The BSC is a balance between:
Capital Investment Appraisal
Investment Appraisal
What is investment appraisal?
The appraisal techniques
The complications
Summary and Review
What is investment appraisal?
Cash out now in return for cash in later
Includes capital expenditure:
Acquisition of a company
Purchase of an asset
Investment in systems
Expansion of working capital
Also may include revenue expenditure:
Branding
R&D
Systems development
Training
The importance of investment appraisal
Capital projects may be:
large and long-term
essential to business strategy
determinants of future success
Need an effective appraisal process for:
Generation of ideas
Solving problems and taking opportunities
Identifying the options/alternatives
Gathering information
Analysis and evaluation
Presentation
Audit
Should it be left to the accountants?
The managers input is critical!
The Investment Appraisal Model
Equity Finance
Secondary Investment in Projects
Debt Finance
Equity Finance
Primary Investment in the Company
Funds
Funds
Funds
Returns
Returns
Returns
WACC
RRR
Interest
Investment Appraisal
The Techniques:
Accounting Rate of Return
Payback
Net Present Value
Internal Rate of return
Cash Flows?
Profit or
PaybackNet Present ValueInternal Rate of return
Consider Two Projects:
Both projects require investment new plant with a life of 4 years:-
Project AProject BInitial Investment20,00022,000
The investments will result in the following estimated cash flows and profits:-
PROJECT AYearNet Cash FlowDepreciationProfit19,0005,0004,00028,0005,0003,00037,0005,0002,00045,5005,000500TOTAL29,50020,0009,500
PROJECT BYearNet Cash FlowDepreciationProfit17,0005,5001,50028,0005,5002,50039,0005,5003,50049,0005,5003,500TOTAL33,00022,00011,000
Tear off the back page
Accounting Rate of Return
= Average Annual Profits Average Capital Employed
Project AProject B
Average Profits == 2,375
Average C.E. == 10,000
ARR == 23.75%
Should C.E. include Working Capital?
YES
11,0004
= 2750
22,000 + 02
= 11,000
2,75011,000
= 25%
ARR - Decision Criteria
Accept projects with ARR greater than company's present (or target) ROI
Advantages of ARR:
Simple
Uses normal reporting conventions
Considers whole project
Comparable with ROI
Disadvantages of ARR:
Uses profit not cash flows
Ignores timing of profits
Not an absolute measure
Payback
Time taken for net cash flows to exceed the initial outlay
PROJECT A:-YearNet Cash FlowsCumulative Cash Flows0(20,000)(20,000)19,000 (11,000)28,000 (3,000)37,000 4,000 45,500 9,500 Payback = 2 years, 5 months
PROJECT B:-YearNet Cash FlowsCumulative Cash Flows0(22,000)17,000 28,000 39,000 49,000 Payback = years, months
2
9
3000 x 12 7000
2 years +
(22,000)
(15,000)
(7,000)
2 years +
7000 x 12 9000
Payback - Decision Criteria
Accept projects with payback shorter than the company's target payback
Advantages of Payback:
Simple
Favours quick return
Tests liquidity
Minimises time related risk
Disadvantages of Payback:
Ignores overall profitability
Ignores receipts after payback
Ignores timing of cash flows
Not an absolute measure
The time value of money
Why is 100 now worth more than 100 next year?
1.
2.
3.
Opportunity cost
Inflation
Risk
So my friend must repay me 1100 in 1 years My 1000 will have a value of 1100 in one years time.
(1100 is its Future Value)
A cash Flow of 1100 in a years time is equivalent to 1000 now
(1100 has a Present Value of 1000)
We now have a way of converting future cash flows to a common basis the Present Value
Return
Inflation
Risk
Opportunitycost
I agree to lend a friend 1000How much should I expect as repayment?In practice I might want a 10% return (my opportunity cost)
Present value, P = = S(1 + r)-n
Note: Present value tables show the result of (1 + r)-n for various interest rates and years.Discounting at 10%, what is the present value of 100 received annually for three years, starting next year?
YearCash FlowsPV factorPresent value11000.909 90.921000.82682.631000.75175.1248.6
b) Discounting:-
Present Value Tables:
Value of 1 to be received in n years time at a discount rate of r%
Present value, P = = S(1 + r)-n
Note: Present value tables show the result of (1 + r)-n for various interest rates and years.Discounting at 10%, what is the present value of 100 received annually for three years, starting next year?
