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Finance for engineers evaluation and funding of capital projects f k crundwell (springer, 2008)


Finance for Engineers


F.K. Crundwell

Finance for Engineers
Evaluation and Funding of Capital Projects

123


F.K. Crundwell, PhD
CM Solutions
Wimbledon
London SW19
United Kingdom

ISBN 978-1-84800-032-2

e-ISBN 978-1-84800-033-9


DOI 10.1007/978-1-84800-033-9
British Library Cataloguing in Publication Data
Crundwell, F. K.
Finance for engineers : evaluation and funding of capital projects
1. Capital investments 2. Project management - Finance
3. Engineering - Finance
I. Title
620’.00681
ISBN-13: 9781848000322
Library of Congress Control Number: 2008922273
© 2008 Springer-Verlag London Limited
Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced,
stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms of licences issued by the
Copyright Licensing Agency. Enquiries concerning reproduction outside those terms should be sent to
the publishers.
The use of registered names, trademarks, etc. in this publication does not imply, even in the absence of
a specific statement, that such names are exempt from the relevant laws and regulations and therefore
free for general use.
The publisher makes no representation, express or implied, with regard to the accuracy of the information
contained in this book and cannot accept any legal responsibility or liability for any errors or omissions
that may be made.
Cover design: eStudio Calamar S.L., Girona, Spain
Printed on acid-free paper
987654321
springer.com


For Natascha and Nicholas


Preface

Investment decisions are critical part of a company’s success, and capital budgeting
is a central topic of financial management. However, in contrast to other strategic
decisions in business, decisions on capital projects are decentralized, from corporate
to divisions, divisions to operations, from operations to departments. Engineers at
various levels within the organization who make a capital proposal are contributing
to the strategic success of the organization. This book will assist engineers to contribute strategically to the organization, so that they can contribute to the success of
their company and can make a success of their careers.


The purpose of this book is to provide engineers and managers with a working
knowledge of the financial evaluation and the funding of capital projects. Four main
topics concerning capital investment are covered, namely, the context of these decisions, the assessment of their returns, the assessment of their risks, and their funding
and financing. Engineers have developed the field of engineering economics, and
financial managers have developed the discipline of capital budgeting, each with
its own approach and slightly different terminology. This book borrows from both
these disciplines in order to provide engineers with the best possible knowledge
about capital projects.
An important aspect of the approach adopted here is to provide context to the
techniques, methods and concepts of the economic assessment of engineering decisions. An engineer who knows her subject is able to communicate her ideas to people of different professions and with different training. An essential part of effective
communication is to understand the other person’s paradigm, to know their basic
assumptions. As a result, it is important to understand the basics of decision making, of financial management, and accounting. It is also important to understand the
terminology used by different professions. Part I of the book examines these topics,
which forms the introduction to the economic assessment of an engineering project.
A project is assessed on its economic merits, its profitability. Part II of the book
covers the techniques and methods of capital budgeting and engineering economics.
In-depth case studies demonstrate the application of these techniques to practical
situations.

vii


viii

Preface

The assessment of the economic merits of a project usually refers to the returns
expected from the project. The cornerstones of finance are risk and return, and it
is essential to address the risk of the project in a discussion of its merits. The risk
is the chance of the expected returns not materializing. The types of risk, such as
stand-alone risk and portfolio risk, for a capital project are examined in Part III of
this book.
It is also important to understand the financing of a project, the sources of finance,
and the structure of financial arrangements such as project finance and public-private
partnerships. Part IV of the book examines both the internal and external sources of
funding and the structuring of the financial and legal relationships that enable the
project to be built.

Intended Readers
This book is designed for use both as an undergraduate textbook for engineers and
as a reference for practising engineers. The material assumes little prior knowledge
of engineering, accounting or financial management. It is intended for use as a text
in undergraduate courses on either engineering economics or financial management.
It may also be used in an engineering design course where the financial implications
of design are under discussion.
This book has been designed to accommodate all branches of engineering. Examples and case studies have been drawn from as wide a range of the engineering
disciplines as possible. For example, there are case studies on, amongst others, hydroelectric power, pumping stations, toll roads, mining, processing technologies,
and petroleum production. In addition, these examples cover different geographies,
such as the US, the UK, Australia and Brazil, so that this book is relevant to the
experience of engineers across the World. Another important example of this is that
the difference in the accounting terminology used in the US and the UK for the
preparation of financial statements is examined, and a translation table is provided
as an Appendix.

