Evaluation and Accounting for Projects
Before a company invests in a new or expanded business it will evaluate if the project will produce a cash inflow during its life (generally from sales of a product) that recovers the cost of the initial investment, and a return to the shareholders. The initial investment includes not only physical equipment and the cost of its installation, but also interest on loans used to finance the development and other costs.
During the life of the project the likely net cashflow will be recalculated and compared with the cost of the project or business. If the projection shows that the net cashflow is not enough to recover the investment, the owner will record an “impairment loss” in the profit and loss account. This is not a cash loss. It is merely the result of an evaluation based on assumptions that may or may not prove to be correct. Some of these assumptions may be up to 30 years ahead. While experts assist in making these assumptions, they can not possibly to be absolutely right. They are re-visited periodically. The assumptions in the long distant future are of less significance than those nearby because the net cashflow is reduced in value by “discounting” at an interest rate which itself is an important assumption.
The evaluation of a business takes place at the smallest unit that can generate cash inflows on its own. In the case of our steel business, it will be an individual factory or product line; properties generally are evaluated individually. Our iron ore business segment is an interesting case. It is easy to separate the shipping business and evaluate its future. The majority of the iron ore assets are the mine and a huge range of integrated industrial processes that end up placing iron ore concentrate in a stockyard. These assets are one cash generating unit. This has consequences in the profit and loss account.
In the profit and loss account two expenses are important – depreciation and interest. Depreciation is not a cash outflow so it does not affect the economics of the business. Interest is most likely a cash outflow but it is considered in valuing the business not as an expense but by calculating an internal rate of return. In the case of Sino Iron, depreciation starts when the integrated business starts commercial production. At present, we are in trial production but expect to enter into commercial production in 2014. Other than some relatively minor assets such as earthmoving equipment with a shorter useful life, most of the fixed plants will be depreciated on a “unit of production” method. An estimate is made of the total tonnes of production of the mine over its lifetime and depreciation is applied per tonne of actual production. As depreciation per tonne matches a cash inflow from sales of that tonne, income should exceed the non-cash depreciation. The mine itself has been in operation for some years, and the earthmoving equipment is depreciated over its useful life. This could be quite complicated as each individual piece of equipment has its own operating life.
Including interest in the cost of an asset stops when the asset is ready for production. As much of the equipment is ready for production, interest that previously was added to the cost of the asset on the balance sheet will become an expense in the profit and loss account. This will make the unit cost high in 2014 and 2015 because production will be significantly less than the full capacity of the installed equipment. This is because only two of the six grinding lines at the heart of the industrial process will be in operation by the end of 2014. They have a nominal capacity of 4 million tonnes each. The full nominal capacity of all six lines is 24 million tonnes.
Although depreciation and interest will likely create a loss in the Sino Iron profit and loss account until the grinding mills are in commercial production at a greater scale, the economic value of the Sino Iron project is not affected as it is evaluated using likely cash flows (in and out) over the life of the project.