YearCash FlowsPV factorPresent value11000.909 90.921000.82682.631000.75175.1248.6
b) Discounting:-
Annuity Tables:
Present value of 1 per year for n years at discount rate r, starting one year hence.
Present value, P = = S(1 + r)-n
Note: Present value tables show the result of (1 + r)-n for various interest rates and years.Discounting at 10%, what is the present value of 100 received annually for three years, starting next year?
YearCash FlowsPV factorPresent value11000.909 90.921000.82682.631000.75175.1 248.6
b) Discounting:-
2.486
100 x
= 248.6
What is the NPV of A and B if the company's
pre-tax weighted average cost of capital is 18%?
Project A:YearNet Cash FlowsPV factorNPV0(20,000)1(20,000)19,0000.8477,623 28,0000.7185,744 37,0000.6094,263 45,5000.5162,838 Project Net Present Value 468 Project B:YearNet Cash FlowsPV factorNPV0(22,000)1(22,000)17,0000.8475,929 28,0000.7185,744 39,0000.6095,481 4 9,000 0.5164,644 Project Net Present Value (202)
Shows increase in Shareholders wealth NOW
NPV - Decision Criteria
Accept projects with positive NPV when discounted at company's weighted average cost of capital (WACC)
Advantages of NPV:
Uses cash flows not profits
Considers whole project
Takes account of time value of money
An absolute measure
Disadvantages of NPV:
Complex
Only as accurate as the cash flow estimates
Need to know company's WACC
Internal Rate of Return (IRR)
The discount rate that equates the NPV offuture cash flows to the initial investment.Project A:YearNet Cash PV Factor NPV PV Factor NPV Flowat 18% at 18% at 20%at 20%0(20,000)1(20,000)1(20,000)19,000 0.8477,623 0.8337,497 28,000 0.7185,744 0.6945,552 37,000 0.6094,263 0.5794,053 45,500 0.5162,838 0.4822,651 Project Net Present Value468 (247)
The IRR of Project A is approximately 19%
Interpolation to find the IRR
NPV
468Estimated IRR
018%20%r
-247
Real IRR
Project B:YearNet CashPV Factor NPV PV Factor NPV Flowat 18% at 18% at at 0(22,000)1(22,000) 17,000 0.8475,929 28,000 0.7185,744 39,000 0.6095,481 49,000 0.5164,644 Project Net Present Value(202)
The IRR of Project B is approximately %
N.B.IRR is also called:
DCF Yield
Marginal efficiency of capital
Discounted yield
Actuarial Rate of Return
10.8620.7430.6410.552
16%
16%
(22,000)
6034
5944
5769
4968
715
17.5
Accept projects with IRR greater than company's weighted average cost of capital (WACC).
IRR - Decision Criteria
NPV and IRR compared:
With conventional cash flows NPV and IRR give same ranking
With non-conventional cash flows may be no IRR or multiple IRRs.
NPV is absolute but IRR is relative.
If discount rates alter over projects' life can use NPV but not IRR.
Different reinvestment assumptions:
NPV assumes reinvestment at discount rate
IRR assumes reinvestment at IRR
Summary of Results
ProjectABARR23.8%25%Payback2 yrs 5 mths2 yrs 9 mthsNPV at 18%468(202)IRR19.3%17.5%
What is used in practice?
1975 1980 1986 1992 % % % %Payback 73 81 92 94
Accounting Rate of Return 51 49 56 50
Internal Rate of Return 44 57 75 81
Net Present value 32 39 68 74
Capital Investment Techniques used by UK companies
Pikes Survey of 100 large UK firms 1988 and 1996
Capital Investment Techniques used by UK companies
Arnold and Hatzopoulos 1997 Survey of 300 UK companies in top 1000
Small Medium Large Total %% % %Payback 7175 66 70
ARR 6250 55 56
IRR 7683 84 81
NPV 6279 97 80
The Complications
Inflation
Taxation
Risk
Qualitative Factors
Pragmatic Approach to Risk
RRR
WACC
RiskOnly use WACC to discount projects of normal risk!
Low
SML
Medium
High
SecuritiesMarketLine
Or..apply sensitivity analysis.
Two methods of accounting for risk:
Adjust the discount rate to reflect the increased required rate of return of shareholdersdue to the uncertainty of the cash flows.
Adjust the cash flows to more certain figures = sensitivity analysis.
Should you use both methods together?
