Transcript Investment and Appraisal - Ivailo Chakarov

Investment Appraisal
Geoff Leese Sept 1999 revised
Sept 2001, Jan 2003, Jan 2006,
Jan 2007, Jan 2008, Dec 2008
(special thanks to Geoff Leese)
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Investment Appraisal
Capital Investment is crucial for long
term survival, to give benefit over a
number of years
 On the balance sheet, this consists of
fixed and current assets and current
liabilities
 Can be seen as on-going projects
generating return and cash flow
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Categories of Capital
Investment
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Replacement of existing facilities
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Expansion of existing facilities
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Highly uncertain outcomes in new areas
Welfare projects
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Risk increasing, unknown market or product
Research and development
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Low risk, reliable estimating in familiar markets
New Project
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Relatively low risk
Required by legislation, benefits hard to measure
Context and Control
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Strategic planning
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Management control
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Use of annual or longer plan cycles
Capital budgeting techniques to plan best
allocation and use of current resources to achieve
aims
Operational control
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Long term objectives
Short term routines
Appraisal techniques
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Payback Period
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Accounting rate of return ARR
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initial cost of project with future generated
discounted cash flow
Internal rate of return IRR
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% return achieved over project life (differing
definitions)
Net present value NPV
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Time taken for original cost to be recovered in
cash flows
% return from project over lifetime in discounted
cash flows
Opportunity cost
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When resources are limited, the benefit or
income that is foregone as a result of a
decision
Example: Not spending on new machinery,
but updating the software. Opportunity cost
of the software is the benefit from the new
machinery
Such costs are not recorded in accounts, but
very important in cost benefit analysis
Payback
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Simple measure of the number of years that it will
take to recover your original investment from net
cash flows that result
For example, a small, internal IS program to save
costs:
Original investment
£450
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net cash inflows
–
–
–
–
–
Year 1
Year 2
Year 3
Year 4
Year 5
£100
£200
£100
£100
£220
Payback 3.5 years
running total cash flow
£100
£300
£400
£500
£720
Time Value of Money
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Preference for money to be received earlier
and paid later
Worth more than similar amount received
later, as earlier monies can be invested to
earn interest over the receiving period
Similarly, cash paid later is worth less than
similar sum paid earlier, as you can have the
investment benefit for longer
Judging Payback
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Reasonable to assume that stakeholders prefer
shorter pay back periods
But also need to consider post payback cash flows.
How profitable will they be?
Does not consider profitability of the project as a
whole
Pay back is unlike traditional accounting of profit and
capital employed
Very simple to use
But ignores opportunity cost of amount of money
initially may vary with that received between years
And does not consider time value of money
Accounting Rate of Return
ARR
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Profits from the project are compared with the
investment
Future profit flow considered, also depreciation
Compares average profit per annum, before interest
and taxation with original cost
Variants use profit after interest and taxation and
other measures
All methods acceptable, but need to ensure
comparisons are of the same method
Complements ROCE by relating profits to initial
capital investment
Does not consider time value of money
ARR
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Original investment
£450, Life of asset 5 years
Assume no residual value and straight-line depreciation
charge of £90 (no residual value)
Net cash in
depreciation
profit
– Year 1
– Year 2
£100
£200
£90
£90
£ 10
£110
– Year 3
£100
£90
£ 10
– Year 4
– Year 5
£100
£220
£90
£90
£ 10
£130
Average profit £54 per annum
ARR as annual average profit flow/original cost = 12%
Future value of money
This is the compound interest formula which
tells you the future value of what you are
currently investing
An = P(1 + i)n
An = future amount invested in year n
P = amount invested now, at time n = 0
i = interest rate
n = number of years money is invested
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Rearranging for Investment
Appraisal
Future forecast cash flows need to be
calculated in terms of today’s value.
This is the opposite of compounding,
known as discounting, seen by
rearranging the compound interest
formula
P = An / (1 + i)n
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Net present value NPV
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Covers discounting and weighted average
cost of funds
Difference between the present values of
cash inflows and present value of cash
outflows
If NPV positive, required rate of return likely,
accept
If NPV zero, consider accepting if risk also
acceptable
If NPV negative, project should be rejected
NPV calculation Example
Back to our example of a £450 IS investment
Payback period 3.5 years, ARR 12%
If opportunity cost happened to be 10% (that is we could
have obtained 10% on another use of our money),
estimated cash flows £ per year at present values are:
90.9 + 165.3 + 75.1 + 68.3 + 136.6 = £536.2 total over 5
years
NPV = £536.2 - £450 = £86.2
The project gives 10% return, plus a surplus of £86.2
Go ahead
Try this for 20% opportunity cost
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Internal Rate of Return
Known as discounted cash flow (DCF) yield
IRR is another rearrangement of the equation
It is the interest rate that gives NPV = 0 when
applied to the projected cash flow
Our IS example, where r = IRR:
0 = -P +100/(1+r)+200/(1+r)2 +100/(1+r)3
+100/(1+r)4 +220/(1+r)5
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IRR
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Find the discount rate which produces an
NPV of zero
Do this by interpolation, graphing known
values of NPV, trial and error or using Excel
or financial software
If the discount rate is greater than the cost of
capital – acceptable
If the discount rate is less than the cost of
capital - reject
Investigation
Look at Excel
 Practice using NPV and IRR with the
data we have used
 Look at the help function, and practice
with that data
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You can use other spreadsheet, or
Sage or other financial packages
Which technique
Many large organisations use more
than one, as each analyses and gives
different information
 Payback measures time capital at risk
 ARR measures profitability
 NPV and ARR both show stakeholder
returns
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Cost Benefit Analysis
Much broader view than cash or profit
based analysis, which are purely based
on economics
 Seeks to assess the economic and
social advantages (benefits) and
disadvantages (costs) of a project, then
quantifies in monetary terms
 Major importance in public sector
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Assessing social benefits
Not all easy to translate into monetary
terms
 Broad view of stakeholders may be
necessary, such as society as a whole
 Costs and benefits arise at different
times
 Which discount rate to use?
 Specialist area, under much debate
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Audit of capital investments
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Good practice - any capital project investment
should be assessed when it has been
commissioned and running for a while
Gives a feedback loop for project appraisal
and selection, ensuring an improvement of
the process by performing three functions:
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Improving the quality of investment decisions
under consideration
Improving the quality of future investment
decisions
Assist corrective action for current projects
Further Reading
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Dyson Chapter 19