Financial Appraisal, Sensitivity and Scenario Analysis

R.Ganesh, Sr.faculty, SBSC, Hyd

Capital Investment Process

• TTIdentification Evaluation

Implementation & Follow up

Selection

Type of Investment

•Required Investment•Replacement Investment•Expansion Investment•Diversification investment

Input•Expected cashflow stream•Discount rate

Decision Rule•Net Present Value•Profitability Index•Internal rate of return•Payback period

Performance Evaluation•Monitor magnitude and timing of cash flows•Check project still meets selection criterion•Decide on continuation or abandonment•Review steps if failure rate is high

Payback Period

Payback period is the number of periods for the sum of project’s expected Cash Flows to equal its initial cash outlay.

Payback period is the time it takes to recover its initial investment.

A project is acceptable if the payback period is shorter than or equal to CUT-OFF period.

Expected cashflow streams – alternative investment proposals – Initial outlay of ONE million rupees

End of Year Investment A

Investment B

Investment C

Investment D

Invesrtment E

Investment F

1 600,000 100,000 250,000 250,000 325,000 325,000

2 300,000 300,000 250,000 250,000 325,000 325,000

3 100,000 600,000 250,000 250,000 325,000 325,000

4 200,000 200,000 250,000 250,000 325,000 325,000

5 300,000 300,000 250,000 250,000 325,000 925,000

Total Cashflows

1,500,000 1,500,000 1,250,000 1,250,000 1,625,000 2,275,000

Payback period

3.00 3.00 4.00 4.00 3.08 3.08

Drawbacks of Payback method

• Strongest appeal !!

Adjustment for timing of Cash Flows ?Adjustment for Risk ?

Maximisation of the Firm’s Equity Value ?

Its simplicity & ease of applicationContributes to overall liquidityIt is easy to employ when future events are difficult to quantify

Discounted payback period

Discounted payback is the number of periods required for the sum of present values of project’s expected cash flows to equal its initial cash outlay.

Discounted Payback –calculations- Investment ‘A’

End of Year Expected cashflows

Discount factor Present Value Cumulative Present value

1 600,000 0.9091 545,455 545,455

2 300,000 0.8264 247,934 793,389

3 100,000 0.7513 75,131 868,520

4 200,000 0.6830 136,603 1,005,123

5 300,000 0.6209 186,276 1,191,399

Expected cashflow streams and cost of capital – alternative investment proposals – Initial outlay of ONE

million rupees

End of Year Investment A

Investment B

Investment C

Investment D

Invesrtment E

Investment F

1 600,000 100,000 250,000 250,000 325,000 325,000

2 300,000 300,000 250,000 250,000 325,000 325,000

3 100,000 600,000 250,000 250,000 325,000 325,000

4 200,000 200,000 250,000 250,000 325,000 325,000

5 300,000 300,000 250,000 250,000 325,000 925,000

Total Cashflows

1,500,000 1,500,000 1,250,000 1,250,000 1,625,000 2,275,000

Cost of capital

10% 10% 5% 10% 10% 10%

NPV 191,399 112,511 82,369 -52,303 232,006 635,605

Discounted Payback period

3.96 4.40 4.58 More than 5

3.86 3.86

Internal Rate of Return(IRR)IRR is the discount rate that makes the Net Present Value (NPV) of the Project EQUAL to ZERO.

An investment to be accepted if its IRR is higher than its Cost of Capital and should be rejected, if lower.

IRR can be interpreted as a measure of profitability of its expected cashflows.

IRR takes into account Time Value of money and risk of investment

Expected cashflow streams and cost of capital – alternative investment proposals – Initial outlay of ONE

million rupees

End of Year Investment A

Investment B

Investment C

Investment D

Invesrtment E

Investment F

1 600,000 100,000 250,000 250,000 325,000 325,000

2 300,000 300,000 250,000 250,000 325,000 325,000

3 100,000 600,000 250,000 250,000 325,000 325,000

4 200,000 200,000 250,000 250,000 325,000 325,000

5 300,000 300,000 250,000 250,000 325,000 925,000

Total Cashflows

1,500,000 1,500,000 1,250,000 1,250,000 1,625,000 2,275,000

Cost of capital

10% 10% 5% 10% 10% 10%

IRR 19.05% 13.92% 7.93% 7.93% 18.72% 28.52%

Net Present Value

Discount factor is the inverse of compounding factor.

NPV(k,N) = -CF0 + CF1 X DF1 + CF2 X DF2 + …………… …….CFt X DFt + ………………………...CFN X DFN

NPV = (-)Initial cash outlay + Present value of future cash flows at the cost of capital.

Investment to be undertaken if its NPV is positive and should be rejected if NPV is negative

Why NPV rule is a good investment rule ?

•It is a measure of value creation – when NPV is positive, project creates value and when negative, destroys value.•It adjusts for the timing of project’s expected cash flows

•It adjusts for the risk of project’s expected cash flows

•It is additive.

