Capital investment appraisal (an introduction)

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CAP1 Finance, Academic Year 2011 / 2012

Session 2

Capital Investment Appraisal

(An Introduction)

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Session 2 Capital Investment Appraisal

• By the end of today’s session(s), you should be able to:

– Understand the context of investment appraisal decisions – Evaluate capital projects using the ARR, the payback period method, the discounted payback period, the IRR and the NPV techniques

– Discuss the advantages and disadvantages of each method – Explain research findings in respect of the practical application of the methods

Overall aim of three lectures on this topic – to enable trainees to select appropriate investment methods and to calculate investment returns for competing projects and to justify a course of action including

consideration of relevant non-financial factors and financing options

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Ethics & Professionalism

Objectivity

Perceptiveness of own knowledge,

values and limitations

Strategic Thinking & Problem

Solving Communication Managing Self & Others:

Leadership

IT Awareness Project Management & Change Awareness Stakeholder Management

Financial Reporting

Management Accounting &

Finance Audit & Assurance

Tax & Law Strategy

Competency Wheel

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• This lecture maps specifically to 2.1 on the Competency Statement

Functional Competencies Competencies Business Core Professional Values & Skills

Explain and demonstrate

the ability to use the

payback, discounted

payback, accounting rate of

return, net present value

and internal rate of return

techniques

Be able to appraise a variety of different projects for communication to

management

The need to be objective when evaluating differing projects

Recommend and justify a

course of action, including

consideration of

non-financial factors

Evaluate and communicate

an appropriate course of action given the entity’s unique characteristics and

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Difficulties with Project Appraisal

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Difficulties facing project appraisal

• Goal congruence

• Relevant cash flows

• Time value of money

• Profit versus cash

• Capital rationing

• Projects with unequal lives

• Risk (next class)

• Financing

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Goal Congruence

Ultimately the project’s outcome should increase equity holder value

Decision makers - view the big picture, which may involve rejecting

projects that have short-term returns in favour of projects with higher overall long-term returns.

Take liquidity into consideration

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Relevant cash flows

Not all cash flows should be brought into the appraisal process – only relevant cash flows.

Relevant cash flows are incremental cash flows and opportunity cash flows.

They exclude:

• Sunk costs

• Apportioned costs that were going to be incurred anyway

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Cash flows explained

Incremental cash flows are those that will occur only as a

consequence of a project being undertaken

Opportunity cash flows are cash flows forgone from other

investments, or actions that have been changed, as a result of the project being implemented

Cash flows that occur as a result of decisions made in the past,

which cannot be changed are deemed to be sunk cash flows

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The time value of money/cash V profit

In finance CASH IS KING

Cash is very different to profit.

Management performance is usually assessed using profitability.

However, the pattern of cash is more important for project appraisal because of the time value of money.

Example (assume you are assessing a 5 year period) – in terms of profitability €/£1m each year for 5 years is the same as €/£5 million

at the end of year 5.

In finance, the latter option is valued much LOWER – because of the time value of money

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• Cash synchronisation – match the timing of the cash flows resulting from the investment with the timing of the

repayments on the source of finance

• Cost of finance – take into account the company’s current cost of capital

Note: This topic is covered in detail later in the course

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Project appraisal - techniques

Accounting Rate of Return (ARR) Payback period

Discounted payback period

Internal rate of return (IRR)

Net present value (NPV)

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Accounting Rate of Return

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The accounting rate of return estimates the rate of accounting

profit that a project will generate over its entire life

It compares the average annual profit of a project with the

average cost (book value) of the project

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ARR - calculation

ARR = Average annual profit x 100

Average capital invested

Where the average annual profit is the total profit for the

whole period (after depreciation) divided by the life of the investment in years; and

The average capital invested is the initial capital cost plus the

expected disposal value divided by two

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ARR – example

Cow Ltd is considering three projects (each costing €/£240,000)

The following cashflows are predicted:

Friesian Aberdeen Saler

Given that Cow Ltd has a target average accounting rate of return of 10% per

annum which of the above projects should be accepted, if any? (Assume that the asset is specialised and cannot be sold at the end of the project)

How would the results be affected were you informed that the asset could be sold

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ARR - advantages

Advantages include:

• As it is based on profits management understand it better

• Profits are important, a project should not only have positive cash flows but should also be profitable

• It is a useful target for screening projects

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ARR - disadvantages

Disadvantages include:

• It ignores cash flows

• It ignores the time value of money

• It ignores the size of a project (risk)

• It ignores the duration of a project (risk)

• A project that has a longer life but is overall more profitable and has more cash inflows will be penalised because of its long life

• Subjective (hurdle rate)

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Payback period

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Payback period

The payback period method ranks investments in order of the

speed at which the initial cash outflow is paid back by subsequent cash inflows

This method focuses on cash flows not profits, therefore depreciation and accrual accounting is ignored

