b821 block3unit5 project appraisal

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B821 FinancialStrategyBlock3 FinanceandInvestment

Unit5ProjectAppraisal

Masters


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This publication forms part of an Open University course B821,Financial Strategy. Details of this and otherOpen University courses can be obtained from the Student Registration and Enquiry Service, The Open University,PO Box 625, Milton Keynes, MK76YG, United Kingdom: tel. +44 (0)1908 653231, email [email protected] Alternatively,you mayvisit the Open Universitywebsite at http://www.open.ac.ukwhereyou can learn more about thewide range of coursesand packs offered at all levels by The Open University. To purchase a selection of Open University course materialsvisit http://www.ouw.co.uk, or contact Open UniversityWorldwide, MichaelYoung Building,Walton Hall, Milton Keynes MK76AA, United Kingdom for a brochure.tel. +44 (0)1908 858785; fax +44 (0)1908 858787; email [email protected]

The Open UniversityWalton Hall, Milton KeynesMK76AAFirst published 1998. Second edition 1999. Third edition 2000. Fourth edition 2003. Fifth edition 2006. Reprinted 2007Copyright# 1998,1999, 2000, 2003, 2006, 2007 The Open UniversityAllrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,transmittedorutilisedinanyformorbyanymeans,electronic,mechanical,photocopying,recordingorotherwise,withoutwrittenpermissionfromthepublisheroralicencefromtheCopyrightLicensingAgencyLtd.Detailsofsuchlicences(forreprographicreproduction)maybeobtainedfromtheCopyrightLicensingAgencyLtdof90TottenhamCourtRoad,LondonW1T4LP.OpenUniversitycoursematerialsmayalsobemadeavailableinelectronicformatsforusebystudentsoftheUniversity. Allrights,includingcopyrightandrelatedrightsanddatabaserights,inelectroniccoursematerialsandtheircontentsareownedbyorlicensedtoTheOpenUniversity,orotherwiseusedbyTheOpenUniversityaspermittedbyapplicablelaw.In using electronic course materials and their contentsyou agree thatyour usewill be solely for the purposes of following an Open Universitycourse of study or otherwise as licensed by The Open University or its assigns.Exceptaspermittedaboveyouundertakenottocopy,storeinanymedium(including electronicstorageoruseinawebsite),distribute,transmitorretransmit,broadcast,modifyorshowinpublicsuchelectronicmaterialsinwholeorinpartwithoutthepriorwrittenconsentofTheOpenUniversityorinaccordancewiththeCopyright,DesignsandPatentsAct1988.Edited and designed by The Open University.Typeset in India byAlden Prepress Services, Chennai.Printed and bound in the United Kingdom by Hobbs the Printers Limited, Brunel Road, Totton, Hampshire, SO40 3WX.ISBN 0 74921320 55.3
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C O N T E N T S 1 Introduction 5

Outline of Unit 5 7Aims and objectives of the unit 8

2 Strategy and investment appraisal 92.1 Strategic investment process 112.2 Preparation 122.3 Authorisation 152.4 Implementation 16

Summary 173 Issues in capital budgeting 19

3.1 Capital budgeting 193.2 Issues in appraisal techniques 213.3 Cash flows or accounting flows? 223.4 Cash flow time-periods 263.5 Relevant cash flows 273.6 Inflation 273.7 Taxation 283.8 International capital budgeting 32

Summary 354 Capital Rationing 37

4.1 Capital rationing in practice 374.2 Competing projects 40

Summary 445 Project discount rate 45

5.1 How to deal with risk? 485.2 Hurdle rate vs WACC 485.3 Adjusting hurdle rates for risk 50

Summary 556 Risk issues in CAPEX 57

6.1 Adjusting for risk using probabilities 576.2 Expected net present value (ENPV) 596.3 Investment projects as options 62

Summary 64


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7 Ace Company: Spreadsheet exercise 657.1 Exercise 65

8 Funding capital projects 698.1 Leasing 698.2 Lease vs buy and borrow decisions 72

Summary 749 Project finance 75

9.1 The methods of project finance 759.2 Case study: liquid gas facility in Oman 78

Summary 8410Funding public projects 85

10.1 Main means of financing public-sector capitalformation 87

10.2 The Private Finance Initiative 8910.3 Evaluating PFI projects 93

Summary 98Summary and Conclusions 100Answers to exercises 102References 105Acknowledgements 106


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1 I N TR OD U C TI ON 1 INTRODUCTION

The importance of capital investments cannot be overemphasised.Investments affect the operations and cash flows of organisationsover long periods of time. However, capital investmentperse doesnot necessarily improve organisational performance: successdepends upon how efficiently and effectively capital resources areused. Organisations frequently spend large amounts of money oncapital investmentswhich may only give returns after a long periodof time, and this increases the degree of uncertainty as to thereturns on these investments. Moreover, an organisations capitalresources are usually limited. Consequently, the resource allocationprocess is often critical to the organisations success.The process of making a capital expenditure (CAPEX) decision isa multifunctional undertaking. In most cases this process involvespeople in a range of functionswithin the organisation. Each ofthem provides input according to the type of project underconsideration and their individual expertise.To clarify the issues described in this unitwe make use of a rangeof case studies. These form the basis for explaining theory andprovide means for illustrating the practical issues.The differences between public- and private-sector projects arenow disappearing. Increasingly, public projects arevalued in thesameway as those in the private sector, although the profit motiveof the private sector is replacedwithvalue for money in the publicsector.We devote a section to hybrid public/private sector projectsknown as Public Private Partnerships (PPP) and examine the issuesinvolved.We also illustrate the link between capital expenditureand project financing, showing that capital expenditure is not astand alone topic. For example, the choice of discount rate to usein project appraisal is closely linked to theWACCyou have juststudied in Unit 4. Project appraisal also requires a consideration ofrisk, and Block 4 of B821,which focuses on risk,will elaboratesome of the issues discussed in this unit.Project appraisal is a holistic process,which affects and is affectedby functions other than financewithin the organisation. Some ofthe functional areas involved in the capital investment decision are:l Marketingwhich provides data estimates of salesvolumes if,

for example, the proposed investment is for a facility toproduce new products.

l Productionwhich can determine the use of scarce resourcesin the manufacture of the organisational output.

Holistic: tending toproduce wholes from thegrouping of structures.

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UNIT 5 PROJECT APPRAISAL

l Services departments, institutions, divisions and similarfunctional areas responsible for providing services (e.g. schools,department of transport).

l Accountingandfinancewhich can provide data needed forthe analysis of the project and the expertise to carry outquantitative analysis uponwhich the decision to invest is based.This function examines methods of evaluating and financingcapital investment projects and estimates their effect on cashflows, taxes and profitability.

Management must recognise and integrate the decision-makingprocesswithin the organisational environment and select theprojects that meet the chosen investment criteria in order toachieve the strategic and operational objectives of the organisation.

Economicrationality

Social/organisational rationality

Politicalrationality

The CI decision EnvironmentPre-screening

Personnel

Financialanalysis

Ideas

Implementation Feedback/post-audit

Strategicplanning

Figure1.1 A universal model of the capital investment (CI) decision-makingactivity (Northcott, 1992)The diagram in Figure 1.1 shows a range of factorswhich influencethe decision to invest in capital projects. The level of influencethese factors have on the investment processvaries betweendifferent types of organisations, and mayvary to a certain extentbetween different projectswithin one organisation. The principalpurpose of the model is to illustrate the complexity of the decision-making process and the range of expertisewhich is needed toarrive at an investment decision thatwill contribute to achievementof the strategic objectives of an organisation. The three arrowssymbolise the external influences on the decision-making process,and of course thesevary according to the type of organisation as

well as the individual project.



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1 INTRODUCTION

O UT L I N E O F UN I T 5 The structure of this unit is as follows. Section 2, Strategy andinvestment appraisal, illustrates the importance of strategy in thecapital investment decision-making process.Although this subjecthas already been examined in Units 1 and 2, itwill be revisited inthis unit.In Section 3, Issues in capital budgeting,we explore a range ofissues in connectionwith techniques of investment appraisal andthe principles of capital budgeting. The section also describesspecific issues closely intertwinedwith investment appraisal, suchas inflation and taxation. Specific appraisal problems deriving frominternational investment programmes are also dealtwith in thissection.Section 4, Capital rationing, builds on the issues of funding andexplains the concept of capital rationing in a commercial context.This section also dealswith issues surrounding competing projects.In Section 5we consider how to arrive at a suitable discount ratefor a project, discussingwhether to useWACC and, if so,whether itshould be adjusted to cater for the risk of the project.The discussion of risk issues in CAPEX is continued in Section 6.In this sectionwe also describe the so-called options approach tocapital investment,which is a relatively new approach to theprocess of project decision-making.In Section 7you are asked to attempt a spreadsheet exercise. Thetask requires careful consideration of the aspects of CAPEXyouwillhave covered in the unit andyouwill be able to practiseworking

with Excel spreadsheets. The accompanying file providesyouwitha suggested solution to the exercise.In Section 8, Funding capital projects,we introduce the subjectof leasing. This is avariation on debt that is an important tool forprivate,voluntary and public-sector organisations.