Educational Package
The organization of the themes and the major topics of the book is shown in the
diagram. A number of different courses can be derived from this book. An Introductory course in Engineering Economics might include a topic from the Part I as an
introduction, and then focus on Part II, in which the evaluation of capital projects is
discussed in detail. A more advanced course in Engineering Economics could select
Chaps. 1 and 4 from Part I, move through Part II and end with Part IV. A course
with the title of this book, Finance for Engineers, might cover the material in Part I,


Preface

ix

Part II, Chapter 11 from Part III, and then end with Part IV. An advanced course in
Financial Management for Engineers might cover all the topics.
Since this book is intended as a textbook and a reference, each chapter includes
numerous worked examples and case studies. Each chapter also includes review
questions and tutorial exercises. The review questions are designed to emphasize


x

Preface

the concepts that are covered in the chapter, while the exercises allow the reader to
practise the application of the techniques discussed in the chapter. Worked solutions
to almost all of the exercises are included in an Appendix.
Spreadsheet solutions of all the questions and the case studies presented in the
book can be obtained from the website (www.springer.com/978-1-84800-032-2).
These solutions provide learners and facilitators with hands-on material to ensure
a more thorough understanding of the material. PowerPoint slides for the swift development of course material are also available on the website.
A detailed glossary of the important terms used is also provided as an Appendix.

Acknowledgements
Soon after starting my engineering consulting practice, I happened to meet Dr
Wolter te Riele on campus. He suggested that I run a course on finance and economics for engineers. Several hundred delegates with an engineering training have
attended my courses, including young professionals starting their careers, company CEOs, and MBA graduates. This book is a culmination of that suggestion of
Wolter’s and I would like to thank him for it. In addition, a number of people encouraged me to write this book, and pressed me to finish it. Kevan Ford and Natascha
were prominent in this regard, and I express my appreciation.
I would like to thank Hazel Moller, Deryn Petty and particularly Natascha Uberbacher for reading and correcting the manuscript.
Frank Crundwell


Contents

List of Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxiii
Part I Foundations
1

2

An Overview of the Evaluation and Financing of Capital Projects . . .
1.1
Evaluation and Funding of Projects . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2
Project Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.3
Evaluating the Project Based on Free Cash Flow . . . . . . . . . . . . . . .
1.4
Profit (or Earnings) is Not Required for the Assessment
of the Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5
Investment Decision Precedes the Financing Decision . . . . . . . . . . .
1.6
Past Expenses are Excluded from the Project Financials . . . . . . . . .
1.7
Assessment of the Risk of the Project . . . . . . . . . . . . . . . . . . . . . . . .
1.8
Financing of a Capital Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.9
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.10 Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.11 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.12 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Theory and Practice
of Decision-making Concerning Capital Projects . . . . . . . . . . . . . . . . . .
2.1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2
Cost-benefit Analysis, Engineering Economics
and Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.3
Perspectives for the Assessment of Projects . . . . . . . . . . . . . . . . . . .
2.4
Enhancing Value for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.5
Business Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.5.1
Financial Stewardship Within a Business . . . . . . . . . . . . . .
2.5.2
Sources and Use of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.5.3
Investment and Financing Decisions Within the Business
2.5.4
Evaluation of Investment Opportunities . . . . . . . . . . . . . . .