This method calculates the number of years it takes for cumulative cash flows to achieve breakeven point

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Payback method - advantages

Advantages include:

• Simple and quick to calculate

• Readily understandable

• Useful risk screening technique

• Focuses management attention on projects with more reliable estimates

• Useful for companies with liquidity issues

• Helps decide between two projects with similar ARR’s

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Payback method - disadvantages

• It ignores the time value of money

• It ignores the profitability of a project (risk)

• It ignores cash flows received after the payback period

• It ignores the impact of a project (strategic)

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Discounted Payback Period

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Discounted payback period

The discounted payback period method

overcomes one of the weaknesses of the payback period method, as it takes the time value of money into consideration

This method ranks investments according to the

speed at which the cumulative discounted

cash flows (DCF) of an investment cover the

initial cash outlay

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Discounted payback method - example

Cow Ltd is considering three projects (each costing €/£240,000).

The following cash flows are predicted:

Yearly profits Friesian Aberdeen Saler

Which of the above projects should Cow Ltd invest in Cow Ltd has to

borrow funds at 10% Management decide that this is an appropriate discount rate to use and it is company policy to use the discounted

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Discounted payback method - advantages

Advantages include:

• Simple and quick to calculate

• Readily understandable

• Useful risk screening technique

• Focuses management attention on projects with more reliable estimates

• Useful for companies with liquidity issues

• Helps decide between two projects with similar ARR’s

• Takes the time value of money into consideration.

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Discounted payback method - disadvantages

• It ignores the profitability of a project (risk)

• It ignores cash flows received after the payback period

• It ignores the impact of a project (strategic)

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Net Present Value (NPV)

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Net Present Value (NPV)

The NPV method of project appraisal, discounts the cash

inflows and outflows of an investment, to their present value

Use of the correct discount rate is very important

If the NPV is positive then a project should be accepted; as the positive amount will increase equity holder value

If the NPV is negative then a project should be rejected as

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NPV method – example

Cow Ltd is considering three projects (each costing €/£240,000).

Yearly profits Friesian Aberdeen Saler Before depreciation €/£ €/£ €/£

Year 1 60,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 100,000 40,000 36,000 Year 4 130,000 3,000

Year 5 20,000

Year 6 10,000

REQUIRED

Calculate each project's NPV and rank the resulting information for

reporting to management The company has a WACC of 16% and all the projects being considered are of similar risk to the current operating activities of the company.

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NPV method - advantages

Advantages include:

• The time value of money is taken into consideration

• All relevant cash flows are considered in the appraisal process

• The discount rate can be adjusted for risk

• When there are several alternatives the alternative with the largest NPV will maximise equity holder value

• Unlike the IRR, when cash flows are not conventional, the NPV will provide one answer

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NPV method - disadvantages

• Time consuming calculations (though can be

compiled by a computer).

• It does not provide a method of deciding

which investment provides the best value for money.

• It considers the absolute amount of money

available over a project’s life.

• It does not consider scale, hence risk.

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Internal Ratio of Return (IRR)

.

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Internal Rate of Return (IRR)

The IRR, sometimes referred to as the discounted cash flow yield

method also involves discounting future cash flows to their

present value

It could be considered a type of break-even analysis, which focuses

on trying to find the discount rate at which the present value of the discounted future cash flows (inflows and outflows combined) equals the initial investment cash outlay

This discount rate is then compared to a hurdle rate to determine if the project should be accepted or not

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Calculating the IRR

Step 1: Select two discount rates at random

Step 2: Discount the cash flows at the discount rates to find the net present value

Step 3: Use interpolation to find the rate at which the NPV of the cash flows is zero.

IRR = Rate 1 + NPV 1 (Rate 2 – Rate 1)

NPV 1 - NPV 2

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IRR method – example

Cow Ltd is considering a project (costing €/£240,000).

Yearly profits Friesian

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IRR method - advantages

Advantages include:

• The time value of money is taken into consideration

• All cash flows are considered in the appraisal process

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IRR method - disadvantages

• Time consuming calculations (though can be compiled by a computer)

• The linearity assumption that underlies the interpolation process

• It ignores the scale of projects.

• It is difficult to utilise when investments have unconventional cash flows, as more

than one IRR will result

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Research findings

The payback method is the most commonly used method – used

as screening device – the remaining projects are usually assessed using either the ARR or the IRR.

Most companies set a subjective IRR/ARR hurdle rate and accept projects with a higher return.

Academics consider the NPV to be the most appropriate method

Recent research has shown that use of DCF techniques is

increasing particularly in large entities with a preference for the use of the NPV or a combination of the NPV and the IRR

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Summary

• There are many factors which have to be considered before undertaking investment appraisal

• Identifying relevant cash flows

• The timing of cash flows

• The strategic fit of the project

• The impact on other areas

• The correct appraisal approach

• In most instances all are used with qualitative information

to inform the decision.

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