Should I Invest in This Project?

• Given the capital required to develop a project (red bars on bar chart on book’s front cover), are project cash flows (bar chart) sufficient in size to return the invested capital plus recover the cost of that capital (yellow bars) and generate surplus cash flows (green bars) in the remaining years to create economic profitability?

Answered By:

• Generating a credible forecast of project cash flows (PCF’s).
• Measuring the profitability of the project by deriving four economic metrics directly from the PCF’s: net present value (NPV), internal rate of return (IRR), payout (of capital and optionally its cost) and the capital efficiency index (CEI).

Project Cash Flows

• PCF’s are typically forecast on an annual basis and are equal to gross revenues less capital expenditures less working capital requirements less costs of producing (including taxes and allocated corporate overhead costs).
• If debt, lease and tariff payments are present and material in PCF’s, they need to be restructured through a de-financing procedure (described below), otherwise project profitability is likely overstated.
• Interest and dividends are not netted from PCF’s.
• PCF’s are typically negative at the front end and positive thereafter for project investment situations; for certain capital investment projects designed to accelerate a fixed quantity of remaining production, the resulting incremental PCF profile reverses with front-end positive PCF’s followed by negative PCF’s meaning that this is a financing situation rather than an investment situation.

Capital and Its Recovery

• There are two capital supply processes at work, the first being the supply of capital from external suppliers of capital to the parent company and the second being the supply of capital from the parent company to its projects.
• Capital is provided to the parent company by creditors through loans and by shareholders directly and indirectly;  directly by purchasing shares newly issued by the company; indirectly by allowing the company to keep and use internally generated surplus cash flows.
• Negative PCF’s represent the capital required by the project which is supplied by the parent company; occurs when the sum of capital expenditures, working capital requirements and costs of producing exceed gross revenues.
• Positive PCF’s generated by the project are used to return this capital to the parent company.

Cost of Capital

• Capital is not provided for free but has a cost referred to as its cost of capital (COC).
• The project is expected to return all capital provided to it plus its COC.
• COC is a cash fee paid by the project to the parent company to pay its share of debt Interest and dividend costs and also includes an additional cash amount (determined by financial theory) which is retained and used by the company to increase its asset value and resulting share price (in theory, but no promises regarding share price increase).
• COC is normally calculated at the corporate level and is used to assign a ‘deemed COC‘ to projects; a unique COC is derived for atypical projects; a deemed COC may also be assigned to the company’s business divisions but will likely face implementation difficulties.
• While the traditional COC formula appears simplistic in its form, it originates from sophisticated financial theories which earned the Nobel Prize in 1990; all formula components are interrelated and changing the value of one may change the value of the other components.
• A share price increase does not mean management performed well if lower than COC expectations.

Net Present Value (NPV)

• NPV is normally derived by using a standard discounting calculation applied directly to the forecast PCF’s, but this discounted cash flow (DCF) calculation obfuscates the underlying meaning of NPV.
• The underlying meaning of NPV becomes clear by deriving economic profit (EP) and calculating NPV from EP rather than from PCF’s, but this requires more calculations.
• EP is the surplus cash balance remaining at the end of a project’s life after all project costs, including COC, are recovered from project revenues; this requires that COC dollars be derived.
• NPV measures the EP created by a project over its life and adjusts EP to account for the time value of money by discounting the EP at the end of the project’s life back to the present to determine its economic value (EV) today.
• When NPV is used to measure the EV today created for shareholders by investing capital in a project (its primary role), the only appropriate discount rate is the deemed COC rate assigned to the project; to limit the selection of projects to higher return projects, the discount rate used in the NPV calculation is sometimes set to a rate higher than the project’s deemed COC rate (hurdle rate), but the resulting lower NPV value is not reflective of the true EV created for shareholders by investing capital in the project; the true EV is higher.
• NPV implicitly assumes year-end discounting which needs to be adjusted to reflect mid-year discounting.
• NPV can also be derived for calendar quarter and monthly cash flows, but this requires adjustments to the annual discounting formula; a significant error in NPV value can result if the annual NPV discounting formula is applied to a project that only spans a few months.
• NPV contains an implicit reinvestment assumption which sometime leads to non-intuitive results.
• The NPV metric has several characteristics which are used to interpret economic results.

