Investment appraisal 2

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Investment Appraisal

2BUS0197 – Financial Management

Learning outcomes

By the end of this session students should appreciate:

 The main investment appraisal methods

 The reasons why discounted cash flow methods are preferred

 Why net present value is regarded as superior to internal rate

of return

 Capital rationing and investment appraisal

 The role of taxation, inflation, risk and uncertainty on

investment decisions

The net present value method

 Uses discounted cash flows to evaluate capital

investment projects

 A cost of capital or target rate of return is used to

discount all cash inflows to their present values

 The present value of all cash inflows is then

compared to the present value of all cash outflows

 A positive net present value indicates that an

investment project is expected to give a return in

excess of the cost of capital and will therefore

increase shareholder wealth

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The net present value method

where:

I 0 is the initial investment

C 1 , C 2 , …, C n are the project cash flows occurring in years 1, 2, …, n

r is the cost of capital or required rate of return

N.B Cash flows occurring during a time period are assumed to

occur at the end of that period

Decision rule: accept all independent projects with a

positive net present value

 A project costing £1,000 is expected to yield £500

per year for 2 years Calculate its NPV

Year Cash flow 10% PVF PV

Pros and cons of NPV method

 Advantages:

 Accounts for the time value of money

 Uses cash flows, not accounting profit

 Takes into account timing and amount of project cash flows

 Takes account of all relevant cash flows over the life of a project

The internal rate of return (IRR) method

 IRR of an investment project is the cost of capital

or required rate of return which, when used to

discount the cash flows from a project, produces

a net present value of zero

where:

I 0 is the initial investment

C 1 , C 2 , …, C n are the project cash flows occurring in years 1, 2, …, n r* is the internal rate of return

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The internal rate of return (IRR) method

a project by linear interpolation and then

comparing it with a target rate of return (or

hurdle rate)

projects with an IRR greater than the company’s cost of capital or target rate of return

Internal rate of return

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Investment project

Discount rate IRR

Estimating the IRR of a project

 In the previous example, the NPV for r = 18% is

negative, while the NPV for r = 10% is positive

 Hence, the IRR giving a zero NPV falls between 10 and 18%.

 Using linear interpolation it is possible to estimate the IRR by applying the following formula:

Comparing NPV and IRR methods

 Mutually exclusive projects: If IRR is used, the

wrong project may be selected NPV always gives the correct selection advice

Comparing NPV and IRR methods

 Non-conventional cash flows: If an investment project has cash flows of different signs in successive periods (i.e non-

conventional cash flows), it may have more than one IRR

 Applying the IRR method to projects with non-conventional

may result in incorrect decisions being taken

 The NPV method can accommodate non-conventional cash

flow, hence it gives the correct selection advice

The basic cash flow profiles

IRR and NPV with non-conventional cash flows

RA

•Project rejected by NPV method because NPV<0 for RA

Cost of capital = RB

•NPV>0, so accept project

•IRR does not offer clear advice since IRR1 < RB < IRR2

Comparing NPV and IRR methods

 Changes in the discount rate: NPV can accommodate changes in the discount rate over the life of an

investment project, while IRR ignores them

that cash flows from project can be reinvested at a

rate equal to the cost of capital IRR method assumes that cash flows can be reinvested at a rate equal to

IRR NPV reinvestment assumption is realistic

The payback method

 The payback period is the number of years it

is expected to take to recover the original

investment from the net cash flows resulting from a capital investment project

 Decision rule: accept a project if its payback period is equal or less than a predetermined target value

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Example: a simple investment project

The above cash flows refer to an investment project that requires a cash investment at the start of the project,

followed by a series of cash inflows over the life of the

project (conventional project)

Pros and cons of payback method

 Advantages:

 Simple and easy to apply

 Should not be open to manipulation as it uses cash flows, not accounting profit

 Accounts for risk as it implicitly assumes that a shorter

payback period is superior

 Disadvantages:

 Ignores time value of money

 Does not consider the project as a whole since cash flows outside the payback period are taken into account only out

of managerial judgement

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The return on capital employed method

 ROCE can be defined as:

average annual accounting profit × 100

average investment

 Where average investment is:

(initial investment + scrap value)/2

 ROCE can also be defined as:

average annual accounting profit × 100

initial investment

The return on capital employed method

 Average annual accounting profit can be calculated from project cash flows by taking off depreciation

 Accounting profit is not cash flow since

depreciation does not correspond to a cash

movement

 Decision rule: accept project if ROCE is equal to or greater than target (or hurdle) rate of return (i.e

current company or division ROCE)

 If projects are mutually exclusive, the project with the highest ROCE should be selected

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 A machine costs £10,000 and its useful economic life is 5 years After 5 years, the machine’s scrap value is £2,000 The net cash inflows from the

machine would be £3,000 per year Ignore taxation

Pros and cons of ROCE method

 Advantages:

