1. 1 Introduction to Capital Budgeting and Financing of Capital Projects For UNEP Division of Technology, Industry, and Economics Prepared collaboratively by Gloucestershire Business School- University of Gloucester, and Tellus Institute

2. 2 Introduction

3. 3 Course Background [15 min]

4. 4 Development of the training materials Content has been developed by: –Tellus Institute –Gloucestershire Business School, UK –The Illinois EPA –The Philippine Institute of CPAs –The Asian Institute of Management –UNEP CP financing National Project Coordinators in Zimbabwe and Guatemala –UNEP Cleaner Production financing project team

5. 5 UNEP: Financing Cleaner Production— Support  Division of Technology, Industry, and Economics  This course results from the project: “Strategies and Mechanisms For Promoting Cleaner Production Investments In Developing Countries”  Funding provided by the Government of Norway

6. 6 Words of welcome [15 min] Introduction of Instructors

7. 7 Cleaner Production is... “The continuous application of an integrated preventive environmental strategy applied to processes, products, and services to increase overall efficiency and reduce risks to humans and the environment.” — UNEP

8. 8 Cleaner Production is different  Much of current environmental protection focuses on what to do with wastes and emissions after they have been created, otherwise known as “end-of-pipe” disposal & treatment  The goal of Cleaner Production is to avoid generating pollution in the first place

9. 9 Environmental Management hierarchy Disposal Control/Treatment CLEANER PRODUCTION  Pollution Prevention  On-site Recycling/Reuse BEST LEAST Desirable Off-site Recycling/Reuse

10. 10 Cleaner Production  Production processes: conserving raw materials & energy, eliminating toxic raw materials, and reducing the quantity and toxicity of all emissions & wastes  Products: reducing negative impacts along the life cycle of a product, from raw materials extraction to its ultimate disposal  Services: incorporating environmental concerns into designing & delivering services

11. 11 Cleaner Production benefits  Reduces costs (of raw materials, energy, waste, emissions)  Reduces risk (to employees, human health, and environment)  Identifies new opportunities for more efficient operations

12. 12 Welcome by Senior Official [15 min]

13. 13 Participant Introductions [30 min]

14. 14 Who is here today?  What type of organization do you work for? –e.g., industry, government, other –If from industry, which sector and what size  What are your job responsibilities and areas of expertise? –e.g., management, accounting, finance, engineering, production, environmental  What is your investment perspective? –e.g., developer of investment proposals, funder of investment proposals

15. 15 Why are you here?  What work issues or concerns motivated you to come?  What are your learning goals for this course?  What are your expectations of this course?

16. 16 Course Overview [15 min]

17. 17 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

18. 18 Investment projects  Investment projects and company value  Discussion of course participant experiences with investment projects  Summary - typical project types & goals

19. 19 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

20. 20 Capital budgeting— Profitability Assessment  Estimating project profitability with Net Present Value (NPV) –Time value of money & discounting  Alternative profitability indicators –NPV, IRR, Payback

21. 21 Project financing  Project financing sources –Discussion of course participant experiences with project financing –Types of investment and financing decisions –Different types of funding sources  Bank information requirements –How to demonstrate credit-worthiness –Case study and small group exercise on bank information requirements

22. 22 Conclusion  Other issues?  Where to go for more information  Brief review of what we learned today  Course evaluation

23. 23 Time for a break! [15 min]

24. 24 INVESTMENT PROJECTS

25. 25 Investment Projects and Company Value [15 min]

26. 26 Companies & Projects  Think of a company as a collection of projects that fit together  A project could be –A production process or equipment –A product –An information or management system –etc.  Projects should be evaluated on how they help the company as a whole  So - what are the company’s goals?

27. 27 Company goals  The basic goal of any organization: –“Survive and prosper!”  Economic survival depends on: –Generating income (profits, cash flows) –Raising capital from investors & lenders that supports generation of income  The key question:- do investors & lenders view the company’s income as an adequate return on their capital investment ??

28. 28 Investors and lenders (1)  Two main potential sources –Investors ( = owners, shareholders, ‘equity’) –Lenders ( = ‘debt’) –(Sometimes called ‘financial stakeholders’)  Both types will require a reasonable return on their capital — or may withdraw their support

29. 29 Investors and lenders (2)  Withdrawal of support by investors & lenders could mean collapse of company  So, for any potential new project, first ask... “Will this help to keep our investors & lenders happy ??”

