Introduction to Capital Budgeting and Financing of Capital Projects

1
Introduction toCapital Budgeting and Financing
ofCapital Projects

• For UNEP
• Division of Technology, Industry, and Economics

Prepared collaboratively by Gloucestershire
Business School- University of Gloucester, and
Tellus Institute
2
Introduction
3
Course Background

• 15 min

4
Development of the training materials

• Content has been developed by
• Tellus Institute
• Gloucestershire Business School, UK
• The Illinois EPA
• The Philippine Institute of CPAs
• The Asian Institute of Management
• UNEP CP financing National Project Coordinators
  in Zimbabwe and Guatemala
• UNEP Cleaner Production financing project team

5
UNEP Financing Cleaner Production Support

• Division of Technology, Industry, and Economics
• This course results from the project
• Strategies and Mechanisms For Promoting Cleaner
  Production Investments In Developing Countries
• Funding provided by the Government of Norway

6
Words of welcome
Introduction of Instructors

• 15 min

7
Cleaner Production is ...

• The continuous application of an integrated
  preventive environmental strategy applied to
  processes, products, and services to increase
  overall efficiency and reduce risks to humans and
  the environment.
• UNEP

8
Cleaner Production is different

• Much of current environmental protection focuses
  on what to do with wastes and emissions after
  they have been created, otherwise known as
  end-of-pipe disposal treatment
• The goal of Cleaner Production is to avoid
  generating pollution in the first place

9
Environmental Management hierarchy

• CLEANER PRODUCTION
• Pollution Prevention
• On-site Recycling/Reuse

BEST LEAST Desirable
Off-site Recycling/Reuse
Control/Treatment
Disposal
10
Cleaner Production

• Production processes conserving raw materials
  energy, eliminating toxic raw materials, and
  reducing the quantity and toxicity of all
  emissions wastes
• Products reducing negative impacts along the
  life cycle of a product, from raw materials
  extraction to its ultimate disposal
• Services incorporating environmental concerns
  into designing delivering services

11
Cleaner Production benefits

• Reduces costs (of raw materials, energy, waste,
  emissions)
• Reduces risk (to employees, human health, and
  environment)
• Identifies new opportunities for more efficient
  operations

12
Welcome bySenior Official

• 15 min

13
Participant Introductions

• 30 min

14
Who is here today?

• What type of organization do you work for?
• e.g., industry, government, other
• If from industry, which sector and what size
• What are your job responsibilities and areas of
  expertise?
• e.g., management, accounting, finance,
  engineering, production, environmental
• What is your investment perspective?
• e.g., developer of investment proposals, funder
  of investment proposals

15
Why are you here?

• What work issues or concerns motivated you to
  come?
• What are your learning goals for this course?
• What are your expectations of this course?

16
Course Overview

• 15 min

17
Todays focus

• Capital Budgeting
• Project Financing
• Also to incorporate your experiences, questions,
  and goals into todays presentation,exercises,
  discussions

In the context of Cleaner Production
18
Investment projects

• Investment projects and company value
• Discussion of course participant experiences with
  investment projects
• Summary - typical project types goals

19
Capital budgetingIntroduction

• Capital budgeting definition and main
  implementation steps
• Case study and small group exercise on cost
  identification
• Discussion of small group exercise findings

20
Capital budgetingProfitability Assessment

• Estimating project profitability with Net Present
  Value (NPV)
• Time value of money discounting
• Alternative profitability indicators
• NPV, IRR, Payback

21
Project financing

• Project financing sources
• Discussion of course participant experiences with
  project financing
• Types of investment and financing decisions
• Different types of funding sources
• Bank information requirements
• How to demonstrate credit-worthiness
• Case study and small group exercise on bank
  information requirements

22
Conclusion

• Other issues?
• Where to go for more information
• Brief review of what we learned today
• Course evaluation

23
Time for a break! 15 min
24
INVESTMENT PROJECTS
25
Investment Projects and Company Value

• 15 min

26
Companies Projects

• Think of a company as a collection of projects
  that fit together
• A project could be
• A production process or equipment
• A product
• An information or management system
• etc.
• Projects should be evaluated on how they help the
  company as a whole
• So - what are the companys goals?

