ch. 4 project and private benefit-cost analysis

Private Benefit-Cost AnalysisDeriving ‘Project’ and ‘Private’ cash flows: • Project cash flow refers to cash flow for the overall project • At market prices • Irrespective of who gains o

© Harry Campbell & Richard Brown

School of Economics The University of Queensland

BENEFIT-COST ANALYSIS

Financial and Economic

Appraisal using Spreadsheets

Ch 4: Project and Private Benefit-Cost Analysis

Private Benefit-Cost Analysis

Deriving ‘Project’ and ‘Private’ cash flows:

• Project cash flow refers to cash flow for the overall project

• At market prices

• Irrespective of who gains or loses

Private Cash Flow

• at market prices

Private cash flow refers to cash flow to the individual investor

engaged in project

• after allowing for loan service costs

• after payment of profits taxes

Deriving Private Cash Flow

To derive private cash flow, we begin by calculating overall project cash flow

• Debt/financing inflows and outflows to creditors

• Taxes paid to government

We then subtract from the project cash flow:

Cash Flow on Equity

• The private cash flow is the cash flow on the investor’s own funds or ‘equity’

• Project cash flow minus debt cash flow = cash flow on equity (before tax).

• Cash flow on equity is the residual: what is left over after servicing debt

Deriving Project Cash Flow

To derive project cash flow we need to be mindful of some important concepts and conventions:

• Inflation: usual to use constant prices with a real

discount rate (otherwise, nominal prices with nominal interest rate) See table 4.1

• Incremental rather than total cash flow: ‘with project’

less ‘without project’ cash flow See table 4.2.

Deriving Project Cash Flow

• Interest on debt excluded from cost to avoid double

counting

• Depreciation excluded from cost to avoid double counting (See table 4.3)

• Changes in working capital appear under investment costs

at the beginning and end of the project (See table 4.4)

Debt Financing Cash Flow

To derive debt financing flow, for each period, from theborrower’s perspective, begin with project cash flow, then:

• Add all loan receipts in each period

• Subtract all interest payments in each period

• Subtract all principal repayments in each period

Private Cash Flow (Equity)

To derive private cash flow, for each period, before tax:

• Add debt financing flow to project cash flow

(See table 4.5)

Project = Debt + Equity

Cash flow from the perspective of lenders and investors adds

up to Project Cash Flow (See table 4.6)

Deriving IRR on Equity

We can calculate IRR on each ‘component’ of cash flow: project, debt and equity

• First, calculate IRR on Project Cash Flow:

when NPV = 0-5000 (1.0) + 1000(AF10) = 0

AF10 = 5000/1000

= 5IRR = 15%

Deriving IRR on Equity

• Second, calculate IRR on Debt Financing Cash Flow:

when NPV = 03512(1.0) - 500(AF10) = 0

AF10 = 3512/500

= 7.024IRR = 7%

Deriving IRR on Equity

• Third, calculate IRR on Equity Cash Flow:

when NPV = 0

-1488(1.0) + 500(AF10) = 0

AF10 = 1488/500

= 2.976IRR = 31%

Gearing and Debt: Equity Ratio

• IRR on Equity + IRR on Debt = Project IRR

• Project IRR minus IRR on Debt = IRR on Equity

– By changing the ratio of debt to equity, you can change the IRR on equity, given the Project IRR and IRR on debt

An Example of Gearing

• Assume debt:equity is $60:$40

• Assume Project IRR = 10%,

and, cost of debt = 5%

– What is the IRR on equity?

HINT: IRR on Debt + IRR on Equity = Project IRR

An Example of Gearing

IRR on project = 0.6(IRR on debt)

+ 0.4(IRR on equity)10% = 0.6(5%) + 0.4(x%)

0.4(x%) = 10% - 3%

IRR on equity = x% = 7/0.4

= 17.5%

Calculating After Tax Cash Flow

• Some items of project cost that do not enter into a project's

cash flow directly affect the net cash flow indirectly through their effect on the project's taxable profits.

• The analyst needs to prepare a separate statement to calculate

the project's taxable profits.

• The two items that are not part of the project’s cash flow that

enter into the calculation taxable profits are:

– depreciation– interest on debt

Calculating After Tax Cash Flow

• These should be added to the operating costs in the project cash flow for the purpose of calculating taxable profits

• Taxes due are then calculated as some % of taxable profits and are deducted from the private cash flow to derive the

after tax private cash flow.

Calculating Taxes

It should be noted that tax laws vary from one country or state to another In most cases, losses can be written off profits earned elsewhere or of future profits

• This implies that there could be negative taxes in some

project years

To Summarise

equals private cash flow

(on equity after tax)

Project cash flow

minus debt finance

minus taxes

Using Private BCA

• Why would the project analyst who is concerned with the wider public or social interest be concerned with the return

on private equity?

– When the private investor is one of the stakeholder’s

whose gains are part of the ‘Referent Group’ net benefits

– Because the policy maker needs to know what is ‘in it’ for the investor: need incentives or tax concessions? etc

Distribution of Net Benefits

• The project net benefits (at market prices) can be disaggregated among three stakeholder groups:

– equity holders (private or public sector) – lenders

– recipients of taxes (government)

50%

20%

Lenders (Debt ) Invest ors (Equit y) Government (Taxes)

Shares of Project’s Net Benefits

(hypothetical)

Distribution of Net Benefits

• At a later stage we will be looking at the distribution of all project net benefits among stakeholders, including those not included in the project’s net benefits at market prices

• At this stage it is still useful to distinguish between

Referent Group and Non-Referent Group Net Benefits

Distribution of Project Benefits

B (non-referent group net benefits)

A (referent

NFG Case Study: Project & Private