-1000 0.6930 -693
-1100 0.6133 -675
200 0.5428 +109 -2983
NPV for making in-house Costs of buying in (000) Purchase costs Discount factor of 13% WACC DCF NPV for buying in 0 1.0 0 -900 0.8850 -796 -1000 0.7831 -783 -1100 0.6931 -762 -1400 0.6133 -859
0 0.5428
-3200
Hence making in-house is 217K (i.e. 3200K - 2983K) cheaper than buying in.
A correct make or buy decision can often be a major determinant of profitability. The choice of which components to outsource is sometimes made by ascertaining what will save most on overhead costs, rather than on what makes the most long-term economic sense. In the public sector, outsourcing has found favour as a means of cost cutting, as labour provided by the private sector may entail lower costs and related employee benefits. Even so, there are some important factors which are not quantifiable, for example the security of supply if the firm has outsourced its supplies. An argument for outsourcing is often stated to be the rapid changes in the market and the lack of flexibility that characterises in-house production. Guided by the arguments for retaining and building up its core competency strategic framework, Telequip, a telecom equipment supplier, outsourced many of its activities which included assembly operations, piece part manufacture and in some cases design.
In August 2005, British Airways had just such a problem with its London Heathrow aircraft meals supplier, Gate Gourmet.
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But a study of Telequips outsourcing policy found that the actual decisions to outsource ended up as cost-cutting devices rather than really helping company strengthen its core business, which was re-defined by the company as minimising the time between an order being received and fulfilment of that order (McIvor, 2000). This tendency to outsource components or services which were formerly performed in-house can result in unexpected cost increases, with many organisations failing to integrate the make or buy decision into the overall business strategy. This can lead to a situation where manufacturing processes or services are dispersed at random throughout the organisations operations and facilities and it becomes dependent on a much wider range of suppliers of components and services. An additional risk is that management can lose control over its operations and output and hence severely put the companys cash flows at risk. This is in contradiction to the original objective of outsourcing in order to save costs. One approach suggested to enhance the chances of successful outsourcing of non-core activities is to apply mergers and acquisitions principles to outsourcing deals. This entails specifying the goal of the outsourcing deal clearly, a dedicated project team, focus on the economics of the deal, a due diligence process, anticipating risks, internal and external negotiation and planning for transition (Craig and Willmott, 2005). You will read in Box 4.2 below about the biggest outsourcing deal from Europe to date. Note how the benefits of outsourcing have been carefully quantified.
BOX 4.2 ABN AMRO IN $2.2BN INDIAN IT DEAL

By Khozem Merchant in Mumbai, Sarah Laitner in Amsterdam and Richard Waters in San Francisco ABN Amro, the Dutch financial services group, has agreed one of the biggest outsourcing deals in Europe and given the Indian IT sector its most lucrative contracts in a five-year programme worth at least $2.2bn. As well as IBM and Accenture of the US, the contractors include Tata Consultancy Services, Infosys Technologies and Patni Computer Systems of India. For ABN it represents a bid to cut technology costs and release funds for investment in emerging markets as it implements cost and job cuts. Analysts say Indian companies inclusion in the deal after nine months of negotiation sends a powerful message to larger global rivals, which have traditionally dominated big, multicountry technology deals. This deal is a tipping point for Indian IT, said Nandan Nilekani, chief executive of Infosys. Mumbai-based Ramesh Venkataraman of McKinsey, the consultancy, added: It shows Indian IT
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4 CAPITAL RATIONING
companies are on a level-footing with larger global competitors.The five-year partnership is expected to produce technology savings of E258m a year from 2007, a figure that could more than double with similar initiatives elsewhere in ABNs operations. It will cut ABNs IT workforce from 5,300 to 1,800 with about 1,500 losing their jobs. The bank said 2,000 jobs would be transferred to the IT companies, with most going to IBM. ABN employs about 100,000 worldwide. When combined with job cuts in its human resources division and changes to its property portfolio management, both of which were announced in December, ABN expects to save E600m a year from 2007. ABN said: Although it has important consequences for part of our staff, this is good news for the bank because it lowers our cost base and gives us access to new technology to improve our service quality. IBM will mainly provide IT infrastructure. TCS and Infosys will provide application support. All five companies will provide application development. For the Indian companies, the earnings from ABN will be their biggest gain from one client in a single transaction. TCS and Infosys are guaranteed revenues of $250m and $140m each, with the potential for more with discretionary contracts. IBM will benefit most from the deal, receiving E1.5bn over the fiveyear period. Tata will receive E200m and Infosys E100m. The deal is a fillip for IBM following JPMorgans cancellation of a $5bn deal last year in the wake of its Bank One purchase. Bank One had made heavy IT investments, which JPMorgan decided to take back in house.
Additional reporting by Paul J Davies in London Source: www.ft.com
ACTIVITY 4.1
Listen to Audio Programme Project appraisal, in which a companys managers discuss the pros and cons of a make or buy decision from the production, marketing and strategic points of view, as well as from a financial perspective.
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SUMMARY
In this section, we have illustrated the issues surrounding the shortage of investment capital to which most, if not all, organisations are subject most of the time. Capital rationing issues involve the selection of an optimal array of investment projects under financial and other resource constraints. We have discussed the aspect of competing projects and the make or buy decision, where an organisation has the opportunity to outsource its production or services instead of the internal creation of their products. The section also dealt with the investment choice organisations must make in the case of competing projects. In order to illustrate this concept we provided a numerical example, which showed one of the selection methods management can apply in their decision-making process. While this section has concentrated on the financial aspects, it is essential for decisions to be taken in light of their non-financial and strategic implications.
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5 PROJECT DISCOUNT RATE
PROJECT DISCOUNT RATE
In this section we will consider the choice of discount rate which should be used to estimate the NPV of projects when we take a projects risk into account. But to put these ideas into context and before we go into detail, read Box 5.1 a cautionary tale about company and project risk.
BOX 5.1 ALWAYS EXPECT THE UNEXPECTED: ENRON S COLLAPSE SHOULD REMIND US THAT NO ACCOUNTING OR VALUATION TECHNIQUE CAN DISGUISE THE INHERENT RISKINESS OF BUSINESS
By Peter Martin At its heart, business is a gamble
The peasant farmer who plants a crop to sell next year and the semiconductor boss who commits his company to $2bn chip plant are both placing the same bet: that there will be enough customers, at the right price, for what they produce. Most of the time the gamble pays off. But sometimes it fails. And when it does, disaster ensues. This fundamental uncertainty at the centre of business is so unsettling that most of the time we choose to ignore it. We have developed techniques to analyse and manage the risks it implies and we tell ourselves that these have made the gamble go away. They have not. There is a more disturbing twist. The techniques that we have invented can themselves distort or conceal the underlying risks. And, exploited to the full, as at Enron, they can produce businesses that are concealed time-bombs. This is a good moment, therefore, to remember the gamble inherent in business activity and to explore how the techniques we use to mitigate it can themselves lead us into danger. Take a routine business calculation. Every day, hundreds of thousands of managers all over the world attempt to calculate the value of an investment by placing a value today on all the cash it is likely to generate over its life.
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To do this there are any number of technical approaches and much scope for disagreement over which is best. The arguments miss the point. The techniques are fine. But all of them rely on the ability to predict cash flows years into the future. Yet as the problems of Energis, the UK-based alternative telecommunications network, reveal - we sometimes cannot predict cash flows even a few weeks ahead. Energis is having to renegotiate with its bankers after sales fell short of predictions and it risked breaching banking covenants agreed as recently as December. Inability to guess the future is only part of the problem. A much bigger drawback is the temptation to invent the future we want. It is all too easy to manipulate future estimates to produce a desirable present value. One big chemical company told me this month that it had stopped using discounted cash flow calculations to put a value on technological innovations because its scientists had got too good at gaming the system: adjusting the forecasts to produce the present value needed for project approval. In that case excessive optimism merely resulted in new technologies that never quite lived up to their promise. Sometimes it can be much more serious. When company collapses comes out of the blue, the cause is often wishful thinking about future income streams or an underestimate of the future costs of present obligations. Atlantic Computers, a UK computer leasing firm, went bankrupt in 1990 because the resale value of computers it had leased to customers turned out to be much less than it had expected and their eagerness to escape leases much greater. In Ireland, GPA Group borrowed huge sums of money to buy new jet aircraft to lease to airline customers. But it underestimated the impact of a recession on the creditworthiness of its customers and had to be rescued in 1993 by GE Capital. Equitable Life promised guaranteed annuity returns to some of its policyholders, assuming that the future obligations thus created were trivial because interest rates would never fall to todays levels. The painful consequences are visible today. And everywhere the nuclear power industry underestimated the future costs of long-term waste management obligations that it had cheerfully accepted on our behalf. Enron seems to have been an extreme case. It did not just use estimates of future cash flow for internal purposes; it sold them. Enron and Blockbuster set up a partnership that was no more than a pilot scheme to supply video on demand to a thousand homes. The Wall Street Journal says Enron sold its future earnings from the partnership to a bank in return for $115m in finance then booked the money as profit.
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Enron made a routine of capturing future earnings as current profit. That made its results look better every year. Investors then performed their own alchemy on the companys future, by assuming that these profits would continue to rise and applying a multiple to reflect that. Between them, Enron and its investors valued the same future earnings twice once in the companys calculation of profits and once in the multiple the stock market applied to them. Of course, there was no guarantee that those earnings would ever materialise. They certainly will not now. Just vowing not to misuse the techniques we use to measure and manage risk is not enough. Even scrupulous caution will not save us if we place too much faith in techniques that are inherently limited. The solution is not to invent ever more sophisticated measures of risk or ever more elaborate means of parcelling it out to others. It is to face up to the inherent riskiness of business activity and to understand where the vulnerabilities lie. Simpler calculations of the value of an investment will, in the end, work better if they expose the factors that will make the difference between success and failure. Adopting simplicity as the test will have the side benefit of offering protection against those business ventures that are too complicated to be easily comprehensible. The underlying challenge, though, is to accept the inherent uncertainty of business activity, rather than covering it up with a layer of apparently rigorous calculation. That is not easy. A few free-market zealots apart, most human beings have spent their lives attempting to escape economic uncertainty, not relishing it. In developed countries, these attempts have paid off in clean food, safe transport, secure savings, stable employers and predictable careers. But they have not eliminated uncertainty altogether. And as Equitables policyholders and Japans bank depositors are discovering apparently certain guarantees are good only as long as they last. Business is a gamble. We can choose between bigger and smaller risks but we cannot eliminate the uncertainty altogether. Trying too hard to do so may expose us to still greater dangers, by placing too much faith in analysis that will always be vulnerable to wishful thinking or outright manipulation.
Financial Times; 29 January, 2002
As you can see from the press cutting above, it is important to recognise, and learn how to deal with, the specific types of risk issues which relate to CAPEX, because they are intrinsically intertwined with investment decision-making processes. In this section, we describe a number of methods to measure risk, such as
simple risk-adjustment and probabilistic risk analysis. But we have to recognise that, given the uncertainty involved in project appraisal, it is difficult to allow accurately for risk. In this section, we also describe some recent trends and developments in the field of project appraisal. In the first part of this section we look at how to determine the discount rate for a particular project. In the second we look at how to improve on DCF techniques more particularly to allow for uncertainty.
5.1
HOW TO DEAL WITH RISK?
The correct discount rate for a particular project is simply the opportunity cost of capital for a particular project, that is, the expected rate of return that could be earned from an investment of similar risk. In theory the opportunity cost should reflect the non-diversifiable, or systematic, risk that is associated with a particular project, as outlined in the capital asset pricing model (CAPM). This risk might have characteristics that differ from those of the organisations other individual projects or from its average investment programme. In practice, however, the opportunity cost of a particular project may be difficult to determine and, as we saw in Unit 4, many organisations use the weighted average cost of capital (WACC) as a substitute. The WACC offers a good approximation only as long as the organisations projects are similar to one another in their non-diversifiable risks. A firm can be viewed as a collection or portfolio of projects. So far, we have been assuming the discount rate used in NPV calculations will be the firms cost of capital. However, the implication of this assumption is that all projects undertaken by a firm are in same risk class. This is a simplistic assumption as, in reality, projects may have different risk profiles from the average risk profile of the company and therefore we need to explore how to devise project specific discount rates.
5.2
HURDLE RATE VS WACC
Let us first briefly recap what we know about WACC. Firms can be financed either by equity or debt. The providers of both types of finance naturally require a return on the funds they have provided. This required return represents the cost of capital for the company. We saw in Unit 4 how to calculate both the cost of equity and the cost of debt. The WACC represents the average of the cost of equity and debt weighted by the proportions each contribute to the total funding of the company. It should then be possible simply to use the WACC as the discount, or hurdle, rate when evaluating individual projects within the firm. However, life is rarely simple and there are a number of issues, both theoretical and practical, which suggest this is not appropriate in all cases.
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New projects may result in incremental change in the risk of the whole firm and this needs to be taken into account. However, for dealing with such risk in project evaluation, it is quite common for companies to adjust the WACC upwards before using it as the hurdle rate or discount rate. Gregory and Rutterford (1998) found the firms base hurdle rate for a project to be on an average 0.93% higher than the WACC they had themselves estimated. There are five possible explanations for this difference. One is that finance managers responsible for project appraisal do not trust the cash flow forecasts which are used in discounted cash flow spreadsheets by, say, divisional or country managers wishing to get approval for a project. So, in order to counter over-optimism on the part of managers sponsoring projects, they add a premium to the WACC to obtain a hurdle rate, making the hurdle that bit harder to jump. A second explanation is that some projects have a negative NPV and yet have to be undertaken. A typical example here is a Health and Safety Regulations requirement, such as additional fire protection equipment. In order to compensate for this type of project, potentially profitable projects are in effect charged an overhead cost through a higher hurdle rate.
ACTIVITY 5.1
Is this a sensible approach to investment-decision making? No. This adjustment may mean that projects which should be undertaken in order to create shareholder value through positive NPVs are discarded through the imposition of an artificially high hurdle rate.
The third explanation is to do with the nature of DCF analysis and its failure to take into account inherent options embedded in projects. For example, it may be that a project can be delayed for a year, by which time better estimates of future cash flows will be available. There is therefore a cost to starting a project now which is not easily reflected in the cash flows. As a result, managers use a rough and ready approach by adding a premium to the WACC for discounting the value of the project undertaken now, to reflect the option value of delaying the project until later. Section 6.3 will discuss this option element of project appraisal in more detail. The fourth is that we saw how the cost of debt and the cost of equity will change over time with the risk-free rate. Risk-free rates are (at the time of writing) at their lowest levels for more than 40 years. Many organisations only change their hurdle rates once every few years, particularly large and complex companies. Finally, it may be that managers recognise that the projects they are considering are in some way riskier than the current average for the organisation. By adding a premium to the WACC, they are
adjusting for relative project risk. For example, Gregory and Rutterford (1998) noted that many companies viewed company acquisitions as inherently riskier than projects and always adjusted the WACC for company rather than project appraisals. Surveys of actual practice about assessment and management of project risk show that nearly two-thirds of organisations in the UK, US and Canada adjust hurdle rates to reflect project-specific risk while discounting projected cash flows from a project (Pike, 1996; Payne et al., 1999). This is discussed in the next sub-section.
5.3
ADJUSTING HURDLE RATES FOR RISK
Now, suppose that a firm has decided on its base hurdle rate. This will be the rate for typical risk projects within the firm. However, adjustment to the hurdle rate should be made for projects which are atypical in terms of risk both upwards and downwards. In practice, there are two factors which might make a particular project atypical:
For revision of the concept of weighted average, see Vital Statistics, Section 3.2.5.
(i) Operating risk The operating or business risk of a company is in a sense the weighted average of the operating risks of its divisions. The same is true for the betas. For example, some divisions may choose to invest in new ventures which are riskier than the average risk of the company, or in countries where political and other factors increase risk relative to the home market. (ii) Financial risk The second reason for changing the cost of capital relates to instances when you might wish to change the debt/equity ratio embedded in the WACC. For example, you may wish to carry out a leveraged buyout, buying a company and increasing the debt/equity ratio. We saw in Unit 4 how, in such a case, the WACC would decrease given the assumption that all the debt interest would be deductible against corporation tax. Or you may wish to carry out a share repurchase, using debt to buy back some shares, which will also have the effect of increasing your debt/equity ratio. In either case, you will need to adjust the cost of capital estimate.
Operating risk and WACC

