CaPex(Feasibility Study)

In the event that the company wishes to make investments, it is important to measure returns on these investments. And given the importance of the subject, it is necessary to consider the idea of the investment to be undertaken and measure its returns and the comparison of investment decisions.

*Characteristics of the investment decision-making process:

1. It is a long-term decision: In case the company needs to make a specific investment (such as the set-up of another business, new branch, or factory) this decision takes over one year, and therefore the time factor must be taken into consideration while preparing variables and factors which can have an effect on this investment.

2. Taking into consideration the time value of money: if these investments are made, the return on them will be at intervals, so the project cost will therefore be greater than those returns if we do not take into consideration the time value of the money when forecasting the returns.

3. Risks and uncertainties, since the investment decision needs periods of more than one year, the degree of certainty and the risks associated with the returns on the investment are therefore limited.

4. Price fluctuations are among the problems affecting investment decision-making, because they relate to important factors such as the costs of raw materials or products that expected to make the investment to produce them.

5. Fixed and sunken investment costs: the investment cost must be in line with this investment's productive capacity (you can create a production line to manufacture one million units, while the demand does not accept more than 100 thousand).

6. The impact of the financing structure on the decision to invest: We can determine the required rate of return by knowing the type of financing.

* There are several classifications of capital budgets, including:

1. Classification of capital projects by their effect on the capability of the facility and include the following types:

-- New projects: that is mean these projects are independent of the organization and often represent an investment in an activity that differs from that of the parent company (which is one of the most challenging forms of investment due to the lack of previous experience within the company and thus start from scratch).

--Expansion projects: They are used to increase the parent company's production capacity (and this form of investment is the most common and widespread among companies because of its ease and the presence of previous experience).

--Capital replacement projects: New, modern assets replace the old assets.

--Technological development projects: conversion of the manual system into a technology-based system, or replacement of old technology with modern technology.

2. Classification of projects according to their economic relation, which includes:

-- Complementary projects to other existing projects (for example, a car factory has been set up and then a battery production facility is required).

-- Projects required for other projects (Ex: there is factory for the development of electric cars and therefore stations for the supply of electricity to these cars must be established).

-- Projects compete with other projects of the same organization and therefore it is important to choose between them and to agree on what is best and which ones are made.

-- Conflicting and blocking projects for other projects: if you do a specific project, you will not be able to do the other project (for example, if the state creates a water dam, so it will not be able to cultivate the land around the dam).

* In order to carry out any capital project, a "feasibility study" must be undertaken to demonstrate the feasibility of establishing the proposed project before it is implemented in a practical manner through studies which clarify:

1. To what degree there is enough demand to pull out the output of the project.

2. The degree to which raw materials, manpower and essential services are available to them.

3. The extent of funding sources being available, and in a timely and sufficient manner.

4. More specifically, whether or not the project can achieve the appropriate return for its nature and degree of its risk?

*Now, how do you do the "feasibility study"?

-Through certain phases:

1- The identification phase: in which the focus is on the basic idea of the project and is typically decided on the basis of the project owner's experience-related activities (for example, Engineer establish a construction company).

2 – Preparation phase: where marketing, technological, financial, economic and social studies are performed, and where a decision is taken to make the project or not.

3- The evaluation stage: in which the project's financial benefits are evaluated (and most projects are evaluated in this stage), as follows:

-Economic investment evaluation: by increasing growth rates for the company and opening up new markets.

-Social evaluation by reducing unemployment in a given society.

-Environmental evaluation: by studying the impact of this project on the environment (some industries harmful to the environment, such as cement and ceramics, are not manufactured in developed countries due to the existence of strict legislation which prevents this).

4- Implementation phase: Project execution, based on previous studies.

5- Assessment phase: by comparing the actual project outcomes with those previously planned and to what degree the anticipated return is achieved.

* Usually, at the beginning of any investment project, an approximate initial feasibility study is undertaken by the company prior to the start of a detailed feasibility study due to the high costs of these detailed studies and, therefore, it must first be certain that the project idea is feasible or not.

* Once the project idea has been initially confirmed and its success anticipated a detailed feasibility study for the project is carried out through:

First: performing a project marketing analysis: it is considered to be the most important stage in the feasibility study because of its connection with the demand for the good or service produced in terms of the quantity produced and its prices and study of potential customers in terms of (the nature of their consumption, their beliefs and customs, public taste, their interest) also, competitors are studied in this Market and the degree of competitors ' influence over it, and the capacity of the company to compete as the level of technology is studied in the invested community in it (advanced countries work with low labor intensity projects in view of technological progress unlike developing countries, where labor intensity levels are high for most projects).

