Modulus e-Books: Evaluation of Capital Projects - Introduction

All organisations, large and small, are faced with the challenge of how to evaluate investment proposals and, in particular, how to choose the best portfolio of proposals to maximize their stakeholder benefits. The practices for evaluation of investment proposals have been steadily developed over time and are readily understood and implemented, at a level of detail appropriate for each organization. However, it is fair to say that even large organisations with sophisticated budgetary and evaluation disciplines are often disappointed with the outcome of investment decisions. In the long term, the average rates of return to shareholders tends to be lower than that which could be inferred from the promises of the investment proposals which the organisation has approved over the years. The identification and management of risk associated with these proposals has lagged significantly behind the mechanistic process of evaluation and portfolio optimisation.

Modulus e-Books: Evaluation of Capital Projects - Investment Proposal Evaluation

Present Value of Money

We place a different value on disposable money (or other, equivalent assets) we have now as more valuable than money we might receive in the future. Thus we consider $100 we have now as more valuable than, say, a promise to pay $100 in the future. There are a number of reasons for this, including:

• money available now provides us with options which we can exercise now, e.g. we can invest the money in long term or short term investments, or spend it on current needs, or put it under the mattress.
• a promise of money in the future may not be kept, i.e. there is a risk associated with that promise.
• our own circumstances may have change when a future promise comes due, resulting in the value of that future promise being devalued (this is a euphemism for "We may be dead...").
• the economic environment may change such that, when a promise comes due, the value of the money promised is quite different than our current perception of it.

We can express our preference for money now rather than a promise to pay by way of a discount rate...

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Discounted Cash Flow Analysis

Discounted Cash Flow (DCF) analysis is one the key techniques used for evaluating capital proposals, or, indeed, for evaluating any series of cash flows which are spread out over time. The analysis proceeds by laying out all of the cash flows to be considered over time and then discounting them by the appropriate discount indices such that they are brought to present day value equivalence, and then summing the result to give a Net Present Value for the project. There is nothing complex about the analysis; indeed the mathematics are very simple, However, determining the correct parameters and cash flows to plug in to the analysis can be quite challenging in itself.

The Analysis Method

The analysis is performed by a series of steps; we will first outline and illustrate those steps and then turn to a more detailed analysis of each of the steps.

Step 1: Establish the Operating Period

Each DCF Analysis is performed over a particular operating period, representing that time period in which we can reliably expect the investment to generate returns.

Step 2: Determine Evaluation Parameters

Once the operating period is determined, the evaluation parameters can be determined. The key parameters are the reference discount rate (a single percentage figure), the inflation indices (at least a set of indices for general inflation to be applied over the project duration, i.e. the construction time plus the operating period), the tax rate and tax timing. These evaluation parameters are (generally) independent of the project and may already have been established as part of corporate policy.

Step 3: Identify the Cash Flows

The next step is to identify the cash flows which will result from the project decision. Essentially, this is the determination of what would change as a result of undertaking the project. To state the converse, there is no need to model or include cash flows which will be unaffected by the decision to proceed with the project. The principal cash flows usually fall into four general categories, viz:

1. Costs associated with constructing, commissioning and initial promotion of the project. These costs (or a large proportion of them) are typically accounted for as capital investment.
2. Working capital increases or decreases occasioned by the project.
3. Ongoing income generated by the project over the operating period.
4. Ongoing operational costs of the project over the operating period.
5. Residual value of the project, including provision for de-commissioning costs.
6. Tax effects resulting from the above cost categories (although these are best calculated later).

Step 4: Sequence the Cash Flows Over Time

With the cash flows determined, the timing sequence of these cash flows can now be laid out over time.

Step 5: Apply Indices

Now that the cash flows are sequenced in Real Terms (i.e. current) values, the next thing is to apply the appropriate inflationary indices to each of these cash flows in their year of occurrence. The result will be a Money-of-the-Day (MOD) cash flow model.

Step 6: Calculate the Tax Effects and Consequent Cash Flows

As the taxation effect cash flows require depreciation calculations and also recognition of the tax timing for the organisation, this is best treated as a separate step.