You then have a choice as towhether to study Section 9 orSection 10.Section

9

discusses

project

finance;

this

is

designed

mainly

for

private-sector students, althoughwe believe that those ofyou moreconcernedwith the public sectorwould also find the material hereuseful.In Section 10we introduce the Private Finance Initiative andPublicPrivate Partnerships, mechanisms to allow public-sectororganisations to use the private sector to fund public-sectorprojects.We expect that public-sector oriented studentswill chooseto study Section 10 instead of Section 9. However, since there is afair chance that, ifyou are a private-sector manager,you maybecome involvedwith a PPP undertaking,wewould recommendthat ifyou have timeyou do read Section 10 too.



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Note that any relevant assessment questionwill be able to beanswered using Section 9or Section 10.

AI MS AN D O BJ E C T I V E S OF T HE UN I T By the end of this unityou should be able to:l appreciate how organisations implement their capital appraisal

proceduresl recognise thewide range of issues involved in capital

investment decisionsl assess the strategic implications of investing in capital

equipment and facilitiesl understand how to apply project appraisal methods tovarious

types of projects in public and private sector organisationsl appreciate the importance of, and the problems in identifying

and measuring, risk in the context of capital investment decisionmaking

l understand the problems and opportunities of raising funds forcapital projects in the private and public sectors.



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2 STR A TEGYA N D I N VESTM EN T AP P R A I SA L2 STRATEGY AND INVESTMENT APPRAISAL

Youhavealreadybeenintroducedtoorganisationalstrategyinyourearlierstudies.Inthissectionwediscusshowthecapitalinvestmentappraisalprocessfitsintotheformulationandimplementationofanorganisationsoverallstrategy.

Anorganisationsstrategyistheformulationofitsplanforachievingitsmission,goalsandobjectives.Itcanbearguedthatstrategyismainlyconcernedwithadjustingtotheopportunitiesandchangesinthebusinessenvironment.However,strategyalsohastobedetermined

withintheconstraintsoftheorganisationsresources,orsuchresourcesascanbeobtained.Fromthisitfollowsthatexpenditureoncapitalprojectsmustbeintegrallylinkedtotheseresources.

ACTIVITY 2.1Eachyear theWorld Bank lends between US$15 and $20billion for projects in the more than 100 countrieswithwhichitworks. Projects range across the economic and socialspectrum in these countries from infrastructure to education,from health to government financial management. The projectsthe Bank finances are conceived and supervised according to awell-documented project cycle, as shown in Figure 2.1. In thiscontext,what inyour opinionwould be the actions associatedwith the different phases in such a project appraisal cycle?ThefullWorldBankdiagramshown inFigure2.2answerstheActivitysquestion,butdonotbesurprised ifyourversiondifferssomewhat.Whileyoushouldbeable toseegeneralsimilaritiesbetweenyour ideasand theWorldBankset, therearemanysensibleandconsistentways tofollowthrough

a

project

cycle.

Thus

your

set

of

actions

is

unlikely

tomatch indetail that in thediagram.



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CountryAssistanceStrategy

Identification

Preparation

AppraisalNegotiationsand Boardapproval

Implementationand supervision

Implementationand completion

Evaluation

The completedproject cycle

Figure2.1 World Bank: The Project Cycle

CountryAssistanceStrategy

Identification

Preparation

AppraisalNegotiationsand Boardapproval

Implementationand supervision

Implementationand completion

Evaluation

1 Country Assistance StrategyThe Bank prepares lending andadvisory services, based on theselectivity framework and areas ofcomparative advantage, targeted tocountry poverty reduction efforts.

2 IdentificationProjects are identified that

support strategies and thatare financially, economically,socially and environmentallysound. Development strategiesare analysed.

3 PreparationThe Bank provides policy and projectadvice along with financial assistance.Clients conduct studies and preparefinal project documentation.

4 AppraisalThe Bank assesses the economic,technical, institutional, financial,environmental and social aspects of the project.The project appraisal document and draftlegal documents are prepared.

5 Negotiations and Board approvalThe Bank and borrower agreeon loan or credit agreementand the project ispresented to the Board for approval.

6 Implementation and supervisionThe borrower implementsthe project. The Bank ensures that theloan proceeds are used for the loanpurposes with due regard for economy,efficiency and effectiveness.

7 Implementation and completionThe Implementation CompletionReport is prepared to evaluatethe performance of both the Bank andthe borrower.

8 EvaluationThe Banks independent OperationsEvaluation Department prepares an auditreport and evaluates the project.Analysis is used for future project design.

The completedproject cycle

Figure2.2 World Bank: The Project CycleIfyou are interested, theWorld Bank has detailed documents on itsproject cycle, and many of them can beviewed on theWorldBankswebsitewww.worldbank.org.

10 OU BUSINESS SCHOOL
http:///reader/full/www.worldbank.orghttp:///reader/full/www.worldbank.org


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2 STRATEGY AND INVESTMENT APPRAISAL

In general, strategy is understood to encompass the decisions madeby governing bodies, senior management and personswho occupysimilar positions in government and not-for-profit organisations(e.g. senior clinicians in hospital, senior officers in the armedforces) concerning the long-term relationship between theorganisation and its environment. These decisions tend to be of atop-down nature. Strategy attempts to answer such questions as:What business shouldwe be in?What course of action shouldwepursue?What is the optimal organisationenvironment fit? Howcan the organisation remain flexible? Strategic planning attemptsto identify an operational environment inwhich the organisationhas real competitive advantages. In the business sector, manylarge conglomerates have divested profitable divisions from theirportfolios, thus foregoing opportunities, just because theseparticular operations did not fit into the overall group profile. Inthe government sector, postWorldWar II strategies of economicintervention and in-house provision of services have now given

way to more market-oriented policies and to the outsourcing ofservices. Many activities previously carried out by government havepassed to the private sectorvia privatisation.Capital investment proposals essentially seek approval to proceed

with specific building blocks for the implementation of theorganisations strategic plan. The preparation of capital investmentproposals is just one of three main elements in the financialimplementation of a companys strategic plan (see Table 2.1).

In Unit 1 you learnt aboutstrategic options thatmanagement mayexercise to operateprofitably using Porters(1985) competitivestrategy model.

Privatisation is thetransfer of governmentownership of public sectorunits to the private sector.The UK led in the 1980sand 1990s in privatisingits public utilitycompanies, but this hasnow become a policyobserved in manycountries.

Table2.1 Financial implementation of strategies

Development ofstrategies c Strategicplan

c Capital investmentproposals

c Budgetsc Cash flow and other

ad hoc forecasts

Itisimportantthatthisstrategicperspectivebemaintainedthroughouttheorganisationsfinancialmanagementandthatthedifferentelementsformacoherentwhole.Capital investmentproposalswilltypicallycontaincashflowforecastsforthenextfivetotenyears,ortobemoreexact,containforecaststhatareconsistentwiththeinvestmenthorizonfor thebusiness. Theorganisations investmentprogramme

willalsobepredicateduponthegenerationofsufficientcashflows;managementsabilitytomeetthisrequirementmaybejudgedontheirsuccessatdeliveryonpast investmentprogrammes.

S T R AT E G I C I N V E S T M E N T P R O C E S S 2 . 1 Largeorganisationswillhavetheirownproceduresforthepreparationandsubmissionofcapitalinvestmentproposals.Typically,thesewillgivediscretiontolocalmanagementuptoaset



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limit,withamountsabovethislimitneedingapprovalfromdivisionalmanagement,orwhateveristhenextstageupintheorganisationshierarchy.However,becausecapitalexpendituredecisionsareforthelongtermandnormallyimpossibletoreverse,majorproposalsofanysizewillneedapprovalbyaseniormanagementtieroftheorganisation.

Although the authorisation procedureswillvary betweenorganisations, theywill almost always contain the steps shownin Figure 2.3.

Preparation

Authorisation

Implementation

Strategic plan

Capital investment proposal

Assumptions

Strategic options

Authorisation

Implementation

Post-implementation

Figure2.3 Strategic investment authorisation proceduresThe three main stages identified above are:1 Preparation The formulation and preparation of a case to put

to the directors of the organisation.2 Authorisation Presenting the business case to the directors

and obtaining authorisation.3 Implementation Implementing the project and carrying out

a post-implementation audit.

P R E P AR AT I O N2 . 2 If it is to survive, no business can afford to stand still. This appliesequally to a family run business, a business unitwithin a largeorganisation or an organisation delivering public services.



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The strategic planwill set the frameworkwithinwhich differentstrategic optionswill be generated. It isvery easy for managers atthe unit level to champion a particular course of action rather thanstep back and evaluate several options.For instance, consider a business unitwithin a financial servicesgroup

which

sells

insurance

products

to

travel

companies.

