Project feasibility analysis

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Materials for Lecture • Read Chapter 13 • Read three articles on web site – J. Agribusiness Including Risk in Economic Feasibility Analysis: The Case of Ethanol Production in Texas – IAMA Journal Article on economic feasibility of Bio-ethanol Production for Wheat in South Africa – SJAE Use of Probabilistic Cash Flows • • • • Lecture Lecture Lecture Lecture 20 20 20 20 Ethanol Feasibility.xls Project Feasibility.xls Changing Risk Over Tme.xls Growth Functions.xls Project Feasibility Analysis • Ice Plant article by Richardson and Mapp, Southern Journal of Agricultural Economics (SJAE), 1976 – use risk for feasibility analysis – Demonstrated methodology for risk based feasibility studies – Probability of Economic Success • Probabilistic Cash Flows to meet cash needs – Recent Feasibility Studies on Class Website • Including Risk in Economic Feasibility Analysis • Bio-ethanol Production for Wheat in South Africa Project Feasibility Analysis • Most feasibility studies are done using Excel spreadsheets – This trend by business started in mid-90s • Feasibility studies often ignore risk – many do a “What if …” study for the Best Case and Worst Case scenarios • Some analysts think they considered risk by including a 10 year “average” price • Excel feasibility models are easily converted to be stochastic simulation models – Just make the forecasted variables stochastic using the residuals from the forecast models Project Feasibility Analysis • Risks to consider for a feasibility analysis are: – – – – – Price of raw inputs, as fuel and labor Price of the product or output Production risk Black Swans Competition and market share over the life of investment – Cost of the plant and product development – Cost of production for the finished product • Project feasibility is where we put it all together in an analysis of Time, Money, and Economic Viability Project Feasibility Analysis • Project Feasibility: consider the Time, Money (Cost), and Economic Viability of the finished business • Simulate the Time to complete the plant • Simulate the Cost of developing the plant incorporating risk into the plant’s development costs • Simulate the Economic Viability of the completed plant (business) P(T) Project Management Time P(C) Bid Analysis Cost (money) P( ) Project Feasibility Rate of Return Project Feasibility Analysis • Proposed business with a new product • Tasks and duration/costs Tasks Description Time (mo.) Costs ($1,000) 1 Plant Modification 3-5 300-325 2 Product Development 1-3 200-300 3 Distribution System 2-3 50-100 4 Marketing Program 3-4 100-150 • Finance 100% of project costs @ 9% • Cost of production/unit Uniform(10,15), can be a scenario variable • Fixed Costs/year $200,000 • Inflation Uniform(0.04, 0.05) percent per year • Demand Projections Years Price/Unit Quantity Sold/Year 1-3 U(13.5,14) U(500K, 600K) 4-5 U(13,13.5) U(400K, 500K) 1-3 U(12.5,13) U(300K, 400K) Project Feasibility Analysis • Setting the proposed project up in a Project Management setting yields the following cost and time to complete the project • If these answers are acceptable to management the next questions is – – Will the business be economically viable? Project Feasibility Analysis • The stochastic final cost of building the plant becomes input into the project analysis phase of study Project Feasibility Analysis • 10 Year analysis gives way to lots of reports – Annual rate of return to assets – Things look bad after 6th year Project Feasibility Analysis • 10 Year analysis gives way to lots of reports – Annual net cash income – Things look bad after 6th year Project Feasibility Analysis • Scenario analysis of management control variables to see if the plant could be more profitable. Project Feasibility – Ethanol Plants in Texas • Ethanol production is dependent on – – – – Inputs could be: corn, sorghum, wheat, potatoes, etc Fuel requirements are: natural gas and electricity Sale of co-product of DDGS Sale of ethanol • Local communities want a plant because it hires 35 to 50 people year around, farmers have dependable market for grain, and given a $2.25/gallon construction cost it generate jobs (at least for 6-9 months) Project Feasibility – Ethanol Plants in Texas • Develop a Feasibility Model for an Ethanol plant in Texas • Location: High Plains due to feedlots and local corn/sorghum supplies • Rail transportation facilities available to import corn and ship ethanol • KOVs – – – – Net Present Value Annual cash flows Probability of cash flow deficits Probability investors get their money back or the P(Increase Real Net Worth) Project Feasibility – Ethanol Plants in Texas • Stochastic variables – – – – Corn and sorghum prices DDGS price Ethanol price Electricity and natural gas prices • Develop MVE distribution for these prices based on prices for the past 10 years • Problem with stochastic prices – Must use Texas prices and we have forecasts for National prices Texas Price = a + b National Price + e Simulate a stochastic national price and use in Texas price Project Feasibility – Ethanol Plants in Texas • Develop a Financial Simulation Model : Income Statement, Cash Flow, and Balance Sheet • Simulate 10 years using corn as the feed stock • Assume a learning curve for management to bring the plant up to its full capacity • Validation exercises – – – – 4 Ps Touring test with other economists Presented results to local investors Presented results to politicians Learning Curve or Demand Cycle • A new business may need a few months or