3
3
4
8
11
11
12
12
13
14
16
16
17

19
19
19
22
23
24
24
25
27
28

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xii

Contents

2.6
2.7

2.8

2.9
2.10
2.11
2.12
3

Business Decision-making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A Framework for Decision-making . . . . . . . . . . . . . . . . . . . . . . . . . .
2.7.1
Steps in the Decision-making Process . . . . . . . . . . . . . . . . .
2.7.2
Frame: the Decision Context and Possible Alternatives . .
2.7.3
Evaluate: the Assessment of Alternatives
Based on Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.7.4
Decide: the Act of Decision-making . . . . . . . . . . . . . . . . . .
The Practice of Decision-making for Capital Projects . . . . . . . . . . .
2.8.1
Classification of Capital Projects . . . . . . . . . . . . . . . . . . . .
2.8.2
Relationship Between Projects . . . . . . . . . . . . . . . . . . . . . . .
2.8.3
Decision Authority for Capital Projects . . . . . . . . . . . . . . .
2.8.4
Case Study: Small Project . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.8.5
Case Study: Large Project . . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2
Business Process and the Dual Nature of Transactions . . . . . . . . . .
3.2.1
The Dual Nature of Transactions . . . . . . . . . . . . . . . . . . . . .
3.2.2
Business Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3
Financial Records . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4
Accounting Principles and Conventions . . . . . . . . . . . . . . . . . . . . . . .
3.4.1
Business Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4.2
Accrual Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4.3
Historical Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5
Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.1
Basic Transactions in a Business . . . . . . . . . . . . . . . . . . . .
3.5.2
Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.3
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.5.4
Cash Flow Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.6
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.7
The Interaction Between the Financial Statements . . . . . . . . . . . . . .
3.8
Relationship Between the Financial Statements
and the Project Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.9
Case Study: Santa Anna Hydroelectric Power Scheme . . . . . . . . . .
3.9.1
Project Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.9.2
Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.9.3
Cash Flow Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.9.4
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.10 Examining the Business Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.11 Case Study: Apex Foods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.12 Ratio Analysis and Financial Trees . . . . . . . . . . . . . . . . . . . . . . . . . . .

29
31
31
32
34
35
36
36
36
37
38
40
42
43
43
44
45
45
45
46
48
49
49
50
50
51
52
52
55
60
62
65
69
71
72
72
74
75
76
77
78
83


Contents

3.13
3.14
3.15
4

xiii

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

Cash Flows for a Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
4.1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
4.2
Determining the Cash Flows for a Project . . . . . . . . . . . . . . . . . . . . . 91
4.3
Overview of the Stages of Engineering Design and Construction . . 92
4.4
Approval Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.5
Estimation of the Capital Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.5.1
Components of Capital Cost Estimates . . . . . . . . . . . . . . . . 94
4.5.2
Classification of Capital Cost Estimates
Based on their End Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
4.5.3
Classification of Capital Cost Estimates
Based on their Level of Accuracy . . . . . . . . . . . . . . . . . . . . 97
4.6
Estimation Techniques for Capital Costs . . . . . . . . . . . . . . . . . . . . . . 101
4.6.1
Factored Estimate Techniques . . . . . . . . . . . . . . . . . . . . . . . 101
4.6.2
Unit Costs Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
4.7
Estimation of the Total Operating Costs . . . . . . . . . . . . . . . . . . . . . . . 106
4.7.1
Direct Production or Manufacturing Costs . . . . . . . . . . . . . 107
4.7.2
Fixed Manufacturing Costs . . . . . . . . . . . . . . . . . . . . . . . . . . 108
4.7.3
Plant Overheads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
4.7.4
General and Administrative . . . . . . . . . . . . . . . . . . . . . . . . . 108
4.7.5
Royalties and Production Payment . . . . . . . . . . . . . . . . . . . 109
4.8
Forecasts of the Sales or Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
4.9
Calculation of the Direct Taxes and Royalties . . . . . . . . . . . . . . . . . 111
4.9.1
Corporate Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.9.2
Capital Gains Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
4.9.3
Royalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
4.10 Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
4.11 Case Study: Order of Magnitude Estimate
of the Capital Cost of a Plant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.12 Case Study: Factored Estimate of the Capital Cost of a Plant . . . . . 115
4.13 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
4.14 Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
4.15 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
4.16 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Part II Evaluation of Capital Projects
5

Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
5.1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
5.2
Interest and Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.3
Effect of Timing on the Value of Money . . . . . . . . . . . . . . . . . . . . . . 126
5.4
Future Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128


xiv

Contents

5.5
5.6

5.7

5.8

5.9

5.10
5.11
5.12
5.13
5.14
6

Multiple Periods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
Types of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
5.6.1
Nominal and Period Interest Rate . . . . . . . . . . . . . . . . . . . . 130
5.6.2
Effective Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
5.7.1
Single Payments: Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
5.7.2
Multiple Equal Payments: Annuities . . . . . . . . . . . . . . . . . . 140
5.7.3
Multiple Periods: Growth Annuities . . . . . . . . . . . . . . . . . . 143
5.7.4
Multiple Payments of Unequal Amounts . . . . . . . . . . . . . . 146
Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
5.8.1
Single Amounts of Future Cash Flow . . . . . . . . . . . . . . . . . 147
5.8.2
Multiple Equal Amounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
5.8.3
Uneven Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Compound Interest Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
5.9.1
Single Payment Interest Formula . . . . . . . . . . . . . . . . . . . . . 151
5.9.2
Multiple Equal Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
5.9.3
A Notation for Interest Rate Factors . . . . . . . . . . . . . . . . . . 152
Case Study: Zero Coupon and Coupon Bonds . . . . . . . . . . . . . . . . . . 155
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

