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Ó 1998, Andover Technology Partners
Proper Handling of Capital
Recovery in Project Analysis
In any project that involves substantial,
up-front commitments of capital, such as the purchase of a large facility or
plant, project economics are driven to a large extent by how the project
recovers the cost of the initial capital outlay. For that reason, it is crucial
that project financial analysis properly treat the capital costs of the
project.
Andover Technology Partners performs
comprehensive analysis of capital projects, business plans, or other long-term
investments. The following discussion addresses some issues that have arisen in
some of our analyses for capital projects in the electric power industry. This
discussion, while directed primarily at electric power industry capital
projects, addresses some issues common to all capital projects.
In its Technology Assessment Guide (TAG),
the Electric Power Research Institute has developed some guidelines for project
evaluation. These guidelines have been formulated to assist project engineers
and others who may not have formal financial training in analyzing the economic
merits of a project. The TAG offers procedures for calculating revenue
requirements without the need for performing detailed cash-flow analysis of
financing and tax effects. In these procedures the TAG has developed a factor
called the Capital Recovery Factor (CRF) to assist in assessing the revenue requirements
needed to address the up-front capital costs for projects (also called the
capital carrying charge) based on certain financing assumptions considered
typical for the electric power industry. CRF being defined as:
CRF =
(annual capital carrying charge)/(initial capital cost)
So that, if the cost of purchasing or
building a facility is $10 million and the CRF equals 0.12, then the capital
carrying charge is $1.2 million.
As will be discussed later, there are
different ways to determine CRF depending upon the purpose of the project
analysis, and it is important that people performing the analysis understand
the different approaches to evaluating CRF.
But first, a review of the costs that are
captured in the CRF:
A capital expenditure involving the purchase
or construction of a facility will result in the following costs:
Cost of Capital - The initial capital needed to construct a project
comes from money borrowed from a bank or other institution in the form of debt
and money "borrowed" from shareholders in the form of a reduction in
shareholder retained earnings or an issuance of capital stock. Money is also
borrowed from Preferred Shareholders at an interest rate as well. The bank
charges interest on the debt, and shareholders have an anticipated return on
equity for the money they have provided the company. The Weighted Average Cost
of Capital (WACC) is the weighted average of the interest and the ROE
shareholders expect from investments of similar risk. We will we neglect income
tax effects for the moment (see next bullet). If interest on project debt is
7%, preferred shareholders receive 8%, ROE is 15% and 50% of the project costs
are financed with debt, 10% with preferred shares and the balance with equity,
then the WACC is (7% x 50%) + (8% x 10%) + (15% x 40%) = 10.3%. Therefore,
10.3% is the aggregate rate of what the bank and shareholders want their money
paid back at (in addition to principal). IRR of the project must exceed this
value for the Net Present Value to be positive.
Income Tax Shelters - Depending upon the way that the facility is
financed and how the plant cost is depreciated, income tax reductions can
result that offset some of the cost. For example, depreciation is an expense on
the income statement that has the effect of reducing income taxes but is not an
actual cash outflow. Therefore, its effect on cash flow is to reduce the income
tax liability of the business. Also, interest on debt is an expense on the
income statement that, too, reduces the income tax burden, having the net
effect of reducing the cost of financing with debt. On the other hand, the
costs of financing with equity are paid back to shareholders in the form of
earnings and are not expensed on the income statement. Dividends paid to
preferred shareholders are not tax deductible. Therefore, financing with equity
provides no income tax sheltering effect for the business. For the previous
example, if the corporate income tax rate is 40%, the actual cost of capital to
the business is: (15% x 40%) + (8% x 10%) + (7% x 50% x(1-40%)) = 8.90%, rather
than 10.3% - a substantial reduction in cost of capital. It is important to
note that this tax sheltering effect assumes that there is positive income to
shelter.
Property Taxes - The local government usually imposes property
taxes. While the property tax rules vary from locality to locality, in most
cases they are equal to some fraction of the assessed value of the property,
which is often the book value. Depending upon the location, some facility
improvements are exempt from property tax. In fact, we've found that many
communities do not assess property tax on facility improvements involving
purchase of pollution control equipment.
Insurance -
The cost of insurance on the plant assets is normally included in the CRF. It
is typically a very small fraction of the book value of the plant assets.
In order to capture the annual revenue
requirement to cover the net effect of these costs and tax shelters, the TAG
offers tables that capture the net effect of these costs using financing and
taxation assumptions that are considered typical for the electric power
industry. However, depending upon the purpose of the financial analysis - for
near-term budgeting or for evaluation of long-term project alternatives - the
way CRF is determined and used will vary. For this reason, there are two
different types of CRF: 1) Current
Dollar CRF; and, 2) Constant Dollar CRF.
A Current Dollar CRF is designed to determine the capital carrying charge
in current, or "nominal", dollars for a particular project year. It is important to use this form of CRF for capital
budgeting. For each year of a particular project, CRF in constant dollars will be different. Because most costs are recovered
in the early years and because book value (and property taxes, etc.) are higher
in the initial years, the Current Dollar CRF value for a project will tend to
be highest in the first year and will decrease somewhat thereafter. In general,
Current Dollar analysis becomes very inaccurate much beyond 5 years because the
effects of inflation can distort the results of the analysis significantly.
Constant Dollar CRF is designed for evaluating long-term projects typically
over 10 years in duration where the effects of inflation over the life of the
project can be very significant. Constant Dollar CRF is, therefore, inflation
adjusted and results in a value represented in the dollars for a benchmark
year. However, it is important to note that if the estimated costs for any one
particular year of the project are of interest, then Current Dollar analysis is
necessary, and the Current Dollar CRF for that year should be used. When
comparing two or more different approaches to a long-term project that may
involve different levels of initial capital expenditure and different levels of
annual operation and maintenance, failure to use Constant Dollar Analysis can
distort the results to the point where the truly less preferable approach could
appear more preferable.
Because of the effect of inflation, Constant
Dollar CRF will always be lower than Current Dollar CRF.
Examples of when to use which version of CRF are
shown below:
A company plans to purchase a
facility and wants to know what the capital carrying charges will be for each
of the first three years of operation.
This is clearly a
situation requiring Current
Dollar Analysis because the budgets for
specific years less than five years out are being asked for.
A company is assessing two
different project approaches - one approach involving purchase of a more
expensive facility than the other but with lower operating costs. The company
wants to know which approach is preferred over the project lifetime of 20 years.
This is clearly a
situation requiring Constant
Dollar Analysis because there are
different levels of capital spending, different levels of annual expense, and
the project is very long-term in nature, which makes it important to adjust for
the effects of inflation.
As noted above, the purpose of the
analysis will determine the type of analysis that should be performed. Using
the wrong approach will yield misleading results. And, when comparing the
results of two analyses of similar projects, it is important that the purpose
of the analyses and the assumptions used in each be thoroughly understood. It
should not be surprising that two different analyses of the same project that
are performed for different purposes will yield apparently different results.