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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)

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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

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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

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Context and Control

Strategic planning Long term objectives

Management control Use of annual or longer plan cycles Capital budgeting techniques to plan

best allocation and use of current resources to achieve aims

Operational control Short term routines

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Appraisal techniques Payback Period

Time taken for original cost to be recovered in cash flows

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

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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

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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 £100

– Year 2 £200 £300– Year 3 £100 £400– Year 4 £100 £500– Year 5 £220 £720

Payback 3.5 years

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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

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Judging Payback

Reasonable to assume that stakeholders prefer shorter pay back periods

But also need to consider post payback cash flows. How profitable will they be?

Does not consider profitability of the project as a whole

Pay back is unlike traditional accounting of profit and capital employed

Very simple to use But ignores opportunity cost of amount of

money initially may vary with that received between years

And does not consider time value of money

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Accounting Rate of Return ARR

Profits from the project are compared with the investment

Future profit flow considered, also depreciation

Compares average profit per annum, before interest and taxation with original cost

Variants use profit after interest and taxation and other measures

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

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ARR Original investment £450, Life of asset 5 years Assume no residual value and straight-line

depreciation charge of £90 (no residual value)Net cash in depreciationprofit

– Year 1 £100 £90 £ 10– Year 2 £200 £90 £110– Year 3 £100 £90 £ 10– Year 4 £100 £90 £ 10– Year 5 £220 £90 £130

Average profit £54 per annum ARR as annual average profit flow/original cost = 12%

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Future value of money

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

An = P(1 + i)n

An = future amount invested in year nP = amount invested now, at time n = 0i = interest raten = number of years money is invested

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Rearranging for Investment Appraisal

Future forecast cash flows need to be calculated in terms of today’s value. This is the opposite of compounding, known as discounting, seen by rearranging the compound interest formula

P = An / (1 + i)n

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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

If NPV negative, project should be rejected

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NPV calculation ExampleBack to our example of a £450 IS investmentPayback 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

NPV = £536.2 - £450 = £86.2

The project gives 10% return, plus a surplus of £86.2 Go ahead

Try this for 20% opportunity cost

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Internal Rate of Return

Known as discounted cash flow (DCF) yield

IRR is another rearrangement of the equation

It is the interest rate that gives NPV = 0 when applied to the projected cash flow

Our IS example, where r = IRR:0 = -P +100/(1+r)+200/(1+r)2 +100/(1+r)3

+100/(1+r)4 +220/(1+r)5

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IRR

Find the discount rate which produces an NPV of zero

Do this by interpolation, graphing known values of NPV, trial and error or using 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

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Investigation

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

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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

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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

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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

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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 Improving the quality of future investment

decisions Assist corrective action for current projects

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Further Reading

Dyson Chapter 19