30. 30 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

31. 31 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

32. 32 Company value - Acme (2) What is the value of Acme to its investors & lenders if they expect: - Acme will continue in business indefinitely into the future? - Acme will generate sustainable net income of $12,000 per year? - Investors/lenders expect a return of at least 20% on their capital?

33. 33 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%

34. 34 Discussion of Course Participant Experiences with Investment Projects [30 min]

35. 35 Questions for discussion  Think of examples of capital investment projects that have been implemented (or funded) by your organization  What were the specific goals of the projects?  What was the typical investment size?  Would you consider any of those projects to be Cleaner Production (CP) projects?

36. 36 Investment Projects — Summary [15 min]

37. 37 Investment projects (1)  An investment project might focus on: –A production process –Production or other equipment –A product –An information or management system –etc.  Investment projects might focus on existing equipment, processes, or products or focus on brand-new ones

38. 38 Investment projects (2)  Some investment projects require only a moderate investment of time/labour  Others require more significant up- front capital (i.e., investment funds) for the purchase of physical assets such as equipment

39. 39 Investment projects (3)  Timing and frequency of investment projects and amount of investment capital required may vary with: –Industry sector — Company size –Company location —State of the economy –etc.  However, for long-term survival, most companies periodically need capital for investment projects

40. 40 Typical project types & goals (1)  Maintenance –Maintain existing equipment & operations  Improvement –Modify existing equipment, processes, and management & information systems to improve efficiency, reduce costs, increase capacity, improve product quality, etc.  Replacement –Replace outdated, worn-out, or damaged equipment or outdated/inefficient management & information systems

41. 41 Typical project types & goals (2)  Expansion –e.g., obtain and install new process lines, initiate new product lines  Safety –Make worker safety improvements  Environmental –e.g., reduce use of toxic materials, increase recycling, reduce waste generation, install waste treatment  Others...

42. 42 Single project- Multiple benefits  A single investment project often has multiple benefits  Cleaner Production projects are typical - they often have multiple benefits –e.g., a project that is implemented to improve product quality also reduces the use and purchase cost of toxic chemicals, as well as disposal costs  So, do not place your project idea into a single narrow category — think broadly about all the possible benefits

43. 43 Project implementation process  Capital budgeting –Identify company goals & strategies; identify potential projects; evaluate projects; select projects to implement  Project financing –Identify potential sources of capital; raise external capital if needed  Project implementation & assessment –Implement project; monitor progress & control; review & learn for next time!

44. 44 CAPITAL BUDGETING— INTRODUCTION

45. 45 Capital Budgeting - Definition and Main Implementation Steps [15 min]

46. 46 Capital budgeting The process by which an organization:  Decides which investment projects are needed & possible, with a special focus on projects that require significant up- front capital  Decides how to allocate available capital between different projects  Decides if additional capital is needed

47. 47 Capital budgeting practices  Capital budgeting practices vary widely from company to company –Larger companies tend to have more formal practices than smaller companies –Larger companies tend to make more & larger capital investments than smaller companies –Some industry sectors require more capital investment than others  Capital budgeting practices may also vary from country to country

48. 48 Basic capital budgeting steps  Identify potential projects –talk to employees, industry colleagues, trade association, suppliers/vendors, government technical assistance office  Evaluate and compare projects –technical, organizational, regulatory, and financial evaluation  Select project(s) to implement –may choose one or several projects, depending on availability of capital

49. 49 Decision-making factors Project selection Technical Organizational Financial Regulatory

50. 50 Financial analysis steps  Estimate cash flows  Characterize project risk  Select required rate of return on project  Calculate project profitability We will discuss this now We will discuss these after lunch

51. 51 Cost identification & estimation  Initial investment costs –e.g., equipment, installation, training  Annual operating costs, savings,and revenues –Current operations, before the project –After project implementation –e.g., materials, energy, labour  Need to identify, estimate, and allocate all relevant and significant items impacted by the project

52. 52 Case Study & Small Group Exercise on Cost Identification [30 min]

53. 53 Exercise instructions  Break into small groups  Review the company description  Work with your group to answer question 1  Work with your group to answer question 2  Discussion of answers as entire class 10 min 15 min

54. 54 Acme Electroplaters (see also documentation under ‘Exercises’)  A small metal plating firm in a developing country  Products include candlesticks, picture frames, screws, nuts, bolts, & other metal-plated products  75 employees  A Cleaner Production (CP) assessment at Acme identified some potentially profitable investment projects that also had environmental benefits

