2015 eup 222 project finance lecture 4

EUP 222 ENGINEER

IN SOCIETY

PROJECT FINANCEUnderstand the financial concepts to appraise a project

efficiently and make decisions effectively.

Dr. Sharifah Akmam Syed Zakaria, PPKA . email: [email protected]

OutlineLecture Objective & Context

Project Financing Owner Project Contractor

Financial Evaluation Project Income Inflation Operating Costs Time value of money Present value Rates Interest NPV Internal Rate of Return (IRR) Return on Capital Employed (Accounting Rate of Return) Payback period

Case Study: Mbox by ECOLEX

A small electronic firm, ECOLEX intends to produce a magnetic

heating lunch box (Mbox)

A Cleaner Production (CP) assessment at ECOLEX identified

some potentially profitable

investment projects that also has

environmental benefits.

Financial Information: A

Initial investment = RM 4 million

Selling price (current price terms)

= RM 40 per unit

Variable operating costs (current price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price terms) = RM340,000 per year

Expected operating cost inflation = 8 % per year

Financial Information: B

Demand forecast for Mbox by ECOLEX marketing team:

Year 1 2 3 4

Demand (units) 120,000 140,000 240,000 90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.

Financial Information: C

Given discount rates :

Year 0 1 2 3 4

Discount at 10% 1.000 0.909 0.826 0.751 0.683

Discount at 20% 1.000 0.833 0.694 0.579 0.482

Year 1 2 3 4

RM RM RM RM

Inflated selling

price

(RM/unit)

RM 40 +

.06 (40)

42.40

RM 42.40 +

.06(42.40)

44.94

RM 44.94 +

.06(44.94)

47.64

RM 47.64 +

.06(47.64)

50.50

Demand(units/year) X 120,000 X 140,000 X 240,000 X 90,000

Income(RM/year)

5,088,000 6,291,600 11,433,600 4,545,000

Project Income: Selling price (current price terms)

= RM 40 per unitExpected selling price inflation

= 6 % per year

1 2 3 4

RM RM RM RM

Inflated variable cost

(RM/unit)

RM 16 +

.08 (16)

17.28

RM 17.28 +

.08 (17.28)

18.66

RM 18.66 +

.08 (18.66)

20.15

RM 20.15 +

.08 (20.15)

21.76

Demand (units/year) X 120,000 X 140,000 X 240,000 X 90,000

Total Variable costs (RM/year) 2,073,600 2,612,400 4,836,000 1,958,400

(+) Inflated Fixed

Costs(RM/year)

RM 340,000 + .08

(340,000)

367,200

RM 367,200

+ .08 (367,200)

396,576

RM 396,576 +

.08(396,576)

428,302

RM 428,302 + .08

(428,302)

462,566

Total Operating costs (RM/year) 2,440,800 3,008,976 5,264,302 2,420,966

Operating Costs: Variable operating costs

(current price terms)

= RM 16 per unit

Fixed operating costs


= RM340,000 per year

Expected operating

cost inflation

= 8 % per year

Net Present Value Suppose we had a collection (or stream, flow) of costs and revenues

in the future.

The net present value (NPV) is the sum of the present values for all

of these costs and revenues.

Treat revenues as positive and costs as negative

Calculation of Net Present Value

Total Revenue (R) (+) Various Costs (C) (-)

Calculate Gross Return

Calculate Net Return

PV of Net Return

NPV of the Project

Tax (-)

Discount Rate (r)

Initial Invest (-I)

Net Present Value Decision Rule:

Accept a project which has 0 or positive NPV

Alternatively,

Use NPV to choose the best among a set of (mutually exclusive) alternative projects

Mutually exclusive projects: the acceptance of a project precludes the acceptance of one or more alternative projects.

> Accept the project NPV = 0 Indifferent to the project < Reject the project

Discount Rate in NPV:NPV (and PV) is relative to a discount rate

In the absence of risk or inflation, this is just the interest rate of the

reliable source (opportunity cost)

Correct selection of the discount rate is fundamental. If too high, projects

that could be profitable can be rejected. If too low, the firm will accept

projects that are too risky without proper compensation.

Its choice can easily change the ranking of projects

An investment has money going out (invested or spent), and money coming in (profits, dividends etc).

