Chapter 6

The Application of Project Evaluation Methods

Learning ObjectivesExplain the principles used in estimating project cash flows.Compare mutually exclusive projects with different lives.Determine when to retire (abandon) or replace assets.Use sensitivity analysis and break-even analysis to analyse project risk.Use decision trees to analyse sequential decisions.Explain the role of qualitative factors in project selection.Explain the effects of resource constraints on project selection.

IntroductionPractical project evaluation has to accommodate:Uncertainty with respect to cash flows.Uncertainty with respect to the estimation of the projects required rate of return.The existence and implications of taxes.

Application of the NPV MethodEstimation of cash flows in project evaluation:Exclude financing charges The required rate of return used to discount CFs incorporates both the cost of equity and debt. Avoid double counting financing charges in the CFs.Focus on incremental cash flowsIs it a cash item?Will the amount change if the project is undertaken?Exclude sunk costsSunk cost irrelevant to future decision making.Whether to continue a project should be based only on expected future costs and benefits.

Application of the NPV Method (cont.)Beware of allocated costsAny costs that will not change as a result of the project should be excluded from the analysis.Include residual valuesThis will provide a CF at end of project.Recognise the timing of the cash flows Just as in the valuation of debt securities such as bonds, the exact timing of CFs can affect the valuation of an investment project.A simplifying assumption is that net CFs are received at the end of a period.

Application of the NPV Method (cont.)Consistency in the treatment of inflationEstimate cash flows based on anticipated prices, and discount the cash flows using a nominal rate; orEstimate cash flows without adjusting them for anticipated price changes, and discount the cash flows using a real rate.The key is consistency. If the cash flows are nominal (real), the discount rate must also be nominal (real).

Inflation and the Need for ConsistencyExample 6.1: Assume that an investment of $1000 is expected to generate cash flows of $500, at constant prices, at the end of each of 3 years. Assume that the expected rate of inflation is 10% p.a., and that the nominal required rate of return is 15% p.a.

Inflation and the Need for Consistency (cont.)

Inflation and the Need for Consistency (cont.)(1 + p) (1 + i*) = (1 + i)i* = (1 + i)/(1 + p) 1 i* = (1 + 0.15)/(1 + 0.10) 1 = 0.0455Solution:

Inflation and the Need for Consistency (cont.)NPV = $1000 + $500/(1.0455)+ $500/(1.0455)2+ $500/(1.0455)3= $373NPV is > 0

Mutually Exclusive Projects with Different LivesOne project may end before the other.How to compare?Assume that company will reinvest in a project identical to that currently being analysed: Constant Chain of Replacement.Make assumptions about the reinvestment opportunities that will become available in the future.The second approach is more realistic and could be implemented if the future investment opportunities are known.However, in practice, this approach would be impossible to implement unless managers have extraordinary foresight.So, the constant chain of replacement approach is often used.

Constant Chain of Replacement AssumptionEach project is assumed to be replaced at the end of its economic life by an identical project.Valid comparison only when chains are of equal length. This can be achieved by:Lowest common multiple method.Constant chain of replacement in perpetuity.Equivalent annual value method.

Constant Chain of Replacement in Perpetuity The idea is to make both projects comparable. This is done by the following calculations, which lead both chains to continue indefinitely:

Equivalent Annual Value Method (EAV)Another way of making the projects comparable:Involves calculating the annual cash flow of an annuity that has the same life as the project and whose present value equals the net present value of the project.

Chain of Replacement and InflationChain of replacement methods assume that, at the end of the projects life, it will be replaced by an identical project.In an inflationary environment, the nominal cash flows will obviously not be the same.All cash flows and the required rate of return should be expressed in real terms (to maintain consistency).

Is the Chain of Replacement Method Realistic?The assumption that the machines replaced and the services they provide are identical in every respect is unrealistic.The impact of such assumptions is reduced by the fact that the associated cash flows are further into the future and are discounted to a present value.However, it may be more unrealistic for management to make predictions on replacement projects further into the future.

Deciding When to Retire (Abandon) or Replace a ProjectRetirement decisions:Situations where assets are used for some time, and then it is decided not to continue the operation in which the assets are used. Therefore, the assets are sold and not replaced.Replacement decisions:Situations where a particular type of operation is intended to continue indefinitely. The company must decide when its existing assets should be replaced.

Retirement DecisionsWant to determine, during the life of a project, whether the project is still worthwhile.NPV rule is the appropriate tool for retirement decisions.A project should be retired if the NPV of all its expected future net cash flows is less than zero.Example: Mortlake Ltd owns a 6-year-old machine.

Sheet1

End of yearNet cash flowResidual value

612 000

78 0006 000

85 0000

Example: Retirement DecisionsThe required rate of return is 10%: When should the machine be retired?PV of retiring now is $12 000.Maintaining machine will provide cash flows:need to calculate NPV if we run machine to end of years 7 and 8.Solution:

Example: Retirement Decisions (cont.)In this case, the NPV of running the machine for one additional year (year 7) is +$727. As this NPV is positive, the machine should be retained for year 7.In the case of year 8, the NPV of running the machine for the second additional year is $595. As this NPV is negative, the machine should be retired at the end of year 8.