Evaluation Criteria for Investment Decisions . . . . . . . . . . . . . . . . . . . . . . 163
6.1
Creating Value for the Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
6.2
Non-discounted Cash Flow Techniques . . . . . . . . . . . . . . . . . . . . . . . 164
6.2.1
Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
6.2.2
Return on Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
6.3
Discounted Cash Flow Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
6.3.1
Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
6.3.2
Profitability Index or Benefit-cost Ratio . . . . . . . . . . . . . . . 172
6.3.3
Internal Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
6.3.4
Modified Internal Rate of Return . . . . . . . . . . . . . . . . . . . . 180
6.3.5
Discounted Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . 181
6.3.6
Benefit-Cost Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
6.3.7
Equivalent Annual Charge . . . . . . . . . . . . . . . . . . . . . . . . . . 183
6.4
Comparison Between Discounted Cash Flow Techniques . . . . . . . . 188
6.4.1
Relative and Absolute Measures . . . . . . . . . . . . . . . . . . . . . 188
6.4.2
Agreement and Conflict Between Measures . . . . . . . . . . . 189
6.4.3
The Reinvestment Assumption in the NPV and IRR . . . . . 193
6.5
Case Study: Decision Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
6.6
Survey of the Most Used Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
6.7
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
6.8
Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200


Contents

6.9
6.10

xv

Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201

7

Mutually Exclusive, Replacement and Independent Projects . . . . . . . . 205
7.1
Classification of Asset Allocation Decisions . . . . . . . . . . . . . . . . . . . 205
7.2
Mutually Exclusive Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
7.2.1
Ranking Mutually Exclusive Options with Equal Lives . . 207
7.2.2
Ranking Mutually Exclusive Projects with Unequal Lives 210
7.2.3
Selection of Mutually Exclusive Alternatives . . . . . . . . . . . 217
7.3
Replacement Studies: Mutually Exclusive Decisions
with an Incumbent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
7.3.1
Economic Service Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
7.3.2
Selection of Defender or Challenger
Based on Equivalent Annual Charge . . . . . . . . . . . . . . . . . . 221
7.3.3
Replacement for Service Required for Defined Period . . . 223
7.4
Non-mutually Exclusive or Independent Projects . . . . . . . . . . . . . . . 226
7.4.1
Effect of Starting Times Delays and Project Life . . . . . . . . 226
7.4.2
Ranking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
7.4.3
Selection of Projects Under Capital Rationing . . . . . . . . . . 232
7.5
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
7.6
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
7.7
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

8

Practical Issues in the Evaluation of Projects . . . . . . . . . . . . . . . . . . . . . . 247
8.1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
8.2
Inflation and Price Escalation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
8.3
Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
8.3.1
Tax Position of the Company . . . . . . . . . . . . . . . . . . . . . . . . 253
8.3.2
Methods of Calculation of Depreciation . . . . . . . . . . . . . . . 253
8.3.3
Comparison Between Depreciation Methods . . . . . . . . . . . 260
8.3.4
Effect of the Depreciation Method on NPV and IRR . . . . . 260
8.3.5
Disposal of a Depreciable Asset . . . . . . . . . . . . . . . . . . . . . . 263
8.4
Choice of the Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
8.5
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
8.6
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
8.7
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269