Consider a company Chiragdin with four main activities: building materials, heating, bathrooms and property. Are these all of equivalent operating risk? It may be that the risk of making bathroom fittings is very different from that of building homes and that the rate of return required by investors for each will be different. The best way of thinking about this is to think how the beta of each operating activity will vary. If we could find a beta for bathrooms or a beta for house building, we would easily be able
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to adjust the required discount rate for projects in each activity by changing the required rate of return on the equity portion of the WACC. There are two ways of finding such a beta. The first is to see if there is a sector which carries out the same business as the division in question, for example house building. You can then use the beta of the house-building sector to estimate the cost of equity and then estimate the WACC for your house building division. This is exactly what several retailers do. It is quite common for them to have property divisions which buy shops and offices which the retail divisions then rent at market rates. Examples in the UK include Boots, Kingfisher and Tesco. It makes sense for such companies to use a different discount rate for property investment reflecting the risk of property rather than the risk of retailing. An alternative is to go straight to a single competitor which you feel has the same activity as your division. For example, Boots used to include a pharmaceutical division within its portfolio of companies. It might have decided to use the beta of GlaxoSmithKline or of AstraZeneca to determine the cost of equity of its pharmaceutical division rather than apply the Boots beta which primarily reflects the risk of a retailing activity. If you do not find any companies in your home country which match your division in terms of operating activity, you can spread your comparison more widely. Information databases on companies will allow you to search globally for companies in the same sector as the one you specify. You can then look at their betas for further guidance. For example, Boots might have preferred to look at Novartis or Roche, both listed on the Swiss Exchange (SWX), to obtain a pharmaceutical beta. There is an additional problem once we look at companies operating activities. Many companies are also diversified internationally. For example, Chiragdins geographic segmentation split its activities into five areas: Europe, North America, South America, Africa and Asia. In 2005, 7% of turnover and 10% of operating profits were generated by group companies in South America. Should Chiragdin have used the same discount rate for investing in a cement plant in South America as it did for investing in a cement plant in the UK? What if Chiragdin wanted to invest in a country in which it had no presence as yet? One approach might be to add a premium to the equity cost of capital to allow for political and currency risk. For example, companies such as the Diageo group, which invests in over 97 different countries, add a factor for political risk using risk ratings provided by the Economist Intelligence Unit. Another approach would be to look at equity rates of return required by investors in the South American equity market if there are suitable South American companies also manufacturing cement in South America. In either case, it is likely that a different discount rate will be used for at least some overseas projects and divisions. This also applies to nationalised companies. Electricit de France, a partially
privatised company, will not use the rate of return required by the French government for overseas projects. It will use a risk-adjusted and country-adjusted discount rate in exactly the same way as do its fully private-sector competitors.
The comment I make in terms of the hurdle rates for investment purposes is that we do it relatively simplistically in terms of low risk, high risk, country specific risk. Is it a low risk country or a high risk country? (Company P) Well we have a sort of nebulous formula which we use. Its
pseudoscientific. What we try and say are what are all the
risks ... it helps to focus the mind. (Company J)
The only sort of risk we categorise, in terms of changing the objective or hurdle rate, is country related. Everything else we handle subjectively and we do it by using sensitivity analysis. (Company E)
(Gregory and Rutterford, 1998)
EXERCISE 5.1
The idea behind using a weighted average is that the robustness of the beta estimate is better the larger the company concerned. An unweighted average would give equal weight to each beta estimate, no matter how small the company. The disadvantage of small firm beta estimates is that their shares may not be frequently traded and hence the beta estimates inaccurate.
Suppose a company such as Chiragdin were considering expanding into UK housebuilding. Suggest a suitable beta for the sector using a weighted average estimate. Use market capitalisation as the weighting measure.
Company Beta Market capitalisation (m)
610 347 71 511 82 3400
D/E ratio (% in market value terms)

4.3 11.7 25.3 4.9 8.5 15.2
Barratt Developments Bryant Group Countryside Properties Hewden Stuart Wainhomes Chiragdin
1.19 1.12 1.17 1.20 1.21 1.10
Financial risk and the WACC

We have already seen how financial gearing and hence financial risk can alter the required rate of return on equity. This will feed through into the equity beta of a share so that two companies with the same operating risk and different debt/equity ratios will have different equity betas.
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Table 5.1
Capital structure and debt/equity ratios

50/50 debt/equity Company B Assets
0 100 100 0/100 100 Fixed assets 100
All equity Company A Assets

100
Liabilities
Debt Equity 100
Liabilities
Debt Equity 50 50 100 50/(50+50)
Debt/ equity ratio
0%
50%
We will use the example of Company A and Company B as given in Table 5.1 (this is the same example you used in Unit 4s discussion about capital structure) to show how the beta and hence the cost of equity will change with the debt/equity ratio. This will be done using a formula for beta which is exactly equivalent to the WACC formula, as shown in Unit 4. The principle is that the average operating, or asset beta of a firm is the weighted average of its equity beta and its debt beta. There is a fundamental level of operating business risk reflected in the asset beta which can be split between the equity holders and the lenders according to the choice of capital structure. If the business risk remains the same, the asset beta also remains the same, but the equity beta can change if the debt/equity ratio changes. For Company A, with no debt in its capital structure, we can write:
asset =
E
equity
(D + E )
and for Company B, which has debt:
asset =
D E debt (1 T) + equity (D + E) (D + E)
Company debt has an element of risk (reflected in the credit risk premium in basis points of return over and above a risk-free rate) so the debt beta will not be zero as is the case for the risk-free rate. However, provided the level of gearing is reasonable, bdebt will be close to zero and we will assume, for simplicity, that it is zero. We now apply numbers to the asset beta formulas for Companies A and B. Suppose that the asset beta of their (identical) activities is 1.0, that the risk-free rate is 5% and that the expected return on the market is 10%. For Company A, we have equity beta equal to the asset beta since, for an ungeared company such as Company A, E/(D + E) = 1.
If you are concerned about making this simplifying assumption, estimate the debt beta by regressing the excess returns of the debt against the excess market returns exactly as we did to estimate the equity beta.
So,
E(R A ) = R f + [E(R M ) R f ]
= 5% + 1 6 (10% 5%) = 10% What is the equity beta of Company B? We use the beta formula for Company B with asset beta equal to 1. basset = D/(D + E) 6 bdebt 6 (1 T) + E/(D + E) 6 bequity We assume that bdebt is 0 so that the first term disappears. Remember that Company B had 50% debt and 50% equity so D/(D + E) = E/(D + E) = 0.5. Substituting for basset, and for E/(D + E), we can write: 1.0 = 0.5 6 bequity Thus, bequity = 1/0.5 = 2.0 So, the equity beta of Company B is twice as high as for Company A although the asset beta is 1 for both companies. This reflects the different financial risk of the two companies shares although they have the same operating risk. Substituting the equity beta of Company B in the formula for the expected return on B:
See Block 4 for further discussion of different types of risk.
E(R B ) = R f + [E(R M ) R f ]
= 5% + 2.0 6 (10% 5%)
= 15%.
Company B has a higher cost of equity of 15% compared with Company As 10%, entirely due to increased financial risk.
EXERCISE 5.2
Using the data in Exercise 5.1, estimate the market-capitalisation weighted average debt/equity ratio for house-building. Then, using the target debt/equity ratio of 25% debt, 75% equity for Chiragdin, estimate the equity beta which it could have used in its estimate of the cost of equity for house-building. What should be the weighted average cost of capital or hurdle rate for this activity? Assume that the risk-free rate is 7.5%, the equity risk premium is 5.5% and the cost of debt for Chiragdin averages 9.0%. Corporate tax value can be taken as 30%. Hint: First calculate the asset beta for house-building.
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SUMMARY
This section has been concerned with the appropriate cost of capital to use when appraising a project, i.e. the discount rate for ones DCF analysis. The critical point here was how to ensure that the discount rate used included an element for the systematic risk associated with a project, but left out the non-systematic (i.e. diversifiable) risk. This was continued with the discussion about whether using a hurdle rate or the companys WACC is more appropriate for project appraisal, and if the former how should such a rate be adjusted for the (systematic) risk pertaining to the project instead of the corporation. The latter point was illustrated with the Chiragdin case a fictional company but based on a real one.
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6 RISK ISSUES IN CAPEX
RISK ISSUES IN CAPEX
As we saw in Box 5.1 about Enron at the beginning of the previous section, the DCF model can be insufficient for a complete solution when making certain kinds of investment decisions. The hypothesis we present in this section is that the traditional DCF and other appraisal rules may be adequate to appraise pure cash-saving investment projects but leave something to be desired where there is a requirement for operational flexibility, or contingent opportunities for growth. In these circumstances a capital project may be considered an option to invest. We suggest that DCF methods consistently undervalue projects due to their failure to allow for strategic flexibility (Buckley, 1998). This compels managers to consider project proposals in a wider context. In the public sector, with wider costbenefit issues and externalities, these broader considerations are more common. Ironically, in recent years, the public sector has been under pressure to act along stricter economic lines, encouraging a narrower view of the worth of investment projects. The CAPM was developed in the context of financial investment. Since its development, academics and practitioners have struggled with the task of extending and applying the framework to capital investment, with only limited success. At the same time, in the volatile commercial environment, the problem of handling risk has grown. Uncertainty in the underlying economic environment has increased because of the considerable instabilities in future inflation levels, tax rates and exchange rates. We will now look at three possible ways in which the conventional DCF approach can be adjusted to allow better for risk. The three are:
l l l
Refer to Unit 4 and Vital Statistics (Section 5.2.5) for descriptions of the CAPM.
probability methods Expected Net Present Value real options.
6.1
ADJUSTING FOR RISK USING PROBABILITIES
Project risk usually indicates that the results of an investment decision are inherently imprecise and consequently may have undesirable outcomes or losses. An integrative model for handling project risk developed by Ho and Pike (1991) and Pike (1996), based on their survey of capital budgeting practices in the companies in UK, suggested that all investment decisions in
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practice should go through a series of steps in a logical manner. This requires: (i) risk identification (ii) application of methods of reducing the risk (iii) risk evaluation and its subsequent incorporation in the financial project appraisal. Attempts by organisations to reflect the different risks inherent in projects fall into two broadly identifiable categories: (i) Simple risk adjustment methods based on adjustments to either the underlying cash flows or the economic evaluation model (e.g. changing the discount factor or the payback criterion for projects carrying different levels of risk). (ii) Probabilistic risk analysis (PRA) techniques based on the evaluation of the uncertainties associated with critical variables and their probabilities before any riskreturn trade-off is made. Commonly used PRA techniques include sensitivity analysis, probability analysis, decision tree analysis and Monte Carlo simulation. From both a theoretical and an intuitive perspective, investors taking a greater risk should be compensated with greater expected returns. This applies to investment in capital assets as well as investment in financial assets. In a survey (Pike, 1996) a number of organisations were asked to rank in order of importance the use of risk assessment techniques for projects of higher perceived risk than that of the company as a whole. These techniques were (most popular first, least popular last):
l
applying sensitivity analysis, combined with the best/worst case analysis raising the discount rate/required rate of return shortening the required payback period using probability analysis (expected net present value or ENPV) using beta analysis.
l l l l
Other methods of adjusting project-specific risks include adjusting estimated cash flows to allow for the cost of the risk premium and using certainty-equivalent cash flows. Certainty equivalents are attained by replacing each periods expected cash flow by the certain cash flow that would be equivalent in value or utility (a rather cumbersome method). Very few organisations use one technique exclusively. The use of two or more risk-adjusting techniques is common, and many organisations use four or more methods. The most popular combinations of risk adjustments are: raised discount rate/required rate of return and shortened required payback period; and raised discount rate/required rate of return and shortened required payback period and subjective adjustment of estimated cash flow. This may indicate that there is deemed to be no single method for management to determine an acceptable level of project risk.
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One should note that the implication in the work by Ho and Pike (together and by Pike alone) is that a DCF methodology is being used whenever talk is of changing a discount rate, and it is probable that DCF is being used when mention is made of sensitivity analysis. Graham and Harvey (2002) state this more explicitly in the analysis of their survey of 392 CFOs:
With respect to capital budgeting, most firms follow academic advice and use present value techniques to evaluate new projects.
(Graham and Harvey, 2002)
Capital budgeting technique IRR NPV Hurdle rate Payback Sensitivity analysis P/E multiples Discounted payback Real options Book rate of return Simulation analysis/VAR Profitability index APV 0 10 20 30 40 50 60 70 80
CFOs who always or almost always use a given technique (%)
Figure 6.1
Survey evidence of CFOs from Graham and Harvey, 2002
A minority of the firms reviewed by Ho and Pike (1991) used the CAPM to determine the required discount rate. For those companies which used the CAPM to assist in determining the overall cost of capital, few used it specifically to adjust for project risk. The general consensus appears to be that the extent of the discount rate adjustment for a particular project should be a matter of managerial judgement.
6.2
EXPECTED NET PRESENT VALUE (ENPV)
The NPV method can be used to investigate the expected cash flows of a project. Here managers do not just produce a series of single-figure estimates of each years cash flows, but attempt to establish a range of estimates. For example, they may estimate the annual cash flows based on three economic states: boom, normal and recession conditions. From these data the projects NPV may be calculated for each state and the probability or likelihood of
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each state actually occurring may be applied. The expected net present value (ENPV) of the project is based on the different estimates and their probabilities of occurrence. It is on the magnitude of the ENPV that an investment appraisal decision may be determined. In Box 6.1, the ENPV of a project is estimated for Paraiso plc.
BOX 6.1 PARAISO PLC

