investment appraisal lecture

7/26/2019 Investment Appraisal Lecture

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Investment Appraisal

a. Introduction. Profit and Cash Flow.

b. Methods of Investment Appraisal:1. Return on Capital Emploed!Accountin" Rate of Return #ARR$

%. Pabac& period.

'. (et Present )alue.*. Internal Rate of Return.

c. Cost of capital.

d. +ncertaint and ris&

After studying this chapter you should be able to

+nderstand the difference between usin" cash flow and profit in

ma&in" investment appraisals

Calculate and interpret the Accountin" Rate of Return!Return on

Capital Emploed of a pro,ect and appreciate its uses and limitations

Calculate and interpret the Pabac& Period of a pro,ect and appreciateits uses and limitations

+nderstand the principles of discountin" and calculate a pro,ect-s (et

Present )alue and Internal Rate of Return

Evaluate the stren"ths and wea&nesses of iscounted Cash Flow

#CF$ approaches to investment appraisal

+nderstand which cash flows are relevant and should be included in

a CF calculation/ and which are not

Appreciate the importance of cost of capital in investment appraisal/

and evaluate the relevance of cost of capital calculations

+nderstand that there is alwas uncertaint and ris& in investmentappraisal and appreciate various was of dealin" with this

1. Introduction

Financial accountin" is concerned with reportin" to shareholders on the success ofmana"ement in achievin" what shareholders want. It ma be assumed that the ob,ective

is to ma0imise shareholder value2/ and this value depends on the future profits and cash

flows that a compan is e0pected to "enerate. Actual results are reported re"ularl andcan be compared with e0pectations. 3here is alwas the ris& that e0pectations are

e0a""erated4 that actual results will disappoint4 and that companies- share prices willreflect this. A compan-s share price will suffer if the are &nown to produce finesoundin" plans which fail to deliver the promised results. Companies which plan

effectivel how their shareholders- funds are to be utilised in financin" fi0ed assets and

current assets are most li&el to ma0imise shareholder value. 3o achieve this the shoulduse proper investment appraisal techni5ues to ensure that shareholders- funds are used

onl to finance activities which will produce an ade5uate return. 3he must allow for ris&

and uncertaint4 stri&e a balance between hi"h ris& pro,ects which seem to promise a hi"h

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return/ and safer pro,ects producin" a lower return4 and the should tr to mana"e

investors- e0pectations. 3he should also be aware of a compan-s cost of capital. A

compan with a low cost of capital should be able to find man investment opportunitieswhich will "enerate substantial returns. A compan with a cost of capital of 167 per

annum will find that pro,ects ieldin" 1%7 per annum are attractive. A compan with a

hi"her cost of capital #e.". 187$ will find that fewer pro,ects are attractive/ and it is moredifficult to "enerate "ood returns for shareholders.

InvestmentIndividuals and companies invest mone in the short term with the idea of "ettin" bac&

more/ in the lon"er term/ than the initial cost of the investment. 3his is a strai"htforward

enou"h idea/ but there are a number of issues that have to be addressed if we are to

appraise2 our investments properl.

1. 9ow much do ou need to "et bac& to ,ustif the amount invested

%. 9ow 5uic&l does the mone need to come bac& If ou can invest ;1 toda/ and

"et bac& ;16 after 86 ears/ the return mi"ht loo& brilliant/ but the timin" isterribleeein" an answer as a percenta"e appears to be eas to understand and can becompared with a compan-s cost of capital

'. It is difficult to &now what a compan-s cost of capital is/ and so what discount

rate should be used to calculate (P). +sin" IRR sidesteps this. A compancould simpl ran& all pro,ects accordin" to the IRR that each achieves4 it would

select the pro,ects with the hi"hest IRRs/ and re,ect those with the lowest.

Assumin" that the compan has onl limited funds for investment/ those funds

would be allocated to the pro,ects which have the hi"hest IRR.

3he main disadvanta"es of usin" Internal Rate of Return are

1. It involves more calculations than other methods4 and%. It is technicall flawed and can lead to incorrect decisions. 3his is particularl

true where there are irre"ular patterns of cash flows #perhaps with inflows comin"

before outflows$/ and hi"h discount rates.