55. 55 Figure 1: Overall Process Flow Diagram

56. 56 Figure 2: Existing Rinse Step (2-stage static rinse system)

57. 57 Figure 3: Proposed New Rinse System (3-tank counter-current rinse system)

58. 58 Discussion of Small Group Exercise Findings [15 min]

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

60. 60 Cost estimation  Problematic accounting practices may make it difficult to collect cost data –Hidden in accounting records –Misallocated from overhead accounts –Classified as fixed when really variable –Not in accounting records at all –(Others?)  UNEP’s CP3 course will cover cost estimation in more detail

61. 61 Time for lunch! [60 min]

62. 62 CAPITAL BUDGETING — PROFITABILITY ASSESSMENT

63. 63 Estimating Project Profitability with Net Present Value (NPV) [30 min]

64. 64 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?

65. Converting cash flows to their present value  You can convert future year cash flows to their present value using a “discount rate” that incorporates: –Desired return on investment –Inflation  The discount rate calculation is simple — mathematically, it is the reverse of an interest rate calculation 65

66. 66 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

67. 67 Discounting  Expressing future amounts in terms of their present value is called discounting  ‘Exchange rates’ can be calculated for any combination of: –Required rate of return –Period of time into the future  These ‘exchange rates’ are called: –Discount factors, or –Present value factors

68. 68 Question: If Acme wants to borrow $18,000 in order to finance a new project, what factors are likely to influence how much interest it will have to be prepared to pay?

69. 69 Return, risk, and inflation  Basic Rate –pure compensation for deferring consumption –even if there is no risk or inflation  Risk –of the particular investment –the ‘risk premium’’  Inflation –expected fall in the value of money over time

70. 70 What Rate of Return?  What amount should be set as the required rate of return for a project?  This rate must cover the costs of raising the finance from investors/ lenders (i.e. the 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

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

72. 72 Summary (1)  Money has more value now than it does in the future  How much more value depends on: -amount of discount rate -how many years into future  Required rate of return* reflects time value of money and risk  This is true with or without inflation Note: * also called “discount rate”

73. 73 Summary (2)  Discount rate level reflects cost to company of raising capital  Present value (PV) factors can be calculated from discount rates  PV factors are conversion rates to convert future money into its present value (like exchange rates with foreign currencies)

74. 74 NPV and Cleaner Production Projects Any special issues in doing NPV analyses on CP projects? –Estimating future cash flows –Predicting project life –Identifying appropriate discount rate

75. 75 Influences on Project Appraisal [20 min]

76. 76 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 ??

77. 77 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?

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

79. 79 Project life (1)  The project could have to finish early for any of several possible reasons, e.g.: –The equipment wears out through use –Company’s lease on the property expires –New environmental regulation makes the equipment obsolete –Market demand for electro-plating falls –Etc.

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

81. 81 Payback (simple) Conclusion: The company is at risk of losing money on the project if it comes to an end before 22.5 months. (The shorter the payback period, the lower the risk). Note: this method is called simple payback, since it is calculated without first discounting the future cash flows

82. 82 Payback (discounted)  Payback period can alternatively be calculated based on discounted future cashflows  This is more correct, since it recognises the time value of money (at least partly)  If based on discounted cash flows (which is more correct), the payback period would be 27.5 months

83. 83 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.

84. 84 Alternative project appraisal methods — Summary  Net Present Value (NPV)  Internal Rate of Return (IRR)  Payback (simple or discounted)

85. 85 Net Present Value (NPV) = net amount of discounted future cashflows less initial investment reflects amount (in $) added by project to total company value recognizes time value of money  complex to calculate  needs prior estimate of cost of raising capital

86. 86 Internal Rate of Return (IRR) = discount rate at which NPV = 0 basis to compare with costs of different sources of finance recognises time value of money  complex to calculate  does not directly reflect impact on value

87. 87 Payback = time needed for net cash inflows to equal the initial investment simple to calculate and understand reflects risk of project life being shorter than expected  ignores all cash flows after payback point  simple version completely ignores time value of money

88. 88 PROJECT FINANCING

89. 89 Project Financing Sources [30 min]

90. 90 What are the different sources of project financing available?

91. 91 Questions  What sources has your company raised capital from in order to finance projects?  Why were these sources used?  In what form was the finance provided (loans, grants, other… )?  Were any possible sources considered but not used?

