AC6101

Lecture 2
Project Finance
Valuing Unlevered Projects (2)
 Inflation
“A general rise in the price of goods and services over time”

Two issues when incorporating inflation into project finance.

• Cash-Flows – costs/revenues will rise over life of project. May rise at
general inflation rate (CPI or other measure) or at specific inflation rates
(wages, commodities, services etc.)
• Discount Rate – Investors opportunity cost of capital assumes a particular
inflation rate. This should be consistent with inflation rate projected for cash-
flows (general inflation rate because investors are subject to general
inflation).

• Terminology – “Real” – excluding effects of inflation

– “Nominal” – including effects of inflation
 Inflation
• Two approaches can be used
- discount real cash-flows at real cost of capital
- discount nominal cash-flows at nominal cost of capital

To convert real cash-flows to nominal – scale by projected inflation rate

To convert nominal discount rate use Fisher Equation

(1 + nominal rate of return) = (1 + real rate of return) × (1 + anticipated rate of inflation)

(1 + real rate of return) = (1 + nominal rate of return) / (1 + anticipated rate of inflation)

How inflation is dealt with in
Practice
 Forecasting inflation
• Current/past rates – inflation is relatively persistent –
relatively strong predictive power.
• Econometric models (output gap/unemployment/growth
etc.) – limited predictive power
• Explicit expectations (Surveys) – surveys of
economists/forecasters/households – relatively strong
predictive power
 Forecasting inflation
• Implied expectations – YTM on inflation protected/linked
bonds minus YTM on nominal bonds (same maturity &
risk)
– Current US 30yr (nominal) yield =2.92%
– Current US 30yr (TIPS) yield = 1.02%
• Implied inflation 1.9% avg. over next 30 years
• Note liquidity issue: TIPS daily turnover (June 2011) -
$11.6bn…Total daily turnover in US Treasuries (June
2011) - $586bn
• More significant liquidity issue in other countries e.g.
German has total of €40bn in ILB from $2.7trn
• Would expect a liquidity premium in YTM of inflation protected
bonds – especially in times of market stress.
• Seem to consistently underestimate inflation (c. 50 bp in 10 years to
2007)
 Mutually Exclusive Projects
• Firms can be faced with a number of
potential projects, not all of which can be
undertaken:
– Use of a particular site etc.
– Capital rationing - hard or – soft
 Capital Rationing
• Capital rationing occurs when funds are not available to finance all wealth-
enhancing projects
• Soft rationing
Internally imposed
e.g. divisional budget limits
should ensure that only the most +NPV projects undertaken
unwillingness to increase debt
• Hard rationing
external limits on capital
should theoretically never occur in a perfect capital market
but is a particular problem for small and/or high risk firms.

• One-period investment appraisal under capital rationing – requires ranking

of projects.
– 1 Divisible projects – use Profitability Index
– 2 Indivisible projects – use NPV.
Choosing single investment among
alternatives.
• Decision rule when faced with multiple
alternatives – accept alternative with highest
positive NPV, if no alternative has a positive
NPV reject all alternatives. Using IRR/MIRR will
not give the correct decision
• Examples
Company owns site: sell it, develop new factory,
develop car park etc.
 Multiple Alternative Example
• You are FD of CoffeeBean (CB) Properties Ltd, a
company involved in the commercial property
sector.
• CB is considering the acquisition of the former
ESSO station on Western Rd at a cost of €3.5m.
• The Board have asked you to investigate a
number of possible projects to be undertaken on
the site.
• CB’s cost of capital is 15%.
 Projects.
• If the site is to be developed it will have to be
decontaminated and cleared at a cost of €350,000, and
this will take 1 year.
• Alternative 1. Purchase and clear the site and sell on to
developer after 1 year, expected sale price €4m.
• Alternative 2. Purchase and clear the site, develop a
number of retail outlets (construction time 2 years) costs
of €2m per year of construction estimated. Sell retail
units for €11m after 3 years.
• Alternative 3. Purchase and clear site, rent as car
parking for 6 years, expected revenue €200,000 per year
– sell as site after 7 years. Expected sale price of €5.5m
 Mutually Exclusive Projects
• Excel spreadsheet – mutually exclusive
projects
  NPV IRR