27
Company goals

• The basic goal of any organization
• Survive and prosper!
• Economic survival depends on
• Generating income (profits, cash flows)
• Raising capital from investors lenders that
  supports generation of income
• The key question- do investors lenders view
  the companys income as an adequate return on
  their capital investment ??

28
Investors and lenders (1)

• Two main potential sources
• Investors ( owners, shareholders, equity)
• Lenders ( debt)
• (Sometimes called financial stakeholders)
• Both types will require a reasonable return on
  their capital or may withdraw their support

29
Investors and lenders (2)

• Withdrawal of support by investors lenders
  could mean collapse of company
• So, for any potential new project, first ask ...
  
• Will this help to keep our investors lenders
  happy ??

30
Company value

• So what do investors/lenders seek?
• Value is what investors lenders consider worth
  paying NOW for the companys expected future
  income
• Value NOW called present value
• This must exceed the cost of raising capital from
  investors lenders

31
Company value - Acme (1)

• As an example, lets consider a company called
  Acme
• A small metal plating firm in a developing
  country
• Products include candlesticks, picture frames,
  screws, nuts, bolts, other metal-plated
  products
• 75 employees

32
Company value - Acme (2)

• What is the value of Acme to its investors
  lenders if they expect
• - Acme will continue in business indefinitely
  into the future?
• - Acme will generate sustainable net income of
  12,000 per year?
• - Investors/lenders expect a return of at least
  20 on their capital?

33
Company value - Acme (3)
Acmes value is then 12,000 60,000
20 If investors/lenders consider Acme to be a
risky company and require 30, then Acmes value
will be less 12,000 40,000 30

34
Discussion of Course Participant Experienceswith
Investment Projects

• 30 min

35
Questions for discussion

• Think of examples of capital investment projects
  that have been implemented (or funded) by your
  organization
• What were the specific goals of the projects?
• What was the typical investment size?
• Would you consider any of those projects to be
  Cleaner Production (CP) projects?

36
Investment Projects Summary

• 15 min

37
Investment projects (1)

• An investment project might focus on
• A production process
• Production or other equipment
• A product
• An information or management system
• etc.
• Investment projects might focus on existing
  equipment, processes, or products or focus on
  brand-new ones

38
Investment projects (2)

• Some investment projects require only a moderate
  investment of time/labour
• Others require more significant up-front capital
  (i.e., investment funds) for the purchase of
  physical assets such as equipment

39
Investment projects (3)

• Timing and frequency of investment projects and
  amount of investment capital required may vary
  with
• Industry sector Company size
• Company location State of the economy
• etc.
• However, for long-term survival, most companies
  periodically need capital for investment projects

40
Typical project types goals (1)

• Maintenance
• Maintain existing equipment operations
• Improvement
• Modify existing equipment, processes, and
  management information systems to improve
  efficiency, reduce costs, increase capacity,
  improve product quality, etc.
• Replacement
• Replace outdated, worn-out, or damaged equipment
  or outdated/inefficient management information
  systems

41
Typical project types goals (2)

• Expansion
• e.g., obtain and install new process lines,
  initiate new product lines
• Safety
• Make worker safety improvements
• Environmental
• e.g., reduce use of toxic materials, increase
  recycling, reduce waste generation, install waste
  treatment
• Others...

42
Single project-Multiple benefits

• A single investment project often has multiple
  benefits
• Cleaner Production projects are typical - they
  often have multiple benefits
• e.g., a project that is implemented to improve
  product quality also reduces the use and purchase
  cost of toxic chemicals, as well as disposal
  costs
• So, do not place your project idea into a single
  narrow category think broadly about all the
  possible benefits

43
Project implementation process

• Capital budgeting
• Identify company goals strategies identify
  potential projects evaluate projects select
  projects to implement
• Project financing
• Identify potential sources of capital raise
  external capital if needed
• Project implementation assessment
• Implement project monitor progress control
  review learn for next time!

