Topic 2 – Investment Appraisal: Background and Techniques

1. Topic 2 – Investment Appraisal: Background and Techniques

2. Learning Objectives After studying this topic you will: • understand the basis of long-term decision making; • be able to use traditional appraisal techniques of Accounting Rate of Return and Payback; • know the reasons why Discounted Cash Flow (DCF) techniques are used; • be able to calculate and interpret Net Present Value (NPV); • understand Internal rate of Return (IRR); • know what is meant by the Excess Present Value Index; • understand the effects of inflation on investment appraisal

3. Long Run Decision Making Assuming that finance is available the decision to invest will be based on three major factors: • The investor’s beliefs in the future • The alternative available in which to invest • The investor’s attitude to risk

4. Traditional Investment Appraisal Techniques • Accounting rate of return • Payback

5. Accounting Rate of Return • This is the ratio of average annual profits, after depreciation, to the capital invested. • Alternative term: Return on Capital Employed (ROCE).

6. A firm is considering three projects each with an initial investment of $1,000 and a life of 5 years. The profits generated by the projects are estimated to be as follows: After tax and depreciation profits • Calculate the accounting rate of return (ARR) on • Initial capital • Average capital Example 1

7. 1,000 1,000 1,000 5 5 5 200 200 200 1,000 1,000 1,000 Accounting rate of return on Initial Capital Project III Project II Project I Average Profits = = 200 p.a. = 200 p.a. = 200 p.a. ARR is = 20% = 20% = 20% Example 1

8. 1,000 1,000 1,000 2 2 2 200 200 200 500 500 500 Accounting rate of return on Average Capital Project III Project II Project I Average capital = = 500 = 500 = 500 ARR is = 40% = 40% = 40% Example 1

9. Payback • A period, usually expressed in years which it takes for the project’s net cash inflows to recoup the original investment. • The usual decision rules is to accept the project with the shortest payback period.

10. Calculate the payback periods for the following three projects: Net Cash Flow Example 2

11. Calculate the payback periods for the following three projects: Net Cash Flow Example 2

12. Calculate the payback periods for the following three projects: Net Cash Flow Example 2

13. Calculate the payback periods for the following three projects: Pay back Periods Project I = 3 years Project II = 3 years Project III = 4 years Net Cash Flow Example 2

14. Discounted Cash Flow (DCF) • Net Present Value (NPV) • Internal Rate of Return (IRR)

15. Net Present Value (NPV) • NPV calculates the PV of expected cash inflows and outflows and finding out whether in total the present value of cash inflow is greater than the PV of cash outflows.

16. An investment is being considered for which the net cash flows have been estimated as follows: What is the NPV if the discount rate is 20%? Is the project acceptable? Example 3

17. An investment is being considered for which the net cash flows have been estimated as follows: What is the NPV if the discount rate is 20%? Is the project acceptable? Example 3

18. Year Amount 0 -9500 1 3,000 2 4,700 3 4,800 4 3,200 Example 3

19. Year Amount PV 0 -9500 1 3,000 2 4,700 3 4,800 4 3,200 Example 3

20. Year Amount PV 0 -9500 1.000 1 3,000 0.833 2 4,700 0.694 3 4,800 0.579 4 3,200 0.482 Example 3

21. Year Amount PV 0 -9500 1.000 -9,500 1 3,000 0.833 2,499 2 4,700 0.694 3,262 3 4,800 0.579 2,779 4 3,200 0.482 1,542 Example 3

22. Year Amount PV 0 -9500 1.000 -9,500 1 3,000 0.833 2,499 2 4,700 0.694 3,262 3 4,800 0.579 2,779 4 3,200 0.482 1,542 582 Example 3

23. Meaning of NPV Example 3

24. Meaning of NPV Example 3

25. Meaning of NPV Example 3

26. Meaning of NPV Example 3

27. Meaning of NPV Example 3

28. Meaning of NPV Example 3

29. Meaning of NPV Example 3

30. Meaning of NPV Example 3

31. Meaning of NPV Net Terminal Value has a present value of 1,213 x 0.482 = 585 Example 3

32. Internal Rate of Return • Discount rate which gives zero NPV • Alternative names: • DCF yield • Marginal efficiency of capital • Trial and error method • Discounted yield • Actuarial rate of return

33. Year Amount PV 0 -9500 1.000 -9,500 1 3,000 0.800 2,400 2 4,700 0.640 3,008 3 4,800 0.512 2,458 4 3,200 0.410 1,312 -322 r = 25% Example 3

34. NPV @ 20% = 582 600 400 200 Discount rate NPV 0 5% 10% 15% 20% 25% 30% 35% 40% -200 -400 NPV @ 25% = -322 IRR = 20% +5% (582/904)=23.2% Example 3

35. Decision rule using IRR • Where the calculated IRR is greater than the company’s cost of capital then the project is acceptable.

36. NPV and IRR compared • Accept/reject decisions • Absolute and relative measures • Mutually exclusive projects

37. Accept/reject decisions

38. Absolute and relative measures • NPV is an absolute measure of the return on a project • IRR is a relative measure relating the size and timing of the cash flows to the initial investment

39. Assume a project has the following cash flows: Project acceptable by both methods – assuming 10% is the cost of capital. Now assume that the project is scaled up by a factor of 10. The NPV method clearly discriminates between Project X and Project 10X whereas the IRR remains unchanged at 15%. Example 4

40. Mutually exclusive projects • Only one of several alternative projects can be chosen

41. Mutually exclusive projects of differing scale A property company wishes to develop a site it owns. Three sizes of property are being considered and the costs and revenues are as follows: The cost of capital is 10% and it is required to rank the projects by NPV and IRR and to select the most profitable. The projects are mutually exclusive because the building of one size of development excludes the others. Example 5

42. Ranking of NPV and IRR Incremental IRR Example 5

43. Mutually exclusive projects, same scale Two mutually exclusive investments have cash flows as follows: The cost of capital is 10% and it is required to rank the projects by NPV and IRR and to select the most profitable. Example 6

44. Mutually exclusive projects, same scale The NPV and IRR of these projects are as follows: The ranking differ and, assuming that 10% is the appropriate discount rate, the ranking given by the NPV, i.e. Project A being preferred, gives the maximum wealth to the company. Example 6

45. Non-conventional cash flows

46. Examples of Non-Conventional Cash-Flow Patterns • Project X has 2 outflows and is thus non-conventional • Project Y has an outflow in a year’s time instead of initially and is thus non-conventional • When a project has non-conventional cash flows it may have • One IRR • Multiple IRRs • No IRR Example 7

47. Examples of Non-Conventional Cash-Flow Patterns Multiple IRRs Present Value Profile of Project X Example 7

48. Examples of Non-Conventional Cash-Flow Patterns Not a real number! No IRR Example 7

49. A labour saving machine costs $60,000 and will save $24,000 p.a. at current wage rates. The machine is expected to have a 3 year life and nil scrap value. The firm’s cost of capital is 10%. • Calculate the project’s NPV • With no inflation • With general inflation of 15% which wage rates are expected to follow (i.e. synchronised inflation). • With general inflation of 15% and wages rising at 20% p.a. (i.e. differential inflation). Example 8

50. NPV – No inflation Project unacceptable as it has a negative NPV at company’s cost of capital.