A variet of different techni5ues for investment appraisal ma be used. >ometimes the

use of one techni5ue rather than another can lead to a different/ and perhaps a poor/

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investment decision. 3he best approach is to use CF to calculate the (P). In order to do

this it is necessar to &now what discount rate to use/ or the cost of capital2.

+hich cash flows to include

It is eas to "et lost in the technicalities and complications of CF and overloo& the factthat the calculations can be no better than the basic data on which the are based.

Estimates have to be made of the cost of the pro,ect/ of the future cash inflows and

outflows that it will "enerate/ and of the cost of capital/ and there is alwas an element ofris& and uncertaint.

3he appraisal should ta&e into account all cash flows that would result from the pro,ect

bein" underta&en/ and e0clude all cash flows that would arise whether or not the pro,ectis underta&en. 3here are a number of problem areas/ includin" the followin" as shown

below. It is important not onl to have the best estimates of the amounts of the cash

flows/ but also to be clear about the timin" of them.

1. Dor&in" capital. Dhere a pro,ect involves e0pansion/ there is usuall a re5uirementfor additional wor&in" capital #financin" stoc&s and debtors$ at the be"innin"/ which is

treated as a cash outflow. It is usuall assumed that at the end of the pro,ect-s life theadditional wor&in" capital will no lon"er be re5uired/ and so becomes a cash inflow.

%. Installation. Dhere a new piece of e5uipment is bein" bou"ht/ the cash outflow for it

should include an paments for installation and settin" it up.'. >crap values. If a new machine is bein" bou"ht there is often a cash inflow from the

sale of the old machine. If this scrappin" is a direct result of buin" the new machine/

then the cash inflow from the scrap value should be included in the appraisal.

Dhen the new machine comes to the end of its life/ perhaps after 8 or 16 ears/ weusuall assume that there will be a cash inflow from sellin" it.

*. 3a0ation. If a new pro,ect is "oin" to ma&e more mone for the compan #that is

usuall the intention$/ more corporation ta0 will be paable on the profits/ and theappraisal should include these additional paments. 3he usuall ta&e place in the ear

after the profit has been earned. 3he ta0 computations can be rather complicated. 3he

Inland Revenue allows profits to be reduced for ta0 purposes b substantial allowancesfor depreciation #usuall more "enerous$ than the amounts that the compan char"es in

their financial accounts$. 3here ma also be additional paments in respect of an profit

on sale of the old machiner4 or a reduction in paments if there is a loss.

8. Relevant costs. >ome costs will be incurred/ and the paments made/ whether or notthe pro,ect is underta&en. A pro,ect ma be char"ed its share of fi0ed overheads #such as

the costs of providin" a factor and its administration$/ but as those costs will be incurred

whether or not the pro,ect is underta&en/ the cash flows for fi0ed overheads are usualle0cluded.

. >un& costs. 3here are often si"nificant paments for mar&et research and feasibilit

studies which are underta&en before a decision is made on whether or not to "o ahead.As those costs have alread been incurred or paid #the are sun&2$/ the are irrelevant in

decidin" whether or not to "o ahead/ and should not be included in the appraisal.

N. @pportunit costs. 3he cost of usin" an asset for a particular pro,ect is often the

opportunit cost2 and the best alternative use.

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%ost of %apital

>ome or"anisations establish a cut off2 cost of capital fi"ure almost arbitraril. An

pro,ect which "ives a positive net present value when discounted at/ sa/ 167 is

acceptable. @ne advanta"e of this is that everone &nows where the are/ and whichpro,ects are "oin" to be acceptable/ and which are not. In the unli&el event that a

compan has unlimited funds available at a cost of 167/ then the more pro,ects the ta&e

on/ provided the clear the hurdle rate of 167/ the better.

If the amount of finance available is limited/ the compan chooses those pro,ects which

"ive the "reatest net present value when discounted at 167.

@ne wa of establishin" the cost of capital is to loo& at the opportunit cost of capital2.

If there are limited funds available/ and more than enou"h pro,ects that show a net

present value when discounted at/ sa/ 1*7/ then the cut off rate for pro,ects should be

1*7. (o pro,ects should be underta&en unless the show a positive net present valuewhen discounted at 1*7. If there are plent of pro,ects that can do better than 1N7/ then

the compan should underta&e onl those pro,ects which show a positive net presentvalue at 1N7. 3here is no point in tin" up limited funds on pro,ects that achieve onl/

sa 117/ if there is the opportunit to invest in pro,ects that achieve 1*7 or more.

