© 2005, Monash University, Australia CSE5806 Telecommunications Management Lecturer: Dr Carlo Kopp,...

© 2005, Monash University, Australia

CSE5806

Telecommunications ManagementLecturer: Dr Carlo Kopp, PEng

Lectures 15-16

Investment Decision Techniques

Many projects compete for scarce capital & operational budgets.

Which project should be chosen to go ahead, and why?(The one that gives the greatest return for the resources allocated)


Reference Sources

NOTE: These sources are indicative - there are many other good texts available in

libraries. They are referenced here as this presentation draws on them extensively

Introductory Accounting and FinanceAltehea Bell editor (1990)Publisher: Thomas Nelson AustraliaMonash University library: 657 B433.I

Cost Accounting – a Managerial EmphasisSixth EditionHorngren and FosterPublisher: Prentice Hall Monash Library: H657.4 H816C6

Engineering Economics – Analysis for Evaluation of AlternativesKleinfeld, Ira (1993)Publisher: Van Nostrand ReinholdMonash University library: 658.15 K64E


Investment Decisions

Management of existing assets

Appraisal of future assets;

Capital budgeting Balancing and sharing the use of capital monies among several/many competing demands

Investment appraisal Considering which is the best way to invest our capital


Areas of capital budgeting:

Forecasting Project Cash Flows

Allowing For Uncertainty

Cost Of Capital (Time-preference Rate)

Arithmetic: Formulae & Tables

Decision-making: Screening & Ranking May Be Mutually Exclusive Capital rationing


Discounted Cash Flow Analysis (DCF) DCF is a relatively new technique (US: late 50s, Europe 60s)

Usually used for long-range decisions Considers time-value of money,

Time value of money is based on the fact that ‘future money’ is equated to today’s money invested in some interest bearing scheme.

Ie $100 invested today is worth, say, $110 magically acquired in two years time. Conversely $110 needed to pay for something in two years time equates to $100 today.

Two main methods: internal rate of return (IRR) AND nett present value (NPV)

Both methods require a year-by-year cash flow be developed ie projected costs and income flows - year-by-year

Note that: depreciation/book value ignored

it is covered by the initial purchase outgoing cash flow, and estimated ‘disposal value’ giving an incoming cash flow at end of period

depreciation is not a cash flow itself, but an accrual or allocation of funds interest payments not included

(capital source is not part of the project.) Tables and tools are available for calculations of compound interest / discounting


Compound Interest and Discounts

Interest or Discount rate "k" 10.00% change this figure to vary the interest or discount rate for 'future money'

Year "n" of number of years to be considered

0 1 2 3 4 5 6 7

Compounded interest factor 1.0000 1.1000 1.2100 1.3310 1.4641 1.6105 1.7716 1.9487Compounded discount factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132

Applying these figures to an initial investment of

$1.00 change this figure to match the initial investment

Compound interest (what you get back at the end if

loaning money)

$1.00 $1.10 $1.21 $1.33 $1.46 $1.61 $1.77 $1.95

Compounded discount (NPV)(What would need to be invested

today to achieve a specified future amount in 'n' years)

$1.00 $0.91 $0.83 $0.75 $0.68 $0.62 $0.56 $0.51

This calculator shows the factors for •compounded interest (value increasing) and •compounded discounting (value decreasing)

•for one unit (say, $1.00) over several years, at an annual rate of 10%

See Tables 1 and 2 in handouts, and Compound Interest and Discounts.xls

tool


DCF Example (1) A piece of land is

bought for $4,500 (buying expenses of $218, interest rate of 10%) ,

kept for 3 years (annual costs $50) and sold for $10,500 at the beginning of the 4th year

(selling expenses are $500, therefore nett sales value is $10,000)

Cash Flow Table

DCF involves treating the later-year cash flows as though their value has declined by a certain proportion. (r%)

That is, future money is considered to be worth less than present money The figures for future years must be discounted according to Table 2 factors

Year 0 1 2 3 4

Raw Cash Flow

-$4,718 -$50 -$50 -$50 +$10,000


Nett Present Value (NPV) Discount each of the future cash flows by the cost of capital (k=10% per

annum) and add them up. Subtract the capital outlay to get the NPV. If the NPV is > 0, the project can be considered as profitable

if NPV = 0, the project is marginalif NPV is less than zero, the project is considered not worthwhile.

