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Chapter 14 Capital Investment Appraisal Capital investment appraisal Capital investment involves the sacrifice of current funds in order to obtain the benefit of future wealth. It involves investing now in the hope of generating future cash flows which will exceed the initial investment. Investment in capital projects involves large initial financial outlays, with long waiting periods before these funds are repaid from future cash flows or profits. Features of capital investments Capital investment involves the use of significant levels of finance to acquire assets for long-term use in an organisation with the desire to increase future revenues and profits. Capital investment decisions The decision to charter or purchase an aircraft. The decision to lease or buy property to open a retail outlet, restaurant, leisure centre or other such business. The decision to install an energy saving control system within a property. The decision to extend or refurbish a hotel, pub, restaurant or retail outlet. The decision to develop leisure or conference facilities within a hotel. The decision to invest in a central reservations computer system in a hotel. The decision to employ a computerised point of sales stock control system in a retail chain. The decision to purchase new fun activities equipment within a leisure park. The decision by a catering firm to purchase more equipment in order to tender for a school meals contract. Features of capital investment decisions The sums involved are relatively large. The timescale over which the benefits will be received is relatively long, with greater risks and uncertainty in forecasting future revenues and costs. The nature of a business, its direction and rate of growth is ultimately governed by its overall investment programme. The irreversibility of some projects due to the specialised nature of certain assets for example, some plant and machinery bought with a specific project in mind could have little or no scrap value. In order to complete projects on time and within budget, adequate continuous control information is required. Capital investment is long-term and the recoupment of investment may involve a significant period of time. Factors to consider in assessing capital projects The size of the investment. The phasing of the investment expenditure. The period between the initial investment and the asset actually generating revenues and profits for the business. The economic life of the project. The level of certainty regarding the projected cash flows. The working capital required. The degree of risk involved in the project. Capital appraisal methods As capital investment decisions usually involve significant amounts of finance, it is important to fully evaluate each decision using sound appraisal techniques. The main methods used to evaluate investment in capital projects are: Accounting rate of return. Payback method. Net present value. Internal rate of return. Capital appraisal methods Accounting Rate of Return (ARR) Profits Payback Cash flows Net Present Value (NPV) Cash flows Internal Rate of Return (IRR) Cash flows Capital appraisal methods The accounting rate of return is based on the use of operating profit. The operating profit of a project is the difference between revenues earned by the project, less all the operating costs associated with the project, including depreciation. All other appraisal methods use net cash flows as the basis for appraising capital projects. This is due to the nature of assessing capital investment projects where one must spend cash now and reap the cash rewards later. The calculation of accounting profit is not concerned with the timing of cash flows. This is due to its adherence to the accruals concept whereby profits are calculated by deducting expenses charged from revenues earned. Net cash flow Net Net cash cash flow flow == operating operating cash cash flows flows ++ // -- capital capital cash cash flows flows Net profit and net cash flow Net profit Net cash flow Related revenue earned less Related cash inflows (operating + capital) less All related costs (including depreciation) equals Related cash outflows (operating + capital) (NOT including depreciation) equals Profit Net cash flow Accounting rate of return (ARR) The accounting rate of return method calculates the estimated overall profit or loss on an investment project and relates that profit to the amount of capital invested and to the period for which it is required. A business will have a required minimum rate of return for any investment. This is related to the cost of capital of the business. If an investment yields a return greater than the cost of capital, then the investment would be considered suitable and profitable. The accounting rate of return is an average rate of return calculated by expressing average annual profit as a percentage of the average value of the investment. Accounting rate of return (ARR) ARR = Average annual profit Average investment Average annual profit Total project profit after depreciation and before interest, tax and dividends, divided by the estimated life of the project. Average investment Initial investment, plus value of investment at project-end, divided by two. Example 14.1: Accounting rate of return Example 14.1: Accounting rate of return Accept or reject criteria for ARR method Accept the project Reject the project Project ARR greater than the minimum required return. Project ARR less than the minimum required return. Advantages of ARR It takes account of the overall profitability of the project. It is simple to understand and easy to use. Its end result is expressed as a percentage, allowing projects of differing sizes to be compared. Disadvantages of ARR It is based on accounting profits rather than cash flows. The ARR does not take into account the timing of cash flows. The ARR does not take into account the time value of money. It does not take into account the cost of waiting to recoup the investment. The ARR takes no account of the size of the initial investment. The payback method This method of investment appraisal simply asks the question ‘how long before I get my money back?’ How quickly will the cash flows arising from the project exactly equal the amount of the investment. It is a simple method, widely used in industry and is based on management’s concern to be reimbursed on the initial outlay as soon as possible. It is not concerned with overall profitability or the level of profitability. Example 14.2: Payback Example 14.2: Payback Accept or reject criteria for payback method Accept the project Reject the project Payback period is less than that required by investors. Payback period is greater than that required by investors. Advantages of payback It is simple to understand and apply. It promotes a policy of caution in investment. Disadvantages of payback It takes no account of the timing of cash flows (€100 received today is worth more than €100 received in 12 months time). It is only concerned with how quickly the initial investment is recovered and thus it ignores the overall profitability and return on capital for the whole project. Time value of money The time value of money concept plays an important role in appraising capital projects because the time lag between the initial investment and payback can be quite long. €1 earned or spent sooner, is worth more than €1 earned or spent later. To evaluate any project taking into account the time value of money, the cash flows received in the future must be reduced or discounted to a present value, so that all relevant cash flows are denominated in todays value (present value). The cost of capital All investment projects require funding. Generally, funding can be classified into: Equity funding, where investors buy an equity or ownership share in a project. This is done through the issue of shares or by retaining profits in the business. Debt, where the company can borrow or issue its own debentures. Each source of finance has a cost. The cost of debt is the interest rate that applies to the debt. The costs of equity finance are the dividends and increases in share price expected by shareholders. This cost of capital becomes the benchmark or minimum required return on a project. A project is only truly profitable when its actual return on assets is greater than the company’s cost of capital. Example 14.3: Cost of capital Weighed average cost of capital If a project is funded by more than one method of financing, the weighted average cost of capital (WACC) should be calculated. •Loan finance €100,000 at 9%. •Equity finance €50,000 at 12%. Debt Equity €100,000 x 9% = €9,000 €50,000 x 12% = €6,000 €150,000 €15,000 Thus the WACC is 10% (15,000 ÷ 150,000 x 100). Discounted cash flow (DCF) DCF is the investment appraisal technique that takes account of the time value of money. DCF looks at the cash flows of a project, not the accounting profits. It is concerned with liquidity not profitability. The timing of cash flows is taken into account by discounting all future cash flows to present value. The effect of discounting is to give a bigger value per euro for cash flows that occur earlier. The discount factor to use is the cost of capital to the business. Net present value (NPV) Present value can be defined as the cash equivalent now of a sum of money to be received or paid at a stated future date, discounted at a specified cost of capital. The net present value is the value obtained by discounting all the cash outflows and inflows of a capital investment project, at a chosen target rate of return or cost of capital. The present value of the cash inflows, minus the present value of the cash outflows, is the net present value. Net present value (NPV) If the NPV is positive, it means that the cash inflows from the investment will yield a return in excess of the cost of capital and thus the project should be undertaken, as long as there are no other projects offering a higher NPV. If the NPV is negative, it means that the cash inflows from the investment yield a return below the cost of capital and so the project should not be undertaken. If the NPV is exactly zero, the cash inflows from the investment will yield a return which is exactly the same as the cost of capital and thus the project may or may not be worth undertaking depending on other investment opportunities available. Example 14.4: Net present value Example 14.4: Net present value Accept or reject criteria for NPV method Accept the project NPV is positive. In choosing between mutually exclusive projects, accept the project with the highest NPV. Reject the project NPV is negative. Advantages of NPV It takes into account the time value of money. Profit and the difficulties of profit measurement are excluded. Using cash flows emphasises the importance of liquidity. It is easy to compare the NPV of different projects. Disadvantages of NPV It is not as easily understood as the payback and accounting rate of return. It requires knowledge of the company’s cost of capital, which is difficult to calculate. The internal rate of return (IRR) The IRR method calculates the exact rate of return which the project is expected to achieve, based on the projected cash flows. It is the discount rate which, when applied to the projected cash flows, ensures they are equal to the initial capital outlay. The IRR is the discount factor which will give a NPV of zero. It is the actual return from the project, taking into account the time value of money. The internal rate of return (IRR) The internal rate of return (IRR) Example 14.5: Internal rate of return Example 14.5: Internal rate of return Accept or reject criteria for IRR method Accept the project Reject the project IRR greater than the cost of capital. IRR less than the cost of capital. Advantages of IRR The main advantage of the IRR is that the information it provides is more easily understood by managers, especially non-financial managers. Disadvantages of IRR The trial and error process of