>hareholders are not li&el to be impressed when companies start investin" in pro,ectsthat have lower returns than previousl. If mana"ement are trin" to ma0imise

shareholder wealth/ the must aim to increase profitabilit and cash flows/ and so

#hopefull$ share prices. 3he should not underta&e pro,ects which are li&el to lower

the compan-s returns/ and share price. Dhen companies cannot find sufficientlprofitable opportunities for investin" funds that the have available/ the should return

those funds to shareholders as dividends/ or use them to bu up the compan-s shares.

3here are plent of e0amples of companies that have invested surplus funds unwisel/and so have reduced the value of the compan.

Most companies have some idea of a hurdle rate2 which an investment should achieve/otherwise the investment will be re,ected. 3he hurdle rate should also be the compan-s

opportunit cost of capital: the should not invest in a ard if that would mean losin"

the opportunit to invest in a Ka"".

In practice it is usuall difficult to &now for sure what cash flows an investment will

produce/ how man ears the return will continue for/ and what its value will be/ if an/ at

the end O if indeed the proposal has an end in mind. Jiven these uncertainties/ ansophisticated attempts to calculate a compan-s cost of capital ma be a waste of time

and effort. It is probabl better to put the effort into forecastin" the pro,ect itself/ and

evaluatin" alternative scenarios/ than trin" to pretend that we can "uess what discountrate is re5uired to meet shareholders- e0pectations.

Most companies prepare some sort of business plan/ perhaps loo&in" 8 O 16 ears into the

future. @ften/ particularl with smaller businesses/ these are prepared mainl for their

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ban&ers/ or others who suppl funds. If the ban& is "oin" to char"e/ sa/ 167 per annum

interest/ this is probabl a reasonable appro0imation of a compan-s cost of capital. If

buddin" entrepreneurs decide to accept all pro,ects with a positive net present value whendiscounted at 167/ and re,ect those that do not/ the probabl won-t "o far wron". 3heir

hurdle rate would be the rate of interest to be char"ed'.

It is important that a compan has a sensible hurdle discount rate for investment

appraisal. If it is set too low/ perhaps at N7/ then the compan is li&el to invest in

pro,ects that barel earn their &eep4 that disappoint the owners of the business4 and thatresult in the value of the business fallin".

If the hurdle rate is set too hi"h/ perhaps at %%7/ then the compan is li&el to re,ect

pro,ects that more than earn their &eep. If pro,ects which earn a "ood return are re,ected/then the business loses opportunities to increase its value.

Companies are usuall financed partl b borrowin"/ and partl b shareholders- funds.

At first si"ht it is not difficult to establish the cost of borrowin": the interest rate onborrowin"s is usuall specified. 3he cost of shareholders- funds is more difficult. As

there is no re5uirement for companies to pa dividends on ordinar shares/ we mi"ht betempted to thin& that shareholders funds have no real cost. 3he are free2/ and provided

the compan ma&es some profit/ that is @. =ut directors who do not meet

shareholders- e0pectations in terms of profit will probabl soon find themselves out of a,ob. ow profits lead to low share prices4 low share prices invite ta&eover bids4 and

when another compan ac5uires a compan that is seen to be failin"/ the will soon "et

rid of the previous mana"ers.

3he cost of ordinar shareholders- funds depends on mar&et e0pectations. 3he compan

should aim to invest in was which increase the value of the compan/ not in was which

reduce the value of the compan. Attempts to identif a compan-s cost of capital areattempts to identif the discount rate that pro,ects must achieve in order to at least

maintain the value of the compan. 3here are widel used methods of indicatin" the cost

of capital for a compan that is listed on the stoc& mar&et. For unlisted companies/comparisons can be made with listed companies/ and common sense su""ests a discount

rate of between 167 and 187 would usuall be a reasonable appro0imation.

%onclusion

In theor mana"ers use investment appraisal techni5ues to ensure that a compan-s funds

are used in was which ma0imise shareholders- wealth. In practice mana"ers ma havetheir own a"endas/ favourin" particular pro,ects/ see&in" to impress their superiors/

enhancin" their reputation/ increasin" their personal remuneration pac&a"es/ and "ettin"

'After allowin" for ta0ation/ the cost of interest would be less4 but the cost of shareholders- funds would be

more4 so 167 would be a reasonable appro0imation. A hi"her discount rate/ up to sa 187/ could be used

for more ris& pro,ect.