Paraiso plc is considering whether to purchase a machine to produce glue for ceramic tiles. The machine costs 1,000 and is expected to have a productive life of three years. However, the estimate of the annual net revenue from the machine is uncertain and depends on the state of the house-building industry. The companys management have produced the following estimates: Year State of Industry
Boom Normal Depressed
0 ()
1,000 1,000 1,000
1 ()
+500 +500 +300
2 ()
+700 + 600 +300
3 ()
+980 +700 +250
Paraiso normally use a 10% discount rate in project appraisal, believing that this currently reflects the risk of the project. On this basis, the project NPVs have been calculated as follows: State
NPV ()
+769.4 + 476.3 - 291.5
Latest figures from the Building Trades Research Institute suggest the following probabilities for the industrys future prospects: State
Probability
0.20 0.60 0.20
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On this basis, Paraiso plc estimate the projects expected (i.e. arithmetic mean) NPV: State
Probability
0.20 0.60 0.20 6 6 6
NPV ()
+769.4 +476.3 -291.5 = = = ENPV
()
+153.9 +285.8 -58.3 +381.4
As the project has a positive expected net present value (ENPV), it is accepted.
EXERCISE 6.1
Rework the numbers with the probabilities of the economic states being 0.1 for boom, 0.3 for normal and 0.6 for depressed. Does the final ENPV of the project still warrant consideration of the proposal?
You should be aware that the ENPV itself (the 381.4 in the example above) does not take account of risk, because all that ENPV analysis shows is a measure of the investments expected results, whereas risk is concerned with the likelihood that the actual results may differ from what is expected. However the range of NPVs (291.5 to +769.4) and their associated probabilities do give some indication of the riskiness of the project. Risk-averse managers, investing in capital projects of any kind, may be more concerned that an investment may perform below expectations, that is, with downside risk rather than its upside potential. In this case, what managers are actually doing is looking at one side of the probability distribution more than the other. Instead of being sophisticated about the probability distributions of project outcomes, most organisations prefer to use relatively simple risk adjustment techniques such as a risk-adjusted discount rate or even a standard WACC, and then apply sensitivity analysis. This typical method of managing risk involves the choice of a discount factor to allow for systematic risk (as, for example, in the CAPM) and the application of a payback criterion which allows (in an approximate way) for total risk. In addition, managers employ their judgement based on experience and knowledge of their business to allow for any unacceptable downside risk or as yet unquantifiable upside potential. However, a significant number of financiers and managers use a comprehensive risk checklist in their evaluation of
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the impact of each risk on a proposed projects NPV. The most important risk factors other than the market risk are interest rate risk, exchange rate risk, business cycle risk and inflation risk. (Graham and Harvey, 2002).
6.3
INVESTMENT PROJECTS
AS OPTIONS
The purpose of this section is to examine the shortcomings of the conventional approaches to CAPEX decision-making and to present a different approach for thinking about investment procedures. The standard NPV method of appraising capital project proposals suggests that managers should: (i) determine an appropriate discount rate (ii) calculate the PV of the stream of expenditures incurred when undertaking the project (iii) calculate the PV of the expected stream of cash flows that the investment will generate (iv) determine the difference between the two (this is the NPV of the project). If the NPV is greater than zero, applying the NPV decision rule suggests that management should go ahead with the investment. It would be nave to believe, however, that the NPV rule is applied without recourse to other considerations. In practice, managers often seek a consensus projection for the cash flow streams or, as we have seen with ENPV, use an average of high, medium and low estimates. However, managers are often unaware of making an implicit faulty assumption, which is that the implementation or development of a project begins at a fixed point in time, usually the present. In effect, the NPV rule assumes a fixed scenario in which an investment is made which, when completed, generates cash flows during its expected life cycle, without any contingencies. More importantly, although the NPV rule requires managers to consider all relevant cash flows, even if not directly related to the particular project, it does not suggest that managers explore the impact of delaying the project or abandoning it if market conditions change adversely. Instead, the NPV rule compares investing today with never investing. A more useful technique would be to examine a range of possibilities: investing today, or waiting one or two years, etc. Unfortunately, the basic NPV rule, although relatively easy to apply, is built on a restrictive assumption. It assumes that a project must be started immediately a now or never proposition and cannot be delayed. Although some investment decisions fall into the above category, most do not. It is often possible to delay investment decisions. This possibility of delay can be valuable as, for example, in the case of an oil exploration company which delays drilling for oil until the results of geological surveys have been analysed, or of a pharmaceutical company which wants to delay investment in a
production line for a new drug until it has obtained approval to sell the drug in the US. At this stage we must briefly introduce the concept of options (which will be dealt with in greater depth in Unit 8). If we note that opportunities are options, i.e. rights but not obligations to take some action in the future, then capital investments are essentially about options. An organisation with an opportunity to invest in a capital project has the right but not the obligation to make an investment outlay in a project (in return for the entitlement to a stream of profits/cash flows from the project) at a future time of its choosing. When a company makes the investment outlay, it exercises its option. However, once undertaken, such investment may be irreversible, in the sense that once the project is started, it cannot be reversed at no cost. If it could be, there would be no value in being able to delay the project. So how does a company choose when to exercise that option? In exercising its option by making an irreversible investment, the organisation effectively kills the option. This means that, by deciding to invest, the organisation forgoes the possibility of waiting for new information that might affect the desirability or timing of the project; it cannot disinvest should market conditions change adversely. The lost option value is an opportunity cost that must be included as part of the cost of investing now. As a result the simple NPV rule must be modified. Instead of being greater than or equal to zero, the PV of the expected cash flow streams must exceed the cost of the project by an amount equal to the value of keeping the investment option alive. This opportunity cost is highly sensitive to uncertainty over the future value of the project. New economic conditions may affect the perceived riskiness of future cash flows and have a large impact on investment spending (larger, for example, than the impact of a change in interest rates and hence discount rates). Viewing capital investments as options puts greater emphasis on the role of risk and less emphasis on interest rates and other variables. The recognition that CAPEX decisions can be irreversible adds significance to the ability to delay investments. In reality, organisations do not always have the opportunity to delay investing in capital projects. For example, strategic considerations can make it imperative for a company to invest quickly in order to pre-empt investment by a competitor. In most cases, however, it is at least feasible to delay. There may be a cost the risk of entry by rivals or the loss of cash flows but the cost can be set off against the benefits of waiting for new information, and those benefits are often substantial. On the other hand, making one investment decision can open up the possibility for making new investments in the future. Unless you as a firm have invested in Project A, and acquired technology
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and expertise in it, you may not be in a position to invest in Project B (which you may not even know about yet). In other words, doing Project A also gives you the option of doing Project B, and this too has value. Options emphasise the value of flexibility, and, in an uncertain world, the ability to value and use flexibility is critical. This means that simply applying the NPV rule to the CAPEX appraisals is not sufficient. Management must be able to make intelligent investment decisions and be able to consider constantly the value of keeping their options open, creating new options, and deciding when to exercise options.
ACTIVITY 6.1
Read the Course Reader article by Leslie and Michaels entitled Real options. This looks at how option theory was applied to project investment for BP and National Power.
SUMMARY
In this section, we examined the issues surrounding risk in relation to CAPEX. We explained a number of methods which can measure risk, such as simple risk-adjustment and probabilistic risk analysis. We also provided information as to what risk adjustment techniques organisations are using in their management of risk. We mentioned sensitivity analysis, shortened payback, discount rate adjustments, the adjustment of cash flows and the use of certainty equivalents. We included an activity where you are asked to examine the expected net present value, which illustrates how to estimate project cash flows under a range of economic situations. This is achieved by applying probabilities to the range of cash flows which are estimated to be generated by the project under review. We then examined the CAPEX decision-making process in the light of the ability to take out an option on a project proposal which could be exercised now or at a future date. We decided that since an option has value it should be taken into account when considering whether to invest in a project now. In particular, we noted that the option to delay or defer a project is more valuable the greater the uncertainty about future cash flows and the lower the initial project cash flows which would be lost or postponed by waiting. We stated that there are inherent problems with applying the traditional NPV rule to a range of investment decisions in that it ignores the option to delay investment.
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7 ACE COMPANY: SPREADSHEET EXERCISE
ACE COMPANY: SPREADSHEET EXERCISE
Now that we have covered the main aspects of project appraisal, it is time to try them out on a case study. The case study, based on ACE Company, consists of a relatively complex project proposal. Students are required to answer the two main questions at the end of the case, which are self-explanatory. The use of Excel is recommended in order to solve the quantitative element of the questions. In addition to achieving the skills to prepare project cash flow profiles, by the use of spreadsheets, and arriving at a reasonable conclusion to the financial appraisal, you are encouraged to support their conclusion with qualitative information. This case helps to develop your understanding of the importance of strategic considerations in capital budgeting decisions, as well as how to incorporate such considerations into your analysis.
7.1
EXERCISE
ACE Company is the technology and market leader in the portable electronic games industry. The company is currently very successful with its Model X, which has been on the market for several years. ACEs management believe that because of increased competition from other types of entertainment, the demand for Model X will dry up after three more years. The company has forecast Model Xs net cash inflows in the next three years to be 400 million, 300 million, and 200 million, respectively.
New product development

ACEs senior managers are considering the development and introduction of a replacement for Model X, to be called Model Z. According to the engineers, ACE already possesses the technical expertise to develop Model Z. However, the earliest that this product can be introduced into the market is one year from now, as it will take this long to develop and test the new product, co-ordinate with suppliers for parts, set up the production process, and arrange for other related activities. The total cost of these development activities is estimated at 550 million. All of ACEs top managers agree that Model Zs market potential in terms of net cash inflow would be 200 million in Year 2, 400 million in Year 3, 300 million in Year 4, and 100 million in Year 5. They also agree that Model Z would maintain ACEs leadership position in the portable electronic games industry.
Management expect that, in addition to developing its own customer base, Model Z also would draw some sales away from Model X. The expected amount of this cannibalisation is 100 million of net cash inflows per year. Table 7.1 summarises ACEs prediction of net cash flows for the next five years, for Model X by itself and with the introduction of Model Z at the end of Year 1 (in effect the beginning of Year 2). For simplicity, cash outflows are assumed to occur at the beginning of the year while cash inflows are assumed to occur at the year-end. Thus, for example, the 550 million development cost in Year 1 is assumed to occur at Time 0, while the net cash inflow from introducing Model Z at the beginning of Year 2 is assumed to occur at the end of that year. Also note that, in the table, net cash inflows of 100 million per year are shifted from Model X to Model Z in Years 2 and 3. Table 7.1 Model X, introducing Model Z at end of year 1 (m)
Net cash flow (m) Year
0 1 2 3 4 5
Model X only
0 400 300 200 0 0
Model X
0 400 200* 100* 0 0
Model Z
(550) 0 300* 500* 300 100
Total
(550) 400 500 600 300 100
* Reflects 100m cannibalisation of Model X by Model Z.
ACEs after-tax cost of capital is 10%. The development costs would attract a 25% writing down allowance, based on the reducing balance method, for taxation purposes. The corporate tax rate is 35%, payable one year after year-end.
Extending the development period for Model Z