Second: the engineering technical and engineering feasibility analysis in terms of (the most suitable production methods, the level of technology, the type of machinery and equipment, the design of the plant, the location of the plant, the determination of raw materials, manpower, the timetable of implementation of the project, facilities, and spare parts).

Third: the project's financial feasibility study: where the project costs, funding sources and projected profits are evaluated, as it is the financial translation of what has been accomplished in marketing feasibility in terms of (determining the amount of revenue, anticipated demand and expected sales) and technical feasibility in terms of (determining expenditure and cost of productivity) and It is presented in the form of estimated statements, including:

1.Investment costs: all that has been spent on the project since thinking about it, including all the project's fixed assets, facilities and set-up expenses.

2. Working capital: It is including the costs of continuing the project out of materials, salaries and other monthly expenses that differ from project to project.

3- Capital structure: where the sources of project funding (self-financing from project owners, or bank loans or mixed financing between the two types) are determined.

4- An estimation of the project's revenues and expenses: Also, by studying the financial feasibility we will know if the project will be successful in terms of profitability or not, since this analysis addresses important questions for any investor, namely:

- The internal rate of return for the project.

- Net present value of the project.

- Capital recovery period of the project (the lower this period the higher the project quality will be indicated).

-The rate of return on investment.

- Break-even analysis.

- Sensitivity analysis for the project.

*The stages of the project's financial feasibility study:

1-The stage of identifying potential capital projects (possibly one or more project).

2. Stage of Estimating cash inflows and outflows and the project costs of returns.

* When preparing a financial capital budget, a forecast “income statement” is made for the project in which the estimated benefit for the project is determined on the basis of previous studies, but the information to evaluate the expected profit for the project is not sufficient to take a final decision on the project's execution or is not, due to the following:

1. According to the accounting definition, the results differ from one analyst to another (there are many treatments for some items like the type of depreciation, and some items are capitalized or not).

2. The accounting data is not taken into consideration the time element (presume that the income is $100,000 in the first three years, there is no doubt that the profit is not equal to the same amount for the second and third year depending on the time factor).

3. It has non-cash expenses such as depreciation.

* Consequently, the projected income statement for the project is not sufficient to ensure the success of the project or not (this statement is made for advice only and is not entirely based on it).

* Thus, a "cash flow statement" must be made and the actual evaluation of the project is made through this statement, due to its use of the cash principle, not the estimated accounting principles, which consists of:

1. Outgoing cash flows such as:

-Investment costs.

-Working capital.

-Operating costs.

-Tax payments.

2- Cash inflows, such as:

-Operating income and returns

-Recovering working capital

-The scrap value of the assets at the end of the project (this item may be from the outflow, not the inflows cash, as in some projects that require the removal the assets at the end of the project).

The time value of money: is the amount of change in the value of money over time due to the difference in the purchasing power of a certain amount at the present time from the future, due to factors such as the interest rate and the amount of inflation that works to raise or lower prices from time to time.

- Given the difference in the time dimension of payments and cash receipts in investment projects, it must be equal between them by doing what is called "the present value of money" by using what is called "discount rate"

- The future value of money = present value of money * discount rate.

- The present value of money = future value ÷ discount rate.

-Discount rate for one year = (1 + interest rate)

- Discount rate for two years = (1 + interest rate) 2 ……and so on.

*Example: assume you invest an amount of $ 1,000 and suppose that the prevailing interest rate is 10%, calculate the future value of the investment after the first and second years.

The answer:

- Future value for the first year = $ 1,000 * (1 + 10%) = $ 1,100

-Future value for the second year = $1000 *(1 + 10%) 2 = $ 1,210

*For example, we assume that a particular project will be invested in an amount of one million dollars, and after five years an amount of one and a half million will be collected from it, this is undoubtedly not good because, according to the present value of one and a half million, it will be worth 930,000 dollars (1,500,000 (1 + 10 %)5).

*There are 3 ways to evaluate investment projects:

First: the recovery period method:

- This approach depends on the number of years during which the value of the investment is recovered and the shorter the period, the more acceptable the investment is, this method has two cases as follow:

1. If the cash inflows are equal in each year: the recovery period is calculated by dividing the total value of the investment in the project (if there is a scrapping value of the invested asset in it, the value of the invested cash must be subtracted) on the net annual cash inflows generated by the investment (if the depreciation value of the invested asset is present, the income value must be add with the depreciation expense).

