1 introduction to capital budgeting and financing of capital projects for unep division of...
TRANSCRIPT
1
Introduction toCapital Budgeting and Financing ofCapital Projects
For UNEP
Division of Technology, Industry, and Economics
Prepared collaboratively byGloucestershire Business School-
University of Gloucester,
and Tellus Institute
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Introduction
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Course Background
[15 min]
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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
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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
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Words of welcome
[15 min]
Introduction of Instructors
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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
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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
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Environmental Management hierarchy
Environmental Management hierarchy
Disposal
Control/Treatment
CLEANER PRODUCTION Pollution Prevention On-site Recycling/Reuse
BEST
LEASTDesirable
Off-site Recycling/Reuse
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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
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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
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Welcome bySenior Official
[15 min]
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Participant Introductions
[30 min]
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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
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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?
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Course Overview
[15 min]
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Today’s focus
Capital Budgeting Project Financing
Also to incorporate your experiences, questions, and goals into today’s presentation,exercises, & discussions
In the context of Cleaner Production
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Investment projects
Investment projects and company value
Discussion of course participant experiences with investment projects
Summary - typical project types & goals
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Capital budgeting—Introduction
Capital budgeting definition and main implementation steps
Case study and small group exercise on cost identification
Discussion of small group exercise findings
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Capital budgeting—Profitability Assessment
Estimating project profitability with Net Present Value (NPV)– Time value of money & discounting
Alternative profitability indicators– NPV, IRR, Payback
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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
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Conclusion
Other issues? Where to go for more
information Brief review of what we learned
today Course evaluation
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Time for a break! [15 min]
Time for a break! [15 min]
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INVESTMENT PROJECTS
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Investment Projects and Company Value
[15 min]
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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 company’s goals?
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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 company’s income as an adequate return on their capital investment ??
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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
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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 ??”
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Company value So what do investors/lenders seek? Value is what investors & lenders
consider worth paying NOW for the company’s expected future income
Value NOW — called ‘present value’ This must exceed the cost of raising
capital from investors & lenders
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Company value - Acme (1)
As an example, let’s 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
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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?
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Company value - Acme (3)
Acme’s value is then:$12,000 = $60,000 20%
If investors/lenders consider Acme to be a risky company and require 30%, then Acme’s value will be less:
$12,000 = $40,000 30%
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Discussion of Course Participant Experiences
with Investment Projects[30 min]
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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?
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Investment Projects — Summary
[15 min]
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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
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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
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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
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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
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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...
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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
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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!
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CAPITAL BUDGETING—INTRODUCTION
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Capital Budgeting -Definition and Main
Implementation Steps[15 min]
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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
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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
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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
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Decision-making factors
Project selectionProject
selection
Technical
Organizational
FinancialRegulatory
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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 this now We will discuss
these after lunch
We will discuss these after lunch
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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
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Case Study & Small Group Exerciseon Cost Identification
[30 min]
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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
10 min
10 min
10 min
15 min
15 min
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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
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SurfacePreparation
SurfacePreparation
ElectroplatingElectroplating
Post-treatment
Post-treatment
fresh water,chemicals,heat
oil, grease, sludgewastewater
oil, grease, sludgewastewater
air emissions
wastewater
Wastewatertreatment
Wastewatertreatment
wastewaterdischarge
RinsingRinsingfresh water
fresh water,chemicals,heat
fresh water,chemicals,heat
wastewater
coated part
part
sludge
treatmentchemicals
air emissions
air emissions
airemissions
Figure 1: Overall Process Flow Diagram
Figure 1: Overall Process Flow Diagram
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freshwater
in
Wastewatertreatment
Wastewatertreatment
wastewaterdischarge
freshwater
in
unrinsed part
rinsed part
SurfacePreparation
SurfacePreparation
ElectroplatingElectroplating
Post-treatment
Post-treatment
RinsingRinsing
treatmentchemicals
sludge
air emissions
air emissions
Figure 2: Existing Rinse Step (2-stage static rinse system)Figure 2: Existing Rinse Step (2-stage static rinse system)
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freshwater
in
part flow
rinsewater flow
pump pump
unrinsed part
rinsed part
new new
SurfacePreparation
SurfacePreparation
ElectroplatingElectroplating
Post-treatment
Post-treatment
RinsingRinsing
Wastewatertreatment
Wastewatertreatment
wastewaterdischarge
treatmentchemicals
sludge
air emissions
air emissions
new
Figure 3: Proposed New Rinse System (3-tank counter-current rinse system)Figure 3: Proposed New Rinse System (3-tank counter-current rinse system)
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Discussion ofSmall Group Exercise
Findings[15 min]
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Ease of identifyingand 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 purchasedirect materials, energy, & labor
waste disposal
recycle/reworktreatmentwaste handling regulatory compliance other indirect costs
less tangible costs
EASY
DIFFICULT
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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?)