Several members of top management are concerned about Model Zs erosion of Model Xs sales. They propose that it would be better to spread the development of Model Z over two years and to introduce it at the beginning of Year 3 instead of Year 2. They suggest that this plan has two major advantages: (1) it would avoid the 100 million erosion in Model Xs net cash inflows in Year 2; and (2) the engineers have projected that extending the time for the development process will yield substantial savings due to efficiencies in scheduling. They have estimated that the two-year plan would reduce Model Zs total development cost to 300 million. Half of this total would be spent in each of the two years.
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7 ACE COMPANY: SPREADSHEET EXERCISE
Table 7.2 summarises the estimated net cash flows for the two-year plan. Compared with the one-year plan, Model Xs Year 2 net cash inflow is higher by 100 million. This is because cannibalisation by Model Z in Year 2 is avoided. Table 7.2 Introducing Model Z over two years (m)
Net cash flow (m) Year
0 1 2 3 4 5
Model X only
0 400 300 200 0 0
Model X
0 400 300 100* 0 0
Model Z
(150) (150) 0 500* 300 100
Total
(150) 250 300 600 300 100
* Reflects 100m cannibalisation of Model X by Model Z.
Proponents of the two-year plan acknowledge that delaying Model Zs introduction by one year would require forgoing its Year 2 300 million net cash inflow. They emphasise that this sacrifice is more than made up by the additional 100 million cash inflow from Model X in Year 2 and the 250 million savings in Model Z development costs.
Other considerations
Supporters of the one-year plan argue that proponents of the twoyear plan have overlooked a major factor: that the timing of Model Zs introduction could have an impact on competitors actions. They maintain that if ACE does not introduce Model Z as quickly as possible, ACEs major competitor would most certainly enter the market with a comparable product. In response to a query from these managers, ACEs engineers have conducted a study of the competitors current capabilities. They have reported that due to the competitors less sophisticated technologies, it will require two years to develop a comparable product for market introduction. The nature of the industry is such that there is a significant first mover advantage. Similar products that reach the market at the same time tend to get equal shares of the market. Once a product is introduced, it tends to get so entrenched that comparable products subsequently introduced can gain only insignificant market shares.
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ACTIVITY 7.1
(i) Using NPV computations, analyse the one-year and twoyear development alternatives. At this time, ignore the potential introduction of a comparable product by ACEs major competitor. Which alternative would you recommend? (ii) How would you modify your analysis in (i) to address the potential introduction of a competing product by ACEs major competitor? We have supplied three files on disk for you to use in this Activity. They are CAPX, CAPXACEA and CAPXACEB.
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8 FUNDING CAPITAL PROJECTS
FUNDING CAPITAL PROJECTS
In the previous two sections we have considered different methods of financial appraisal of projects. The investment decision depends on whether the proposed project satisfies the expectations of the suppliers of funds to an organisation. In a commercial firm two main sources of funds are lenders and shareholders each with associated expectation called cost of debt and cost of equity respectively. In Unit 4, we considered how to estimate cost of capital of a firm and how different weights of debt and equity might impact the cost of capital. Earlier in this unit we considered how risk should be taken into account, for example by making adjustments to the organisations WACC. In this section we look at a particular method of capital funding, namely leasing. This is an important topic to understand, whether one is in the private, public or voluntary sectors. Organisations from any of the three sectors may decide, at some time, to use leasing as the preferred method of borrowing. The two sections following this one can be treated by you as an either/or choice (though if you have time you are likely to find both worthwhile). If you are primarily interested in private sector financing methods, study Section 9 Project finance; if the public sector is more important to you, study Section 10 Funding public projects. You will be able to answer any relevant TMA (or exam) question with knowledge of Section 9 or Section 10.
8.1
LEASING
Leasing is a form of secured borrowing specifically linked to a particular project. Under a lease agreement, the owner of the asset, or lessor, leases (allows the use of) the asset to the lessee in return for agreed payments over a fixed term, exactly as in a debt agreement. However, since the lessor retains title to the asset, the loan is more secure than in the case of a conventional lender. Since it is less risky than ordinary lending, leasing can be a cheaper form of finance than debt. Over time, leasing has become an important alternative to outright purchase for acquiring the use of assets. Leasing in the UK accounts for between 20% and 25% of all new assets acquired (Samuels et al., 1995). Leasing might therefore be seen as a source of finance and the lease or purchase decision analysed as a financing decision. In this case, leasing arrangements are economically equivalent to secured long-term debt. However, other writers maintain that the decision of whether to lease or not cannot be
viewed as a pure financing decision, as it involves interactions with the investment decision (Lumby and Jones, 2000). One important reason is that a true leasing agreement, unlike a hire-purchase arrangement, does not give the lessee the right to final ownership. Payments under a lease contract can vary in terms of time and amount and can be determined according to the lessees requirements. When a lease is terminated, the leased equipment in law reverts to the lessor and thus any residual value of the underlying asset also belongs to the lessor. However, with long-term leasing agreements it is quite common for the lessee, when the period of the primary lease has expired, to have the option to purchase the equipment for a nominal sum or to take out a secondary lease. The latter means that the lessee can continue to use the facility, even though still not the legal owner. The rental payments during the period of the second lease are usually very low (often a peppercorn rent). Leases can broadly be divided into two types of contracts, finance leases and operating leases. A finance lease usually means that the lessor is assured by the initial agreement of the full recovery of his or her financial outlay plus a suitable return on the capital invested. This type of lease is also known as a full payout lease. The risks and rewards of ownership have effectively passed to the lessee. The risks and rewards from the use of the asset are, of course, also with the lessee. Undertaking a financial lease contract is the same as borrowing funds (Samuels et al., 1995). The lessee undertakes a binding agreement to make the specified payments in the lease contract to the lessor. This is equivalent in cash-flow terms to borrowing the funds needed for the asset by entering into a binding contract to make interest and principal repayments to a lender. An operating lease is usually for a shorter period than a finance lease. It is certainly for less than the estimated economic life of the asset. During the period of the lease contract the net cost of the asset to the lessor is not fully recovered. It is the lessor who retains the usual risks and rewards that come from the ownership of the equipment as distinct from the use of it. If the life of the asset turns out to be less than expected, due to obsolescence, it is the lessor who loses. As a result, the lessor normally assumes the responsibility for repairs, maintenance and insurance under an operating lease (in the case of aircraft, for example, or of property). The life of an operating lease is not always known at the outset, for the lease may be cancelled or cover only a short period with options for continued short periods, each being less than the economic life of the asset. Where rental periods are extended, these will be on a negotiated economic basis. The rental payments, together with the tax and any other benefits received by the lessor over the period of a particular lease, will not necessarily cover the cost of the asset. The lessor may sell the asset at the end of any of the short periods of the lease. When the operating lease contract is signed, the lessor is not sure whether he or she will recover the capital and generate a return. There are future agreements to be negotiated and a sale of the assets to be determined.
Reasons f or leasing
There are many reasons why organisations may prefer to lease plant and equipment rather than buy it. Some of these are:
l
A company may not have the funds available to purchase the assets or it may not have access to alternative sources of funds. On the other hand, the company may want to use funds available for other purposes, which could be more profitable, or where the acquisition of other assets cannot be achieved through the use of leasing. The acquisition of aircraft or ships tends to be very expensive while the purchase of computer facilities can be beyond the means of smaller companies. Hence, leasing is a source of finance and a way to enable the immediate use of assets upon payment of the first rental instalment. There can be considerable tax advantages in leasing. For example, a lessor who owns the leased asset is able to deduct the associated capital allowance (depreciation) from taxable income. If the lessor can make better use of capital allowance tax shields than an assets user can, it may make sense for the leasing company to own the equipment and pass on some of the tax benefits to the lessee in the form of lower lease payments. Companies which do not show taxable profits in the years prior to acquiring an asset may not be able to obtain the immediate advantages of any capital allowances. These companies can only obtain an early advantage of the investment tax allowances through leasing. A company may not wish to own a certain type of asset, such as a computer. These assets tend to become obsolete very quickly, and the firm may always want to use the latest equipment. Lease arrangements allow the lessee to carry out this policy whilst avoiding the risks of selling second-hand IT equipment (at a cost of course). Traditionally, leasing was seen as off-balance sheet financing. Under earlier accounting rules, financial leases were off-balance sheet financing under UK accounting standards and the only requirement was to add a brief note to the accounts describing the extent of lease obligations. A company that leased its equipment could show a higher return on capital employed (ROCE) and a higher asset utilisation ratio (AVR) in its accounts than a company that purchased its fixed assets. Also, under these earlier accounting rules, companies which leased appeared to have less debt than companies which borrowed to finance assets and apparently lower gearing ratios could put firms in a better light as far as future borrowing was concerned. Accounting standards now typically require that all finance leases be capitalised, that is, the present value of the lease payments be shown alongside the debt portion of the balance sheet. The leased asset must also be shown on the asset part of the balance sheet. However, the capitalisation of leased assets only applies to finance leases and not to operating leases.
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Not-for-profit organisations do not have access to equity finance and their access to debt finance may be limited either by central government controls or by banks and other lenders applying normal commercial risk criteria. Leasing offers an alternative source of funding for capital investment, although government may apply restrictions to ensure that this method is used properly and not just as a way of subverting control. An example would be central government imposing regulations on local governments leasing of assets.
8.2
LEASE VS BUY AND BORROW DECISIONS
We will deal next with the financial aspects of the lease vs buy and borrow decision. Despite the non-quantitative reasons given above for undertaking a leasing arrangement, organisations also undertake an initial financial analysis of the two possible options to acquire an asset. The decision to be taken is lease, or borrow and buy. The choice between a finance lease and borrowing is complex, since the lease can be long-term in nature. Nevertheless, companies need to compare leasing with borrowing in order to choose the most cost-effective alternative on offer.
Although, as noted earlier, lessors are even more secure than secured lenders!
As stated above, a finance lease is effectively the same as debt capital in that, from a gearing standpoint, the present value of a lease contract liability is similar to the liability on debt finance. For simplicity, we also assume that the cost of capital is the same for purchasing and leasing because we noted that leasing is equivalent to secured debt finance. Box 8.1 illustrates one of the more traditional lease vs purchase analysis approaches.
BOX 8.1 LEASE VS BORROW

The problem
A company is considering a venture which requires the purchase of a machine. The machine costs 1,000 and will have a zero scrap value at the end of its three-year life. The project is forecast to generate the following net cash flows (i.e. revenues less operating costs), pre-tax: Year
1 2 3
Cash flow ()
+ 600 + 550 + 250
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The plant could either be purchased outright or acquired through a finance lease. The lease contract requires three payments of 375, paid annually in advance. We assume that the initial transaction is made on the last day of the previous accounting period and the firm expects to have a corporate tax liability throughout the next three years, against which it can offset any debt interest or lease payments. Managers require that the project generate an after-tax return of at least 20%. This can be considered the appraisal discount rate. The corporate tax rate is 30%, payable one year in arrears. Capital allowances for tax purposes of 25% on the reducing balance method are available on capital investments. The pre-tax cost of debt is 14%.
For revision of the reducing balance method, see Section 4.4.3 of Vital Statistics.
The solution
The approach we adopt is to treat the decision as a two-stage process. First, we compare the present value of the cost of leasing against purchasing; second, we evaluate the project using the least-cost method of purchase as the outlay. In the first stage, the after-tax cost of debt is used to reflect the low-risk nature of the cash flows and to take into account the taxdeductibility of debt. In the second stage, a discount rate is used which reflects the projects own systematic risk, in this case 20%.
Stage one
After-tax cost of debt: 14% (1 0.30) = 9.8% = discount factor PV of lease cash flows: Year
0 1 2 3
Lease ()
- 375 - 375 - 375
Tax relief ()
6 + 112.50 + 112.50 + 112.50 6 6 6
Discount factor (9.8%)

1.0000 0.9107 0.8295 0.7554 = = = = =
()
- 375.00 - 239.06 - 217.74 + 84.98 - 746.82
PV of lease payments
PV of purchase cash flows: Year Outlay ()

-1,000 + 75.00
Capital tax allowance ()

6 6
Discount factor (9.8%)

1.0000 0.9107 = =
()
0 1
- 1,000.00 + 68.30
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2 3 4
+ 56.25 + 42.19 + 126.56
6 6 6
0.8295 0.7554 0.6880 PV of purchase
= = = =
+ 46.66 + 31.87 + 87.07 - 766.10
Therefore it is cheaper to acquire the plant with a lease rather than to purchase.
Stage two
PROJECTS NPV ANALYSIS
Year
PV cost ()
- 746.82
Net cash flow ()
Tax charge ()
6
Discount factor (20%)

1.0000 0.8333 0.6944 0.5787 0.4823 NPV
()
0 1 2 3 4
= - 746.82 = + 499.98 = + 256.93 = = = + 49.19 36.17 + 23.11
+ 600 + 550 + 250 - 180.00 - 165.00 - 75.00
6 6 6 6
Therefore the project is worth undertaking by using a finance lease.