Replacement DecisionsThe constant chain of replacement method may be used to evaluate replacement decisions.Two cases of replacement:Identical replacement.Non-identical replacement.Identical replacement:Choose the replacement frequency that maximises the projects net present value for a perpetual chain of replacement, or maximises its equivalent annual value.

Replacement Decisions (cont.)Non-identical replacement: When should the old machine be discarded in favour of the new one?First, determine the optimum replacement frequency for the new machine, based on identical replacement.Second, the equivalent annual value (EAV) of the new machine at its optimum replacement frequency is compared with the NPV of continuing to operate the old machine.The changeover should be made when the NPV of continuing to operate the old machine for one more year is less than the EAV of the new machine.

Analysing Project RiskEffect of risk on the value of a project is included in the required rate of return.However, many assumptions are made in forecasting cash flows.How do we factor in variability of these forecasts?Through the use of:Sensitivity analysis.Break-even analysis. Simulation techniques.

Sensitivity AnalysisAnalyse effect of changing one or more input variables to observe the effects on the results (similar to what if we changed ?).Steps:Pessimistic, optimistic and expected estimates made for each variable.NPV is calculated using expected estimates for each variable except one. Procedure repeated using the optimistic and pessimistic estimates of each variable.Difference between pessimistic and optimistic NPV is calculated for each variable.

Break-Even AnalysisA form of sensitivity analysis.Measuring sensitivity of profitability of project to variation in one variable, sales for example.Calculating the sales volume at which the present values of the projects cash inflows and outflows are equal, such that the net present value is zero.Predicting minimum sales required for the project to be profitable the break-even point.

SimulationChanging all the variables whose values are uncertain.Steps:Random selection of values by computer from the distribution of each of the specified variables.Computer calculates values for projects cash flows for each year and stores results.Procedure repeated at least 100 times.Results of all individual runs are combined to produce a probability distribution for the projects cash flows.

Decision-Tree AnalysisUsed to evaluate a sequence of decisions relating to an investment in a risky project.The decision-tree approach takes into account the probability of various events occurring and the effect of those events on the expected NPV of a project.Useful when a limited number of contingencies are possible at different stages, otherwise it becomes too complex.

HECS-HELP: Decision-Tree AnalysisHECS-HELP loan scheme allows students to defer payment of university fees.Several ways to pay involving contingencies imply that decision-tree analysis can be applied.Main features:Pay up-front and receive a 20% discount.Take the HECS-HELP loan and repay through taxation, contingent on income.Loan charge (interest rate) is the inflation rate.Voluntary repayments attract a 10% discount.

HECS-HELP: Decision-Tree Analysis (cont.)Decision-tree analysis allows us to consider the best approach to dealing with a HECS-HELP debt.Do we repay now with a 10% discount or pay off gradually through tax without a discount?We can decide by calculating NPV of various decisions along the decision tree.Need to take into account various factors such as level of income, required return on funds and possibility of leaving workforce/unemployment.

Qualitative Factors and the Selection of ProjectsQualitative factors may be important in terms of project selection.For example: corporate image, improved employee satisfaction, union pressure, etc.Difficult to value some of these factors, but they are important. Quantitative analysis should be supported by qualitative analysis.

Project Selection with Resource ConstraintsSometimes a companys managers believe that they are prevented from undertaking all acceptable projects because of a shortage of funds.Capital rationing:A condition where a firm has limited resources available for investment and must reduce the number and/or size of projects chosen because of this limitation.Internal capital rationing:Management impose a limit on capital expenditure, choosing not to take on all positive NPV projects available.

Project Selection with Resource Constraints (cont.)Possible reasons:Conservative management unwilling to borrow.Unwilling to issue more shares because of possible effects on the control of the company.Project proposals based on optimistic forecasts can be used by divisional managers to expand divisions, empire building.

Project Selection with Resource Constraints (cont.)External capital rationing:Occurs when the capital market is unwilling to supply the funds necessary to finance the projects that a companys management wishes to undertake.Reasons:Financial intermediaries are subject to controls on the amount of lending (unlikely in a deregulated system).Empirical evidence suggests that capital rationing is unlikely to arise from an unwillingness of the capital market to supply funds.

SummaryPractical aspects of project evaluation were covered.Estimating cash flows:Exclude financing charges, allocated costs and sunk costs.Include all incremental cash flows.Consistency in treatment of inflation on cash flows and rates.Constant chain of replacement is used to evaluate and compare projects of differing lives and in analysing asset replacement decisions.

Summary (cont.)Effects of risk on a project evaluated using sensitivity, break-even, simulation and decision-tree analysis.Qualitative factors cannot be incorporated into NPV calculations but are important and must be considered.Resource constraints lead to capital rationing in project evaluation.

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