2015 eup 222 notes project finance lecture 3

EUP 222 ENGINEER

IN SOCIETY

PROJECT FINANCEUnderstand the financial concepts to appraise a project

efficiently and make decisions effectively.

Dr. Sharifah Akmam Syed Zakaria, PPKA . email: [email protected]

Outline

Lecture Objective & Context

Project Financing OwnerProject Contractor

Financial Evaluation

Project Financing Investment is paid back from the project profit rather than the general assets or

creditworthiness of the project owners

For larger projects due to fixed cost to establish Small projects not much benefit

Investment in project through special purpose corporations Often joint venture between several parties

Need capacity for independent operation Benefits

Off balance sheet (liabilities do not belong to parent) Limits risk External investors: reduced agency cost (direct investment in project)

Drawback Tensions among stakeholders

OutlineLecture Objective & Context

Project Financing Owner ProjectContractor

Financial Evaluation

Contractor Financing

Owner keeps an eye out for Front-end loaded bids (discounting)

Unbalanced bids

Contractors frequently borrow from Banks (Need to demonstrate low risk)

Interaction with owners Some owners may assist in funding

Help secure lower-priced loan for contractor

Sometimes assist owners in funding! Big construction company, small municipality

PART 2: FINANCIAL

EVALUATION

PART 1 : PROJECT

FINANCING

Todays

Focus

In the context

of cleaner

production

and

sustainability

Develop or Not Develop?

Is any individual project worthwhile?

Given a list of feasible projects, which one is the best?

How does each project rank compared to the others on the list?

Project Evaluation Example:

Project A

Construction=3 years

Cost = RM 1M/year

Sale Value= RM 4M

Total Cost?

Profit?

Project B


Cost=RM 1M/year

Sale Value=RM 8.5M

Total Cost?

Profit?

Quantitative Method:

Profitability

Create value for the company


Project Financing Owner Project Contractor

Financial Evaluation Project Income Inflation Operating Costs Time value of money Present value Rates Interest NPV Return on Capital Employed (Accounting Rate of Return) Payback period

Profit: TOTAL RM

REVENUES 5,500,000.00

COSTS 4,600,000.00

Project management 400,000.00

Engineering 800,000.00

Material & transport 2,200,000.00

Construction/commissioni

ng

1,300,000.00

Contingencies 200,000.00

GROSS MARGIN 900,000.00

Time factor?

Quantitative Method: Profitability

Create value for the company

Opportunity Cost

Time Value of Money

A ringgit today is worth more than a dollar tomorrow

Investment relative to best-case scenario

E.g. Project A - 8% profit, Project B -10% profit

Case Study: Mbox by ECOLEX

A small electronic firm, ECOLEX intends to produce a magnetic

heating lunch box (Mbox)

A Cleaner Production (CP) assessment at ECOLEX identified

some potentially profitable

investment projects that also has

environmental benefits.

Financial Information: A

Initial investment = RM 4 million

Selling price (current price terms)

= RM 40 per unit

Variable operating costs (current price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price terms) = RM340,000 per year

Expected operating cost inflation = 8 % per year

Financial Information: B

Demand forecast for Mbox by ECOLEX marketing team:

Year 1 2 3 4

Demand (units) 120,000 140,000 240,000 90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.

Financial Information: C

Given discount rates :

Year 0 1 2 3 4

Discount at 10% 1.000 0.909 0.826 0.751 0.683

Discount at 20% 1.000 0.833 0.694 0.579 0.482

Year 1 2 3 4

RM RM RM RM

Inflated selling

price

(RM/unit)

RM 40 +

.06 (40)

42.40

RM 42.40 +

.06(42.40)

44.94

RM 44.94 +

.06(44.94)

47.64

RM 47.64 +

.06(47.64)

50.50

Demand(units/year) X 120,000 X 140,000 X 240,000 X 90,000

Income(RM/year)

5,088,000 6,291,600 11,433,600 4,545,000

Project Income: Selling price (current price terms)

= RM 40 per unitExpected selling price inflation

= 6 % per year

Inflation & DeflationInflation means that the prices of goods and services increase over time

either undetectably or in leaps and bounds.

Inflation effects need to be included in investment because cost and benefits are measured in money and paid in current ringgit, dollars or

pounds.

An inflationary trend makes future ringgit have less purchasing power than present ringgit.

Deflation means the opposite of inflation. Prices of goods & services decrease as time passes.

Project Evaluation Example: Which one is better?

Project A


Cost = RM 1M/year

Sale Value = RM 4M

Total Cost?

Profit?

Project B


Cost = RM 1M/year

Sale Value = RM 8.5M

Total Cost?

Profit?

Drawing out the examples:

Project A

Project B

RM 1M

RM 4M

RM 1M

1

RM 8.5M

6

RM 1M MR 1M RM1M

RM 1M

RM 1MRM 1M

Assume 10% discount rate

0 32

RM 1M

0 1

Variable Costs:

Variable costs are corporate expenses that vary in direct proportion to the quantity of output.

Variable costs are those costs that vary depending on a company's production volume; they rise as production increases and fall as production decreases.

Variable costs can include direct material costs or direct labour costs necessary to complete a certain project.

Fixed costs are expenses that have to be paid by a company, independent of any business activity.

Fixed costs are costs that are independent of output. These remain constant throughout the relevant range.

Fixed costs are not relevant to output decisions.

Fixed costs often include rent, buildings, machinery, etc.

