ASSIGNMENT 1

Project Appraisal Models

Submitted in partial fulfilment of the requirements for the degree in Master in Project Management

by

Erbynn Moroka Mpho Mogasha

at the

Department of Civil Engineering UNIVERSITY OF BOTSWANA

Supervisor: Dr. J. Ssegawa

16th April 2013

QUESTION 1: Identify the suggested project appraisal models and their associated cutoff rates for the different types of projects.

The policy at Pan Europa Foods S.A. is that investment proposals are subjected to two financial tests, payback period and internal rate of return (IRR).

MAXIMUM ACCEPTABLE PAYBACK IN YEARS

The payback period is the exact length of time needed for a firm to recover its initial investment as calculated from cash inflows. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred.

Payback period is the least precise of all capital budgeting methods because the calculations are in cash terms and not adjusted for the time value of money, (Kerzner, 1998). This determines that the payback period method is usually used as a supplemental tool to accompany other methods.

The length of time allowed for each type of project is determined by the nature of the project. For new products or markets the length of time may be longer as management recognises that it takes time to penetrate an unknown market, or for customers to appreciate a new product. Other project types such as efficiency improvements may be expected to have a shorter payback period as they have comparatively lower returns. The maximum acceptable payback periods for each project type are as indicated in table 1.

INTERNAL RATE OF RETURN

The internal rate of return (IRR) is a sophisticated capital budgeting technique. It is the discount rate where the present value of the cash inflows for a project exactly equals the initial investment amount, (Kerzner, 1998). The IRR is therefore the discount rate when NPV = 0. IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's IRR, the more desirable it is to undertake the project. In its simplest form, the IRR rule is intuitively appealing. In essence, it says: Does the expected rate of return on the investment exceed the hurdle rate of the company?

The various types of projects implemented by Pan Europa Foods S.A. present varying levels of risk and return. Projects for which the risk levels are considered high, the IRR is also higher, ensuring that the company receives greater returns on their investment. For projects with lower risk levels, the IRR is lowered accordingly. The cut-off rates for the various project types are as indicated in table 1. Table 1: Financial tests established by Management in project appraisal Type of Project Minimum Acceptable IRR (%) Maximum Acceptable

Payback (Years) 1 2 3 4 New product or new market Product or market extension Efficiency Improvements Safety or Environmental 12 10 8 No Test 6 5 4 No Test

The weighted-average cost of capital (WACC), is used to balance the sources of finance to be used by Pan Europa Foods S.A. This allows for the company to balance the use of its reserves, its equity, and debt in financing new projects. By applying a weighted average of sources of finance, the company is able to adapt to different environmental situations in order to minimise risk exposure, whilst maximizing on its financial gains. Different types of projects are subjected to varying criteria, depending on risk exposure and expected gain.

QUESTION 2: Write a step-by-step selection criteria for use in selecting projects in PAN EUROPA FOOD S.A. You need to incorporate the suggested project appraisal models you have identified above. This write-up will be used by the project selection council during project selection.

The selection criteria will help with the following: 1. Specifying needs 2. Prioritizing the needs 3. Evaluating, rating and comparing the needs and solutions 4. Selecting the preferred solution Proposed step-by-step criteria: 1. THE NEEDS a. Expansion of market presence and introduction of new products to boost sales. b. To reduce the companys debt by financing new projects through the use of more reserves and equity rather than debt. c. To reduce the companys debt by ploughing back profits into the company and repaying debts. d. An improvement of the companys market value. e. Funding limit (total capital spending limited to ECU 80 million). One of the initial steps taken by the board in deciding the nature of quantity of projects to be undertaken was to decide on a spending limit. A weighted average cost of capital was also set at 10.5 percent, ensuring a suitable composition of reserves, equity and debt in their sources of finance.

2. PRIORITIZING THE NEEDS a. Most members of management view the expansion of the companys market presence and the introduction of new products to boost sales as a priority. b. The companys creditors on the other hand seem to prioritize debt reduction. Pan Europas bankers, led by Banque du Bruges, are very reluctant to finance any increases in the companys leverage beyond the current level.

3. EVALUATING, RATING AND COMPARING THE NEEDS AND SOLUTIONS A non-scoring numeric model for appraisal shall be used: for a project to be selected it must demonstrate a positive cash flow. The project should demonstrate sufficient cash flows and a positive Net Present Value and Internal Rate of Return above the opportunity cost of capital. Furthermore the project should also incur minimum risk and meet the current corporate strategy.

a. Payback Period i. The payback period is used to screen and hence eliminate all projects with an unfavourable payback duration. ii. Projects with a payback period better than the minimum, score favourably. iii. The application of the payback period method signals that the company requires quicker returns. b. IRR i. The WACC should favour more the use of reserves and equity, rather than debt, to reduce the current debt-to-equity ratio of 125%. ii. iii. Projects with a negative IRR are not considered. Projects with an IRR better than the minimum score favourably.

iv. A sliding scale of IRR tests is employed to take into account the different levels of risk exposure inherent in the different project types. v. Projects with a higher risk exposure must give higher returns.

c. Does the project incur excessive risk i. Projects with less risk score favourably. ii. Projects which incur more risk are less favoured.

Projects that are a must do for reasons outside of the company's control such as compliance, legal reasons, regulation and environmental reasons are not evaluated by IRR or payback period. These projects must simply be done because the organisation does not have any control over those.

