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Investment Appraisal

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Investment Appraisal

Financial Evaluation Methods Basic Methods

Advanced Methods

Payback Period

Net Present Value NPV

Accounting Rate of Return (ARR)

Internal Rate of Return (IRR) Discounted Payback Period

Accounting Rate of Return(ARR) The Average return of a project expressed as a percentage of the capital outlay or average investment. ARR = Average Annual profit x 100 Initial investment ARR = Average Annual profit x 100 Average Investment Where “Average Investment” is = Initial Investment + Scrap value 2 Decision rule If ARR of the project > Target ARR then Accept the project. Else Reject the project

Advantages & Disadvantages of ARR Advantages Disadvantages 1. It is easy to understand and easy to 1. It fails to take account of the timing of calculate. cash flows and time value of money within that life 2. The impact of the project on a

3.

company’s financial statement can 2. also be specified

It uses accounting profit, hence subject to various accounting conventions.

Managers may be happy in expressing 3. project attractiveness in the same 4. terms in which their performance will be reported to shareholders, and according to which they will be 5. evaluated and rewarded.

It Ignores the size of investment.

4.

It takes into account the whole life of the project

5.

It can be used as a relative measure in case of mutually exclusive projects

Like all rate of return measures, it is not a measurement of absolute gain in wealth for the business owners. The ARR can be expressed in a variety of ways and is therefore susceptible to manipulation

Cash flows

Relevant Cash flows Future Cash flows

Irrelevant Cash flows Sunk Cost/ Historical Cost

Variable Costs

Non-cash cost Depreciation

Incremental Cash flows

General Overheads

Opportunity Cost

Central Office Overheads

Payback Period It is the time period required to recover the initial investment. Example: Initial Investment is $100000. The Cash flow for four years are $40000, $30000, $50000, $20000, respectively. Determine the payback period. Solution:

Years

Cash flows Cumulative Cash flows

0

(100000)

(100000)

1

40000

(60000)

2

30000

(30000)

3

50000

20000

Payback Period

= 2 years + (30000/ 50000 x 12) = 2 years and 7 months

Payback Period (Decision Criteria, Advantages & Drawbacks) Decision Criteria: If Payback Period < Target Payback, Accept the Project. Advantages 1. It is simple to use (calculate) and easy to understand 2.

3.

It is a particularly useful approach for ranking projects where a company faces liquidity constraints and requires a fast repayment of investment. It is appropriate in situations where risky investments are made in uncertain market that are subject to fast design and product changes or where future cash flows are particularly difficult to predict.

4.

The method is often used as the first screening device to identify projects which are worthy of further investigation.

5.

Unlike the other traditional methods payback uses cash flows, rather than accounting profits, and so is less likely to produce an unduly optimistic figure distorted by assorted accounting conventions

Disadvantages 1. It does not give a measure of return, as such it can only be used in addition to other investment appraisal methods. 2.

It does not normally consider the impact of discounted cash flow although a discounted payback may be calculated (see later).

3.

It only considers cash flow up to the payback, any cash flows beyond that point are ignored.

4.

There is no objective measure of what is an acceptable payback period, any target payback is necessarily subjective

Time Value of Money Money received today will have more worth than the same amount received at some point in the future. FV = PV × (1 + r)n Where PV FV rn -

Present value. Future value. Rate of interest or cost of capital. Number of periods (years)

Revising the formula

𝑃𝑣 =

𝐹𝑉 1+r n

Or

PV = FV × (1 + r)-n

NET PRESENT VALUE (NPV): The NPV of the project is the sum of the PVs of all cash flows that arise as a result of doing the project. Decision Rule:If NPV of the project, discounted at cost of capital, is positive then Accept the project, Else Reject the Project. Example Years

Cash flows

Discount Factor(10%)

0

(500000)

1.000

(500000)

1

300,000

0.909

272,700

2

200,000

0.826

165,200

3

200,000

0.751

150,200

4

600,000

0.683

409,800

NPV

= Present Value of all inflows – Present Value of all outflows =997,900 – 500000 =497,900

Present Values

Net Present Value (Advantages & Drawbacks) Advantages Disadvantages 1. A project with a positive NPV increases the 1. Determination of the correct discount rate wealth of the company’s, thus maximise can be difficult. the shareholders wealth. 2. Non-financial managers may have 2. Takes into account the time value of difficulty understanding the concept. money. 3. The speed of repayment of the original Discount rate can be adjusted to take account of different level of risk inherent in 4. different projects.

investment is not highlighted.

4.

Unlike the payback period, the NPV takes 5. into account events throughout the life of the project.

5.

Better than accounting rate of return because it focuses on cash flows rather than profit.

NPV assumes cash flows occur at the beginning or end of the year, and is not a technique that is easily used when complicated, mid-period cash flows are present

3.

The cash flow figures are estimates and may turn out to be incorrect.

