Capital budgeting principles for port investments

Abstract

To stay ahead in a competitive landscape, the Port of Antwerp needs to ensure it makes the right decisions for its future. With investments that require large commitments and tie up valuable resources for extensive periods, there is a high need for accurate investment valuation. The aim of this report is to provide the best practices and give recommendations on how the Port of Antwerp can improve its capital budgeting process. This is achieved through an extensive review of current academic literature and continuous dialogue with the project’s stakeholders to uncover the current internal points of discussion. Advice is given on how to implement these best practices, and how to address the specific uncertainties that the port faces. Besides providing a general description of the most important considerations in capital budgeting, particular attention has been given to areas such as risk analysis where significant room for improvement has been found. Cash Flows: To build a valuation model, one must start by forecasting the cash flows that the project will generate. The results of the analysis will only be as accurate as the quality of the inputs allow for, stressing the importance of the cash flow forecasting process. The relevant cash flows to consider are all incremental cash flows that occur because the project is undertaken. Forecasting these involves estimating the size of the initial investment and subsequent cash flow generation, as well as determining any other effects the project has on cash flows elsewhere in the company. Resources that could potentially generate value in other parts of the company if they were not used by the project should be captured through the inclusion of opportunity costs. Furthermore, external effects of the project should also be included, such as increased tugboat business from a new terminal. Assets that have a remaining lifetime at the end of a project should be assigned an “exit value”. This should be captured by their economic value, representing future cash flows or their market value. Additionally, costs that are unavoidable to the company, regardless of whether it undertakes a project, should be considered as sunk costs and be excluded from the project valuation. In cases where not all decisions need to be made at the stage of the initial investment, real options can significantly increase the value of a project. The ability to postpone, reinvest, abandon, expand or reduce a project at a later stage in time allows the company to take new critical information into consideration before it commits further resources. This can both increase the upside potential and decrease the downside potential of a project compared to committing these resources before new critical information is known. Valuation methods: Except for the Average Accounting Return method, all the models presented in this report do provide some unique information that can be useful in certain situations. However, not all of these models are suitable as the sole method of valuation to determine whether and to what extent a project will be profitable. The Net Present Value (NPV) method is the only method that sufficiently accounts for the scale, timing and risk (time value of money) of a project. Combined with the fact that it takes all relevant cash flows over the entire lifetime of the project into account, the NPV method is clearly the preferred method that should be at the core of any valuation. The ease of comparing projects, non-arbitrary results as well as the money-value output makes the NPV a flexible tool that should never be disregarded. Furthermore, the use of a project-specific discount rate allows for the incorporation of a project’s risk, which also makes results of different projects more comparable. With the NPV as core, the valuation can be extended to include tools such as the Profitability Index to compare projects in situations where capital rationing needs to be considered. The other valuation methods should mainly be applied as an additional source of information or back-up. This is mainly due to a lack of consideration for the scale, risk and time factors of the value created. In particular, all these three elements represent the shortfall of the commonly used IRR method. The Payback Period and Discounted Payback Period methods also disregard the total value creation by simply focusing on how fast the investment will be recuperated. With this in mind, it is important to know the limitations of these other models if they are applied. Risk analysis: The NPV value represents a point estimate, but cash flows cannot be perfectly forecasted. Therefore, an extensive risk analysis will be important: what is the risk that the project’s NPV will be negative and that hence the project will destroy value? With this basis, sensitivity analyses can be conducted to test how sensitive the results are to changes in the assumptions. This is a highly important step that is crucial when uncertainty exists around the values of certain assumptions. The sensitivity analysis should start with a basic break-even and ‘standard’ sensitivity analysis, which will help determine the values used in further analyses. Additionally, a scenario analysis can be conducted in the case that there are a few different but likely scenarios. However, the most important step of the risk analysis is the use of a Monte Carlo simulation. This requires the determination of appropriate ranges and probability distributions for all the important uncertain assumptions, but in return gives a complete overview of possible outcomes and their associated probabilities. This is achieved through thousands of scenarios that are built using assumption values generated based on their probability distribution, allowing to test far more scenarios than what the traditional sensitivity analysis is capable of. This analysis also provides valuable information to which assumptions the valuation is most sensitive towards, both in positive and negative effect. It hence highlights what the most important risk factors are. The Monte Carlo simulation gives the user unparalleled insights into the value created in all possible scenarios and how frequent certain values are achieved. This allows the user to determine the probability that the project will be profitable or reach a certain NPV, being able to put certain confidence behind NPV values. It also allows for the detection of extreme values that may exist within realistic scenarios, such as losses or very high profits. With this information, the company is able to better manage its risk by understanding the complete range of possible outcomes and knowing which factors are most critical to the success of the project. Specific topics and enhancing projections: In this report, different valuation topics that deal with specific scenarios and valuation components have been covered. The usefulness and application of each of these topics have been discussed in their individual section. All these sections serve a purpose to represent considerations that should be made when evaluating projects. Topics such as inflation and interest rates describe practices that are essential to any valuation scenario, clarifying any doubt to how these factors should be incorporated. Other topics such as externalities, opportunity cost and real options encourage the analyst to think about the strategic and practical implications of a project, beyond the scope of the project itself. These are factors that are important to understand to properly assess the total value that a project may create at a company-wide level. Further, advice is given on how the company can improve its internal processes to enhance the accuracy of future investment valuations. In particular, post-investment analysis, external data and internal operational data can prove useful to verify and improve the assumptions of future projects. By conducting thorough post-investment analyses, one is able to identify any structural biases in the assumptions made. By gathering and developing objective and comparable data, future projects can be compared to the company’s past experiences, both with regards to value creation and practical aspects. This allows for early interpretation of potential pitfalls such as overly optimistic growth forecasts or unreasonably high traffic expectations. Once such pitfalls are identified, further investigation can be directed towards verifying these suspicions. Comparison and determining profitability: The comparison of projects should be conducted using an NPV-based metric. In cases of capital rationing, the Profitability Index can be used to choose the most optimal combination of projects. When resources such as land are limited, the company will need to choose between different projects. Often, different projects have different lifetimes, rendering a direct NPV comparison insufficient. The Equivalent Annual Annuity and Real Options approaches allow to make comparisons that incorporate differences in the duration of the projects. When the amount of land available is limited but projects don’t come up simultaneously, it can be useful to compare the value created against other projects in the port. This way, the port can ensure a satisfactory value creation from its resources. As an absolute minimum, the port should always ensure that the cost of capital of its investment is lower than the value of the cash flows that the project generates. This is only the case when the project has a positive NPV and should preferably be determined with a degree of certainty such as estimated by the Monte-Carlo simulation. When projects do not have a positive NPV, the company is not giving its shareholders the value they expect. Implementation: Improving existing processes through analyzing data from existing operations and past projects can be seen as the next step forward at the port. Besides developing data for the comparison of key assumptions, the assumptions also need to be studied so that statistical distributions and ranges can be assigned to them. Once this is achieved, the company should implement the Monte Carlo simulation technique to conduct more comprehensive risk analyses. This will help the port gain a more complete view on the potential value creation of future projects.