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COST MANAGEMENT 642 Paper 7

COST MANAGEMENT 642 Paper 7. NUMERICAL METHODOLOGIES FINANCIAL. Paper 7 FINANCIAL METHODOLOGIES. 1.0. FINANCIAL METHODOLOGIES - INTRODUCTION 2.0. PAYBACK 3.0. ACCOUNTING RATE OF RETURN 4.0 DISCOUNTED CASH FLOW - NPV & IRR 5.0 OTHER ECONOMIC METHODOLOGIES

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COST MANAGEMENT 642 Paper 7

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  1. COST MANAGEMENT 642 Paper 7 NUMERICAL METHODOLOGIES FINANCIAL

  2. Paper 7 FINANCIAL METHODOLOGIES • 1.0. FINANCIAL METHODOLOGIES - INTRODUCTION • 2.0. PAYBACK • 3.0. ACCOUNTING RATE OF RETURN • 4.0 DISCOUNTED CASH FLOW - NPV & IRR • 5.0 OTHER ECONOMIC METHODOLOGIES • 6.0. PROJECT SELECTION - GRAND SUMMARY

  3. FINANCIAL METHODOLOGIES - INTRODUCTION • Many projects characterised by initial costs in return for a stream of benefits that span several time periods. • If costs & benefits presentable in $, financial evaluation relatively straightforward. • Some projects not easily selected on financial appraisal. E.g. Public Relations project to generate prestigious image • In this situation perhaps scoring more appropriate.

  4. FINANCIAL METHODOLOGIES - INTRODUCTION CASH FLOWS • FM use cash inflows and outflows as the basis of analysis • Focus on amount and timing of cashflows • So, critical aspect is estimation of future cashflows • Validity is reliant on accuracy of estimates of cashflows. • Cashflows occur throughout year. For simplicity, assumed to occur as lump sum at start or end of a time period.

  5. Financial Methodologies - Types • Payback (PB) • Accounting Rate of Return (ARR) • Discounted Cash Flow [DCF] • Net Present Value (NPV) • Internal Rate of Return (IRR) To simplify the understanding of financial methodologies, taxation and inflation are ignored

  6. PAYBACK • PB = length of time taken to recoup initial investment costs. • Add inflows in successive years until total = initial outlay. • PB period can be viewed as break-even measurement • The shorter the PB period, the better the project. • Can set a maximum PB that any project must meet to ‘go’

  7. PAYBACK - Example Payback for Project A • Manufacturing organisation considering buying new production equipment for $10,000. It will generate income for 4 years after which equipment will have no value. End of year 1 2 3 4 Annual Income ($) 7,000 3,000 1,000 1,000 • Outlay at Day 1 = $10,000 • Payback Period = Time it takes to receive $10,000. • ANSWER: 2 YEARS ( 7,000 + 3,000) • YOU DO PROJECTS B, C, D

  8. PAYBACK Advantages • Quick and simple to use. Easy to understand • Emphasises liquidity. Useful if firm has weak cash or credit position • Useful in high risk projects • Identifies projects which are unusually profitable early in their life • Useful if precision not crucial & preliminary screening is required Disadvantages • Ignores timings of cashflows within PB period. • Ignores cashflows beyondPB period • So PB not considered a reliable measure of financial effectiveness. • PB commonly used as a supplementary method to DCF

  9. ACCOUNTING RATE OF RETURN • Also called: • average rate of return, • accrual rate of return, • approximate rate of return. • ARR = ratio that expresses project's average annual income , over a selected period of time, as a % of the capital outlay. • ARR compared to required return. If ARR less , project rejected

  10. ARR - EXAMPLE ARR for Project A • Average Annual Income : [7,000 + 3,000 + 1,000 + 1,000 - 10,000] / 4 years = $500 pa • ARR = [500/10,000] * 100 = 5% pa • YOU DO PROJECTS B, C, D

  11. ACCOUNTING RATE OF RETURN Advantages • Quick and simple to use • Easy to understand • Uses readily available accounting data • % provides a useful comparison to the firm’s required return Disadvantages • Different calculation methods creates confusion Eg. capital outlay represented by initial outlay, or average outlay over project life? • Ignores timings of cashflows • Not commonly used to appraise financial side of projects. • Best for small projects involving relatively small amount of funds.

  12. DISCOUNTED CASH FLOW (DCF) - NPV & IRR MONEY HAS A TIME VALUE • The time that a cashflow occurs affects its true value. • 1$ now worth more than 1$ in future, even ignoring inflation • Unlike PB & ARR, DCF allows for this time value of money. • DCF brings all cashflows to common point in time to permit appropriate comparison. • DCF commonly used in business & supported in texts - "DCF is the best for analysing investment cash flows. Discounting for time is an essential part of capital budgeting project evaluation . • Also, behavioural aspects give money a time value - we prefer $1 now than later: $1 now is certain, future $1 at risk.