Fixed Costs:

Financial Information: A

Initial investment = RM 4 million

Selling price (current price terms)

= RM 40 per unit

Variable operating costs (current price terms) = RM 16 per unit

Expected selling price inflation

= 6 % per year

Fixed operating costs (current price terms) = RM340,000 per year

Expected operating cost inflation = 8 % per year

Financial Information: B

Demand forecast for Mbox by ECOLEX marketing team:

Year 1 2 3 4

Demand (units) 120,000 140,000 240,000 90,000

No terminal value or machinery scrap value.

A nominal (money) discount rate = 10% per year

A target return on capital employed = 30% per year.

Ignore taxation.

1 2 3 4

RM RM RM RM

Inflated variable cost

(RM/unit)

RM 16 +

.08 (16)

17.28

RM 17.28 +

.08 (17.28)

18.66

RM 18.66 +

.08 (18.66)

20.15

RM 20.15 +

.08 (20.15)

21.76

Demand (units/year) X 120,000 X 140,000 X 240,000 X 90,000

Total Variable costs (RM/year) 2,073,600 2,612,400 4,836,000 1,958,400

(+) Inflated Fixed

Costs(RM/year)

RM 340,000 + .08

(340,000)

367,200

RM 367,200

+ .08 (367,200)

396,576

RM 396,576 +

.08(396,576)

428,302

RM 428,302 + .08

(428,302)

462,566

Total Operating costs (RM/year) 2,440,800 3,008,976 5,264,302 2,420,966

Operating Costs: Variable operating costs

(current price terms)

= RM 16 per unit

Fixed operating costs

(current price terms)

= RM340,000 per year

Expected operating

cost inflation

= 8 % per year

Time Value of Money:

If we assume That money can always be invested in the bank (or some other reliable

source) now to gain a return with interest later.

That as rational actors, we never make an investment which we know to offer less money than we could get in the bank.

Then Money in the present can be thought as of equal worth to a larger

amount of money in the future.

Money in the future can be thought of as having an equal worth to a lesser present value of money.

Time Value of Money: Revisit If we assume

That money can always be invested in the bank (or some other reliable source) now to gain a return with interest later

That as rational actors, we never make an investment which we know to offer less money than we could get in the bank

Then Money in the present can be thought as of equal worth to a larger amount of

money in the future

Money in the future can be thought of as having an equal worth to a lesser present value of money

Basic Compounding:

Suppose we invest RM x in a bank offering interest rate, i

If interest is compounded annually, asset will be worth

$x(1+i) after 1 year

$x(1+i)2 after 2 years

$x(1+i)3 after 3 years .

$x(1+i)n after n years

RM x

0 1 RM x(1+i) 2 RM x(1+i)2 n RM x(1+i)n

Present Value (Revenue)

How is it that some future revenue, r at time, t has a present value?

Answer: Given that we are sure that we will be gaining revenue, r at time t, we can take and spend an immediate loan from the bank

We choose size of this loan l so that at time t, the total size of the loan (including accrued interest) is r

The loan, l is the present value of r

l = PV(r)

Future to Present Revenue:

x

t

-x

tPV(x)

0 Ill pay this back to the bank later

I can borrow this from the bank now

tPV(x)

If I know this is coming

The net result is that I can convert a sure x at time tinto a (smaller) PV(x) now!

Present Value (Cost) How is it that some future cost c at time t has a present value?

Answer: Given that we are sure that we will bear cost c at time t, we immediately deposit a sum of money x into the bank yielding a known

return

We choose size of deposit x so that at time t, the total size of the investment (including accrued interest) is c

We can then pay off c at time t by retrieving this money from the bank

The size of the deposit (immediate cost) x is the present value of c.

Future to Present Cost

x

tPV(x)

I retrieve this back from the bank later

I can deposit this in the bank now

t

The net result is that I can convert a sure cost x at time tinto a (smaller) cost of PV(x) now!

PV(x)

-x

t0

If I know this cost is coming

Summary: Present Value

Because we can flexibly switch from one such value to another without cost, we can view these values as equivalent

Given a reliable source offering annual return i (i.e., interest) we can shift without additional costs between cash v at time 0 and v(1+i)t at time t

Rates

Difference between PV (v)

and FV ( =v(1+i)t ) depends

on interest, i and time, t.

Rates

Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.

Interest Rate

Contractual arrangement between a borrower and a lender

Discount Rate (real change in value to a person or group)

Worth of Money + Risk

Discount Rate > Interest Rate

Minimum Attractive Rate of Return (MARR)

Minimum discount rate accepted by the market corresponding to the risks of a project (i.e., minimum standard of desirability)

Interest Formulas

i = Effective interest rate per interest period (discount rate or MARR)

n = Number of compounding periods

PV = Present Value

FV = Future Value

A = Annuity (i.e., a series of payments of set size) at end-of-period

Interest Formulas: Payment - Example

If you wish to have RM100,000 at the end of five years in an account that pays 12 percent annually, how much would you need to deposit now?


If you wish to have RM 100,000 at the end of five years in an account that pays 12 percent annually, how much would you need to deposit now?

(P/F, 0.12, 5) or (F/P, 0.12, 5)?

P=?

n0

F=RM 100,000


If you wish to have RM 100,000 at the end of five years in an account that pays 12 percent annually, how much would you need to deposit now?

P = F(P/F, 0.12, 5)

P = 100,000 (P/F, 0.12, 5)

P = 100,000 0.5674 = RM 56,740

2015 eup 222 notes project finance lecture 3

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