1    INTRODUCTION

Economic evaluations encompass a wide variety of financial analyses. Five categories of economic evaluations are commonly encountered in the business community. These are:

1. Project economic evaluations
2. Financing evaluations
3. Cost-of-service (tariff) evaluations
4. Acquisition and divestiture (A&D) evaluations
5. Working capital evaluations

The purpose of this guide is to provide a single reference document that describes the underlying concepts, measurements and methodologies employed by companies to perform economic evaluations in each of these five categories. A brief description of each follows.

1. Project economic evaluations: The economic evaluation of a project assesses the economic profitability of investing capital in a project. This requires a good understanding of several interrelated financial concepts and measurement metrics. Approximately 50% of this guide is devoted to this first economic evaluation category. The discussion begins at the grass roots level by defining project cash flows and the meaning of capital and its cost. This is followed by a discussion on the meaning and creation of economic profitability and the economic measures used to measure economic profitability. The discussion concludes by demonstrating why four particular measures of economic profitability need to be considered together in order to make an informed investment decision.

The four remaining economic evaluation categories each encompass a wide spectrum of financial analyses which are too far-ranging to adequately cover in a single reference guide. For this reason, specific business applications commonly encountered in each of these categories are selected for examination.  These are described next.

2. Financing evaluations: A common form of financing evaluation performed by companies is the determination of whether it is more cost effective to lease or purchase an asset. Under a lease arrangement, the owner of the asset (the lessor) allows a third party (the lessee) to use the asset in exchange for a series of payments. The lease payments are designed to recover a reasonable portion, if not all, of the cost of the asset plus financing costs, a profit component, income tax payments and overhead costs incurred by the lessor. The lease versus purchase decision is examined in detail using numeric examples and the analysis is viewed from both the perspective of the lessor and lessee.

3. Cost-of-service (tariff) evaluations: A cost-of-service arrangement goes one step further than a lease arrangement in that the owner of the asset not only supplies the asset for use but also operates the asset thereby providing a service to the customer. For example, the service might be to transport oil through a pipeline owned by the service provider. Service providers charge a cost-of-service fee (tariff) for the service provided. This fee is designed to recover not only the capital invested in the asset, but also financing costs, a profit component, the costs of operating the asset as well as income tax and overhead costs. The traditional cost-of-service fee formula is normally applied in these situations and is described and numerically illustrated. To supplement this discussion, three alternative approaches for determining a cost-of-service fee are also presented.

4. Acquisition and divestiture (A&D) evaluations: The objective of an acquisition evaluation is to determine a reasonable purchase price to bid in order to acquire an asset or corporation. The bid purchase price should be economically beneficial, or perhaps just economically neutral but with strategic gains to the purchaser, acceptable to the seller, and competitive with other bids. The methodology for determining a bid purchase price depends on whether assets are purchased or the shares of a company are purchased because the evaluation methodologies differ. These two acquisition methodologies are described and numerically illustrated. While the focus of this guide is on the acquisition evaluation, the perspective of the seller is also briefly considered thereby touching on the divestiture side.

5. Working capital evaluations: The focus of this final economic evaluation category is on the inventory component of working capital. The sample problem presented is the determination of whether it is more cost effective to sell or keep project component inventory. Under this scenario, project related inventory is initially purchased for use in the construction of a new project, but construction is postponed because of a deteriorating economic environment. With the expectation that economic conditions will improve in several years’ time and that project development will proceed at that time, the economic evaluation required is to determine whether project component inventory should be kept or whether it should be sold and new project component inventory purchased later when project development proceeds. This economic evaluation is performed using two contrasting approaches.

De-financing Project Cash Flows

A specialized topic is introduced in this guide that is seldom addressed in current financial literature. This is the concept of de-financing project cash flows. When economic measures of profitability are derived from project cash flows, the project cash flows may contain lease payments and cost-of-service payments. These two forms of costs contain embedded financing charges which need to be removed by restructuring these costs into alternative cost forms within the project cash flows. If these embedded financing charges are not removed, the resulting project profitability measures are distorted. This is explained and illustrated with numeric examples.

Special Purpose Present Value Formulas

Several special purpose present value formulas are described at the end of this guide. The concept of present value is described in an earlier chapter and is used later to develop these formulas. These formulas are useful for back-of-the-envelope calculations, checking the output of economic models and developing and illustrating financial concepts. Of particular interest is the terminal value formula which is used to capture additional economic value that is expected to be generated by the project beyond the project’s last year modeled in the economic evaluation spreadsheet. The terminal value formula is not well understood and is easily misused. This can distort the economic measures used to describe the project’s economic profitability for reasons explained. The application of this and the other special purpose present value formulas are illustrated with numeric examples and their algebraic derivations provided.