Step 7: Discount the Cash Flow for General Inflation

We now reduce the cash flows to Real Terms by discounting them by inflation indices established at step 2. Regardless of what indices were used to inflate the figures to Money-of-the-Day (e.g. construction indices, energy price indices) the discounting is performed using the general inflation indices, which are quite commonly set equal to predictions for the Consumer Price Index. The result is a cash flow reduced to Real Terms.

Step 8: Discount the Cash Flow for Interest

Next, we discount the Real Terms cash flow in each year by an appropriate index calculated from the Reference Discount Rate for our organisation, which is likely to be the Average Weighted Cost of Capital for our organisation (or some arbitrarily higher figure).

Step 9: Determine the Net Present Value

The sum of the Discounted Real Terms cash flows over time forms the Net Present Value of the project at the Reference Discount Rate. This figure can be seen as a value representing the expected incremental value of the project to the organisation, having taken into account the timeliness of the cash flows and the environment within which the organisation operates

Detail for Step 1: Establish the Operating Period

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Portfolio Optimisation

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Dealing with Uncertainty

Uncertain Estimates

Most of the estimates for cash flows that go into a discounted cash flow model are uncertain, i.e. there is an amount of variation likely to be experienced in practice when the cash flows are actually realized. This arises because estimating is difficult and projecting the future is even more so.

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Uncertain Environments

Investments do not take place in static environments. In fact, the very nature of investment (returns realized over a period of time) dictates that the environment hosting the investment will change. Thus the analysis of an investment proposal requires a projection of the future operating environment to be made. Many tools are available to assist in making such projections, and some of these are discussed in the appendix "Resources". When economic conditions are relatively stable, making consistent projections of the environment is not especially difficult; most environmental variables affecting investment proposals are similar to, and derived from, their prior values. For example, a graph of Australian Standard Variable Mortgage rate for the last 50 years looks like this:

As can be seen, even though the values over time vary from 5% to 17%, each individual value is strongly related to the several years preceding it. Even during the sharpest drop off from 1990 to 1994, each year's value was closely related to the preceding year's value. This degree of predictability does not, however, usually apply when there are major disruptions. In the 50-year period covered by the graph above, there were no major, global discontinuities. In particular, the political system in Australia was essentially stable (a two-part democracy with continuous elections), there were no global wars in the period and the only serious global political shift, the disintegration of the USSR, had few economic implications for Australia.

Scenario Planning

One approach to the management of risk arising from uncertain environments is the approach referred to as scenario planning. Scenario planning is performed by developing two or more separate scenarios for the development of the investment environment. These scenarios are developed independently of any investment proposals which might be under consideration and are used to aid in the assessment of risk

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Monte-Carlo Simulation

One well-established technique for dealing with compound uncertainties in called Monte Carlo Simulation. As the name suggests, there is an element of chance involved. While we can test individual cash flow items of a project readily, this fails to answer the important question of how the various uncertainties of each part of the project might interact when they occur together. Obviously, we could test the worst-of-all-cases scenario (i.e. when the construction cost is 20% higher than the base estimate, the market share gained is 30% less than estimated and margins fall way by 10% etc.) but this does not inform us as to how probable such a disastrous outcome is ...

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Capital Budgeting

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Post Implementation Review

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Problems with Discounted Cash Flow Based Methods

The techniques discussed in this book are not without some problems, and certainly not without their critics. Some of the more rational criticisms are discussed here, although I admit to discarding trivial criticisms such as "excess complexity"; if you can multiply, it isn't complex. In our view, none of these problems or criticisms comes close to invalidating DCF techniques. However, consideration of the criticisms may help you to identify projects that need special treatment due to their characteristics.

Difficulty of Determining Cost of Equity

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Modulus e-Books: Evaluation of Capital Projects - Where Next?

The complete series of Business Process Management e-books is as follows:

• "Business Process Management Overview" (the grey book)
• "Generating & Selecting KPI Sets" (the blue book)
• "Implementation Guide for Service Level Agreements" (the plum book)
• "Identifying, Documenting & Analysing Processes" (the teal book)
• "Selecting & Implementing Internal Controls" (the red book)
• "Good Practice for Commercial Website Design" (the saffron book)

The series is available at the following website:
http://www.modulus.com.au/

Modulus provides tools, applications and services to consultancies and website developers.
For more information contact Peter Hill, peter.hill@modulus.com.au .