INCREMENTAL POST-TAX CASHFLOWS
To evaluate project investment value, it is vital to consider the incremental after-tax cashflows net to the shareholder from doing the deal as opposed to not doing the deal. Assessing whether to pursue greenfield projects is fairly straightforward, as the incremental cashflows = the project cashflows as the alternative is to do nothing. For brownfield projects, project cashflows should be assessed against cashflows in a minimum stay in business scenario where future capital expenditure is limited to non-discretionary capex.
INFLATION AND CURRENCY
In project economic evaluation, it is best practice to consider nominal (money of the day) cashflows which accounts for inflation effects for each line item. This is particularly important in investments in emerging or frontier markets where the inflation rate for costs can vary wildly from that of revenues. For instance, a crude oil producer in Indonesia sells oil in US Dollars (USD) which inflates at USD inflation rates, but incurs costs in Indonesian Rupiah (IDR) that are subject to IDR inflation rates. For modelling purposes, cash costs and revenue receipts should be modelled in the currency that they are expected to be incurred or received in, respectively. That means matching currency specific inflation rates to each cashflow and thereafter converting them to the model functional currency.
Working Capital
Cash tied up in receivables, inventory and payables can be materially large, especially for large infrastructure projects. Over-simplifying or ignoring assumptions regarding working capital can severely under-estimate the amount of capital required to develop your project. A recent example of this in Singapore was when Jurong Aromatics Corporation Pte Ltd ran out of working capital, causing plant operations at the US$2 billion condensate splitter to stall when it was unable to service payment obligations. For modelling purposes, working capital should be directly tied to the price sets used to derive revenues and costs. Sensitivity and scenario analysis should also be performed based on past receivables and payables ageing records, voyage and storage durations, and also changes in unit prices. Trade and structured trade finance provided by banks, MNCs and specialist funds can also provide solutions to unlock cash tied up in working capital.
Counterparty Credit Risk
Where projects are dependent on long term contractual obligations to supply or purchase goods and services from third parties, it may be prudent to consider the credit risk of performance under those obligations. This would clearly demonstrate that cash flows under evaluation have considered such risks. There are a few ways to go about incorporating expected credit losses into cashflows.
1. Applying theoretical probabilities of default and assumed recovery rates to exposures is one way to implement this. Large credit rating agencies such as Standard & Poor’s regularly publish updates to their default probabilities. A problem with this approach is that loss given defaults becomes more dubious without the backing of historical data.
2. Indicative pricing on credit insurance policies can also be used as a proxy, especially in the absence of credit ratings. Based on our experience, such premiums represent 60-70% of what insurers assume to be the net interest margin on the transaction.
3. Cost of Credit Default Swaps (CDS) can also be a useful reference point to estimate the fair market assessment of the credit risk on the payment obligation.
Trapped Cash
In evaluating project feasibility, surplus cash generated at the project level that cannot be pooled back to corporate is known as trapped cash. If cash generated cannot be used for distributing dividends, reinvestment or servicing payment obligations, then they have no present value to shareholders and create a working capital issue. Trapped cash is usually an issue when investing in countries that do not form part of the corporate treasury pooling system or where legal constraints persist, including:
- Local government regulations, including rules around thin-capitalisation capital outflows
- FX effects, including a shortage of currency to be repatriated
- Shareholder or joint venture agreements
A recent example of trapped cash is the situation in Papua New Guinea which prompted the country to seek a World Bank loan to alleviate its US dollar liquidity issue.
In evaluating project economics, using any structure that creates payment obligations with fixed timing and amount e.g. shareholder loans or service agreements are usually commonly used solutions. Of course, these structures need to be backed by commercial substance, and should not be mere artificial constructs to evade regulations or paying taxes. Where there is no feasible work around solution, trapped cash should be only be released at the end of the project’s economic life. The silver lining to trapped cash is that the balance should earn cash interest based on local deposit rates. That said, external legal, tax and accounting advice should be sought as each trapped cash situation is likely unique in nature.
Taxation
Profits can only be distributed as dividends to shareholders once all taxes have been paid. For evaluating project economics, it would be prudent to assume all surplus cash gets repatriated back to the corporate which would be subject to applicable withholding tax and/or branch profits remittance tax. On a positive note, it may helpful in evaluating project economics to consider tax losses or tax credits available for deduction against profits. Consult local tax planning specialists to consider these effects for modelling purposes.
Hidden Costs
Missing out costs incurred outside the project is common mistake in evaluating project economics. For instance, post-investment integration costs may be incurred on an ongoing basis for a long time including systems integration and facilities sharing costs. In addition, there may be costs of seconding expatriate employees from the company into the project which have nothing to do with the project, including expenses for equalising personal tax for overseas secondees.
Return Metrics
There are a number of commonly used metrics used by investment professionals to encapsulate the deal being presented. No individual return metric is all-encompassing, and so for evaluating project economics it would be useful to take note of the drawbacks of each.
1. Net Present Value (NPV)
While NPV distils the project economics into a single number, it does not consider the efficiency of resources being deployed to create shareholder value. The NPV also depends on the discount rate being used, which could be a point of contention.
2. Internal Rate of Return (IRR)
Conceptually, IRR is the discount rate which yields a NPV zero result. The shortcoming to evaluating project economics solely on IRR is that it biases towards short-term projects that have larger positive cash flows in initial years. This may run counter to the ultimate objective of maximising long term shareholder value, as high IRR projects may yield lower value compared to some low IRR, high NPV projects with higher initial capex requirements.
3. Payback or Discounted Payback
This refers to the time taken by a project to break even, which may be presented on both a discounted and an un-discounted basis. Conceptually the shorter the payback period, the more positive the project looks. Alternatively, it conveys the number of consecutive years that assumptions need to be correct for the project to return the initial investment.
While getting to the above return metrics is useful, it may also be illuminating to reverse engineer the highly sensitive assumptions required to support value creation.