calculating the IRR can be time consuming, however this disadvantage can easily be overcome with the use of computer software. It is possible to calculate more than two different IRR’s for a project. This occurs where the cash flows over the life of the project are a combination of positive and negative values. Under these circumstances it is not easy to identify the real IRR and the method should be avoided. In certain circumstances the IRR and the NPV can give conflicting results. This occurs because the IRR ignores the relative size of investments as it is based on a percentage return rather than the cash value of the return. Appraisal methods Accounting Rate of Return (ARR) Non time based Time based (DCF) Profits Payback Cash flows Net Present Value (NPV) Cash flows Internal Rate of Return (IRR) Cash flows Appraisal methods Of the four appraisal methods presented, it is clear that the discounted cash flow methods (NPV and IRR) have a distinct advantage over the payback and accounting rate of return methods because they are cash based and they take the time value of money into account. The NPV approach is considered superior to the IRR because of the disadvantages associated with the IRR method. However it is clear that there is a place for all four methods, which inform judgement, not replace it. Appraisal methods Newport Leisure Park Ltd investment appraisal summary Comparing mutually exclusive projects with unequal lives When comparing mutually exclusive projects, the appraisal method to use is the net present value approach. However businesses often have to decide on two or more competing projects that have unequal or different life spans. To simply compare the net present values of each project without looking at the unequal lifespan would not be comparing like with like. The net present value of both projects needs to be expressed in equal terms. The ‘equivalent annual annuity method’ to compare the net present values on an annualised basis. Comparing mutually exclusive projects with unequal lives 1. Calculate the NPV of each project. 2. Divide the NPV of each project by the annuity factor for the period of the project. This calculates what is called the ‘equivalent annual annuity’ or EAA. 3. Compare the EAA of each project, accepting the project with the highest equivalent annual annuity. Example 14.6: Project appraisal with unequal lives Example 14.6: Project appraisal with unequal lives The calculation of cash flows Operating cash flows represent sales revenues, less variable cost attributed to the project or investment. Fixed costs are also included but only if they relate to the new investment and are incremental. All costs that would occur irrespective of the investment decision should be ignored. The cash flows that are to be considered are those that would not arise without the investment. The calculation of cash flows Sunk costs are past costs that have already been paid and should be ignored. Incremental costs that relate to the decision should be taken into account. Opportunity gains or costs should be taken into account. Replacement costs of using that resource or asset should be used, not its original cost. Loan interest and dividend payments should not be taken into account in calculating the operating cash flows (for DCF) as the discount factor already takes into account the cost of financing. Incremental working capital should be treated as part of the initial expenditure or capital investment. At the end of the project's life, the total investment in working capital is assumed to be liquidated (turned into cash) at original cost and is treated as a cash inflow in the final year of the life of the project. Depreciation: is a non-cash item and must be ignored in calculating operating cash flows. Year-end assumption: in calculating the cash flows of a project, it is assumed that they arise at the end of the relevant year. Taxation: will usually be an important consideration as investors are interested in the after tax returns generated from the business Example 14.7: Calculation of cash flows Example 14.7: Calculation of cash flows Example 14.7: Calculation of cash flows Project appraisal and risk All future projects are subject to some element of uncertainty and risk. Operating risk: This occurs where a business has a high fixed operating cost structure and hence it must ensure it generates sufficient revenues and contribution to cover fixed costs. In general, the hospitality and tourism sectors suffer from a high level of operating risk. Financial risk: This arises from the methods chosen to finance an operation. High financial risk implies that a business is highly financed through borrowings and hence must ensure operating profit and cash flows are sufficient to meet the interest costs of these financial instruments. Business risk: This occurs as a result of changes to the economic and business environment that can be caused by a range of factors such as hurricanes, terrorism, tsunamis, technological advances, consumer confidence, inflation and fluctuations in national and global economies. All businesses are subject to this type of risk and it is this type of risk that is associated with investment appraisal. Discounted payback One of the weaknesses of the payback period is that it does not take into account the cost of waiting. The discounted payback method overcomes this by simply discounting the cash flows of a project with the cost of capital for the business and calculating the payback period based on the present value of the cash flows. Discounted payback Newport Leisure Park Ltd. – discounted payback Sensitivity analysis Sensitivity analysis assesses how sensitive the NPV of a project is to changes in the various inputs to the NPV model. Inputs include: The value of the initial investment. The estimated life of the project. The sales volume forecast. The forecast price used. The forecast sales mix used. The cost forecasts. The disposal value of the investment assets. The discount rate used. Illustration 