* Example: Assume a company decides to replace the old machine with a new one and the existing value of the old is $5,000 and the new machine's value is $80,000, considering that the new machine's annual depreciation value is $10,000 and is expected to generate profit of $20,000.

The answer:

First: Calculating the cost of investing in the machine = the cost of the new machine - the scrapping value

= $ 80,000 - $ 5,000 = $ 75,000.

Secondly: calculating the net cash inflows from the machine = net income + depreciation

= $ 20,000 + $ 10,000 = $ 30,000.

Third: Calculating the recovery period for the value of the invested machine =

 $ 75,000 ÷ $ 30,000 = 2.5 years.

2. In case cash inflows are not the same from one year to another: the recovery period is determined by adding cash flows from one year to the next to be equivalent to the original cost of the project.

*Example: Assume that the investment value is $90,000, the net inflows in the first year are $40,000, in the second year $20,000, in the third year $10,000, in the fourth $20,000 and in the fifth $25,000 In this case, the period of redemption is calculated by collecting the flows from one year to the next until they are equal to the original cost of the project, and in this example the recovery period is 4 years.

**The recovery period method is characterized by its ease and its focus on the speed at which the capital invested is recovered, and is therefore common in companies.

** This approach has a limitation in not taking into consideration the time value of money (this aspect is certainly significant, since the value of the money decreases from one year to the next) and also it will be difficult to distinguish in this way, if certain projects have similarity in recovery period.

-To avoid the first limitations of the previous method, it has been modified to the "discounted payback period" method, which relies on calculating the present value of future project flows, and so we can differentiate between projects if they have an equal payback period between them.

*For example, suppose that the recovery period for Project " A " equals Project "B" " 3 years", and therefore we need to back to the cash flows of the two projects in the first year and calculate their present value (assume that Project "A" had a present value of $ 30,000 and for Project "B" It was $ 25,000)as well as cash flows for the two projects in the second year and calculating their present value (suppose that project "A" had a present value of $ 47,000 and project "B" was $ 49,000) and also in the third year (project "A" was $ 30,000 and project "B" was $ 30,000)

Then we sum the present values after calculating them for the two projects, so that it becomes clear that Project "A" is better according to the discounted payback period method, although the payback period is equal to them (3 years).

*To avoid a limitation that this method does not take into consideration cash flows after the recovery period, it has been modified to the "net present value method" and this method is used to differentiate between investments if they are equal or differ in value and time.

*The discount rate used in this method is the required rate of return from this investment.

* The net present value method is the difference between the project's investment cost and the present value of the estimated net cash flow (the net cash flow is the difference between the cash flow in and out).

- The project is accepted in the event that the net cash flow is higher than the investment cost of the project (in case the result is zero this means that the rate of return for this investment is equal to the required rate of return and therefore the project can be accepted).

* Example: The Company is studying a project that achieves an annual net cash flow of $15,000 for a period of 5 years, and the investment value of the project was $50,000, given that the required rate of return is 12%. Does the company accept this project or not?

The answer:

- It can be done in Excel by the following function:

 = NPV (0.12,15000,15000,15000,15000,15000) -50000

 Or we use the table of current values for payments "Annuties" and we search under the percentage 12% and the number of periods 5 to find that the coefficient of the present value of the payments according to the previous data is 3.6048

Net present value = (net annual payment * coefficient of present value of payments) - the investment value of the project

Net present value = (15,000 * 3.6048) –50,000 = 54,072–50,000 = 4072 and thus the project is accepted

**Internal rate of return method (economic) IRR:

-In the previous method, the “net present value method” used in the differentiation between different investments, which is the difference between the investment cost and the present value of the net inflows and outflows of the project (and to reach the present value of the cash flows, the net inflows are multiplied by the discount rate used (which is the rate of return Required from this investment).

 - Often when the company wants to invest, it creates a "required rate of return" to determine the minimum return on the capital invested in it, which the company accepts in order to make this investment and is compared with the "internal rate of return IRR" and whenever the internal rate of return is greater than required for a particular project The more profitable.

- To reach the internal rate of return, it is calculated using the same formula of "net present value" by making the net present value zero, and giving a symbol , let's say "x" for the internal rate of return and we make several attempts until we actually reach the value of zero "You can start trying at 10%".

- When comparing between specific projects and we assume that the investment costs are equal to them, there is no doubt that the project with the highest internal return is the best and is implemented first

-The common uses of this method are to compare the profit of creating a new business with the profit resulting from expanding an old business (for example opening a new factory or expanding into an old one)The company can compare internal rates of return with rates of return in the stock market for evaluation.