Alternative 1 282,609 24.29%

Alternative 2 601,011 20.27%

Alternative 3 (1,078,523) 9.05%

• When faced with mutually exclusive

projects – NPV analysis will give correct
decision – IRR may not.
 One-period capital rationing
with divisible projects
•Capital at time zero has been rationed to £4.5m
 Bigtasks plc (continued)
Ranking according to absolute NPV
Ranking using Profitability Index
PV of Future Cash-Flows
Profitability index = ––––––––––––––––
Initial outlay
• PI greater than 1 means projects are +NPV
• Calculate PI for projects A,B,C & D and assign available
funds based on PI ranking.
 Capital Rationing
Bigtasks plc.
Project NPV PV – Future Initial PI
(10%) CFs Outlay
A 4,281 6,281 2000 3.1405
B 3,215 4,215 1000 4.215
C 2,389 3,389 1000 3.389
D 14,355 17,355 3000 5.785
Bigtasks plc: Ranking according
to the highest profitability index
 Single Period Capital Rationing
with Indivisible Projects
• PI is not appropriate (doesn’t take
magnitude of NPVs in to account)
• Use NPV
• Try different combinations of project NPVs
(Trial & Error) – only + NPV projects.
Indivisible projects
 Capital Rationing Example
• Paper Plc faced with a number of possible
projects
• Capital of €4m available
• Projects are all divisible
• Using PI, determine Paper’s optimal
investment.
• Discount rate of 10%
Paper PLC – €4m Capital Available
Projects Outlay CF1 CF2 CF3

A 1.5m 400K 750K 1.5m

B 2.5m 1.2m 1.4m 1.2m

C 3m 1m 1.5m 1.8m

D 2m 1.1m 750K 750K

E 2m 400K 800K 1.2m

 Modelling Cash Flow of a
Project
• Accounting profits are irrelevant - project may be loss making in accounting
terms but + NPV or vice versa.
• Key elements of cash-flow forecast
– Sunk vs. Incremental

– Ignore all sunk costs (overhead allocation?)

– Consider all incremental costs and revenues (may not be obvious)

 Elements of cash-flow forecast
• Capital Costs – generally at outset, although may be recurring
capital costs associated with project. Depreciation is not relevant to
Capital Costs.
• Operating & Maintenance Costs – project may increase/reduce
OMC’s. The incremental change is relevant. i.e. additional labour,
o’heads or reduced labour etc.
• Incremental Revenue – revenue streams may increase and/or
decrease with new project (e.g. introduction of new product line will
generate new revenues but may cannibalise existing sales – both
are incremental)
 Elements of cash-flow forecast
• Operating Benefits – Project may generate operating benefits
outside the immediate project.

• Working Capital – Project may involve and increase/decrease in

NWC.

• Taxation – Project may increase/reduce the company’s tax liability.

 Working Capital Investments
• Net Working Capital (NWC) is Current Assets – Current
Liabilities.
• Projects will often require an increase in the firms NWC,
some projects may involve a reduction in NWC e.g. more
efficient manufacturing process.
• Investment in working capital may be recovered, in
whole or in part, at the end of a project.
• These are incremental cash flows and need to be
accounted for in the analysis.
• Working capital is often a function of sales e.g. growth in
sales will result in growth in WC investment req’d
 Elements of Working Capital
Investment
• Cash – if project requires that a larger/smaller cash float be
maintained.
• Inventory – if project requires that a higher/lower level of WIP and/or
stock be maintained.
• Debtors – if project requires that a higher/lower level of debtors be
maintained.
• Creditors - if project requires that a higher/lower level of debtors be
maintained