NOTE: Increasing the discount rate drives the NPV down Present values of each year’s cash flows in the land purchase and sale are:

The discounted values are calculated using the formula: discount (n,k) = 1/(1+k)**n Where n = number of years and k = discount rate

+$7513.15-$37.57-$41.32-$45.45-$4,718.00Value in current year terms

(using k=10%)

+$10,000.00-$50.00-$50.00-$50.00-$4,718.00Cash flow

4 (Beginning of year)3210Year


NPV (2)

Year 0 1 2 3 4 (beginning)

Cash flow -$4,718.00 -$50.00 -$50.00 -$50.00 +$10,000.00

Value in current year terms

(using k=10%)

-$4,718.00 -$45.45 -$41.32 -$37.57 +$7,513.15

Nett present value at each

year

0 -4718.00-45.45

=-$4763.45

-4763.45-41.32

=-$4804.77

-4804.77-37.57

= -$4842.34

-4842.34+7513.15

=+$2,670.81

The nett present value (in ‘this years’ money) is:


Relationship: NPV and Discount Rate

The relationship between the NPV and the discount rate ‘k’ can be seen below As the discount rate increases, the NPV value is reduced.

Discount Rate or Cost of Capital %8% 12% 16% 20%

$NPV

NPV Profile


Internal Rate of Return (IRR)

Also known as “Time-adjusted Rate of /return” If:

C is the initial capital outlay Ai is the cash flow in year i then the IRR is r in the following formula:

Another way to describe IRR is “The interest rate that would make NPV = Zero”,

thus it is the maximum rate that could be paid to obtain capital for this project.

n

i r

AiC

1i)1(


Relationship NPV and IRR

The relationship between the NPV and the IRR can be seen below The IRR can also be used to estimate the maximum rate of interest to

pay for funds.

Discount Rate or Cost of Capital %8% 12% 16% 20%

$NPV

NPV Profile

IRR


Another Example

Exhibit 19.2 in Horngren and Foster - "Cost Accounting - a Managerial Emphasis”

Initial Investment $3,791

Useful Life 5 Years, after which theequipment has no value

Annual Cash Savingfrom Operations

$1,000 Used to pay back the loan, andto gain profits

See spreadsheet Exhibit 19_2.xls for details

Rate0

initial outlay 1 2 3 4 5 NPV

8.000% 3,791.00-$ 925.93$ 857.34$ 793.83$ 735.03$ 680.58$ $201.71

9.00% 3,791.00-$ 917.43$ 841.68$ 772.18$ 708.43$ 649.93$ $98.65

10.00% 3,791.00-$ 909.09$ 826.45$ 751.31$ 683.01$ 620.92$ -$0.21

11.00% 3,791.00-$ 900.90$ 811.62$ 731.19$ 658.73$ 593.45$ -$95.10

12.00% 3,791.00-$ 892.86$ 797.19$ 711.78$ 635.52$ 567.43$ -$186.22

Year


NPV or IRR? Which is best? Basically, both based on the same issues, and can be

calculated for fixed or variable rates of discount or interest

NPV has advantages: results are expressed in terms of money ($),not ratios (%). Money

terms are more easily understood by people.

IRR has advantages: results are expressed in terms of percentages that immediately identify

the maximum rate of interest that could be paid for a loan to undertake the project.

And disadvantages IRR is not so meaningful when the interest rate is expected to vary

over the period - an average IRR can be calculated,but its relevance is questionable - whereas NPV is still expressed in terms of $$$


Choosing between Competing Projects Consider a simple example (assume k is 10%)

Summary of the table: Project A returns more value for the initial outlay (IRR=20%) Project B produces a greater nett return of money ($1091)

Which is the more financially rewarding project? Should we:

choose the highest NPV? choose the highest IRR?

Year 0 Year 1 IRR NPV

Project A -$10,000 +$12,000 20% $909

Project B -$15,000 +$17,700 18% $1,091


Why the conflict in signals? We need to look at the "differential cash flow"

(aka “incremental cash flow”) This evaluates the additional value (if any) of investment B over

investment A (Differential or Incremental Cash Flow) Subtract cash flows for A from cash flows for B,then calculate the IRR and

NPV based on the differential or incremental cash flows if IRRinc > k choose the larger project

If NPVinc > 0 choose the larger project

Year 0 Year 1 IRR NPV

Project A -$10,000 +$12,000 20% $909

Project B -$15,000 +$17,700 18% $1,091

B - A -$5,000 +$5,700 14% inc $182 inc

IRR inc and NPV inc both indicate Project B

Which do we choose?


Conflict in Signals (2)

For ranking mutually exclusive projects, do not rank on IRR. Instead choose the highest NPV.

(Only the incremental or differential IRR sends valid signals.) Need also to consider capital rationing.