NO
Sensitivity Analysis
Measures the change necessary to reduce NPV to zero
Thus shows which are the sensitive elements of the project
How to do it???
Consider each component of the calculation in turn
keeping all others constant
Work out change in that element necessary
to reduce NPV to zero
Express this as a % change on original figure.
Lowest % change is most sensitive
Project A- Sensitivity
Year
01234
Net CashFlows
NCFLess 10%
(20000)9000800070005500
(20000)8100720063004950
PV Factor
10.8470.7180.6090.516
PV
(20000)6860517038372554(1579)
A 10% change in NCF= reduction from 468 to (-1579)ie a change of 2047 in NPVSo a 1% =204.7 reduction To reduce NPV to zero will require a fall in NCF of 468/204.7=2.3%
This can be repeated for
initial investment,
life of project and
discount rate
In addition if available also look at
Sales price
Sales volume
Costs
Scrap values
This then builds a profile of which are
the most sensitive elements.
(usually sales price and volume will be the most sensitive)
Management can then evaluate if they feel the
sensitivity is acceptable
Sensitivity
Risk
Other methods include:
Expected values (assigning probabilities to outcomes)
Simulation
Adjust discount rate to include a risk premium
Hurdle rates
Some firms will use a hurdle ( target) rate
This may incorporate an arbitrary?? element to cover risk
It can lead to a profitable project being rejected
Example
A company has a cost of capital of 12%It uses a hurdle rate of 20% to assess projectsA project with an NPV of say 1m at 12% may have an NPV of -0.5m at 20%(Its IRR may be say 16%)
The company would reject this project thus losing the opportunity to increase shareholder wealth
Inflation
Cost of Capital incorporates inflation assumptions
Cash flows must therefore be be in money (i.e. inflated) terms
Different rates may apply to different items
Taxation
Tax charged on profits (30%)
Tax paid during and after the year on an estimated basis
Capital Expenditure can reduce liability (Capital Allowances at 25% of reducing balance)
Normally tax will reduce NPV and may make project unviable
CAPITAL RATIONING 1
Exists when there is a limit on capital
Need to select the combination of projects which
gives the best NPV
This is found by calculating the NPV per of investment
This is known as the Profitability Index
Profitability Index = NPV
Investment
Use projects with highest PI first
CAPITAL RATIONING 2
Cash flows m
ProjectC0C1C2 NPV@10%
A-20+60+10 42B-10+10+40 32C-10+10+30 24
Only 20m is available
Project InvestmentNPVProfitability IndexA2042 2.1B1032 3.2C1024 2.4
Choose B+C to give total NPV = 56mA only has NPV of 42m
CAPITAL RATIONING 3
If we have 30m to invest the problem gets more complicated
If we can do part of a project then we do all of B32all of C24half of A21Total NPV77
If we can only do whole projects then we must select the best combination
all of B32all of A42Total NPV 74
This is most easily done by trial and error
SUMMARYCAPITAL RATIONING
Applies when there is a limit on capital available
Must make best use of Capital
Rank projects by Profitability Index
i.e. NPV invested
Choose projects with highest PI first
If a portion of a project can be undertaken then use
up capital by adopting a proportion of a project.
If portions cannot be undertaken then necessary to
choose the optimal mix of projects.
This can be done by trial and error if only a small number
of projects are available.
.and finally
Do not judge by numbers alone:
Perform Sensitivity Analysis
Consider qualitative factors
These may be more important than the figures!
Perform a post completion audit:
Internal but independent
Control the project throughout
Justification becomes Budget
How good were estimates?
Learn from the audit.be right next time!
Relevant Costs and Revenues
Sunk costs are irrelevant.
Committed costs are sunk.
Consider only future costs and revenue
that arise as a result of the decision.
What is the capacity position?
Consider opportunity costs.
