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Intro to Financial Management of the Organisation

Week 9Capital Investment Appraisal

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Capital Investment Appraisal

If a company is going to invest in a project it need to ensure

The project will be financially viable

It will be successful Risk levels will be minimised

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Discount or not? We will consider 4 methods of

decision making for capital projects Each method can be used to Make comparisons between projects

competing for scarce resources Make comparisons between a project

and a company benchmark 2 methods employ discounting 2 do not

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Company scenarioVerminous Ltd (cost of capital =

10%) Verminous Ltd are contemplating the purchase of a new machine. They have a choice of either the "Weasel" or the "Stoat". The company has made some estimates of costs and expected cash inflows and

this is rovided below:Weasel Stoat

£,000 £,000 Cost of Machine -400 -600 Cash inflows Year 1 80 -20 Year 2 90 260 Year 3 90 185 Year 4 120 200 Year 5 120 215 Year 6 60

Profit 160 240

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Payback Period (PP) The payback period Is the period of time required for the

cumulative expected cash flows from an investment project to equal the initial cash outflow

This method computes the amount of time required to recover the initial investment

The acceptance criterion is dependent upon the maximum cutoff period established by management for projects of a similar type

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Pros and Cons of PP Advantages

Easy to use and understand Can be used as a measure of liquidity Easier to forecast short term than long

term cashflows Disadvantages

Does not account for time value of money***

Does not consider cashflows beyond the payback period

The cutoff period is subjective

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Weasel & Stoat cumulative cumulative -400 -400 -600 -600

Year 1 80 -320 -20 -620 Year 2 90 -230 260 -360 Year 3 90 -140 185 -175 Year 4 120 -20 200 25 Year 5 120 100 215 Year 6 60 Weasel = 4yrs 1/6th (4 yrs 2 months) Stoat = 3 yrs 7/8th (3 yrs 10.5 months)

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A PP conundrum

M1 M2 M3Cost of machine -100 -100 -100Yr 1 cashflow 20 5 40Yr 2 cashflow 40 10 50Yr 3 cashflow 40 85 10Yr 4 cashflow 30 -20 200Yr 5 cashflow 20 -10 500What is PP? PP = 3 years for each

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Accounting Rate of Return (ARR)

This technique is similar to ROCE ratio you are familiar with

Remember, ROCE can be used as a measure of management efficiency

How effectively can management make profit (return) from capital in the business (capital employed)

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Accounting Rate of Return (ARR)

All other appraisal techniques are concerned with NET cashflows

ie cash generated less cash costs ARR considers Accounting Profit as

the measurement Accounting Profit = Income less all costs incurred in

generating that income, therefore includes depreciation

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Accounting Rate of Return (ARR)

ARR = Average annual profit X 100 Average Investment

Average annual profit = total profit for project / number of years

Average Investment = (Capital cost + residual value) / 2

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So, applying it toWeasel & Stoat

Weasel Stoat Total dep'n -400 -600

Year 1 80 -20 Year 2 90 260 Year 3 90 185 Year 4 120 200 Year 5 120 215 Year 6 60

Total profit 160 240

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Which means..

There is no residual value, so full cost is depreciated.

Average Annual Profit = (Total Net cashflows – Full cost of asset) / years of project

Again, as no RV average investment = Cost/2

Weasel (160/6)/200*100 = 13% Stoat (240/5)/300*100 = 16%

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ARR and ROCE Assume Verminous Ltd’s ROCE is 14% If Weasel were chosen it would reduce

(if only marginally) the company’s ROCE

If Stoat were chosen it would, of course, increase ROCE

In this case higher ARR = project with higher profit

But what is most important Profits or ROCE? Assume Verminous has ROCE of 12%...

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ARR a conundrum Weasel Stoat Total depreciation -400 -600

Year 1 80 -20 Year 2 90 260 Year 3 90 185 Year 4 120 200 Year 5 120 145 Year 6 60

Total profit 160 170 ARR Av profit (160/6) 27 (170/5) 34 13% (W) Av Investment 200 300 11% (S)

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Pros & Cons of ARR Advantages

generally accepted provides index of performance encourages managers to improve ARR can be used to gauge performance & make

comparisons Disadvantages

lack of consensus on definitions of capital or profit

can be manipulated can distort overall allocation of resources noncash items included ignores the timing of cash flows

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Discounting methods Both PP and ARR assume absolute

values in cashflows The value of a cashflow today = the

same as its value in 5 or 6 years time There is no consideration of risk

involved (cashflows are estimates!) They assume the capital used is

costless Apart from the projects they assume

there is no alternative use for the capital (ie invest it)

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A question..