14.1: Sensitivity analysis Illustration 14.1: Sensitivity analysis Illustration 14.1: Sensitivity analysis Scenario analysis and the use of probabilities The use of probabilities in investment appraisal allows a range of outcomes or alternatives to be considered, with probabilities assigned to show how likely it is that these outcomes could actually occur. In its simplest form, these alternatives would include optimistic, most likely and pessimistic scenarios. Once probabilities have been assigned to these scenarios, statistical measures of expected value (return) and standard deviation (risk) can be used to measure the expected NPV and the probability of a negative NPV for a project. This information can be presented graphically in the form of a decision tree showing all the possible outcomes that may result from a particular project and their probabilities of occurrence. Illustration 14.2: Calculation of expected values Non-financial considerations Health and safety issues for both employees and customers. Environmental objectives. Relations with the other stakeholders in the business. Ethical values. Technological developments. Other considerations The effect of an investment on the competitive environment. The effect of the investment on the risk profile of the business. The location of the investment. Future trends in the industry. The effects of the investment on the internal organisation and company stakeholders. [...]... minimum rate of return for any investment This is related to the cost of capital of the business If an investment yields a return greater than the cost of capital, then the investment would be considered suitable and profitable The accounting rate of return is an average rate of return calculated by expressing average annual profit as a percentage of the average value of the investment Accounting rate... expected by shareholders This cost of capital becomes the benchmark or minimum required return on a project A project is only truly profitable when its actual return on assets is greater than the company’s cost of capital Example 14 .3: Cost of capital Weighed average cost of capital If a project is funded by more than one method of financing, the weighted average cost of capital (WACC) should be calculated... does not take into account the cost of waiting to recoup the investment The ARR takes no account of the size of the initial investment The payback method This method of investment appraisal simply asks the question ‘how long before I get my money back?’ How quickly will the cash flows arising from the project exactly equal the amount of the investment It is a simple method, widely used in industry and... cost of capital to the business Net present value (NPV) Present value can be defined as the cash equivalent now of a sum of money to be received or paid at a stated future date, discounted at a specified cost of capital The net present value is the value obtained by discounting all the cash outflows and inflows of a capital investment project, at a chosen target rate of return or cost of capital The... from the investment will yield a return in excess of the cost of capital and thus the project should be undertaken, as long as there are no other projects offering a higher NPV If the NPV is negative, it means that the cash inflows from the investment yield a return below the cost of capital and so the project should not be undertaken If the NPV is exactly zero, the cash inflows from the investment. .. cash inflows (operating + capital) less All related costs (including depreciation) equals Related cash outflows (operating + capital) (NOT including depreciation) equals Profit Net cash flow Accounting rate of return (ARR) The accounting rate of return method calculates the estimated overall profit or loss on an investment project and relates that profit to the amount of capital invested and to the... average value of the investment Accounting rate of return (ARR) ARR = Average annual profit Average investment Average annual profit Total project profit after depreciation and before interest, tax and dividends, divided by the estimated life of the project Average investment Initial investment, plus value of investment at project-end, divided by two Example 14.1: Accounting rate of return Example 14.1:... understand and apply It promotes a policy of caution in investment Disadvantages of payback It takes no account of the timing of cash flows (€100 received today is worth more than €100 received in 12 months time) It is only concerned with how quickly the initial investment is recovered and thus it ignores the overall profitability and return on capital for the whole project Time value of money The... at 9% •Equity finance €50,000 at 12% Debt Equity €100,000 x 9% = €9,000 €50,000 x 12% = €6,000 €150,000 €15,000 Thus the WACC is 10% (15,000 ÷ 150,000 x 100) Discounted cash flow (DCF) DCF is the investment appraisal technique that takes account of the time value of money DCF looks at the cash flows of a project, not the accounting profits It is concerned with liquidity not profitability The timing... value of money, the cash flows received in the future must be reduced or discounted to a present value, so that all relevant cash flows are denominated in todays value (present value) The cost of capital All investment projects require funding Generally, funding can be classified into: Equity funding, where investors buy an equity or ownership share in a project This is done through the issue of shares ... required Capital investment is long-term and the recoupment of investment may involve a significant period of time Factors to consider in assessing capital projects The size of the investment. .. initial investment Investment in capital projects involves large initial financial outlays, with long waiting periods before these funds are repaid from future cash flows or profits Features of capital. . .Capital investment appraisal Capital investment involves the sacrifice of current funds in order to obtain the benefit