4. SELECTING THE PREFERRED SOLUTIONS

a. The first step of selection is choosing must do projects for reasons outside of the company's control e.g environmental reasons b. The next step of selection is a screening of all projects using the payback period. c. Only projects with a positive payback period may be considered in the next selection step. d. Projects with the required payback period are now considered under the IRR test in which only those projects with a positive IRR are considered.

e. After eliminating projects with unfavourable payback periods and IRRs , the remaining projects are now selected to meet the overall developmental budget of ECU80 million.

f. Projects with a higher Spread and less risk are selected first until the entire budget is exhausted.

QUESTION 3: Use the criteria developed in Question 2 to select from projects to be implemented by PAN EUROPA FOOD S.A. in the planning period, noting the funding constraints. Table 2 below illustrates the payback periods and IRRs of the different projects. From the table we can determine that some projects do not meet the evaluation criteria. Only projects 7, 8, 9, 10, and 11 meet both the payback period test and the IRR test.

Table 2: Appraisal of projects according to payback period ,internal rate of return and risk
PROJECT 1 PAYBACK (YEARS) PROJECTED 6 PAYBACK MAXIMUM ALLOWABLE 4 EVALUATION NOT ACCEPTED IRR (%) PROJECTED IRR MINIMUM IRR 7.8% 8.0% EVALUATION NOT ACCEPTED

OUTCOME : NOT ACCEPTED

PROJECT 2 PAYBACK (YEARS) PROJECTED 6 PAYBACK MAXIMUM ALLOWABLE 5 EVALUATION NOT ACCEPTED IRR (%) PROJECTED IRR MINIMUM IRR EVALUATION ACCEPTED

11.3% 10.0%

OUTCOME: NOT ACCEPTED

PROJECT 3 PAYBACK (YEARS) PROJECTED 6 PAYBACK MAXIMUM ALLOWABLE 5 EVALUATION NOT ACCEPTED IRR (%) PROJECTED IRR MINIMUM IRR EVALUATION ACCEPTED

11.2% 10.0%

OUTCOME: NOT ACCEPTED

PROJECT 4 PAYBACK (YEARS) PROJECTED 7 PAYBACK MAXIMUM ALLOWABLE 6 EVALUATION NOT ACCEPTED IRR (%) PROJECTED IRR MINIMUM IRR EVALUATION ACCEPTED

17.3% 12.0%

OUTCOME: NOT ACCEPTED

PROJECT 5 PAYBACK (YEARS) PROJECTED 6 PAYBACK MAXIMUM ALLOWABLE 4 EVALUATION NOT ACCEPTED IRR (%) PROJECTED IRR MINIMUM IRR EVALUATION ACCEPTED

8.7% 8.0%

OUTCOME: NOT ACCEPTED

7

PROJECT 6

PAYBACK (YEARS) PROJECTED NONE PAYBACK MAXIMUM ALLOWABLE NONE

EVALUATION ACCEPTED

IRR (%) PROJECTED IRR MINIMUM IRR

NONE NONE

EVALUATION ACCEPTED

OUTCOME: ACCEPTED

PROJECT 7

PAYBACK (YEARS) PROJECTED 5 PAYBACK MAXIMUM ALLOWABLE 6

EVALUATION ACCEPTED

IRR (%) PROJECTED IRR MINIMUM IRR

21.4% 12.0%

EVALUATION ACCEPTED

OUTCOME: ACCEPTED

PROJECT 8

PAYBACK (YEARS) PROJECTED 6 PAYBACK MAXIMUM ALLOWABLE 6

EVALUATION ACCEPTED

IRR (%) PROJECTED IRR MINIMUM IRR

18.8% 12.0%

EVALUATION ACCEPTED

OUTCOME: ACCEPTED
PROJECT 9 PAYBACK (YEARS) PROJECTED 5 PAYBACK MAXIMUM ALLOWABLE 6 EVALUATION ACCEPTED IRR (%) PROJECTED IRR MINIMUM IRR EVALUATION ACCEPTED

20.5% 12.0%

OUTCOME: ACCEPTED
PROJECT 10 PAYBACK (YEARS) PROJECTED 3 PAYBACK MAXIMUM ALLOWABLE 4 EVALUATION ACCEPTED IRR (%) PROJECTED IRR MINIMUM IRR EVALUATION ACCEPTED

16.2% 8.0%

OUTCOME: ACCEPTED
PROJECT 11 PAYBACK (YEARS) PROJECTED 5 PAYBACK EVALUATION ACCEPTED IRR (%) PROJECTED IRR EVALUATION ACCEPTED

28.7%

MAXIMUM ALLOWABLE

MINIMUM IRR

12.0%

OUTCOME: ACCEPTED

Table 3 below illustrates the projects selected for funding

Table 3: Project selection
PROJECT SELECTION

PROJECT Project 6

Project 7

Project 8 Project 9

SELECTION JUSTIFICATION European Community has requires companies to comply Spread of 9.4% Payback period of 1 year earlier than maximum Spread of 6.8% Spread of 8.5% Payback period year earlier maximum Spread of 8.2% Payback period year earlier maximum

EXPENDITURE ECU4 millions

CUMULATIVE BUDGET ECU4 millions

ECU20 millions

ECU24 millions

ECU20 millions ECU18 millions

ECU44 millions ECU62 millions

of 1 than ECU15 millions of 1 than ECU77 millions

Project 10

Even though project 11 meets the criteria considering payback period and IRR, it carries a high risk since it is a new product and requires a lot of expenditure.As such this project is less favourable.

REFERENCES

Kerzner, H. Project Management, A Systems Approach to Planning, Scheduling, and Controlling. 6th Edition. John Wiley & Sons Inc., 1998.

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