9

Sensitivity, Scenario and Other Decision Analysis Techniques . . . . . . . 273
9.1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
9.2
Influence Diagrams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
9.3
Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
9.4
Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
9.5
Strategy Space . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
9.6
Decision Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283


xvi

Contents

9.7
9.8
9.9
9.10

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

10 Case Studies on the Application of the Decision-making Criteria . . . . 291
10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
10.2 Santa Clara HEPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
10.2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
10.2.2 Decision Frame . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
10.2.3 Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
10.2.4 Decide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
10.3 Mobile Crusher . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
10.3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
10.3.2 Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
10.3.3 Recommendation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
10.4 Mobile Crusher Contractor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
10.4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
10.4.2 Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
10.5 Filtration Joint Venture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
10.5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
10.5.2 Project Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
10.5.3 Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
10.5.4 Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
10.5.5 Commercial Arrangement Between Alex and WasteTek . . 313
10.5.6 Financing of the Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
10.5.7 Recommendation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
10.6 Bakersfield Water Pumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
10.6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
10.6.2 Project Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
10.6.3 Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
10.6.4 Recommendation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
10.7 Combine Harvester . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
10.7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
10.7.2 Project Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
10.7.3 Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
10.7.4 Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
10.7.5 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
10.7.6 Recommendation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
10.8 PetroGen Oil Field and Petroleum Refinery . . . . . . . . . . . . . . . . . . . 327
10.8.1 Project Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
10.8.2 Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
10.8.3 Financing of the Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
10.9 Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331


Contents

xvii

10.10 Review Questions and Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
10.10.1 Santa Clara HEPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
10.10.2 Mobile Crusher . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
10.10.3 Mobile Crusher Contractor . . . . . . . . . . . . . . . . . . . . . . . . . . 332
10.10.4 Filtration Operation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
10.10.5 Water Pumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
10.10.6 Combine Harvester . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
10.10.7 Petroleum Field and Refinery . . . . . . . . . . . . . . . . . . . . . . . . 334
Part III Risk Assessment
11 Risk and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
11.2 Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
11.3 Certainty and Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
11.3.1 Business Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
11.3.2 Financing Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
11.3.3 Investment Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
11.4 Portfolio Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
11.5 Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
11.6 The Attainable Region and the Efficient Frontier . . . . . . . . . . . . . . . 351
11.7 Capital Asset Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
11.8 Portfolio Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
11.9 Critique of Finance Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
11.10 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
11.11 Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
11.12 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
11.13 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
12 Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
12.2 Cost of Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
12.2.1 Calculating the Cost of Equity from the CAPM . . . . . . . . 368
12.2.2 Calculating the Cost of Equity from the Growth Model . . 370
12.2.3 Calculating the Cost of Equity
from the Historical Returns . . . . . . . . . . . . . . . . . . . . . . . . . 370
12.3 Interest Rates and the Cost of Debt . . . . . . . . . . . . . . . . . . . . . . . . . . 371
12.4 Pooling of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
12.5 Weighted Average Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
12.6 Entity Versus Equity Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
12.7 Practices in the Calculation of WACC . . . . . . . . . . . . . . . . . . . . . . . . 379
12.7.1 Cost of Equity Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
12.7.2 Risk-free Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
12.7.3 Market-risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
12.7.4 Beta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380


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Contents

12.7.5 Weighting Factors in WACC . . . . . . . . . . . . . . . . . . . . . . . . 382
12.7.6 Tax Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
12.7.7 Review Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
12.8 WACC, Leverage and Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . 383
12.9 Opportunity Cost of Capital, MARR and the Hurdle Rate . . . . . . . . 386
12.10 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
12.11 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
12.12 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
13 Risk in Engineering Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
13.2 Sources of Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
13.2.1 Company-level Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
13.2.2 Project-level Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
13.3 Probability Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
13.4 Risk-adjusted Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
13.4.1 Company-risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
13.4.2 Project-risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
13.5 Certainty Equivalent Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
13.5.1 Certainty Equivalent Coefficients . . . . . . . . . . . . . . . . . . . . . 404
13.5.2 Certainty Equivalent Risk Premiums . . . . . . . . . . . . . . . . . . 406
13.6 Relationship Between the RADR and the CE Methods . . . . . . . . . . 407
13.7 Risk Adjustment Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
13.8 Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
13.8.1 Discrete and Continuous Distributions . . . . . . . . . . . . . . . . 409
13.8.2 Drawing a Random Sample . . . . . . . . . . . . . . . . . . . . . . . . . 412
13.8.3 Monte Carlo Simulation of a Project
with One Source of Uncertainty . . . . . . . . . . . . . . . . . . . . . . 413
13.8.4 Value at Risk (VaR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
13.8.5 Monte Carlo Simulation with Multiple Sources
of Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
13.8.6 Review of Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
13.9 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
13.10 Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
13.11 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
13.12 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
14 Decision Tree Analysis and Utility Theory . . . . . . . . . . . . . . . . . . . . . . . . . 427
14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
14.2 Decision Tree Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428
14.2.1 Decision, Event and Terminal Nodes . . . . . . . . . . . . . . . . . . 428
14.2.2 Basic Decision Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
14.2.3 Events and Probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430
14.2.4 Value of Terminal Nodes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
14.2.5 Expected Value and Decision Trees . . . . . . . . . . . . . . . . . . . 433