NPV Profile Expected Cash Flows – CF(0),

CF(1), CF(2)…….CF(n)

Risk of expected cashflow stream

Cost of Capital (k) required

rate of return

NPV = --CF(o) + ∑CF(t)/(1+k) tt=1,n

NPV>0

NPV<0

Accept Project

Reject Project

Cost of capital The Project is going to be financed entirely with Debt, so its relevant cost of capital is the INTEREST Rate of Debt – or – Project is going to be financed entirely with Equity, so its cost of capital is Cost of Equity

Although project does not have same risk as the Co, its relevant cost of capital should be equal to firm’s WACC because firm’s shareholders and

debtors are paid with cash from firm’s cash flows, NOT from the Project’s cash flows

When Project’s risk is different from the risk of the Firm, the Project’s cost of capital should be lowered to account for the

risk reduction that diversification brings to the firm.

SummaryEvaluation Method

Inputs Required Decision Rule Does the Rule

Adjust cash flows for

For Calculation

For Decision Accept Reject Time ? Risk ?

Net present Value(NPV)

• Cash flows•Cost of Capital(k)

NPV NPV > 0 NPV < 0 Yes yes

Profitability Index (PI)

•Cash flows•Cost of capital(k)

PI PI > 1 PI < 1 Yes Yes

Internal Rate of return(IRR)

• Cash flows •IRR•Cost of capital(k)

IRR > k IRR < k Yes Yes

Discounted Payback period(DPP)

•Cash flows•Cost of capital (k)

•DPP cut off period

DPP < cutoff period

DPP > cutoff period

Only within DPP

Only within DPP

Payback period(PP)

•Cash flows •PP•Cutoff period

PP < cutoff period

PP > cutoff period

No No

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Financing Operation in IndiaEquity/Risk Capital

Public Equity Issue

Debt/Borrowed Capital

Foreign direct Investment

Project Finance

Term loans & Working capital finance

External Commercial Borrowings

Corporate Loan Market

Corporate Debt Market

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Equity Capital

• Various means of raising equity capital– Bringing foreign funds

• Foreign direct Investment including ADRs/GDRs and FCCBs

• Preference share capital (not included in ECBs or FDI sectoral caps)

– Raising domestic funds• Private placements• Public issue of equity

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Raising Domestic equityPrivate Placement• To raise funds and dilute equity in favor of Indian shareholders (as per FDI

sectoral caps) while limiting the no. of shareholders.• Private equity/venture capital investors to provide funding from ideation

stage as well as help nurture the growth.

Public Issue• Well developed Equity markets with total market cap in excess of

Rs 60 lakh Crores as of Dec,2010• Liquidity mainly in large cap and some mid cap companies• Main participants – Mutual funds, Insurance companies, FIIs and retail

investors

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Private Equity

• Can be used to raise funds and dilute equity in favor of Indian shareholders (as per FDI sectoral caps) while limiting the no. of shareholders.

• Private equity/venture capital investors provide funding for Sunrise industries – Biotech, Hightech, etc.– Many US based funds invest in Indian companies or US companies with

focus on India– Funding for startups and small scale units hard to come by, funding

mainly for second stage or later– Typically look for the management team, their speed of execution,

ability to scale, managing customer expectation, infrastructure, client relationships and dependence, order book/ pipeline and profitability.

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Corporate debt market in India• Less deep than Equity markets contrary to world markets

• Liquidity mainly in Govt. securities and highly rated corporate papers (AAA and AA)

• Primarily an OTC Market

• Listed corporate debt market – Listed market underdeveloped

– Listed debt markets are also regulated by SEBI

– Listing requirements• Rating must for listing of debt

• Credit Rating Agencies – Crisil (alliance with S&P), ICRA (alliance with Moody’s), CARE and Fitch India.

• Banks investment in unlisted non SLR securities restricted to 10% of the total investments in non SLR securities.

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Corporate debt market in IndiaMarket players:

• Qualified Institutional Investors (QIB)– Public financial institution

– Scheduled commercial banks

– Mutual funds

– Foreign institutional investor registered with SEBI

– Multilateral and bilateral development financial institutions

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Project finance• Project Finance

– Rupee project loans to fund Land & Buildings, Plant & Machinery, pre-operative and preliminary expenses (including interest for the construction and installation period) and margin money for working capital

– Foreign currency project loans to fund imported capital equipment, services incidental to the equipment such as technology transfer and servicing fees, and domestic project expenditure.

– Syndication of domestic/international debt

– Use of EXIM bank US/Developed countries- funding for import of capital equipment from those countries

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Project Finance (contd.)• Rupee assistance by way of subscription to debentures and

shares• Assistance by way of underwriting shares and debentures• Guarantees for

• Foreign currency loans • Export credits.• Suppliers of equipment • Foreign lenders• Bond guarantees and confirming guarantees

• Equity • Mezzanine finance • Equity • Take-out finance

• Assistance for a project loan would typically be for a longer tenure than for a corporate loan

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Term loans and working capital finance

Fund based working capital services

Cash credit facility Working capital demand

loan Export packing credit /

Pre-shipment credit Packing credit & foreign

currency Short term loan MIBOR linked loans Commercial paper Invoice bill discounting

(Clean & LC backed) Foreign currency non

resident (bank) loan Buyers & suppliers credit Over draft

Securitization

Receivables (present and future)

Off balance sheet funding

Plain vanilla corporate loans

Structured finance

Long term loans