Capital Budgeting Financial Appraisal of Investment Projects

Contents......Page 3
1 Capital budgeting: an overview......Page 10
Study objectives......Page 11
Shareholder wealth maximization and net present value......Page 12
Classification of investment projects......Page 13
Strategic planning......Page 14
Preliminary screening of projects......Page 15
Qualitative factors in project evaluation......Page 16
Post-implementation audit......Page 17
Organization of the book......Page 18
Concluding comments......Page 19
Review questions......Page 20
2 Project cash flows......Page 21
Principle of the stand-alone project......Page 23
Example 2.1......Page 24
Sunk costs......Page 25
Overhead costs......Page 26
After-tax cash flows......Page 27
Treatment of depreciation......Page 28
Financing flows......Page 29
Within-year timing of cash flows......Page 30
Inflation and consistent treatment of cash flows and discount rates......Page 31
Asset expansion project cash flows......Page 32
Net operating cash flows......Page 33
Terminal cash flow......Page 34
Recovery of working capital......Page 35
The proposal......Page 36
Delta Project: cash flow analysis......Page 38
Incremental operating cash flows......Page 40
Example 2.4. The Repco Replacement Investment Project......Page 41
Concluding comments......Page 43
Review questions......Page 44
3 Forecasting cash flows: quantitative techniques and routes......Page 46
Forecasting with regression analysis......Page 48
The two-variable regression model......Page 49
The multiple regression model......Page 51
Forecasting using regression results......Page 52
Forecasting using smoothing models......Page 54
Simple moving average......Page 55
Exponential smoothing......Page 57
More complex time series forecasting methods......Page 58
Forecasting by the top-down route......Page 60
Concluding comments......Page 61
Review questions......Page 62
4 Forecasting cash flows: qualitative or judgemental techniques......Page 64
Conducting a survey......Page 65
The sales force composite method......Page 68
Using groups to make forecasts......Page 69
The Delphi method......Page 70
Other group techniques......Page 72
A simple model for appraising forestry investment......Page 73
Example 4.1. Appraising forestry projects involving new species......Page 74
Example 4.2. Collecting data for forestry projects involving new planting systems......Page 75
Scenario projection......Page 78
Example 4.3. Using scenario projection to forecast demand......Page 79
Which method provides the most reliable estimates?......Page 80
Which method to choose?......Page 81
Review questions......Page 82
5 Essential formulae in project appraisal......Page 83
Symbols used......Page 84
Note on timing and timing symbols......Page 85
Example 5.2......Page 86
Example 5.4......Page 87
Example 5.6......Page 88
Example 5.8......Page 89
Present value of an ordinary annuity......Page 90
A note on financial tables......Page 91
Example 5.12......Page 92
Perpetuity......Page 93
Net present value of an infinite chain......Page 94
Example 5.14......Page 95
Example 5.15......Page 96
Concluding comments......Page 98
Review questions......Page 99
6 Project analysis under certainty......Page 100
Certainty Assumption......Page 101
Net present value model......Page 102
The net present value model applied......Page 104
Accounting rate of return......Page 105
Net present value......Page 106
Internal rate of return......Page 107
Payback period......Page 109
Accounting rate of return......Page 110
Mutual exclusivity and project ranking......Page 111
Projects with cash flow timing pattern disparities......Page 112
Projects with unequal lives......Page 113
Replacement chains......Page 114
Equivalent annual annuity......Page 115
Timing within a replacement chain......Page 116
Asset replacement investment decisions......Page 117
Project retirement......Page 118
Review questions......Page 120
7 Project analysis under risk......Page 123
The concepts of risk and uncertainty......Page 124
Main elements of the RADR and CE techniques......Page 125
Estimating the RADR......Page 127
Estimating the RADR using the firm’s cost of capital......Page 128
Estimating the RADR using the CAPM......Page 129
The basic CAPM equation......Page 130
Calculation of returns from stock-market index values and share prices......Page 131
Estimating Beta......Page 133
NPV computation for the Delta Project using the RADR estimate from the CAPM......Page 134
The certainty equivalent method......Page 135
Example 7.2. Computing NPV using CE: Cecorp......Page 136
Example 7.3. Ceradr Company investment project......Page 137
Comparison of RADR and CE......Page 138
Review questions......Page 139
Study objectives......Page 142
Terminology used within sensitivity analysis......Page 143
The variables......Page 144
Ability of management to control variables......Page 145
Variables which give rise to extrinsic project benefits......Page 146
Developing pessimistic and optimistic forecasts......Page 147
Pessimistic and optimistic values established by using expert opinion......Page 148
Forecasting approach......Page 149
Pessimistic and optimistic forecasts of variable values for the Delta Project example......Page 150
Applying the sensitivity tests......Page 153
Sensitivity test results......Page 154
Identification of the sensitive variables......Page 155
Further analysis of the identified sensitive variables......Page 156
Other sensitive variables which may be investigated......Page 157
Break-even analysis......Page 158
Concluding comments......Page 159
Review questions......Page 160
9 Simulation concepts and methods......Page 162
What is simulation?......Page 163
The nature of simulation models......Page 164
Elements of simulation models for capital budgeting......Page 165
Variables in the model......Page 166
Steps in simulation modelling and experimentation......Page 167
System synthesis......Page 168
Testing the model......Page 169
Performing experiments......Page 170
Risk analysis or Monte Carlo simulation......Page 171
Example 9.1. Computer project......Page 172
Replicated sampling......Page 174
The cumulative relative frequency distribution......Page 177