Consider what happens to the NPV profiles of both projects as k increases

k 10% 14% 18% 20%

Project A $909 $526 $176 $0

Project B $1091 $526 $0 -$250

Mutually exclusive decisions are where a decision to go one way automatically prevents consideration of the other


Conflict in Signals (3)

You can also consider the differential IRR as a breakpoint From previous slides, we can see that

the differential IRR is 14% (about two slides back), and the NPVs are equal at $526 when k=14% (previous slide)

-500

0

500

1000

1500

10 12 14 16 18 20

Interest or discount rates

NP

V Project A

Project B

NPVs always cross at the differential IRR


Cash Flow Elements in DCF

Book value of: existing assets to be used for in project - ignore existing assets no longer needed - ignore or sell if significant

Residual value of assets at the end of the project - sell; include estimated value (maybe?)

Changes in working capital - include only if using accrual basis

Interest expenses on loans - ignore, or treat as interest Taxation - include in each period Inflation - ignore, or include on consistent basis Future depreciation - NO!


Depreciation & DCF

Arguments: Depreciation is not a real cash flow, so ignore it. but it affects tax, and therefore changes the real cash flow

Options: ignore tax totally, and use a pre-tax discount rate include all tax effects,

including the tax deductions associated with depreciation


Payback Period (PP) An old approach, largely superseded today by DCF approaches.

Measures the time until the initial investment is recovered by ‘profits’. For screening projects: PP < target (e.g. 4 years) For ranking projects: choose lowest PP.

Problems with the PP method 1. PP ignores the time value of money eg

0 1 2 3 4 PP IRRProject A -300 50 100 150 400 3 30.9%

Project B -300 150 100 50 400 3 36.2% PP cannot distinguish between Projects A and B in 1.above.

2. PP ignores cash flows after the payback has been reached eg0 1 2 3 4 5 PP

IRR.

Project A -50 30 20 10 5 5 27.83%

Project B -50 10 20 20 50 100 386.89%

PP ranks Project A better than Project B in 2. above


PP Problems

Projects with long incubation times (eg lengthy construction times) are unlikely to be favourably considered, despite having massive advantages after the Payback Period ends

An arbitrary cutoff of project benefits occurs when comparing projects.

This can lead to unscrupulous project proposers deliberately distorting the picture by inflating close in profits and ignoring profits beyond the PP

Summary: The main problem with PP is that the following two concepts are

ignored: time-value of money within the payback period, and operating profit beyond the payback period

Problems expressed in DCF terms: k = 0 before the PP AND k = infinity after the PP


Common Arguments for PP Method

Common arguments for PP methods are: “good in times of uncertainty”

(because it is better to get your money back ASAP) “good for capital rationing”

(because it ‘recycles’ capital more quickly) “PP is easier to calculate than DCF methods at any time, and

particularly in times of change”

None of these arguments are really valid. PP still persists for reasons of tradition more than science. Decisions should be based on considering best information available,

not on short term difficulty of working out the figures


Example of Project Ranking You are considering two types of communications controller for a

project: Supplier A:

Large switch with plenty of shelf-space. Would need extra shelves in 3 years. Approx. $500/yr of extra cards needed.

Supplier B: Smaller initial unit, and stackable modules approx. $2,000/yr.

The purchase schedule would be: 0 1 2 3 4 5

Supplier A $10,000 $ 500 $ 500 $ 2,000 $ 500 $ 500Supplier B $ 6,500 $ 2,000 $ 2,000 $ 2,000 $ 2,000 $ 2,000

The maintenance costs each year are 10% of the purchase cost of the equipment in operation at that start of that year. Thus the year 5 maintenance for A is $1,350 and B is $1,450.

1. Assuming the company's cost-of-capital is 8%, which supplier's equipment has the lower discounted purchase and maintenance cost?

2. Your new finance director has just announced that investment funds are tight, and a discount rate of 20% is to be used for all project ranking decisions. Does this change things?

3. What would you do in this situation?


Project Ranking Example (2)

Years>>> 0 1 2 3 4 5 Equipment A 10,000 500 500 2,000 500 500Maintenance A - 1000 1050 1100 1300 1350Total A 10,000 1,500 1,550 3,100 1,800 1,850

Equipment B 6,500 2,000 2,000 2,000 2,000 2,000Maintenance B - 650 850 1,050 1,250 1,450Total B 6,500 2,650 2,850 3,050 3,250 3,450

Rate >>> 8% 15% 20% NPV for Supplier A: $17,761 $16,464 $ 15,732 NPV for Supplier B: $18,555 $16,538 $ 15,406

Answers:Question 1: Lower NPV at 8% rate is Supplier A by $794 over 5 years

Question 2. Lower NPV at 20% rate is Supplier B by $326 over 5 years – thus rate is significant

Question 3: Results are very close at 20% and five years. You should discuss anticipated future rates with the finance director. If these are likely to increase significantly, then propose B because the increasing rate favours it over A. However, if likely to decrease or remain stable then propose A.