(Source: adapted from Wilkes, Samuels and Greenfield, 1996)
SUMMARY
In this section we looked at leasing, an important variation on financing capital investment through debt. We started by describing the two main forms of leasing, i.e. operational and financial. The section then looked at the key reasons for using a lease method rather than, for example, borrowing the money to buy the asset directly. One should note that this part of the section made clear that leasing is often an appropriate financing method for public sector or not-for-profit organisations because of their tax position: since they usually do not pay tax, then the tax shields provided through the purchase of capital assets would be wasted. The section concluded with a worked example of how to decide whether to lease or buy an asset.
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PROJECT FINANCE
This section is intended for those students whose primary interest is in private-sector financing techniques; for those of you more concerned with public-sector methods, you can if you wish skip this section and study Section 10 Funding public projects instead. We would like to stress that if you have time, reading both sections will be worthwhile, but you will be able to complete any assessment task from knowledge of one of Sections 9 or 10. Note that state bodies may well use project finance which is why public sector students are encouraged to read this section if they have time but usually this would be done through some form of quasi-private sector entity, for example a government-owned corporation. This section is about project finance, an important method for raising the finance for large, stand-alone investments. By stand alone we mean investments that can be regarded as forming reasonably self-contained projects. So an oil platform might be an appropriate candidate, but a single production line within a larger factory probably would not. Project finance can be all debt or all equity or a combination of debt and equity, but is essentially designed to finance a large project where potential investors consider the expected returns from a particular project rather than the creditworthiness of the whole firm.
9.1
THE METHODS OF PROJECT FINANCE
This sub-section describes the specific issues relating to project finance, that is, the financing of large projects in the private sector. Project finance can be defined as:
[The] financing of a project such that the lender is prepared to look only to the earnings of the project as the source of funds from which his loan will be repaid and to the assets of the project as collateral for the loan.
Nevitt and Fabozzi (1996)
Project finance is not exactly a newcomer to the finance scene. Indeed, in 1856, financing for the construction of the Suez Canal was raised by a variant of this technique.
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A number of variations on this theme developed, but it was not until the expansion in North Sea oilfields that project finance grew beyond production payment financing and assumed some of the variety that it now has. Today, international banks provide project financing for a vast range of projects, including mineral developments, toll roads, tunnelling projects (such as the Channel Tunnel), theme parks, power stations, and shipping and aircraft finance. Project finance is difficult to define exactly because there is no single technique that is always used each financial facility is tailored specifically to suit the individual project and the needs of the parties sponsoring it. In essence, the expression project finance describes a large-scale, highly leveraged financing facility established for a specific undertaking whose creditworthiness and economic justification is based on the projects expected cash flows. It is the projects own economics rather than its sponsors (in many cases the equity owners) financial strength that determines its viability. In this way, the sponsor isolates this activity, a method sometimes called ring-fencing, from its other business. Through careful structuring the sponsor may shift specific risk to project customers, developers and other participants, thus limiting its own financial risk. This process of sharing risk is not without cost. Project financing is normally more expensive than conventional company debt (Buckley, 1998). The increased cost is caused by the identification of a whole range of risks which must be incorporated in any contract documentation. However, since project financing is normally highly leveraged, its overall cost of finance may still be lower than a companys usual WACC. Furthermore, project finance is usually off-balance sheet and thus better reflects the actual legal nature of non-recourse financing. In project finance terms, non-recourse financing occurs when lenders do not at any stage during the loan period, including the pre-production period, have recourse for repayment from any cash flows other than project cash flows. In practice, such financing is almost unobtainable. Most projects are financed on a limitedrecourse basis, that is with a limited amount of recourse to sponsors and other parties. The essential difference between non-recourse and limited-recourse finance occurs when a project is abandoned. In the non-recourse case, the sponsors can, in principle, walk away from the project without liability to repay the debt. Limited-recourse financing is a more accurate description of most project financing involving bank lenders, where the ability of lenders to look to project sponsors for repayment of debt in the event of problems with the loans is restricted. Lenders are attracted to project finance because they receive high fees compared with other business transactions they undertake. They can be protected from interest and capital repayment default by a range of covenants from the sponsor and other parties.
9 PROJECT FINANCE
Spreading specific project risk over several participating lenders lessens dependence on a single sponsors own credit standing.
Hes in conference at the moment about raising investment funds.
While specific features distinguish project finance from conventional corporate borrowing they may not all be present in a particular project. These features include:
l l
The project is usually established as a distinct, separate entity. It relies primarily on debt financing. Borrowings generally provide 70% to 80% of the total capital with the balance being equity contributions or subordinated loans from the sponsors. Some projects have been successfully structured with over 90% debt, but only in very special cases (this point highlights that projects funded through PFI and project financing have comparable financial structures). The project loans are linked directly to the ventures assets and potential cash flow. The sponsors guarantees to lenders do not, as a rule, cover all the risks. Some sponsors may also be off-takers (see Section 9.2) and, as a result, may also be subject to project post-completion risks. Firm commitments by various third parties, such as suppliers performance guarantees, purchasers of the projects output, government authorities providing planning permission etc., and the project sponsors themselves, are obtained and these create significant components to support the credit financing of the project. The debt of the project entity is often completely separate from the sponsor companies direct obligations. The lenders security usually consists only of the projects assets, apart from project cash generation.
PFI projects are discussed in Section 10.
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The finance is usually for a longer period than normal bank lending.
Project finance is most frequently used in capital-intensive projects,

such as in the case study which follows in Section 9.2. These
projects are expected to generate strong and reasonably certain
cash flows which are consequently able to support high levels
of debt.
Finally, the critical part of the lenders analysis embraces a view on
the risks of the project. We broadly identify two risk categories,
although they can vary with the different types of organisation or
even the types of projects.
Internal risks which include:
l l l
operating risk
raw material handling risk
completion (or construction risk).
country/political risk
off-take risk
market risk
financial risks, including foreign exchange risk
documentary risk
force majeure risk.
Externally derived risks which include:
l l l l l l
ACTIVITY 9.1
The above list states a rather comprehensive range of risks. Try to provide a short description of each of these risks in the context of project financing. If need be, base the definitions on the various risks to which your own organisation is exposed.
The list gives an indication of the range of risks the providers of capital for projects must consider. At this stage, it is necessary only to obtain a general appreciation of the concept of such risks. The topic will be dealt with in more depth in Block 4.
9.2
CASE STUDY: LIQUID GAS FACILITY IN OMAN
This case study describes a specific example of project financing, the funding of a liquid gas facility in Oman, an oil-rich state in the Persian Gulf. In order to place the range of activities involved in project financing in context, it is helpful to obtain an overview of the
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structure of the project finance functions in the main bank involved, ABN-Amro. The banks structure is as follows:
l
Independent Finance Units of which Project Finance is the largest Additional divisions which provide support are: Industry Group Export Group Structures Group Syndication Group
The Project Finance unit has subdivisions including: Natural Resources Energy Finance (Oil/Gas).
Project funding arrangements

Project funding arrangements follow a well-established pattern. The project risks related to the gas facility project, of which more later, are deemed too high even for large banks and are diversified. The diversification of risk is done through a syndication procedure and is akin to the manner in which insurance companies reinsure their risks to a range of other insurance companies. This reinsurance of risk has been in operation in the UK for many years, for example through Lloyds syndicates, and has simply been copied by the banks in the case of the funding of large and costly projects.
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In all large projects, the principal banks, called arranging banks, underwrite the funding for the project. In the Oman project, which cost about $2bn, the arranging banks were ABN-Amro, the largest Dutch bank which operates globally, and NatWest Bank which is involved in large projects all over the world in energy, power and telecommunications. The loan for this project was syndicated to seven banks. These banks in turn sub-syndicated part of their funding commitment to a further 43 syndicate banks, making 50 banks in total. The choice of these banks is typically based on a range of factors, including:
l
syndicate banks which are known to be interested in project finance for specific types of project banks which are experienced in specific countries/industries and have a track record in these areas.
The general rule is that the principal arranging banks take on a significant part of the total amount funded, although this depends on the amount of the loan. The largest amount funded by any member of this syndicate was about $75m, from both ABN-Amro and NatWest, and the lowest was about $2m. However, the maximum amount of $75m was re-financed in the so-called secondary market. This market consists of smaller banks which were not invited into the original lending syndicate. It is held that these arrangements offer opportunities to improve the return on capital for the original syndicate. It is possible to refinance the total amount of funding to the secondary market but this is subject to the following conditions:
l
It is usually done with the borrowers consent, based on agreement with the original funding syndicate in general and the arranging banks in particular. Borrowers and syndicate banks prefer the arranging banks to remain part of the loan syndicates, thus demonstrating their commitment, as well as for prestige and other credibility reasons.
The decision-making process

Before deciding to underwrite large projects, such as that in Oman, ABN-Amro conducts a range of financial analyses, to model the proposed project. These models allow for a wide range of factors and risks which might impinge on the project. After the models have been completed and analysed, these are audited by independent groups of experts appointed by the arranging banks. The analysis includes:
l
Project base case scenario (based on the most reasonable assumptions known and ascertainable at the time the model is being constructed). Tests are then performed to check the robustness of the assumptions in the model. The model examines a range of ratios in relation to the project.
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For example the debt service history of the projects sponsors will be reviewed as well as their debt/equity ratios. In any event all sponsors must show commitment to the project by injecting a predetermined percentage of equity into the project.
l
DCFs of the proposed project are calculated based on a whole range of financial forecasts, for such variables as interest rates, foreign currency exchange rates, and their sensitivities tested (sensitivity and scenario analysis).
As noted above, the recognition and appraisal of risk forms a major part of the decision-making process. The largest concern of the lending banks is to recognise the risks and manage them through an array of well-tried measures. However, the spreading of risks has costs: for example, refinancing the Oman project reduces the total profit available to the arranging banks. Nevertheless, given the size of the project, it is imperative that the overall risk of lending is reduced by the underwriting banks, in this case ABN-Amro and NatWest. The following sub-sections describe a range of risks which were considered for the Oman liquid gas facility. They are included in the lists of internal and external risks earlier in this section.
Completi on risk
This type of risk embraces technical risk, which depends on the type of technology used in the project. For example, has the proposed technology been used before or is the project based on new technology? Technical risk is dependent on the available skills and expertise in the host country. In practice, the banks allocate dedicated finance to complete the project. The pre- and post-completion loan structures are different, because they are linked to different risk profiles, as the banks perceive pre- and post-completion risks to be totally different. During the construction stages of the project the contractors provide certain completion guarantees which are released against completion certificates. In the case of completion difficulties the banks can call in certain of the completion guarantees.
Country/political risk
The banks view this category as the most important risk factor in these types of project. Country risk is closely associated with political risk. In addition to examining purely economic assumptions one must look at:
l l
fiscal conditions in the host country (Oman) the investment climate based on the range of investments which have taken place in Oman the ability to repatriate funds the current climate and the likely policies of future governments the stability of government political risk also refers to attitudes of consumers, customers, the general population, etc.
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The legal framework of the host country forms a major consideration in the decision-making process. For example, does local legislation support the local project partners to the detriment of outside lenders? Brazil, Egypt and many other countries do not recognise legal frameworks and decisions made in courts outside their own jurisdiction. Similarly, countries such as Indonesia do not have legal systems which allow foreign banks easy recourse to repayment in the event of a default. The pricing of political risk in the financing of a project is based on the characteristics of each country in which the project is taking place. The costing of the risk in the market is based on precedents in deals with that country. Difficulties naturally arise when no previous dealing or projects have taken place. The banks will then be more hesitant when looking at the risk profiles under which the loans will take place. However, there exist national risk ratings, similar to those provided for companies by ratings agencies such as Moodys, etc. The pricing of these risks changes with the stages of the projects implementation based on information provided by each banks economic department usually in association with Moodys, Standard & Poors or IBCA. In addition, The Economist regularly provides tables which estimate country risks. In some cases, political risk can be hedged with export credit agencies. These agencies guarantee, at a price, the payment to home country suppliers of goods and services sold to foreign customers, in the event that these customers default on paying for these goods and services. Of course, these agencies charge premiums on the amount of funds which are to be guaranteed under the agreements between the various parties of the project, and their charges are related to their perception of country/ political risk. Finally, the involvement of the International Finance Corporation (IFC), which forms part of the World Bank, is considered in the management of country risk, particularly for countries perceived to have relatively large country/political risk. This organisation supports some private-sector projects, as it did the one in Oman, and is often willing to accept a different risk profile from that of normal lenders. This in turn provides a reduction in risk for the lending banks. IFC, as part of their financial involvement could provide:
l l
a loan direct to the project in question (this happens rarely) a syndicated loan to a group of bankers under the IFC umbrella. This in turn gives a measure of comfort to the lending banks. As a result a large portion of the political risk is deemed to be diversified away an equity stake in the project.
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Off-take risk
Off-take risk, applicable to utility supply projects, is essentially the risk of guaranteeing purchase from the customers, wherever these customers might be. This risk is dependent on the number of countries which are involved with the project and its markets and is linked to commercial risk. The off-taker signs a contract with the project to buy the product. Thus the cash flows depend on the perception of the creditworthiness of the off-taker, which in turn is a function of location and financial strength. In the Oman project the main customer for the liquid gas is Korea. Hence the political risk analysis for this project included an evaluation of the risks associated with both Oman and Korea in order to provide the lenders with a more complete picture.
Ma rket risk
The projects ability to generate cash streams to service the interest payments and the ultimate redemption of the capital outlay depends on whether and for what price the output of the project can be sold over the life of the project. The risk is obvious, for example, oil and gas prices can fluctuate wildly. There is a range of risk management instruments available to manage market risk, e.g. derivatives. Finally, the legal agreements between parties in project financing contain clauses which are concerned with these matters.
As you will see in Block 4, financial markets give a good indication of these through what are known as forward prices.
Financial statement issues for the lending banks