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promotion b claimin" credit for all that "oes well/ and blamin" others for all that "oes

badl. It is eas to "ain approval for a pet pro,ect b producin" forecasts and appraisals

which meet the compan-s criteria and show it as bein" viable. It is important thatcompanies have post investment appraisal2 procedures in place that chec& if actual

results are in line with the fi"ures that were included in the appraisal which the compan

approved. >uccessful mana"ers will have done some/ or all/ of the followin"1. Made sure that actual results are in line with the ori"inal appraisals.

%. =een promoted and transferred so that the are no lon"er around to ta&e the

blame.'. ept a careful record of all the forecasts that made up the appraisal/ and made

sure that someone else is responsible for each element that made up the total

appraisal. If the pro,ect does not come up to e0pectations/ it is =ill-s fault because

the sales forecasts were wron"4 or Kane-s fault because she underestimated theori"inal cost4 or Ko-s fault because actual costs were wa out of line.

>uccessful investment pro,ects are the &e to the financial success of a compan/ and to

ma0imisin" shareholder value. Mana"ement cannot avoid the results of their investmentactivities bein" assessed b the outside world throu"h their published financial

statements. For individual mana"ers/ ta&in" credit for successful investment pro,ects isimportant in success. All mana"ers need to understand investment appraisals if the are

to be the ones who ta&e the credit/ and not the ones who end up ta&in" the blame. Jood

mana"ers ensure that decisions are ta&en on the basis of information that is as honest aspossible/ with ris&s and uncertainties specified and ta&en into account. Jood decisions

are ta&en b responsible "roups of mana"ers who understand the limitations of the data/

and of the techni5ues used for appraisin" the data.

Review of #ey points

3he ARR of a pro,ect is calculated usin" profits/ not cash flow/ and is

comparable with the return on capital emploed for the compan as a

whole

3he Pabac& Period is calculated usin" cash flows/ not profits/ and

tells us how 5uic&l a pro,ect is li&el to pa for itself

3o improve the advice provided b the pabac& period method it is

useful to use the cost of capital to discount future cash flows

#iscounted Pabac&$

CF properl allows for the timin" of cash flows

3he (et Present )alue method of CF is the preferred method of

investment appraisal It is necessar to &now the compan-s cost of capital to use =P)

CF calculations can be no better than the underlin" data which are

based on estimates/ and there is alwas some ris& and uncertaint

APPENDIX

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1. Return on capital employed

If a compan has a return on capital emploed of/ sa/ 187/ then we can assume thatshareholders e0pect that this rate of return will continue in the future4 and if the compan

fails to achieve this/ the share price is li&el to fall. 3his does not/ however/ mean that

the compan-s cost of capital for CF purposes is 187. If the compan re,ected allpro,ects that did not show a net present value when discounted at 187/ the mi"ht be

re,ectin" "ood pro,ects that would increase the value of the compan. Return on capital

emploed is based on profits/ not cash flows4 and the calculation i"nores timin". 3hereare also different was of calculatin" return on capital emploed. If we are "oin" to

compare R@CE for the compan as a whole with ARR for particular pro,ects/ we should

loo& at the return on the avera"e amount of capital emploed over a pro,ect-s life/ not the

return on the initial amount of capital invested in the pro,ect *.

A compan which accepts all pro,ects that show a positive net present value when

discounted at 1%7/ mi"ht achieve a return on capital emploed of 187. It would be a

mista&e to assume a 187 cost of capital for CF purposes4 and it would be a mista&e tore,ect all pro,ects which failed to show positive net present value when discounted at

187.

It could also be the other wa round/ particularl with pro,ects that are ver profitable/

but which ta&e a lon" time to earn the profits. A compan mi"ht be tempted to invest inpro,ects which show a return on avera"e capital emploed of more than 187. =ut if those

pro,ects are too slow to "enerate positive cash flows/ the mi"ht fail a 1%7 cost of capital

hurdle.

There is no clear relationship beteen a company!s return on capital employedand

their cost of capitalto be used for D"#.