44
CAPITAL BUDGETINGINTRODUCTION
45
Capital Budgeting -Definition and Main
Implementation Steps

• 15 min

46
Capital budgeting

• The process by which an organization
• Decides which investment projects are needed
  possible, with a special focus on projects that
  require significant up-front capital
• Decides how to allocate available capital between
  different projects
• Decides if additional capital is needed

47
Capital budgeting practices

• Capital budgeting practices vary widely from
  company to company
• Larger companies tend to have more formal
  practices than smaller companies
• Larger companies tend to make more larger
  capital investments than smaller companies
• Some industry sectors require more capital
  investment than others
• Capital budgeting practices may also vary from
  country to country

48
Basic capital budgeting steps

• Identify potential projects
• talk to employees, industry colleagues, trade
  association, suppliers/vendors, government
  technical assistance office
• Evaluate and compare projects
• technical, organizational, regulatory, and
  financial evaluation
• Select project(s) to implement
• may choose one or several projects, depending on
  availability of capital

49
Decision-making factors
Technical
Project selection
Regulatory
Financial
Organizational
50
Financial analysis steps

• Estimate cash flows
• Characterize project risk
• Select required rate of return on project
• Calculate project profitability

We will discuss this now
We will discuss these after lunch
51
Cost identification estimation

• Initial investment costs
• e.g., equipment, installation, training
• Annual operating costs, savings,and revenues
• Current operations, before the project
• After project implementation
• e.g., materials, energy, labour
• Need to identify, estimate, and allocate all
  relevant and significant items impacted by the
  project

52
Case Study Small Group Exerciseon Cost
Identification

• 30 min

53
Exercise instructions

• Break into small groups
• Review the company description
• Work with your group to answer question 1
• Work with your group to answer question 2
• Discussion of answers as entire class

10 min
10 min
10 min
15 min
54
Acme Electroplaters(see also documentation under
Exercises)

• A small metal plating firm in a developing
  country
• Products include candlesticks, picture frames,
  screws, nuts, bolts, other metal-plated
  products
• 75 employees
• A Cleaner Production (CP) assessment at Acme
  identified some potentially profitable investment
  projects that also had environmental benefits

55
Figure 1 Overall Process Flow Diagram
56
Figure 2 Existing Rinse Step (2-stage static
rinse system)
57
Figure 3 Proposed New Rinse System (3-tank
counter-current rinse system)
58
Discussion ofSmall Group Exercise Findings

• 15 min

59
Ease of identifying and estimating costs
In general, as you go down this list, costs are
more likely to be hidden or difficult to
quantify (but every case is different!)
equipment purchase direct materials, energy,
labor
EASY DIFFICULT
waste disposal
recycle/rework treatment waste handling
regulatory compliance other indirect costs
less tangible costs
60
Cost estimation

• Problematic accounting practices may make it
  difficult to collect cost data
• Hidden in accounting records
• Misallocated from overhead accounts
• Classified as fixed when really variable
• Not in accounting records at all
• (Others?)
• UNEPs CP3 course will cover cost estimation in
  more detail

61
Time for lunch! 60 min
62
CAPITAL BUDGETING PROFITABILITY ASSESSMENT
63
Estimating Project Profitability withNet Present
Value (NPV)

• 30 min

64
QuestionIf we were giving away free money,
would you rather have(A) 10,000 today, or(B)
10,000 3 yearsfrom now Why?
65
Converting cash flowsto their present value

• You can convert future year cash flows to their
  present value using a discount rate that
  incorporates
• Desired return on investment
• Inflation
• The discount rate calculation is simple
  mathematically, it is the reverse of an interest
  rate calculation

65
66
Net Present Value

• Net Present Value (NPV) is the sum of the present
  values of all the projects cash flows
• Cash inflows are positive numbers
• Cash outflows are negative numbers
• If NPV is more than zero, the project is
  profitable since it will increase total company
  value
• If NPV is less than zero, the project is not
  profitable since it would destroy value

67
Discounting

• Expressing future amounts in terms of their
  present value is called discounting
• Exchange rates can be calculated for any
  combination of
• Required rate of return
• Period of time into the future
• These exchange rates are called
• Discount factors, or
• Present value factors