Internal Rate of Return (IRR): IRR is the total rate of return offered by an investment over its life, based on cashflows and time value of money

𝐼𝑅𝑅 = 𝑎% + Where: a%A b%B

𝐴 𝐴−𝐵

𝑋 𝑏−𝑎 %

Small Disc. Rate at which NPV is Preferably positive NPV at a% Bigger Disc. Rate at which NPV is Preferably negative NPV at b%

Decision Rule If IRR of the project > Cost of capital, Accept the project. Else Reject the Project

Calculation of IRR Years

Cash flows

D.F @ 20%

P.Values

D.F @ 10%

P.Values

0

(200,000)

1.00

(200,000)

1.000

(200000)

1

40000

0.833

33,333

0.909

36360

2

30000

0.694

20,833

0.826

24780

3

120000

0.579

69480

0.751

90120

4

40000

0.482

19290

0.683

27320

5

80000

0.402

32160

0.621

49680

NPV IRR

(24904) = 10% + 28260 x (20 -10) (28260 + 24904) = 15.32%

28260

Internal Rate of Return (Advantages & Drawbacks) Advantages 1.

Like the NPV method, IRR recognises the time value of money.

2.

3.

4.

Disadvantages 1.

It is based on cash flows, not accounting profits.

Does not indicate the size of the investment, thus the risk involve in the investment.

2.

More easily understood than NPV by nonaccountant being a percentage return on investment.

Assumes that earnings throughout the period of the investment are reinvested at the same rate of return.

3.

It can give conflicting mutually exclusive project.

4.

If a project has irregular cash flows there is more than one IRR for that project (multiple IRRs).

For accept/ reject decisions on individual projects, the IRR method will reach the same decision as the NPV method

signals

with

Discounted Payback period method: The time period in which initial investment is recovered in terms of present value is known as payback period It is same as simple payback period. The only difference is that the discounted cash flows are used instead of simple cash flows for calculation. Decision Rule If payback period is less than target payback period then ACCEPT the project, Else, Reject the project Years

Cash flows

D.F @ 10%

Present Values

Cumulative Values

0

(500000)

1.000

(500000)

(500000)

1

300000

0.909

272700

(227300)

2

200000

0.826

165200

(62100)

3

200000

0.751

150200

88,100

4

600000

0.683

409800

Discounted Payback

= 2 years + (62100/ 150200 x 12)

= 2 years and 5 months

Discounted Payback Period (Advantages & Drawbacks) Advantages

Disadvantages

1.

It takes into account the time value of 1. money and timings of cash flows.

It does not consider the whole life of project.

2.

It considers cash flows rather than 2. accounting profits.

It requires knowledge of cost of capital which is difficult to calculate.

3.

Short payback period result in 3. increased liquidity and enable business to grow more quickly 4.

Life expectancy ignored.

of

It ignores cash payback period

flows

a

project after

is the

Effect of Taxation in investment appraisal

 Timing of Tax Cashflows: Either in the same year or in arrears.  Calculation of cashflows o Tax on Operating Cashflows: Operational Cashflows X Rate of Tax o Tax Savings on Capital Allowances: Calculate the capital Allowances/ Balancing Allowances and then multiply with Tax Rate.

Example (Tax Savings on capital Allowances) Example Initial Investment = 2000 Capital Allowances = 25% reducing balance Useful life = 4 years, Tax rate = 30% payable in arrears, Scrap Value = 500 Years

Written Down Value

Capital Allowances @ 25%

Tax Savings @ 30%

Timing

1

2000

500

150

2

2

1500

375

113

3

3

1125

281

84

4

4

844

344

103

5

Effect of Inflation in investment appraisal: Inflation may be defined as a general increase in prices, leading to general decline in the real value of money, (decrease in purchasing power). Real Rate of Return Money/ Nominal Rate of Return General Inflation

(1 + n) = (1 + r) (1 + i)

Inflating Cashflows If General inflation rate is given Money Method

Inflate all Cash flows with general inflation rate. Discount these cash flows with money discount rate.

If Specific inflation rate is given

Real Method

Money Method

Do not inflate Cash flows. Discount all Cash flows with real discount rate.

Inflate each variable cash flow with its specific inflation rate. Discount with money cost of capital (calculated through real rate and general inflation rate.

Nominal Cashflow = Real cashflows ( 1+ i)n

Working Capital 1. Calculate working capital requirement one year in advance e.g. working capital is 10% of sales at the start of each year 2. Calculate incremental working capital by taking change of each year working capital 3. In last year, there will be an assumption that all working capital will be recovered (Only for project and not for ongoing business)

Performa for Net Present Value Years

0

1

2

3

4

X

X

X

X

Variable Cost

(X)

(X)

(X)

(X)

Incremental Fixed Cost

(X)

(X)

(X)

(X)

X

X

X

X

(X)

(X)

(X)

(X)

X

X

X

X

(X)

(X)

(X)

X

Sales

Operating Profits Tax Expense Tax Savings on Capital Allowances Change in Working Capital

(X)

Initial Investment

(X)

Scrap Value

X

Net Cash flows

(X)

X

X

X

X

Discount Factor

X

X

X

X

X

Present Values

(X)

X

X

X

X

Net Present Value

X

Annuity & Perpetuity Cashflows Annuity: If Consistent cashflow for a certain Period. e.g Y1-5 or Y3-7 Perpetuity: If Consistent cashflow for infinite period e.g. Y1-∞ or Y3-∞

Present Values of Consistent Cashflows The Annuity Factor =

𝟏− 1 + r −n

The Perpetuity Factor =

𝒓 𝟏 𝒓

Annuity

Perpetuity

If Cashflows Start from Period 1. Annual Cashflow X Annuity Factor e.g. Y1-5 $10,000 at Disc. Rate of 10% $10,000 X 3.791(from annuity table) =$37,910

If Cashflows Start from Period 0.

