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## Capital Investment Appraisal

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**Aims…**• For you to be able to understand the concepts of Payback, ARR, IRR, DCF & NPV • To be able to calculate Investment Appraisal methods.**What is an Investment?**• Any act which involves the sacrifice of an immediate and certain level of consumption in exchange for the expectation of an increase in future consumption. • forgo the present consumption in order to increase resources in future**What is an Investment?**An investment requires expenditure on something today that is expected to provide a benefit in the future the decision to make an investment is extremely important because it implies; the expectation that expenditure today will generate future cash gains in real terms that greatly exceed the funds spent today**Investment Appraisal**• A means of assessing whether an investment project is worthwhile or not • Investment project could be the purchase of a new PC for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc**Investment Appraisal**• Types of investment appraisal: • Payback Period • Average Rate of Return (ARR) • Net Present Value (discounted cash flow) What factors need to be considered before investing in equipment such as this? Source: Gergely Erno, http://www.sxc.hu**Investment Appraisal**• Why do companies invest? • Importance of remembering investment as the purchase of productive capacity NOT buying stocks and shares or investing in a bank! • Buy equipment/machinery or build new plant to: • Increase capacity (amount that can be produced) which means: • Demand can be met and this generates sales revenue • Increased efficiency and productivity**Investment Appraisal**• Investment therefore assumes that the investment will yield future income streams • Investment appraisal is all about assessing these income streams against the cost of the investment • Not a precise science! A fork lift may be an important item but what does it contribute to overall sales? How long and how much work would it have to do to repay its initial cost?**Looking at the figures…**A failing farmer wants to investigate the financial implications of possible farm diversification.**Farm Diversification – the 3 options**So what other factors should the farmer consider before deciding on which project to go with?**What other factors?**State of the farming industry Price of land Interest rates The economy – growing or shrinking? The farmers interests – no good doing something the family has no interest in! Competition in area Level of demand for each option!**Outcomeis uncertain.**Large amounts ofmoney involved. Decision may bedifficult or impossibleto reverse. Investment involveslong-term commitment. Capital Budgeting**Payback Method**• Payback method - length of time it takes to repay the cost of initial investment**Payback Method**LBS Ltd uses the payback period as its sole investment appraisal method. LBS invests ¢ 30,000 to replace its computers and this investment returns ¢ 9,000 annually for the five years. From the information above evaluate the investment using the payback. Assume that ¢ 9,000 accrues evenly throughout the year.**Payback Method**• Solution • Year Yearly cash flow cumulative net cash flow • ¢ ¢ • 0 (30,000) (30,000) • 1 9,000 (21,000) • 2 9,000 (12,000) • 3 9,000 (3,000) • 4 9,000 6,000 • 5 9,000 15,000 • Therefore 3years = 27,000 • then 3000/9000 x 12 = 4 • Payback period = 3 years 4months**Payback Period**Time period required to recover the cost of the investment from the annual cash inflow produced by the investment. Amount invested Expected annual net cash inflow**Payback Method**The length of time taken to repay the initial capital cost Requires information on the revenue the investment generates E.g. A machine costs ¢600,000 It produces items that sell at ¢ 5 each and produces 60,000 units per year Payback period will be ?????**Payback Method**• 2 Years Computed as; • 600,000 / 300,000 = 2**Example**• Casey Co. is considering an investment of ¢130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: • Sales ¢200,000 • Cost of goods sold ¢145,000 • Depreciation expense 13,000 • Selling & Admin expense 22,000180,000 • Income before income tax ¢20,000 • Income tax expense 7,000 • Net Income ¢13,000**Computation of Annual Cash Inflow**Expected annual net cash inflow = Net income ¢13,000 Depreciation expense 13,000 ¢26,000**Cash Payback Period**5 years 130,000 / = 26,000****Operating Cashflow**During 2009, RIT Corp. had sales of $798,456. Costs of goods sold, administrative and selling expenses, and depreciation expenses were $565,600, $98,555, and $89,561, respectively. In addition, the company had an interest expense of $223,544 and a tax rate of 35 percent. What is the operating cash flow for 2009? Ignore any tax loss carry-back or carry-forward provisions.****Cashflow to stockholders & creditors**A. What is the cash flow to stockholders for 2009? B. What is the cash flow to creditors for 2009?**Solution**Minus**Solution cont’d**Minus**Payback Period –Uneven Cash Flows**Casey Co. wants to install a machine that costs ¢16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:**4.2**Payback Period –Uneven Cash Flows We recover the ¢16,000 purchase price between years 4 and 5, about4.2 years for the payback period.