Contents

14.3
14.4

14.5
14.6
14.7

xix

14.2.6 Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
14.2.7 Joint Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
14.2.8 Short-cut Notation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
Decision Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
Utility Theory and Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444
14.4.1 Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444
14.4.2 Utility Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444
14.4.3 Lotteries and Certainty Equivalents . . . . . . . . . . . . . . . . . . . 445
14.4.4 Expected Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
14.4.5 Utility and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . 448
14.4.6 Exponential Utility Function . . . . . . . . . . . . . . . . . . . . . . . . 450
14.4.7 Using Utility to Account for Risk in NPV Calculations . . 451
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454

15 Real Options Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
15.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
15.2 Financial Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
15.2.1 Options Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
15.2.2 Payoff from an Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460
15.2.3 Price of an Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461
15.2.4 Use of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462
15.3 Options on Non-financial Assets: Real Options . . . . . . . . . . . . . . . . 463
15.4 Examples of Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
15.4.1 Option to Invest (or Deferral Option) . . . . . . . . . . . . . . . . . 465
15.4.2 Time-to-built Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
15.4.3 Growth Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
15.4.4 Abandonment Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
15.4.5 Switching Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
15.5 The Valuation of Financial Options . . . . . . . . . . . . . . . . . . . . . . . . . . 467
15.5.1 Risk-free Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
15.5.2 Risk-neutral Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
15.5.3 Binomial Lattice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470
15.5.4 Black–Scholes Option Pricing Formula . . . . . . . . . . . . . . . 474
15.6 Valuation of Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476
15.6.1 Option to Invest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476
15.6.2 Option to Abandon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
15.6.3 Option to Temporarily Close Operations . . . . . . . . . . . . . . . 480
15.6.4 Option to Expand or Contract . . . . . . . . . . . . . . . . . . . . . . . . 480
15.6.5 Option to Switch Between Alternatives . . . . . . . . . . . . . . . . 482
15.7 Decision-making Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482
15.8 Real Options Analysis is Not Decision Tree Analysis . . . . . . . . . . . 483
15.9 Strategic Thinking and Real Options . . . . . . . . . . . . . . . . . . . . . . . . . 484


xx

Contents

15.10 Case Study: Phased Expansion of Gas-to-Liquids Operation . . . . . 485
15.10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
15.10.2 Staging the Investment Decision . . . . . . . . . . . . . . . . . . . . . 486
15.10.3 Real Options Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486
15.10.4 Concluding Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.11 Case Study:
Value of the Joint Venture Contract for Cuprum . . . . . . . . . . . . . . . . 489
15.11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.11.2 Market for Copper Concentrates . . . . . . . . . . . . . . . . . . . . . 490
15.11.3 Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491
15.11.4 Capital and Operating Costs for Cuprum and Smelters . . . 492
15.11.5 NPV of Copper Smelting and Cuprum’s Process . . . . . . . . 493
15.11.6 The Value of the Technology . . . . . . . . . . . . . . . . . . . . . . . . 495
15.11.7 Concluding Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.12 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.13 Looking Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501
15.14 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501
15.15 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502
Part IV Financing of Capital Projects
16 Sources of Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
16.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
16.2 Lenders, Borrowers and Financial Institutions . . . . . . . . . . . . . . . . . 507
16.3 Financial Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
16.3.1 Equity Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
16.3.2 Debt Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
16.3.3 Types of Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
16.3.4 Long-term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
16.3.5 Short-term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
16.3.6 Public Issue and Private Placement
of Financial Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
16.4 Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
16.4.1 Equity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
16.4.2 Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
16.4.3 Futures and Derivatives Markets . . . . . . . . . . . . . . . . . . . . . 522
16.5 Financing Decisions Within a Company . . . . . . . . . . . . . . . . . . . . . . 525
16.5.1 Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
16.5.2 Dividend Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
16.6 Comparison of Equity and Debt Financing . . . . . . . . . . . . . . . . . . . . 527
16.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527
16.8 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528
16.9 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528


