Development Finance Appraisal Models November 2016 kpmg.co.za Financial and Economic Appraisal of Investment Projects South Africa is a country facing many difficulties, unemployment being one of the key issues. Statistics show that 1 in 4 people in South Africa are currently unemployed. The role of development finance institutions in South Africa will play a key role in improving unemployment and ultimately achieving the government’s 2020 target of creating five million new jobs. With the above in mind, we present to you our research and conclusions on the financial and economic appraisal tools used by development finance institutions to evaluate the investment decision. Friedel Rutkowski Andre Coetzee Trainee Accountant at KPMG - Trainee Accountant at KPMG - Financial Services Audit Financial Services Audit [email protected] [email protected] (+27) 72 767 8910 (+27) 82 576 2909 Background 1 Development finance can be defined as the provision of finance to projects or sectors of the economy that are not sufficiently serviced by the traditional financial system (Gumede, et al., 2011). With this in mind, it is important to make a distinction between development finance and public finance. Public finance may invest funds in non-revenue generating projects for the public good, where development finance focuses on projects that are financially sustainable and will have acceptable financial returns. Moreover, the projects in which development finance institutions (DFI’s) invest, should seek to address financial market failures to ensure the development of the economy. According to a paper by the Development Bank of Southern Africa, DFI’s play a crucial role in addressing financial market failures such as: • The correct appraisal of economic and social impacts of investing in projects that require financing; • Assisting entrepreneurs who may not qualify for funding through traditional channels, such as banks, with the provision of long-term financing as well as business support; • Identifying sectors that are crucial for stimulating economic growth and providing them with technical assistance; • Facilitating the financing of projects, thereby attracting further investment; and • Providing liquidity during economic downturns and cyclical slumps by offering financing to projects in order to assist in mitigating the negative economic effects of the above. DFI’s use the same appraisal models that would be used in any normal business environment, facing an investment decision. The appraisal models use a systematic approach, to ensure consistent application of financial and economic principals. Therefore the aim of this paper is to briefly outline the financial and economic appraisal models used internationally to evaluate the investment decision of projects that are funded by DFI’s and how it can be implemented in the South African development finance sector. Development Finance Appraisal Models 3 Key considerations 2 Before an appraisal methodology is The effects of capital rationing values produced by the alternative adopted, it is crucial to consider the models, the appraisal can be This becomes applicable when a following concepts that may impact considered to be reasonable. DFI does not have sufficient funds how various DFI’s invest in projects: to invest in all the projects it has Alternatively, if it falls outside the identified as viable and therefore has range of the values produced by the to ration its capital between projects. main model, the assumptions and Discount rate The effects of capital rationing may inputs of the main model should An appropriate discount rate to affect a DFI for a single financial be reassessed for reasonability. be used in the models should be period or over multiple periods. The The reason for assessing the calculated. However, this paper does implementation and duration of reasonability of an appraisal not deal with the calculation of this capital rationing may affect the level methodology is to avoid instances rate and, the discount rate referred to of funding provided to projects (Skae, where positive factors lead to the in this paper is stated as “a suitable 2012). overestimation of value and vice discount rate”. versa. Divisible versus indivisible projects Mutually exclusive versus A matter often forgotten in the Divisible projects are those where it independent projects appraisal process is the consideration is possible to fund only a portion of of qualitative factors impacting the Mutually exclusive projects are the project allowing projects to be quantitative factors. That said the projects where only one out of increased or decreased in size (Skae, following models are explored in several alternatives can be chosen 2012). Conversely, indivisible projects more detail: (Skae, 2012) whereas independent need to be funded in full before the projects are those where the project is possible. Financial acceptance of one project has no Discounted payback period, In addition to the above, when impact on the ability to invest in discounted cash flow, internal rate of developing an appraisal methodology, another project. return and modified internal rate of it is vital to test the reasonability return and multiples. of the value arrived at by a specific model. This may be done by using Economic two additional models in conjunction Cost benefit and option appraisal. with the main model. If the value of the main model falls between the Financial appraisal models 3 Discounted payback period Discounted cash flow The discount payback period is one of the most basic In its simplest form, the discounted cash flow (DCF) methods of appraising an investment as it gives the valuation model requires that future cash flows be investor the “gut – feel” (Skae, 2012) for risk associated estimated and then discounted back at a suitable with the project. The longer the project payback period, discount rate, in order to determine the net present value the greater the risk involved. This method makes of a project. The net present value (NPV) calculated by provision for the time value of money in the appraisal the model is then used to evaluate the attractiveness methodology by discounting the cash flows of the project and potential of the project. If the NPV of the project is at a suitable rate to arrive at a present value. Moreover, greater than the financing required, then the project is this method is mainly used at the beginning of the accepted, if not it is rejected. investment decision by using it as a screening method. The model is made attractive in that it provides an actual The application of this model to development finance monetary figure that is easily comparable to the initial is especially important since the length of a payback investment amount or the NPV of another project. periods will affect how rapidly new projects can be Further, adding to the attractiveness of this model is invested in, the shorter the payback period the faster new that it provides insights into the key drivers of value for projects can be financed. a specific project such as expected revenue, the cost of financing equity and debt, the major expenses, capital outlays and working capital requirements. This model therefore depicts a thorough image of all the factors affecting the success of the project. Nevertheless the DCF is a mechanical valuation tool which makes it subject to the principle that if inaccurate, insufficient data is entered into the model then an inaccurate value will be produced by the model (Investopedia , 2016). Development Finance Appraisal Models 5 Internal rate of return (IRR) and modified internal rate Multiples of return (MIRR) Valuation multiples are an expression of market value The internal rate of return is a model that calculates the relative to a key statistic that is assumed to relate to discount rate where the NPV of the project would be the value of the company (Suozzo, et al., 2011). Further, zero. Therefore if the calculated IRR is greater than the multiples based valuations are one of the fastest ways to weighted average cost of capital (WACC) the project is appraise a project and are very useful when it comes to accepted. There are, however, shortcomings with this comparing projects that are similar. model, primarily in that it assumes cash inflows are It should be noted that appraising a project using a reinvested at the IRR. multiple approach has many drawbacks (discussed To overcome this problem the MIRR model was below) and should rather be used as a proxy to test the developed. MIRR assumes that all cash outflows take reasonability of the outcome of another model such as place at inception of the project (T0) and all cash inflows the DCF model. at the last period of the project (Tn). This then requires The major disadvantages of multiples are: that all outflows be discounted to a present value at the WACC and all inflows be discounted to a future value • The model is simplistic and aggregates large amounts using the WACC. Internal rate of return is then calculated of data into a single metric that may skew the results as usual to give the MIRR. (Skae, 2012). of an appraisal; • The model is static and only provides a value at a point in time; • Mckinsey states that in their experience, multiples can be misleading indicators as they ask whether companies are truly comparable, different multiples may have conflicting conclusions and multiples may be meaningful in different contexts (Goedhart, et al., 1996-2016); and • Lastly, multiples can only be used for appraising projects that already have established cash flows and market prices, as a market price is required to determine the multiple. Economic appraisal models4 Cost benefit analysis (CBA) Option appraisal model Cost benefit analysis is defined as an analytical Option appraisal is a technique for reviewing the options method used for judging economic advantages and available and analysing the positives and negatives of disadvantages of an investment decision by assessing its each option.