68
Question If Acme wants to borrow 18,000 in
order to finance a new project, what factors are
likely to influence how much interest it will
have to be prepared to pay?
69
Return, risk, and inflation

• Basic Rate
• pure compensation for deferring consumption
• even if there is no risk or inflation
• Risk
• of the particular investment
• the risk premium
• Inflation
• expected fall in the value of money over time

70
What Rate of Return?

• What amount should be set as the required rate
  of return for a project?
• This rate must cover the costs of raising the
  finance from investors/ lenders (i.e. the
  companys cost of capital)
• The required rate of return will usually
  incorporate 3 distinct elements
• a basic return - pure compensation for deferring
  consumption
• any risk premium for that projects risk
• any expected fall in the value of money over
  time through inflation

71
Questions(1) What is a typical rate of return
at your organisation?(2) Do you use this rate
of return in capital budgeting?
72
Summary (1)

• Money has more value now than it does in the
  future
• How much more value depends on
• amount of discount rate
• how many years into future
• Required rate of return reflects time value of
  money and risk
• This is true with or without inflation
• Note also called discount rate

73
Summary (2)

• Discount rate level reflects cost to company of
  raising capital
• Present value (PV) factors can be calculated from
  discount rates
• PV factors are conversion rates to convert future
  money into its present value (like exchange rates
  with foreign currencies)

74
NPV and Cleaner Production Projects

• Any special issues in doing NPV analyses on CP
  projects?
• Estimating future cash flows
• Predicting project life
• Identifying appropriate discount rate

75
Influences on Project Appraisal

• 20 min

76
Acmes CP project

• Potential project
• initial investment (now) 18,000
• net cash inflows each year 9,600
• life of project 3 years
• discount rate (per year) 20
• Projected NPV 2,221
• BUT what could go wrong ??

77
Acmes CP project

• 4 main items in the data analysis
• initial investment (now) 18,000
• net cash inflows each year 9,600
• life of project 3 years
• discount rate (per year) 20
• If any of these deteriorate too far, NPV may fall
  below zero and the project would not be viable.
• How far could each deteriorate, before NPV falls
  to zero?

78
Initial investment
PV of future cash inflows 20,221 Expected
initial investment 18,000 Net Present
Value (NPV) 2,221 If cost of initial
investment were to increase by more than 2,221
(12.3) then project would not be worthwhile
79
Project life (1)

• The project could have to finish early for any of
  several possible reasons, e.g.
• The equipment wears out through use
• Companys lease on the property expires
• New environmental regulation makes the equipment
  obsolete
• Market demand for electro-plating falls
• Etc.

80
Project life (2)
Initial investment 18,000 Annual cash inflow
of 9,600 is equivalent to 800 per month It
will take 18,000 22.5 months 800 for the
project to pay back to the company its initial
investment
81
Payback (simple)

• Conclusion
• The company is at risk of losing money on the
  project if it comes to an end before 22.5 months.
• (The shorter the payback period, the lower the
  risk).
• Note this method is called simple payback, since
  it is calculated without first discounting the
  future cash flows

82
Payback (discounted)

• Payback period can alternatively be calculated
  based on discounted future cashflows
• This is more correct, since it recognises the
  time value of money (at least partly)
• If based on discounted cash flows (which is more
  correct), the payback period would be 27.5 months

83
Discount rate

• The rate at which the Net Present Value is zero
  (27.76, here) is the projects
• internal rate of return (IRR)
• The company should implement the project only if
  it can raise the money needed to finance it at a
  lower rate than this.
• If it has to pay more than 27.76 to raise
  finance, the project will destroy value.