  13. Discounted cash Flow (DCF) - Discounting • Discounting is the reverse of compounding. • Compounding: $100 @ 10% compound interest = $110 in yr 1, $121 in yr 2, etc. • Formula for compounding is: Future value = P x (1+i)n • P = present sum • i = interest rate [in decimal form] per period • n = period of time being considered • Discounting converts future $ into equivalent present money • So, PV equivalent of $110 due in 1 year's time @ 10% = $100. • Formula for discounting is simply the inverse of compounding: • Discounted present value = F x 1 (1+i)n where, F = future sum

  14. Discounting - Calculation of Present Value • $100 is to be spent in 3 years time. What is the present value equivalent of this $100 for each of the following discount rates: 5%, 10%, 15% • This shows that ______ the discount rate, lower its present value • What is present value for $100, at a discount rate of 5%, to be spent in: 2 years time; 4 years time; 6 years time • This shows that ______ number of years to a future sum, lower its present value • Summary, the present value of a future sum depends on 2 factors

  15. Discounting - Net Present Value (NPV) • 2 main methods for discounted cash flow techniques: • Net Present Value (NPV) • Internal Rate of Return (IRR). • NPV discounts future cashflows to their equivalent present values. • Steps: I. Select a discount rate ii. Calculate the PV of each cashflow iii. Deduct PV of outlays from PV of inflows. iv. The difference is the NPV.

  16. Net Present Value (NPV) Year 0 1 2 3 4 Cashflow($) -10,000 7,000 3,000 1,000 1,000 PV Factor,10% 1.00 0.909 0.826 0.751 0.683 PV -10,000 6,364 2,479 751 683 NPV = +277 NPV shows economic performance in single $ amount • +ve NPV = PV profit of a project. • +ve NPV means project return > selected discount rate, so selected. • -ve NPV means project return < selected discount rate, so rejected. • Project selection - 1 with highest NPV would be favoured. • NPV = maximum over-run of predicted costs with no loss • YOU DO PROJECT C

  17. NPV - Selection of the Discount Rate • There are 3 alternative basis for selecting the discount rate: • cost of capital • opportunity rate • target/hurdle rate COST OF CAPITAL (CC) • Many projects use external funds. (i.e. not firm’s own money). • CC = cost of these funds. • CC depends on source and mix of funds • 2 sources of long-term funds - equity (eg shares) or debt • Using DR = CC gives NPV after allowing for cost of finance. • So +ve NPV = a return in excess of all costs, including finance • CC is most commonly used basis for selecting DR

  18. CC accounts of the cost of financing - ProofProject A - $10,000 borrowed at 10%. Repay loan & interest with inflows: Yr 1, Day 1 Loan -10,000 Interest, end of yr 1 - 1,000 Income, end of yr 1 + 7,000 Yr 2, Day 1 balance - 4,000 Interest , end of yr 2 - 400 Income, end of yr 2 + 3,000 Yr 3, Day 1 balance - 1,400 Interest, end of yr 3 - 140 Income, end of yr 3 + 1,000 Yr 4, Day 1 balance - 540 Interest , end of yr 4 - 54 Income, end of yr 4 + 1,000 End of yr 4 BALANCE + 406 PV equivalent of $406 receivable in 4 years = $406 x (PVF, 4 yrs, 10%) = $406 x 0.683 = +$277 = income after finance = Same answer as NPV example So, NPV of $277 takes account of finance costs.

  19. Dealing with finance costs - Alternative Way • Cashflows associated with financepayments entered into DCF: • Cash inflow recorded at point where loan is taken out • Cash outflows recorded when interest & loan repayments made. • If DR = interest rate, & ignoring tax, both methods give same result • But, “effort of recording interest & loan repayments into an analysis does not pay back with a higher level of information or accuracy”

  20. +veNPV means project return> selected discount rate-veNPV means project return< selected discount rate • Project X: $100 outlay on Day 1. 1 Cash inflow at end of year of $110 • Clearly, this project provides a return of ? % • 10% • Now, if 5% discount rate used, the NPV calculation is: Year 0 1 Cashflow($) -100 +110 Present Value Factor, 5% 1.00 0.952 Present Value ($) -100 +104.72 NPV = +$4.72 • Now, if 15% discount rate used. NPV calculation + Year 0 1 Cashflow($) -100 +110 Present Value Factor,,15% 1.00 0.869 Present Value ($)-100 +95.59 NPV = -$4.41

  21. NPV - Selection of the Discount Rate • ii. OPPORTUNITY COST • If firm uses own funds, then return must > alternative investments, • This alternative return is known as the opportunity cost. iii. TARGET OR HURDLE RATE • Whether int/ext funds, firm selects DR = minimum desirable return • -ve NPV = the project returning less than target rate. • TR based on risk, complexity, size, duration, management effort

  22. NPV - Profitability Index (PI) • PI is a variant of NPV • PI = PV of inflows / PV of initial cash outlay. • PI > 1, project is acceptable. • PI consistent with NPV: If PI < 1, then the NPV is always negative. • Independent projects - NPV & PI give same accept/reject decision • Mut Exclusive projects - PI may not select project that returns most $: • A: Initial Outlay $40, PV of inflows = $100.PI = 2.5.NPV = $60 • B: Initial Outlay $1000, PV of inflows = $1500.PI = 1.5.NPV = $500 • Organisation that wants to maximise absolute dollar income would select B. So "while PI may be useful for exposition it should not be used as a measure of investment worth for projects of differing size when mutually exclusive choices have to be made"