2.,ncertainty and Ris# - ,se of robabilities

All investment is based on assumptions about the future and there is usuall some

uncertaint about our forecasts/ and a de"ree of ris&. 3here are some ris& free2investments/ such as lendin" mone to the "overnment b buin" "ilts2. =ut mana"ers

are more li&el to be involved in evaluatin" pro,ects where there is some uncertaint and

ris& in estimatin":

*3 his is because loo&in" at the compan as a whole/ on avera"e/ pro,ects are li&el to be half wa throu"h

their lives

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1. 3he initial cost of the pro,ect. Dith ma,or pro,ects the initial capital e0penditure

often turns out to be much hi"her than was ori"inall planned.

%. 3he cash inflows that the pro,ect will "enerate. Forecasts ma prove to be muchtoo hi"h/ or much too low.

'. 3he cash outflows/ includin" costs/ that will be involved.

*. 3he timin". A pro,ect ma ta&e lon"er to be completed and to "enerate cash flowsthan was anticipated. And it is difficult to be sure how lon" a pro,ect will last. It

is eas to assume2 a five ear life/ but difficult to &now how lon" it will reall

continue.

3here are various was of dealin" with ris& and uncertaint/ all of which involve a 5uite a

bit of sub,ectivit/ but which help to "ive some credibilit to forecasts and appraisals.

@ne approach is to use a hi"her discount rate for pro,ects which are seen as involvin"

more ris& than others. >uch an approach ma be theoreticall sound4 the problem is

&nowin" how much e0tra ris& there is/ and b how much the discount rate should be

increased.

A second approach/ where there are several possible outcomes/ is to appl probabilittheor to arrive at an e0pected value2. For e0ample/ if there is a %67 chance that a cash

flow will be ;16/666/ a *87 chance that it will be ;%6/666/ and a '87 chance that it will

be ;'6/666/ the e0pected2 cash flow can be calculated as follows:

%67 0 ;16/666 B ;%/666

*87 0 ;%6/666 B ;/666

'87 0 ;'6/666 B ;16/866E0pected cash flow ;%1/866

3he actual cash flow for a particular pro,ect is unli&el to be the e0pected2 fi"urecalculated in this wa. =ut if probabilities can be applied in this wa to a number of

different pro,ects/ on avera"e the actual results are li&el to be in line with what is

e0pected. 3he problem is/ of course/ &nowin" what the probabilit is for an particularoutcome.

A third approach is to reco"nise that a ran"e of different outcomes is possible/ and to

produce one appraisal based on rather pessimistic assumptions/ one based on ratheroptimistic assumptions/ and one realistic2 appraisal between these two e0tremes. 3his

ma be attractive in terms of sain" #a$ this is the worst that is li&el to happen4 this is the

downside ris&4 #b$ this is what is most li&el to happen4 and #c$ this is the best that isli&el to happen. If #a$ loo&s prett dreadful/ then a prett "ood #c$ is li&el to be needed

to ma&e the ris& loo& worthwhile. 3his ma "ive a useful feel2 for a pro,ect/ and

provide a basis for considerin" other li&el outcomes. It ma not be too difficult to "eta"reement on a ran"e of li&el outcomes/ which can help to "et decisions made. =ut it is

all/ of course/ ver sub,ective. 3here is no wa of determinin" how dreadful the

pessimistic assumptions should be/ or how brilliant the optimistic assumptions should be.

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A fourth approach is to use sensitivit analsis2 to consider a wide ran"e of different

possible outcomes. 3he appraisal can be done a"ain and a"ain/ usin" different

assumptions/ to see how sensitive it is to particular chan"es. It ma be unsure whether apro,ect will last for five ears/ or ten ears/ or somewhere in between. >ensitivit analsis

mi"ht show that it is brilliant if it lasts for ten ears/ but it is still viable if it lasts for onl

five ears. It ma be unsure whether the initial pro,ect cost will be ;1million/ or;%million/ or somewhere in between. >ensitivit analsis mi"ht show that it is a brilliant

pro,ect if it costs onl ;1 million4 a waste of mone if it costs ;%million4 and that/

provided it does not cost more than ;1. million/ it is viable. Dherever there isuncertaint/ the proposal can be recalculated to see how sensitive it is to a chan"e in

assumptions. 3his approach does not remove sub,ectivit/ but it enables the financial

effects of particular uncertainties to be 5uantified to provide a basis for ,ud"ement and

decision ma&in".

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investment appraisal lecture

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