Session 2 Capital Investment Appraisal (An Introduction)

1. Session 2 Capital Investment Appraisal (An Introduction)

2. Session 2 Capital Investment Appraisal • By the end of today’s session(s), you should be able to: • Understand the context of investment appraisal decisions • Evaluate capital projects using the ARR, the payback period method, the discounted payback period, the IRR and the NPV techniques. • Discuss the advantages and disadvantages of each method • Explain research findings in respect of the practical application of the methods. Overall aim of three lectures on this topic – to enable trainees to select appropriate investment methods and to calculate investment returns for competing projects and to justify a course of action including consideration of relevant non-financial factors and financing options.

3. Competency Wheel 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 Ethics & Professionalism Objectivity Perceptiveness of own knowledge, values and limitations

4. Mapping • This lecture maps specifically to 2.1 on the Competency Statement

5. Difficulties with Project Appraisal

6. 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

7. Goal Congruence Ultimately the project’s outcome should increase equity holder value. Decision makers - view the big picture, which may involve rejecting projects that have short-term returns in favour of projects with higher overall long-term returns. Take liquidity into consideration.

8. 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

9. Cash flows explained Incremental cash flows are those that will occur only as a consequence of a project being undertaken. Opportunity cash flows are cash flows forgone from other investments, or actions that have been changed, as a result of the 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.

10. 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 of profitability €/£1m each year for 5 years is the same as €/£5 million at the end of year 5. In finance, the latter option is valued much LOWER – because of the time value of money

11. 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 the project itself • Cash synchronisation – match the timing of the cash flows resulting from the investment with the timing of the repayments on the source of finance. • Cost of finance – take into account the company’s current cost of capital Note: This topic is covered in detail later in the course

12. Project appraisal - techniques Accounting Rate of Return (ARR) Payback period Discounted payback period Internal rate of return (IRR) Net present value (NPV)

13. Accounting Rate of Return

14. ARR The accounting rate of return estimates the rate of accounting profit 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.

15. ARR - calculation ARR = Average annual profit x 100 Average capital invested Where the average annual profit is the total profit for the whole period (after depreciation) divided by the life of the investment in years; and The average capital invested is the initial capital cost plus the expected disposal value divided by two.

16. ARR – example Cow Ltd. is considering three projects (each costing €/£240,000). The following cashflows are predicted: Friesian Aberdeen Saler Cashflows €/£ €/£ €/£ Year 1 160,000 120,000 238,000 Year 2 60,000 120,000 2,000 Year 3 120,000 40,000 35,000 Year 4 140,000 Year 5 20,000 Year 6 10,000 REQUIRED Given 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 the asset 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 sold after three years for €/£60,000 and after six years for €/£30,000.

17. 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

18. 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 more cash inflows will be penalised because of its long life. • Subjective (hurdle rate)

19. Payback period

20. Payback period The payback period method ranks investments in order of the speed at which the initial cash outflow is paid back by subsequent cash inflows. This method focuses on cash flows not profits, therefore depreciation and accrual accounting is ignored. This method calculates the number of years it takes for cumulative cash flows to achieve breakeven point.

21. Payback Period Cow Ltd. is considering three projects (each costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Aberdeen Saler Before depreciation €/£ €/£ €/£ Year 1 160,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 120,000 40,000 36,000 Year 4 140,000 Year 5 20,000 Year 6 10,000 REQUIRED Using the payback method, advise Cow Ltd. as to the investment to undertake.

22. 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 ARR’s.

23. 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)

24. Discounted Payback Period

25. Discounted payback period The discounted payback period method overcomes one of the weaknesses of the payback period method, as it takes the time value of money into consideration. This method ranks investments according to the speed at which the cumulative discounted cash flows (DCF) of an investment cover the initial cash outlay.

26. Discounted payback method - example Cow Ltd. is considering three projects (each costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Aberdeen Saler Before depreciation €/£ €/£ €/£ Year 1 160,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 120,000 40,000 36,000 Year 4 140,000 Year 5 20,000 Year 6 10,000 REQUIRED Which of the above projects should Cow Ltd. invest in. Cow Ltd. has to borrow funds at 10%. Management decide that this is an appropriate discount rate to use and it is company policy to use the discounted payback period method for capital investment appraisal.

27. 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 ARR’s • Takes the time value of money into consideration.

28. 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)

29. Net Present Value (NPV)

30. Net Present Value (NPV) The NPV method of project appraisal, discounts the cash inflows and outflows of an investment, to their present value. Use of the correct discount rate is very important. If the NPV is positive then a project should be accepted; as the positive amount will increase equity holder value. If the NPV is negative then a project should be rejected as acceptance will damage equity holder value.

31. NPV method – example Cow Ltd. is considering three projects (each costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Aberdeen Saler Before depreciation €/£ €/£ €/£ Year 1 60,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 100,000 40,000 36,000 Year 4 130,000 3,000 Year 5 20,000 Year 6 10,000 REQUIRED Calculate each project's NPV and rank the resulting information for reporting to management. The company has a WACC of 16% and all the projects being considered are of similar risk to the current operating activities of the company.

32. 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.

33. NPV method - disadvantages Disadvantages include: • Time consuming calculations (though can be compiled by a computer). • It does not provide a method of deciding which investment provides the best value for money. • It considers the absolute amount of money available over a project’s life. • It does not consider scale, hence risk.

34. Internal Ratio of Return (IRR) .

35. Internal Rate of Return (IRR) The IRR, sometimes referred to as the discounted cash flow yield method also involves discounting future cash flows to their present 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 of the 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 if the project should be accepted or not.

36. Calculating the IRR Step 1: Select two discount rates at random Step 2: Discount the cash flows at the discount rates to find the net present value Step 3: Use interpolation to find the rate at which the NPV of the cash flows is zero. IRR = Rate 1 + NPV 1 (Rate 2 – Rate 1) NPV 1 - NPV 2

37. IRR method – example Cow Ltd. is considering a project (costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Before depreciation €/£ Year 1 160,000 Year 2 60,000 Year 3 120,000 Year 4 40,000 Year 5 30,000 REQUIRED Calculate the IRR of the above named project using interpolation.

38. IRR method - advantages Advantages include: • The time value of money is taken into consideration. • All cash flows are considered in the appraisal process.

39. 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.

40. Research findings The payback method is the most commonly used method – used as screening device – the remaining projects are usually assessed using either the ARR or the IRR. Most companies set a subjective IRR/ARR hurdle rate and accept projects with a higher return. Academics consider the NPV to be the most appropriate method Recent research has shown that use of DCF techniques is increasing particularly in large entities with a preference for the use of the NPV or a combination of the NPV and the IRR

41. Summary • There are many factors which have to be considered before 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 information to inform the decision.