Presentation - Session 13

7/27/2019 Presentation - Session 13

http://slidepdf.com/reader/full/presentation-session-13 1/46

Investment AppraisalPart I



© Copyright Coleago 2010

Learning Objectives

Objectives Understand the objectives of investment appraisaland process of decision making

Techniques Identify popular investment appraisal techniques and

understand the basis of each approach

Cash Flow Identify which revenues, costs and capital

expenditure to include in appraisal techniques

Pay Back Learn how to calculate Pay Back and apply it to a

worked example

Break Even Learn how to calculate the Break Even Point and

apply it to a worked example

1




Learning Objectives

Objectives Understand the objectives of investment appraisaland process of decision making






worked example



2



Objectives of investment appraisal

Investment appraisal techniques are designed to help managers make moreappropriate business decisions

Projects may involve heavy levels of cash expenditure which are difficult toreverse once initiated and so making the right choices is vital for creating or avoiding destroying shareholder value

Investment appraisal techniques are only one element of the decision makingprocess and are complimentary to qualitative assessment techniques

A number of investment appraisal techniques should be used and the resultslooked at as a whole and in conjunction with overall business strategy andgoals and the results of qualitative analysis

© Copyright Coleago 2010 3



Generic steps in the decision making process

Preparationof DetailedBusiness

Case

Idea Generationand Initial

Feasibility Study

BusinessCase Review

and

Decision

Implemen-tation and

Review




Excel based templates

Many companies have pre-built Excel spreadsheet models to support theinvestment appraisal process

Those responsible for investment appraisal should ensure they are familiar withthe workings of any spreadsheets developed within the organisation

This course focuses on the theory behind the spreadsheets rather than themodelling techniques necessary to create the spreadsheets



http://slidepdf.com/reader/full/presentation-session-13 7/46© Copyright Coleago 2010

Learning Objectives

Objectives

Understand the objectives of investment appraisaland process of decision making






worked example



6



Research has shown that businesses typically use 3 techniques inpractice for assessing investment decisions

Payback Period

– How long does the project take to recoup the initial outlay

Net Present Value (NPV)

–

The application of Discounted Cash Flow (DCF) and answers the question, if wewere to spend all the monies and receive all the benefits today, what would it beworth

Internal Rate of Return (IRR)

– A concept closely related to the NPV which gives the discount rate which if applied in DCF would give a NPV of zero





Learning Objectives

Objectives

Understand the objectives of investment appraisaland process of decision making






worked example



8



Basic concepts

It’s all about CASH

Investors buy a share in a company and companies invest in projects withCASH

Investors and companies are only interested in future returns measured inCASH

It must be INCREMENTAL

Only cash flows resulting directly from an investment decision are relevant for anassessment of that decision

Investment appraisal is concerned only with incremental cash flows




Use the best estimate

When preparing a financial forecast for use in an investment appraisaltechnique the forecast should be the BEST ESTIMATE of what the anticipatedfuture cash flows are expected to be

The investment appraisal techniques penalise the project cash flows for risk

– where risk is the risk that the cash flows are higher or lower than the

anticipated cash flows

If a business manager reduces his estimates of the cash flows because hethinks they are risky, when the investment appraisal techniques are applied therisk will be DOUBLE COUNTED

Cash flows should represent the best estimate, expected or most likely

outcome from the project




The cash flow that we appraise is Free Cash Flow and so a forecast mustinclude all the elements that impact Free Cash Flow

Total Revenue

Gross Profit

Operating Profit or EBITDA

Free CashFlow

Cost of Sales

Cost of Sales

OperationalExpenditure

Cost of Sales

OperationalExpenditure

CapexCashTaxes

Tax is ignored in the case of investment appraisalfor a project within an existing company.




Relevant revenues – future revenues

The general principle is that only those incremental cash flows that would occur as a direct result of the proposed project should be included in its financialappraisal

– Only incremental revenues generated as a direct result of the businessdecision should be included

By definition, any cash flows that are already being generated or that areanticipated to arise as a result of earlier decisions, should not be included withinthe financial appraisal of the project

– Existing or anticipated revenue streams resulting from earlier decisions

should not be included




Relevant revenues must take into account the potential cannibalisation of existing revenue streams

Year 1 Year 2 Year 3 Year 4 Year 5

SMS Revenue 100 110 120 130 140

Revenue Stream without the launch of MMS


SMS Revenue 100 90 80 70 60

MMS Revenue 10 40 60 120 180

Total Revenue 110 130 140 190 240

Revenue Stream with the launch of MMS


Incremental 10 20 20 60 100

Incremental Revenue Stream from launching MMS (included in investment Appraisal)




The implications of doing nothing

A project involves investing in customers with additional upgrades to protecttheir existing revenue stream

– If the investment is not made the customers will churn and the revenuestream will be lost

– If the investment is made revenues will remain at their current levels

Although there are no “incremental” revenues the relevant revenues to be

considered for the project are the potentially lost revenues in the “do nothing”

case




Relevant cash outflows include capital investment as well as any initialoperating losses that require funding – “costs”

