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Capital investment appraisal

Capital investment appraisal. Introduction. As investments involve large resources, wrong investment decisions are very expensive to correct Managers are responsible for comparing and evaluating alternative projects so as to allocate limited resources and maximize the firm’s wealth

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Capital investment appraisal

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  1. Capital investment appraisal

  2. Introduction • As investments involve large resources, wrong investment decisions are very expensive to correct • Managers are responsible for comparing and evaluating alternative projects so as to allocate limited resources and maximize the firm’s wealth • Basic techniques of making capital investment appraisal for evaluating proposed capital investment projects

  3. Investment appraisal methods Considering the time value of money concept Ignoring the time value of money concept • Payback period • Accounting rate of return • Net present value • Internal rate of return

  4. Net present value method

  5. Time value of money • When facing different investment proposals, the management should choose the project that can generate the greatest addition of value to the company. For example, Project A Project B Initial investment $100 $100 Cash inflow at end of year Year 1 $110 Year 2 $121

  6. At first sight, some may think that project B is better because it has a higher cash inflow. • However, the time value of money concept states that a dollar today is always worth more than a dollar in the future • The two projects are of equal value to the company because their present values are the same

  7. After taking timing of cash flow into consideration, Project A Project B Present value of cash flow (interest rate is 10% per annum) 110 121 (1+10%) (1+10%)2 = $100 $100 • The two projects are of equal value to the company because their present values are the same

  8. Factors leading to the changes in value of money • Opportunity cost of money • Erosion of purchasing power due to inflation • Uncertainty and risk

  9. Opportunity cost of money • Opportunity cost of money refers to the cost incurred or income forgone by not using the money for other purpose • For surplus cash, the opportunity cost is the interest income forgone by investing the cash in other investments or depositing it in the bank

  10. Erosion of purchasing power due to inflation • Inflation refers to the continual increase in the general price level of goods or services • During a period of inflation, prices of goods increase while the purchasing power of money decrease. The purchasing power of a dollar today is greater than that of the future

  11. Uncertainty and risk • Investors tend to avoid risk. The uncertainty involved in future cash inflows is much higher than that in present cash inflows • If the level of risk rises, investors will expect a higher return as compensation. • For example, suppose an investor expects $100 for return now. After adding a 10% risk premium, he will expect $110 one year later

  12. Discounting

  13. Discounting • According to the time value of money concept, a dollar in one year is not worth the same as a dollar in anther year. • In evaluating a multi-year investment, cash inflows and outflows are generated in different years • It is necessary to convert the cash flows fordifferent years into a common value at a commonpoint of time, either at present or in the future

  14. Discounting is the process of reducing future cash flows to present values with the use of an interest rate Present value = FVn (1+r)n Where FV = Future value of an investment n= Number of years r= Appropriate interest rate

  15. Example

  16. John has won a lucky draw. He is deciding whether to receive the Prize money of $3000 today or the following set of cash flows over the next three years: Year Cash flow 1 $1100 2 $1210 3 $1331

  17. Net present value method

  18. Net present value method • Net present value (NPV) method is a process that uses the discounted cash flow of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return • With the NPV method, we can compare the return on investment in capital projects with the return on an alternative equal risk investment in securities traded in financial market

  19. Calculation procedures • Determining the discount rate • Calculating the NPV: FV1 FV2 FV3 FVn + + + NPV = - I0 (1+r)1 (1+r)2 (1+r)3 (1+r)n where FV = future value of an investment n = no. of years r = Rate of return available on an equivalent risk security in the financial market I 0= initial investment

  20. Interpreting the NPV derived as follows:

  21. Example

  22. A company is considering making several investments in the Production facilities for the new products with an estimated useful Life of four years. The cash inflows and outflows are listed as follows: Project A B C D $ $ $ $ Initial investment 900000 1000000 303730 1500000 Cash inflow Year 1 120000 400000 100000 10000 Year 2 250000 400000 100000 10000 Year 3 400000 400000 100000 1000000 Year 4 1300000 400000 100000 1000000 The appropriate discount rate of these investment is 12%

  23. Required: • Calculate the NPV of each investment and determine whether • to accept it or not (assuming the company has unlimited • resources) • If the company has limited resources, determine which • investment should be accepted by referring to the highest NPV

  24. (a) Project A 120000 250000 400000 1300000 + + + NPV = - 900000 1.12 1.122 1.123 1.124 = $517327 (accepting) Project B 40000 400000 400000 400000 + + + NPV = - 1000000 1.12 1.122 1.123 1.124 = $214920(accepting)

  25. (a) Project C 100000 100000 100000 100000 + + + NPV = - 303730 1.12 1.122 1.123 1.124 = $0 (indifferent to accept or reject) Project D 10000 10000 1000000 1000000 + + + NPV = - 1500000 1.12 1.122 1.123 1.124 = -$135801(rejecting) (b) With limited resources, the company should only accept project A because it generates the highest NPV

