CAP1 Finance Session 2 Slides

8/10/2019 CAP1 Finance Session 2 Slides

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CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland

Session 2

Capital Investment Appraisal(An Introduction)


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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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Mapping

This lecture maps specifically to 2.1 on the Competency Statement

FunctionalCompetencies

BusinessCompetencies

Core ProfessionalValues & Skills

Explain and demonstrate

the ability to use thepayback, discountedpayback, accounting rate ofreturn, net present valueand internal rate of returntechniques.

Be able to appraise a

variety of different projectsfor communication tomanagement.

The need to be objective

when evaluating differingprojects.

Recommend and justify acourse of action, includingconsideration of non-financial factors.

Evaluate and communicatean appropriate course ofaction given the entitysunique characteristics andthe environment


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CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 5

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 projects outcome should increase equity holder value.

Decision makers - view the big picture, which may involve rejectingprojects that have short-term returns in favour of projects with higheroverall 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 aconsequence of a project being undertaken.

Opportunity cash flows are cash flows forgone from other

investments, or actions that have been changed, as a result ofthe 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 ofprofitability /1m each year for 5 years is the same as /5 millionat the end of year 5.

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


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Financing

BRIEF POINTS Matching principle match the life of the project with the

life of the finance Self-liquidating try to ensure that the finance selected

has liquidity commitments that can be serviced from theproject itself Cash synchronisation match the timing of the cash flows

resulting from the investment with the timing of therepayments on the source of finance.

Cost of finance take into account the companys currentcost of capital

Note: This to pic i s c overed in de ta il later in the co urs e


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Project appraisal - techniques

Accounting Rate of Return (ARR)Payback periodDiscounted payback periodInternal rate of return (IRR)Net present value (NPV)


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Accounting Rate of Return


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ARR

The accounting rate of return estimates the rate of accountingprofit 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 thewhole period (after depreciation) divided by the life of theinvestment in years; and

The average capital invested is the initial capital cost plus theexpected 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

Cashflows / / /Year 1 160,000 120,000 238,000Year 2 60,000 120,000 2,000Year 3 120,000 40,000 35,000Year 4 140,000Year 5 20,000Year 6 10,000

REQUIREDGiven 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 theasset 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 soldafter three years for /60,000 and after six years for /30,000.


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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 morecash 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 thespeed at which the initial cash outflow is paid back bysubsequent cash inflows.

This method focuses on cash flows not profits, thereforedepreciation and accrual accounting is ignored.

This method calculates the number of years it takes forcumulative 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 ARRs.


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Payback method - disadvantages

Disadvantages include: 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 size of a project (risk)

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 thepayback period method, as it takes the timevalue of money into consideration.

This method ranks investments according to thespeed at which the cumulative discountedcash flows (DCF) of an investment cover theinitial 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 SalerBefore depreciation / / /Year 1 160,000 120,000 238,000Year 2 60,000 120,000 1,000

Year 3 120,000 40,000 36,000Year 4 140,000Year 5 20,000Year 6 10,000

REQUIRED

Which of the above projects should Cow Ltd. invest in. Cow Ltd. has toborrow funds at 10%. Management decide that this is an appropriatediscount rate to use and it is company policy to use the discounted paybackperiod method for capital investment appraisal.


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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 ARRs Takes the time value of money into consideration.


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Discounted payback method - disadvantages

Disadvantages include: It ignores the profitability of a project (risk) It ignores cash flows received after the

payback period It ignores the size of a project (risk) 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 cashinflows and outflows of an investment, to their presentvalue.

Use of the correct discount rate is very important.

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

If the NPV is negative then a project should be rejected asacceptance will damage equity holder value.


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NPV method example

Cow Ltd. is considering three projects (each costing /240,000).The following cash flows are predicted:Yearly profits Friesian Aberdeen SalerBefore depreciation / / /Year 1 60,000 120,000 238,000Year 2 60,000 120,000 1,000

Year 3 100,000 40,000 36,000Year 4 130,000 3,000Year 5 20,000Year 6 10,000

REQUIREDCalculate each project's NPV and rank the resulting information forreporting to management. The company has a WACC of 16% and allthe projects being considered are of similar risk to the current operatingactivities 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

Disadvantages include: Time consuming calculations (though can be

compiled by a computer).

It does not provide a method of decidingwhich investment provides the best value formoney.

It considers the absolute amount of moneyavailable over a projects 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 yieldmethod also involves discounting future cash flows to theirpresent 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 ofthe 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 ifthe 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 findthe net present value

Step 3: Use interpolation to find the rate at which the NPV ofthe 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).The following cash flows are predicted:Yearly profits FriesianBefore depreciation /Year 1 160,000Year 2 60,000Year 3 120,000Year 4 40,000Year 5 30,000

REQUIREDCalculate the IRR of the above named project using interpolation .


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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

Disadvantages include: 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 usedas screening device the remaining projects are usuallyassessed using either the ARR or the IRR.

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

Academics consider the NPV to be the most appropriate methodRecent research has shown that use of DCF techniques is

increasing particularly in large entities with a preference for theuse 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 consideredbefore 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 Financing

Several methods ARR Payback Discounted payback Net present value IRR

In most instances all are used with qualitative informationto inform the decision.

CAP1 Finance Session 2 Slides

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