Determining whether a project is financially acceptable......Page 178
Software packages available......Page 179
Development of the FlyByNight basic simulation model......Page 180
Structure of the FlyByNight basic model......Page 181
Testing the FlyByNight basic simulation model......Page 182
Example 9.3. FlyByNight deterministic model......Page 184
Example 9.4. FlyByNight stochastic simulation......Page 186
Advantages and disadvantages of simulation compared with other techniques in capital budgeting......Page 188
Review questions......Page 189
Generating uniform variates over a specified range......Page 190
Generating values from an empirical probability distribution (discrete probability table)......Page 191
Generating values from a triangular distribution......Page 192
Study objectives......Page 194
Key parameters for forestry models......Page 195
Sources of variability in forestry investment performance......Page 196
Methods of allowing for risk in the evaluation of forestry investments......Page 198
Problems faced in developing forestry financial models......Page 199
Developing a financial model: a step-by-step approach......Page 200
Step 1: Identifying the forestry system......Page 201
Step 3: Estimating cash inflows......Page 203
Step 4: Developing the financial model......Page 204
Step 5: Undertake a sensitivity analysis......Page 206
Example 10.2. FVC Ltd: comparison of one-stage and two-stage harvest options......Page 208
Example 10.3. Simulation analysis of FVC Ltd forestry project......Page 209
Concluding comments......Page 211
Review questions......Page 212
11 Resource constraints and linear programming......Page 213
Example 11.1. Roclap: product mix problem......Page 215
Graphical solution to the product mix problem......Page 216
Finding optimal activity levels for the product mix problem with Excel Solver......Page 218
Sensitivity or post-optimality analysis......Page 219
Example 11.2. Capital rationing problem......Page 221
LP and project choice......Page 223
Example 11.3. Project portfolio selection problem......Page 224
Review questions......Page 226
Study objectives......Page 228
Independence of activities......Page 229
Expanding the number of projects and constraints......Page 230
Example 12.1. Power generator’s decision problem......Page 231
Indivisible investments and integer activity levels......Page 233
Example 12.2. Resort development problem......Page 234
Example 12.3. Borrowing and capital transfer problem......Page 235
Example 12.4. Infrastructure problem......Page 237
Mutually exclusive projects......Page 238
Example 12.5. Sports gear problem......Page 239
Plant size and economies of scale......Page 240
Dealing with multiple goals......Page 241
Concluding comments......Page 242
Review questions......Page 243
13 Financial modelling case study in forestry project evaluation......Page 245
Forestry evaluation models: uses and user groups......Page 246
Financial models available to evaluate forestry investments......Page 247
The Australian Cabinet Timbers Financial Model (ACTFM)......Page 248
Default values of the model......Page 250
Timber prices and price changes over time......Page 252
Further comments about the model......Page 254
Review of model development and design options......Page 255
Concluding comments......Page 258
Review questions......Page 259
14 Property investment analysis......Page 260
Income-producing properties......Page 261
Establishing the operating cash flows before tax......Page 262
The building management records......Page 263
Estimating the resale proceeds before tax......Page 264
Example 14.1. Property cash flows from the industrial property......Page 265
Adjusting the property flows before tax for loans......Page 266
Reasons for analysing project and financing flows together......Page 267
Rents and operating expenses......Page 268
Loan interest......Page 269
Example 14.3. Equity cash flows after tax from the industrial property......Page 270
Example 14.4. Acquiring the industrial property for operations......Page 272
Lease or buy......Page 274
Example 14.5. Leasing or buying the industrial property for operations......Page 275
Sale and leaseback of a property......Page 276
Example 14.6. Initial screening of an industrial building project......Page 277
Basic NPV sensitivity analysis for a property development......Page 279
Example 14.8. Equity cash flows from the development project......Page 280
Review questions......Page 281
15 Forecasting and analysing risks in property investments......Page 283
Rent under the lease......Page 284
Allowing for vacancy......Page 285
Determinants of market changes......Page 286
The lease rent......Page 287
The market rent......Page 288
More formal methods of incorporating these effects on forecast rents......Page 291
Example 15.2. Forecasting resale proceeds for the industrial property......Page 292
Forecasting development cash flows......Page 293
Example 15.3. Forecasting development cash flows for a residential project......Page 294
Adjusting for tax and financing......Page 296
Default by the tenant......Page 297
Example 15.4. Net present value of the industrial property – sensitivity analysis......Page 298
Buying versus leasing – break-even analysis......Page 299
Risks in property development......Page 300
Concluding comments......Page 302
Review questions......Page 304
16 Multinational corporations and international project appraisal......Page 306
Local currency......Page 307
Management fees and royalties charged by the parent company......Page 308
Exchange rate movements......Page 309
Example 16.1. Garment project......Page 310
Possible alternative arrangements to make the project viable to both parent and subsidiary......Page 311
Exchange rate risk......Page 312
Country risk......Page 313
A strategy to reduce a project’s exchange rate and country risks......Page 314
Basic elements and operational features of the strategy......Page 315
Is it feasible to obtain a considerable amount of finance for a host country project from an NPF?......Page 317
Insurance against country risks......Page 318
Incorporating exchange rate and country risk in project analysis......Page 319
Review questions......Page 320
References......Page 322
Index......Page 325