  26. Advantages of NPV • Consistency with the time value of money concept • Consideration of all cash flows • Adoption of cash flows instead of accounting profit

  27. Internal rate of return

  28. Internal rate of return • The internal rate of return is the annual percentage return achieved by a project, of which the sum of discounted cash inflow over the life of the project is equal to the sum of discounted cash outflows • If the IRR is used to determine the NPV of a project, the NPV will be zero. • The company will accept this project only if the IRR is equal to or higher than the minimum rate of return or the cost of capital

  29. Calculation procedures • By trial and error, find out the discount rate that will give a zero NPV where FV = future value of an investment n = no. of years r = internal rate of return I 0= initial investment • If the NPV is positive, try a higher discount rate in order to give a negative NPV and vice versa FV1 FV2 FV3 FVn + + + NPV = - I0 = 0 (1+r)1 (1+r)2 (1+r)3 (1+r)n

  30. After getting one positive NPV and one negative NPV, use interpolation to find out the rate giving zero NPV P P – N IRR = L + (H – L) Where L = Discount rate of the low trial H = Discount rate of the high trial P = NPV of cash flows of the low trial N = NPV of cash flows of the high trial

  31. In evaluating an investment project, the IRR is compared with the management’s predetermined rate

  32. Example

  33. A project costs $400 and produces a regular cash inflow of $200 at the end of each of the next three years. Calculate the IRR. If the minimum rate of return is 15 %, suggest with reason whether you Should accept the project or not. $200 $200 $200 + + - $400 = 0 NPV = (1+r)1 (1+r)2 (1+r)3 Assuming the discount rate is 22% $200 $200 $200 + + - $400 = 8.4 NPV = 1.22 1.222 1.223 Assuming the discount rate is 24% $200 $200 $200 + + - $400 = -3.8 NPV = 1.24 1.242 1.243

  34. P P – N IRR = L + (H – L) Where L = Discount rate of the low trial H = Discount rate of the high trial P = NPV of cash flows of the low trial N = NPV of cash flows of the high trial 8.4 8.4 – (-3.8) IRR = 22% + (24 – 22)% = 23.38% Since the IRR (23.38%) is higher than the minimum rate of return (15%), The project should be accepted

  35. Payback period

  36. Payback period • Payback period is the period of time it takes for a company to recover its initial investment in a project • The method measures the time required for a project’s cash flow to equalize the initial investment

  37. Acceptance criterion

  38. Example

  39. A company is considering making the following mutually exclusive Investments in the production facilities for the new products with an Estimated useful life of four years. The cash inflow and outflows are Listed as follows: Project A Project B $ $ Initial investment 900000 1000000 Cash inflow at the end of year Year 1 700000 600000 Year 2 100000 400000 Year 3 100000 400000 Year 4 1300000 400000 Project A : 3 years Project B: 2 years Project B takes only two years to recover its initial investment. With The shortest payback period, the company will accept project B

  40. Advantages of payback period • Easy to adopt • Facilities further evaluation • After obtaining an acceptable payback period, the project will be evaluated by other financial capital budgeting techniques

  41. Disadvantages of Payback period • Ignore the cash flows after payback period • Adopt an arbitrary standard for the payback period • Ignores the timing of cash flow

  42. Discounted payback period • The payback period method is criticized for ignoring the timing of cash flows, therefore discounted cash flows are used to calculate the discounted payback period

  43. Example

  44. A company is considering making the following mutually exclusive investments in the production facilities for the new products with an estimated useful life of four years. The cash inflow and outflows are listed as follows: Project A Project B Initial investment 900000 1000000 Cash inflow at the end of year Year 1 700000 600000 Year 2 100000 400000 Year 3 100000 400000 Year 4 1300000 400000 Discount cash inflow (20%)

  45. Project A Project B $ $ Initial investment 900000 1000000 Discounted cash flow Year 1 700000 400000 1.21 1.21 Year 2 100000 400000 1.22 1.22 Year 3 100000 400000 1.23 1.23 Year 4 100000 400000 1.24 1.24 Discount payback period Project A 900000-710647 626929 = 583333 = 500000 = 69444 = 277778 = 57870 = 231481 = 192901 = 626929 3+ = 3.3 years Project B 100000-777778 231481 2+ = 2.96 years

  46. Accounting rate of return

  47. Accounting rate of return • The accounting rate of return compares the average accounting profit with the average investment cost of project • The accounting profit can be expressed either before tax or after tax

  48. Calculation procedures Average net profit per year (over the life of the project) Average investment cost ARR = Total profit No. of life of the project Average net profit per year = Initial investment 2 Average investment cost =

  49. Acceptance criterion In evaluating an investment project, the ARR of the project is compared with a predetermined minimum acceptable accounting Rate of return:

  50. Example

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