UNEP’s CP3 course will cover cost estimation in more detail
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Time for lunch! [60 min]
Time for lunch! [60 min]
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CAPITAL BUDGETING — PROFITABILITY ASSESSMENT
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Estimating Project Profitability with
Net Present Value (NPV)[30 min]
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Question:
If we were giving away free money, would you
rather have:(A) $10,000 today, or(B) $10,000 3 years
from now
Why?
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
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Net Present Value Net Present Value (NPV) is the sum of
the present values of all the project’s 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
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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
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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?
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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
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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 company’s “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 project’s risk– any expected fall in the value of money over time
through inflation
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Questions:
(1) What is a typical rate of return at your
organisation?
(2) Do you use this rate of return in capital
budgeting?
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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”
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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)
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NPV and Cleaner Production
ProjectsAny special issues in doing NPV
analyses on CP projects?– Estimating future cash flows– Predicting project life– Identifying appropriate discount rate
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Influences on Project Appraisal
[20 min]
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Acme’s 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 ??
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Acme’s 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?
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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
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Project life (1)
The project could have to finish early for any of several possible reasons, e.g.:– The equipment wears out through use– Company’s lease on the property expires– New environmental regulation makes the
equipment obsolete– Market demand for electro-plating falls– Etc.
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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
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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
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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
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Discount rate
The rate at which the Net Present Value is zero (27.76%, here) is the project’s
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.
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Alternative project appraisal methods —
Summary
Net Present Value (NPV) Internal Rate of Return (IRR) Payback (simple or discounted)
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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
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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
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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
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PROJECT FINANCING
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Project Financing Sources
[30 min]
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What are the different sources of project
financing available?
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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?
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Potential sources of project financing
A. Internal fundsB. 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
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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?
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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
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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?
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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)
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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?
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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
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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
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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
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Financing projects:Summary (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
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Financing projects:Summary (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)
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Financing projects:Summary (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)
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Time for a break! [20 min]
Time for a break! [20 min]
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Bank Information Requirements
[55 min]
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What information is a bank likely to want?
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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?
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Typical information to evidence a company’s 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)
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Acme’s Balance Sheet (in $’000)
Capital & liabilities
Share capital 60
Retained 42profits
Accounts 23payable ____
125
Assets
Equipment 73
Inventory 21
Accounts 29receivable
Cash 2___125
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Acme’s 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
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Typical information to evidence a company’s 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
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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
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Presenting a fund application:
Commercial bankAn application to a commercial
bank should focus on:– The increase in efficiency achievable
by the investment– The firm’s increased flexibility to
respond swiftly to future changes in environmental regulation
– Ensuring the firm’s competitiveness– Return on investment
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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 firm’s fiscal stability and ability to repay the loan
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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 company’s intention to match the
grant by also raising a loan
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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
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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 budgeting—Introduction
Capital budgeting definition and main implementation steps
Case study and small group exercise on cost identification
Discussion of small group exercise findings
123
Capital budgeting—Profitability 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]