years to grow sales to their potential • It may take months or years to learn how to reach potential of prod function • In either case, assume a stochastic growth function and simulate it, if nothing else is available, use a Uniform distribution • Example of a growth function for 8 years Learning Curve or Demand Cycle Life Cycle Costing • A new concept in project feasibility analysis • Explicitly consider externalities – Such as cleanup costs at end of business • Buried gas tanks • Disposal of dirt with oil and gasoline spills • Disposal of old parts and tires/batteries • Renovation of land after a strip mine • Cleanup after oil well is drilled • Oil spills (ship wreck, train wreck w/ haz chem) Changing Uncertainty Over Time • We may want to change the uncertainty for a random variable as time progresses • This is done by adding an Expansion factor (Et)to the stochastic variable • For an Empirical Distribution Ỹ= Ŷ *(1+EMP(.) * Et) where Et is a fraction from 0 to infinity Et = 1 causes risk to equal historical risk Et = 2 doubles historical risk Changing Uncertainty Over Time Changing Uncertainty Over Time • For a Normal Distribution the process is slightly more complicated Ỹt = NORM(Ŷt , σ * Jt * Et) where Jt normalizes the standard deviation for changes in the mean – Jt = (Ŷt / Historical Ŷ) – Et is a fraction from 0 to infinity Et = 1 causes risk to equal historical risk Et = 2 doubles historical risk Changing Uncertainty Over Time Life Cycle Costing • Steps to Life Cycle Costing Analysis – Identify the potential externalities – Determine costs of these externalities – Assign probabilities to the chance of experiencing each potential cost • Assume distributions with GRKS or Bernoulli – Simulate costs given the probabilities – Incorporate costs of cleanup and prevention in the project Life Cycle Costing • Bottom line is that LCC will increase the costs of a project and reduce its feasibility • Affects the downside risk • Does nothing to increase the positive returns • Need to consider the FULL costs of a proposed project to make the correct decision • J. Emblemsvag – Life Cycle-Costing: Using Activity-Based Costing and Monte Carlo Simulation to manage Future Costs and Risks John Wiley & Sons Inc. 2003 [...].. .Project Feasibility Analysis • Scenario analysis of management control variables to see if the plant could be more profitable Project Feasibility – Ethanol Plants in Texas • Ethanol production is dependent on – – – – Inputs could be: corn, sorghum, wheat, potatoes, etc... because it hires 35 to 50 people year around, farmers have dependable market for grain, and given a $2.25/gallon construction cost it generate jobs (at least for 6-9 months) Project Feasibility – Ethanol Plants in Texas • Develop a Feasibility Model for an Ethanol plant in Texas • Location: High Plains due to feedlots and local corn/sorghum supplies • Rail transportation facilities available to import... function and simulate it, if nothing else is available, use a Uniform distribution • Example of a growth function for 8 years Learning Curve or Demand Cycle Life Cycle Costing • A new concept in project feasibility analysis • Explicitly consider externalities – Such as cleanup costs at end of business • Buried gas tanks • Disposal of dirt with oil and gasoline spills • Disposal of old parts and tires/batteries... Costing Analysis – Identify the potential externalities – Determine costs of these externalities – Assign probabilities to the chance of experiencing each potential cost • Assume distributions with GRKS or Bernoulli – Simulate costs given the probabilities – Incorporate costs of cleanup and prevention in the project Life Cycle Costing • Bottom line is that LCC will increase the costs of a project and... available to import corn and ship ethanol • KOVs – – – – Net Present Value Annual cash flows Probability of cash flow deficits Probability investors get their money back or the P(Increase Real Net Worth) Project Feasibility – Ethanol Plants in Texas • Stochastic variables – – – – Corn and sorghum prices DDGS price Ethanol price Electricity and natural gas prices • Develop MVE distribution for these prices... Problem with stochastic prices – Must use Texas prices and we have forecasts for National prices Texas Price = a + b National Price + e Simulate a stochastic national price and use in Texas price Project Feasibility – Ethanol Plants in Texas • Develop a Financial Simulation Model : Income Statement, Cash Flow, and Balance Sheet • Simulate 10 years using corn as the feed stock • Assume a learning curve... cleanup and prevention in the project Life Cycle Costing • Bottom line is that LCC will increase the costs of a project and reduce its feasibility • Affects the downside risk • Does nothing to increase the positive returns • Need to consider the FULL costs of a proposed project to make the correct decision • J Emblemsvag – Life Cycle-Costing: Using Activity-Based Costing and Monte Carlo Simulation to ... economically viable? Project Feasibility Analysis • The stochastic final cost of building the plant becomes input into the project analysis phase of study Project Feasibility Analysis • 10 Year analysis. .. the finished product • Project feasibility is where we put it all together in an analysis of Time, Money, and Economic Viability Project Feasibility Analysis • Project Feasibility: consider the... 6th year Project Feasibility Analysis • 10 Year analysis gives way to lots of reports – Annual net cash income – Things look bad after 6th year Project Feasibility Analysis • Scenario analysis