84
Alternative project appraisal methods Summary

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Payback (simple or discounted)

85
Net Present Value (NPV)

• net amount of discounted future
• cashflows less initial investment
• ? reflects amount (in ) added by
• project to total company value
• ? recognizes time value of money
• ? complex to calculate
• ? needs prior estimate of cost of
• raising capital

86
Internal Rate of Return (IRR)

• discount rate at which NPV 0
• ? basis to compare with costs of
• different sources of finance
• ? recognises time value of money
• ? complex to calculate
• ? does not directly reflect impact
• on value

87
Payback

• time needed for net cash inflows to equal the
  initial investment
• ? simple to calculate and understand
• ? reflects risk of project life being shorter
  than expected
• ? ignores all cash flows after payback point
• ? simple version completely ignores time value
  of money

88
PROJECT FINANCING
89
Project Financing Sources

• 30 min

90
What are the different sources of project
financing available?
91
Questions

• What sources has your company raised capital from
  in order to finance projects?
• Why were these sources used?
• In what form was the finance provided (loans,
  grants, other )?
• Were any possible sources considered but not used?

92
Potential sources of project financing

• A. Internal funds
• B. Private sector
• 1. commercial banks
• 2. development corporations
• 3. equipment vendors/ subsidiary
• finance companies
• 4. owners capital (equity)
• C. Governmental sector
• grants/ earmarked capital from
  governmental programmes

93
Investing and financing decisions

• Distinguish between
• The investing decision
• The financing decision
• Investing decision is the project acceptable?
  (i.e. does it have a positive NPV, at the
  relevant discount rate?)
• Financing decision what is the best (usually,
  the cheapest) way to fund it?

94
Internal funds and the financing decision

• Internal funds are generated from past cash flows
• Internal funds (if available) are usually the
  best source, but
• They have an opportunity cost - what else could
  be done with these funds? (e.g. finance other
  projects, invest in financial securities, etc.)
• Soft funds specifically for CP projects may be
  preferable to internal funds

95
The variety of securities for Financing Companies

• International firms use different kinds of
  securities
• Stocks and shares
• Long-term debt (secured or unsecured by mortgages
  on plant and equipment)
• Short-term debt
• Lease or rent on long term basis
• Why are these securities not all relevant to
  small and medium-sized companies?

96
Commercial banks

• Banks are businesses that offer a variety of
  options to other organisations to finance their
  investments. The most frequent options are
• 1. Loans to finance the purchase of fixed assets
  (land and/or equipment)
• 2. Lines of credit (debt provided by the bank
  without conditions on how the borrower must use
  those funds)

97
Development corporations

• Development corporations/banks are established to
  contribute to the economic development of a
  particular community or region
• CP projects which comply with their criteria can
  apply for loans
• Question what development corporations/banks
  are you aware of?

98
Equipment vendors and Subsidiary finance companies

• Leasing has become a major source of financing
  that is provided by some equipment vendors and
  subsidiary finance companies (lease-providers).
  
• With financial leases (or capital leases)
• Title to the equipment is held by the firm which
  operates it (the lease-holder)
• The lease-provider retains a first security
  interest in the equipment
• The lease-holder faces the risks and receives
  the rewards of ownership

99
Owners capital (equity)

• Represented by ordinary shares in a company (or
  stock)
• Can be raised from either/both
• Present owners (shareholders)
• New shareholders
• But
• Present owners may not have spare capital
  available
• Bringing in new shareholders may dilute the
  shareholdings of present shareholders
• Issues of new shares in a company can be by
• A public issue
• A private placement of stock

100
Share issues

• Public issues of stock
• For larger companies
• Requires a stock market listing
• Substantial administrative costs
• Not usually suitable for single projects
• Private placements of stock
• Stock is bought by private persons but not on a
  public market
• Still significant administrative costs

101
Financing projectsSummary (1)

• Keep the financing decision distinct from the
  capital budgeting decision
• Identify the pool of funds available to your
  company
• Map the rates and terms of payment of different
  possible sources (differences may be huge!)
• Try to establish long-term relationships with
  potential sources of finance

102
Financing projectsSummary (2)

• The main factors are
• How much capital is available in the country
• The characteristics of CP-projects
• Important characteristics of each application
  include
• The level of uncertainty of future cash flows
• The duration of the project (long or short term)

103
Financing projectsSummary (3)

• Each source of capital has its own mechanisms
  which the company has to manage
• The application process
• The criteria of the fund provider
• The terms of repayment
• Any other restrictions put on the company (e.g. a
  maximum ratio of debt to equity, to limit risk)

104
Time for a break! 20 min
105
Bank Information Requirements

• 55 min

106
What information is a bank likely to want?
107
Question

• If your company were to apply to a bank for a
  loan to finance a CP project
• What information is the bank likely to require
  from you?
• Is there any further information that you could
  provide to support your application?