The

management may consider upgraded information systems to beessential. However, the central board of directors may take adifferent perspective and ask, for instance:l Has the possibility of outsourcing been investigated?l Could this business be integrated in anotherwaywith other

unitswithin the group?l An eventual upgrade may be essential, butwould the benefits

ofwaiting ayear outweigh the costs?All these options can be investigated and financial projections foreach prepared. The presentation of these alternatives and theevidence that they have been actively considered all improve thecase for authorisation.Note how difficult it is to separate this project from the overallstrategy of the business unit and indeed the group. Here there isa case for the financial projections to be prepared for this unit as a

whole, essentially treating the future of thewhole business unitas the project.Having generated options, the next stepwill be to collectinformation for the business case.Whoever prepares the proposal,this stepwill involve awide range of managerswithin theorganisation, as inputs from operations, marketing, finance,information technology and human resourceswill be required.The collection of data should be aimed at justifying theassumptions made in the financial projections.Where managementshows detailed understanding of the markets, services andtechnologies inwhich the unit operates, the financial projectionsgain enormously in credibility.The assumptions underlying the financial casewill be both internaland external. Internal production and other operational assumptionscan be derived from the records of the business. More difficult arethevolume and pricing assumptions underlying the marketing plan,and the general assumptions about economic growth, inflation andcommodity prices.One critical set of assumptions that it is easy to overlook are thoserelating to timing, for instance:l Eventual salesvolume projections may be realistic, butwill they

really build up as rapidly as is projected?l Will the technology needed be available in the time-scale

envisaged, or should more time be allowed?l 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 havea considerable effect on the cash flow projections and, inparticular, the NPVof the project, as cash flows are moved back.

An example of senior managements strategicview of investmentis the decision of many large European or US manufacturingcompanies

to

invest

in

manufacturing

capacity

in

emerging

economies such as India and China. In Box 2.1 andActivity 2.2weprovide one such example:why Siemens finds it strategicallymeaningful to invest in manufacturing and R&D facilities in India.

Unit6

looks

at

company

valuation. In this case acapital expenditureproposal of $500m is analternative strategy toan acquisition of a localcompany.

BOX 2.1SIEMENSTOINVEST $500MININDIANEXPORT HU BBy Khozem Merchant in MumbaiSiemens

is

to

invest

up

to

$500m

over

the

next

three

years

in

India, which the German engineering group said was emerging asits 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 powerdemands.Siemens move, which was unveiled yesterday by Heinrich vonPierer, supervisory board chairman, in Mumbai, is the latestevidence of Indias appeal, often at the expense of China, as abase for the manufacture of engineering products.Last month, Swiss/Swedish rival ABB said it would expand itsstrong Indian manufacturing operations to meet rising demand forautomation technology and control systems from customers in Indiaand the Middle East, and strengthen its research and developmentpresence in Bangalore, Indias technology capital.Indias economy is forecast to grow 66.5 per cent this year, withmanufacturing recording a notable revival.Jrgen Schubert, managing director of Siemens Indian unit, toldthe FT that the fresh investment in India reflects our confidence inthis

market

.

He said the reason behind our confidence should become moreapparent later this month when Indias budget is expected tostrengthen official commitment to improving the countrys poorinfrastructure, notably power.Siemens sales in India rose 26 per cent to Rs17.9bn ($410m)while new orders nearly doubled to Rs30.1bn in the year toSeptember 2004.Analysts say Siemens and ABB are good examples of Europeanmanufacturers turning from mature home markets towards vibrantAsian 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 pioneerssuch as drug groups Novartis and AstraZeneca.Mr Schubert said Siemens wanted to double exports from India toabout 20 per cent of output, strengthening the countrys position asa supplier of products such as transmission equipment and partsfor turbines to south-east Asia and Germany. Two years agoSiemens exported almost nothing from India, he said.A senior foreign power industry executive said Siemens latestinvestment [in India] was unsurprising given the massive pent updemand for power in the country.The share price of Siemens Indian affiliate rose sharply in Mumbaion the investment announcement. Last year, Siemens had alsoannounced an initial Rs1bn fund for fresh investments in India.FT.com website; 9 February 2005

ACTIVITY 2.2Putyourself in the position of a Siemens main board directorconsidering the case for investmentof the $500m in India.What strategic questions mightyou have asked of team ofmanagers presenting the case?Your

questions

might

have

included

the

following:

l Dowewant tostay in thebusinessofproducing

engineeringproducts?l Why cannotwejustexport toIndia?l Whynot investelsewhere inAsia?l Would itbebetter to consider takingovera local

company?

AUT HO RI SAT I ON2 . 3 Howeversurelocalmanagementisofthestrengthofitscase,itmuststillpersuadeheadofficetoapprovetheinvestmentexpenditure.The central document in achieving approval is the capitalinvestment proposal or business case. The evaluation of theproposalwill not take place in isolation:when aventure capitalist

was askedwhat three things he looked for in a proposal, he isreported as replying the person, the person, the person, i.e. thepersonal qualities of the entrepreneur making the proposal areeverything. Similarly, however convincing andwell-argued theproposal, senior managementwill look primarily at the qualities ofthe local management team. This does not mean that the financial



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projections are unimportant indeed, good management teamswilluse them to improve the quality of decision-making independent ofthe need to have central approval.The headings underwhich investment proposals are submittedwill

vary but those that are used by one multinational group are shownin

Table

2.2.

Table2.2 Capitalinvestment proposalheadings 1 Executive summary Onepage summary2 Project definition Theaimsandboundariesof the

project3 Strategic plan Whatpartof theorganisations

strategicplan theproposalseeksto implement

4 Marketing plan Thecasesupporting themarketingassumptions

5 Production plan The resourcesat thecompanysdisposalandhow theywillbeused

6 Technology If theproject requiresnewtechnology, thebackgroundandtheR&Dneeded

7 Implementation issues Availabilityof resourcesandtimescales

8 External and internalassumptions

All thekeyassumptionsuponwhich theproposal isbased

9 Financial projections Probably insummary formwithdetailedprojectionsasanappendix

I M P L E M E N T AT I O N2 . 4 A Gantt chart is a type of Project timetables in the form of Gantt or other charts should havebar chart, that shows the been presented as part of the Implementation issues in the capitalinterrelationships of howa projects schedules investment proposal document. These implementation proposalsprogress over time. 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 thefirm does not have the resources to implement the project. If thenecessary management or technical skills necessary to implementa proposal are not currently availablewithin an organisation, thenthe proposal should showwhether these skillswill be developedinternally through training orwhether recruitment is possible.Progress on the implementation of the project may be madethrough special reporting procedures and through the normalmonthly management reports. Major projects may impact upon the



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organisations overall cash flows and require separate treasuryplanning.Finally, the groups internal auditors or another dedicated task forceshould carry out a post-implementation audit. The auditwillcomparewhat the capital proposal saidwould happenwithwhathas

actually

happened.

Questions

to

be

asked

would

include:

l Was actual capital expenditure greater than that in the proposal?l Are sales and expenses in linewith the financial projections?l Was the project implemented according to the time-scales set

out in the proposal?The purpose of a post-implementation audit is to learn lessonsfromwhat has happened so as to improve the quality of futureproposals.

S UM M AR Y The investment appraisal process forms an important part of theimplementation of an organisations strategic plans. Projectproposals should make this clear link to the organisations strategy.Large organisationswill have formal procedures for theauthorisation of investment proposals. The preparation of theproposalwill usually involve all areas and disciplineswithin theorganisation. The merits and demerits of alternative proposalswillbe carefully evaluated. Resource implications and timing areessential factors that are often given too little importance.Senior management or directors of an organisation considering aproposalwill look as much at the quality of the local managementteam as at any accompanying financial projections, judging theaccuracy of the latter by the impression of the former.If approved, progress on the implementationwill need to beregularly monitored and assessed.A post-implementation audit maybe carried out so that organisational learning takes place to thebenefit of future projects.



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3 I SSU ES I N C A P I TA LB U D GETI N G 3 ISSUES IN CAPITAL BUDGETING

In Section 3we look at some of the issues in preparing thefinancial projections needed to support a capital investmentproposal. The most important of thesewill be the cash flowprojections detailing both the expenditure required to set up theproject and the expected improved cash inflows in futureyears.

Youwill already have learnt about cash flow projections inyourearlier studies andwill have the opportunity to practise further inSection 7 of this unitwhenyou prepare projections for theACEcompany. In this sectionwe consider the following issues:l What is meant by capital budgetingl What are the capital budgeting (project appraisal) techniquesl Why cash flows rather than accounting measurements should

be projectedl The choice of time periods for the projections.l The identification of relevant cash flows.l Whether cash flow projections should be prepared pre- or

post-tax.l The treatment of inflation in the preparation of cash flows.l Issues in international capital budgeting decisions.Some of these issues are described in Section 4 ofVital Statisticsand referencewill be made back to this materialwhere relevant.