Contents

xxi

17 Financing Engineering Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
17.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
17.2 Financing Engineering Construction of Capital Projects . . . . . . . . . 531
17.2.1 Project Delivery Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
17.2.2 Risk in Engineering Contracting . . . . . . . . . . . . . . . . . . . . . 533
17.2.3 Construction Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
17.2.4 Financial Guarantees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
17.2.5 Indiantown Cogeneration Facility . . . . . . . . . . . . . . . . . . . . 535
17.2.6 Eurotunnel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536
17.3 Project Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
17.3.1 Overview of Project Finance . . . . . . . . . . . . . . . . . . . . . . . . 537
17.3.2 Project Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
17.3.3 Risks and Risk Mitigation . . . . . . . . . . . . . . . . . . . . . . . . . . . 538
17.3.4 Assessing Debt Capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539
17.3.5 Application of Project Finance . . . . . . . . . . . . . . . . . . . . . . . 540
17.3.6 Project Finance for the Pembroke Cracking Company . . . 541
17.3.7 Project Finance for the Ras Gas Project . . . . . . . . . . . . . . . 541
17.4 Public–private Partnerships and the Funding
of Public Infrastructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
17.4.1 Risk Sharing in Public–private Partnerships . . . . . . . . . . . . 543
17.4.2 Structuring of a Public–private Partnership . . . . . . . . . . . . 545
17.4.3 The A1-M1 Link Road . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545
17.5 Case Study: Project Finance of a Cogeneration Facility . . . . . . . . . . 546
17.5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
17.5.2 Legal Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
17.5.3 Contractual Arrangements for the Project . . . . . . . . . . . . . . 547
17.5.4 Project Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549
17.5.5 Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552
17.5.6 Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552
17.5.7 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555
17.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
17.7 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
17.8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
A

Equivalent US and UK Terms Used in the Financial Statements . . . . . 559

B

Answers to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 595
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607


List of Abbreviations

AOC
APR
B/C
BOOT
BTO
CEV
CF
CPI
CR
DDB
EAC
EPC
EPCM
ESL
FV
FVA
FVIFA
GAAP
GDP
ICO
IPO
LIBOR
MACRS
MARR
NPV
OTC
PV
QDB
RADR
ROA
ROE
SEC
SGA
SL
SOYD
TV
VaR
WACC

Annual Operating Charge
Annual Percentage Rate
Benefit Cost Ratio
Build, Own, Operate Transfer
Build, Transfer, Operate
Certainty Equivalent Value
Cash Flow
Consumer Price Index
Capital Recovery
Double Declining Balance
Equivalent Annual Charge
Engineering, Procurement and Construction
Engineering, Procurement and Construction Management
Economic Service Life
Future Value
Future Value of an Annuity
Future Value Interest Factor of an Annuity
Generally Accepted Accounting Practices
Gross Domestic Product
Initial Capital Outlay
Initial Public Offering
London Interbank Offer Rate
Modified Accelerated Cost Recovery System
Minimum Attractive Rate of Return
Net Present Value
Over The Counter
Present Value
Quarter Declining Balance
Risk-Adjusted Discount Rate
Return On Assets
Return On Equity
Securities Exchange Commission
Sales, General and Administrative
Straight Line Depreciation
Sum Of Years Digits Depreciation
Terminal Value
Value At Risk
Weighted Average Cost of Capital

xxiii


Part I

Foundations


The engineering design and business assessment of capital projects are intertwined
with another. The business and the engineering aspects of investing in a capital
project form the foundations for financial planning and capital budgeting. The business context includes the roles and responsibilities of the financial management of
a company, the sources and use of funds, and the decision-making functions within
a company. An understanding of accounting, particularly of the financial statements,
is important in determining the effects of capital investments on the financial health
of the company. The purpose of an engineering design is twofold: to enable the
project to be built and to estimate the cost to build it. In this way, the engineering
design plays a central role within a company by determining the financial requirements of a project and by ensuring its successful implementation.
The foundation for the evaluation of capital projects is an understanding of the
components of the cash flows of a project. Chapter 1 provides an overview of evaluation and financing activities and an introduction to the main themes and topics of
the other chapters. Particularly important in Chapter 1 are the concepts of project
financials and of free cash flow. After this overview, the foundation topics are examined. Chapter 2 is a discussion of the context within a company for decisionmaking concerning capital projects. Chapter 3 presents the financial statements of
a company. The development of the free cash flows for the project is discussed in
Chapter 4. A full appreciation of the components of the cash flows often requires
an understanding of the financial statements of a company and an understanding
of engineering design. The integration of the engineering design with the decisionmaking process within a company is discussed in Chapters 2 and 4.