 Measured in %, so comparable with company’s ROCE

 Fairly simple to apply

 Can be used to compare mutually exclusive projects

 Considers all cash flows arising during a project’s life,

unlike payback method

 Disadvantages:

 Uses accounting profit rather than cash

 Profit not directly linked to primary financial objective of shareholder wealth maximisation

 Uses average profits and hence ignores timing of profits

 Ignores time value of money

 Relative measure and so ignores size of initial investment21

Recap on investment appraisal methods

 NPV is academically preferred as an

investment appraisal method – it has no

major defects and is consistent with

shareholder wealth maximisation

 IRR comes a close second and can prove to

be a useful alternative

 ROCE and payback methods are flawed as

Capital rationing

Hard capital rationing :

limitations are externally

imposed

Capital markets may be

depressed

Investors may consider the

company to be too risky to

invest in

Issue costs may make a small

issue of finance expensive

Soft capital rationing : limitations are internally imposed Arises if managers

Want to avoid dilution of control

Want to avoid dilution of EPS

Wish to avoid fixed interest payments (debt)

Wish to follow policy of steady growth

Believe restricting available funds will encourage better investment projects

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Arises if a firm has insufficient funds to invest in all projects

with positive NPV

Single period rationing

maximise total NPV

to correct decision

profitability index (PI):

PI = PV of future cash flows

Initial investment

Single period rationing

by looking at total NPVs of possible

combinations of projects

not exceed capital rationing limit will be optimal investment schedule

to the investment decision

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Multi-period period rationing

combinations do not help

the optimum combination

complex problems by computer

Relevant project cash flows

 Relevant cash flows are incremental cash flows

arising from an investment decision, such as initial investment, cash from sales and direct costs

 Usually exclude:

 Sunk costs – incurred prior to the project start, hence not

relevant to project appraisal (e.g market research)

are incurred regardless of whether a project is undertaken (e.g rent)

 Usually include:

 Opportunity costs – if an asset is used for a project, relevant to know what benefit has been foregone

 Incremental working capital – increase in working capital will be

a cash outflow for the company relevant for the project appraisal

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Optimising capital investment decisions

 The investment appraisal process must

account for:

 The effects of taxation and inflation on project

cash flows

 The required rate of return

 The risk and uncertainty to which future cash

flows are subject

 In the last year of an investment project a

balancing allowance is needed in addition to a

capital allowance to ensure that the capital value consumed by the firm over the project’s life has been deducted in full in calculating taxable profits

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as materials, wages and maintenance

these are included in the discount rate

relevant after-tax cost of capital

 Inflation can adversely affect capital investment

decisions by reducing the real value of future cash

flows and increasing their uncertainty

 Future cash flows must be adjusted to take into

account any expected inflation

 The real cost of capital is found from the nominal (or money) cost of capital by making an adjustment for

inflation:

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

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Risk and uncertainty

 Risk refers to a set of unique circumstances,

which can be assigned probabilities

 Uncertainty implies probabilities cannot be

assigned to different sets of circumstances

 In practice, the terms ‘risk’ and ‘uncertainty’ are often used interchangeably

 The business risk of an investment increases with the variability of returns

Sensitivity analysis

 A method of evaluating project risk by examining how responsive the NPV of a project is to changes in the

variables from which it has been calculated

 Only one variable is changed at a time (i.e variables

assumed to be independent)

 Two methods to measure sensitivity:

 Both methods give indication of the key variables of an investment project, i.e small changes in these variables can have a significant adverse effect on the project

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Problems with sensitivity analysis

 Only one variable at a time can be changed

 No indication is given of the probability of

changes in key project variables

 Not really a method of analysing project risk, since probabilities are ignored

Today we looked at:

Textbook

 Watson D and Head A., (2007), Corporate Finance Principles and

Practice, 5th (4 th ) edition, FT Prentice Hall, Chapters 6 and 7

Research paper

 Arnold, G C., Hatzopoulos, P D (2000), The Theory-Practice Gap

in Capital Budgeting: Evidence from the United Kingdom, Journal

of Business Finance & Accounting, Vol 27, 5, pp 603-626

 Barwise, P., Marsh, P R., Wensley, R (1989), Must Finance and Strategy Clash?, Harvard Business Review, September- October,

pp 85-90

Your tutorial activities for next week

During the seminar you will be expected to work on:

Q2 p.187; Q1 p.220 (5 th ed)

Q2 p.179; Q2 p.206 (4 th ed)

To prepare for the seminar you should answer the

following practice questions:

EQL - UFM4

Textbook - Q4 p.183; Q5 p.185; Q3 p218 (5 th ed)

Q4 p.176; Q5 p.178; Q4 p205 (4 th ed)

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