Incremental NWC = ( ∆Cash + ∆ Inventory + ∆ Debtors) - ∆

Creditors
 Example Investment in NWC
• Orion Plc is considering purchase of a new machine for
making tennis balls (Project Alpha). Initial cost of
€200,000. Machine will last for 4 years and produce
cash-flows of +€60,000 in years 1 to 4. There are no
ongoing maintenance costs associated with the
purchase of the equipment. At the end of 4 years the
machine will be obsolete and will have a zero scrap
value.
• Project will require an increase of €35,000 in NWC,
which will be recovered at the completion of the
project.
• Should Orion Plc implement project Alpha.
• Assume a discount rate of 10% for the project.
 Project Alpha
P Cash-flows DF @10% DCF

0 -235,000 1 -235,000
Inv in Equip & NWC

1 60,000 .909 54,540

2 60,000 .826 49,560

3 60,000 .751 45,060

4 95,000 .683 64,885

NWC is recovered

NPV -20,955
 Non Discounted Cash Flow
Techniques
• Two commonly used alternative
techniques do not use DCF analysis
• Payback Analysis
• Accounting Rate of Return (ARR)
 Payback
The payback period for a capital investment is the length of time
before the cumulated stream of forecasted cash flows equals the
initial investment.

•Payback
Project A: 4 years, Project B: 4 years, Project C: 5 years.
 Tradfirm: Net Present Values (£m)

Exhibit 4.3 Tradfirm: Net Present Values (£m)

 Reasons for the continuing
popularity of payback
•Supplements the more sophisticated methods
e.g. an early stage filter
•It is simple and easy to use & understand
•Projects which return their outlay quickly reduce the
exposure of the firm to risk
• If funds are limited, there is an advantage in receiving a return
on projects earlier rather than later
•It is often claimed that the cash flows in the first few years of a
project provide some indication of the cash flows in later
years
 Drawbacks of payback
•It makes no allowance for the time value of money
and thus risk
•Receipts beyond the payback period are ignored
•Arbitrary selection of the cut-off point
 Discounted Payback period
• The discounted payback period for a capital investment
is the length of time before the cumulated stream of
forecasted discounted cash flows equals the initial
investment.
• A project with a +NPV will have a finite DPP, a project
with a –NPV will not have a finite DPP
• Remedies TVM issue but still applies arbitrary cut-off
period.
 Accounting rate of return
•The accounting rate of return (ARR) method may be
known by other names such as the return on
capital employed (ROCE) or return on
investment (ROI)
•ARR is a ratio of the accounting profit to the
investment in the project, expressed as a
percentage
•The decision rule is that if the ARR is greater than, or
equal to, a hurdle rate then accept the project

ARR = Average Annual Profit * 100

 Accounting Rate of Return
• Asset value of €50,000 – useful life of 5
years – no scrap value
• Cash-flows of €20K, €25K, €28K, €25K,
€20K
• Straight-line depreciation over 5 years.
• Firm requires projects return ARR of 25%
 ARR
Y1 Y2 Y3 Y4 Y5

Cash-Flow 20 25 28 25 20

Depreciation 10 10 10 10 10

Profit 10 15 18 15 10 13.6

ARR = 13.6 *100 = 27.2%

50
Drawbacks of accounting rate of return
•Definition of profit and asset values open to
interpretation/manipulation
•Profit figures are very poor substitutes for cash flow e.g.
depreciation/amortisation.
•Fails to take account of the time value of money
•High degree of arbitrariness in defining the cut-off or
hurdle rate
Drawbacks of accounting rate
of return (continued)
•Accounting rate of return can lead to some perverse decisions
•Suppose that Timewarp uses ARR, with a hurdle rate of 15 per cent
•The appraisal team discover that machinery, which was originally
thought to last 3 years, will in fact generate an additional profit of €1,000
in a fourth year
•Original situation

(5,000 + 5,000 + 5,000)/3

ARR = –––––––––––––––––––––– =
16.67%. Accepted
•New30,000
situation
(5,000 + 5,000 + 5,000 + 1,000)/4
ARR = ––––––––––––––––––––––––––– = 13.33%.
Rejected 30,000
 Reasons for the continued use
of accounting rate of returns
•Managers are familiar with this long established and
extensively used profitability measure
•Divisional performance and the entire firm is often
judged on a profit-to-assets employed ratio
•ROCE is the primary industry measure of
profitability/efficiency
Use of Investment Appraisal
techniques in UK Firms