Payout

• Measures the time it takes to recover capital and, optionally, the cost of that capital as well.
• Choice of capital varies from the project’s front-end development capital only to all capital provided to the project over its life.
• Payout calculations utilize nested ‘if’ statement logic.
• Non-intuitive payout values can result depending on the choice of capital being tracked for payout and the presence of an unusual PCF pattern.
• The payout metric has several normal characteristics which are used to interpret economic results, but circumstances can occur where these normal characteristics do not hold.

Internal Rate of Return (IRR)

• Analogous to the interest rate earned in a bank savings account where deposits are capital provided to the project and withdrawals are positive PCF’s generated by the project such that a $0 cash balance results at the end of the project’s life.
• Generated by calculators and spreadsheet packages, or alternatively, by two trial-and-error calculation techniques.
• IRR formula only exists for a simplified two endpoint PCF with zero cash flow values in between.
• When IRR’s are derived for calendar quarter and monthly cash flows, they need to be annualized by compounding the resulting IRR values by 4 and 12 times respectively for comparison to annual IRR’s of other projects.
• Occasionally multiple IRR values exist for the same cash flow which means that the resulting IRR’s are meaningless and cannot be used; unfortunately calculator and spreadsheet IRR functions do not recognize these unusual situations and provide one IRR value anyway which is erroneous in these situations; PCF’s need to be visually inspected for two cash flow warning signs that suggest that multiple IRR values might exist; this is easily confirmed or dismissed with a simple NPV plot.
• When multiple IRR values exist, a modified IRR (MIRR) metric is sometimes substituted in its place but this is not recommended because its meaning is quite different from the standard IRR metric creating confusion; also, its value can be  manipulated through two input parameters and its cash flow stream is often submitted incorrectly resulting in an incorrect answer; it is safer to avoid presenting the IRR metric in these situations.
• IRR contains a reinvestment assumption meaning that high IRR values overstate the project’s true return.
• IRR provides no hint of economic value and ignores the time value of money.
• The IRR metric has several characteristics which are used to interpret economic results; particularly useful when used in combination with NPV characteristics.

Capital Efficiency Index (CEI)

• Bang for the buck metric, measures NPV created for each dollar of capital invested (discounted).
• When spending is constrained by a capital budget, selecting the subset of projects with the highest CEI values from a larger set of projects results in the subset having the highest consolidated NPV value.
• Alternative forms of the CEI metric are sometimes employed which utilize capital expenditures rather than capital for practicality reasons, but capital is the theoretically correct choice.
• The CEI metric has several characteristics which are used to interpret economic results.

Which Project to Select?

• Economic metrics are used to select profitable projects to invest in, but economic metrics for competing projects often reveal conflicting economic trade-offs among projects meaning that a clear project choice is not always evident from economic metrics.
• The financial priority of a company (e.g. generating quick payout or maximizing shareholder value or maximizing reported return, etc.) may cause it to rely more heavily on a particular economic metric in its project selection.
• No single economic metric should be relied on exclusively for project selection because all economic metrics need to be considered together to understand the economic trade-offs being presented.

Leasing Versus Purchasing

• A lease is a contract where the party owning the asset (lessor) provides the asset to another party (lessee) for that party’s use for a series of payments.
• From the lessor’s perspective, lease payments must be of sufficient size to recover asset cost (net of future selling value), COC, profit, income tax on profit, and a portion of office costs.
• From lessee’s perspective, four analytical steps are performed to evaluate whether it is more cost effective to lease the asset or purchase the asset; for analytical integrity, the purchased asset is assumed to be financed with 100% debt even though this may not occur in reality.
• Care is required in selecting the appropriate discount rate for present value calculations and in deriving the debt servicing payment profile for the purchase so as not to bias the results.
• The magnitude of the cost difference  between leasing and purchasing will vary depending on whether the asset is purchased or returned to the lessor at the conclusion of the lease contract.
• When comparing the cost of leasing to a financed purchase, the same ownership status is assumed at contract termination; either the asset is kept in both cases or released in both cases by the customer.
• Several other aspects will influence the lease versus purchase cost outcome including lessor-lessee differences on asset acquisition cost, future asset resale value, funding cost and tax treatment.