Lease or Buy? Leasing of equipment is a source of finance

a finance organisation buys the equipment and leases it in return for regular payments over the entire lease period.

Two main variations: finance leases

(‘common property’ lease where ownership passes to the lessee) and

operating leases (ownership does not pass to lessee at end of lease).

Why lease? Form of finance (is it cheaper than alternatives?) Protection against obsolescence(?)

only if can the lease be cancelled or replaced part way through Tax deductions for entire lease payments

(but note that depreciation of equipment and the interest on a normal loan are deductible)


Leasing (2) Matters to question:

Who handles the ‘residual value’ at end of a lease, and how is it handled?.

Is maintenance included in lease payments? Consumables generally not included eg paper, electricity etc But is a replacement laser drum a ‘wear and tear’ maintenance item or a

consumable - (and many other short-life components) Fire, theft, accidental damage insurance?

Deliberate damage usually addressed separately How do you handle obsolescence of equipment during lease period? Who is funding the lease - and their financial stability?

They have ownership, and if liquidated you may suddenly lose the use of the equipment

Problem - as you do not own the leased equipment, you can neither sell nor substantially modify it without permission. In fact, can you modify it at all?

Generally must return it in original condition, apart from ‘fair wear and tear’ aspects

DCF of lease will typically use an "implicit interest rate".


Telecommunications Investment Evaluation

This material is loosely based information from Telstra about its investment decision-making methods in the 1990s.

Distributed hierarchical approval system for projects from $2M to $50M ie applicable to middle range projects

Smaller Projects had a simpler system Larger Projects (over $50M) needed Board approval.

Basis was that Projects must: Conform to company strategy Be financially sound Meet investment evaluation criteria


Capital Expenditure Effectiveness & Efficiency

Investment Decisions

Strategic Planning

Planning & Programming

Implementation Monitoring

Re-alignmentof Objectives


Investment Evaluation DCF is used extensively

Discount rate based on weighted effective cost of capital. Related to:

cost of borrowing; expected return to shareholders

Investment period based on: asset life and foreseeable cash flows

NPV is calculated on both "hard" and "soft" cash flows

High discount rates to allow for "capital rationing" is no longer used, as it tended towards short-term projects.

Project selection weighted towards strategic directions


Investment Programming

Increasing Risk

New Revenue Opportunities

ModernisationProductivity

Service Quality

Growth in Established

Products

SupportInfrastructure

Eg Replacing existingexchanges & lines

Eg BuildingsVehiclesComputers

Eg Adding extraexchanges & lines

Eg Rollout of new servicesmobiles phones, cable TV


Project Criteria

Initial selection of projects biased toward:

customer service market priorities/market share retention competitive edge

Ongoing review criteria:

Projects deviating by more than 10% from approved budget need re-approval.

Projects lagging behind their planned progress by more than a set figure need re-approval


Telstra Gating Process

Telstra has a set of six ‘gates’ to evaluate and review medium size projects:

during planning during development and testing, and after initial operations (say, one year)

‘Gates’ are a formal review by a ‘Gating Committee’

Gating Committees provide forums for evaluation and review of products, services, IT systems and infrastructure projects. Membership of committees is from the senior managers of the major

stake-holders in projects (Stakeholders include user groups, maintainers etc).


For Systems Investment Gates for ‘Products & Services’ Projects

Gate 0: checks viability prior to Business Case Gate 1: examines Business Case Gate 2: technical, operational & support requirements prior to field trial Gate 3: assesses results of field trials Gate 4: assesses project launch & sets up post-implementation review Gate 5: assesses ongoing life cycle

Gates for IT projects over $0.5M over 3 years. Gate 0: business concept, business drivers and deliverablesGate 1: Business Case Gate 2: technical design, analysis & planning Gate 3: pre-deployment review Gate 4: deployment plan, and post-implementation reviewGate 5: reviews necessity and decommissioning option

Similar approaches used for Network Infrastructure and other major projects


Summary

Investment Decision Techniques are widely used to determine which (if any) projects go ahead.

Management must ensure that funds and other resources are expended to best advantage of organisation

Main financial methods used for screening and ranking of projects are:

Nett Present Value (NPV) - a discounted cash flow (DCF) approach Internal Rate of Return (IRR)- DCF applied differently Payback Period - older approach, falling from favour Lease or buy comparisons

Other aspects considered are risk and philosophies Once started, projects should have regular Evaluation

and Review stages, such as the Telstra Gating procedures

© 2005, Monash University, Australia CSE5806 Telecommunications Management Lecturer: Dr Carlo Kopp,...

Documents

Transcript of © 2005, Monash University, Australia CSE5806 Telecommunications Management Lecturer: Dr Carlo Kopp,...