New Investment and Project Appraisal
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Transcript of New Investment and Project Appraisal
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INVESTMENTAND PROJECT
APPRAISALPrepared by: Kha Pham1
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CHAPTEROBJECTIVES
The methods of project appraisal: accounting rateof return, payback and discounted cash flow
The concepts of time preference, the opportunitycost of finance and the cost of capital
Relevant cash flows
Net present value and internal rate of returnmethods
The implications of taxation and inflation indiscounted cash flow
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I. STEPSINPROJECTAPPRAISALDecision making and control cycle:
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GROUP DISCUSSION
Imagine you were Starbucks top managers. Thecorporation planned to open the second Starbuckstore in Vietnam, following their successful operationof the first one in Ho Chi Minh City.
Appraise the potentials of this project in Hanoi andDanang City and make your conclusion!
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METHODSOFPROJECTAPPRAISAL
1. The accounting rate of return: calculates theaccounting profit (rather than cash flow) that willbe earned by a project and expresses this as apercentage of the capital invested in the project
2. Payback period: Calculates the length of time aproject will take to recoup the initial investment,based on cash flows
3. Discounted cash flow (DCF):
i. Net present value method (NPV)
ii. Internal rate of return (IRR)5
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NON-FINANCIALFACTORS
Legal
Ethical
Changes to regulations
Political Quality implication
Personnel
Coherence
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II. ACCOUNTINGRATEOFRETURN
=
100
Estimated average profits = Average annual cash flows
Estimated average investment = +
2
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ARR EXAMPLE
ABC Limited is now choosing between twoalternatives of machine for the upcoming project:
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Machine A Machine B
Cost $15,000 $15,000Estimated Scrap value $3,000 $4,000
Estimated life 3 years 3 years
Estimated future cash flows
Year 1 $4,000 $5,000
Year 2 $7,000 $7,000
Year 3 $7,000 $3,500
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A ($) B ($)Total Cash flows 18,000 15,500Total depreciation 12,000 11,000Total profit after depreciation 6,000 4,500Average profit (3 years) 2,000 1,500Value of investment initially 15,000 15,000Eventual residual value 3,000 4,000
18,000 19,000Average value of investment (/2) 9,000 9,500
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ARR for:A22%B16%Machine A is preferred!
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III. PAYBACKPERIOD
Gives greater weight to cash flows generated inearlier years
The length of time required before the total cashinflows are equal to the original cash outlay
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Machine P Machine Q
Cost $10,000 $10,000
Estimated future cash flows
Year 1 $3,000 $5,000
Year 2 $4,000 $7,000
Year 3 $4,000 $3,500
Year 4 $2,000 $2,000
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IV. TIMEVALUEOFMONEY
The value of money (purchasing power) today isdifferent from the value of money in the future!
For example, a $1,000 saving in a bank gives you$1,100 in one year
The interest rate is 10%
The two amounts have the same purchasing power tothe owner who expects the 10% interest!
In other words, $1,100 is the future value of $1,000 inone year!
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V. DISCOUNTINGANDCOMPOUNDINTEREST
Simple interest: = (1 )
Compound interest: = (1 )
Discounting: Compounding in reverse
=
( 1 )
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VI. DISCOUNTEDCASHFLOW
A technique of evaluating capital investmentprojects, using discounting arithmetic to determinewhether or not they will provide a satisfactory return
Ignore Depreciation
Only deal with Cash!
Can be used in two ways
Net Present Value (NPV)
Internal Rate of Return (IRR)
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NETPRESENTVALUE(NPV)
The sum of all present value of cash flows (bothoutflow/ initial outlay and inflow) over the period ofthe project
If NPV > 0: PV of benefits > PV of cost so theproject earns higher return than the cost of capitalshould be accepted!
If NPV < 0: PV of benefits < PV of cost so theproject earns lower return than the cost of capitalshould be rejected!
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NPV EXAMPLE
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Project A
Outlay cost $15,000
Estimated future cash flowsYear 1 $4,000
Year 2 $7,000
Year 3 $7,000
Discount rate/ Cost of capital/Required rate of return
10%
Evaluate the following project
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Year Cash
flow
Present value
factor
Present value
$ 10% $
0 (15,000) 1.000 (15,000)
1 4,000 0.909 3,636
2 7000 0.826 5782
3 7000 0.751 5257
NPV (325)
16NPV < 0: Reject the project!
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DISCOUNTEDPAYBACKPERIOD
Reflect the time value of money!
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Year Cash flow Presentvalue
CumulativePV
$ $ $
0 (15,000) (15,000) (15,000)
1 4,000 3,636 (11,364)
2 7,000 5,782 (5,582)3 7,000 5,257 (325)
4 6,000 4,098 3,773
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DISCOUNTEDPAYBACKPERIOD
Discounted payback period = 3 yrs + 325/4,098
= 3.079 years
This compares with a non-discounted payback period,instead of occurring near the end of year 3, thediscounted payback period suggests that the initialoutlay can only be recouped at the beginning of year 4
If the project stops at year 3, it will not add value to thecompany!
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COSTOFCAPITAL
The appropriate discount rate to use in investmentappraisal is the companys cost of capital difficultto determine
Both shareholders and debt holders expect somesort of returns cost of financing to the company
Cost of capital = Weighted average cost of all thesources of capital that a company uses
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ANNUITIES
In DCF, annuities are an annual cash payment/receipt that is the same amount every year for anumber of year
Instead of using the normal DCF calculation, thereis a short-cut formula for annuities
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INTERNALRATEOFRETURN(IRR)
IRR is the rate of return at which NPV = 0 (or thetotal cash inflows are equal to the total cashoutflow)
There are two steps involved in IRR calculation
Calculating IRR expected from a project
Comparing IRR with cost of capital
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VIII. TAXATIONANDPROJECTAPPRAISAL
The incremental tax cash flows should be includedin the cash flows of the project for discounting toarrive at the projects NPV
When taxation is ignored in the DCF calculation,the discount rate is pre-tax rate of return
When taxation is included in the cash flows, a post-tax rate is required!
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