C AP I T AL BUD G E T I N G 3 . 1 Capital budgeting is awidely used term for the process ofevaluating investments in capital projects. These projects mayaccount for a significant proportion of the total assets of anorganisation. The range of possible investments includesexpenditure on buildings, equipment, land, research anddevelopment, information technology, changes in stock levels,shares, retail outlets, hotels, roads, railways, coastal defences,mental health institutions and so on.Which particular types ofexpenditure are considered depends entirely onwhich type oforganisation is planning the investment.In addition, the decision to invest or not to invest in capitalprojects may have a major impact on the financing of theorganisation.

Expenditure

on

assets

requires

management

to

make

decisions aboutwhere and inwhat form to raise funds.Awiseacquisition of capital assets togetherwith appropriate funding of



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Thehurdle rate is theadjusted cost of capitalused as discount rate inproject evaluation toreflect a projectsparticular risk assessmentby the management. Wediscuss the choice ofhurdle or discount rate inmore detail in Section 5.

those assets can often mean the difference between a business thatis competitively strong,with opportunities for growth and marketexpansion, and a business that isweak and uncompetitive; or, inthe not-for-profit sector, an organisation delivering high-qualityservices responsive to public need, and an organisation that isineffective and out of touchwith its client base.The purpose of capital budgeting is to provide policy makers andmanagementwith a sound quantitative basis onwhich to found acapital investment decision.When an investment is made, a cashoutlay is exchanged for benefits to be realised in the future interms of cash or services for public consumption. Proposedinvestment projects should be judged by their expected return. Inthis context a number of questions must be askedwhich form thecore of the capital investment decision.Will a particular investmentmeet the requirements of investors, creditors or members? Is theprobable timing of cash inflows and outflows good enough tomeet certain investment criteria?What should those criteria be?Willthe effect of an investment decision be a gain to the companysshare price (or, in the not-for-profit sector, an increase in, say,customer satisfaction)?In the commercial sector each proposed project is appraised interms of the future cash flows that are expected to be generatedby the investment in the project. The evaluation typically involvesboth the timing of returns and costs and the application of anappropriate hurdle or discount rate. Cash flow items are discountedaccording to their distance from the present and the rate ofdiscount

is

applied

to

all

changes

in

revenues

and

costs

(including

tax) thatwill occur if the project proceeds. These issues are liableto cause some controversywhen the hurdle rate for a particularproject is to be determined. Should the assessment use theaveragecost of capital for the firm, theWACC, themarginal cost of capitalfor the project in question or a discount ratewhich also takesaccount of specific risks? In practice, qualitative factors, aswe sawearlier, may also carryweight in the decision-making process.Foreachinvestmentproposal,seniormanagementtypicallyrequirethattheexpectedfuturecashflowsbesupportedbydetailedeconomic,competitiveandtechnicalanalyses.Thequalityoffinancialforecastsisnobetterthantheassumptionsusedintheirpreparation.Hencetheneedtoappreciateandchallengetheseassumptionsandformanagerstoconsiderarangeofquestionssuchas:Dotheymakebusinesssense?Whatwouldourforecastslooklikeondifferentassumptions?Doestheprojectfittheorganisationalstrategy?Finally, decision-makers must be aware that certain costs do notnecessarily involve a cash outlay but involve an opportunity cost.If a currently unused building is to be part of a project but itcould be sold now for 3m, net of tax, that amount should betreated as a cash cost (albeit an opportunity cost) at the outset ofthe project.



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3 ISSUES IN CAPITAL BUDGETING

Section 4 ofVitalStatistics describes the most commonly usedcapital budgeting appraisal techniques in more detail. These are: netpresentvalue (NPV), the internal rate of return (IRR), payback, theannualised rate of return (ARR) and the profitability index (PI).However, in public-sector services,where costs are often moresignificant than user revenues, a common practice is to calculatethe EquivalentAnnual Charge of a project. This involves convertingthe annual capital outlay, or expenditure on fixed assets, to anannual amount. The annual amount is equal to the interest andprincipal repayments on an instalment loan repayable over theeconomic life of the assets at the cost of capital prevailingwhenthe projectwould proceed.Putting it differently, this is the amount the public sectorwould payif it leased the assets on an annual basis rather than purchasingthem outright. This annual charge is added to the annual operatingcosts of the project (e.g. staff, materials, administration) and thetotal annual cost is comparedwith the quantity and quality of theservices and other benefits generated by the project eachyear.Politicians must judgewhether thevalue of theannual benefitsexceed the annual costs. No doubt they alsoweigh upvariouspolitical and social priorities, and the effect of their decisions onpublic opinion.Each of these appraisal techniques is based on certain assumptionsand, therefore, has certain limitations. To compensate for theselimitations, many organisations use more than one evaluationmethod. In the next section,wewill see how organisations usethese different capital budgeting techniques in practice.

You may wish to refer toVitalStatistics to revisethese capital budgetingappraisal techniques.

I S S UE S I N AP P RAI S AL T E C H N I Q UE S 3 . 2 It is useful at this stage to summarise briefly the reasons for the useof thevarious financial appraisal methods.l NPV is used by many firms and is theoretically the best method

because:(i) it takes account of the timevalue 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 ofcapital

(iii) since presentvalues are all measured in todays monetaryvalues, they can be added up the alternative methods donot have this additive property.

l IRR appears to be the appraisal method preferred bypractitioners, because it is seen to provide an instantindication of the rate of return oryield on the investedcapital. However, there is nowholly satisfactoryway ofdefining the true rate of return of a long-term asset (Brealeyand Myers, 1996).



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l Firms still use payback because it is easy to calculatewhen theinitial investment outlay has been recovered by the projectscash inflows. This approach may encourage short-termism,since the faster the project pays back, the better it is deemed tobe. Many firms use the payback method togetherwith NPVorIRR appraisal techniques.

For the rest of this sectionyouwill be concentrating on some ofthe details of accurate investment appraisal, but before doing soitwill be useful to remindyourself that aswas shown in the

World Bank diagram in Section 1 a project decision is basedon much more than just crunching the numbers.A positivequantitative assessment is anecessary but not asufficient conditionfor proceedingwith an investment;without a proper economicappraisal onewill not get an investment approved, but having suchan assessment is just one element in the process. Other factors suchas product strategy, corporate culture, team psychology, and so on,may also play important roles in the process. The following activityis intended to helpyou to remember that seeing both thewood(broad picture) and the trees (the details) is crucial to an effectiveproject process.

ACTIVITY 3.1ReadthearticleintheCourseReaderbyRoyer,entitledWhybadprojectsaresohardtokill.Itdiscussespossiblereasonswhycompaniesdonotalwaysrejectorcurtailcapitalprojectswhicharelikelytofail,andsuggestsprocedurestobeincludedintheprojectprocesstohelpforestallsuchproblems.

C AS H F L O W S ORA C C OUNT I NG F L O W S ?

3 . 3 In carrying out capital investment appraisal,we are concernedwiththe return a projectwill make over a number ofyears; five- andten-year projections are common forecasting periods.While profit isconcernedwithwealth created during a discrete time period,investment appraisal is concernedwith returns over the life of theproject as awhole and for this reason uses cash flow figures ratherthan profit.Over the life of a project as awhole, accounting flows shouldequal cash flows. It isworth showing a small example to illustratethis point.Just for the momentwewill ignore discounting and thetimevalue of money.



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RobertTeal Scenario1Robert Teal is considering launching a new product. Itwill involvean investment of 15,000 in plantwith a life of fouryears, at theend ofwhich itwill have novalue. Increased sales of 12,000 a

yearwill be generated. The cost of saleswill be equal to 30% ofsales and increased expenses of 3,000 ayearwill be incurred.Customerswill pay on average after sixty days. Taxes are ignoredfor simplicity.Table3.1Cash flowprojections

Year 0 Year 1 Year 2 Year 3 Year 4 CumulativeCash inflowSales 10,000 12,000 12,000 14,000 48,000CashoutflowCapital expenditure (15,000) (15,000)Cost of sales (3,600) (3,600) (3,600) (3,600) (14,400)Expenses (3,000) (3,000) (3,000) (3,000) (12,000)

(15,000) (6,600) (6,600) (6,600) (6,600) (41,400)

Netcash flow (15,000) 3,400 5,400 5,400 7,400 6,600

Income statementprojections Year 1 Year 2 Year 3 Year 4 CumulativeSales 12,000 12,000 12,000 12,000 48,000Cost of sales (3,600) (3,600) (3,600) (3,600) (14,400)Gross profit 8,400 8,400 8,400 8,400 33,600Less expensesDepreciation (3,750) (3,750) (3,750) (3,750) (15,000)Other expenses (3,000) (3,000) (3,000) (3,000) (12,000)

(6,750) (6,750) (6,750) (6,750) (27,000)

Profit 1,650 1,650 1,650 1,650 6,600

In theaboveexamplewecansee thatover the lifeof theproject thecumulativenetcash inflowsof6,600equalthecumulativeprofitsof6,600. The cash flows show an immediate outflow of 15,000 andsales for only ten months inYear 1 because of the credit taken bycustomers. In contrast, the profit is constant over the life of theproject.