Chapter 1

An Overview of the Evaluation
and Financing of Capital Projects

1.1 Evaluation and Funding of Projects
The activities of a company can be seen as a collection or a succession of projects.
These projects involve the acquisition of assets and the operational use of these assets for production. For example, an oil company will acquire lease rights for an area
of land, explore for oil, drill wells, and produce oil from the wells for a number of
years. This may be the only activity, or one of many of the activities, that constitute
the company. As such, the project is the basic unit of activity for a company.
Projects range from those that are large relative to the size of the company to
those that are relatively small. Usually, the company engages in lots of smaller
projects, such as the replacement of ageing equipment, and fewer large projects,
such as the construction of a new production facility or the building of a high-rise
office block. The decision-making process for projects is usually decentralized, so
that the evaluation and approval of a project is performed at a level of authority
appropriate to the size of the project.
The evaluation of a project is a multidisciplinary task, and is not solely the domain of any one of the professions or of management. It involves elements of engineering economics, capital budgeting, financial management, and strategic planning.
It is performed by a variety of members of staff throughout the organization who
may have different professional approaches. Many companies standardize the procedures for the evaluation of projects. However, these methods differ from company
to company, indicating that there is no consensus between different companies on
the best methods to adopt. There are also slight differences in terminology and notation within the different disciplines. All these different approaches have been used
in this book in order to provide students and practitioners with a thorough and clear
understanding of evaluation procedures. An integrated approach allows employees
and management at the different levels and functions to have a common basis for
communication and decision-making where analysis and decision-making occurs.
The funding of large capital projects, either from the internal resources of the
company or by raising additional finance from external sources, is the field of cor-

3


4

1 An Overview of the Evaluation and Financing of Capital Projects

porate finance and investment banking. However, because engineers are integrally
involved in capital projects, it is important for them to understand the basic mechanisms of finance for these large projects. This includes a clear understanding of
return and risk from the viewpoint of both the company’s investors and the financial
markets.
The aim of this chapter is to provide an overview of the evaluation and the funding of projects. The evaluation of a project is comprised of forecasting the project’s
financials and evaluating these financials based on decision criteria. The financials
for a project are discussed in the next section, and after that the evaluation of these
project financials are discussed.

1.2 Project Financials
In order to assess the merits of a project, the engineer or manager must determine the
project’s ability to consume and produce cash for each year of the project’s life. In
other words, they must determine the project’s cash flow. The project financials represent the forecast of the project’s cash flow for each year of the life of the project.
Broadly, the components of the cash flow are the capital expenditure, the revenue
generated, the costs incurred in generating the revenue, the taxes paid and the working capital requirements. A forecast of these values and their timing is needed to
calculate the cash flow for each year of the project’s life and to prepare the project
financials.
There are five basic inputs to the project financials. Each component is discussed
separately as follows:
1. Revenue. The revenue is the money that flows to the project because of the
project’s activities. Consider the following simple example. The project aims
to sell 100,000 items per year at $1.50 per item. The total revenue is $150,000
per year. The projections of revenue may be based on marketing data and forecasts or on contractual agreements.
2. Costs. These are the operating and overhead costs of the project. Operating costs
are those costs that are incurred in the direct manufacture of the items. They
include the costs of purchasing the raw materials, the energy, and the labour required for manufacturing the company’s products. These costs vary with the
amount of production; as a result, they are sometimes called variable costs.
Overhead costs are those that are not operating costs, such as those arising from
administration and from selling and marketing. Overhead costs generally do not
vary with the amount of production. If this is the case, they are also referred to
as fixed costs.
3. Taxes and royalties. The taxes are the charges made by the government, such as
income tax and capital gains tax. Royalties may be charged by the government
for the use of a natural resource, such as in mining or oil production.
4. Capital expenditure. The sum of money required to develop and install a manufacturing facility is the capital expenditure. The capital expenditure is also referred to as the fixed capital in order to distinguish it from working capital.


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