Let us suppose you were given the choice of receiving £10,000 today or £10,000 in 3 years time.

Which would you choose?

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Discounting cashflows The value of that £10,000 today can be

measured as £10,000 plus the potential value of interest earned.

If you were to receive your cash in 3 years time, then, you would expect to receive not just £10,000 but an additional sum for the interest receivable over that time period.

Conversely the value today of that £10,000 plus interest received in 3 years, would simply be £10,000.

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Graphically represented

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Calculating Future Value (FV) By applying interest at a given rate to the £10,000

we can calculate what it would be worth in n years time

But how can we calculate the present value of a sum receivable in n years time?

Take option (A), assume you can get 4.5% interest on your £10,000

The future value of the £10,000 after 1 year would be £10,450, which of course is calculated by multiplying the principal amount of £10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:

Future value of investment at end of first year: = (£10,000 x 0.045) + £10,000 = £10,450

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Calculating Future Value (FV)

You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:

Original equation: (£10,000 x 0.045) + £10,000 = £10,450

Manipulation: £10,000 x [(1 x 0.045) + 1] = £10,450

Final equation: £10,000 x (0.045 + 1) = £10,450

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Calculating Future Value (FV)

Take the £10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have £10,920:

Future value of investment at end of second year: = £10,450 x (1+0.045) = £10,920.25

The above calculation, then, is equivalent to the following equation:

Future Value = £10,000 x (1+0.045) x (1+0.045) We can simplify this equation as follows: Future Value = £10,000 x (1 + 0.045)(1+1)

= £10,000 x (1 + 0.045)2

= £10,920.25

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Working BackPresent Value (PV)

Formula

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PV Calculation Applying this to option B Present Value= £10,000 x (1 + 0.045)-

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= £8,762.97 The present value of a future payment

of £10,000 is worth £8,762.97 today if interest rates are 4.5% per year

That is choosing option B is like taking £8,762.97 now and then investing it for three years.

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The easier option

The concepts of using FV and PV will be used again in looking at dividend valuations

But, to simplify….. Present Value Tables

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Net Present Value

The essence of a business is to maximise shareholder wealth

If “raw” cashflows are considered it is possible that an apparent increase in wealth could actually result in a diminution

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Application to Weasel & Stoat

Weasel Stoat DF @ 10% PV DF @ 10% PV

-400 1.000 -400.0-600 1.000 -600.0

Year 180 0.909 72.7 -20 0.909 -18.2 Year 290 0.826 74.3 260 0.826 214.8 Year 390 0.751 67.6 185 0.751 138.9 Year 4120 0.683 82.0 200 0.683 136.6 Year 5120 0.621 74.5 215 0.621 133.5 Year 660 0.564 33.8

NPV = 4.97 NPV = 5.63

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Comparison of results

The 2 machines both have POSITIVE NPVs

But only just… It is up to management to

decide if the factors incorporated in the Discount Rate are sufficient to accept the project with the higher NPV

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Internal Rate of Return (IRR)

The application of Present Values to the cashflows shows that the actual rate of return must be >10%

In some instances management would want to know the exact rate of return

We can find this by formula

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Internal Rate of Return (IRR)

Ideal Scenario By “trial & error” calculate

Negative NPV As 10% gives Positive NPV Choose a higher Discount Rate In this case 11% should do Apply DF to cashflows &

determine NPV Then apply formula

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IRR Formula IRR = A + C (B – A) C – D Where: A = discount rate of low trial B = discount rate of high trial C = NPV of low trial cashflow D = NPV of high trial cashflow

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Weasel & Stoat Weasel Stoat

DF @ 11% DF @ 11%

-400 1.000 -400.0 -600 1.000 -600.0

Year 1 80 0.901 72.1 -20 0.901 -18.0 Year 2 90 0.812 73.1 260 0.812 211.1 Year 3 90 0.731 65.8 185 0.731 135.2 Year 4 120 0.659 79.1 200 0.659 131.8 Year 5 120 0.593 71.2 215 0.593 127.5 Year 6 60 0.535 32.1

NPV = -6.71 NPV = -12.37

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Weasel & StoatOutcomes

Weasel IRR = 10 + [4.97/(4.97+6.71)]*1 10 +0.425514 = 10.43% Stoat IRR = 10 + [5.63/(5.63+12.37)]*1 10 +0.3128 = 10.31%