108
Typical information to evidence a companys
credit-worthiness (1)

• Historical financial statements for the past
  three years (balance sheet, income statement)
• Projected financial statements for the next 1-3
  years (balance sheet, income statement, cash flow
  forecast)

109
Acmes Balance Sheet (in 000)

• Capital liabilities
• Share capital 60
• Retained 42
• profits
• Accounts 23
• payable ____
• 125

• Assets
• Equipment 73
• Inventory 21
• Accounts 29
• receivable
• Cash 2
• ___
• 125

110
Acmes Income Statement (in 000)

• Sales revenue 203
• less Cost of goods sold - 156
• GROSS PROFIT 47
• less Overhead (indirect) costs - 35
• e.g. staff costs, rent, etc.
• NET PROFIT 12

111
Typical information to evidence a companys
credit-worthiness (2)

• For sole traders and partnerships personal
  financial statements and/or tax returns of the
  owner(s)
• Bank and credit references payment histories on
  other loans or leases
• Additional background information on the business

112
Presenting a fund application

• Acme wants to implement its 3-stage rinse CP
  project. The project requires an initial
  investment of 18,000 but Acme has only 2,000
  in cash, which it needs for day-to-day
  operations. It therefore needs to seek external
  finance. Three potential sources have been
  identified
• a commercial bank
• a development bank
• environmental programme to stimulate CP

113
Presenting a fund applicationCommercial bank

• An application to a commercial bank should focus
  on
• The increase in efficiency achievable by the
  investment
• The firms increased flexibility to respond
  swiftly to future changes in environmental
  regulation
• Ensuring the firms competitiveness
• Return on investment

114
Presenting a fund application Development bank

• An application to a development bank should focus
  on
• The company is small and has difficulties in
  obtaining funds through conventional channels
• Explain that the company is also applying for a
  matching grant, e.g.from a government programme
• Potential growth of the company due to increased
  cash flows from the investment
• The firms fiscal stability and ability to repay
  the loan

115
Presenting a fund application Government
environmental programme

• An application to a government environmental
  programme should focus on
• The potential use of the project as a
  demonstration project
• The potential environmental improvement from the
  project
• The companys intention to match the grant by
  also raising a loan

116
Summary

• Gather information on the past lending practices
  of each potential funding source (to gain insight
  into their motivations)
• Consider the motivation of the funding source
  when preparing an application
• Anticipate the information needs for the sources
  of capital

117
CONCLUSION
118
Other Issues?

• 10 min

119
Where to gofor more information

• 15 min

120
Review of the day

• 15 min

121
Investment projects

• Investment projects and company value
• Discussion of course participant experiences with
  investment projects
• Summary - typical project types goals

122
Capital budgetingIntroduction

• Capital budgeting definition and main
  implementation steps
• Case study and small group exercise on cost
  identification
• Discussion of small group exercise findings

123
Capital budgetingProfitability assessment

• Estimating project profitability with Net Present
  Value (NPV)
• Time value of money discounting
• Alternative profitability indicators
• NPV, IRR, Payback

124
Project financing

• Project financing sources
• Discussion of course participant experiences with
  project financing
• Types of investment and financing decisions
• Different types of funding sources
• Bank information requirements
• How to demonstrate credit-worthiness
• Case study and small group exercise on bank
  information requirements

125
Conclusion

• Other issues?
• Where to go for more information
• Brief review of what we learned today
• Course evaluation

126
Your next steps

• When you return to work, think about how to use
  what you have learned
• Keep Cleaner Production in mind!
• Consider taking one of the other UNEP courses, or
  sending an employee or colleague
• Learn more about accounting practices that will
  facilitate the tracking and collection of useful
  cost information

127
Course evaluation

• 15 min