Summary & Review
Good Investment Appraisal is critical to success
Managers input is crucial
Relevant to minimising costs and maximising profits
Need to identify and use relevant cash flows
Qualitative issues need to be fully considered
Cant ignore risk
Conduct sensitivity analysis
There are other complications:
e.g. Taxation, Inflation, Capital rationing
Consider Two Projects:
Both projects require investment new plant with a life of 4 years:-
Project AProject BInitial Investment20,00022,000
The investments will result in the following estimated cash flows and profits:-
PROJECT AYearNet Cash FlowDepreciationProfit19,0005,0004,00028,0005,0003,00037,0005,0002,00045,5005,000500TOTAL29,50020,0009,500
PROJECT BYearNet Cash FlowDepreciationProfit17,0005,5001,50028,0005,5002,50039,0005,5003,50049,0005,5003,500TOTAL33,00022,00011,000
Tear off the back page
n1%2%3%4%5%6%7%8%9%10%11%12%13%14%15%16%17%18%19%20%
10.9900.9800.9710.9620.9520.9430.9350.9260.9170.9090.9010.8930.8850.8770.8700.8620.8550.8470.8400.833
20.9800.9610.9430.9250.9070.8900.8730.8570.8420.8260.8120.7970.7830.7690.7560.7430.7310.7180.7060.694
30.9710.9420.9150.8890.8640.8400.8160.7940.7720.7510.7310.7120.6930.6750.6580.6410.6240.6090.5930.579
40.9610.9240.8880.8550.8230.7920.7630.7350.7080.6830.6590.6360.6130.5920.5720.5520.5340.5160.4990.482
50.9510.9060.8630.8220.7840.7470.7130.6810.6500.6210.5930.5670.5430.5190.4970.4760.4560.4370.4190.402
60.9420.8880.8370.7900.7460.7050.6660.6300.5960.5650.5350.5070.4800.4560.4320.4100.3900.3700.3520.335
70.9330.8710.8130.7600.7110.6650.6230.5830.5470.5130.4820.4520.4250.4000.3760.3540.3330.3140.2960.279
80.9230.8530.7890.7310.6770.6270.5820.5400.5020.4670.4340.4040.3760.3510.3270.3050.2850.2660.2490.233
90.9140.8370.7660.7030.6450.5920.5440.5000.4600.4240.3910.3610.3330.3080.2840.2630.2430.2250.2090.194
100.9050.8200.7440.6760.6140.5580.5080.4630.4220.3860.3520.3220.2950.2700.2470.2270.2080.1910.1760.162
110.8960.8040.7220.6500.5850.5270.4750.4290.3880.3510.3170.2870.2610.2370.2150.1950.1780.1620.1480.135
120.8870.7880.7010.6250.5570.4970.4440.3970.3560.3190.2570.2310.2080.1870.1680.1520.1370.1240.1120.069
130.8790.7730.6810.6010.5300.4690.4150.3680.3260.2900.2580.2290.2040.1820.1630.1450.1300.1160.1040.093
140.8700.7580.6610.5770.5050.4420.3880.3400.2990.2630.2320.2050.1810.1600.1410.1250.1110.0990.0880.078
150.8610.7430.6420.5550.4810.4170.3620.3150.2750.2390.2090.1830.1600.1400.1230.1080.0950.0840.0740.065
n1%2%3%4%5%6%7%8%9%10%11%12%13%14%15%16%17%18%19%20%
10.990.980.970.960.950.940.930.930.920.910.900.890.880.880.870.860.850.850.840.83
21.971.941.911.891.861.831.811.781.761.741.711.691.671.651.631.611.591.571.551.53
32.942.882.832.782.722.672.622.582.532.492.442.402.362.322.282.252.212.172.142.11
43.903.813.723.633.553.473.393.313.243.173.103.042.972.912.852.802.742.692.642.59
54.854.714.584.454.334.214.103.993.893.793.703.603.523.433.353.273.203.133.062.99
65.805.605.425.245.084.924.774.624.494.364.234.114.003.893.783.683.593.503.413.33
76.736.476.236.005.795.585.395.215.034.874.714.564.424.294.164.043.923.813.713.60
87.657.337.026.736.466.215.975.755.535.335.154.974.804.644.494.344.214.083.953.84
98.578.167.797.447.116.806.526.256.005.765.545.335.134.954.774.614.454.304.164.03
109.478.988.538.117.727.367.026.716.426.145.895.655.435.225.024.834.664.494.344.19
1110.379.799.258.768.317.897.507.146.816.506.215.945.695.455.235.034.844.664.494.33
1211.2610.589.959.398.868.387.947.547.166.816.496.195.925.665.425.204.994.794.614.44
1312.1311.3510.639.999.398.858.367.907.497.106.756.426.125.845.585.345.124.914.714.53
1413.0012.1111.3010.569.909.298.758.247.797.376.986.636.306.005.725.475.235.014.804.61
1513.8712.8511.9411.1210.389.719.118.568.067.617.196.816.466.145.855.585.325.094.884.68