Target Audience

This guide is written for individuals interested in learning about the economic evaluation of projects and business costs or who wish to enhance their understanding of economic evaluation concepts and methodologies. There are four audience groups in particular who will benefit from reading this guide. These are:

• Project economists
• Corporate managers
• Business students
• Contract lawyers

Project economists: A supervisor would be well advised to assign this guide as required reading to an entry level project economist starting a new job. Reading this guide will eliminate months of training by the supervisor and will reduce the risk of errors being made by the project economist. Practicing project economists are also encouraged to read this guide to enhance their understanding of key financial concepts and evaluation methodologies. They will be pleasantly surprised at the creative insights and explanations provided which they have likely not seen before.

Corporate managers: Corporate managers are the investment decision makers for a company. Decision makers rely on several economic measures to portray the economic profitability of investing capital in a project. These economic measures of profitability are relied on extensively to make investment decisions. Unfortunately, some of these measures will occasionally provide false and misleading information, oftentimes inconspicuously. It is imperative that the investment decision maker understands the underlying meanings, strengths, weaknesses and characteristics of all economic measures in order to ensure that project profitability is fairly addressed. Corporate managers who have a reasonable understanding of economic evaluation concepts, methodologies and economic profitability measures have the advantage of knowing the appropriate questions to ask to ensure that project profitability is being fairly evaluated.

Business students: Business students are assigned financial textbooks in business schools that appropriately cover a wide spectrum of financial concepts and theories that are written by experts in these fields. This guide is intended to supplement these readings by focusing on the practical side of financial theory. This guide specifically addresses the economic evaluations of projects and other business applications commonly encountered in the business community. It introduces business students to the practical side of these applications and the issues typically encountered. Even so, the discussion never loses sight of the financial theories that drive economic evaluations by referring to these theories in the explanations of concepts and methodologies. For business schools considering offering the equivalent of an economic evaluations 101 course, this guide provides excellent course material.

Contract lawyers: Corporate contract lawyers are tasked with writing legal agreements that cover a wide variety of financial applications. For example, a tariff agreement describes the individual cost parameters and calculations employed in determining the tariff. A royalty contract describes the different royalty rate tiers and the economic profitability triggers that activate higher royalty rate tiers. A lease contract describes the timing and size of lease payments, termination penalties, and renewal and purchase options. While contract lawyers are wise to rely on project economists to assist them in these matters, a base level of understanding by the contract lawyer of economic evaluation fundamentals will enhance communication between the lawyer and project economist and expedite the legal drafting process.

This guide is written in a manner to encourage anyone with the slightest interest in learning about the economic evaluation of projects, leases, tariffs and acquisitions to read its contents. No prior knowledge of this subject matter is required.

What Differentiates this Guide?

There are three distinguishing features that differentiate this guide from current financial books:

• Creative explanations
• Separation of detail
• Specialized topics

Creative Explanations: The arithmetic calculations required to determine economic profitability are carefully described and illustrated with numeric examples, but describing calculations does not explain meanings. Financial calculators and spreadsheet packages are available with built-in functions to calculate profitability measures. The more crucial task of this guide is to explain the meanings and characteristics of these profitability measures.

To explain meanings effectively, creative explanations and analogies are utilized extensively throughout this guide in a manner and to an extent not found in other financial books. For example, the concept of economic profit is carefully developed and utilized to explain the concept of net present value. Analogies are drawn to the common bank savings account to explain the meaning of certain economic measures. The difficult concept of cost of capital is explained by treating cost of capital as a cash fee paid by a project to its parent company. This cash fee is divided into three cash components, one to pay debt interest, one to pay stock dividends and one to be retained by the company to increase the value of its shares and hopefully its share price by an amount specified by financial theory.

Explanations are supported by diagrams, point form summaries, simplified numeric examples and bar charts presented in 278 figures.

Separation of detail: The second differentiating characteristic of this guide is the separation of overview explanations and detailed calculations into Parts A and B of this guide (further description below). With this construct, readers can choose to limit their reading to Part A to obtain a general understanding of key concepts and methodologies; or readers can choose to dig into the numeric details and explanations by reading Part B as well to develop a more comprehensive understanding.

Specialized topics: The three chapters on cost of service fees, de-financing project cash flows and acquisition evaluations warrant special mention because they described specialized topics not commonly encountered in business textbooks. Simplified descriptions of these topics, illustrated through numeric examples, are not easily located in current financial literature because of their specialized nature.

Content and Structure

This guide is divided into two parts:

Part A:  
Provides high level explanations of all the basic concepts, measurements and methodologies required to perform economic evaluations in each of the five categories of economic evaluations listed at the beginning of this chapter. These are illustrated through simplified numeric examples (which cannot be avoided for subject matter like this). All numeric examples are limited to the minimum detail necessary to illustrate the key concepts.

Part B:
Picks up from where Part A leaves off by digging deeper into the concepts and calculations. The calculations used to derive the economic results presented in Part A are described in more detail. Additional numeric examples are introduced to expand on Part A concepts and supplementary methodologies are also presented. All economic formulas presented in Part A are derived algebraically in Part B.

