Investment appraisal 3

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Investment Appraisal

Geoff Leese Sept 1999 revised Sept 2001, Jan 2003, Jan 2006, Jan 2007, Jan 2008, Dec 2008 (special thanks to Geoff Leese)

Investment Appraisal

Capital Investment is crucial for long term survival, to give benefit over a number of years

On the balance sheet, this consists

of fixed and current assets and current liabilities

Can be seen as on-going projects generating return and cash flow

Categories of Capital

Investment

Replacement of existing facilities

Relatively low risk

Expansion of existing facilities

Low risk, reliable estimating in familiar markets

New Project

Risk increasing, unknown market or product

Research and development

Highly uncertain outcomes in new areas

Welfare projects

Required by legislation, benefits hard to measure

Context and Control

Operational control

Short term routines

Accounting rate of return ARR

% return achieved over project life (differing definitions)

Net present value NPV

initial cost of project with future generated discounted cash flow

Internal rate of return IRR

% return from project over lifetime in discounted cash flows

Opportunity cost

When resources are limited, the benefit or income that is foregone as a result of a

decision Example: Not spending on new machinery, but updating the software

Opportunity cost of the software is the benefit from the new machinery

Such costs are not recorded in accounts, but very important in cost benefit analysis

Payback

Simple measure of the number of years that it will take to recover your original investment from net cash flows that result

For example, a small, internal IS program to save costs:

Original investment £450

net cash inflows

– Year 1 £100 running total cash flow

Time Value of Money

Preference for money to be received earlier and paid later

Worth more than similar amount received later, as earlier monies can be invested to earn interest over the receiving period

Similarly, cash paid later is worth less than similar sum paid earlier, as you can have the investment benefit for longer

years And does not consider time value of money

Accounting Rate of Return

All methods acceptable, but need to ensure comparisons are of the same method

Complements ROCE by relating profits to initial capital investment

Does not consider time value of money

ARR

Assume no residual value and straight-line depreciation charge of £90 (no residual value)

Future value of money

This is the compound interest formula which tells you the future value of what you are currently investing

A n = P(1 + i) n

A n = future amount invested in year n

P = amount invested now, at time n = 0

rearranging the compound interest formula

P = An / (1 + i)n

Net present value NPV

Covers discounting and weighted average cost of funds

Difference between the present values of cash inflows and present value of cash outflows

If NPV positive, required rate of return likely, accept

If NPV zero, consider accepting if risk also acceptable

NPV calculation Example

Back to our example of a £450 IS investment

Payback period 3.5 years, ARR 12%

If opportunity cost happened to be 10% (that is we

could have obtained 10% on another use of our money), estimated cash flows £ per year at present values are:

90.9 + 165.3 + 75.1 + 68.3 + 136.6 = £536.2 total over 5 years

Internal Rate of Return

Known as discounted cash flow (DCF) yield IRR is another rearrangement of the

Excel or financial software

If the discount rate is greater than the cost

of capital – acceptable

If the discount rate is less than the cost of capital - reject

Look at Excel Practice using NPV and IRR with the data we have used

Look at the help function, and practice with that data

You can use other spreadsheet, or Sage or other financial packages

Which technique

Many large organisations use more than one, as each analyses and gives different information

Payback measures time capital at risk

ARR measures profitability NPV and ARR both show stakeholder returns

Cost Benefit Analysis

Much broader view than cash or profit based analysis, which are purely based on economics

Seeks to assess the economic and social advantages (benefits) and

disadvantages (costs) of a project, then quantifies in monetary terms Major importance in public sector

Assessing social benefits

Not all easy to translate into monetary terms

Broad view of stakeholders may be necessary, such as society as a

whole Costs and benefits arise at different times

Which discount rate to use?

Specialist area, under much debate

Audit of capital investments

Good practice - any capital project investment should be assessed when it has been commissioned and running for a while

Gives a feedback loop for project appraisal and selection, ensuring an improvement of the process by performing three functions:

Improving the quality of investment decisions under consideration

Further Reading

Dyson Chapter 19