Project Valuation

central message of project valuation

a project is worth the present value of the cash it generates (not its accounting profit)

what perspective is project valuation based on?

cash flows

what does incremental ask?

what cash flows change because we undertake this project?

what do you focus on with cash flows?

with versus without

what do you ask whenever you're unsure whether something belongs in project CF?

would this CF be different if we don't do the project? (if yes, probably include difference)

what do you do with sunk costs?

ignore them!

what are sunk costs?

past CFs (R&D always sunk cost)

what is the key question asked by opportunity costs?

what are we giving up by choosing this project?

what do we do with opportunity costs?

include them

what is an opportunity cost?

the foregone value

what is the key question with cannibalisation / externalities?

what changes with versus without the project?

how should project valuation act with taxes?

project CFs should include taxes (income statement useful for calculating them)

why must we consider depreciation?

depreciation isn't a CF, but it reduces taxable income, so it reduces tax

what is working capital?

money tied up in running the business

what do you need to remember about working capital?

increase in WC = cash outflow; decrease / recovery of WC = cash inflow

what is general rule for overhead costs?

WITH project - WITHOUT project

what do you ask for overhead costs?

does the company's ret (for eg) change if we accept the project? (suppose no then incremental cost = 0 & isn't included)

what do you do with interest payments?

do not subtract interest when calculating project operating CF (don't include them)

what does project valuation deliberately separate?

investment decision (whether project is economically worthwhile) from financing decision (how we pay for it)

what do you do with terminal value?

include the project's terminal value & associated taxes

what are the 2 general rule's for inflation?

1) constant/real CFs = real discount rate & 2) nominal CFs = nominal discount rate

what do you need to remember when thinking about inflation?

nominal goes with nominal, real goes with real

what is a project valuation checklist?

1) what is the initial investment?; 2) what are the incremental operating CFs?; 3) ignore sunk costs; 4) include opportunity costs; 5) include cannibalisation/externalities; 6) include taxes; 7) include changes in working capital; 8)only include genuinely incremental overheads; 9) don’t subtract interest payments; 10) include terminal value & working capital recovery 11) match nominal CFs with nominal rates & real CFs with real rates; 12) discount everything to today —> NPV

what is a simple way to determine the sign of an incremental operating effect

1) more revenues --> + (good thing); 2) more costs —> - (bad thing); 3) less revenue —> - (bad thing); 4) less costs —> + (good thing)

what does NPV ask?

after converting all future CFs into today's money, how much value does this project create?

what is the decision rule for NPV?

NPV > 0 —> accept; NPV < 0 —> reject

what does NPV represent?

gain in wealth associated with implementing project

what is the internal rate of return?

it is the discount rate that makes NPV = 0

what is the decision rule for IRR?

IRR > require return --> accept; IRR < required return —> reject

what is the payback period?

the number of years required to recover the initial investment

what are weaknesses of payback?

1) it doesn't discount CFs; 2) no risk adjustment; 3) it ignores CFs after the payback date

what are 2 major reasons for NPV & IRR giving different rankings?

Scale & time

When IRR & NPV disagree, which one do you choose?

NPV

what kind of CF gives you one sensible IRR?

conventional CF

what kind of CF gives you multiple IRR's?

non-conventional CF

what is a non conventional CF?

when you invest money initially, earn cash, but later incur a large cleanup / decommission cost

what is the basic idea of the profitability index?

how much value am I creating per euro invested?

what is the accept criterion for PI?

PI > 0 (for NPV / investment); PI < 0 (for PV / investment)

what does PI lead to?

capital rationing (helps identify which projects generate most NPV per euro invested)

what is the difference between PI & NPV?

PI - helps you allocate scarce capital; NPV - remains the ultimate value measure

what is NPV's main weakness?

requires appropriate discount rate

what is PI's main weakness?

mainly useful under capital constraints

what are the 2 categories in risk analysis?

1) stand-alone / total risk; 2) market / systematic risk

what are the types of risk analysis in stand-alone / total risk?

1) sensitivity analysis; 2) scenario analysis; 3) break-even analysis;4) Monte Carlo simulation

what are the types risk analysis in market / systematic risk?

1) CAPM; 2) APT

what do we need to ask once we have calculated a base NPV?

How sensitive is that NPV to our assumptions?

what does sensitivity analysis mean?

change ONE assumption at a time & see what happens to NPV

what does scenario analysis mean?

to change several assumptions simultaneously

what does break-even analysis ask?

how bad can something get before the project stops creating value?

for finance / project valuation, where is the break-even point generally?

where NPV = 0

what does sensitivity analysis ask?

what happens if price changes?

what does scenario analysis ask?

what happens under a bad / base / good scenario?

what does Monte Carlo simulation ask?

what happens if many uncertain variables take many possible values simultaneously, thousands of times?

what should the appropriate discount rate to calculate NPV reflect?

project's relevant risk

what does it mean if there is a higher appropriate discount rate?

There is lower PV of future CFs = lower NPV

what doe real options incorporate?

future flexibility into current decisions

what are the different real option types?

1) abandonment option; 2) expansion option; 3) timing option; 4) flexibility option; 5) fundamental option

what is the abandonment option (real options)?

"we can stop the project if it performs badly"

what is the expansion option?

"if this works brilliantly, we can expand"

what is the timing option?

"we don't have to invest today. we can wait until we know more" (waiting itself can be valuable)

what is the flexibility option?

"we can later how we operate depending on what happens"

what is the fundamental option?

"sometimes the investment is essentially an option"

what does the decision tree explicitly model?

if x happens, management does A: if y happens, management does B

what is positive NPV?

it is an abnormal return (normal return = 0)

why can a company earn an abnormal return?

competitive advantage

what are some examples of competitive advantage?

patents, technology, brand, lower costs, superior expertise, network effects etc.

what aren't particularly strong sources of NPV?

market growth & financing decisions

what is the strategic question behind an impressive spreadsheet (competition matters)?

what economically allows this project to generate these CFs?

what is the capital budgeting process?

1) generate ideas; 2) analyse individual projects; 3) plan/integrate capital budget; 4) monitor & audit

what are the types of projects?

1) replacement - business maintenance; 2) replacement - cost reduction; 3) expansion - existing products / markets; 4) expansion - new products/markets; 5) safety/environmental projects; 6) other projects

why does it matter to consider the type of project?

because not every project value comes from additional revenues (CF logic depends on what type of project you're valuing)

what does impact investing also consider?

impact on society (including ESG)

what is project valuation essentially asking?

what CFs change if we accept the project, & are those CFs worth more today than what we have to invest?

steps for conducting project valuation

1) draw timeline; 2) identify incremental cash flows; 3) deal with inflation/constant prices; 4) build the income statement; 5) calculate tax; 6) working capital; 7) investment cash flow; 8) calculate FCFF; 9) NPV; 10) IRR; 11) payback period; 12) risk analysis