You hope more comes in than goes out, and you make a profit! But before adding it all up you should calculate the time value of

money.

Money now is more valuable than money later on.

.




= RM 40 per unit



= 6 % per year



Financial Information: B

Demand forecast for Mbox by ECOLEX marketing team:

Year 1 2 3 4

Demand (units) 120,000 140,000 240,000 90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.



Year 0 1 2 3 4

Discount at 10% 1.000 0.909 0.826 0.751 0.683

Discount at 20% 1.000 0.833 0.694 0.579 0.482

Net present value with discount rate at 10% :

Year 1 2 3 4

RM RM RM RM

Inflated selling

price

(RM/unit)

RM 40 +

.06 (40)

42.40

RM 42.40 +

.06(42.40)

44.94

RM 44.94 +

.06(44.94)

47.64

RM 47.64 +

.06(47.64)

50.50

Demand(units/year) X 120,000 X 140,000 X 240,000 X 90,000

Income(RM/year) 5,088,000 6,291,600 11,433,600 4,545,000

Project Income: Selling price (current price terms)

= RM 40 per unitExpected selling price inflation

= 6 % per year

1 2 3 4

RM RM RM RM

Inflated variable cost

(RM/unit)

RM 16 +

.08 (16)

17.28

RM 17.28 +

.08 (17.28)

18.66

RM 18.66 +

.08 (18.66)

20.15

RM 20.15 +

.08 (20.15)

21.76

Demand (units/year) X 120,000 X 140,000 X 240,000 X 90,000

Total Variable costs (RM/year) 2,073,600 2,612,400 4,836,000 1,958,400

(+) Inflated Fixed

Costs(RM/year)

RM 340,000 + .08

(340,000)

367,200

RM 367,200

+ .08 (367,200)

396,576

RM 396,576 +

.08(396,576)

428,302

RM 428,302 + .08

(428,302)

462,584

Total Operating costs (RM/year) 2,440,800 3,008,976 5,264,302 2,420,966

Operating Costs: Variable operating costs


= RM 16 per unit

Fixed operating costs


= RM340,000 per year

Expected operating

cost inflation

= 8 % per year

Year 0 1 2 3 4

RM RM RM RM RM

Investment (4,000,000)

Income 5,088,000 6,291,600 11,433,600 4,545,000(-)Operating

Costs 2,440,800 3,008,976 5,264,302 2,420,966

Net cash

flow 2,647,200 3,282,624 6,169,298 2,124,034Discount at

10% 1.000 0.909 0.826 0.751 0.683

PRESENT VALUES (4,000,000) 2,406,305 2,711,447 4,633,143 1,450,715

Initial investment = RM 4 millionYear 0 1 2 3 4

Discount at 10% 1.000 0.909 0.826 0.751 0.683


PRESENT VALUES (4,000,000) 2,406,305 2,711,447 4,633,143 1,450,715

Net present

value: 7,201,610

INVESTMENT EVALUATION:

The investment proposal has a positive net present value (NPV) of RM 7,201,610 and is

therefore financially acceptable.

The results of the other investment appraisal methods do not alter this financial

acceptability, as the NPV decision rule will always offer the correct investment advice.


Internal Rate of Return (IRR)

Internal rate of return is used to evaluate the attractiveness of a project or investment.

If the IRR of a new project exceeds a companys required rate of return, that project is desirable.

If IRR falls below the required rate of return, the project should be rejected.

The IRR is a good way of judging different investments.

First of all, the IRR should be higher than the cost of funds.

If it costs you 8% to borrow money, then an IRR of only 6% is not good enough!

It is also useful when investments are quite different.

Maybe the amounts involved are quite different.

Or maybe one has high costs at the start, and another has many small costs over time.