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Asyou are aware, the decisionwhether or not to go aheadwiththe projectwill depend on cash flow and not profit. This is not tosay that income statement and balance sheet projections are notto be considered. For external reporting purposes, it may beimportant not to have sudden falls in a companys profits, eventhough an investment mayyield excellent long-term profits.Consider the case of Robert Teal if total sales over the fouryears

were 48,000 but that these built up slowly.Robert TealScenario 2

ACTIVITY 3.2Restate the cash flow and profit and loss projections forRobert Teal, presuming all assumptions are the same but thatsales are 6,000 inYears 1 and 2, 12,000 inYear 3 and24,000 inYear 4.Cash flowprojections

Year 0 Year 1 Year 2 Year 3 Year 4Cash inflowSalesCashoutflowCapitalexpenditureCost of salesExpenses

Netcash flowIncome statementprojections Year 1 Year 2 Year 3 Year 4Sales 6,000 6,000 12,000 24,000Cost of salesGross profitLess expensesDepreciationOtherexpensesProfit



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SUGGEST ED SOLUT ION Cash flowprojections

Year 0 Year 1 Year 2 Year 3 Year 4 CumulativeCash inflowSales 5,000 6,000 11,000 26,000 48,000CashoutflowCapitalexpenditure (15,000) (15,000)Cost of sales (1,800) (1,800) (3,600) (7,200) (14,400)Expenses (3,000) (3,000) (3,000) (3,000) (12,000)

(15,000) (4,800) (4,800) (6,600) (10,200) (41,400)

Netcash flow (15,000) 200 1,200 4,400 15,800 6,600Income statementprojections Year 1 Year 2 Year 3 Year 4 Cumulative

figureSales 6,000 6,000 12,000 24,000 48,000Cost of sales (1,800) (1,800) (3,600) (7,200) (14,400)Gross profit 4,200 4,200 8,400 16,800 33,600Less expensesDepreciation (3,750) (3,750) (3,750) (3,750) (15,000)Otherexpenses (3,000) (3,000) (3,000) (3,000) (12,000)

(6,750) (6,750) (6,750) (6,750) (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 thefouryears but it may be unacceptable for the company to showa loss inYears 1 and 2, particularly if investors in the company arelooking for a steady stream of income. In practice, the company

will probably have a range of projects and so the cash flowswill even out over time, but for a major project the directors ofthe organisationwill have to communicate carefullywith itsshareholders how the cash flow and key indicators may sufferin the earlyyears of the project.



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C AS H FLOW T I M E - P E R I O D S 3 . 4 Cash flows in and out of an organisation every day as bills are paidand customer receipts are banked. From a treasury-management

viewpoint, cashwill be managed on a daily basis and dailyforecasts of cash flows for, say, the nextweek may be appropriate.The owner-manager of a small business may have towatch thecash 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 stretchseveralyears into the future and it is not practical nor useful toforecast on a daily basis. Such forecasts are usually prepared on anannual basis. In the Robert Teal example above, the forecast cashflows for eachyear have been accumulated and shown under themain headings. The only exception to this is the initial capitalinvestment of 15,000,which, if it takes place at the beginning ofthe

forecast

period,

will

be

treated

as

being

made

in

Year

0.

In many cases, however, it may be appropriate to show a monthlycash flow for the first twelve months. Thiswill be the caseparticularlywhere the funding for the project is only just sufficientand it is important to establish the maximum borrowingrequirement. For instance, for a manufacturer dependent on

wholesale Christmas tradewith a calendaryear end, the cash flowpositionwill be most favourable at theyear end andwill becomeless favourable during theyear as it builds stocks for the autumnpurchases by thewholesalers.This leaves the question as to how manyyears into the futureweshould forecast. Benefits may flow from the purchase of a piece ofplant for the next twentyyears. Should the forecast therefore be fortwentyyears? In practice, the answer is probably no as, although

we can produce financial forecasts that look plausible on paper, thefuture becomes so uncertain the further the projection that theexercise has littlevalue. Imagine a twenty-year forecast producedby an organisation in 1985 predicting the outcome for theyear2005 just how accuratewould the economic, political andtechnological 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 offat the end of the finalyear. In the Robert Teal example above, thecustomers take 60 days credit so only ten months sales are shownin the firstyear. In the secondyear and thirdyears twelve monthsreceipts are shown as there are both opening and closing debtors.In the fourthyear onewould think twelve months receipts shouldagain be shown. However, as the projection is only for fouryearsall receipts after the end of the fourthyear are rolled back into this

year and fourteen months receipts are shown. Similarly, if plantpurchases have a scrapvalue, then thisvaluewill be shown in thefinalyear as a receipt even if there is no actual intention to disposeof the asset in thatyear.


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The production manager of a chemical company regularly putforward projects to build chemical reactors to the Company Board.Because there was no standard forecasting time horizon, themanagers took advantage by varying the project life each time.The less profitable the project, the longer the life they assumed inorder to be able to show a positive NPV!

R E L E V AN T C AS H F L O W S 3 . 5 Section 4.4.1 ofVitalStatistics discusses the identification ofrelevant costs and revenues and includes aworked example. Onlythe cash flows that occur as a consequence of making a proposedinvestment should be included sometimes called the opportunitycash flows or the incremental cash flows. For instance, if RobertTeal had already paid 1,000 for a marketing report into his newproduct thiswould not be included in the cash flow forecast as themarketing consultantwould have to be paidwhether or not thenew project goes ahead.In practice, there can be great difficulties in identifying the relevantcash flows. Earlierwe defined capital investment decisions asbeing central to the strategy of an organisation.As such, the effectsof such investments are likely to impact on all parts of theorganisation and it can become difficult to identify any cash flowsthat are not affected by the investment decision. If an organisationmust either replace a piece of critical plant or simply stop trading,then it can be argued that the relevant cash flows for the decisionare the cash flow projections for thewhole company. The questionfor the organisation then becomes a fundamental one ofwhethertheywant to continue in this line of business. Relevant cashflows are also difficult to define in the public sector.When theEurotunnel projectwas originally considered, only freight and trainrevenueswere considered.A more comprehensive costbenefitanalysiswould have included increased tax revenues fromincreased

tourism,

for

example.

I N F L AT I O N3 . 6 The correct treatment of inflation requires thatwe compare like

with like in the financial appraisal. This means that real cash flowsshould be discounted at a real discount rate or nominal cashflows discounted at a nominal rate. There is clearly potential fora mismatch of assumptions regarding cash flows and discount rates.The most obvious pitfall is to use a nominal discount rate derivedfrom

financial

market

data

and

apply

this

to

current

price

or

real

cash flows. Thiswould result in NPVvalues being understated.In some cases this could contribute to the rejection of project



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proposals. The converse situation can also occurwhere nominalcash flows are discounted at the real discount rate. This mismatch

will result in NPV calculations being overestimated.Even if thecash flowsanddiscountratesarecorrectlyspecified(both inreal termsorboth innominal terms),cash flowanddiscount

rate

estimates

must

include

aconsistent

estimate

of

expected inflation.Any mismatchof inflationassumptionsembedded in cash flowsand in thediscountratecanhaveapronounced effecton longer-termprojectsbecause theeffectsof thefailure toallow for inflation in cash-flow estimatescompoundwithtime.Under thesecircumstancesdistantcash flowshavepresent

valueswhichmaybeseriouslydistortedcomparedwithnearerones.EXERCISE 3.1Supposeyou are forecasting a projectwhichwill generatesales growing at around 6.5% peryear for tenyears. Thediscount rateyou have been asked to use is based on a risk-free rate from a quoted 10-year government bond of 5%.Youare also aware that 10-year index-linked government bondshave a realyield of 1.5%.What is the implied real growth ratein sales?

Issues in internationalcapital budgeting andtaxes are discussed laterin the unit.

T AX AT I O N 3 . 7Although Section 4.4.3 ofVitalStatistics explains the mathematicaltreatment of taxation in the capital budgeting appraisal procedure,some additional comments may helpyou to understand thisimportant topic.The main point thatwe stress in this unit, and indeed in thewholeof this course, is that if an organisation can produce high cashflows for its stakeholders it isvaluable. Since taxes typicallyrepresent a large cash flow that goes to one stakeholder (the taxcollector) at the expense of others, it is important to understand thebasics of the taxation system, for the following reasons:l Virtually every financial decision changes the amount of taxes

the organisation or its stakeholderswill pay. It is unrealistic toevaluate a decision in financial termswithout including theimpact of taxes.

l If there are moreways than one to accomplish a goal, and ifthey differ in their tax impact, the amount of the tax cash flowsmust enter the decision-making process for the comparison tobe complete.

l Tax authorities require onlywhat is specified by law, and theorganisation fully satisfies its tax obligations by paying thespecified amount.An organisation that pays more tax than itneeds is takingvalue away from the other stakeholders.