Tariff (Cost of Service, COS) Arrangements

• Similar to a lease contract except that asset owner also operates the asset and charges an additional operating fee.
• Applies to larger and/or regulated assets, often shared by multiple customers.
• Traditional COS rate base formula is used to determine COS payments.
• Formula comprises four primary algebraic components and resolves logic circularity associated with recovering income tax on COS profit.
• Formula ensures that a predetermined project IRR is achieved for COS asset when  evaluated as a project (assuming all costs and revenues materialize as forecast).
• There are two forms of the traditional COS rate base formula: ‘flow-thru-tax’ and ‘deferred-tax’ forms.
• For regulated assets, there are four primary considerations employed in determining a fair and equitable return on capital.
• Three alternative COS fee structures are also available for use.

De-financing Project Cash Flows

• Investment economics are derived from PCF’s based on the project’s revenues and costs only (raw PCF’s) and exclude debt funding, repayment and interest costs.
• Introducing debt and disguised debt (lease and COS) payments in PCF’s result in overstated (sometimes understated) economic metrics and profitability.
• Debt, lease and COS payments if present and material in size in PCF’s need to be de-financed in PCF’s through a 3-step calculation procedure.
• Accomplished by replacing payment stream with front-end pseudo capital expenditure and adjusting for income tax; this is a pretend capital expenditure required to maintain analytical integrity.
• De-financing reveals the project’s true underlying economic profitability and further penalizes project profitability for interest rates embedded in debt, lease and COS payments that exceed company’s normal borrowing interest rate.
• The de-financing procedure is not an exact science and has several weaknesses, but it is financially prudent to make investment decisions based on de-financed PCF’s rather than on levered PCF’s which result in exaggerated, false and misleading economic metrics.

Acquisition Evaluations

• Capital is used to purchase an already developed producing asset; this might represent one producing asset or several producing assets, or a company that owns producing assets.
• At the minimum, the purchaser wants to recover the purchase price it paid for the asset and its associated funding COC from the future PCF expected to be generated by the purchased producing asset; if surplus PCF remains, all the better.
• Value of producing asset is today’s value (present value, PV) of its PCF  as forecast by the purchaser; this value is adjusted to determine the breakeven purchase price by taking into account the impact of corporate income taxes resulting from the purchase transaction.
• Determining the breakeven purchase price differs depending on whether producing asset is purchased directly (tax circularity involved) or indirectly by purchasing all the shares of the company that owns the producing asset (unused tax deduction balances acquired).
• The breakeven purchase price can be determined by trial and error analysis or by application of algebraic formulas (for a direct asset purchase, not shares).
• A bid curve can be derived showing the NPV gain or loss for different bid prices and where the x-axis intersection point represents the breakeven purchase price.
• The addition of synergistic cash flows will boost the breakeven purchase price, but overly optimistic synergy assumptions will result in overpayment.
• Purchasing all shares of a company also requires that working capital, future tax savings and debt obligations be properly valued and incorporated in deriving the breakeven purchase price.
• NPV, PV and IRR calculations need to be modified to account for exact date of the acquisition.

Inventory Sell Versus Keep

• Optimal level of inventory is usually determined through operational experience.
• Situations sometime occur where asset components for a new project proposal are purchased and stored in inventory in advance of project sanction to take advantage of cost-saving opportunities, but project sanction is unexpectedly postponed.
• Two analytical approaches can be used to determine whether it is more cost effective to continue holding project component inventory, or sell inventory now and purchase later when the project is sanctioned.

Special Purpose Present Value Formulas

• Present value (PV) calculation utilizes the same calculation as NPV but where the PCF stream contains no initial capital outlay.
• The sum of an infinite geometric series formula is used to generate two special purpose PV formulas: i) terminal value; and ii) future income tax savings.
• The terminal value formula measures the PV of future positive cash flows that extend beyond the last year modeled in the spreadsheet.
• A terminal value is added to the NPV calculated in the worksheet to reflect additional future value; this may result in unintended (or perhaps deviously intended) exaggeration of project economics.
• The terminal value formula needs to be applied carefully and is prone to user error because it is typically applied incorrectly.
• When the project’s NPV is increased by a terminal value, the project’s IRR cannot be derived by utilizing the standard IRR spreadsheet function, but needs to be derived independently by utilizing the combined NPV and terminal value calculations.
• The future  income tax savings formula measures the PV of future income tax savings resulting from spending today; provides a convenient means of performing back-of-the-envelope income tax calculations; can be coded directly into the spreadsheet logic or used to check spreadsheet income tax calculations.