Annual Cashflow X Perpetuity Factor e.g. Y1-∞ $10,000 at Disc. Rate of 10% $10,000 X (1/10%) = $100,000

Annual Cashflow X (Annuity Factor + 1) e.g. Y0-5 $10,000 at Disc. Rate of 10% $10,000 X (3.791+1) =$47,910

Annual Cashflow X (Perpetuity Factor + 1) e.g. Y0-∞ $10,000 at Disc. Rate of 10% $10,000 X ((1/10%)+1) = $110,000

Annual Cashflow X Annuity Factor of No. of periods X Discount factor of preceding period from Start e.g. Y4-8 $10,000 at Disc. Rate of 10% $10,000 X 3.791 X 0.751 =$28,470

Annual Cashflow X Perpetuity Factor X Discount factor of preceding period from Start

If Cashflows Start from Subsequent Period e.g. Year 3.

e.g. Y4-∞ $10,000 at Disc. Rate of 10% $10,000 X (1/10%) X 0.751 = $75,100

©ACCA

Capital Rationing A limit on the level of funding available to a business, there are two types  Hard capital rationing (External)  Soft capital rationing (Internal)

Divisible – An entire project or any fraction of that project may be undertaken. Projects displaying the highest profitability indices (i.e. NPV/Initial Investment) will be preferred. Indivisible – An entire project must be undertaken, since it is impossible to accept part of a project only. In this event different combination of projects are assessed with their NPV and the combination with the highest NPV is chosen.

Capital Rationing (Solving) Steps for divisible project 1. Calculate the NPV of each Investment

2. Calculate the Profitability indices 3. Ranking 4. Investment Plan Note: In case of Mutually exclusive Projects, the project with the Higher Profitability Indices will be ranked and lower will be ignored.

Non-divisible project We will make possible combinations and see which has better NPV

Capital Rationing Example Project D B A Total

Investment 700 1,200 600 2,500

NPV 450 700 300 1,450

Available Funds – $ 2,500 Divisible Project

Investment

NPV

A B C D

1,000 1,200 800 700

500 700 300 450

PI (NPV/Investment) 0.5 0.58 0.375 0.642

Ranking 3rd 2ND 4TH 1ST

The Investment Schedule We will do Project D and B complete and Project A 60%. Non-Divisible Projects Combination A,B A,C,D B,C B,D

Total Investment 2,200 2,500 2,000 1,900

Total NPV 1,200 1,250 1,000 1,150

We will choose combination of A,C,D because it’s gives the best NPV of $1,250

Asset Replacement Asset Replacement issues:  How frequently an asset be replaced?

 Is it worth paying more for an asset that has a longer expected life. In both of these scenarios, the ideal approach is to keep the costs per annum (in NPV terms) to a minimum. This is calculated as an equivalent annual cost (EAC). 𝑵𝑷𝑽 𝒐𝒇 𝒄𝒐𝒔𝒕𝒔

EAC = 𝒂𝒏𝒏𝒖𝒊𝒕𝒚 𝒇𝒂𝒄𝒕𝒐𝒓 𝒇𝒐𝒓 𝒕𝒉𝒆 𝒍𝒊𝒇𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒑𝒓𝒐𝒋𝒆𝒄𝒕

Lease or Buy Decision The decision here is whether buying the asset or leasing the asset is more cost-effective Calculation Discount rate = post tax cost of borrowing The rate is given by the rate on the bank loan in the question, if it is pre-tax then the rate must be adjusted for tax. If the loan rate was 10% pre-tax and corporation tax is 30% then the post -tax rate would be 7%. (10% x (1 – 0.3) Cash flows Bank loan 1. Cost of the investment

Finance Lease

2. WDA tax relief on investment

1. Lease rental - in advance - annuity

3. Residual value

2. Tax relief on rental

Sensitivity Analysis Sensitivity Analysis A technique that considers a single variable at a time and identifies by how much that variable has to change for the decision to change (from accept to reject). Formula to calculate sensitivity of a particular cashflow: 𝑁𝑃𝑉 𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 % = 𝑋 100% 𝑃𝑉 𝑜𝑓 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑠𝑒𝑛𝑠𝑡𝑖𝑣𝑖𝑡𝑦

Formula to calculate sensitivity of a particular variable:𝑆𝑒𝑛𝑠𝑒𝑡𝑖𝑣𝑖𝑡𝑦 % =

𝐼𝑅𝑅 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑋 100% 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