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EuropeanUnioncountriesare facingchallengingtaskofharmonisingtaxstructuresbutmeanwhilethecompaniesoperatingacross theEuropeanUnionmaygainor losebecauseofdifferenttaxsystems inthe individualcountries.Marks&Spencerarecurrently involved insuchacase intheUK,as isshownfrom thearticle inBox3.1.

BOX 3.1MARKS & SPENCER TAX DISPUTE MA Y FORCEEU STATES TO CHANGE RULESApril62005 (Bloomberg)TheEuropeanUnionshighestcourtwill signal tomorrowwhetheraU.K. taxdisputewill forceEUnations to refundbillionsofeuros tomultinationalcompanies.Marks & Spencer Group Plc, the Britains largest clothing retailer,is seeking a rebate of more than 30 million ($56 million), arguingthat it should have been allowed to deduct losses made at itsBelgian, French and German units. An aide to the European Courtof Justice in Luxembourg will tomorrow say whether UK lawsbarring such deductions are legal.Tax rules in most other EU member states broadly follow theUK rule, so this appeal will have a major impact on tax systemsaround Europe, Guy Brannan, a tax lawyer at Linklaters, a UK lawfirm that advised on European mergers last year worth more than$193 billion, said in a statement.About 300 other companies, including BT Group Plc, CaterpillarInc. and BNP Paribas SA, have made separate claims at the UKHigh Court that tax authorities discriminate between domestic andoverseas units, according to court documents. Another group ofcompanies, including Wal-Mart Stores Inc., Ford Motor Co. andPepsiCo Inc., are preparing similar actions.The final ruling, which follows the advisers opinion in about85 percent of cases, is expected later this year.Marks & Spencer argued at a 1 Feb hearing that the UK lawbreaks the 25-nation blocs single-market rules.RebatesThis has a potentially huge budgetary effect, said Johann Mueller,a tax lawyer at Dutchtax.net, a consultancy. Every company inEurope that has a cross-border subsidiary could benefit.Thousands of EU companies could follow the U.K. retailersexample.Rebates running into billions of euros may follow if the courtupholds Marks & Spencers claim, Howard Liebman, aninternational tax lawyer at Jones Day in Brussels, said in aninterview before the February hearing.



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With the exception of Denmark, Austria and Italy, a majority ofcountries in the then 15-member bloc could lose billions of euros inrevenue, he said. In May 2004, the EU added 10 mainly EasternEuropean nations.Christine Scheel, the head of a German parliamentary committee,said in February that Germany may be forced to change its law ifthe U.K. retailer wins.Tax discriminationMarks & Spencer expanded from its U.K. market and establishedsubsidiaries in Belgium, France, Germany and Spain. In the late1990s, these units incurred increasingly heavy losses, accordingto court documents. In early 2001, the retailer decided to close thebusinesses.The company sought to offset losses between 1998 and 2001through group tax relief under UK law. The rule allows a memberof 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 canonly be claimed for losses in the UK Marks & Spencer appealed,arguing the legislation harms companies that have subsidiariesoutside the country, a violation of EU law. The UK High Courtreferred the case to the EU tribunal.If Marks & Spencer wins, it would harm the cohesion of theUKs tax system, Eoghan Fitzsimons SC, a lawyer for the Irishgovernment, said during the hearing. Tax relief should be grantedonly where the government has the power to tax. Since the UKdoesnt tax foreign-based subsidiaries, no deductions for lossesshould be granted, he said.The case is C-446/03 Marks & Spencer Plc v. U.K. Inspector ofTaxes.

Section 4.2 of Unit 4 introduced the issue of taxation in the contextof the capital structure of the firm. The text notes that debtfinancing is cheaper, after tax, than equity. This concept can becarried forward into the context of capital investment funding.Taxation can have an important influence on the capital investmentdecision, in that there exists a fundamental difference between debtand equity funding. If, for example, a capital project is funded byequity capital, no tax benefitswill accrue,whereas interest ondebt-funded investments is usually tax deductible. In one sense, theimpact of the tax deductibility of interest expense is to create asort of asset, normally referred to as a tax shield, because theexpected future post-tax cash flows are increased.Aswith allassets, it is possible to derive avalue for this debt-created taxshield by calculating the presentvalue of its expected future cashflows. The expected future cash flows can be estimated by



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computing the expected reduction in future tax payments causedby the required interest payments on the debt financing.

Alternatively, if the tax rate and debt/equity ratio are assumedconstant throughout the life of the project, aswas the case inUnit 4, thevalue of the tax shield can be included through thefactor(1T) in theWACC formula.If theWACC isusedasadiscountrate,noallowanceshouldbemadefor the taxshield in thecashflows tobediscounted.The(1T) term in theWACCallowsfor this.

ACTIVITY 3.3Forwhich type of project is use of theWACCwith a taxshield inappropriate?Anewsingleprojectcompanysuchasacablecompanywhich isunlikely tohavea tax liability (andhencepossibilityof taxshield) in itsearlyyears.Essentially,suchacompany isunlikely tomeet theconstantdebt/equityratiocondition.It isbetter insuchconditions to include taxshieldeffectsexplicitly through thecashflowfigures, rather thanrelyingon tax-adjusting thecostofcapital.

However, it should be noted that tax deductible allowances orcapital allowances, aswell as changes in tax rates, affect after-taxcash flows. Capital allowances, although not cash flows, providea tax shield for revenues. In order to improve the realism ofinvestment appraisals, DCF methods should use after-tax cash flowsin the assessment of project proposals. However, the tax rates andallowable depreciation ratesvalidwhen analysing an investmentmay not be the ones in effectwhen the project is implemented.

Any such changes can cause the actual NPVand IRR amounts todiffer from those originally estimated for the project.Finally,you may now be under the impression that tax must beconsidered in every project appraisal. Note, however, that manyorganisations are not legally required to pay tax, includingcharities and many public sector organisations. Nevertheless, thesetypes of organisations spend funds on capital projects. In additionasyou saw in the activity above, new or loss-making companiesmay not be liable to tax either. However, their circumstances aredifferent again, in that losses can be carried forward under theassumption that eventually the companywill become profitable inthe future.

Refer to Unit 4. Capitalallowances is the UK termfor tax-deductibledepreciation allowances.



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ACTIVITY 3.4Discusswhat inyour opinion is the impactof taxation on theChannel Tunnel project.BecausetheChannelTunnelisaprojectofalong-termnatureitwillbesubjecttoarangeofchangingtaxfactorsovertime.Intheearlyyearsithasbeenloss-making,buildinguptaxlossesagainstwhichanyeventualfutureprofitsmaybeoffsettable.Taxationratesmaychangeovertime,whichcouldaltertheprofileofthetaxpayments.Allthesefactorswillimpactuponthetaxationchargesand,inaddition,managerswillbeabletomakedecisionswhichwillaffectthetaxflows.Also,sincethecompanyisunlikelytobepayingtaxes,the(1T)factorintheWACCshouldnotbeusedforthecostofdebt,sincetaxreliefisnotlikelytobeavailable.Oneshouldnotethat,despiteerrorsinthesalesforecasts,theTunneldoesusuallymake

an

operating

profit.

It

is

the

cost

of

the

huge

debt

that

has

madetheoverallresultssoproblematic.

I N T E R N AT I O N AL C AP I T AL BUD G E T I N G

3 . 8 No discussion about capital budgeting is completewithoutconsidering it in an international context. In the sameway as fordomestic capital investment decisions, international capitalbudgeting focuses on expected incremental cash flows linked tothe project. The same difficulties apply to assessing these cashflows but international project appraisal is often more complex, inthat, for example, a multinational company must consider factorsspecific to the international environment, including financial issuessuch as cross-border taxation and foreign currency risk.

Additional complexities inherent in international capital budgetinginclude the following:

Block 4 will deal with thetopic of foreign exchangerates.

l differing project and parent cash flows (due to difficulties inremitting cash to the parent because of exchange controls)

l exchange rates may not be constant throughout the projects lifel different tax rates may apply in the host country and the

parents country.

Exchangecontrols relateto controls on trading andmovement of currencies,usually used bygovernments

through

their

central banks to stabilisethe exchange rates of thedomestic currency.