Year 0 1 2 3 4

Discount at 10% 1.000 0.909 0.826 0.751 0.683

Discount at 20% 1.000 0.833 0.694 0.579 0.482

Year 0 1 2 3 4

RM RM RM RM RM



Costs 2,440,800 3,008,976 5,264,302 2,420,966

Net cash

flow 2,647,200 3,282,624 6,169,298 2,124,034Discount at

10% 1.000 0.909 0.826 0.751 0.683

PRESENT VALUES (4,000,000) 2,406,305 2,711,447 4,633,143 1,450,715


Discount at 10% 1.000 0.909 0.826 0.751 0.683


Net present value (discount rate 10%):

PRESENT VALUES (4,000,000) 2,406,305 2,711,447 4,633,143 1,450,715

Net

present

value: 7,201,610

Net Present Value (discount rate of 20%)

: RM 5,079,067

Net cash

flow (4,000,000) 2,647,200 3,282,624 6,169,298 2,124,034Discount at

20% 1.000 0.833 0.694 0.579 0.482

PRESENT

VALUES (4,000,000) 2,205,118 2,278,141 3,572,024 1,023,784

Internal Rate of Return (IRR) with discount rate at 20%,

For investment appraisal purposes, this company uses a nominal

(money) discount rate of 10% per year.

= nominal discount rate per year + [ (current discount rate - nominal discount

rate per year) X NPV of nominal discount rate] / (NPV of nominal discount

rate + NPV of current discount rate)

= 10 + [ (20 10) X 7,201,610 ] / (7,201,610 + RM 5,079,067)

= 10 + 5.9

= 15.9%

Internal Rate of Return (IRR) with discount rate at 20%,

Given: a nominal (money) discount rate of 10% per year.


The internal rate of return (IRR) method also recommends accepting the investment

proposal, since the IRR of 15.9 % is greater than the 10% return required by this company.

If the advice offered by the IRR method differed from that offered by the NPV

method, the advice offered by the NPV method would be preferred.

Return on Capital Employed (Accounting Rate of Return)

Defined as the rate of return that makes the NPV of the project equal to zero.

To see whether the projects rate of return is equal to or higher than the rate of the firm to expect to get from the project.

Return on Capital Employed (Accounting Rate of Return)

Oftentimes, IRR and NPV give the same decision/ranking among projects.

IRR only looks at rate of gain not size of gain IRR does not require you to assume (or compute) a discount rate. IRR ignores capacity to reinvest IRR may not be unique

Use both NPV (size) and IRR together (rate)However, Trust the NPV: It is the only criterion that ensures wealth

maximization. It measures how much richer one will become by undertaking the investment opportunity.




= RM 40 per unit



= 6 % per year



Year 0 1 2 3 4

RM RM RM RM RM



Costs 2,440,800 3,008,976 5,264,302 2,420,966

Net cash

flow 2,647,200 3,282,624 6,169,298 2,124,034Discount at

10% 1.000 0.909 0.826 0.751 0.683

PRESENT VALUES (4,000,000) 2,406,305 2,711,447 4,633,143 1,450,715


Discount at 10% 1.000 0.909 0.826 0.751 0.683


Total net cash flow = 2,647,200 + 3,282,624 + 6,169,298 + 2,124,034 = RM 14,223,156

Total depreciation and initial investment are same, as there is no scrap value.

Total accounting profit = Total net cash flow - Initial investment

= RM 14,223,156 RM 4,000,000 = RM 10,223,156

Average annual accounting profit = RM 10,223,156 /4 = RM 2,555,789 (A)

Average investment = 4,000,000/4 = RM 1,000,000(B)

Return on capital employed = (A) / (B) X 100

= RM 2,555,789 / RM 1,000,000(B) X 100

= 256 %

Return on Capital Employed (Accounting Rate of Return):

Given: a target return on capital employed of 100% per year. Ignore taxation.


The calculated return on capital employed of 256% is more than the target return of 100%.

So, the project is acceptable.

As indicated earlier, the investment proposal is financially acceptable as it has a positive NPV.

The reason why this company has a target return on capital employed of 100% cab be investigated. This may be due to changed economic circumstances with high demand on sustainable products.

Payback Period

Payback period (Time to return)

Minimal length of time over which benefits repay costs

Typically only used as secondary assessment

What are we Assuming Here? That only quantifiable monetary benefits matter.

Certainty about future cash flows:

Main uncertainties:

Financial concerns

Currency fluctuations (international projects)

Inflation/deflation

Taxes variations

Project risks

Project Management Phase

FEASIBILITYDESIGN

PLANNING CLOSEOUTDEVELOPMENT OPERATIONS

Financing & Evaluation

Risk

2015 eup 222 project finance lecture 4

Documents

price current price

flow of costs

selling price inflation

total operating costs

operating cost inflation

net present value npv

total variable costs

terminal value