This subsection describes the treatment of the income streams in the profit and loss accounts and balance sheets of the banks. The level of income depends on the role of each syndicated bank in the funding process, as the income streams of the various lenders are based on a complicated range of fee structures. ABN-Amro and Natwest as the arranging banks receive the bulk of the fees which include: (i) an arrangement fee (ii) a fee for underwriting the project (iii) a participation fee this is a flat fee and received in advance (iv) the loan spread this is the percentage (points) above the base lending rate (v) a commitment fee on the undrawn portion of the total amount to be financed (vi) technical bank fee (this could be paid to the arranging bank or any other bank which specialises in the technical issues of the project and its lending procedures) (vii) an administrative role fee to the arranging bank only. All syndicated banks receive one or more of these fees, based on the degree of their involvement in the projects funding. In addition, if these banks offer a particular expertise to the project and its planning, an additional fee can be negotiated.
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As a rule the project sponsors returns are based on a required return on equity capital. However, the banks are also interested in the return on debt capital which is based on the predicted income streams of the project over the life of the loan. All banks have a main-requirement under the capital adequacy requirement directive (Basel Accord, 1988) and determine their required return within the constraints of this accord. It is common practice that banks do not set a hurdle rate for project financing. The most important consideration is the evaluation of the risks involved with the particular project for which the funds are provided. It is interesting to note that no standard pricing of any loan agreement exists. This means that the system of costing a loan, i.e. the interest rate applied, is different from one project to another. These rates are based on a whole range of factors which banks take into consideration when analysing each project proposal. In all cases the balance sheets of the banks must report the amount of debt funded. The disclosure in the balance sheet is itemised depending on the specific amount underwritten, in which context these amounts are underwritten, as well as the time scales of the project. Typically, large projects are highly leveraged with a debt/equity ratio of approximately 70/30 or 80/20. These large loans form an important part of the banks balance sheet profile. The Annual Report must explain in the notes how the banks reported the following items in the balance sheet:
l l l
commitment to lend (intention to lend to the project) the total capital requirement for the project the total funds dedicated to the project, but not yet lent to the borrower.
The total funds intended for the project appear as assets on the balance sheet.
SUMMARY
In this section we considered how capital projects can be funded by the system of project finance, a method that, in essence, treats the project (for financing purposes) as a entity separate from the parent organisation. Having looked at the process in general we then investigated a specific example, the Oman liquid gas facility. Project financing has the advantage to a borrower that a separate entity is set up and hence the debts arising from the project may not be recorded on the balance sheet; in other words the financing is off-balance sheet from the borrowers point of view. However, project financing can be costly to arrange.
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10 FUNDING PUBLIC PROJECTS
10
FUNDING PUBLIC PROJECTS
This section is intended for those students whose primary interest is in public-sector financing techniques; for those of you more concerned with private-sector methods, you can if you wish skip this section and only study Section 9 Project finance. We would like to stress that if you have time, reading both sections will be worthwhile, but you will be able to complete any assessment task from knowledge of one of Sections 9 or 10. Even if you are not in the public sector it is quite possible that at some time you will become involved in a publicprivate partnership (PPP), so reading this section as well as Section 9 would be useful and, we would hope, interesting. Within the public sector, fixed assets (such as land, buildings, IT, equipment, etc.) are an essential component in the provision of public services. Just a few examples will illustrate this:
l l l
defence buildings, weapon systems education schools, computers health hospitals, medical equipment, ambulances.
The acquisition of these fixed assets (sometimes referred to as capital formation) is undertaken in various ways and this section discusses the financing of capital formation in the public sector. Thus we look at:
l
the main means of financing capital formation in the public sector the use of private finance capital investment appraisal in the public sector.
l l
The section will take its examples primarily from the UK context because the theory and practice of publicprivate partnership is more highly developed in Britain than elsewhere the UK started earlier. But the concept is being considered and used in a number of countries, as is indicated in Box 10.1.
BOX 10.1 PFINANCIAL SERVICES

British firms are flogging PFI around the world, and the world is buying
STEPHEN HARRIS is a busy man. He works for International Financial Services, London formerly known as British Invisibles which promotes the export of City expertise. Last
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week he was in Switzerland, this week hes hosting the Estonians, next week its the Mauritians and the Danes. In fact, Mr Harris is talking to over 30 foreign governments. What is he talking about? The private finance initiative (PFI), which he hopes will be Britains most eye-catching invisible export since privatisation. Privatisation, said one of its early champions, is an ugly word for a beautiful concept. Governments could get shot of underperforming industries, pocket the proceeds and spread popular share-ownership at the same time. Having sold a bunch of Britains state-owned assets to the public, the Citys bankers, lawyers, accountants and consultants went on to sell the idea around the world, as far afield as Brazil and China. The private finance initiative is an ungainly term for a more subtle concept. Rather than selling off assets the government already owns, the PFI raises private finance for infrastructure projects bridges, hospitals, or prisons that dont yet exist. According to Tim Stone of KPMG, an accountancy firm, Britain is ten years ahead of everyone else in the delicate art of matching private money to public needs. Almost 500 PFI projects have been signed in Britain; nowhere else yet comes close. But the PFI is not universally loved in its country of origin. The British press and public either ignore it or lampoon it. The unions hate it. In the same week that Mr Harris meets the Estonians, UNISON, Britains biggest public sector union, is holding a conference accusing the PFI of Failing Our Future. What do the Estonians see in PFI that UNISON doesnt? Mr Stone thinks foreign governments are keen to learn from mistakes, as well as successes, in Britain. In particular, the British experience starkly illustrates the importance of getting the contract right. If the contract does not spell out who takes on the risks of a project, theyll usually end up in the governments lap. If the contract does not penalise bad service, then bad service is probably what youll get. On the other hand, if written well, a PFI contract can align the interests of the financiers backing the project with the interests of the public using the project. If poor service brings poor financial returns, it will be rooted out by ruthless financiers, not tolerated by sleepy bureaucrats. Some of Britains overseas clients have been quite innovative in spelling out what counts as good service. In South Africa, for example, the plan for the Gautrain rail link between Johannesburg and Pretoria includes clauses on black empowerment and local investment. Speaking from Uganda, Charles Morrison of the City law firm Denton Wilde Sapte argues that these new styles of procurement give poorer African governments, in Uganda, Ghana
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or Tanzania, the chance to decide for themselves what their needs are and how they should be met, rather than having their donors decide for them. For some overseas governments, PFI may have another, less noble, appeal. Mr Harris admits that some of his guests roll up thinking PFI is a way to get free infrastructure. Its certainly not that. As he and Mr Stone emphasise, the government pays for the services the infrastructure provides, and these payments, extending over 20 or 30 years, must be generous enough to attract private finance in the first place. Since private finance is usually more expensive than public finance, PFIs critics see it as a costly way for governments to shift borrowing off their books. If overseas governments do see PFI as a neat accounting trick, it will no doubt be a hit export, improving Britains invisible overseas trade. Whether it will visibly improve overseas infrastructure is another matter.
The Economist, 12 September 2002
A study by the Pharmaceutical R&D Policy Project of the London School of Economics shows that, as at December 2004, of the 63 neglected disease drug projects, 75% were part of publicprivate partnerships. In the 30 years up to 2005, only 13 drugs were developed for neglected tropical diseases, whereas the current increase in activity since 2000 has produced two new drugs already and there are 18 further products in clinical trials. The study demonstrated clearly that publicprivate partnerships are more effective in these circumstances than either the private or public sectors operating alone:
There is an urgent need to support the new model of neglecteddisease drug development, in particular the PPP approach, which is
already generating new drugs, is highly cost-effective, appears to
offer the highest health value, and is a crucial factor in continuing
cost-effective industry involvement in neglected-disease R&D.
(Moran et al., 2005)
Neglected diseases are usually maladies that primarily afflict poor countries and have relatively little impact on rich, Western populations. It is thus difficult for large drug companies to earn a market return on R&D expenditure targeted at such diseases so they tend to become neglected.
There is a link to the Moran et al. paper on the B821 website; if you have a particular interest in PPP methods or in health policy formation, you are likely to find reading the paper worthwhile.
10.1
MAIN MEANS OF FINANCING

PUBLIC-SECTOR CAPITAL
FORMATION
Public sector organisations (PSOs) can obtain fixed assets in a number of ways:
l l l
purchase leasing as part of a publicprivate partnership arrangements.

These approaches are briefly discussed below.
Purchase
PSOs may use direct purchase for much of their capital expenditure, typically using one of three main sources for the necessary funds: capital grants, accumulated cash balances or loans. With regard to the latter, borrowing will be discussed under leasing below, since for a public-sector (or voluntary-sector) body this method is often preferable to taking out a direct loan. In the course of undertaking its operational activities, a PSO will generally accumulate cash balances. These balances may be large or small depending on the size of the organisation and its level of financial performance. Such cash balances may be used, in part, to finance capital expenditure and are often referred to as internal finance. PSOs may receive capital funds in the form of grants from a number of organisations to finance capital expenditure. For example, Further Education Colleges might receive capital allocations from their funding council, or local authorities might receive capital grants from government departments. The key point to note is that there is no interest charge associated with grants and PSOs do not, in normal circumstances, have to make any repayments of the grant itself.
Leasing
Leasing for the public sector is essentially the same as for the private sector, i.e. operating and finance leases are treated differently for accounting and reporting purposes, as described in Section 8.1. However, there is often a considerable benefit to using leasing, for example, to a local government organisation. This is because such bodies usually have no regular, taxable surpluses, and so the deductible tax shields are likely to remain unused. It is frequently better for a profitable private sector company to purchase the required assets, use the tax-deductible amounts to shield their profits and then charge the PSO for the asset costs net of tax through lease payments. From the point of view of the government as a whole this is a zero-sum process the PSO saves at the expense of central governments corporate tax revenue but it can be an important cost saving at the organisational level.
Public private partnership arrangements

This involves public-sector capital expenditure being financed by private-sector organisations. The private finance initiative (PFI) has been a prominent means of financing public-sector capital expenditure since about 1995, though the scheme started in 1987. Basically it involves the private sector funding the creation of
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a fixed asset (such as a building) and leasing that asset back to the public-sector organisation along with the provision of other services. Publicprivate partnership (PPP) is an umbrella term to describe all forms of partnership, including but not restricted to PFI projects. The term publicprivate partnerships was developed to describe any types of partnerships between PSOs and the private sector. We will concentrate on PFIs in this section, but examples of other forms of PPP include:
l
Contracts between the Department of Health and private health providers to provide a range of elective surgery services to NHS patients at an agreed payment per case. Under this arrangement virtually all of the service provision (including doctors and nurses) would be provided by the private sector. Contracting-out of a wide range of support services (such as building maintenance, cleaning, security) to one private firm on a managed contract basis.
10.2
THE PRIVATE FINANCE INITIATIVE
Public services, in the United Kingdom and in most, if not all, countries in the world, often face service demands they cannot meet for want of infrastructure and/or facilities. As part of an attempt to alleviate this situation, many governments around the world are encouraging the use of private investment in services traditionally provided by the public sector. In the UK, this has been done through what is known as the Private Finance Initiative and more recently through the broader-in-scope publicprivate partnerships. PFI has been described officially as follows:
The reason for including both the Treasury and Health descriptions is that the former regards itself as the controller of government finance, whereas Health is a major spending department and capital user. Their two views of PFI are likely to be similar but not exactly congruent
By the Treasury
The Private Finance Initiative (PFI) is a small but important part of the Governments strategy for delivering high quality public services. In assessing where PFI is appropriate, the Governments approach is based on its commitment to efficiency, equity and accountability and on the Prime Ministers principles of public sector reform. PFI is only used where it can meet these requirements and deliver clear value for money without sacrificing the terms and conditions of staff. Where these conditions are met, PFI delivers a number of important benefits. By requiring the private sector to put its own capital at risk and to deliver clear levels of service to the public over the long term, PFI helps to deliver high quality public services and ensure that public assets are delivered on time and to budget
(Source: Treasury website, 2005, www.hm-treasury.gov.uk)
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By the Department of Health

The private finance initiative (PFI) provides a way of funding major capital investments, without immediate recourse to the public purse. Private consortia, usually involving large construction firms, are contracted to design, build, and in some cases manage new projects. Contracts typically last for 30 years, during which time the building is leased by a public authority
(Source: Department of Health website, 2005, www.dh.gov.uk)
Table 10.2
Department
Cabinet Office
UK PFIs by Department from 1987 to 2004