Exchange controls A project may generate substantial cash flows abroad, but becauseof exchange control restrictions, it may be impossible to repatriatesome or all of these foreign cash flows back to the parentcompany. Ifyou 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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presentvalue of a project is a function of future cash flowsdistributable to the investors or owners. But if the greater part ofthe foreign cash flowswere blocked by exchange controls, onlythe residual cash flows could be transmitted back to the parentcompany.Which cash flows should be considered?International

capital

projects

can

be

viewed

from

two

standpoints

incrementalprojectcashflowsorincrementalparentcashflows.First,projectcashflowscanbedeterminedfromtheforeigndivisionsstandpoint,asifitwereanindependententity,andsolelyanalysedfromwithinthehostcountry.Thesecondstagemovestotheparentcompanyandfocusesontheamountandtimingofdistributablecashflows.If no exchange controls exist in the host country, all foreign projectcashflowsshouldberepatriable.Ifexchangecontrolsareinplace,furthercomplexitiesareaddedtothedecision-makingprocess.Therearewaysbywhichremittancestotheparentcanbeachieveddespiteexchangecontrols.Forexample:l repatriating dividends from abroad to host countryl payment of royalties and management feesl loan repaymentsl countertrade.Countertrade involves a reciprocal agreement for the exchange ofgoods or services and may be used as away to remit profits. Theparties involved may be companies or governments, and theseagreements can take a number of forms, for example, barter,counter purchase, industrial offset (reciprocal arrangements to buymaterials or components from sources in the foreign country). Suchmethods to avoid unremittable profits may change the project frombeing undesirable to acceptable.International taxation

We have discussed international capital budgeting from thestandpoint of the parent company.Any project cash flowswill inthe first place be subject to host country taxes. Then, upondistribution (or presumed distribution) to the parent, the cash flowsmay be subject to awithholding tax (a tax levied on dividendspaid abroadwhich are expatriated to another country) and finallyto corporation tax of the parents home country.Let us provide an examplewhich illustrates this procedure.

Assume that a firmwith a proposed project abroad has providedan earnings forecast equivalent to 1m in pre-tax profit.With atax rate in the host country of 15%, awithholding tax rate of 10%and a home country corporation tax rate of 30%,we show thenumbers to be incorporated in the investment appraisal inTable 3.2.



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Table3.2 Projectappraisal parentcompany cashflowsnetof taxes

Profit generated before tax 1,000,000Foreign tax charge at 15% (150,000)Witholding tax charge 1m6 85%(foreign post-tax profit = 850,000 at 10%) (85,000)

(235,000)Home country tax

1m @30% (300,000)Foreign tax credit

Providing net of tax home country profit

235,000(65,000)700,000

NB:Foreign tax credit is the amount of tax paid in a foreign country claimed by the companyas a credit against home country tax.

Please note that in Table 3.2we have ignored any potential capitalallowanceswhich might accrue to the firm.

We assume that the above investment scenario takes place undera tax regime inwhich all foreign taxes paid are credited againsthome

country

tax

liabilities.

This

may

not

always

be

the

case

and

will depend on the particular tax treaty in operation betweenthe two countries concerned. If full double tax reliefwere notavailable, for example, the project proposal might not generate apositive NPV for the parent company. However, the project mightlook acceptable by, for example, rerouting funds around theworld

without being returned to the home country, thus avoiding the30% tax charge. Relevant tax information such as this ought to beincluded in the decision-making process andwill enhancemanagers ability to make optimal international investmentdecisions.One could infer from the above scenario,which exemplifies aheavy tax regime aswell as difficulties in the repatriation of profitsto the home country, that many countries discourage direct foreigninvestment. On the contrary, many countries are now competing

with each other to attract multinational organisations andinvestments. These countries offer a range of incentiveswhichinclude:l low corporate taxation rates (Isle of Man)l tax relief on a range of inward investments (UK)l subsidies (regional grants and European Union grants)l taxation holidays (i.e. firms can operate for fiveyears in the

guest countrywithout paying taxes, e.g. Ireland).



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Indeed, two major factors for multinationals decidingwhether ornot to invest in a country/location are the tax regulations andincentives. In recentyearswith opening up of economies in China,India, and several Central European and LatinAmerican countries,multinational companies have increased direct foreign investmentsin these countries. The main reasons for increasing internationalinvestments are the cost advantages and large domestic demand forgoods and services. Tax issues have not been seen to be adisadvantage.Finally, there is evidence that multinational organisations charge allof their foreign projects (for investment appraisal purposes)with ahypothetical average home tax rate that smoothes out anomalies(Buckley,1998). Perhaps the best appraisal approach for projectsabroad is to apply the harshest tax treatment to a base case andthen apply sensitivity analysis assuming either zero home countrytax or the average home country tax rate. This type of exercise

would provide additional data to decision-makers in their continualquest for perfect capital appraisal techniques.International capital budgeting is also an issue for governmentalorganisations. Most developed countries provide foreign aid to lessdeveloped countries, often in the form of aid projects inwhichexpertise and fixed assets are supplied from the donor country tothe recipient country. These projects areweighed up in part on thebasis of the benefits to the recipient country and of the costs to thedonor country. No doubt, also, matters of international politics anddiplomacy play a part. One issue they raise is how and how muchdonor

country

taxpayers

benefit

from

projects

and

services

provided in host countries.S UM M AR Y In this sectionwe discussed a range of inter-related issues on thesubject of investment appraisal techniques.We studied a range ofappraisal techniques used by organisations. Not only mustweunderstand the use of the correct appraisal techniques, but also theoverall context of the CAPEX decision process inwhich the choiceof technique takes place.The articleyouwere asked to read asActivity 3.1 provides someinsights into a projects implementation and review phase. It shows

why a decision to go for a project needs to be revieweddispassionatelywhen earlywarnings for the potential failure of aproject arevisible. In real lifewhen managers attach emotionalimportance to completion of a project rather than its possibleconsequences on ownerswealth, the company may lose substantial

value. In some organisations managers manipulate the process inorder to advance their own project proposals in a financiallyconstrained environment.Inflation and taxation add to the complexity of project evaluationand theywere briefly discussed in the context of CAPEX. Underconditions of inflation, cash flows and discount rates are difficult to



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estimate.We also examined aspects of taxation in the context ofCAPEX appraisals and the potential effect tax has on the cash flowprofiles over the life of a project.Finally, as many organisations operate in an internationalenvironment, it is important to review aspects of internationalcapital

budgeting,

since

managers

have

an

additional

range

of

complicating factors in their decision-making process.At the sametime, international taxation is an important consideration formultinational organisations in their foreign investment programmes.Competition for global market share is driving force for largecapital investments by multinational organisations in internationalcontext.



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4C A P I TA L R A TI ON I N G 4 CAPITAL RATIONING

So farwe have implicitly assumed that all project proposalswhichhave a positive NPV should be implemented. In this sectionweexaminewhy an organisation may not be able to undertake all theinvestment projects it maywant to because of a shortage ofinvestment funding. Organisations may also face other constraints

which force them to make choices between competing projects.We examine the issues surrounding the shortage of investmentcapital towhich most, if not all, organisations are subject most ofthe time. Capital rationing involves the selection of an optimalarray of investment projects under financial and other resourceconstraints.We discuss competing projects and the make or buydecision,where an organisation has the opportunity to outsourceits production or services as opposed to producing its productsin-house. In the same contextwe review aspects of competingprojects.We expand the issues further by examining the privatesector question ofwhether a company should grow organically orthrough the acquisition route.

C AP I T AL R AT I O N I N G I N P R AC T I C E 4 . 1 A capital rationing problem is defined as a situationwhere thereare insufficient funds to finance all available beneficial projects.

Amajorproblemwhichmayfaceprivatesectororganisations iscashshortage.Ontheotherhand,public-sectororganisationscanbeconstrainedbycentralgovernmentideologyandpolicyfromraisingloanfinance.Ifanorganisation identifiesseveralprojectsthatarebeneficial(i.e.haveapositiveNPVorbenefitswhichoutweighcosts),itwouldliketoundertakeallof them.However, itmaybepreventedfromdoingsothroughalackof funds.Therestriction isapracticalone.Intheory,ifaprofit-orientedprojectproposalshowsapositiveNPV,thereshouldbenoproblemraisingthecashforitsimplementation.ApositiveNPVindicateshowmuchbetteroffabusinesswouldbeafteradequatelyrewardingallsuppliersofcapital.In practice, a businesswill find its capital rationed mostly forinternal reasons rather than external constraints. The organisationmust choosewhich projects to invest in so that its objectives aremet as fully as possible. In addition, an organisation may also beconstrained by its inability to manage all projects itwould like toundertake in otherwords, management skills themselves arealso a scarce resource.

Some organisations haveexcess cash and notenough attractive projectsto invest cash in. In suchcases they may returnexcess cash throughspecial dividends or sharerepurchase schemes.Microsoft Inc. did so in2004 and is one of manyexamples.



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The profitability indexmethod is discussed indetail in Section 4.4.4 ofVitalStatistics.