The chapters in Part A are each partitioned into sections identified by section names. A number of sections, but not all, are supported by supplemental information in Part B. These particular sections are identified by the descriptor ‘More detail in Part B’ appearing directly below the section name. The identical section names are repeated in Part B in corresponding chapters and the supplemental information is provided there. The text in Part A points to the specific figures and supplemental information provided in Part B which appear under the identical section name.

There are 22 chapters in Part A and 13 chapters in Part B. These are summarized below:

Part A:  The Fundamentals

Economic Evaluation of Projects:
          Components of a Project Economic Evaluation (Chapter 2)
          Project Cash Flows (Chapters 3, 4, 5 & 6)
          Capital and its Cost (Chapters 7, 8, 9 & 10)
          Measures of Economic Profitability (Chapters 11, 12, 13, 14, 15 & 16)
Leasing Versus Purchasing (Chapter 17)
Cost-of-Service Fees (Chapter 18)
De-financing Project Cash Flows (Chapter 19)
Acquisition Evaluations (Chapter 20)
Inventory Sell Versus Keep (Chapter 21)
Special Purpose Present Value Formulas (Chapter 22)

Part B:  More Detail

Supplementary Information (Chapters 23 thru 35)
Chapters 23 thru 35 support the chapters with the bolded numbers listed above.

The economic evaluation of projects is addressed in Chapters 2 thru 16. Specialized economic evaluation topics are presented in Chapters 17 thru 22. Supplementary information is provided in Chapters 23 thru 35 in Part B. Each chapter in Part B supports a chapter in Part A identified by a bolded chapter number in the above list.

 Chapter 2: This chapter begins by identifying the three fundamental components that underlie all economic evaluations of projects and which inspired the bar chart design on the front cover of this guide. The discussion begins by asking the fundamental question, why perform an economic evaluation of a project in the first place? The answer is resolved by answering three basic questions which provide the framework for the topics presented in Chapters 3 through 16.

Chapters 3 thru 6: An economic evaluation cannot be undertaken until project cash flows are prepared which is the focus of these four chapters. Project cash flow components are defined, costs requiring restructuring in these project cash flows to meet de-financing requirements are identified, the method of restructuring these costs is introduced, and a typical project investment cash flow profile is examined. Situations can sometimes occur in which the typical project investment cash flow profile is reversed which causes non-intuitive results to occur. This is described and illustrated.

Chapters 7 thru 10: All projects require capital and that capital has a cost, so this is the focus of these four chapters. The meaning of capital, recovery of capital, supply and flow of capital, and cost of capital are described in turn. Chapter 10 is one of the longer chapters in this guide because it describes the key concept of cost of capital. Cost of capital is a key determinant of economic profitability but is probably the least understood concept of all the economic evaluation concepts.

Chapters 11 thru 16: Once cash flows are prepared and the concepts of capital and cost of capital established, economic profitability is explained and measured by the application of four economic measures. These are the net present value measure, payout measure, internal rate of return measure and capital efficiency index measure. Detailed descriptions and explanations of each of these four economic measures are provided in Chapters 12 thru 15 respectively. A simplified five year project, termed the Base Project, is introduced in Chapter 11 and is applied in Chapters 12 through 15 to illustrate the application of these four economic measures. The reasons why all four economic measures need to be considered together in order to make an informed investment decision are explained in Chapter 16.

Chapters 17 thru 22: The subject matter now expands beyond the economic evaluation of projects to specialized topics. Leasing versus purchasing, cost-of-service fees, acquisition evaluations and the inventory sell-versus-keep decision are described in Chapters 17, 18, 20 and 21 respectively. The concept of de-financing is described in Chapter 19. As the de-financing procedure applies to lease and cost-of-service fees, de-financing is described in Chapter 19 following Chapters 17 and 18. The applications of several special purpose present value formulas are described in Chapter 22 with particular focus on the terminal value formula. As described previously, the terminal value formula is used to capture additional economic value that is expected to be generated by the project beyond the project’s last year modeled in the economic evaluation spreadsheet. This concludes Part A of this guide.

Chapters 23 thru 35: These thirteen chapters in Part B support the thirteen chapters in Part A identified by the bolded chapter numbers listed in the previous page. The supporting calculations used to derive the economic results presented in Part A are described and explained in Part B, additional numeric examples are introduced, and supplementary methodologies are described. All economic formulas presented in Part A are derived algebraically in Part B. The relationship between the Part A and Part B chapters becomes clear as each chapter in Part A is read.
    Part B is not structured to be read as a standalone unit. For those readers intending to read Part B, Part B should be read concurrently with Part A. As each chapter and section are read in Part A, if the descriptor ‘More detail in Part B’ appears directly below the section name, the corresponding chapter and section in Part B should be read concurrently.
    The discussion on economic evaluations now begins in Chapter 2 by examining the three fundamental components that underlie all economic evaluations of projects and which inspired the bar chart design on the front cover of this guide.