The combination of operating losses and capital expenditure provides the totallevel of investment

The investment consists of $19,000 in 2011 and $7,880 in 2012

2011 2012 2013 2014 2015 2016 2017Revenue 12,000 24,000 30,000 40,000 55,000 75,000

Gross Profit 8,400 17,280 22,200 30,400 42,900 60,000

Operating Costs (14,000) (14,280) (14,566) (14,857) (15,154) (15,457) (15,766)

EBITDA (14,000) (5,880) 2,714 7,343 15,246 27,443 44,234

Capital Expenditure (5,000) (2,000) (500) (250) (250) (250) (250)Free Cash Flow (19,000) (7,880) 2,214 7,093 14,996 27,193 43,984




A project may be undertaken as it will lead to future cost savings


Staff Costs 230 240 250 260 270

Cash costs without the project

Year 1 Year 2 Year 3 Year 4 Year 5Staff Costs 180 190 200 210 220

Cash costs with the project

Year 1 Year 2 Year 3 Year 4 Year 5Cash saving 50 50 50 50 50

Cash saved




Relevant costs are cash costs

Relevant costs must result in an incremental cash outflow for the business

Consider the following

– A business rents a building on which it pays rent at $10k per year, and hasdone so for many years

– Within the building is an empty room for which there is no alternative use

– A project is being considered which would involve using the room

Assessing the project

– If the project did not go ahead, what would be the rent?

– If the project did go ahead, what would be the rent?

– What is the incremental rental cash outflow for the project?




Relevant costs are cash costs - continued

MobileCo has built a mobile network

– Rent, power and maintenance charges are incurred and paid in cash each year at $450 milion

– There is unutilised capacity on the network between 2:00am and 4:00am

A project to provide the secure transfer of data for business users between 2:00am

and 4:00am is considered

– If the project were not to go ahead, what are the rent, power and maintenancecharges?

– If the project were to go ahead, what are the rent, power and maintenancecharges?

– What are the incremental rent, power and maintenance cash outflows to beincluded in the appraisal of the project?




Relevant costs are cash costs - continued

MobileCo has built a mobile network

– MobileCo has spent many millions in previous years to construct the network andmakes a depreciation charge for network assets of $500 million per year

– There is unutilised capacity on the network between 2:00am and 4:00am

A project to provide the secure transfer of data for business users between 2:00am

and 4:00am is considered

– If the project were not to go ahead, what would be the change in network capexand depreciation?

– If the project were to go ahead, what would be the change in network capex anddepreciation?

– Should depreciation be included in the assessment of the project?

– If the project resulted in incremental capex, should depreciation now be included?




Relevant costs should include opportunity costs

A company owns a building which is currently unutilised, the company could sell thebuilding for $1 million

A project is being considered which would utilise the building


Sale proceeds $1 m

Cash flow in relation to the building without the project


Sale proceeds

Cash flow in relation to the building with the project


Opportunity cost $1 m

Cash flows to be included in the financial appraisal of the project




Relevant costs do not include “sunk” costs

MobileCo conducts a market research exercise costing $30,000 to examinewhether customers want to be able to send cartoons via their mobile phones

– The results are positive

MobileCo prepares a business case for mobile cartoons examining futurerevenues and costs

– If the project were to proceed the market research spend has already takenplace

– If the project were not to go ahead, the market research spend has still beenspent

The market research spend is an example of a sunk cost




Relevant costs do not include financing

Financing costs are costs such as the interest paid on monies borrowed to financethe project

Financing costs are not relevant costs and should not be included in the cashflows of the project

The costs of finance are automatically considered in investment appraisal

techniques such as Discounted Cash Flow analysis




Summary of relevant revenues and costs

Revenues and Costs Include ?

Incremental revenue Yes

Incremental cash costs Yes

Incremental cash savings Yes

Opportunity costs Yes

Sunk or historic costs No

Depreciation No

Allocated overheads No

Financing No




Timing of cash flows in investment appraisal techniques

$

2011 20132012 20142010

It is common to assumethat cash flows take

place at the end of eachyear in one lump

An alternative assumption is that cash flows take place at

the mid-point of each year, i.e. they occur evenly throughoutthe year and so the average timing point is the mid-point

A very prudent view is thatcosts take place at the startof the year and revenuesare received at the end





Learning Objectives

Objectives Understand the objectives of investment appraisal

and process of decision making



Cash Flow Identify which revenues, costs and capitalexpenditure to include in appraisal techniques


worked example



25

P B k



Pay Back

Pay back is the most widely used of all investment appraisal methods

Pay Back is defined as the length of time for the initial investment to be repaidout of the net cash inflows from the project

The Pay Back rationale is that projects that recoup their costs quicker are moreattractive as they are deemed to be

– Less risky

– More cash generative

In some markets, where capital is in short supply, pay back is popular as itfocuses on financing issues


P B k th f h fl J C



Pay Back – the free cash flow J-Curve

This chart shows the free cash flow for aproject or new business on a year by

year basis (blue bars) and the cumulativefree cash flow (orange line).