92. 92 Potential sources of project financing A. Internal funds B. Private sector: 1. commercial banks 2. development corporations 3. equipment vendors/ subsidiary finance companies 4. owners’ capital (“equity”) C. Governmental sector: grants/ earmarked capital from governmental programmes

93. 93 Investing and financing decisions  Distinguish between: –The investing decision –The financing decision  Investing decision: is the project acceptable? (i.e. does it have a positive NPV, at the relevant discount rate?)  Financing decision: what is the best (usually, the cheapest) way to fund it?

94. 94 Internal funds and the financing decision  Internal funds are generated from past cash flows  Internal funds (if available) are usually the best source, but…  They have an opportunity cost - what else could be done with these funds? (e.g. finance other projects, invest in financial securities, etc.)  “Soft” funds specifically for CP projects may be preferable to internal funds

95. 95 The variety of securities for Financing Companies  International firms use different kinds of securities: –Stocks and shares –Long-term debt (secured or unsecured by mortgages on plant and equipment); –Short-term debt –Lease or rent on long term basis  Why are these securities not all relevant to small and medium-sized companies?

96. 96 Commercial banks  Banks are businesses that offer a variety of options to other organisations to finance their investments. The most frequent options are: 1. Loans to finance the purchase of fixed assets (land and/or equipment) 2. Lines of credit (debt provided by the bank without conditions on how the borrower must use those funds)

97. 97 Development corporations  Development corporations/banks are established to contribute to the economic development of a particular community or region  CP projects which comply with their criteria can apply for loans  Question: what development corporations/banks are you aware of?

98. 98 Equipment vendors and Subsidiary finance companies  Leasing has become a major source of financing that is provided by some equipment vendors and subsidiary finance companies (‘lease-providers’).  With ‘financial leases’ (or ‘capital leases’): –Title to the equipment is held by the firm which operates it (the ‘lease-holder’) –The lease-provider retains a first security interest in the equipment –The lease-holder faces the risks and receives the rewards of ownership

99. 99 Owners’ capital (equity)  Represented by ordinary shares in a company (or ‘stock’)  Can be raised from either/both –Present owners (shareholders) –New shareholders  But: –Present owners may not have spare capital available –Bringing in new shareholders may dilute the shareholdings of present shareholders  Issues of new shares in a company can be by: –A public issue –A private placement of stock

100. 100 Share issues  Public issues of stock: –For larger companies –Requires a stock market listing –Substantial administrative costs –Not usually suitable for single projects  Private placements of stock: –Stock is bought by private persons but not on a public market –Still significant administrative costs

101. 101 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

102. 102 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)

103. 103 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)

104. 104 Time for a break! [20 min]

105. 105 Bank Information Requirements [55 min]

106. 106 What information is a bank likely to want?

107. 107 Question  If your company were to apply to a bank for a loan to finance a CP project: –What information is the bank likely to require from you? –Is there any further information that you could provide to support your application?

108. 108 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)

109. 109 Acme’s Balance Sheet (in $’000) Capital & liabilities Share capital60 Retained42 profits Accounts23 payable____ 125 Assets Equipment73 Inventory21 Accounts29 receivable Cash 2 ___ 125

110. 110 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

111. 111 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

112. 112 Presenting a fund application Acme wants to implement its 3-stage rinse CP project. The project requires an initial investment of $18,000; but Acme has only $2,000 in cash, which it needs for day-to- day operations. It therefore needs to seek external finance. Three potential sources have been identified: – a commercial bank – a development bank – environmental programme to stimulate CP

113. 113 Presenting a fund application: Commercial bank An 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

114. 114 Presenting a fund application: Development bank  An application to a development bank should focus on: –The company is small and has difficulties in obtaining funds through conventional channels –Explain that the company is also applying for a matching grant, e.g.from a government programme –Potential growth of the company due to increased cash flows from the investment –The firm’s fiscal stability and ability to repay the loan

115. 115 Presenting a fund application: G overnment 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

116. 116 Summary  Gather information on the past lending practices of each potential funding source (to gain insight into their motivations)  Consider the motivation of the funding source when preparing an application  Anticipate the information needs for the sources of capital

117. 117 CONCLUSION

118. 118 Other Issues? [10 min]

119. 119 Where to go for more information [15 min]

120. 120 Review of the day [15 min]

121. 121 Investment projects  Investment projects and company value  Discussion of course participant experiences with investment projects  Summary - typical project types & goals

122. 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. 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. 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. 125 Conclusion  Other issues?  Where to go for more information  Brief review of what we learned today  Course evaluation

126. 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. 127 Course evaluation [15 min]