  23. Internal Rate of Return (IRR) • Project X: $100 outlay on Day 1. Cash inflow at end of year of $110 • If 5% discount rate used. NPV calculation : Year 0 1 Cashflow($) -100 +110 PV Factor, 5% 1.00 0.952 PV -100 +104.72 NPV = +$4.72 • What would be the NPV if a 10% discount rate was used ? Year 0 1 Cashflow($) -100 +110 PV Factor, 10% 1.00 0.9091 PV -100 +100 NPV = +$0. So IRR = 10%

  24. Internal Rate of Return (IRR) • IRR = actual % return on a project investment. • IRR = DR at which NPV is 0. ie PV of outflows = PV of inflows • IRR = maximum CC at which project breaks-even • If IRR > required return, project accepted • if IRR < required return, project rejected. • NPV is expressed in $$, IRR is expressed as % • NPV vs. IRR: NPV - DR chosen & NPV found; IRR - NPV set at O, IRR found

  25. NPV vs IRR - Graphic Explanation

  26. IRR - Example: Project A • Project A : IRR = 11.92%. • Found by trial and error - calculate NPV at different discount rates until discount rate is found at which the NPV = 0. • As a check, let’s discount cashflows at discount rate of 11.92%. • Year 0 1 2 3 4 • Cashflow($) -10,000 7,000 3,000 1,000 1,000 • PV F, 11.92% 1.00 0.893 0.798 0.713 0.637 • PV -10,000 6,255 2,295 713 637 NPV = 0 • IRRs for Project B = 7.7%, C=27.27%, D = 24.42%

  27. Summary: PB vs. ARR vs. NPV vs. IRR

  28. OTHER FINANCIAL METHODOLOGIES • NPV & IRR are most commonly used financial methodologies for project selection, there are numerous others. • 3 general categories: • those that subdivide net cash flow into the elements that comprise the net flow • those that include specific terms to introduce risk into the evaluation • those that consider the effects that the project might have on other projects or activities in the firm

  29. OTHER FINANCIAL METHODOLOGIES rdp (T+B)E Project Figure of Merit = ------------------- Total Investment E - R Project Index = rdp . ------------------- Total Investment r = probability of research success; d = probability of development success, p = probability of market success, T = technical merit, B = business merit, E = present value of all future earning from project R = present value costs of R&D activities to complete the project

  30. Portfolio Methodologies • Determine optimum use of funds amongst acceptable projects. • Hundreds of different portfolio methodologies - Simple example: • 3 projects, each with differing funding levels and expected projects. AVAILABLE FUNDS = $300,000 Funding Level Expected profits ($m) Project A Project B Project C 100,000 100 120 10 200,000 250 285 215 300,000 310 335 350 • Optimum funding allocation is: A - $100,000, B - $200,000, C - $0. This combination provides the highest expected profits, totalling $385m

  31. PROJECT SELECTION - GRAND SUMMARY Horses for Courses • No overall best approach to selecting projects.For example: • Size • small projects do not need involved selection processes • large $$ projects generally require formal selection processes • Client • government would not typically consider profit • private sector usually sees profit as primary selection criteria The Future • PB and ARR methods in the 1950's . DCF from the 1960's onwards. • 1970/80s - extensive use of NPV/IRR • 1980/90s growth in scoring methodologies with multiple criteria - "almost everyone who has studied project selection in recent years has noted the need for selection processes using multiple criteria".

  32. FINANCIAL METHODOLOGIES 1.0. FINANCIAL METHODOLOGIES - INTRODUCTION 1.1. Financial Methodologies - Purpose 1.2. Financial Methodologies - Cash Flows 1.3. Financial Methodologies - Types 1.4. Financial Methodologies - Case Study 2.0. PAYBACK 2.1. Payback Period (PB) 2.2. PB - Case Study 2.3. PB - Advantages and Disadvantages 3.0. ACCOUNTING RATE OF RETURN 3.1. Accounting Rate of Return (ARR) 3.2. ARR - Case Study 3.3. ARR - Advantages and Disadvantages 4.0 DISCOUNTED CASH FLOW - NPV & IRR 4.1. Money has a Time Value 4.2. Discounting 4.3. Net Present Value (NPV) 4.4. Internal Rate of Return (IRR) 4.5. NPV v IRR 5.0 OTHER ECONOMIC METHODOLOGIES 5.1. General 5.2. Portfolio Methodologies 6.0. PROJECT SELECTION - GRAND SUMMARY 6.1. The Situational Approach 6.2. The Future

  33. COST MANAGEMENT 642 - Paper 7 PROJECT SELECTION FINANCIAL METHODOLOGIES Money makes the world go round ….. Project Z Project A Project B

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