The cumulative free cash flow is the cashflow for each year added year after year.The cumulative free cash flow line hasthe shape of the letter J and hence isreferred to as the J-curve.

Payback is the length of time required for the project to reach a free cash flowbreak even point, i.e. the point in timewhere initial cash outflows equals the

sum of subsequent cash inflows Payback occurs in year 5

-400

-300

-200

-100

0

100

200

300

400

500

600700

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

U S $ ' 0 0 0 0

Free Cash Flow

During Year Cumulative Peak funding is the maximumcumilative cash outflow


P B k St th



Pay Back - Strengths

Pay Back is quick and easy to calculate

It is easily understood by managers

Pay Back explicitly handles the timing of cash flows

Pay Back implicitly deals with risk to some extent as later cash flows areeffectively regarded as more risky

A forecast for the entire lifetime of the project is not required

If capital is rationed then a shorter payback period is good as capital can berecycled quicker


Pay back Weaknesses



Pay back - Weaknesses

Pay Back ignores the cash flows received after the payback period

It says nothing about the size of a project

Pay Back provides an ambiguous result if cash flows follow the pattern of outflows, inflows, outflows

The risks associated with cash flows are not examined in a rigorous manner


Introduction to the MobileCo worked example



Introduction to the MobileCo worked example

MobileCo has decided to launch a new data based service that resembles MultiMedia Messaging and MSN’s Chat service

We will review the financial forecasts together

– Summary profit and loss to the EBITDA level

– Capital expenditure forecasts


MobileCo Investment Appraisal Exercise



MobileCo Investment Appraisal - Exercise

Calculate Pay Back for the MobileCo project

Calculate free cash flow for each individual year

– EBITDA less Capital Expenditure

Calculate cumulative free cash flow for each year

Assume cash flows take place at the end of the year

Plot the J-Curve on the axes provided

Identify the peak funding requirement

Identify the year of Pay Back

For those wanting a challenge, the number of months for Pay Back to twodecimal places


MobileCo Investment Appraisal - Workings Page



MobileCo Investment Appraisal - Workings Page

$

2011 20132012 2014


MobileCo Investment Appraisal - Your Answers



MobileCo Investment Appraisal - Your Answers

Peak funding requirement

Year (and approximate month) of pay back

Number of months to payback


Financial investment appraisal hurdle rates



Financial investment appraisal hurdle rates

Hurdle rates or benchmarks define the level of financial performance required

for a project to be accepted

Some companies set strict hurdle rates for projects

Participants are advised to seek local guidance from their finance support teamsas to acceptable levels of financial performance




Investment appraisal levers – develop as credible a set of assumptions aspossible that would provide payback in 24 months



possible that would provide payback in 24 months


Learning Objectives




g j

Objectives

Understand the objectives of investment appraisal

and process of decision making



Cash Flow Identify which revenues, costs and capitalexpenditure to include in appraisal techniques


worked example



37

Break Even Analysis



y

Break Even Analysis often forms part of Investment Appraisal Analysis but does

not represent a decision rule for projects

Break Even analysis provides additional useful analysis to supplement Pay Backor NPV calculations

Break Even Analysis traditionally focuses on identifying how much of a product

or service needs to be sold for a project to neither make a profit nor a loss

The Break Even Point, the point at which a project is neither making a Profit or aLoss, can be expressed in terms of the volume of goods sold or the revenuesgenerated


Break Even Analysis – Profit / Volume Chart



-1,000

-500

-

500

1,000

1,500

2,000

0 1 2 3 4 5 6 7 8 9 10

$ ' 0

0 0

Volume '000

Break Even Chart

Operating Costs Operating Profit Gross Profit

Break even volumeat is at 4,000 units


Margin of Safety



-1,000

-500

-

500

1,000

1,500

2,000

0 1 2 3 4 5 6 7 8 9 10

$ ' 0

0 0

Volume '000

Break Even Chart

Operating Costs Operating Profit Gross Profit

Break even volume

Budgeted volume

Margin of safety


Break Even Analysis - Strengths



Useful for managers examining sales prices, volumes and profitability

The break even point is a useful reference when assessing the validity of salesprojections

Provides an insight into the relationship between fixed costs, variable costs andthe volume of activity

Break even charts are powerful communication tools

Useful for sensitivity analysis

– Changing one variable at a time to determine which the decision is mostsensitive to


Break Even Analysis - Weaknesses



Break even analysis can only relate to one product or a fixed mix of products

Assumes fixed costs do not alter for changes in volumes and variable costs arethe same for all volumes

– an over simplification

Fixed costs tend to relate to more than one product

Sales prices are assumed constant at all volume levels

– may have to reduce price to achieve higher volumes

Assumes costs accurately forecast and that all relationships are linear


Break Even Analysis



Break Even can be couched in many ways

– For example, the level of adoption required for a particular service to breakeven

Break Even can also be couched in terms of other financial measures

– such as the Operating Cash Flow break even point

Break Even analysis often requires the use of financial models to solve thesemore involved types of problem


What level of MMS adoption would give break-even FCF in 2003?



Session Summary

Presentation - Session 13

Documents

Transcript of Presentation - Session 13