Number of signed projects
2 2 13 7 13 45 121 136 8 11 2 2 37 8 52 39 61 1 84 33 677
Capital value (m)

347.7 170.3 306.4 68.6 632.7 21,432.1 2922.8 4901.2 180.8 1341.0 91.0 189.0 1095.8 453.8 4254.8 528.8 972.1 10.0 2249.3 551.3 42,699.5
HM Customs and Excise Constitutional Affairs Culture, Media and Sport Environment, Food and Rural Affairs Transport Education and Skills Health Trade and Industry Work and Pensions Foreign and Commonwealth Office HM Treasury Home Office Inland Revenue Defence Northern Ireland Office of the Deputy Prime Minister Office of Government Commerce Scotland Wales Total
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Between 1987 and 2004 there were 677 PFI projects set up in the UK, representing a capital value of approximately 42.7bn. In Table 10.2 and Figure 10.1 you can see the breakdown of the total by government department and by year. The Departments of Health and Education signed the most deals, but the average value of projects was much higher for Transport and Defence. Also, it is worth noting that while the number of projects signed peaked in 2000, by capital value 2003 was much greater; this indicates that the size of PFI projects can vary greatly the process is not restricted either to small or to very large capital projects.
120 No. of signed projects 100 Capital value (bn)
80
60
40
20
0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 n/a
Figure 10.1
UK PFIs: number and value by year
In its simplest form, PFI involves a PSO contracting with privatesector organisations for the provision of two main types of service:
l l
the provision of certain fixed assets (e.g. buildings, equipment) the provision of certain services.
It should be noticed that under PFI, it is not permissible for the private-sector organisations to merely finance the construction of a new building and to provide and lease that building back to the PSO. As a major borrower of funds, HM Treasury should always be able to obtain capital finance at a lower rate of interest than a commercial organisation. Hence it would be uneconomic for the private sector to borrow funds (at a higher rate to HM Treasury) and then to pass on these financing costs (via the lease payment) to the PSO when conventional financing routes should have proved better. Thus a typical PFI project will be based on what is termed DBFO, which stands for design, build, finance and operate, or BOT, which is build, operate and transfer. The main difference between
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the two is whether at the end of the PFI period the assets are kept by the private-sector partner or passed over to the public sector. For example, an infrastructure project such as a motorway or bridge would almost certainly be transferred to the state (so BOT), but an office building might well not (and would thus be a DBFO contract). Under a PFI project the division of responsibility between the PSO and the private sector partner will typically be as follows:
l
Private-sector partner: design new building

build new building
finance construction of new building
operate new building (in terms of maintenance, cleaning,
security, etc.).
Public-sector organisation: provide services use new building employ core staff.
To illustrate this division of responsibilities, let us take the example of a new hospital being constructed under the PFI arrangement. Under PFI the arrangements would be as follows:
l
Private-sector partner: design new hospital in accordance with brief provided by NHS Trust build new hospital
finance construction of new hospital
operate new hospital (in terms of maintenance, cleaning,
security, etc.).
NHS Trust: provide health services use new hospital building employ core staff such as doctors and nurses who work in the new hospital.
Under this arrangement, the NHS Trust would make payments to the private-sector partner to cover both the costs of leasing the building and for the provision of services such as maintenance and cleaning.
ACTIVITY 10.1
Watch Video Programme, Public project, private finance and PF1: The Story Continues, and link the events taking place to the theory and practice described in this section of the unit.
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10.3
EVALUATING PFI PROJECTS
The objectives of the PFI system can be considered in both micro- and macro-economic terms.
Micro-economic objectives
These objectives, put forward by governments, concern:
l
Value for money an objective of PFI is to improve the value for money with which public resources are used to deliver public services. At the outset this may seem odd since it is often argued that using the private sector to construct buildings, provide services, and so on, must result in lower value for money since the private sector has to generate a profit and rate of return which the equivalent service provider in the public sector does not. However, governments have argued that improved value for money can be achieved since the private sector can bring improved management approaches to publicsector projects which will result in improvements in efficiency. Other may argue that this is little more than code for the private sector reducing the wage rates of already low paid public-sector workers. Also, it has been argued that specialist private-sector providers can bring added value to projects through innovation, notably in design and quality of service. Risk transfer another key objective of PFI is the transfer of certain risks from the PSO to the private-sector provider. Certain risks such as volumes of service provision are unlikely to be accepted by the private sector but two examples of where risk transfer can take place are: Often PSOs perform badly in controlling the capital costs of buildings projects and there are plenty of examples of large overspends on buildings projects. Under PFI, the risks of such overspends are transferred to the private-sector partner. Some of the long-term operating risks, such as higher maintenance costs for the facility or a less than predicted working life, can be transferred to the private-sector company which may be obliged to hand back the facility in working condition at the end of the (perhaps 25-year) contract.
However, the transfer of the risk means that the annual expected cost to the public purse is higher than if the services were provided by the public sector.
Macro-economic objectives
In the UK, the economic policy has made government protective of limits on the Public Sector Net Cash Requirement (PSNCR). Consequently, it is keen to reduce the impact of public sector
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capital formation on the PSNCR by shifting the burden of capital expenditure to the private sector. Although the public sector still has to pay lease charges, the effects of PFI are that those costs are spread over a period of years and shifted many years into the future. Thus, the potential downside of the PFI is that the public sector may find itself gaining access to capital funding in the short term only by committing to pay out increasingly large shares of future revenue streams in the long term. In considering whether to proceed with a PFI project, it is usually the case that PSOs also have to prepare a public-sector comparator. This is the same project but financed through conventional financing means involving the provision of public-sector finance. In assessing the PFI project against the public sector comparator, PSOs will need to consider the following issues:
l
Value for money (VFM) the PFI project must be shown to give better value for money in the use of public resources that the public-sector comparator. Risk transfer the PFI project must be shown to involve a significant transfer of risk from the public sector to the private partner. Affordability the PFI project must be shown to be affordable by the PSO in the longer term.
Approaches to investment appraisal in the public sector often fall into two main types: financial and economic appraisal. Financial appraisal practices in the public sector are broadly equivalent to practices in the private sector. Financial projections have to be made of costs and revenues of projects and calculations of NPV have to be made. However, unlike the private sector where the discount rate to be used would have to be made by the organisation using an approach such as WACC, in the public sector the discount rate is laid down by HM Treasury and is to be used by all PSOs for appraisal purposes. In the public sector, goods and services are provided primarily to meet the needs of the population and not just for commercial purposes. Consequently, the economic appraisal process in PSOs often has to look beyond the purely commercial issues of profitability, cash flow, rate of return, and so on, and into broader issues such as the costs and benefits to the population. This is the province of economic appraisal. An example of this was shown in the video when discussing the Altcourse Prison case. The PFI route gave an NPV of 247m cost to the government (financial appraisal), compared with 249.5m for a public-sector project.
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ACTIVITY 10.2
Do you think the Altcourse project decision could be made on the basis of the NPV figure? The figures differ by almost exactly 1%, which, considering the uncertainties inherent in a 25-year project, would normally be regarded as insignificant and thus not appropriate as a decision-making criterion. However, the PFI rules require that the PFI project be better value for money than the public-sector route. For the prison project a realistic view might be that it was too close to call between private and public, but the figures allowed the requirement to be met. It is important to note that this is not implying that the Altcourse PFI should not have proceeded, just that the VFM criterion (as demonstrated by the NPV figures alone) was not the appropriate one to use for a decision in this case. For example, risk transfer and affordability were probably dominant in the deliberations. In other words, economic appraisal was probably more important in the Altcourse decision, since financial appraisal did not give a clear indication.
Potential private-sector consortia or contractors will appraise each PFI project using capital budgeting, as discussed in the earlier parts of this unit. However, the finance for a PFI project will usually be specific to the project and not provided from general resources available to the companies in the consortium. This is why banks are usually included in the bidding consortium and why privatesector firms treat investment in PFI projects as a type of project financing. The PFI projects costs and benefits are ring-fenced (separate and independent from the contractors main business) and often a separate profit centre or division is created entirely devoted to funding and operating the facility for the length of the contract. However, contractors must take into account a number of specific questions:
l l
Is finance available at the usual rates of interest? Is there a stable government policy environment in which the contractors can plan? What are the degrees of certainty, in the form of guarantees, especially to the revenue streams if they are vulnerable to the changing policy decisions of the public-sector user of the project?
In addition to these questions, PFI projects are subject to a range of risks affecting all capital projects, and even with the most sophisticated forecasting procedures it is impossible to anticipate the outcome of future events. The range of risks includes such items as design problems, variation in operating costs, volume
changes over time, residual value and early cessation of the project. The probability, and the costs, of the risks must be ascertained by the bidding consortium and form part of their PFI project investment appraisal processes. Some private-sector organisations are discouraged from bidding because of the time it takes to put a PFI deal together. For larger projects this bidding process can take well over a year. Accordingly, staff costs for those involved with the project analysis and negotiation procedures can be substantial. In Video Programme 1, Dawn Stephenson, the Finance Director at the Calderdale Healthcare NHS Trust, refers to the lengthy discussions and timeconsuming negotiations which took place before the PFI deal was concluded.
If you want to read more about the detail of the PFI contracting process (perhaps you are involved in an actual or potential transaction, from either the public or private sector standpoint), there are links and files on the B821 website.
In order to deliver a PFI solution to a particular funding problem, a complex process needs to be undertaken. The PSO will have to determine exactly what the project is to be and state the timescales for completion.
Advantages and disadvantages of PFI projects

There is a considerable degree of controversy concerning the advantages and disadvantages of the PFI as a means of providing fixed assets and services for the public sector. Proponents of the PFI will argue that:
l l l
PFI gives better value for money PFI projects are completed on time and within cost budget PFI projects provide greater innovation in the delivery of public services PFI projects ensure better management of public services through the introduction of private sector management in certain areas. PFI projects do not give better value for money since private organisations have to incorporate a profit element into their cost structure which cannot be recovered through greater efficiency, etc. PFI project evaluations are unsound since the results have been manipulated by public-sector managers who are aware that if the PFI scheme does not go ahead there will be no alternative public funding PFI is merely passing the costs of public-sector assets to future generations of taxpayers.
Opponents of PFI will argue that:

l
It is very difficult to draw clear conclusions about PFI projects due to a combination of lack of solid evidence, obfuscation and the political sensitivity of some of the projects. To conclude your look at PFI, you will read a short piece describing the Treasurys view as at mid-2003, given in Box 10.2. It sums up well many of the key concerns about the PFI system.
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BOX 10.2 ONE STEP BACK

The Treasury admits to problems with the PFI
At Labours party conference in Blackpool last autumn, there was an exciting bust-up over a boring-sounding issue: the private finance initiative. Ministers fought with trade-union leaders calling for an independent review of this method of funding public investment. Tony Blair and Gordon Brown lost the vote but declared it made no difference: PFI was here to stay. But just before Parliament rose for the summer recess, the Treasury quietly delivered its own review and made some important concessions. Under PFI, the government no longer finances and builds new public investments like roads and hospitals. Instead it gets the private sector to raise the cash, build the thing and maintain it afterwards. Instead of paying for the investment up front, the public sector repays private firms over a long period, typically 25 years. The capital value of PFI deals has recently shot up because the contracts to renovate the London underground have finally been signed. This investment will be spread over several years. Since 1997, actual investment through PFI schemes has accounted for about a third of total net investment in the public services. The unions oppose PFI because they suspect the government is using it as a way of getting the private sector more involved in public services. But since the Labour Party conference the government has imposed more restrictions on how private firms can treat staff working on contracts with the public sector. The Treasury now says that staff in soft services like catering and security do not have to be transferred to the private sector in PFI projects. This extends a concession already made in the health service. But the big question about PFI is whether it really offers value for money. The government argues that the higher costs of private borrowing are outweighed by the transfer of risk, preventing expensive construction overruns and maintenance bills. But critics doubt that much risk is really transferred to the private sector and worry about whether the way PFI bids are compared with conventional procurement methods is fair. The Treasury finds that most PFI projects have been delivered on time a welcome improvement on the delays that used to occur with public investment. But it accepts that it needs to reform the way PFI is compared with public-sector alternatives. It also concedes that PFI does not work for information-technology
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projects because IT changes so fast that it is difficult to specify long-term contracts. And the government will no longer generally use PFI for projects costing less than GBP20m because they take too long to procure and bidding costs are too high. But small projects represent only a small share of the value of all PFI deals. The Treasury is standing firm on the big stuff the infrastructure projects in transport, defence, health and education. The report argues that PFI brings substantial benefits in big, complex capital schemes where the private sector can offer project-management skills, innovative design and expertise in risk management. This doesnt satisfy many of its critics, however: they point out that earlier studies have suggested that PFI, while delivering genuine value for money for prisons and roads, has delivered only marginal gains for new hospitals and schools. The suspicion remains that the Treasury has an ulterior motive in backing PFI for big projects as a device to get borrowing off the books. If the government had procured this years PFI investment conventionally, public-sector net borrowing already forecast in the budget at 2.5% of GDP would instead be about 3%. Would the Treasury be so enthusiastic about PFI if it did not flatter the public finances?
The Economist, 24 July 2003
SUMMARY
Publicprivate partnerships are an important if sometimes controversial financial tool in modern finance. Given the size of the public sector in most Western countries, and its responsibility for infra-structure and services, it is quite likely that you will at some time in your career become involved with a PPP or PFI project, from either the public- or private-sector standpoint. It is thus appropriate to consider the topic in this course. In this section we have looked mainly at PFI but also noted that such projects are a sub-set of PPP, but it is the key type when considering capital formation (as opposed to contracting for services only). Key factors involved in PFI processes include:
l
PFI or equivalent systems have raised 43bn in the UK, and are becoming increasingly popular in other countries. Projects must involve both provision of capital formation and continuing services. Judgement criteria include: value for money, risk transfer, affordability. These can be extremely difficult to assess accurately, particularly due to the typical length of contracts (e.g the Altcourse PFI is for 25 years).
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Politics as well as economic/financial factors are likely to need to be included in the deliberations. Contracting for and then measuring performance are necessarily very detailed and can become highly complex. As was seen with the Calderdale hospital case, PFI may be the only feasible way of obtaining necessary public services.
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SUMMARY AND CONCLUSIONS

