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Session 2 Capital Investment Appraisal (An Introduction) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland Session 2 Capital Investment Appraisal • By the end of today’s session(s), you should be able to: – Understand the context of investment appraisal decisions – Evaluate capital projects using the ARR, the payback period method, the discounted payback period, the IRR and the NPV techniques. – Discuss the advantages and disadvantages of each method – Explain research findings in respect of the practical application of the methods. Overall aim of three lectures on this topic – to enable trainees to select appropriate investment methods and to calculate investment returns for competing projects and to justify a course of action including consideration of relevant non-financial factors and financing options. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland Competency Wheel Financial Reporting Ethics & Professionalism Strategic Thinking & Problem Solving Management Accounting & Objectivity Communication Perceptiveness of own knowledge, values and limitations Managing Self & Others: Leadership Finance Audit & Assurance Tax & Law Strategy IT Awareness Project Management & Change Awareness Stakeholder Management CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland Mapping • This lecture maps specifically to 2.1 on the Competency Statement Functional Competencies Business Competencies Explain and demonstrate the ability to use the payback, discounted payback, accounting rate of return, net present value and internal rate of return techniques. Be able to appraise a variety of different projects for communication to management. Recommend and justify a course of action, including consideration of nonfinancial factors. Evaluate and communicate an appropriate course of action given the entity’s unique characteristics and the environment CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland Core Professional Values & Skills The need to be objective when evaluating differing projects. Difficulties with Project Appraisal CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 5 Difficulties facing project appraisal • • • • • • • • Goal congruence Relevant cash flows Time value of money Profit versus cash Capital rationing Projects with unequal lives Risk (next class) Financing CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 6 Goal Congruence Ultimately the project’s outcome should increase equity holder value. Decision makers - view the big picture, which may involve rejecting projects that have short-term returns in favour of projects with higher overall long-term returns. Take liquidity into consideration. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 7 Relevant cash flows Not all cash flows should be brought into the appraisal process – only relevant cash flows. Relevant cash flows are incremental cash flows and opportunity cash flows. They exclude: • Sunk costs • Apportioned costs that were going to be incurred anyway CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 8 Cash flows explained Incremental cash flows are those that will occur only as a consequence of a project being undertaken. Opportunity cash flows are cash flows forgone from other investments, or actions that have been changed, as a result of the project being implemented. Cash flows that occur as a result of decisions made in the past, which cannot be changed are deemed to be sunk cash flows. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 9 The time value of money/cash V profit In finance CASH IS KING. Cash is very different to profit. Management performance is usually assessed using profitability. However, the pattern of cash is more important for project appraisal because of the time value of money. Example (assume you are assessing a 5 year period) – in terms of profitability €/£1m each year for 5 years is the same as €/£5 million at the end of year 5. In finance, the latter option is valued much LOWER – because of the time value of money CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 10 Financing BRIEF POINTS • Matching principle – match the life of the project with the life of the finance • Self-liquidating – try to ensure that the finance selected has liquidity commitments that can be serviced from the project itself • Cash synchronisation – match the timing of the cash flows resulting from the investment with the timing of the repayments on the source of finance. • Cost of finance – take into account the company’s current cost of capital Note: This topic is covered in detail later in the course CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland Project appraisal - techniques Accounting Rate of Return (ARR) Payback period Discounted payback period Internal rate of return (IRR) Net present value (NPV) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 12 Accounting Rate of Return CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 13 ARR The accounting rate of return estimates the rate of accounting profit that a project will generate over its entire life. It compares the average annual profit of a project with the average cost (book value) of the project. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 14 ARR - calculation ARR = Average annual profit x 100 Average capital invested Where the average annual profit is the total profit for the whole period (after depreciation) divided by the life of the investment in years; and The average capital invested is the initial capital cost plus the expected disposal value divided by two. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 15 ARR – example Cow Ltd. is considering three projects (each costing €/£240,000). The following cashflows are predicted: Friesian Aberdeen Cashflows €/£ €/£ Year 1 160,000 120,000 Year 2 60,000 120,000 Year 3 120,000 40,000 Year 4 140,000 Year 5 20,000 Year 6 10,000 Saler €/£ 238,000 2,000 35,000 REQUIRED Given that Cow Ltd. has a target average accounting rate of return of 10% per annum which of the above projects should be accepted, if any? (Assume that the asset is specialised and cannot be sold at the end of the project). How would the results be affected were you informed that the asset could be sold after three years for €/£60,000 and after six years for €/£30,000. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 16 ARR - advantages Advantages include: • As it is based on profits management understand it better. • Profits are important, a project should not only have positive cash flows but should also be profitable. • It is a useful target for screening projects CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 17 ARR - disadvantages Disadvantages include: • • • • • It ignores cash flows It ignores the time value of money. It ignores the size of a project (risk) It ignores the duration of a project (risk) A project that has a longer life but is overall more profitable and has more cash inflows will be penalised because of its long life. • Subjective (hurdle rate) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 18 Payback period CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 19 Payback period The payback period method ranks investments in order of the speed at which the initial cash outflow is paid back by subsequent cash inflows. This method focuses on cash flows not profits, therefore depreciation and accrual accounting is ignored. This method calculates the number of years it takes for cumulative cash flows to achieve breakeven point. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 20 Payback Period Cow Ltd. is considering three projects (each costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Aberdeen Saler Before depreciation €/£ €/£ €/£ Year 1 160,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 120,000 40,000 36,000 Year 4 140,000 Year 5 20,000 Year 6 10,000 REQUIRED Using the payback method, advise Cow Ltd. as to the investment to undertake. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 21 Payback method - advantages Advantages include: • • • • • • Simple and quick to calculate. Readily understandable. Useful risk screening technique Focuses management attention on projects with more reliable estimates. Useful for companies with liquidity issues Helps decide between two projects with similar ARR’s. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 22 Payback method - disadvantages Disadvantages include: • • • • • It ignores the time value of money. It ignores the profitability of a project (risk) It ignores cash flows received after the payback period It ignores the size of a project (risk) It ignores the impact of a project (strategic) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 23 Discounted Payback Period CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 24 Discounted payback period The discounted payback period method overcomes one of the weaknesses of the payback period method, as it takes the time value of money into consideration. This method ranks investments according to the speed at which the cumulative discounted cash flows (DCF) of an investment cover the initial cash outlay. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 25 Discounted payback method - example Cow Ltd. is considering three projects (each costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Aberdeen Saler Before depreciation €/£ €/£ €/£ Year 1 160,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 120,000 40,000 36,000 Year 4 140,000 Year 5 20,000 Year 6 10,000 REQUIRED Which of the above projects should Cow Ltd. invest in. Cow Ltd. has to borrow funds at 10%. Management decide that this is an appropriate discount rate to use and it is company policy to use the discounted payback period method for capital investment appraisal. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 26 Discounted payback method - advantages Advantages include: • • • • • • • Simple and quick to calculate. Readily understandable. Useful risk screening technique Focuses management attention on projects with more reliable estimates. Useful for companies with liquidity issues Helps decide between two projects with similar ARR’s Takes the time value of money into consideration. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 27 Discounted payback method - disadvantages Disadvantages include: • It ignores the profitability of a project (risk) • It ignores cash flows received after the payback period • It ignores the size of a project (risk) • It ignores the impact of a project (strategic) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 28 Net Present Value (NPV) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 29 Net Present Value (NPV) The NPV method of project appraisal, discounts the cash inflows and outflows of an investment, to their present value. Use of the correct discount rate is very important. If the NPV is positive then a project should be accepted; as the positive amount will increase equity holder value. If the NPV is negative then a project should be rejected as acceptance will damage equity holder value. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 30 NPV method – example Cow Ltd. is considering three projects (each costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Aberdeen Saler Before depreciation €/£ €/£ €/£ Year 1 60,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 100,000 40,000 36,000 Year 4 130,000 3,000 Year 5 20,000 Year 6 10,000 REQUIRED Calculate each project's NPV and rank the resulting information for reporting to management. The company has a WACC of 16% and all the projects being considered are of similar risk to the current operating activities of the company. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 31 NPV method - advantages Advantages include: • • • • The time value of money is taken into consideration. All relevant cash flows are considered in the appraisal process. The discount rate can be adjusted for risk. When there are several alternatives the alternative with the largest NPV will maximise equity holder value. • Unlike the IRR, when cash flows are not conventional, the NPV will provide one answer. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 32 NPV method - disadvantages Disadvantages include: • Time consuming calculations (though can be compiled by a computer). • It does not provide a method of deciding which investment provides the best value for money. • It considers the absolute amount of money available over a project’s life. • It does not consider scale, hence risk. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 33 . Internal Ratio of Return (IRR) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 34 Internal Rate of Return (IRR) The IRR, sometimes referred to as the discounted cash flow yield method also involves discounting future cash flows to their present value. It could be considered a type of break-even analysis, which focuses on trying to find the discount rate at which the present value of the discounted future cash flows (inflows and outflows combined) equals the initial investment cash outlay. This discount rate is then compared to a hurdle rate to determine if the project should be accepted or not. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 35 Calculating the IRR Step 1: Select two discount rates at random Step 2: Discount the cash flows at the discount rates to find the net present value Step 3: Use interpolation to find the rate at which the NPV of the cash flows is zero. IRR = Rate 1 + NPV 1 (Rate 2 – Rate 1) NPV 1 - NPV 2 CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 36 IRR method – example Cow Ltd. is considering a project (costing €/£240,000). The following cash flows are predicted: Yearly profits Friesian Before depreciation €/£ Year 1 160,000 Year 2 60,000 Year 3 120,000 Year 4 40,000 Year 5 30,000 REQUIRED Calculate the IRR of the above named project using interpolation . CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 37 IRR method - advantages Advantages include: • The time value of money is taken into consideration. • All cash flows are considered in the appraisal process. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 38 IRR method - disadvantages Disadvantages include: • • • • Time consuming calculations (though can be compiled by a computer). The linearity assumption that underlies the interpolation process. It ignores the scale of projects. It is difficult to utilise when investments have unconventional cash flows, as more than one IRR will result. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 39 Research findings The payback method is the most commonly used method – used as screening device – the remaining projects are usually assessed using either the ARR or the IRR. Most companies set a subjective IRR/ARR hurdle rate and accept projects with a higher return. Academics consider the NPV to be the most appropriate method Recent research has shown that use of DCF techniques is increasing particularly in large entities with a preference for the use of the NPV or a combination of the NPV and the IRR CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 40 Summary • There are many factors which have to be considered before undertaking investment appraisal • • • • • • Identifying relevant cash flows The timing of cash flows The strategic fit of the project The impact on other areas The correct appraisal approach Financing • Several methods • • • • • ARR Payback Discounted payback Net present value IRR • In most instances all are used with qualitative information to inform the decision. CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland [...]... 2012 © Chartered Accountants Ireland 14 ARR - calculation ARR = Average annual profit x 100 Average capital invested Where the average annual profit is the total profit for the whole period (after depreciation) divided by the life of the investment in years; and The average capital invested is the initial capital cost plus the expected disposal value divided by two CAP1 Finance, Academic Year 2011 / 2012... synchronisation – match the timing of the cash flows resulting from the investment with the timing of the repayments on the source of finance • Cost of finance – take into account the company’s current cost of capital Note: This topic is covered in detail later in the course CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland Project appraisal - techniques Accounting Rate of Return (ARR) Payback... Cow Ltd invest in Cow Ltd has to borrow funds at 10% Management decide that this is an appropriate discount rate to use and it is company policy to use the discounted payback period method for capital investment appraisal CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 26 Discounted payback method - advantages Advantages include: • • • • • • • Simple and quick to calculate Readily... payback period method overcomes one of the weaknesses of the payback period method, as it takes the time value of money into consideration This method ranks investments according to the speed at which the cumulative discounted cash flows (DCF) of an investment cover the initial cash outlay CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 25 Discounted payback method - example Cow... Accountants Ireland 28 Net Present Value (NPV) CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 29 Net Present Value (NPV) The NPV method of project appraisal, discounts the cash inflows and outflows of an investment, to their present value Use of the correct discount rate is very important If the NPV is positive then a project should be accepted; as the positive amount will... €/£ €/£ €/£ Year 1 160,000 120,000 238,000 Year 2 60,000 120,000 1,000 Year 3 120,000 40,000 36,000 Year 4 140,000 Year 5 20,000 Year 6 10,000 REQUIRED Using the payback method, advise Cow Ltd as to the investment to undertake CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 21 Payback method - advantages Advantages include: • • • • • • Simple and quick to calculate Readily understandable... Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 18 Payback period CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 19 Payback period The payback period method ranks investments in order of the speed at which the initial cash outflow is paid back by subsequent cash inflows This method focuses on cash flows not profits, therefore depreciation and accrual accounting... Year 2011 / 2012 © Chartered Accountants Ireland 31 NPV method - advantages Advantages include: • • • • The time value of money is taken into consideration All relevant cash flows are considered in the appraisal process The discount rate can be adjusted for risk When there are several alternatives the alternative with the largest NPV will maximise equity holder value • Unlike the IRR, when cash flows... Chartered Accountants Ireland 32 NPV method - disadvantages Disadvantages include: • Time consuming calculations (though can be compiled by a computer) • It does not provide a method of deciding which investment provides the best value for money • It considers the absolute amount of money available over a project’s life • It does not consider scale, hence risk CAP1 Finance, Academic Year 2011 / 2012... considered a type of break-even analysis, which focuses on trying to find the discount rate at which the present value of the discounted future cash flows (inflows and outflows combined) equals the initial investment cash outlay This discount rate is then compared to a hurdle rate to determine if the project should be accepted or not CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland ...Session Capital Investment Appraisal • By the end of today’s session(s), you should be able to: – Understand the context of investment appraisal decisions – Evaluate capital projects... Average capital invested Where the average annual profit is the total profit for the whole period (after depreciation) divided by the life of the investment in years; and The average capital. .. discount rate to use and it is company policy to use the discounted payback period method for capital investment appraisal CAP1 Finance, Academic Year 2011 / 2012 © Chartered Accountants Ireland 26 Discounted