There are a number of techniques available to enable managementto decide, in principle,which projects can be undertaken underconditions of a shortage of investment capital.Wewill illustrate onesuch method, called the profitability index (PI) or costbenefitindex method. It has its limitations, but is a useful instrument toassist 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 threeinvestment proposalsA, B and C, outlined in Table 4.1.Table4.1Project Investment (m)

T0Inflow (m)

T1Inflow (m)

T2NPV (m)

A 10 +30 +5 +21B 5 + 5 + 20 + 16 C 5 + 5 + 15 + 12

Allthreeprojectsareattractivei.e.theyallhavepositiveNPVs.ButthefirmhasalimitonitsCAPEXspendingof10m,soitcaninvesteitherinprojectAor inprojectsBandC,butnotinallthree.AlthoughindividuallyBandChavelowerNPVsthanprojectA,whenaddedtogether theirNPVsarehigher.The

PI

is

expressed

by

the

following

simple

formula:

Net present value

PI =Investment

For the three above projects the PI can be calculated as inTable 4.2.Table4.2 Profitability indexProject Initial investmentatT0 (m) NPV (m) PIA 10 +21 2.1B 5 +16 3.2C 5 +12 2.4

ProjectBhasthehighestPI,andCthenexthighest.Therefore, ifourCAPEXbudgetlimitis10million,weshouldacceptthesetwoprojectproposals.WhenprojectshavepositiveNPVstheywillalsohavepositivePIs.AllprojectswithapositivePIwouldbeacceptable,but

wherechoices

have

to

be

made

the

magnitudes

can

determine

a

rankingofprojects.



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4 CAPITAL RATIONING

However, there are limitations to the use of PI under certaincircumstances, such aswhen resources are constrained over morethan one period, orwhen two proposed projects are mutuallyexclusive orwhen one project is dependent on another.Nevertheless, the simplicity of PI does allow for rankings to beestablished in many situations.

A more complex capital rationing problem is illustrated by thefollowing example. Let us look at Table 4.3:Table4.3 Multi-period capital rationing Year ProjectAPresent valueof

cash flows ()ProjectB

Present valueofcash flows ()

0 (8,000) (6,000)1 (4,000) (8,000)25 cumulative inflows 28,000 29,000NPV at 10% 16,000 15,000

Notethateachprojectneedsfunding intwoperiodsandeachproducesapositiveNPVwhendiscountedat10%.If therewerenoshortageof fundsbothprojectsshouldbeundertaken,asbothare

worthwhile.Assume, however, that only 10,000 is available at time 0.Assuming that projects must be undertaken as awhole or not atall, projectA should be chosen as itwill produce an NPV of16,000.Although project B uses up only 6,000 of the funds attime 0,whereas projectA consumes 8,000,we have no otherproject onwhich to spend leftover cash and merely leaving it inthe bank earning interest at an (almost) risk-free ratewill give azero NPV.This discussion about capital rationing by no means covers thesubject in full. The problem of investment decision-making inthe

face

of

capital

rationing

over

more

than

one

period

is

both complex and, at present, not completely resolved.Wehave described a decision rule to determine the best use ofscarce investment capital and how best to select projectswhichgenerate the highest positive NPV. In addition,we can applysensitivity analysis to the range of relevant cash flows of thecomparative projects, and use the results to decidewhich projectto select.In the public sector, managers also have to choose betweencompeting projectswhere criteria other than positive NPVs mayalso be relevant. The bottom lines of public service projects



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include such criteria as the ability to defend and attack; the abilityto keep order; the ability to educate theyoung and thenot-so-young; and the ability to keep people and products onthe move. One could argue that benefitcost techniques providea quantitative equivalent to NPV, but applying a benefitcostapproach may involve inputtingvalues on keeping people alive,having people educated to certain standards, protecting people andproperty fromwrongdoers, or shortening travelling times. Theseinputedvalues, apart from being technically and sociallycontroversial (Who can put avalue on human life?), may give aspurious quantitative accuracy to analyseswhich are entirelysubjective. In the end, it is often up to politicians, governmentadministrators and professional people employed in government(soldiers, doctors, teachers, socialworkers, engineers) to reachsubjective decisions through co-operative, competitive/political anddemocratic means, using criteriawhich are social and political as

well as economic.

C O M P E T I N G P R O J E C T S 4 . 2 This sub-section dealswith the choice organisations must make inthe case of competing projectswhich, for example, offer a specificoutput but use a different technology to achieve this output.Wealso describe the situationwhen an organisation has to determine ifit is profitable to invest in, for example, additional plant andmachinery, or buy in the products from an outside supplier. Thisclassic problem in the application of DCF methods is known as themake or buy problem. It illustrates theway that opportunity costscan be taken into accountwithin a single project DCF framework(see Box 4.1).

For simplicity we haveignored tax in thisexample. A cost-savingproject typically has taximplications in the sameway as a revenue-generating project.

BOX 4.1DELTADelta is considering producing an in-house component that itneeds in an assembly operation. Its manufacture requiresadditional plant costing 400,000 which would last for four years,with a residual value of 200,000, which would be received in thefollowing year. Manufacturing costs in each year would be500,000, 700,000, 800,000 and 900,000 respectively. If Deltaoutsources the components the costs are forecast to be 900,000,1,000,000, 1,100,000 and 1,400,000 in each year. However, theplant will occupy floor space which can be put to other usesgenerating 200,000 in each of the four years. This opportunity islost if the make option is adopted. If the WACC is 13%, shouldDelta make or buy the component?



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4 CAPITAL RATIONING

Costs of making in-house (000)Year 0 1 2 3 4 5Plant -400 0 0 0 0 200Manufacturingcost -500 -700 -800 -900Floor spaceopportunitycosts

-200 -200 -200 -200

Total makingin-house costs -400 -700 -900 -1000 -1100 200Discount factorof 13% WACC 1.0 0.8850 0.7831 0.6930 0.6133 0.5428DCF -400 -619 -705 -693 -675 +109NPV formaking in-house -2983Costs of buying in (000)Purchase costs 0 -900 -1000 -1100 -1400 0Discount factorof 13% WACC 1.0 0.8850 0.7831 0.6931 0.6133 0.5428DCF 0 -796 -783 -762 -859NPV forbuying in -3200Hence making in-house is 217K (i.e. 3200K- 2983K) cheaperthan buying in.

A correct make or buy decision can often be a major determinantof profitability. The choice ofwhich components to outsource issometimes made by ascertainingwhatwill save most on overheadcosts, rather than onwhat makes the most long-term economicsense. In the public sector, outsourcing has found favour as ameans of cost cutting, as labour provided by the private sector mayentail lower costs and related employee benefits.Even so, there are some important factorswhich are notquantifiable, for example the security of supply if the firm hasoutsourced its supplies.An argument for outsourcing is often statedto be the rapid changes in the market and the lack of flexibilitythat characterises in-house production.Guided by the arguments for retaining and building up its corecompetency strategic framework, Telequip, a telecom equipmentsupplier, outsourced many of its activitieswhich included assemblyoperations, piece part manufacture and in some cases design.

In August 2005, BritishAirways hadjust such aproblem with its LondonHeathrow aircraft mealssupplier, Gate Gourmet.



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But a study of Telequips outsourcing policy found that the actualdecisions to outsource ended up as cost-cutting devices rather thanreally helping company strengthen its core business,whichwasre-defined by the company asminimising the timebetweenanorderbeing receivedandfulfilmentof thatorder (McIvor, 2000).This tendency to outsource components or serviceswhichwereformerly performed in-house can result in unexpected costincreases,with many organisations failing to integrate the make orbuy decision into the overall business strategy. This can lead to asituationwhere manufacturing processes or services are dispersedat random throughout the organisations operations and facilitiesand it becomes dependent on a muchwider range of suppliers ofcomponents and services.An additional risk is that managementcan lose control over its operations and output and hence severelyput the companys cash flows at risk. This is in contradiction tothe original objective of outsourcing in order to save costs. Oneapproach suggested to enhance the chances of successfuloutsourcing of non-core activities is to apply mergers andacquisitions principles to outsourcing deals. This entails specifyingthe 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 fortransition (Craig andWillmott, 2005).

Youwill read in Box 4.2 below about the biggest outsourcing dealfrom Europe to date. Note how the benefits of outsourcing havebeen carefully quantified.

BOX 4.2ABN AMRO IN $2.2BN INDIAN IT DEAL By Khozem Merchant in Mumbai, Sarah Laitner in Amsterdam andRichard Waters in San FranciscoABN Amro, the Dutch financial services group, has agreed one ofthe biggest outsourcing deals in Europe and given the Indian ITsector its most lucrative contracts in a five-year programme worthat least $2.2bn.As well as IBM and Accenture of the US, the contractors includeTata Consultancy Services, Infosys Technologies and PatniComputer Systems of India.For ABN it represents a bid to cut technology costs and releasefunds for investment in emerging markets as it implements costandjob cuts. Analysts say Indian companies inclusion in the dealafter nine months of negotiation sen

b821 block3unit5 project appraisal

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