In this unit, we have attempted to introduce you to many aspects of capital investment decision-making. Although you may have acquired a knowledge of some of the topics in your previous studies, we tried to amalgamate the wide range of theories and issues which underpin the subject of CAPEX. Organisational strategy appears to be the skeleton on which the whole process of capital decision-making is based, in that a stated or implied mission statement drives the needs for the investment in capital facilities. We then narrowed our discussion to the techniques of investment appraisal, by examining capital budgeting theories, their strengths and weaknesses. The examination of specific appraisal issues explained some of the underlying theoretical inconsistencies in the application of DCF techniques. Inflation and taxation were examined only in so far as they are linked to CAPEX, because in reality these subjects are too comprehensive to be discussed in their entirety in this course. Due to the fact that many organisations have operations in a number of countries, we looked at CAPEX processes within the international environment. We discussed risk issues in the capital expenditure context, since expenditure in long-term projects inevitably involves risks. We also explored the options approach to capital investment, which is a relatively novel approach to the process of CAPEX decision-making. This development is a valuable tool enabling organisations to manage risk. We considered the funding of capital projects and the importance of the financing decision on the overall capital structure, building on the issues described in Unit 4. Leasing is an important finance mechanism for a range of plant and equipment investments, and the description and examples have hopefully added to your understanding of this subject. You then were given a choice of routes through Sections 9 and 10. The former was aimed primarily at those in the private sector and the latter was intended mainly for students from the public sector but, if you had time, reading both was encouraged just because one or the other is at present of greater concern to you does not preclude the possibility that this might change in the future! Project finance was discussed in some depth in Section 9, as this type of financing vehicle is becoming increasingly popular as a method for funding large capital projects, such as power stations, oil refineries, etc. The opportunities and complexities of project finance were described in a case study illustrating the investment in a liquid gas facility in Oman. For those of you more interested in public-sector finance, in Section 10 we introduced and explained the Private Finance Initiative (PFI) and publicprivate partnerships (PPP), which is providing public-sector organisations in the UK with a means of
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SUMMARY AND CONCLUSIONS
tapping into private-sector financial resources for funding their projects. You should now have achieved the following learning objectives and should:
l
appreciate how organisations implement their capital appraisal procedures recognise the wide range of issues involved in capital investment decisions assess the strategic implications of investing in capital equipment and facilities be able to apply a range of project appraisal methods to various types of projects and organisations in which CAPEX decisions are made appreciate the importance of, and the problems of identifying and measuring, risk in the context of capital investment decision-making understand the problems and opportunities of raising funds for capital projects in the market-place, either through project finance (private sector) or publicprivate partnership (public sector) be able to undertake an investment appraisal exercise.
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ANSWERS TO EXERCISES
EXERCISE 3.1
From Unit 1 we know that: (1 + R) = (1 + r)(1 + Expected inflation rate) where R = nominal interest rate r = real interest rate In this example, R = 5% and r = 1.5%, so Expected inflation rate =
1.05 1 = 0.034 or 3.4% 1.015
If nominal sales growth is assumed to be 6.5% per year, and expected inflation is 3.4%, we can say: (1 + Nominal growth rate) = (1 + Real growth rate) (1 + Expected inflation rate) 1.065 = (1 + g) 6 1.034 g=
1.065 1 1.034
= 3.0% So, although nominal sales growth looks good, the projected sales growth in real terms (which will more closely indicate growth in volume) is less than half the headline vote.
EXERCISE 5.1
The weighted average beta estimate for housebuilding, weighted by market capitalisation is 1.18, since b= =
(1.19 610) + (1.12 347) + (1.17 71) + (1.20 511) + (1.21 82) 7 + 71 + 511 + 82 610 + 347
1910.03 1621
= 1.18 However, the equivalent weighted average debt/equity ratio for the sector might be different from that of Chiragdin and the beta would have to be adjusted accordingly as we will see next.
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ANSWERS TO EXERCISES
EXERCISE 5.2
The weighted average debt/equity ratio is 7.2%, since Debt/equity ratio =
(4.3 610 ) + (11.7 347) + (25.3 71) + (4.9 511) + ( 8.5 82) 1 + 511 + 82 610 + 347 + 71 11680.1 = 1621
= 7.206% From Exercise 5.1, the housebuilding equity beta is 1.18. Thus: basset = (1 0.07206) 6 1.18 = 1.0934 Using the asset beta of housebuilders and the gearing of the property division of Chiragdin, we can find the appropriate equity beta for housebuilding for Chiragdin: 1.0934 = bCHI 6 0.75 bCHI = 1.0934/0.75 = 1.46 The equity beta for housebuilding for Chiragdin, at 1.46, is higher than for its competitors since it chooses to have a higher debt/equity ratio. If we assume, as before, a risk-free rate of 7.5% and an expected equity risk premium of 5.5%, this gives a cost of equity for housebuilding of 7.5% + 1.46 6 5.5% = 15.5%. Substituting in the WACC equation, with a cost of debt of 9.0%, and assuming a 25% debt/equity ratio and a corporate tax rate of 30% gives a WACC for housebuilding of 9.0% 6 (1 0.3) 6 25% + 15.5% 6 75% = 13.2%.
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EXERCISE 6.1
State
Probability
0.1 0.3 0.6 6 6 6
NPV ()
+769.4 +476.3 291.5 = = = ENPV
()
+76.9 +142.9 174.9 +44.9
The Paraiso project is still worthwhile under the changed probability assumptions, which are probably a worst case assessment of the probabilities.
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REFERENCES
REFERENCES
Brealey, R.A. and Myers, S.C. (1996) Principles of Corporate Finance, New york, McGraw Hill Buckley, A. (1998) International Capital Budgeting, Prentice Hall. Craig, D. and Willmott, P. (2005) Outsourcing grows up, The McKinsey Quarterly, February [web only www.mckinseyquarterly. com, accessed 24 October 2005]. Graham, J.R. and Harvey, C.R. (2002) How do CFOs make capital budgeting and capital structure decisions?, Journal of Applied Corporate Finance vol. 15, no. 1, pp. 823. Gregory, A. and Rutterford, J. (1998) The Cost of Capital, monograph, Chartered Institute of Management Accountants. Ho, S.M. and Pike, R.H. (1991) The use of risk analysis techniques in capital investment appraisal, Accounting and Business Research, vol. 21, no. 83, pp. 22738. Lumby, S. and Jones, C. (2000) The Fundamentals of Investment Appraisal, Thomson Learning. McIvor, R. (2000) Strategic outsourcing: lessons from a systems integrator, Business Strategy Review, vol. 11, issue 3, pp. 4150. Moran, M., Ropars, A.-L., Guzman, J., Diaz, J. and Garrison, C. (2005) The New Landscape of Neglected Disease Drug Development, The Wellcome Trust. Nevitt, P.K. and Fabozzi, F.J. (1996), Project Finance, Euromoney Publications. Northcott, D. (1992) Capital Investment Decision Making, Academic Press. Payne, D.J., Heath, W.C. and Gale, L.R. (1999) Comparative financial practice in the US and Canada: capital budgeting and risk assessment techniques, Financial Practice and Education, SpringSummer, pp. 1624. Pike, R. (1996) A longitudinal survey on capital budgeting practices, Journal of Business Finance and Accounting, vol. 23, no. 1, pp. 7992. Porter, M.E. (1985) Competitive Strategy: Creating and Sustaining Superior Performance, New york. The Free Press. Samuels, J.M., Wilkes, F.M. and Brayshaw R.E. (1995) (eds) Management of Company Finance, Thomson Learning. Wilkes, F.M., Samuels, J.M. and Greenfield, S.M. (1996) Investment decision making in UK manufacturing industry, Management Decision, no. 4, pp. 6271.
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ACKNOWLEDGEMENTS
Grateful acknowledgement is made to the following sources:
Text
Box 2.1: Merchant, K., Siemens to invest $500m in Indian export hub, Biznews, 10 February 2005, # Financial Times; Box 3.1: Newman, M., Marks & Spencer tax dispute may force EU states to change rules, http://quote.bloomberg.com/apps/news? pid=10000080&sid=avd9zRiBwrLg, Bloomberg L.P.; Box 4.2: Merchant, K., Laitner, S. and Waters, R., ABN Amro in E1.8bn Indian IT deal support services, Financial Times, 2 September 2005, # Financial Times; Box 5.1: Martin, P., Always expect the unexpected: Enrons collapse should remind us that no accounting or valuation technique can disguise the inherent riskiness of business, Financial Times, 29 January 2002, # Financial Times; Box 10.1: PFInancial services, # The Economist Newspaper Limited, London 12 September 2002; Box 10.2: The Treasury admits to problems with PFI, # The Economist Newspaper Limited, London 26 July 2003.
Figures
Figure 1.1: Northcott, D. (1992) A universal model of the CI decision-making activity?, Capital Investment Decision Making, International Thomson Publishing Services; Figures 2.1 and 2.2: The World Bank, Project Cycle, http://web.worldbank.org/ WBSITE/EXTERNAL/PROJECTS/0,,contentMDK:20120731~menuPK: 41390~pagePK:41367~piPK:51533~theSitePK:40941,00.html, The World Bank Group; Figure 6.1: Graham, J.R. and Harvey, C.R., How do CFOs make capital budgeting and capital structure decisions?, Journal of Applied Corporate Finance, vol. 15, no. 1 (2002), Blackwell Publishing Limited.
Illustrations
Page 77: ALB, International Freighting Weekly, 20 August 1987; Page 79: # Shell International UK. Every effort has been made to contact copyright holders. If any have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the first opportunity.
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B821 Financial Strategy Block 3 Finance and Investment

Holistic: tending to produce wholes from the grouping of structures.

UNIT 5 PROJECT APPRAISAL

Feedback/ post-audit Financial analysis

UNIT 5 PROJECT APPRAISAL

AIMS AND OBJECTIVES OF THE UNIT

2 STRATEGY AND INVESTMENT APPRAISAL

STRATEGY AND INVESTMENT APPRAISAL

UNIT 5 PROJECT APPRAISAL

Country Assistance Strategy

Negotiations and Board approval

World Bank: The Project Cycle

Country Assistance Strategy

World Bank: The Project Cycle

2 STRATEGY AND INVESTMENT APPRAISAL

STRATEGIC INVESTMENT PROCESS

UNIT 5 PROJECT APPRAISAL

Strategic options Preparation

Capital investment proposal

Implementation Implementation Post-implementation

Strategic investment authorisation procedures

2 STRATEGY AND INVESTMENT APPRAISAL

UNIT 5 PROJECT APPRAISAL

BOX 2.1 SIEMENS TO INVEST $500M IN INDIAN EXPORT HUB

2 STRATEGY AND INVESTMENT APPRAISAL

UNIT 5 PROJECT APPRAISAL

Capital investment proposal headings

Executive summary Project definition Strategic plan

Marketing plan Production plan

Implementation issues External and internal assumptions Financial projections

2 STRATEGY AND INVESTMENT APPRAISAL

UNIT 5 PROJECT APPRAISAL

3 ISSUES IN CAPITAL BUDGETING

ISSUES IN CAPITAL BUDGETING

UNIT 5 PROJECT APPRAISAL

3 ISSUES IN CAPITAL BUDGETING

ISSUES IN APPRAISAL TECHNIQUES

UNIT 5 PROJECT APPRAISAL

CASH FLOWS OR ACCOUNTING FLOWS?

3 ISSUES IN CAPITAL BUDGETING

Robert Teal Scenario 1

Year 1 Year 2 Year 3 Year 4 Cumulative

Net cash flow

Income statement projections

(3,750) (3,000) (6,750)

(3,750) (3,000) (6,750)

(3,750) (3,000) (6,750)

(3,750) (3,000) (6,750)

(15,000) (12,000) (27,000)

UNIT 5 PROJECT APPRAISAL

Robert Teal Scenario 2

Year 1 Year 2 Year 3 Year 4

Net cash flow

Income statement projections

3 ISSUES IN CAPITAL BUDGETING

Year 1 Year 2 Year 3 Year 4 Cumulative

(3,000) (3,000) (3,000)

(15,000) (4,800) (4,800) (6,600) (10,200)

Net cash flow

Income statement projections

(1,800) (1,800) (3,600) 4,200 4,200 8,400

(3,750) (3,750) (3,750) (3,000) (3,000) (3,000) (6,750) (6,750) (6,750)

(3,750) (3,000) (6,750)

(15,000) (12,000) (27,000)