**Using the Payback Period**Payback = 5 years Payback = 3 years Consider two projects, each with a 5-year life and each costing ¢6,000. Would you invest in Project One just because it has a shorter payback period?**Payback method**• Payback could occur during a year • Can take account of this by reducing the cash inflows from the investment to days, weeks or years.**Payback Method**Payback formula = 600,000 255,000 = 2.35 years What’s just over a 1/3 of a year? = 4 months = 2 years and 5 months… • e.g. • Cost of machine = ¢ 600,000 • Annual income streams from investment = ¢ 255,000 per year • Payback is some where between … Year 2 & year 3 it will pay back – but when? Payback formula 2 years = 255,000 + 255,000 = 510,000 = 2 years & some months…. 600,000 - 510,000 = 90,000 still owing 255,000 = 21,250 12 months = 90,000 = 4.235 month 21,250 = 2 years and 5 months…**Average Rate of Return**• A comparison of the profit generated by the investment with the cost of the investment Average annual return or annual profit • ARR = -------------------------------------------- Initial cost of investment**Average Rate of Return**Average annual operating income from asset Average amount invested in asset • Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk. • The minimum return is based on the company’s cost of capital.**Accounting Rate of Return**Average Investment = Original Investment + Residual Value 2 For Casey, average investment = (¢130,000 + ¢0)/ 2 = ¢65,000**Solution to Accounting Rate of Return Problem**Average annual operating income from asset Average amount invested in asset ¢13,000 / ¢65,000 = 20%**Accounting Rate of Return**The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return. The higher the rate of return for a given risk, the more attractive the investment.**Accounting Rate of Return**• An investment is expected to yield cash flows of ¢ 10,000 annually for the next 5 years. • The initial cost of the investment is ¢ 20,000 • Total profit therefore is: ¢ 30,000 (50,000-20,000) • Annual profit = ¢ 30,000 / 5 = ¢ 6,000 ARR = 6,000/20,000 x 100 = 30% Is this a worthwhile return? Need to compare to interest rates as well alternatives.**ARR- do you need a formula?**• Total revenue (over lifetime) – purchase price = total profit • Total profit / life time of product = average profit • Average profit / purchase price = ARR x 100 • = ARR %**Investment Appraisal**• To make a more informed decision, more sophisticated techniques need to be used. • Importance of time-value of money ¢ now ¢ in 5 years time Which is worth more?**Discounted Cash Flows**Considers both the estimated total cash inflows and the time value of money. Two methods 1) net present value 2) internal rate of return**Investment Appraisal**Purchasing power would have been lost over a year due to inflation money could have been alternatively invested in say risk-free Government securities**Net Present Value**NPV is today’s value of the difference between cash inflows and outflows projected at future dates, attributable to capital investments or long-term projects**Net Present Value**• Takes into account the fact that money's value change with time • How much would you need to invest today to earn x amount in x years time? • Value of money is affected by interest rates • NPV helps to take these factors into consideration • Shows you what your investment would have earned in an alternative investment regime**Net Present Value**• e.g. • Project A costs ¢ 1,000,000 • After 5 years the cash returns = ¢ 100,000 (10%) • If you had invested the ¢ 1 million into a bank offering interest at 12% the returns would be greater - You might be better off re-considering your investment!**Net Present Value**• The principle: • How much would you have to invest now to earn ¢ 100 in 1 year’s time if the interest rate was 5%? • The amount invested would need to be: ¢ 95 • Allows comparison of an investment by valuing cash payments on the project and cash receipts expected to be earned over the lifetime of the investment at the same point in time, i.e the present.**Net Present Value**Don’t need to know this formula!! Future Value PV = ----------------- (1 + i)n Where i = interest rate n = number of years • The Present Value of ¢ 1 @ 10% in 1 year’s time is 0.9090. • If you invested 0.9090p today and the interest rate was 10% you would have ¢ 1 in a year’s time • Process referred to as: ‘Discounting Cash Flow’**Net Present Value**• Cash flow x discount factor = present value • e.g. PV of ¢500 in 10 years time at a rate of interest of 4.25% = 500 x .6595373 = ¢329.77 • ¢329.77 is what you would have to invest today at a rate of interest of 4.25% to earn ¢500 in 10 years time • PVs can be found through valuation tables • (Always given to you in exams!)**Discounted Cash Flow**• An example: • A firm is deciding on investing in an energy efficiency system. Two possible systems are under investigation • 1 yields quicker results in terms of energy savings than the other but the second may be more efficient later • Which should the firm invest in?**Discounted Cash Flow – System A**Watch this….