Capital Project Appraisal

1
Capital Project Appraisal

• Pat Ryan

24 February 2006
2
Capital project appraisal in practicecareer
opportunities for actuarial skills!

• In 1998 the Association of Consulting Actuaries
  (ACA) and the Confederation of British Industry
  (CBI) surveyed large UK firms (turnover gt20m) in
  regard to their approach to key capital
  investment decisions.
• The survey indicated a lack of rigour in the
  decision process of many firms.
• There is no reason to believe that there has
  been much change since, or that practices in
  Ireland are superior.
• We will look at this surveys results first and
  then devote the rest of the lecture to
  considering recommended practice.

3
Findings of survey by ACA CBIhow UK firms
approach key capital investment decisions

• Appraisal techniques are not rigorously
  quantitative
• 23 of firms did not use quantitative analysis
  at all
• Only 60 reviewed the value of decision criteria
  regularly
• management judgement had key role in setting a
  projects target
• Many firms, ignore cashflow methods - rely on
  profit data
• Many viewing cashflow judge only on payback (2 to
  4 yrs!)
• Hurdle rates are often set at higher level than
  theory needs
• Most dont decide solely on whether meets target
  rate
• Most projections ignore inflation
• Risk analysis often performed by people not best
  placed
• Limited attention is paid to inter-related risks
• Firms using high hurdle rates mostly in lower
  risk sectors

4
Capital project appraisalrecommended practice

• This is a key part of the planning risk
  analysis stages
• A capital project is described as up-front
  expenditure on asset creation for subsequent
  profit flows
• intangible (e.g. patent) as well as tangible
  asset
• Approach being discussed follows methodology of
  one stage of RAMP (Risk Analysis Management for
  Projects) process

5
RAMP life cycle of a projectprocess developed by
actuarial civil engineering professions

• Opportunity identification
• Detailed appraisal, leading to investment
  submission
• - the stage being discussed today
• Raising the necessary finance, design, contracts
  etc
• Asset creation
• Operation
• Close-down

see www.ramprisk.com
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Key stages in project appraisal

• Initial appraisal of identified opportunity
• core organisation criteria, strategic financial
  
• synergy with other projects, upside potential
• subjective dimension as well quantitative
• risk for sponsors, lenders, investors. Mitigation
  
• Detailed appraisal
• entails choice of risk discount rate
• risk identification, analysis, modelling,
  mitigation
• investment submission

7
Detailed appraisal

• Project definition, scope and timescale
• must be clearly spelt out and agreed by all
• clear specification of
• success criteria
• to whom goals of the project apply
• responsibilities of people in project team and
  management team
• Evaluation of cashflows, including knock-on
• cap ex, running costs, revenues, termination cost
• rigour is vital - should document all assumptions
• first cut / NPV, IRR, (discounted) payback period
  
• then apply sensitivity analysis / scenario
  testing
• if satisfactory, then apply detailed risk analysis

8
Risk discount rate

• Nominal rates for nominal cashflows
• Distinguish between
• specific (diversifiable / probabilistic) risk,
  and
• systematic (non-diversifiable / market) risk
• Increase discount rate for systematic risk

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Choosing risk discount rate

• Projects carrying normal degree of risk
• incremental after-tax cost of (debt equity)
  capital
• cost of equity risk free rate equity risk
  margin
• Projects above normal systematic risk
• ideally base on rates used by firms experienced
  in such projects ? in practice a judgment call
• Other considerations
• illusion of precision

10
Dealing with specific risks

• Identification steps
• high level cull of clearly-high-risk projects
• brainstorming by project experts, senior internal
  and external people with a long view
• to identify project risks, likelihood,
  interdependency, frequency severity, mitigation
  options
• desktop analysis building on this and research
• set out all identified risks in a Risk Register,
  cross referencing interdependencies

11
Risk types examples

• Political war, govt / policy change, new laws
  taxes, trade restrictions, planning permits,
  third party opposition
• Natural force majeure, climate change
• Economic interest rate and exchange rate moves
• Financial cashflow estimates, capital cost,
  assumptions, finance availability, sponsor
  dissent
• Crime fraud, crime
• Project ill-defined objectives, design flaws,
  information withheld, timescale, leading-edge
  technology, key personnel, contractor bankruptcy,
  decommissioning
• Business volumes revenue, running cost,
  efficiency level, early obsolescence,
  competition, safety hazards

12
Analysis of identified risks

• Each risk could be classified by 4 measures
• frequency of occurrence or risk level
• degree of dependence on other, separate risks
• degree by which it can be mitigated or managed
• financial impact
• Expected cost of a given risk quantified in NPV
• Low probability, high severity risks scrutinised
• Distribution of NPVs for entire project modelled
• by scenario analysis or stochastic modelling
• (volume of assumptions limit stochastic model use)

13
Example probability dist of NPVs
Expected NPV 154,600. Losses 35 of time
Max loss 391,000
14
Risk mitigation

• Options and examples
• reduction
• reducing risk (probability or consequence)
  modify design or build in safety margins
• reducing uncertainty further research
• transfer fixed price contract, pay insurance
  premium
• avoidance redesign / abandon
• absorb or pool organise syndicate, joint
  venture
• Evaluation of each option to assess
• effect on frequency, consequence expected value
• feasibility cost of implementation
• if any secondary risks resulting ? resultant
  mitigating actions
• overall impact on the distribution of NPVs
• Mitigation should reduce downward volatility of
  NPVs
• if decreases expected NPV, need judgement call on
  trade-off

15
Example of trade-off judgement call

• Work with the example in the table in slide
  number 13
• The contractor is prepared to bear the whole of
  any extra costs / losses arising after year 1,
  provided the contract price is increased by
  80,000. This would arise in scenarios C E
• Is it worth accepting the offer?
• See workings on next slide

16
Example continuedeffect on distribution of NPVs
of paying contractor 80,000
Expected NPV 145,350. Losses 20 of time
Max loss 188,000
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The investment submission

• Reflect choice of best possible mix of mitigation
  options
• Show expected NPV probability distribution of
  NPVs
• Identify and analyse residual risks. Special
  attention should be paid to remaining risks which
  could have catastrophic impact (high severity)
• Specify method of finance of the project
• Analyse effect on investors after inflation,
  borrowing, tax

18
The investment decision

• As well as probing the submission, decision
  makers need to consider less concrete matters
  outside the formal analysis, such as
• possible bias or approximations
• lessons learned from previous experiences
• up-to-the minute developments that could impact
  viability
• doubts about feasibility or quality of
  implementation
• overall project credibility
• realism of estimated upside potential and
  justification to proceed